**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

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**FORM 10-K**

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**ANNUALREPORTPURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

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**For the fiscal year ended December 31, 2003**

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**Commission file number: 0-30391**

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| **MEDIS TECHNOLOGIES LTD.**                                   |
|---------------------------------------------------------------|
| (Exact name of registrant as  specified in its charter)       |
|                                                          |
| **Delaware**                                                  |   | **13-3669062** |
| (State of incorporation)                                      |   | (I.R.S. Employer Identification No.) |
|                                                          |   |   |
| **805 Third Avenue  New York, New York 10022**                |
| (Address of principal executive offices,  including zip code) |
|                                                          |
| **(212) 935-8484**                                            |
| (Registrant’s telephone number, including  area code)    |

 

**Securities registeredpursuant to Section 12(b) of the Act:**

 

**None**

 

**Securitiesregistered pursuant to Section 12(g) of the Act:**

 

**Common Stock, par value $.01 per share**

 

**Indicateby check mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) had been subject to such filingrequirements for the past 90 days.     Yes ****ý     No     ****o**

 

**Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.     ****o**

 

**Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).     Yes     ****ý     No     ****o**

 

**Asof June 30, 2003, the aggregate market value of the registrant’s  common stock held by non-affiliates of theregistrant was approximately $91,500,000.**

 

**Asof March 8, 2003, there were outstanding 26,187,578 shares of the registrant’scommon stock.**

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions ofthe Registrant’s Proxy Statement for the 2004 Annual Meeting of Stockholdersare incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III.

 

 

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**TABLE OFCONTENTS**

 
| PART I   |                                                                                                                |   |
|----------|---------------------------------------------------------------------------------------------------------------------|--------|
|     |                                                                                                                |   |
| Item 1.  | Business                                                                                                            |   |
| Item 2.  | Properties                                                                                                          |   |
| Item 3.  | Legal  Proceedings                                                                                                  |   |
| Item 4.  | Submission  of Matters to a Vote of Security Holders                                                                |   |
|     |                                                                                                                |   |
| PART II  |                                                                                                                |   |
|     |                                                                                                                |   |
| Item 5.  | Market  For Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |   |
| Item 6.  | Selected  Financial Data                                                                                            |   |
| Item 7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |
| Item 7A. | Quantitative and Qualitative Disclosures About Market Risk                                                          |   |
| Item 8.  | Financial Statements and Supplementary Data                                                                         |   |
| Item 9.  | Changes in and Disagreements With  Accountants on Accounting and Financial Disclosure                               |   |
| Item 9A. | Controls and Procedures                                                                                             |   |
|     |                                                                                                                |   |
| PART III |                                                                                                                |   |
|     |                                                                                                                |   |
| Item 10. | Directors and Executive Officers of the Registrant                                                                  |   |
| Item 11. | Executive Compensation                                                                                              |   |
| Item 12. | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                     |   |
| Item 13. | Certain Relationships and Related  Transactions                                                                     |   |
| Item 14. | Principal Accounting Fees and Services                                                                              |   |
|     |                                                                                                                |   |
| PART IV  |                                                                                                                |   |
|     |                                                                                                                |   |
| Item 15. | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                                                    |   |

 

References in this Annual Report to “we,”“us,” or “our” are to Medis Technologies Ltd. and its direct and indirectsubsidiaries, unless the context specifies or requires otherwise.

 

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**PARTI**

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## **Item 1**.                                   Business

## ** **

### **Introduction**

### ** **

Our primary business focus is on thedevelopment, manufacturing, marketing and distribution of direct liquid fuelcell products for portable electronic devices, for the consumer (personal andprofessional) and military markets.  Adiscussion of our direct liquid fuel cell products and technology and of ourother technologies, including our CellScan, inherently conductive polymers,stirling cycle system, toroidal technologies and Rankin cycle liner compressor,follows.

 

On March 10, 2004, we announced that we hadentered into a distribution agreement with Kensington Technology Group, aleading maker of computer accessories and a division of ACCO Brands, Inc.  Pursuant to the distribution agreement,among other things, we have granted Kensington the limited, exclusive right tomarket and distribute our Power Pack charger and other products using our fuelcell technology under the Kensington brand name.

 

In January 2004, we raised a total ofapproximately $14,580,000 through the private sale to institutional investorsof 1,425,000 million shares of our common stock. We plan to use the netproceeds of approximately $14,331,000 towards the costs associated withproducing and marketing our fuel cell Power Pack products and refuelingcartridges, as well as for additional working capital.

 

We are a Delaware corporation organized inApril 1992. Our executive offices are located at 805 Third Avenue, New York,New York 10022. Our telephone number is (212) 935-8484. Our website is locatedat www.medistechnologies.com.  We makeavailable free of charge through our website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments tothose reports as soon as reasonably practicable after we filed such materialwith, or furnished it to the Securities and Exchange Commission.  The information on our website is not partof this Annual Report.

 

### **Fuel Cells**

### ** **

#### ***Introduction***

#### *** ***

Our primary business focus is on thedevelopment, manufacturing, marketing and distribution of direct liquid fuelcell products to power and charge portable electronic devices, such as mostcell phones (including the most advanced “3G” cell phones with a full range offunctionality), digital cameras, PDAs (both for personal and professional use,including wireless versions with e-mail capability), MP3 players, hand-heldvideo games and other devices with similar power requirements, as well as abroad array of military devices.

 

Our first planned consumer fuel cell product,which we call our “Power Pack,” is a disposable, portable auxiliary powersource expected to be capable of providing power to operate and charge even themost advanced portable electronic devices. When a device’s battery is running low or is discharged, the Power Packallows the continued use of the device while at the same time charging thebattery. When the Power Pack has depleted its fuel, it can then be disposed ofby the consumer. By contrast, the military product we are developing and whatwe anticipate may be a second generation consumer product is not disposable.This refuelable Power Pack incorporates a removable fuel cartridge that caneasily be replaced in seconds when the fuel in such cartridge is depleted.

 

A fuel cell is an electro-chemical devicethat converts the chemical energy of a fuel, such as hydrogen or methanol, intoelectrical energy. There are a number of different types of fuel cells beingdeveloped for commercial applications, some of which are intended for largescale applications such as automobiles and stationary power generation. Bycontrast, our fuel cells are being developed for small scale applications, andin particular for use in portable electronic devices. While we believe thatcertain technologies used in our fuel cells may be applied towards advancingthe development of larger fuel cells

 

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delivering up to 5 kilowatts of power, we have no current intention todivert resources or funds to develop or manufacture larger fuel cells.

 

Central to our fuel cell products is ourpatented liquid fuel, of which we achieved major advances in power density andenergy capacity without the side effect of generating significant heat.Furthermore, our fuel contains no methanol or hydrogen gas, which avoidsproblems, such as toxicity and flammability, associated with the storage anduse of these compounds. We expect that our fuel will be compatible witheveryday use on all forms of transportation.

 

#### ***Our Fuel CellsCompared to Rechargeable Batteries***

#### *** ***

Fuel cells for small-scale applications havemany of the characteristics of rechargeable batteries and would compete withthem. A key distinguishing feature between fuel cells and rechargeablebatteries is that a fuel cell transforms its fuel directly into electricalpower and produces power as long as the fuel is supplied. Batteries are energystorage devices that release power until the chemical reactant stored in thebattery is depleted. Once the chemical reactant is depleted, the battery mustbe recharged or discarded.

 

We expect that as portable electronic devicesbecome more advanced and continue to offer greater capabilities andfunctionality, device manufacturers, service providers and consumers will seeksignificantly increased and longer lasting power. Since we believe thatbatteries presently used in these devices are approaching their technologicallimit, the power gap that already exists between those ever-increasing powerdemands of electronic applications and the amounts of power in the batterieswill increase. We expect the Power Pack to help fill that gap.

 

#### ***Our Fuel CellsCompared to Other Fuel Cells***

#### *** ***

Much of the other fuel cell development forthe portable electronic device market centers around direct methanol fuel cellsusing a solid polymer membrane (proton exchange membrane, or PEM), unlike ouruse of a liquid electrolyte. Although the proton exchange membrane, itself, hasthe advantage of requiring less space than a liquid electrolyte, we believethat the use of PEM technology has other disadvantages which makes it moredifficult to reduce the overall size of the fuel cell and increase the powerdensities to an amount needed for portable electronic devices at commerciallyacceptable temperature levels for broad consumer use. In a direct methanol fuelcell with a PEM, the concentration of methanol is usually limited to 3% to 6%,reducing the performance of the fuel cell. As a result, some direct methanolfuel cells are constructed with an external delivery system to feed themethanol into the fuel cell and a regulator to control the flow of methanol.Other direct methanol fuel cell external support systems may include a watermanagement system, a temperature control system and where fuel cells arearranged in a stack, a forced air system. Such direct methanol fuel cellsupport systems could result in increased size, complexity and cost.  Direct methanol fuel cells generally alsouse platinum or other expensive noble metals on both the anode and the cathode.

 

Some companies have announced plans to usehighly concentrated methanol which is then diluted inside the fuel cell. Webelieve that high concentrations of methanol raise issues of consumer healthand safety and issues of transportability. Other companies have announced theiruse of reformers inside their fuel cells to convert methanol into hydrogenwhich is then used to create power. The public announcements thus far suggestthe presence of heat of over 200 degrees Celsius in these products. Otherannouncements have suggested the planned use of nanotechnology methods tocreate new forms of fuel cells. We are not aware of any concrete evidence ofsuccessful development of fuel cells using nanotechnology. It should be noted,however, that considerable resources are being applied by many large companiesto develop fuel cells using all of these, as well as other methods, and we cangive no assurance

 

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that a fuel cell product will not be developed using highlyconcentrated methanol, reformers, nanotechnology or other approaches that wouldbe competitive to our products.

 

We have developed a fuel cell that we believehas obviated many of the problems that have traditionally affected PEM-basedfuel cells. Our fuel cell technology enables us to use a safer alcohol in ourfuel instead of methanol, thus avoiding methanol’s levels of toxicity andflammability.  Additionally, our fuelcell is self-regulating, meaning it provides sufficient power to meet thedraw-down of power as needed and it does not require an external fuel deliveryor regulating system. Furthermore, our fuel cell does not require a watermanagement system, a forced air system, a heat control system, a reformer orother complex system. Instead, our fuel cell has a very simple design andarchitecture, consisting of an anode, a cathode, a chamber for the liquid electrolyteand a fuel chamber. We have also eliminated the use of platinum on the cathode,and while we are still using very small amounts of platinum on the anode, weare seeking to eliminate the use of any platinum on the anode, therebyeliminating all platinum and other noble metals in our fuel cells. In addition,the cost of the liquid electrolyte in our fuel cell is substantially lower thanthe cost of a PEM. Eliminating complex systems, using a low cost electrolyteand reducing or eliminating platinum from our fuel cells, we believe enables usto lower the component costs of our product significantly. With initial cellvoltage of 0.40 — 1.0 volt, we use a DC to DC converter in our system toincrease the initial voltage to 5 volts. Finally, our fuel cell technology has allowed us to improve our fuelcell’s performance in power output and operating time relative to size andweight. As a result, we are able to use a single fuel cell in making a product,such as our Power Pack, rather than stacking a number of fuel cells with theadditional complexity that approach may require.

 

#### ***State Of OurFuel Cell Products***

#### *** ***

Our first two fuel cell products are ourdisposable Power Pack for the consumer (both personal and professional) marketand our refuelable Power Pack for military use.

 

##### *Disposable Power Pack*

##### * *

Our disposable Power Pack is a portableauxiliary power source that allows the continued use of a portable electronicdevice whose battery is depleted, while at the same time charging the battery.The disposable Power Pack is expected to provide sufficient power to operateand charge even the most advanced portable electronic devices, such as mostcell phones (including the most advanced “3G” cell phones and those withbuilt-in cameras), digital cameras, PDAs (both for personal and professionaluse, including wireless versions with e-mail capability), MP3 players,hand-held video games and other devices with similar power requirements. Whenused to power a cell phone, each disposable Power Pack is expected to deliverthe equivalent of 15 hours of talk time, or about three to five full charges ofthe battery, depending on the individual cell phone power consumption andbattery type. When used to power a rechargeable digital camera, the disposablePower Pack is expected to deliver two to five full charges of the battery,depending on the individual camera’s power consumption and battery type.

 

The disposable Power Pack has an anticipatedsize of 80 x 55 x 30 mm (3.2 x 2.2 x 1.2 inches) and anticipated weight of 120grams empty and 200 grams fully fueled. The disposable Power Pack is expectedto have a suggested retail price of $14.95 to $19.99. By comparison withbattery-operated portable cell phone chargers in the market today, we expectour disposable Power Pack to offer many advantages, including:

 

•                  considerably more hours of operationrelative to cost;

 

•                  the ability to start a cell phonedepleted of power in seconds rather than minutes;

 

•                  use of a built-in fuel gauge thattells the user how much fuel is still available; and

 

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•                  no reverse polarity which dischargesthe cell phone battery when the charger is left connected.

 

Additionally, the Power Pack may be anattractive product for people to place in a survival kit due to its anticipatedlong life prior to use.

 

We expect that as manufactures of portableelectronic devices continue to offer new products and add functionality toexisting products which require increased battery power and battery life,batteries now on the market will not be able to operate these new devices tothe consumer’s satisfaction. We expect that our Power Pack, by supplying powerto operate continuously and charge the device repeatedly, will bring about aconvergence of power supply and demand. We anticipate that device manufactureswill benefit by having available power for their new products, serviceproviders will benefit by providing increased air time for the new products andfunctions and consumers will benefit from the convenience and freedom of beingable to operate and charge advanced new portable devices on the go.

 

In May 2004, we plan to unveil the prototypeof the disposable Power Pack. By the end of 2004, we plan to make delivery ofinitial units of the Power Pack to distributors and selected others fordemonstration and to seek to accumulate orders for the Power Pack. The actualdate of large scale distribution and sale to the ultimate consumer will dependin large part on the level of orders received and the ability of contract manufacturers,whose services we plan to engage, to scale up production to meet those orders.We expect to be able to make such deliveries by the middle to the end of 2005.However, we can give no assurances that we will engage such contractmanufacturers in time to meet that timetable or that if engaged, they will beable to meet that timetable.

 

##### *Refuelable Power Pack*

##### * *

The refuelable Power Pack, which weanticipate may be a second generation consumer product, is expected to be ableto repeat the charging process a number of times with each fueling, andrefueling can be accomplished in seconds with a small, lightweight andinexpensive refueling cartridge. This refueling process transfers the fuel andelectrolyte in the cartridge into the Power Pack and extracts any remainingfuel, electrolyte and water by-products back into the refueling cartridge. Thecartridge can then be discarded.

 

We are designing and developing a refuelablePower Pack capable of providing auxiliary power to a ruggedized PDA beingdeveloped by General Dynamics to meet military specifications. At present, thePDA is charged  by a battery sleeve witheight lithium mangenese oxide batteries. For a 72 hour mission, always on, thepresent system would require the military team to carry about 140 batteriescosting approximately $450. Our refuelable Power Pack is expected to provideapproximately 72 hours of operating time with the use of only four or fiverefueling cartridges, making it lighter and less expensive than the presentsystem. In May 2004, we plan to deliver a completed prototype of our refuelablePower Pack and fuel cartridges to the C4 Systems division of General Dynamics,who will then commence testing our product against military specifications. Weexpect this testing to conclude at the end of 2004, when we expect C4 Systemsto submit the refuelable Power Pack to the U.S. military for their directtesting.

 

#### ***State of OurFuel Cell Technology***

#### *** ***

Even as we develop completed fuel cellproducts like our Power Packs, we continue to work towards substantial advancesin the development of our technology to enhance the commercial value of ourproducts and of our fuel cell as a primary power source. These advancesinclude:

 

•                  supplying increased energy while alsoreducing size and weight;

 

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•                  perfecting the dischargecharacteristics and length of operating time (discharge characteristicsdetermine how much power the fuel cell can deliver over a period of time.);

 

•                  improving the engineering design;

 

•                  reducing the internal and externaltemperature during operation; and

 

•                  integrating our individual fuel cellsinto a seamless power source.

 

Our fuel cell system integrates each fuelcell through the use of a DC to DC converter, which increases the voltagewithout having to connect a number of fuel cells in a series. We have designeda DC to DC converter that is now in the form of a bread board, or experimentalmodel, which is 88% efficient. We have contracted with FlextronicsInternational Ltd. to develop a DC to DC converter with an efficiency of over90% and a size of approximately one-quarter of the present bread-boardconverter. We are also considering engaging other companies having expertise inthis area for parallel development of a DC to DC converter. In conjunction withthe DC to DC converter, we are developing the power management systems thatallow our Power Pack products to respond to the power requirements of theparticular product which they are charging as well as to show the level of thefuel still available to the user.

 

#### ***MarketOpportunities***

#### *** ***

##### *Portable Electronic Device Market*

##### * *

It has been publicly reported that there arecurrently over 1.5 billion users of portable electronic devices world wide andthis number is expected to reach 2 billion by 2007, with reported annual salesof approximately 450 million devices per year, representing new and replacementsets. In this market, device manufacturers are continuing to add more and moreentertainment, communication and other features on their handsets, particularlyphone manufacturers who are incorporating into the latest 3G cell phonesfunctionality that includes digital cameras, internet access, video games,video clips, text messaging, PDA applications, MP3 players, FM radios and eventelevision broadcasts. We believe that this trend is consistent with thestrategies of mobile operators (service providers) worldwide who are requiringthat products have greater functionality in order to increase their income fromair time usage. Published comments made by mobile operators suggest that theybelieve that the battery life of the cell phones being delivered by cell phoneOEM’s (original equipment manufacturers) fall short of satisfying the consumer.

 

Based on what we have learned fromcompany-sponsored attitude surveys and focus groups dealing with cell phoneuse, we expect there to be a high level of demand for the Power Pack by thosecell phone users who travel frequently and who would use the Power Pack to keeptheir phones charged while traveling. Also discerned from these groups was asurprisingly high level of demand by stay-at-home parents, a very highpercentage of whom stated in these surveys and focus groups that they wouldpurchase and frequently use a Power Pack. Stay-at-home parents also make manyof the purchasing decisions for their households and a very large percentagestated that they would purchase a Power Pack for their children who had cellphones, as well. By contrast, we would expect that cell phone users who chargetheir phones each night and work in an office during the day are less likely tobuy a Power Pack unless they contemplate a trip, and others might buy it toprotect against loss of power by reason of blackouts or for emergency use incase of natural disasters.

 

At the same time, there is a fast growingmarket for digital cameras - already estimated at 53 million sold last year andexpected to reach almost 100 million sold by the end of 2005, according topublished reports. Yet, we have been advised by some digital camera OEM’s thatthe single biggest

 

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consumer complaint about the performance of the digital camera isbattery life. In our company-sponsored attitude surveys and focus groups, thusfar, a very large percentage of those interviewees who owned a rechargeabledigital camera said they would purchase and use a Power Pack to prevent failedbattery life at a crucial picture taking time or a warning of reduced batterylife that would result in rationing pictures. We would also expect thatcustomers whose initial primary motivation to purchase a Power Pack was for usein connection with their digital cameras will soon start using the same PowerPack as a matter of convenience to charge their cell phones and other portableelectronic devices and quickly make it a part of their every day lives.Similarly, we expect cell phone Power Pack users would use them for chargingtheir digital cameras and other portable devices.

 

##### *Military Applications*

##### * *

The U.S. Department of Defense has statedthat it has a pressing need for lighter and more compact electrical powersources as the modern soldier is increasingly equipped with many new portableelectronic devices. As with the latest portable electronics for consumers,these devices require significant power sources and are currently dependent onbatteries that are heavy and expensive and must be recharged frequently at acentral charging source. We intend that our refuelable Power Pack will satisfythese power needs.  In May 2002 we receiveda $75,000 order from C4 Systems towards development of this product.  On May 5, 2003, we announced an agreementwith C4 Systems to design and develop a pre-production prototype of our fuelcell military product for the ruggedized personal digital assistant (PDA)system that they are developing for the military.  The total price for our services provided for in the Agreement is$500,000, with an initial payment of $100,000 and the balance in accordancewith the payment and performance milestones established in the Agreementthrough January 2005.  Under our twoagreements with General Dynamics we have already received five paymentstotaling $350,000. We anticipate further payments totaling $225,000 during 2004and 2005, as we achieve additional milestones.

 

Together with General Dynamics we are alsoevaluating other military products where micro fuel cells would be valuable,including products carried by foot soldiers in the Land Warrior program of theU.S. Department of Defense, with the aim of eventually, where appropriate,replacing batteries with fuel cells. The Land Warrior program is designed tomake each individual soldier function as a complete weapon system, integratingsmall arms with high-tech equipment such as special communications devices,weapons imaging systems, video, and global positioning systems.

 

##### *Business Strategy*

##### * *

Our business strategy with respect to ourfuel cell technology is to translate our advanced fuel cell technology intocommercially viable products sold to consumers throughout the world and sold tomilitary users both in the United States and other countries. To accomplishthose goals, we are in the process of putting into place manufacturing,marketing and distributions systems capable of providing, initially, for the commercialproduction, distribution and sale of our disposable Power Pack to the consumerand potentially, as a second generation product, for the refuelable Power Packand attendant cartridges, as well as for our military fuel cell products.

 

##### *Manufacturing and Distribution*

##### * *

We are engaged in negotiations withlarge-scale contract manufacturers with a view to having in place in the comingmonths one or more relationships capable of producing the components and finalproduct, including the packaging, of the disposable Power Pack and of therefuelable Power Pack. We contemplate that this will take place in two stages.The first stage would involve a contract manufacturer converting the prototypePower Pack into a fully-engineered product ready for large-scale production,which may include applying for and receiving certain regulatory approvals. Thesecond stage, which

 

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would commence after we choose one or more contract manufacturers basedon price and other criteria, would provide for us to place orders and for themanufacturer to produce in high volumes the product for distribution anddelivery.

 

In order to move the production processforward more quickly, we have installed a production line for the cathode, as wellas the catalysts for the cathode and anode, in our facility in Israel and weexpect to install a production line for the anode in 2004.  These production lines are expected toprovide the ability to supply electrodes and catalysts for thousands of unitsin the first year of their completion. These lines are also expected to befully scalable upwards and we plan to transfer them to our contractmanufacturers who will be able to scale them up as required. One of theimmediate advantages of having this automated system in place is that it isexpected significantly to enhance the performance levels of the products wemake from that time forward. Until now, we have been making all the products byhand and cannot achieve the very fine degrees of tolerance that a machine canaccomplish.

 

On March 9,2004, we entered into a distribution agreement with Kensington TechnologyGroup, a leading maker of computer accessories and a division of ACCO Brands,Inc.  Pursuant to the distributionagreement, among other things, we have granted Kensington the limited,exclusive right to market and distribute our Power Pack and other productsusing our fuel cell technology under the Kensington and Medis brand names.

 

We also continue to meet with large originalequipment manufacturers (OEMs) both of cell phones and digital cameras todiscuss both bundling or boxing our Power Pack with the products they areselling to the consumer as well as the potential of providing a fuel cell as anattached secondary power source and ultimately as a primary power source,replacing the battery, for their products.

 

Based on assumptions we have made concerningestimated component, manufacturing and distribution costs and sales prices, ourpreliminary estimates are that the disposable Power Pack, when ready forcommercialization, could be manufactured in commercial quantities of millionsof units at a cost of approximately $4.00 per unit, and could bear a suggestedretail price to the ultimate consumer of $14.95 to $19.95 per unit.

 

Since we have not begun commercial productionor distribution of these products, we can give no assurance that theseassumptions and estimates will prove to be accurate if and when these productsare commercially available.

 

Based upon our discussions with cell phoneservice providers about levels of customer usage, as well as company-sponsoredsurveys and focus groups dealing both with cell phone and digital cameraowners, we believe that heavy users of cell phones or digital cameras wouldpurchase at least six disposable Power Packs a year, with lighter userspurchasing fewer Power Packs.

 

As a hypothetical illustration, if heavyusers representing just one percent of the cell phone market worldwide orfifteen percent of the digital camera market worldwide (approximately15,000,000 people in either case) purchased disposable Power Packs, and if ourexpectations are correct as to usage levels, we, after deducting what webelieve would be appropriate additional costs for production costs, overhead,marketing and advertising, would earn approximately $6.00 per share after taxesfor every 15,000,000 of such users.

 

There is no assurance that we can achievethat level of sales for the cell phone, digital camera or any other markets orthat we will achieve an earnings per share based upon these estimates.

 

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#### ***Competition***

#### *** ***

We expect to compete against other fuel celldevelopers as well as against other advanced battery technologies.  Our primary direct competitors are companiesdeveloping small fuel cells for the portable electronics market. These includeManhattan Scientifics Inc., which has reported that it is developing a fuelcell to provide auxiliary power to cellular phones and pagers. Motorola, withtechnology licensed from the Los Alamos National Laboratory in New Mexico, isalso developing a direct methanol fuel cell for mobile phones that it expectsto run up to ten times longer than existing batteries.  Mechanical Technology Inc., which is workingwith a number of scientists formerly with the Los Alamos National Laboratory,has also licensed certain fuel cell technology from Los Alamos NationalLaboratory to further its efforts to develop direct methanol fuel cells.Lawrence Livermore National Laboratory has also announced that it is developingsmall fuel cells for portable electronic devices. Other companies that haveannounced that they are developing fuel cells for portable electronic devicesare PolyFuel, Inc. (which has announced that it has developed a new membrane thatis superior to others) and Neah Powers Systems, Inc., for both of thesecompanies it has been announced that Intel has invested, and Smart Fuel CellGmbH.

 

We believe other large cell phone andportable electronic device companies may also be developing fuel cells for theportable electronics market. Some of such companies providing publicinformation about their fuel cell development programs include ToshibaCorporation, NEC Corporation, Hitachi, Ltd., Casio Computer Co. Ltd., SamsungElectronics Co. Ltd. and Sony Corporation. Toshiba, Hitachi and other Japanesecorporations have announced their intention to unify the technical standardsfor micro fuel cells powered by methanol they are each developing, in the hopeof boosting the market for such fuel cells. We believe that there are othercompanies that we may not know of that are developing fuel cells for portableelectronic devices.

 

In addition, there are other fuel cellcompanies focusing on different markets than the portable electronic devicemarket that we are targeting. These companies, including Plug Power, AvistaSystems Inc., Fuel Cell Energy Inc., are not primarily targeting the portableelectronics market, although at any time these companies could introduce newproducts that compete directly in the markets we are targeting. Ballard PowerInc., a recognized leader in PEM fuel cell technology, has announced that it isdeveloping a direct methanol fuel cell for transportation and portableapplications, however, we do not know if this is intended for the portableelectronic device market.

 

Additionally, we expect to compete withcompanies that develop, manufacture, and sell battery-operated chargers forportable electronic devices, including lithium battery packages and zinc-airbatteries offered as chargers for cell phones, PDAs and other portableelectronic devices that target many of the same markets we intend to targetwith our Power Pack.

 

We also expect indirect competition frombattery manufacturers who utilize existing battery technologies (bothchargeable and rechargeable). Existing battery technologies have thesignificant advantage of having commercially available products today, and arebacked by companies who are continuously investing in marketing and furtherresearch and development to improve their existing products and explorealternative technologies.

 

W expect our fuel cell products to compete onthe bases of size and weight, length of operating time, flexibility of use ondifferent portable devices, ease of use and cost.

 

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#### ***Our Other Technologies***

#### *** ***

Starting with our formation in 1992, we havebeen working to develop and commercialize new technologies. The first of thesetechnologies, the CellScan, was the primary product of our indirect subsidiary,Medis El Ltd., through 1996. At the time of our formation, Medis El granted usdistribution rights to the CellScan in the United States and its territoriesand possessions. In 1994, Medis El acquired its stirling cycle lineartechnologies and over the ensuing years, acquired additional technologies,including our direct liquid fuel cell technology and the other technologieslisted below. In 1998, we became Medis El’s exclusive agent in North Americafor coordinating licensing arrangements with respect to the stirling cycle andother technologies. In 2000, Medis El became our indirect, wholly-ownedsubsidiary. With the exception of our fuel cells, our inherently conductivepolymers and our CellScan system, all of our technologies are in the developmentstage and no successful commercial prototypes have as yet been developed, norcan we assure you that any such prototypes will be developed or, if developed,commercialized.

 

##### ***CellScan***

##### * *

The CellScan is a static cytometer; aninstrument for measuring reactions of living cells while the cells are in astatic state. A key element of the CellScan is its patented cell carrier whichcan accommodate up to 10,000 cells, each in individual wells. Each well holdsone living, non-adherent cell, such as a tumor cell. The CellScan canrepeatedly and continuously monitor the intensity and polarization of livingcells for purposes of cell research, disease diagnostics and determining theoptimal chemotherapy to be given to a specific patient.

 

We have completed the development and havebuilt a much smaller and less expensive version of our original CellScan systemwith improved performance characteristics, including the number of cells thatcan be screened and analyzed per hour and the number of individual tests that canbe completed per hour. In using the new version of the CellScan, we continue toimprove the methodology and the efficacy of the testing.  As a result of this experience, we haveupdated our production drawings, and we intend to build two CellScans during2004, with a view towards commercialization.

 

Our first focus for commercialization of theproduct is to offer to Israeli-based health insurance companies and HMOs acommercial test for chemosensitivity. In that connection we are in the processof contacting such institutions and establishing the systems to carry out suchtesting in a commercial setting. After establishing a commercial test forchemosensitivity, we would expect that we would also seek to offer othercommercial tests, such as for atherosclerosis and drug allergies. As part ofthe commercialization process, we are also seeking to enter into distributionagreements for the CellScan with entities that have strong marketing anddistribution capabilities in various parts of the world. Our strategy for theCellScan is to seek to create a viable commercial business and based on thatbusiness model, to carry out a program that would enable us to spin-off theassets relating to the CellScan and transfer the personnel to a subsidiary thathas been formed for the commercialization of the CellScan. As part of such aprogram, we expect to seek private venture financing for the subsidiary or seekto enter into a transaction with a company in the biotechnology field wherebythat company would acquire all or part of our interest in the CellScan. We cangive no assurance that such a program can be carried out successfully.

 

We are also continuing to collaborate withthird-party researchers and institutions in the development of potentialapplications for the CellScan, including determining the efficacy ofchemotherapeutic drugs for specific tumors, the early detection of breast,ovarian and colon cancer, atherosclerosis, lupus, tuberculosis and drugallergy.

 

9

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Recent,on-going and planned studies for several CellScan applications include thefollowing:

 

•                                          *Chemosensitivity*.A major clinical problem in the area of oncology is that cancers that areclassified as being identical according to their histopathologicalcharacteristics are in fact highly individual in their drug sensitivities.Current cancer chemotherapy is often based on the results of randomized trialsperformed on patients who have had similar types and stages of the diseasewhich has limited success.

 

We haveon-going studies both in our laboratory in Israel and in collaboration with theOncological Institute in Cluj, Romania, to determine whether the CellScan couldbe used as a tool in determining the efficacy of chemotherapy drugs forspecific tumors. In the CellScan method, cancer cells obtained from humanbiopsies are exposed to anti-cancer agents and then labeled with differentfunctional fluorescent dyes.  Changes influorescence intensity and polarization of the stained cells are monitored bythe CellScan and used to predict drug efficacy.

 

The firstphase of a multi-patent study at the Oncological Institute was completed inJanuary 2004, and we view the results as encouraging. We intend to continue thestudy with more advanced stage cancer patients.

 

•                                          *BreastCancer*.  In two recentstudies performed at Rebecca Sieff Medical Center in Israel and published in ascientific journal, the CellScan was used for both early detection of breastcancer and testing for the risk of benign tumors developing into malignantbreast cancer tumors. As the sensitivity and specificity levels achieved insuch studies were promising, we have established a CellScan laboratory inTashkent, Uzbekistan to perform a multi-patient breast cancer study incollaboration with the Uzbekistan Health Ministry, using a tetramer enhancedMUC-1 antigen, which is a new biological reagent, that we expect will furtherimprove the CellScan results. The initial phase of the sturdy was completed inDecember 2003, and we have begun a new phase of the study in February 2004,utilizing an additional antigen.

 

•                                          *OvarianCancer*. We have entered into an agreement with the EpidemiologyDepartment of Carmel Medical Center in Israel to carry-out a multi-patientstudy to determine whether the CellScan can be used for early detection ofovarian cancer, as well as a further study of breast cancer. We have installeda CellScan at the facility and trained medical center personnel in its use. Thestudy began in August 2003 and we expect it to continue through the firstquarter of 2004.

 

•                                          *Tuberculosis*.In a laboratory study to determine whether the CellScan could be used in thediagnosis of tuberculosis, it was found that the CellScan was more sensitivethan the conventional Mantoux test for tuberculosis. We have begun a dialoguewith the Moscow Institute of Tuberculosis to establish a CellScan laboratoryfor multi-patient tuberculosis testing. We also expect plan to explore the possibility of expanding such testingto other Russian and Eastern European medical facilities.

 

•                                          *Lupus*.In collaboration with Sheba Medical Center in Israel, we have an on-going studyin our laboratory to determine whether the CellScan can be used in thedetection of Systemic Lupus Erythematosus (SLE), which is a systemic autoimmunedisease characterized by the production of autoantibodies directed against cellsurface, nuclear and cytoplasmic proteins. A strong correlation was foundbetween the CellScan results and other tests that measure cell

 

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stimulation,suggesting that the CellScan, used in conjunction with nucleosomal antigen, maybe an efficient tool in the diagnosis and monitoring of lupus patients.

 

•                                          *Drug Allergy*.In collaboration with Sheba Medical Center in Israel, there is an on goingmulti-year study underway in our laboratory to determine whether the CellScancan be used as a new method of diagnosing adverse reactions to drugs, as webelieve that no satisfactory method is currently available for diagnosing drugallergy without the risk of triggering an adverse cutaneous (on the skin)reaction to the allergen. Results to date indicate that the CellScan is apromising apparatus for monitoring drug allergies.

 

•                                          *Atherosclerosis*.  In collaboration with Sheba Medical Center inIsrael, there is an on-going study underway in our laboratory utilizing theCellScan to determine the possibility of identifying patients with severecoronary heart disease through monitoring the response of their lymphocytes todisease-associated antigens. Results to date have demonstrated thatapproximately 85% of patients with severe coronary heart disease manifested asignificant difference in fluorescence polarization when their lymphocytes wereexposed to high doses of certain antigens. We believe that this approach couldpave the way to early detection of coronary heart disease with a non-invasiveprocedure, utilizing the CellScan.

 

##### ***Inherently Conductive Polymers***

##### * *

Our Inherently Conductive Polymers, or ICPs,have electrical properties that can be changed over the full range ofconductivity from insulators to metallic conductors and have the non-corrodingproperties, superior flexibility and durability of plastics. Thus, they have awide and diverse range of commercial uses, including uses for civilian andmilitary products, particularly in electronic products such as sensors andcapacitors. We have previously disclosed that our ICPs can increase thecapacity of the electrodes of an electrochemical supercapacitor by up to fivehundred percent.

 

In January 2002, we entered into an agreementwith a U.S. company to develop a new application for the use of our ICPs in aPEM fuel cell component which could advance the development of such fuel cellsfor automobile, home and stationary power uses. The agreement provided for thepayment to us over time of $300,000, of which we have recognized $268,000 frominception through December 31, 2003. In October 2003, such agreement wasterminated by the other party to the agreement prior to its scheduledtermination date, for reasons unrelated to the Company’s technology orperformance.

 

In 2003, we closed our pilot manufacturingfacility related to the ICPs in Or-Yehuda, Israel, and we are currently notproducing any ICPs for third parties.

 

#### ***Stirling Cycle System***

#### *** ***

Our stirling cycle system is a refrigerationsystem using our stirling cycle technologies and a compressor powered by two ofour linear reciprocating motors. The stirling cycle is based upon a century-oldtechnique that harnesses energy from the expansion and contraction of a gasforced between separate chambers and our linear reciprocating motor is based onour reciprocating electrical technologies. We believe that our stirling cycle system can offer advantages for certainapplications over conventional refrigeration systems, including greater energyefficiency and being more environmentally friendly due to the use of helium asits working gas instead of freon or freon compounds, which are commonlybelieved to be depleting the earth’s ozone layer and contributing to thegreenhouse effect and global warming.

 

We have developed a demonstration stirlingcycle system that achieved in laboratory tests a 130 watt cooling capacity,similar in power to the cooling capacity of a 14 cubic foot beverage cooler, ata

 

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coefficient of performance of 1.7. A coefficient of performance is ameasurement of energy efficiency.  Basedon the cooling capacity and coefficient of performance achieved, we plan toseek a business association to apply our stirling cycle technology to thedevelopment of a 5 watt cryocooler for use in cooling wireless communicationrelay stations, where we believe it may have certain advantages.

 

We have also contacted several largerefrigeration system companies, regarding joint development of the cryocoolerand other stirling cycle technology applications. We are continuing in dialoguewith such companies and would seek to develop customized prototypes, with aview towards licensing or selling the technology. We can give no assurance thatthe stirling cycle system will operate as we plan or that it will attractinterest from companies in this field.

 

#### ***Toroidal Engine***

#### *** ***

We have been developing and have patentsrelating to a toroidal engine which would use a rotary motion as contrastedwith the up and down motion of pistons in a conventional internal combustionengine. We believe that a unique feature of such a  toroidal engine would bethe implementation of pneumatic compression, supplementing the mechanical compression.We believe that if we are able to successfully develop our toroidal engine, itcould offers advantages over a conventional internal combustion engine,including a simple design with fewer moving parts, better mechanical andthermal efficiency and a favorable weight to power ratio and volume to powerratio.

 

We have developed and have recently completedinitial testing of an approximately 61 cubic inch demonstration engine (“GR1000”) based upon our toroidal technologies. Utilizing the information gainedfrom our testing, during July and August 2003 we assembled a new demonstrationengine. In order to increase power and reduce fuel consumption, we havedesigned and are manufacturing a new external and internal combustion system totake advantage of the engine’s high operating pressure.  Additionally, we have designed andmanufactured all of the components of a small demonstration engine (“GR120”).  Unlike the GR 1000, whichrequires the use of a test rig, the GR 120 is portable and may be transportedand demonstrated to potential customers and joint venture partners.  During 2004, we intend to assemble the GR120 engine prototype and present it to major engine and power equipmentmanufacturers, with a view towards licensing or selling the technology. At thisstage of development, we can give no assurance that such a toroidal engine canbe successfully developed, manufactured or licensed or sold.

 

#### ***Rankin Cycle Linear Compressor***

#### *** ***

We have designed a Rankin cycle linearcompressor with a view to make it an efficient, quiet, low cost alternative toconventional compressors used in refrigeration and other cooling systems.Unlike convention compressors driven by electrical motors using a mechanicaldevice to transform rotational motion into linear motion, our Rankin cyclelinear compressor is driven by our linear reciprocating motor which directlydrives the compressor - holding out the possibility that it will be able toreduce losses in power and reduce the size, noise and vibration levels and costof the compressor.

 

We have built an engineering prototype of aRankin cycle linear compressor with circular magnet motors. We intend to designand build a prototype of a Rankin cycle linear compressor for a 500 liter homerefrigerator, utilizing an energy efficient linear reciprocating motor. For usein such prototype, we have designed a flat magnet linear motor that we expectto be energy efficient and have a low production cost.  We believe that we may have an advantage overother linear compressors in that we are using no-wear magnetic springs, ratherthan mechanical springs. We believe that this approach enables us to operate atresonance frequency, which is the lowest energy mode, and to improve the life expectancy of the compressor aswell as the refrigerator that houses it. We intend to present our Rankin cyclelinear compressor with a flat magnet linear motor to major appliancemanufacturers during the fourth quarter of

 

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2004. We can give no assurance that the linear compressor will performas we plan or that it will attract interest from such appliance manufacturers.

 

### **Research And Development**

### ** **

Our research and development programs aregenerally pursued by scientists employed by us in Israel on a full-time basisor hired as per diem consultants. Most of the scientists working in the fuelcell field are émigrés from the former Soviet Union. We are also working withsubcontractors in developing specific components of our technologies.

 

The primary objective of our research anddevelopment program is to advance the development of our direct liquid fuelcell technology to enhance the commercial value of our products and of our fuelcell as a primary power source of portable electronic devices. Another objectiveof our research and development program is to expand the applications for ourCellScan, while we seek to commercialize the product.  We also continue to carry on research related to completingdevelopment of certain of our other technologies and products.

 

We have incurred research and developmentcosts of approximately $4,251,000 for the year ended December 31, 2001,$4,161,000 for the year ended December 31, 2002 and $5,010,000 for the yearended December 31, 2003, net of credits aggregating approximately $299,000recognized during 2003.

 

### **Government Regulation**

### ** **

Currently, the only regulations we encounterare the regulations that are common to all businesses, such as employmentlegislation, implied warranty laws, and environmental, health and safety standards,both in the United States and Israel, to the extent applicable. We will alsoencounter in the future industry-specific government regulations that wouldgovern our fuel cell products, such as Underwriter Laboratory regulations andU.S. Department of Transportation regulations, as well as regulations thatwould govern our other technologies, if and when developed for commercial use.It may become the case that other regulatory approvals will be required for thedesign and manufacture of our fuel cells and the use of our proprietary fuel,and other components of the fuel cell such as the electrolyte. Furthermore, wemust obtain from the State of Israel permits to work with certain chemicalsused to make our fuel cells. To the extent that there are delays in gainingregulatory approval, our development and growth may be constrained.

 

### **Intellectual Property**

### ** **

We rely on a combination of patent,copyright, trademark, trade secret and contract laws, as well as internationaltreaties, to protect our proprietary rights to our intellectual property whichincludes technical know-how, designs, special materials, manufacturingtechniques, test equipment and procedures for fuel cells, fuel cell componentsand fuel cell systems, as well as our other technologies. Our policy is tosecure, directly or through licensing arrangements, patent protection forsignificant innovations to the fullest extent practicable.

 

We have been issued four U.S. patentsrelating to our fuel cell technologies, two of which pertain to our liquidfuel, and we have received a notice of allowance for an additional patentrelated to our liquid fuel. Furthermore, we have several other patents pending which we are pursuingand we continue to prepare new patent applications in the United States with respect to variousaspects of our fuel cell technology, including our fuel, catalyst, electrodes,cartridge system and fuel cells.

 

13

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Corresponding applications have been filed orare intended to be filed under the Patent Cooperation Treaty, which allows uslimited protection in all of its 45 member countries for periods ranging from24-30 months, during which time patent applications can be filed in suchcountries. Although we expect to file patent applications in most of the largermarkets that are member countries, we have not yet ascertained which of thesejurisdictions we will file in. Patent applications filed in foreign countriesare subject to laws, rules and procedures which differ from those of the UnitedStates, and even if foreign patent applications issue, some foreign countriesprovide significantly less patent protection than the United States.

 

We have been granted two patents relating toour stirling cycle system, four patents relating to our toroidal technologies(one of which is owned by a 75% indirect subsidiary), one patent relating toour reciprocating electrical machine and one patent relating to our directcurrent regulating device (which is owned by a 75% indirect subsidiary). Wealso have one patent pending relating to our inherently conductive polymers.Each of such patents expires 17 years from the issue date of such patent, theearliest of which will be in 2014.

 

Furthermore, we are the exclusive worldwidelicensee of Bar-Ilan University’s patents, patent applications and any otherproprietary rights relating to the CellScan. Bar-Ilan owns, or has applied for,corresponding patents in Europe, Japan, Israel, Canada and various othercountries, of which we are the licensees. We are required to pay Bar-Ilan aroyalty through 2005 at the rate of 6.5% of proceeds of sales, after deductingsales commissions and other customary charges, and 4.5% of any fees received onaccount of the grant of territorial rights, and for the ensuing ten years aroyalty of 3.5% of all revenues, whether from sales or fees. In addition, weare required to pay $100,000 to Bar-Ilan during the first year in which ourpost-tax profits relating to the CellScan exceed $300,000. The license containsprovisions relating to the joint protection of the licensed patent rights andother provisions customary in such instruments. We have also been issued apatent relating to our CellScan cell carrier.

 

In addition to patent protection, we rely onthe laws of unfair competition and trade secrets to protect our licensed orproprietary rights. We attempt to protect our trade secrets and otherproprietary information through agreements with our collaborators, throughconfidentiality agreements with employees, consultants, potential jointventures and licensees and other security measures.

 

### **Employees**

### ** **

As of December 31, 2003, in addition to ourchief executive officer and our president, we had 58 full time employees, ofwhich approximately 55 were engineers, scientists and degreed professionals and3 were technical, administrative and manufacturing support personnel. There arealso approximately 21 engineers, scientists and degreed professionals who workwith us as consultants researching and developing our technologies on a parttime basis. We consider relations with our employees to be satisfactory.

 

## **Item 2.**                                   Properties

## ** **

We presently maintain our U.S. executiveoffices in premises of approximately 3,000 square feet at 805 Third Avenue, NewYork, New York 10022 under a sublease from the Stanoff Corporation, which iscontrolled by Robert K. Lifton, our chairman and chief executive officer, andHoward Weingrow, our president. We pay approximately $115,000 for rent peryear. The sublease is on a month to month basis.

 

Our research laboratory and technology centerand Israel-based executive offices and back office functions are located at aleased facility of approximately 12,700 square feet in Yehud, Israel. Therental expense for this lease, which has a term until December 2004 with twoone-year options extending to

 

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December 2006, is approximately $199,000 per year. The lease governingour Or-Yehuda, Israel, ICP pilot manufacturing facility terminated inaccordance with its terms on December 31, 2003.  We determined not to exercise the option to renew such lease. Wealso lease a manufacturing facility of approximately 2,600 square feet in Lod,Israel relating to the production of catalysts and electrodes for our fuelcells. The Lod lease expires on October 31, 2008, with a condition that we canunilaterally terminate the lease on or after October 31, 2006. The annualaggregate rent is $30,000. Although our facilities are adequate for our presentpurposes, as we grow and move forward with our product development andcommercialization plans, we expect to expand our facilities as necessary tomeet such increased demand.

 

## **Item 3**.                                   LegalProceedings

## ** **

We are not party to any material litigation,and we are not aware of any threatened litigation that would have a materialadverse effect on us or our business.

 

## **Item 4**.                                   Submissionof Matters to a Vote of Security Holders

## ** **

No matters were submitted to a vote ofsecurityholders during the fourth quarter of the fiscal year ended December 31,2003.

 

# **PART II**

# ** **

## **Item 5**.                                   MarketFor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

## ** **

Our common stock has traded on the NasdaqNational Market under the symbol “MDTL” since October 3, 2000. Between June 6,2000 and October 2, 2000, our common stock was traded on the Nasdaq SmallCapMarket under the same symbol. Prior to June 6, 2000, there was no public marketfor our common stock. The closing high and low sales prices of our commonstock, as reported by the Nasdaq National Market, for the quarters indicatedare as follows:

 

|            |   | **High** |       | **Low** |       |
|-----------------|--------|----------|------------|---------|------------|
| **2002:**       |   |     | ** ** |    | ** ** |
| First  Quarter  |   | 12.290   |       | 6.950   |       |
| Second  Quarter |   | 11.920   |       | 6.670   |       |
| Third  Quarter  |   | 8.600    |       | 4.010   |       |
| Fourth  Quarter |   | 7.570    |       | 4.159   |       |
|            |   |     |       |    |       |
| **2003:**       |   |     | ** ** |    | ** ** |
| First  Quarter  |   | 5.320    |       | 3.310   |       |
| Second  Quarter |   | 8.880    |       | 5.350   |       |
| Third  Quarter  |   | 12.490   |       | 7.401   |       |
| Fourth  Quarter |   | 12.070   |       | 8.450   |       |

 

As of March 8, 2003, there were approximately753 stockholders of record of our common stock. Such number does not includebeneficial owners holding shares through nominee names.

 

We have never declared or paid any dividendson our common stock. We currently anticipate that we will retain all of ourfuture earnings for use in the expansion and operation of our business. Thus,we do not anticipate paying any cash dividends on our common stock in theforeseeable future. Our future dividend policy will be determined by our boardof directors and will depend on various factors, including

 

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our results of operations, financial condition, capital requirementsand investment opportunities. In addition, the terms of our credit facilityrestrict our ability to pay dividends on our common stock.

 

## **Item 6**.                                   SelectedFinancial Data

## ** **

The selected consolidated statement ofoperations data for the years ended December 31, 1999 and 2000 and the selectedconsolidated balance sheet data as of December 31, 1999, 2000 and 2001 havebeen derived from audited financial statements not included in this report. Theselected consolidated statement of operations data for the years ended December31, 2001, 2002, and 2003 and the selected consolidated balance sheet data as ofDecember 31, 2002 and 2003 have been derived from our audited financialstatements included elsewhere in this report. Such consolidated financialstatements include the financial statements of all of our direct and indirectsubsidiaries. The data should be read in conjunction with the consolidatedfinancial statements and the notes to such statements and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report.

 

### **Statement of Operations Data:**

 
|                                          |   | **For the  Year Ended December 31,** |       |
|-----------------------------------------------|--------|--------------------------------------|------------|
|                                          |   | **1999**                             |       | **2000** |   | **2001** |   | **2002** |   | **2003** |   |
| Sales                                         |   | $                                    | —     |   | $ | — |   | $ | — |   | $ | 192,000 |   | $ | 131,000 |   |
| Cost of  sales                                |   | —                               |       | — |   | — |   | 130,000 |   | 46,000 |   |
| Gross profit                                  |   | —                               |       | — |   | — |   | 62,000 |   | 85,000 |   |
| Operating  expenses:                          |   |                                 |       |   |   |   |   |   |   |   |   |
| Research and  development costs, net          |   | 2,749,000                            |       | 4,493,000 |   | 4,251,000 |   | 4,161,000 |   | 5,010,000 |   |
| Selling,  general and administrative expenses |   | 2,467,000                            |       | 5,405,000 |   | 6,297,000 |   | 3,642,000 |   | 3,991,000 |   |
| Amortization  of intangible assets            |   | 2,574,000                            |       | 13,668,000 |   | 21,129,000 |   | 2,633,000 |   | 997,000 |   |
| Total  operating expenses                     |   | 7,790,000                            |       | 23,566,000 |   | 31,677,000 |   | 10,436,000 |   | 9,998,000 |   |
| Loss from  operations                         |   | (7,790,000                           | )          | (23,566,000 | ) | (31,677,000 | ) | (10,374,000 | ) | (9,913,000 | ) |
| Other income  (expenses):                     |   |                                 |       |   |   |   |   |   |   |   |   |
| Interest and  other income                    |   | 150,000                              |       | 214,000 |   | 178,000 |   | 151,000 |   | 131,000 |   |
| Interest  expense                             |   | (22,000                              | )          | (13,000 | ) | (63,000 | ) | (82,000 | ) | (55,000 | ) |
| Loss before  minority interest                |   | (7,662,000                           | )          | (23,365,000 | ) | (31,562,000 | ) | (10,305,000 | ) | (9,837,000 | ) |
| Minority  interest in loss of subsidiaries    |   | 1,697,000                            |       | 873,000 |   | — |   | — |   | — |   |
| Net loss                                      |   | (5,965,000                           | )          | (22,492,000 | ) | (31,562,000 | ) | (10,305,000 | ) | (9,837,000 | ) |
| Value of  warrants                            |   | —                               |       | (2,971,000 | ) | (3,204,000 | ) | (2,241,000 | ) | (1,226,000 | ) |
| Net loss  attributable to common stockholders |   | $                                    | (5,965,000 | ) | $ | (25,463,000 | ) | $ | (34,766,000 | ) | $ | (12,546,000 | ) | $ | (11,063,000 | ) |
| Basic and  diluted net loss per share         |   | $                                    | (0.51(1    | ) | $ | (1.49(1 | ) | $ | (1.68(1 | ) | $ | (0.57(2 | ) | $ | (0.47 | ) |
| Weighted  average common shares outstanding   |   | 11,788,685(1                         | )          | 17,114,998(1 | ) | 20,720,362(1 | ) | 21,897,871(2 | ) | 23,429,829 |   |

 

### **Balance Sheet Data:**

 
|                                          |   | **As of  December 31,** |      |
|-----------------------------------------------|--------|-------------------------|-----------|
|                                          |   | **1999**                |      | **2000** |   | **2001** |   | **2002** |   | **2003** |   |
| Working  capital(3)                           |   | $                       | 1,083,000 |   | $ | 2,522,000 |   | $ | 5,489,000 |   | $ | 5,037,000 |   | $ | 5,760,000 |   |
| Total assets                                  |   | 10,226,000              |      | 87,202,000 |   | 69,894,000 |   | 67,391,000 |   | 68,451,000 |   |
| Long-term  debt, excluding current maturities |   | 11,000                  |      | — |   | — |   | — |   | — |   |
| Accumulated  deficit                          |   | (23,615,000             | )         | (49,078,000 | ) | (83,844,000 | ) | (96,390,000 | ) | (107,453,000 | ) |
| Total  stockholders’ equity              |   | 8,561,000               |      | 86,142,000 |   | 68,634,000 |   | 65,405,000 |   | 65,977,000 |   |
|                                               |        |                         |           |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Inaccordance with Statement of Financial Accounting Standards No. 128, “EarningsPer Share,” the weighted average shares used in computing basic and diluted netloss per share, and the basic and diluted net loss per share for the years

 

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ended December31, 1999, 2000 and 2001 have been adjusted to give retroactive effect to sharesissued in our March 18, 2002 and March 11, 2003 rights offerings.

 

(2)                                  Inaccordance with Statement of Financial Accounting Standards No. 128, “EarningsPer Share,” the weighted average shares used in computing basic and diluted netloss per share, and the basic and diluted net loss per share for the year endedDecember 31, 2002, have been adjusted to give retroactive effect to sharesissued in our March 11, 2003 rights offering.

 

(3)           Workingcapital is total current assets less total current liabilities.

 

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## **Item 7**.                                   Management’sDiscussion and Analysis of Financial Condition and Results of Operations

## ** **

### **Introduction**

### ** **

Our primary business focus is on thedevelopment, manufacturing, marketing and distribution of direct liquid fuelcell products for portable electronic devices, for the consumer (personal andprofessional) and military markets.  Weare also working to develop and commercialize other technologies we own or ownthe rights to, including the CellScan, inherently conductive polymers, stirlingcycle system, toroidal technologies and Rankin cycle linear compressor. Basedupon our decision to devote more resources to developing our fuel celltechnologies and commercializing fuel cell-based products, in recent years wehave increased funding of our fuel cell related efforts, which increases weexpect will continue until such time as we successfully commercialize our firstfuel cell products, of which we can give no assurance, and perhaps thereafter.

 

This presentation includes the operations ofour wholly and majority owned subsidiaries, unless we tell you otherwise.

 

### **Results of Operations**

### ** **

From our inception in April 1992 throughDecember 31, 2003 we have generated an accumulated deficit of approximately$107,453,000, including approximately $43,387,000 from amortization expense. Weexpect to incur additional operating losses during 2004 and possiblythereafter, principally as a result of our continuing anticipated research anddevelopment costs, selling, general and administrative expenses and theuncertainty of bringing our fuel cell technology or any of our othertechnologies to commercial success. Since our inception, we have reliedprincipally on outside sources of funding to finance our operations, as ourrevenues have been minimal.  We expectthis to continue until we are able to successfully commercialize our fuel cellor any of our other products or technologies, of which we can give noassurance.

 

Our research and development costs haveincreased from approximately $2,749,000 in 1999 to approximately $5,010,000 in2003; however, we anticipate that our failure to successfully commerciallydevelop our fuel cell technology or any of our other technologies will force usto curtail our spending levels until such time, if ever, as we generaterevenues or otherwise receive funds from third party sources. If we begin tomarket and sell any of our technologies, we will increase such expenses to theextent necessary, which we expect to fund out of revenues.

 

#### ***Year endedDecember 31, 2003 compared to year ended December 31, 2002***

#### *** ***

We sustainednet losses of $9,837,000 during the year ended December 31, 2003, compared to$10,305,000 during the year ended December 31, 2002. The decrease in the netlosses can primarily be attributed to decreases in amortization of certainintangible assets as such intangible assets become fully amortized, somewhatoffset by an increases in research and development costs as we increase fundingof our fuel cell related efforts,  andselling, general and administrative expenses.

 

We recognizedrevenues of approximately $131,000 and gross profit of approximately $85,000during the year ended December 31, 2003, compared to revenues of approximately$192,000 and gross profit of approximately $62,000 during the year endedDecember 31, 2002. The revenue in 2003 is attributable to a January 2002agreement to develop for a third party an application for the use of our inherentlyconductive polymers in its fuel cell products. In October 2003, such agreement was terminated by the other party tothe agreement prior to its scheduled termination date, for reasons unrelated toour

 

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technology or performance. Since the inception of such agreement inJanuary 2002, we received approximately $268,000 and expect to receive anadditional amount of approximately $6,000 on billings for the period prior tothe termination. We do not expect to receive the $26,000 balance thatwould have been due under such agreement had it run through its entire term.The revenues recognized in 2002 were attributed both to $138,000 under theJanuary 2002 agreement and to $54,000 under a one-time purchase order in whichwe designed a direct liquid fuel cell for use in a new energy pack for infantrysoldiers. All of such revenues are non-recurring.

 

Research anddevelopment costs amounted to $5,010,000 during the year ended December 31,2003, compared to $4,161,000 during the year ended December 31, 2002. Theincreases in research and development costs incurred during 2003 compared to2002 can be primarily attributed to an increase of approximately $1,318,000related to our fuel cell technologies, somewhat offset by a decrease ofapproximately $222,000 in costs related to our CellScan and a decrease ofapproximately $264,000 in costs related to our toroidal technologies, stirlingcycle system and linear compressor. The research and development activities forthe periods presented include:

 

•                  *Fuel Cell Technologies*. We incurred costsrelating to our fuel cell technologies of approximately $3,598,000 during theyear ended December 31, 2003 (net of credits aggregating approximately $299,000recognized pursuant to our contracts with General Dynamics), compared to costsof approximately $2,280,000 during the year ended December 31, 2002. The netincreases in our research and development expenses relating to our fuel celltechnologies of approximately $1,318,000 in 2003 compared to 2002 reflects ourdecision to continue to devote substantial and increasing amounts of resourcesto the further development of our fuel cell technologies and products.

 

•                  *CellScan*. We incurred costs relating tothe refinement of the desktop CellScan system and on various CellScan researchactivities of approximately $1,013,000 during the year ended December 31, 2003,compared to costs of approximately $1,235,000 during the year ended December31, 2002. The decrease in 2003 compared to 2002 can be primarily attributed todecreases in costs incurred related to the retention of third party researchersin the development and testing of new CellScan applications, labor costs andmaterial costs, partially offset by an increase in other costs.

 

•                  *Toroidal Technologies, Stirling Cycle System andLinear Compressor*. We incurred aggregate costs relating to ourtoroidal engine and compressor, stirling cycle system and linear compressor ofapproximately $361,000 during the year ended December 31, 2003, compared tocosts of approximately $625,000 during the year ended December 31, 2002. Thedecrease in 2003 compared to 2002 can be primarily attributed to decreases incosts incurred from the use of consultants and subcontractors, labor costs, andother costs reflecting management’s decision to allocate more of our researchand development resources to fuel cell development.

 

Selling,general and administrative (“SG&A”) expenses during the year ended December31, 2003 amounted to approximately $3,991,000, compared to approximately$3,642,000 during the year ended December 31, 2002. The increase of $349,000during 2003 compared to 2002 is primarily attributable to an increase innon-cash charges relating to stock options and warrants of approximately$430,000, an increase in insurance costs of approximately $144,000 and anincrease in selling and marketing expenses of approximately $43,000, somewhatoffset by a decrease in executive and other consulting expenses ofapproximately $224,000 and a net decrease in various other SG&A costcategories aggregating to  approximately$44,000.

 

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Amortizationof intangible assets amounted to $997,000 during the year ended December 31,2003, compared to $2,633,000 during the year ended December 31, 2002. Thedecrease is primarily attributable to intangible assets acquired in our June2000 exchange offer for shares of Medis El that we did not already own becomingfully amortized during the year ended December 31, 2003, partially offset byamortization of intangible assets acquired in our March 2003 acquisition of theremaining 7% of More Energy that we did not already own.

 

#### ***Year endedDecember 31, 2002 compared to year ended December 31, 2001***

#### *** ***

We sustainednet losses of $10,305,000 during the year ended December 31, 2002, compared to$31,562,000 during the year ended December 31, 2001. The decrease in the netlosses can primarily be attributed to the discontinuation of the amortizationof goodwill pursuant to our adoption of Statement of Financial AccountingStandards (“SFAS”) No. 142, resulting in a reduction in amortization expense ofapproximately $18,500,000 for the year ended December 31, 2002 and a decreasein costs related to stock options and warrants of $3,451,000 for the year endedDecember 31, 2002.

 

We recognizedrevenues of approximately $192,000 and gross profit of approximately $62,000during the year ended December 31, 2002, compared to none during the sameperiods in 2001. An aggregate of $138,000 of such revenues are attributable toa January 2002 agreement to develop for a third party an application for theuse of our HECPs in its fuel cell products. The remaining $54,000 of suchrevenues are attributable to work performed under a completed January 2002purchase order in which we designed a direct liquid fuel cell for use in a newenergy pack for infantry soldiers.  Allof such revenues are non-recurring.

 

Research anddevelopment costs amounted to $4,161,000 during the year ended December 31,2002, compared to $4,251,000 during the year ended December 31, 2001. Althoughtotal research and development costs incurred during the year ended December31, 2002 decreased slightly compared to 2001, costs relating to our fuel celltechnologies increased by approximately $607,000 during the year ended December31, 2002, compared to 2001. This increase in costs related to our fuel celltechnologies were offset by reductions in costs related to our CellScan ofapproximately $635,000 during the year ended December 31, 2002, compared to2001, and to our toroidal technologies, stirling cycle system and linearcompressor of approximately $67,000 during the year ended December 31, 2002,compared to 2001. The research and development activities for the periodspresented include:

 

•                  *Fuel Cell Technologies*. We incurred costsrelating to our fuel cell technologies of approximately $2,280,000 during theyear ended December 31, 2002, compared to costs of approximately $1,673,000during the year ended December 31, 2001. This increases in our research anddevelopment expenses relating to our fuel cell technologies of approximately$607,000 during the year ended December 31, 2002 reflect management’s decisionto continue to devote substantial resources to the development of our fuel celltechnologies.

 

•                  *CellScan*. We incurred costs relating tothe refinement of the next generation CellScan system and on various CellScanresearch activities of approximately $1,235,000 during the year ended December31, 2002, compared to costs of approximately $1,870,000 during the year endedDecember 31, 2001. The decrease can be primarily attributed to lower labor,materials and depreciation costs, somewhat offset by increases in costsincurred related to the retention of third party researchers in the developmentand testing of new CellScan applications.

 

•                  *Toroidal Technologies, Stirling Cycle System andLinear* Compressor. We incurred costs relating to our toroidal engineand compressor, stirling cycle system and linear compressor of approximately$625,000 during the year ended December 31, 2002, compared to costs ofapproximately $692,000 during the year ended December 31, 2001ss. The decreaseduring the 

 

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year endedDecember 31, 2002 can be primarily attributed to decreases in costs incurredfrom the use of consultants and subcontractors, as well as decreases in laborcosts, with respect to such technologies.

 

Selling,general and administrative expenses during the year ended December 31, 2002amounted to approximately $3,642,000, compared to approximately $6,297,000during the year ended December 31, 2001. The decrease of $2,655,000 isprimarily attributed to a reduction of approximately $3,246,000 in non-cashcharges relating to stock options and warrants during the year ended December31, 2002 compared to the year ended December 31, 2001, partially offset byincreases in salary and related costs and selling and marketing expenses.

 

Amortizationof intangible assets amounted to $2,633,000 during the year ended December 31,2002, compared to $21,129,000 during the year ended December 31, 2001. Thedecrease was primarily due to our adoption of SFAS No. 142. In accordance withSFAS No. 142, we discontinued amortization of our goodwill as of January 1,2002, which resulted in decreases in amortization expense of approximately$18,500,000 for the year ended December 31, 2002, compared to the year endedDecember 31, 2001.

 

### **Liquidity And Capital Resources**

### ** **

We finance our operations primarily throughthe proceeds of investor equity financing, which we expect will continue untilsuch time as we successfully commercialize our fuel cell products or productsderived from any of our other technologies. Furthermore, we currently haveavailable a credit line which has not been drawn upon.

 

Our workingcapital and capital requirements at any given time depend upon numerousfactors, including, but not limited to:

 

•                  the progress of research anddevelopment programs;

 

•                  the status of our technologies; and

 

•                  the level of resources that we devoteto the development of our technologies, patents, marketing and salescapabilities.

 

Another source of revenue or other means toeffect our cash expenditures are collaborative arrangements with businesses andinstitutes for research and development and companies participating in thedevelopment of our technologies. We have entered into a total of fivecollaborative arrangements with third parties relating to our fuel celltechnologies, in which, since January 2002, we have realized revenues of $323,000on costs of sales of $176,000, as well as credits against our research anddevelopment costs of approximately $299,000. There can be no assurance that wewill realize additional revenue or credits to our research and developmentexpense from such collaborative arrangements still in existence or that we willenter into additional collaborative arrangements in the future. There can be noassurance that we will raise additional funds through any financing approachimplemented by us.

 

On March 11,2003, we completed a rights offering in which we offered to our existingstockholders subscription rights to purchase an aggregate of 2,325,600 sharesof our common stock at a purchase price of $2.15 per share. We received grossproceeds of approximately $5,000,000 from the rights offering, less relatedexpenses of approximately $122,000.

 

On September30, 2003, we entered into a third amendment to the agreement governing ourexisting $5,000,000 revolving credit line. Pursuant to the amendment, the termination date of the

 

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revolving credit line was extended from July1, 2004 to July 1, 2005. No other terms of the agreement were changed. Anyoutstanding balances would be collateralized by all deposits with the lenderand an assignment of certain leases owned by a partnership in which our chiefexecutive officer and our president are partners.  Additionally, our chief executive officer and our president havepersonally guaranteed any amounts due under such credit line. We have notborrowed any funds under this credit line to date.

 

On November 13, 2003, we completed an offer to exchange and exercise toholders of our approximately 848,000 outstanding warrants issued pursuant toour 2002 shareholder loyalty program (the “Offer”).  In order to participate in the Offer, holders of loyalty programwarrants who exchanged such warrants for new warrants exercisable at $4.43 pershare were also required to exercise the new warrants at the time of theexchange.  Each holder of a new warrant,upon its exercise, received one share of common stock and a one-year warrant topurchase an additional share of common stock at $9.60 for every two newwarrants exercised. Pursuant to the Offer, we issued in exchange for theloyalty program warrants 839,966 shares of our common stock and warrants topurchase 419,983 shares of common stock for gross proceeds of approximately$3,721,000, less related costs of approximately $112,000.

 

During theyear ended December 31, 2003, warrantholders exercised outstanding warrants toacquire 25,509 shares of our common stock, at an exercise price of $5.00 pershare, for aggregate gross proceeds of approximately $128,000.

 

During theyear ended December 31, 2003, options toacquire an aggregate of 112,350 shares of our common stock issued under our1999 Stock Option Plan, as amended, were exercised, for proceeds ofapproximately $621,000.

 

Proceeds from all of the above financings andoption and warrant exercises have been and will continue to be used for workingcapital, including for the continued development of our direct liquid fuel celltechnologies and related products, as well as for selling, general andadministrative expenses.

 

For the yearended December 31, 2003, net cash used in operating activities was $7,974,000,as compared to $6,782,000 for year ended December 31, 2002. The increase wasprimarily attributable to management’s decision to continue to increase levelsof spending on research and development related to our fuel cell technologiesduring the year ended December 31, 2003 compared to the year ended December 31,2002.

 

For the yearended December 31, 2003, net cash used in investing activities was $734,000,which represented purchases of property and equipment of $576,000 and a long termloan of $158,000 to Gennadi Finkelshtain in connection with our March 2003acquisition from Mr. Finkelshtain of the remaining 7% of More Energy that wedid not already own. This is compared to $238,000 for the year ended December31, 2002, which represented $263,000 for the purchase of property andequipment, partially offset by proceeds of $25,000 from the disposal ofproperty and equipment.  In 2003, ascompared to 2002, we substantially increased the amount of spending on propertyand equipment related to the further development of our fuel cell technologies.

 

For the yearended December 31, 2003, cash aggregating $9,292,000 was provided by financingactivities, compared to $7,057,000 for the year ended December 31, 2002. Duringthe year ended December 31, 2003, cash was provided by the financing activitiesdescribed in detail above. The cashprovided by financing activities during the year ended December 31, 2002related to our March 2002 rights offering, which generated gross proceeds of$7,000,000, as discussed above, less costs of such offering incurred during theyear ended December 31, 2002 of $267,000, the exercise of options to purchaseour common stock, which generated gross proceeds of approximately $309,000 andthe exercise 

 

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of warrants to purchase our common stockissued pursuant to our shareholder loyalty program, which generated grossproceeds of approximately $15,000.

 

As of December31, 2003, we had approximately $6,620,000 in cash and cash equivalents, as wellas an unused $5,000,000 revolving credit line which terminates in accordancewith its terms on July 1, 2005. Additionally:

 

•                  InJanuary 2004, we issued 1,425,000 shares of our common stock in private salesto institutional investors, for gross proceeds aggregating approximately$14,588,000, less related expenses of approximately $257,000.

 

•                  FromJanuary 1, 2004 through March 3, 2004, optionsgranted under our 1999 Stock Option Plan were exercised to acquire an aggregateof approximately 192,600 shares of our common stock, for an aggregate exerciseprice of approximately $1,129,000.

 

•                  From January 1, 2004 through March 3, 2004,warrant holders exercised outstanding warrants to acquire an aggregate of20,713 shares of our common stock, for an aggregate exercise price of $110,000.

 

As of December 31, 2003, we believe that ourcash resources, since augmented by the net proceeds from our January 2004private placements, and monies available to us from our credit facility, willbe sufficient to support our operating and developmental activities for atleast the next two years and five months. Beyond such time, we may requirecapital infusions of cash to continue our operations, whether through debtfinancing, issuance of shares or from companies or other organizationsparticipating in the development of our technologies. However, to the extent weare unable to raise or acquire additional other funds, we will curtail researchand development of one or more technologies until such time as we have adequatefunds available.

 

### **Commitments and Contingencies**

### ** **

The followingtable sets forth our contractual obligations at December 31, 2003.

 
|                                  |   | **Payment  Due By Period** |      |
|---------------------------------------|--------|----------------------------|-----------|
| **Contractual Obligations**           |   | **Total**                  |      | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008 and  thereafter** |   |
| Operating  Lease Obligation           |   | $                          | 202,000   |   | $ | 116,000 |   | $ | 64,000 |   | $ | 22,000 |   | $ | — |   | $ | — |   |
| Purchase  Obligations                 |   | 1,660,000                  |      | 1,545,000 |   | 30,000 |   | 30,000 |   | 30,000 |   | 25,000 |   |
| Other  Long-Term Liabilities (Note 1) |   | 1,193,000                  |      | 119,000 |   | 119,000 |   | 119,000 |   | 119,000 |   | 717,000 |   |
|                                  |   |                       |      |   |   |   |   |   |   |   |   |   |   |
| Total                                 |   | $                          | 3,055,000 |   | $ | 1,780,000 |   | $ | 213,000 |   | $ | 171,000 |   | $ | 149,000 |   | $ | 742,000 |   |

 

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Note 1:          Other Long-Term Liabilities represents our accrued severance pay as ofDecember 31, 2003.  Since we do notexpect a high level of employee turnover giving rise to the payment ofsignificant amounts of severance obligations, we have included approximately10% of the total liability in each of the years  2004 through 2007 and the remainder in 2008 and thereafter.

 

### **Tax Matters**

### ** **

As of December 31, 2003, for U.S. federalincome tax purposes, we have net operating loss carry-forwards of approximately$9,213,000. For Israeli income tax purposes, we have net operating losscarry-forwards of approximately $42,640,000. Since our inception, we have nothad any taxable income. Also, neither we nor any of our subsidiaries have everbeen audited by the United States or Israeli tax authorities sinceincorporation.

 

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The availability of our U.S. net operatingloss carry-forwards may be reduced to the extent one or more direct or indirectholders of 5% or greater amount of our common stock increases their equityinterest in us by more than 50% in the aggregate.

 

### **Grants Obtained From The State Of Israel**

### ** **

Medis El, our indirect wholly-ownedsubsidiary, received approximately $1,800,000 in research and developmentgrants from the Office of the Chief Scientist of the Ministry of Commerce andIndustry of the State of Israel from its inception to 1997. This is based upona policy of the government of Israel to provide grants of between 50% and 66%of qualifying approved research and development expenditures to promoteresearch and development by Israeli companies. Medis El received 50% ofqualifying approved research and development expenditures, with $1,629,000 ofsuch funds being allotted for the CellScan and $167,000 allotted for theneuritor. Pursuant to the grant arrangement, Medis El is required to pay 3% ofits sales of CellScan and neuritor products developed with the grant fundsuntil the grant amounts are paid in full. There is no requirement to repay thegrants if the products developed with the grant funds are not sold. If Medis Elsells the underlying technology prior to repaying the grant funds, it mustfirst seek permission from the Israeli government for such sale. Prior to MedisEl receiving grant funds in 1992, Medis El assumed from Israel AircraftIndustries Inc., our largest stockholder, its obligation relating to therepayment of grants out of future royalties, if any, of approximately $805,000.As of December 31, 2003, Medis El’s total contingent obligation for therepayment of grants, which includes the $805,000, is $2,601,000. Neither we norMedis El presently receive any grants from the State of Israel.

 

### **Approved Enterprise**

### ** **

Under the Israeli Law for the Encouragementof Capital Investments, 1959, Medis El was issued a certificate of approval asan “Approved Enterprise.” Under the law, Medis El elected the “combined path,”pursuant to which Medis El had the right to receive a government guaranteedbank loan of 66% of the amount of the approved investment. In addition, MedisEl had the right to receive a grant of 25% of the approved investment, in whichcase the loan would be reduced by the amount of the grant. Medis El receivedinvestment grants of approximately $97,000 and loans of approximately $893,000.The investment grants were used to invest in equipment, furniture and fixturesand commercial vehicles. The loan proceeds were used for the above as well asto acquire know-how, leasehold improvements, marketing and working capital. Theloans were paid-off in full during the year ended December 31, 2000.Additionally, the tax liability in respect of Medis El’s income deriving fromits Approved Enterprise activities is calculated at a rate of 20% of income fora ten-year period, with tax on dividends distributed of 15%, instead of 25%.These tax benefits expire in 2006.

 

In September 2001, More Energy, our fuel cellsubsidiary, was granted Approved Enterprise status. The benefits from theApproved Enterprise programs depend upon More Energy fulfilling the conditionsunder the grant and the laws governing the grant. More Energy has chosen not tocontinue with its Approved Enterprise program and, thus, is not in compliancewith these conditions.  It does notexpect to incur any costs relating to not participating in the program.

 

### **Critical Accounting Policies**

### ** **

The followingrepresents our critical accounting policies which reflect significant judgmentsand uncertainties and could possibly result in materially different resultsunder different conditions and assumptions.

 

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#### ***Goodwill andIntangible Assets***

 

We consideraccounting policies related to our goodwill and other intangible assets to becritical due to the estimation processes involved and their materiality to ourfinancial statements. As of December 31, 2003, the net book values of ourgoodwill and intangible assets were $58,205,000 and $880,000, respectively. Ourgoodwill and other intangible assets arose primarily as a result of threepurchase accounting transactions: our acquisition of the minority interest inMedis Inc. in 1997, our exchange of our shares for the minority interest in MedisEl in 2000 and our acquisition of the remaining 7% of More Energy that we didnot already own in 2003. In amortizing our goodwill through December 31, 2001and our intangible assets through December 31, 2003, we made estimates andassumptions regarding the useful lives of such assets. If our estimates andassumptions change, the useful lives and resulting charges to operations foramortization of such assets would also change.

 

Additionally, with respect to our goodwilland intangible assets, as of January 1, 2002, we adopted SFAS No. 142,“Goodwill and Other Intangible Assets,” which was issued by the FinancialAccounting Standards Board in June 2001. SFAS No. 142 requires enterprises,effective January 1, 2002, to discontinue amortizing goodwill, and insteadrequires that goodwill be subject to at least an annual assessment forimpairment. As part of our initial evaluation of our goodwill and intangibleassets for any possible impairment, as of January 1, 2002, we were required touse estimates and assumptions with respect to markets for our products, futurecash flows, discount rates and timing of commercialization of our technologiesin determining the fair value of our reporting units. We have also performedannual tests for impairment of our goodwill in 2002 and 2003. The estimates weused assume that our products will be accepted and that we will gain marketshare in the future and will experience growth in such market share. If we failto deliver products or to achieve our assumed revenue growth rates or assumedgross margins, if the products fail to gain expected market acceptance, or ifour estimates and/or other assumptions change or other circumstances changewith respect to future cash flows, discount rates and timing ofcommercialization of our technologies, we may, in the future, be required torecord charges to operations for impairment of our goodwill and/or ourintangible assets.

 

#### ***Stock Optionsand Warrants***

#### *** ***

We also consider accounting policies relatedto stock options and warrants to be critical due to the estimation processinvolved. We utilize stock options and warrants as an important means ofcompensation for employees, directors and consultants and also warrants as aninstrument in our fundraising process. Accounting for such options and warrants,in some circumstances, results in significant non-cash charges to ouroperations or accumulated loss. There are assumptions and estimates involved indetermining the value of such stock options and warrants and the timing ofrelated charges to our operations or accumulated loss. These estimates andassumptions include the expected term of the option, volatility of our stockprice and interest rates. The market price of our stock also has a significantimpact on charges we incur related to stock options and warrants. If theseestimates and assumptions change or if our stock price changes, the charges tooperations and/or accumulated loss could also change significantly.

 

#### ***DeferredIncome Taxes***

#### *** ***

We record a valuation allowance to reduce ourdeferred tax assets to zero. In the event that we were to determine that we arelikely to be able to realize all or part of our deferred tax assets in thefuture, an adjustment to the deferred tax assets would be credited tooperations in the period such determination was made.

 

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### **Recent Accounting Pronouncements**

 

In January2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation46, Consolidation of Variable Interest Entities, an interpretation of ARB No.51(“FIN 46”).  In December 2003, the FASBmodified FIN 46 to make certain technical corrections and address certainimplementation issues that had arisen. FIN 46 provides a new framework for identifying variable interestentities (“VIE”) and determining when a company should include the assets,liabilities, noncontrolling interests and results of activities of a VIE in itsconsolidated financial statements.

 

In general, aVIE is a corporation, partnership, limited-liability corporation, trust or anyother legal structure used to conduct activities or hold assets that either (i)has an insufficient amount of equity to carry out its principal activitieswithout additional subordinated financial support, (ii) has a group of equityowners that are unable to make significant decisions about its activities, or(iii) has a group of equity owners that do not have the obligations to absorblosses or the right to receive returns generated by its operations.

 

FIN 46requires a VIE to be consolidated if a party with an ownership, contractual orother financial interest in the VIE (a variable interest holder) is obligatedto absorb a majority of the risk of loss from the VIE's activities, is entitledto receive a majority of the VIE’s residual returns (if no party absorbs amajority of the VIE’s losses) or both. A variable interest holder that consolidates the VIE is called theprimary beneficiary.  Uponconsolidation, the primary beneficiary generally must initially record all ofthe VIE’s assets, liabilities and noncontrolling interests at fair value andsubsequently account for the VIE as if it were consolidated based on a majorityvoting interest.  FIN 46 also requiresdisclosures about VIEs that the variable interest holder is not required toconsolidate but in which it has a significant variable interest.

 

We do notbelieve that we have any interests in any variable interest entities.

 

### **Risk Factors**

### ** **

**We have had limited revenues since inceptionand none from 1999 through 2001, and we cannot predict when we will achieveprofitability.**

 

We have notbeen profitable and cannot predict when we will achieve profitability. We haveexperienced net losses since our inception in April 1992. We, on a consolidatedbasis with our subsidiaries, have had limited revenues since inception and nonefrom 1999 through 2001. We do not anticipate generating significant revenuesuntil we successfully develop, commercialize and sell products derived from ourfuel cell technologies or any of our other technologies, of which we can giveno assurance. We are unable to determine when we will generate significantrevenues from the sale of any of such products.

 

We cannotpredict when we will achieve profitability, if ever. Our inability to becomeprofitable may force us to curtail or temporarily discontinue our research anddevelopment programs and our day-to-day operations. Furthermore, there can beno assurance that profitability, if achieved, can be sustained on an ongoingbasis. As of December 31, 2003, we had an accumulated deficit of approximately$107,453,000.

 

**We may never complete the development ofcommercially viable fuel cells or any of our other technologies into marketableproducts.**

 

We do not knowwhen or whether we will successfully complete the development of commerciallyviable fuel cells for any of our target markets, or any of our othertechnologies. We continue to seek to improve our fuel cell technologies,particularly in the areas of energy density, stability of power output,operating time, reduction of size and weight, use of the product in anyorientation, as well as the temperature conditions under which the fuel cellscan operate. We also seek to improve the engineering design of our fuel cellsand refill cartridges and integrate each fuel cell into a primary or auxiliarypower source which can power various portable electronic devices, before we areable to produce a commercially viable product. Additionally, we must completethe production model of the converter used in our power pack to step upvoltage. Failure to improve on our fuel cell technologies, including thefailure of any of the above, could delay or prevent the successful developmentof commercially viable fuel cell products for any of our target markets.

 

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Developing anytechnology into a marketable product is a risky, time consuming and expensiveprocess. You should anticipate that we will encounter setbacks, discrepanciesrequiring time consuming and costly redesigns and changes and that there is thepossibility of outright failure.

 

**We may not meet our product development andcommercialization milestones.**

 

We haveestablished milestones, based upon our expectations regarding our technologiesat that time, which we use to assess our progress toward developingcommercially viable fuel cells. These milestones relate to technology anddesign improvements as well as to dates for achieving development goals. If ourproducts exhibit technical defects or are unable to meet cost or performancegoals, including levels and stability of power output, useful life andreliability, our commercialization schedule could be delayed and third partieswho are collaborating with us to develop our fuel cell technology, as well aspotential purchasers of our initial commercial products, may decline topurchase such products or may opt to pursue alternative technologies.

 

Generally, wehave made technological advances meeting our milestone schedule with respect todeveloping commercially viable fuel cells, including the level of power densityand longevity of use obtained. We can give no assurance that ourcommercialization schedule will continue to be met as we further develop ourfuel cells and our fuel cell products, or any of our other technologies orproducts.

 

**Customers will be unlikely to buy our fuelcell products unless we can demonstrate that they can be produced for sale toconsumers at attractive prices.**

 

To date, wehave focused primarily on research and development of our fuel celltechnologies. Consequently, we have no experience in manufacturing fuel cellsor fuel cell products on a commercial basis. We may manufacture our fuel cellproducts through third-party manufacturers. We can offer no assurance thateither we or our manufacturing partners will develop efficient, automated,low-cost manufacturing capabilities and processes to meet the quality, price,engineering, design and production standards or production volumes required tosuccessfully mass market our fuel cell products. Even if we or ourmanufacturing partners are successful in developing such manufacturingcapability and processes, we do not know whether we or they will be timely inmeeting our product commercialization schedule or the production and deliveryrequirements of potential customers. A failure to develop such manufacturingprocesses and capabilities could have a material adverse effect on our businessand financial results.

 

The price offuel cells and fuel cell products is dependent largely on material and othermanufacturing costs. We are unable to offer any assurance that either we or amanufacturing partner will be able to reduce costs to a level which will allowproduction of a competitive product or that any product produced using lowercost materials and manufacturing processes will not suffer from a reduction inperformance, reliability and longevity. Furthermore, although we have estimateda pricing structure for both our proposed power pack charger and our refuelingcartridges, we can give no assurance that these estimates will be correct inlight of any manufacturing process we adopt or distribution channels we use.

 

**A commercially viable market for our fuelcell products may never develop or may take longer to develop than weanticipate.**

 

A commerciallyviable market may never develop for our fuel cell products or any of our othertechnologies, or may develop more slowly than we anticipate. Fuel cellsrepresent a new market, and we do not know whether end-users will want to usethem. The development of a commercially viable market for our fuel cellproducts may be affected by many factors, some of which are out of our control,including:

 

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•                  the level to which the technology ofour fuel cells has advanced;

 

•                  the emergence of newer, morecompetitive technologies and products;

 

•                  improvements to existingtechnologies, including existing rechargeable battery technology;

 

•                  the future cost of glycerol, ethanol,or any other hydrogen-based fuels or other chemicals used for powering our fuelcells;

 

•                  regulations that affect or limit theuse of the components in our fuel cells or our fuel cells in general;

 

•                  consumer perceptions of the safety ofour products; and

 

•                  consumer reluctance to try a newproduct.

 

If a massmarket fails to develop or develops more slowly than we anticipate, we may beunable to recover the losses we will have incurred in the development of ourproducts and may never achieve profitability.

 

**We will be unable to market or sell our fuelcell products or products derived from any of our other technologies if we areunsuccessful in entering into arrangements, alliances, joint ventures orlicensing agreements with third parties.**

 

As we do nothave nor do we intend to develop our own marketing or wide scale manufacturinginfrastructure, our ability to market, manufacture and sell our fuel celltechnologies or any of our other technologies is wholly dependent on our entryinto manufacturing, sales or distributing arrangements, strategic alliances,joint ventures or licensing agreements with third parties possessing suchcapabilities. We can offer no assurance that we will be successful in enteringinto such arrangements, alliances, joint ventures or agreements or that theterms of which will be entirely beneficial to us.

 

**Problems or delays in our collaborationefforts with third parties to develop or market our fuel cell products couldhurt our reputation**and the reputation of ourproducts.

 

We haveentered into agreements with third parties who have agreed to assist us in developingor marketing our fuel cell products. We are in discussions with other thirdparties and may enter into similar agreements with such other parties or othersin the future, of which we can give no assurances of success. Thesecollaboration agreements contemplate that these third parties will work withour scientists to test various aspects of, or assist in developing componentsof, our fuel cells. Such tests or development efforts may encounter problemsand delays for a number of reasons, including, without limitation, the failureof our technology, the failure of the technology of others, the failure tocombine these technologies properly and the failure to maintain and service anytest prototypes properly. Many of these potential problems and delays arebeyond our control. In addition, collaborative efforts, by their nature, oftencreate problems due to miscommunications and disparate expectations andpriorities among the parties involved and may result in unexpectedmodifications and delays in developing or marketing our fuel cell technologies.Any such problems or perceived problems with these collaborative efforts couldhurt our reputation and the reputation of our products and technologies.

 

28

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**Our efforts to protect our intellectualproperty may not offer sufficient protection, which could hinder our growth andsuccess.**

 

We regard our patents, trade secrets, copyrights and similarintellectual property rights as essential to our growth and success. We relyupon a combination of patent, copyright and trademark laws, trade secretprotection, confidentiality and non-disclosure agreements and contractualprovisions with employees and with third parties to establish and protect ourproprietary rights. We own, directly or indirectly through subsidiaries orcompanies in which we have an interest, patents for certain technologies andare currently applying for additional patents. We can offer no assurance thatwe will succeed in receiving patent and other proprietary protection in allmarkets we enter, or, if successful, that such protection will be sufficient.If we successfully develop and market any or all of our technologies, we expectto face efforts by larger companies and other organizations or authorities toundermine our patents by challenging or copying our intellectual property.Moreover, intellectual property rights are not protected in certain parts ofthe world. We intend to vigorously defend our intellectual property against anychallenges that may arise. However, any infringement action initiated by us maybe very costly and require the diversion of substantial funds from ouroperations and may require management to expend efforts that might otherwise bedevoted to our operations.

 

**Claims by third parties that our technologyinfringes upon their patents may, if successful, prevent us from furtherdeveloping or selling our technologies.**

 

Although we do not believe our business activities infringe upon therights of others, nor are we aware of any pending or contemplated actions tosuch effect, we can give no assurance that our business activities will notinfringe upon the proprietary rights of others, or that other parties will notassert infringement claims against us.

 

**If we do not obtain additional financing, wemay be forced to curtail our research and development efforts.**

 

Our ability tosustain our research and development program is dependent upon our ability tosecure additional funding. As of December 31, 2003, on a pro forma basis togive effect to our January 2004 private offerings, we believe that our cashresources, including monies available to us from our unused credit facility,will be sufficient to support our operating and developmental activities andrequirements for the purchase of capital equipment, for approximately the nexttwo and one-half years. After such time, or earlier if we decide to increaseour spending levels, we may need to raise additional funds through public orprivate debt or equity financing in order to be competitive, to accelerate oursales and marketing programs, to establish a stronger financial position and tocontinue our operations. We can offer no assurance that we will be able tosecure additional funding, or funding on terms acceptable to us, to meet our financialobligations, if necessary, or that a third party will be willing to make suchfunds available. Our failure to raise additional funds could require us todelay our research and product development efforts or cause us to default underthe repayment terms of our revolving credit facility, if we were to borrowfunds under that facility and we are unable to repay such borrowings.Furthermore, our failure to successfully develop or market our fuel cellproducts or products derived from any of our other technologies may materiallyadversely affect our ability to raise additional funds. In any event, it is notpossible to make any reliable estimate of the funds required to complete thedevelopment of our fuel cell technologies or any of our other technologies.

 

29

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**If we were to lose our technical talent ormembers of senior management and could not find appropriate replacements in atimely manner, our business could be adversely affected.**

 

Our successdepends to a significant extent upon Zvi Rehavi, Gennadi Finkelshtain and theother scientists, engineers and technicians that seek out, recognize anddevelop our technologies, as well as our highly skilled and experiencedmanagement, including Robert K. Lifton, our chief executive officer, and HowardWeingrow, our president. The loss of the services of Messrs. Rehavi andFinkelshtain, of any of our other technical talent or of Messrs. Lifton andWeingrow could have a material adverse effect on our ability to develop ourfuel cell technologies into commercial products or any of our othertechnologies into commercial products. We possess key-person life insurance of$245,000 on Mr. Rehavi and $3,000,000 on Mr. Finkelshtain. Although to date wehave been successful in recruiting and retaining executive, managerial andtechnical personnel, we can offer no assurance that we will continue to attractand retain the qualified personnel needed for our business. The failure toattract or retain qualified personnel could have a material adverse effect onour business.

 

**There may be adverse effects on our earningsand our stock price due to the large amount of goodwill and intangible assetson our consolidated balance sheet.**

 

At December31, 2003, our consolidated balance sheet showed approximately $59,085,000 ofgoodwill and intangible assets, with estimated useful lives of intangibleassets of five years. Commencing January 1, 2002, in accordance with therecently-enacted Statement of Financial Accounting Standards No. 142 “Goodwilland Other Intangible Assets,” such goodwill is no longer being charged ratablyto expense but is subject to at least an annual assessment for impairment. Ouradoption of SFAS 142 has resulted in the discontinuation as of January 1, 2002of amortization of the remaining goodwill balance of approximately $58,205,000,which resulted in a reduction in operating expenses of approximately$18,500,000 for the year ended December 31, 2002. We continue to amortize theremaining unamortized balance of our intangible assets, which was approximately$880,000 at December 31, 2003.

 

**Risks associated with conducting operationsin Israel could materially adversely affect our ability to complete thedevelopment of our fuel cell technology or any of our other technologies.**

 

Our researchand development facilities, our pilot manufacturing facility for catalyst andelectrodes, as well as some of our executive offices and back-office functions,are located in the State of Israel. We are, therefore, directly affected by thepolitical, economic and military conditions in Israel. Any major hostilitiesinvolving Israel or the interruption or curtailment of trade between Israel andany other country, whether due to the Israeli-Palestinian conflict or America’swar against terrorism, among others, could have a material adverse effect onour ability to complete the development of any of our technologies or ourability to supply our technology to development partners, customers or vendors.Furthermore, any interruption or curtailment of trade between Israel and anyother country in which we have strategic relationships could similarlyadversely affect such relationships. In addition, all male adult permanentresidents of Israel under the age of 54, unless exempt, are obligated toperform up to 36 days of military reserve duty annually and are subject tobeing called to active duty at any time under emergency circumstances. Some ofour employees are currently obligated to perform annual reserve duty. We areunable to assess what impact, if any, these factors may have upon our futureoperations.

 

In addition,historically, Israel has suffered from high inflation and the devaluation ofits currency, the New Israeli Shekel, or NIS, compared to the U.S. dollar.Future inflation or further devaluations of the NIS may have a negative impacton our NIS-based obligations over time upon substantial price increases causedby inflation.

 

30

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**It may be difficult to serve process on orenforce a judgment against our Israeli officers and directors, making itdifficult to bring a successful lawsuit against us, or our officers anddirectors, individually or in the aggregate.**

 

Service of process upon our directors and officers, many of whom resideoutside the United States, may be difficult to obtain within the United States.Furthermore, any judgment obtained in the United States against us may not becollectible within the United States to the extent our assets are locatedoutside the United States. This could limit the ability of our stockholders tosue us based upon an alleged breach of duty or other cause of action. We havebeen informed by our Israeli legal counsel that there is doubt as to theenforceability of civil liabilities under the Securities Act of 1933 and theSecurities Exchange Act of 1934 in original actions instituted in Israel.However, subject to limitation, Israeli courts may enforce United States finalexecutory judgments for liquidated amounts in civil matters, obtained after a trialbefore a court of competent jurisdiction, according to the rules of privateinternational law currently prevailing in Israel, which enforce similar Israelijudgments, provided that:

 

•              due service of process has beeneffected and the defendant was given a reasonable opportunity to defend;

 

•              the obligationimposed by the judgment is executionable according to the laws relating to theenforceability of judgments in Israel, such judgment is not contrary to publicpolicy, security or sovereignty of the State of Israel and such judgment isexecutionable in the state in which it was given;

 

•              such judgments were not obtainedby fraud and do not conflict with any other valid judgments in the same mannerbetween the same parties; and

 

•              an action betweenthe same parties in the same matter is not pending in any Israeli court at thetime the lawsuit is instituted in the foreign court.

 

Foreignjudgments enforced by Israeli courts generally will be payable in Israelicurrency, which can then be converted into United States dollars andtransferred out of Israel. The judgment debtor may also pay in dollars.Judgment creditors must bear the risk of unfavorable exchange rates.

 

**We intend to retain all of our futureearnings, if any, for use in our business operations and do not expect to paydividends to our stockholders.**

 

We have notpaid any dividends on our common stock to date and do not anticipate declaringany dividends in the foreseeable future. Our board presently intends to retainall earnings, if any, for use in our business operations.

 

**We currently face and will continue to facesignificant competition.**

 

Our fuel cellsface and will continue to face significant competition. A large number ofcorporations, national laboratories and universities in the United States,Canada, Europe, Japan and elsewhere are actively engaged in the development andmanufacture of power sources, including batteries and fuel cells, both forportable electronic devices and other uses. Each of these competitors has thepotential to capture market share in various markets, which would have amaterial adverse effect on our position in the industry and our financialresults.

 

We expectcompetition to intensify greatly as the need for new energy alternativesbecomes more apparent and continues to increase. Some of our competitors arewell established and have substantially

 

31

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greater managerial, technical,financial, marketing and product development resources. Additionally,companies, both large and small, are entering the markets in which we compete.There can also be no assurance that current and future competitors will not bemore successful in the markets in which we compete than we have been, or willbe in the future. There can be no assurance that we will be successful in sucha competitive environment.

 

**We expect to be dependent on third partysuppliers for the supply of key materials and components for our products.**

 

If and wheneither we or our manufacturing, strategic alliance or joint venture partnerscommence production of our fuel cells or fuel cell products, of which there canbe no assurance, we expect to rely upon third party suppliers to providerequisite materials and components. A supplier’s failure to supply materials orcomponents in a timely manner, or to supply materials and components that meetour quality, quantity or cost requirements, or our inability to obtainsubstitute sources for these materials and components in a timely manner or onterms acceptable to us, could harm our ability to manufacture our fuel cells.We or our manufacturing, strategic alliance or joint venture partners may beunable to obtain comparable materials or components from alternative suppliers,and that could adversely affect our ability to produce viable fuel cells orsignificantly raise the cost of producing fuel cells or fuel cell products.

 

In addition,platinum is a component of our fuel cells. Platinum is a scarce naturalresource and we are dependent upon a sufficient supply of this commodity. Whilewe do not anticipate significant near or long-term shortages in the supply ofplatinum, such shortages could adversely affect our ability to producecommercially viable fuel cells or significantly raise our cost of producingfuel cells.

 

**Forward-LookingStatements**

 

Because wewant to provide you with meaningful and useful information, this Annual Reportcontains certain forward-looking statements that reflect our currentexpectations regarding our future results of operations, performance and achievements.We have tried, wherever possible, to identify these forward-looking statementsby using words such as “anticipate,” “believe,” “estimate,” “expect,” “plan,”“intend” and similar expressions. These statements reflect our current beliefsand are based on information currently available to us. Accordingly, thesestatements are subject to certain risks, uncertainties and contingencies,including the factors set forth under “Risk Factors,” which could cause ouractual results, performance or achievements to differ materially from thoseexpressed in, or implied by, any of these statements. You should not placeundue reliance on any forward-looking statements. Except as otherwise requiredby federal securities laws, we undertake no obligation to release publicly theresults of any revisions to any such forward-looking statements that may bemade to reflect events or circumstances after the date of this Annual Report orto reflect the occurrence of unanticipated events.

 

**Item 7A****.****         Quantitativeand Qualitative Disclosures About Market Risk**

 

### **Impact Of Inflation And Devaluation OnResults Of Operations, Liabilities And Assets**

### ** **

In connectionwith our currency use, we operate in a mixed environment. Payroll is paid inour local currency and the local currency of each of our subsidiaries, such asthe New Israeli Shekel (NIS) with respect to our Israeli-based operations, asare most of our other operating expenses. Consideration for virtually all salesis either in dollars or dollar-linked currency. As a result, not allmonetary assets and all monetary liabilities are linked to the same base in thesame amount at all points in time, which may cause currency fluctuation relatedlosses. In order to help minimize such losses, we currently invest our liquidfunds in both dollar-based and NIS-based assets.

 

32

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For many yearsprior to 1986, the Israeli economy was characterized by high rates of inflationand devaluation of the Israeli currency against the United States dollar andother currencies. Since the institution of the Israeli Economic Program in1985, inflation, while continuing, has been significantly reduced and the rateof devaluation has been substantially diminished. However, Israel effecteddevaluations of the NIS against the dollar as follows:

 
| 1999 |   | (0.17 | )      |
|------|--------|-------|--------|
| 2000 |   | (2.7  | )      |
| 2001 |   | 9.2   |   |
| 2002 |   | 7.3   |   |
| 2003 |   | (7.6  | )      |

 

In 1999 and2000, the rate of inflation in Israel exceeded the rate of devaluation of theNIS against the dollar, but in 1998, 2001 and 2002 the rate of devaluation ofthe NIS against the dollar exceeded the rate of inflation in Israel. In 2003,Israel experienced both price deflation and an appreciation of the NIS againstthe dollar.  In 2003, the rate ofinflation (deflation) in Israel was (1.9)% and the rate of devaluation(appreciation) of the NIS was (7.6)%, against the dollar. Additionally, in2004, through January 31, the rate of inflation in Israel was (2.1)% and therate of devaluation of the NIS was 2.4% against the dollar.

 

### **Impact Of Political And Economic Conditions**

### ** **

The state ofhostility which has existed in varying degrees in Israel since 1948, itsunfavorable balance of payments and its history of inflation and currencydevaluation, all represent uncertainties which may adversely affect ourbusiness.

 

**Item 8.            Financial Statements and Supplementary Data**

## ** **

Ourconsolidated financial statements and corresponding notes thereto called for bythis item appear at the end of this document commencing on page F-1.

 

**Item 9.            Changes in and Disagreements WithAccountants on Accounting and Financial Disclosure**

## ** **

We havepreviously reported in a current report on Form 8-K, dated June 25, 2002, thatwe terminated our engagement of Arthur Andersen LLP.

 

**Item9A.****         Controls and Procedures**

 

Our managementcarried out an evaluation, with the participation of our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures as of December 31, 2003. Based upon that evaluation,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective to ensure that informationrequired to be disclosed by us in reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized andreported, within the time periods specified in the rules and forms of theSecurities and Exchange Commission.

 

There has notbeen any change in our internal control over financial reporting in connectionwith the evaluation required by Rule 13a-15(d) under the Exchange Act thatoccurred during the quarter ended December 31, 2003 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

33

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# **PART III**

# ** **

**Item10.****          Directors and Executive Officers ofthe Registrant**

## ** **

Theinformation required by this Item is incorporated by reference from our ProxyStatement for the 2004 Annual Meeting of Stockholders.

 

**Item11.****          Executive Compensation**

## ** **

Theinformation required by this Item is incorporated by reference from our ProxyStatement for the 2004 Annual Meeting of Stockholders.

 

**Item 12.          Security Ownershipof Certain Beneficial Owners and Management and Related Stockholder Matters**

## ** **

Theinformation required by this Item is incorporated by reference from our ProxyStatement for the 2003 Annual Meeting of Stockholders.

 

**Item 13.          Certain Relationshipsand Related Transactions**

## ** **

Theinformation required by this Item is incorporated by reference from our ProxyStatement for the 2004 Annual Meeting of Stockholders.

 

## **Item 14.**         Principal Accounting Fees and Services

## ** **

Theinformation required by this Item is incorporated by reference from our ProxyStatement for the 2004 Annual Meeting of Stockholders.

 

# **PART IV**

# ** **

## **Item 15.**         Exhibits, Financial StatementSchedules, and Reports on Form 8-K

## ** **

###### (a)           FinancialStatements.

######  

Our financialstatements as set forth in the Index to Consolidated Financial Statementsattached hereto commencing on page F-1 are hereby incorporated by reference.

 

###### (b)           Exhibits.

######  

The followingexhibits, which are numbered in accordance with Item 601 of Regulation S-K, arefiled herewith or, as noted, incorporated by reference herein:

 
| 3.(i)  |   | Restated Certificate of Incorporation of Medis Technologies Ltd. (1)                                                                                    |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.(ii) |   | Restated By-Laws of Medis Technologies Ltd., as amended (1)                                                                                             |
| 4.1    |   | Form of certificate evidencing shares of common stock (1)                                                                                               |
| 10.1*  |   | Medis Technologies Ltd.’s 1999 Stock Option Plan (1)                                                                                               |
| 10.2*  |   | Employment Agreement dated November 2, 2000 between Zvi Rehavi and  Medis El Ltd. (2)                                                                   |
| 10.3*  |   | Employment Agreement dated March 23, 1999 between Israel Fisher and  Medis El Ltd. (2)                                                                  |
| 10.4   |   | Loan Agreement dated as of December 29, 2000 between Fleet National  Bank, as the lender and Medis Technologies Ltd., as the borrower (2)               |
| 10.5   |   | Amendment to Loan Agreement dated October 24, 2002 but effective as  of September 30, 2002 between Medis Technologies Ltd. and Fleet National Bank  (3) |

 

34

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| 10.6    |   | Amendment No. 2 to Loan Agreement dated as of December 29, 2000  between Fleet National Bank, as the lender and Medis Technologies Ltd., as  the borrower, dated February 20, 2003 (4)                                       |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7    |   | Technology Development Agreement dated as of December 14, 1998 by and  between Medis El Ltd. and The Coca-Cola Company (1)                                                                                                   |
| 10.8    |   | Strategic Agreement dated April 5, 2001 by and between General  Dynamics Government Systems Corporation and Medis Technologies Ltd. (2)                                                                                      |
| 10.9    |   | Option Agreement dated November 9, 2000, by and between Medis  Technologies Ltd. and Gennadi Finkelstein, and amendment thereto (2)                                                                                          |
| 10.10   |   | Letter Agreement dated March 14, 2003 by and between Medis  Technologies Ltd. and Gennadi Finkelshtain, amending the exercise terms of  the Option Agreement dated November 9, 2000 and exercising the option in full  (4)   |
| 10.11   |   | Letter Agreement dated June 1, 1993 between Medis El Ltd. and The  Industrial Research and Development Institute of the Chief Scientist’s Office  of the State of Israel (5)                                            |
| 10.12   |   | Agreement dated October 17, 1991 between Bar-Ilan University and  Israel Aircraft Industries Ltd. (5)                                                                                                                        |
| 10.13   |   | Amendment of License dated August 8, 1992 between Bar-Ilan University  and Israel Aircraft Industries Ltd. and Medis El (5)                                                                                                  |
| 10.14   |   | Assignment of License Agreement between Israel Aircraft Industries  between Israel Aircraft Industries Ltd. and Bar-Ilan University dated August  13, 1992 between Israel Aircraft Industries Ltd. and Medis Israel Ltd. (5) |
| 10.15   |   | Letter Agreement dated July 18, 1996 between Medis El Ltd. and  Bar-Ilan University (5)                                                                                                                                      |
| 10.16   |   | Agreement to Employ a Subcontractor dated as of December 11, 2001  between Elbit Systems Ltd. and More Energy Ltd. (5)                                                                                                       |
| 10.17*  |   | Consultancy Agreement dated as of January 2, 2000 between Medis  Technologies Ltd. and Robert K. Lifton (6)                                                                                                                  |
| 10.18*  |   | Consultancy Agreement dated as of January 2, 2000 between Medis  Technologies Ltd. and Howard Weingrow (6)                                                                                                                   |
| 10.19   |   | Amendment No. 3 to Loan Agreement dated December 29, 2000 between  Fleet National Bank, as the lender, and Medis Technologies Ltd., as the  borrower, dated September 30, 2003                                               |
| 10.20** |   | Distribution Agreement dated as of March 9,  2004 by and between ACCO Brands, Inc. through its Kensington Technology  Group, and Medis Technologies Ltd.                                                                     |
| 14.1    |   | Code of Ethics                                                                                                                                                                                                               |
| 21.1    |   | Subsidiaries of the Registrant (5)                                                                                                                                                                                           |
| 23.1    |   | Consent of Arthur Andersen, LLP (7)                                                                                                                                                                                          |
| 23.2    |   | Consent of Ernst & Young LLP                                                                                                                                                                                             |
| 23.3    |   | Consent of Kost Forer Gabay & Kasierer, a member of Ernst &  Young Global                                                                                                                                            |
| 31.1    |   | Rule 13a-14(a)/15d-14(a) certification of Chief Executive Officer                                                                                                                                                            |
| 31.2    |   | Rule 13a-14(a)/15d-14(a) certification of Chief Financial Officer                                                                                                                                                            |
| 32.1    |   | Section 1350 certifications                                                                                                                                                                                                  |

 

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* Management contract or compensatory plan

 

** Portions ofthis document have been submitted to the Secretary of the Securities andExchange Commission for application for "Confidential Treatment."

 

(1)           Filedas an exhibit to the Registration Statement on Form S-1, as amended (FileNo.:  333-83945), of Medis TechnologiesLtd. and incorporated herein by reference.

 

(2)           Filedas an exhibit to the Annual Report on Form 10-K for the year ended December 31,2000 of Medis Technologies Ltd. and incorporated herein by reference.

 

(3)           Filedas an exhibit to the Quarterly Report on Form 10-Q for the quarter endedSeptember 30, 2002 of Medis Technologies Ltd. and incorporated herein byreference.

 

(4)           Filedas an exhibit to the Annual Report on Form 10-K for the year ended December 31,2002 of Medis Technologies Ltd. and incorporated herein by reference.

 

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(5)           Filedas an exhibit to the Registration Statement on Form S-1, as amended (File No.:333-73276), of Medis Technologies Ltd. and incorporated herein by reference.

 

(6)           Filedas an exhibit to the Annual Report on Form 10-K for the year ended December 31,2001 of Medis Technologies Ltd. and incorporated herein by reference.

 

(7)           Theconsolidated financial statements of the Registrant for the year ended December31, 2001 included in this Annual Report on Form 10-K which are incorporated byreference into the Registrant’s Registration Statements on Form S-8(Registration No.: 333-105557), on Form S-4 (Registration No.: 333-107801) andon Form S-3 (Registration Nos.: 333-63874 and 333-112623), have been audited byArthur Andersen LLP, independent public accountants (“AA”). However, afterreasonable efforts, the Registrant has been unable to obtain the writtenconsent of AA with respect to the incorporation by reference of such financialstatements in the Registration Statement. Therefore, the Registrant hasdispensed with the requirement to file the written consent of AA in relianceupon Rule 437a of the Securities Act of 1933, as amended. As a result, you maynot be able to recover damages from AA under Section 11 of the Securities Actof 1933, as amended, for any untrue statements of material fact or anyomissions to state a material fact, if any, contained in the aforementionedfinancial statements of the Registrant which are incorporated in theRegistration Statement by reference.

 

###### (c)           Reportson Form 8-K:

######  

The followingCurrent Report on Form 8-K was filed or furnished with the Securities andExchange Commission during the quarter ended December 31, 2003.

 
| **Date of Report** |   | **Date Report Filed with SEC** |   | **Items Reported**                                      |
|--------------------|--------|--------------------------------|--------|---------------------------------------------------------|
|               |   |                           |   |                                                    |
| November 14, 2003  |   | November 14, 2003              |   | Item 12 (Results of Operations and Financial Condition) |

 

36

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**SIGNATURES**

 

Pursuant tothe 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 theundersigned, thereunto duly authorized.

 
| Dated:  March 11, 2004 | MEDIS TECHNOLOGIES LTD. |
|-----------------------------|-------------------------|
|                        |                    |
|                        |                    |
|                        | By:                     |      /s/ Robert K. Lifton |   |
|                        |                    | Robert K. Lifton |
|                        |                    | Chairman and Chief Executive Officer |
|                             |                         |  |  |  |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**          |   | **Title**                                                                                   |   | **Date**       |
|------------------------|--------|---------------------------------------------------------------------------------------------|--------|----------------|
|                   |   |                                                                                        |   |           |
| /s/ Robert K. Lifton   |   | Chairman and Chief Executive Officer, Secretary and Director (Principal  Executive Officer) |   | March 11, 2004 |
| Robert K. Lifton       |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Howard Weingrow    |   | President, Treasurer and Director                                                           |   | March 11, 2004 |
| Howard Weingrow        |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Israel Fisher      |   | Senior Vice President-Finance (Principal Financial Officer)                                 |   | March 11, 2004 |
| Israel Fisher          |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Jacob Weiss        |   | Senior Vice President-Business Development and Director                                     |   | March 11, 2004 |
| Jacob Weiss            |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Michael S. Resnick |   | Vice President and Controller (Principal Accounting Officer)                                |   | March 11, 2004 |
| Michael S. Resnick     |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Amos Eiran         |   | Director                                                                                    |   | March 11, 2004 |
| Amos Eiran             |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Zeev Nahmoni       |   | Director                                                                                    |   | March 11, 2004 |
| Zeev Nahmoni           |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Jacob E. Goldman   |   | Director                                                                                    |   | March 11, 2004 |
| Jacob E. Goldman       |   |                                                                                        |   |           |
|                   |   |                                                                                        |   |           |
| /s/ Philip Weisser     |   | Director                                                                                    |   | March 11, 2004 |
| Philip Weisser         |   |                                                                                        |   |           |

 

37

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**INDEX**

 
| **Medis Technologies Ltd. Consolidated  Financial Statements**                                |   |
|-----------------------------------------------------------------------------------------------|--------|
|                                                                                          |   |
| Report of Independent Auditors                                                                |   |
|                                                                                          |   |
| Report of Independent Auditors                                                                |   |
|                                                                                          |   |
| Report of Independent Public Accountants                                                      |   |
|                                                                                          |   |
| Consolidated Financial Statements                                                             |   |
|                                                                                          |   |
| Consolidated Balance Sheets as of December 31, 2002 and 2003                                  |   |
|                                                                                          |   |
| Consolidated Statements of Operations for  the years ended December 31, 2001, 2002 and 2003   |   |
|                                                                                          |   |
| Statements of Stockholders’ Equity for the  years ended December 31, 2001, 2002 and 2003 |   |
|                                                                                          |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2001, 2002 and 2003   |   |
|                                                                                          |   |
| Notes to Consolidated Financial Statements                                                    |   |

 

F - 1

----

 

**REPORT OF INDEPENDENT AUDITORS**

** **

To the Boardof Directors and Stockholders of**Medis Technologies Ltd.**

 

We have audited the accompanying consolidated balance sheet of MedisTechnologies Ltd. (a Delaware corporation) and subsidiaries (the“Company”) as of December 31, 2003, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for the year then ended. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.  The consolidated statementsof operations, stockholders’ equity and cash flows for the year ended December31, 2001 were audited by other auditors who have ceased operations and whosereport dated March 25, 2002 expressed an unqualified opinion on thosestatements before the restatement adjustments described in Note G.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financial statements.An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of MedisTechnologies Ltd. and subsidiaries as of December 31, 2003, and theconsolidated results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates.

 

As discussed above, the consolidated statements of operations,stockholders’ equity and cash flows for the year ended December 31, 2001 , wereaudited by other auditors who have ceased operations. As described in Note G-1,on March 11, 2003, the Company completed a rights offering to all of itsexisting stockholders. As a result of this transaction, earnings-per-shareinformation in the financial statements has been adjusted to reflect thetransactions on a retroactive basis. We audited the adjustments that wereapplied to restate the number of shares and per share information reflected inthe 2001 financial statements. Our procedures included (a) agreeing the dataused in the restated computation of number of shares and loss per share todocuments and underlying records obtained from management, and (b) testing themathematical accuracy of the restated number of shares, and loss per share. Inour opinion, such adjustments are appropriate and have been properly applied

 

 However, we were not engaged toaudit, review, or apply any procedures to the 2001 financial statements of theCompany other than with respect to such adjustments and, accordingly, we do notexpress an opinion or any other form of assurance on the 2001 financialstatements taken as a whole.

 

 
|              |   |                                  |
|-------------------|--------|---------------------------------------|
|              |   | Kost Forer Gabay & Kasierer       |
|              |   |                                  |
|              |   | A MEMBER OF  ERNST & YOUNG GLOBAL |
|              |   |                                  |
|              |   |                                  |
| Tel Aviv, Israel  |   |                                  |
| February 26, 2004 |   |                                  |

 

F - 2

----

 

**REPORT OF INDEPENDENT AUDITORS**

** **

To the Boardof Directors and Stockholders of**Medis Technologies Ltd.**

 

We have audited the accompanying consolidated balance sheet of MedisTechnologies Ltd. (a Delaware corporation) and subsidiaries (the“Company”) as of December 31, 2002, and the related consolidated statement ofoperations, stockholders’ equity, and cash flows for the year then ended. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.  The consolidated balancesheet as of December 31, 2001 and the related consolidated statements ofoperations, stockholders’ equity and cash flows for the years ended December31, 2001 and 2000 were audited by other auditors who have ceased operations andwhose report dated March 25, 2002 expressed an unqualified opinion on thosestatements before the restatement adjustments described in Notes E and G.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of MedisTechnologies Ltd. and subsidiaries as of December 31, 2002, and theconsolidated results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates.

 

As discussed above, the consolidated balance sheet as of December 31,2001 and the related consolidated statements of operations, stockholders’equity and cash flows for the years ended December 31, 2001 and 2000, wereaudited by other auditors who have ceased operation. As described in Note G-1,on March 18, 2002 the Company completed a rights offering to all of itsexisting stockholders. As a result of this transaction, earning-per-shareinformation in the financial statements has been adjusted to reflect the transactionon a retroactive basis. We audited the adjustments that were applied to restatethe number of shares and per share information reflected in the 2001 and 2000financial statements. Our procedures included (a) agreeing the data used in therestated computation of number of shares and loss per share to documents andunderlying records obtained from management, and (b) testing the mathematicalaccuracy of the restated number of shares, and loss per share. In our opinion,such adjustments are appropriate and have been properly applied. In addition,as described in Note E, these consolidated financial statements have beenrevised to include the transitional disclosures required by Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,”which was adopted by the Company as of January 1, 2002. Our audit procedureswith respect to the disclosures in Note E with respect to 2001 and 2000included (a) agreeing the previously reported net loss to the previously issuedfinancial statements and the adjustments to reported net loss representingamortization expense recognized in those periods related to goodwill, as aresult of initially applying Statement No. 142 to the Company’s underlyingrecords obtained from management, and (b) testing the mathematical accuracy ofthe reconciliation of adjusted net loss to reported net loss, and the relatedearnings-per-share amounts. In our opinion, the disclosures for 2001 and 2000in Note E are appropriate.

 

F - 3

----

 

However, we were not engaged to audit, review, or apply any proceduresto the 2001 or 2000 financial statements of the Company other than with respectto such adjustments and disclosures and, accordingly, we do not express anopinion or any other form of assurance on the 2001 and 2000 financialstatements taken as a whole.

 

 
|               |   | ERNST &  YOUNG LLP |
|--------------------|--------|------------------------|
|               |   |
| New York, New York |   |
| February 25, 2003  |   |

 

F - 4

----

 

**THISIS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP INCONNECTION WITH MEDIS TECHNOLOGIES LTD.’S FILING OF ITS ANNUAL REPORT ON FORM10-K FOR THE YEAR ENDED DECEMBER 31, 2001. THIS AUDIT REPORT HAS NOT BEENREISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH THIS FILING OF THE ANNUALREPORT ON FORM 10-K OF MEDIS TECHNOLOGIES LTD. SEE THE NOTE TO EXHIBIT 23.1 FORFURTHER INFORMATION.**

 

**REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS**

** **

To the Boardof Directors and Stockholders of**Medis Technologies Ltd.**

 

We have audited the accompanying consolidated balance sheets of MedisTechnologies Ltd. (a Delaware corporation) and subsidiaries as ofDecember 31, 2001 and 2000, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for the years then ended. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of MedisTechnologies Ltd. and subsidiaries as of December 31, 2001 and 2000,and the results of their operations and their cash flows for the years thenended in conformity with accounting principles generally accepted in the UnitedStates.

 
| ARTHUR  ANDERSEN LLP |
|----------------------|
|                 |
| New York,  New York  |
| March 25, 2002  |

 

F - 5

----

 

**MedisTechnologies Ltd. and Subsidiaries**

 

**CONSOLIDATED BALANCE SHEETS**

** **

**(in U.S.dollars)**

 
|                                                                                                                                                                    |   | **December 31,** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|------------|
|                                                                                                                                                                    |   | **2002**         |       | **2003** |   |
| **ASSETS**                                                                                                                                                              |   |             | ** ** |   | ** ** |
| Current assets                                                                                                                                                          |   |             | ** ** |   | ** ** |
| Cash and cash equivalents                                                                                                                                               |   | $                | 6,036,000  | ** ** | **$** | **6,620,000** | ** ** |
| Accounts receivable—trade, net                                                                                                                                     |   | *—*         | ** ** | **74,000** | ** ** |
| Accounts receivable—other                                                                                                                                          |   | 50,000           | ** ** | **237,000** | ** ** |
| Prepaid expenses and other current assets                                                                                                                               |   | 52,000           | ** ** | **110,000** | ** ** |
| Total current assets                                                                                                                                                    |   | 6,138,000        | ** ** | **7,041,000** | ** ** |
| Property and equipment, net (Note D)                                                                                                                                    |   | 1,199,000        | ** ** | **1,470,000** | ** ** |
| Goodwill, net (Note E)                                                                                                                                                  |   | 58,205,000       | ** ** | **58,205,000** | ** ** |
| Intangible assets, net (Note E)                                                                                                                                         |   | 832,000          | ** ** | **880,000** | ** ** |
| Long-term note (Note C)                                                                                                                                                 |   | *—*         | ** ** | **158,000** | ** ** |
| Severance pay fund (Note B)                                                                                                                                             |   | 497,000          | ** ** | **697,000** | ** ** |
| Other assets (Note C)                                                                                                                                                   |   | 520,000          | * *   | *—* | * * |
| Total assets                                                                                                                                                            |   | $                | 67,391,000 | ** ** | **$** | **68,451,000** | ** ** |
|                                                                                                                                                                    |   |             |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                           |   |             | ** ** |   | ** ** |
| Current liabilities                                                                                                                                                     |   |             | ** ** |   | ** ** |
| Accounts payable                                                                                                                                                        |   | $                | 128,000    | ** ** | **$** | **323,000** | ** ** |
| Accrued expenses and other current liabilities (Note F)                                                                                                                 |   | 973,000          | ** ** | **958,000** | ** ** |
| Total current liabilities                                                                                                                                               |   | 1,101,000        | ** ** | **1,281,000** | ** ** |
| Accrued severance pay (Note B)                                                                                                                                          |   | 885,000          | ** ** | **1,193,000** | ** ** |
| Commitments and contingent liabilities (Note H)                                                                                                                         |   |             | ** ** |   | ** ** |
| Stockholders’ equity (Note G)                                                                                                                                      |   |             | ** ** |   | ** ** |
| Preferred stock, $.01 par value; 10,000 shares authorized; none  issued                                                                                                 |   | *—*         | * *   | *—* | * * |
| Common stock, $.01 par value; 35,000,000 shares authorized;  21,102,301 and 24,538,268 shares issued and outstanding, at December 31,  2002 and 2003, respectively |   | 211,000          | ** ** | **245,000** | ** ** |
| Additional paid-in capital                                                                                                                                              |   | 161,584,000      | ** ** | **173,185,000** | ** ** |
| Accumulated deficit                                                                                                                                                     |   | (96,390,000      | )          | **(107,453,000** | **)** |
| Total stockholders’ equity                                                                                                                                         |   | 65,405,000       | ** ** | **65,977,000** | ** ** |
| Total liabilities and stockholders’ equity                                                                                                                         |   | $                | 67,391,000 | ** ** | **$** | **68,451,000** | ** ** |

 

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F - 6

----

 

**MedisTechnologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED STATEMENTS OF OPERATIONS**

** **

**(in U.S.dollars)**

 
|                                                                                            |   | **Year ended December 31,** |        |
|-------------------------------------------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                                                            |   | **2001**                    |        | **2002** |   | **2003** |   |
|                                                                                            |   |                        |        |   |   |   |   |
| Sales                                                                                           |   | $                           | —      |   | $ | 192,000 |   | **$** | **131,000** | ** ** |
| Cost of sales                                                                                   |   | —                      |        | 130,000 |   | **46,000** | ** ** |
|                                                                                            |   |                        | ** **  |   |   |   | ** ** |
| Gross profit                                                                                    |   | —                      |        | 62,000 |   | **85,000** | ** ** |
| Operating expenses                                                                              |   |                        | ** **  |   |   |   | ** ** |
| Research and development costs, net (Note H-6)                                                  |   | $                           | 4,251,000   |   | $ | 4,161,000 |   | **$** | **5,010,000** | ** ** |
| Selling, general and administrative expenses                                                    |   | 6,297,000                   |        | 3,642,000 |   | **3,991,000** | ** ** |
| Amortization of intangible assets                                                               |   | 21,129,000                  |        | 2,633,000 |   | **997,000** | ** ** |
| Total operating expenses                                                                        |   | 31,677,000                  |        | 10,436,000 |   | **9,998,000** | ** ** |
| Loss from operations                                                                            |   | (31,677,000                 | )           | (10,374,000 | ) | **(9,913,000** | **)** |
| Other income (expenses)                                                                         |   |                        | ** **  |   |   |   | ** ** |
| Interest income                                                                                 |   | 178,000                     |        | 151,000 |   | **131,000** | ** ** |
| Interest and other expense                                                                      |   | (63,000                     | )           | (82,000 | ) | **(55,000** | **)** |
|                                                                                            |   | 115,000                     |        | 69,000 |   | **76,000** | ** ** |
|                                                                                            |   |                        |        |   |   |   |   |
| NET LOSS                                                                                        |   | (31,562,000                 | )           | (10,305,000 | ) | **(9,837,000** | **)** |
| Value of warrants (Note G)                                                                      |   | (3,204,000                  | )           | (2,241,000 | ) | **(1,226,000** | **)** |
| Net loss attributable to common stockholders                                                    |   | $                           | (34,766,000 | ) | $ | (12,546,000 | ) | **$** | **(11,063,000** | **)** |
|                                                                                            |   |                        |        |   |   |   |   |
| Basic and diluted net loss per share (Note B)                                                   |   | $                           | (1.68       | ) | $ | (.57 | ) | **$** | **(.47** | **)** |
|                                                                                            |   |                        |        |   |   |   |   |
| Weighted-average common shares used in computing basic and diluted  net loss per share (Note B) |   | 20,720,362                  |        | 21,897,871 |   | **23,429,829** | ** ** |

 

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F - 7

----

 

**MedisTechnologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

** **

**(in U.S.dollars)**

 
|                                                                             |   | **Common Stock** |       | **Additional  Paid-in Capital** |        | **Accumulated  Deficit** |       | **Deferred Stock  Compensation  Costs** |       | **Total  Stockholders’  Equity** |             |
|----------------------------------------------------------------------------------|--------|------------------|------------|---------------------------------|-------------|--------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------------|
|                                                                             |   | **Shares**       | ** ** | **Amount**                      | ** **  | ** **               | ** ** | ** **                              | ** ** |
| Balance at December 31, 2000                                                     |   | 16,830,991       |       | $                               | 168,000     |                     | $          | 136,819,000                             |       | $                                     | (49,078,000      | ) | $ | (1,767,000 | ) | $ | 86,142,000 |   |
| Net loss                                                                         |   | —           |       | —                          |        | —                   |       | (31,562,000                             | )          | —                                |             | (31,562,000 | ) |
| Issuance of common stock                                                         |   | 701,788          |       | 7,000                           |        | 10,383,000               |       | —                                  |       | —                                |             | 10,390,000 |   |
| Stock options granted to a director                                              |   | —           |       | —                          |        | 138,000                  |       | —                                  |       | —                                |             | 138,000 |   |
| Amortization of deferred stock compensation                                      |   | —           |       | —                          |        | —                   |       | —                                  |       | 1,645,000                             |             | 1,645,000 |   |
| Stock options and warrants granted to consultants                                |   | —           |       | —                          |        | 159,000                  |       | —                                  |       | —                                |             | 159,000 |   |
| Extension of stock options granted to employees,  directors and consultants |   | —           |       | —                          |        | 1,554,000                |       | —                                  |       | —                                |             | 1,554,000 |   |
| Extension of warrants granted to stockholders                                    |   | —           |       | —                          |        | 3,204,000                |       | (3,204,000                              | )          | —                                |             | — |   |
| Extension of warrants granted to consultants                                     |   | —           |       | —                          |        | 168,000                  |       | —                                  |       | —                                |             | 168,000 |   |
| Balance at December 31, 2001                                                     |   | 17,532,779       |       | 175,000                         |        | 152,425,000              |       | (83,844,000                             | )          | (122,000                              | )                | 68,634,000 |   |
| Net loss                                                                         |   | —           |       | —                          |        | —                   |       | (10,305,000                             | )          | —                                |             | (10,305,000 | ) |
| Issuance of common stock pursuant to rights offering                             |   | 3,500,000        |       | 35,000                          |        | 6,504,000                |       | —                                  |       | —                                |             | 6,539,000 |   |
| Issuance of common stock                                                         |   | 69,522           |       | 1,000                           |        | 323,000                  |       | —                                  |       | —                                |             | 324,000 |   |
| Amortization of deferred stock compensation                                      |   | —           |       | —                          |        | —                   |       | —                                  |       | 122,000                               |             | 122,000 |   |
| Stock options granted to consultants                                             |   | —           |       | —                          |        | 91,000                   |       | —                                  |       | —                                |             | 91,000 |   |
| Value of warrants issued pursuant Shareholder Loyalty Program                    |   | —           |       | —                          |        | 2,241,000                |       | (2,241,000                              | )          | —                                |             | — |   |
|                                                                             |   |             |       |                            |        |                     |       |                                    |       |                                  |             |   |   |
| Balance at December 31, 2002                                                     |   | 21,102,301       |       | 211,000                         |        | 161,584,000              |       | (96,390,000                             | )          | —                                |             | 65,405,000 |   |
| Net loss                                                                         |   | —           |       | —                          |        | —                   |       | (9,837,000                              | )          | —                                |             | (9,837,000 | ) |
| Issuance of common stock pursuant to rights offering                             |   | 2,325,600        |       | 23,000                          |        | 4,855,000                |       | —                                  |       | —                                |             | 4,878,000 |   |
| Issuance of common stock pursuant to offer to exchange and exercise              |   | 839,966          |       | 8,000                           |        | 3,601,000                |       | —                                  |       | —                                |             | 3,609,000 |   |
| Issuance of common stock in acquisition of minority interestof  subsidiary       |   | 120,000          |       | 1,000                           |        | 524,000                  |       | —                                  |       | —                                |             | 525,000 |   |
| Issuance of common stock                                                         |   | 150,401          |       | 2,000                           |        | 803,000                  |       | —                                  |       | —                                |             | 805,000 |   |
| Stock options granted to directors                                               |   | —           |       | —                          |        | 131,000                  |       | —                                  |       | —                                |             | 131,000 |   |
| Stock options and warrants granted to consultants                                |   | —           |       | —                          |        | 461,000                  |       | —                                  |       | —                                |             | 461,000 |   |
| Value of warrants issued pursuant to offer to exchange and exercise              |   | —           |       | —                          |        | 1,226,000                |       | (1,226,000                              | )          | —                                |             | — |   |
|                                                                             |   |             |       |                            |        |                     |       |                                    |       |                                  |             |   |   |
| **Balance at December 31, 2003**                                                 |   | **24,538,268**   | ** ** | **$**                           | **245,000** | ** **               | **$**      | **173,185,000**                         | ** ** | **$**                                 | **(107,453,000** | **)** | **$** | **—** | ** ** | **$** | **65,977,000** | ** ** |

 

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F - 8

----

 

**MedisTechnologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 

**(in U.S.dollars)**

 
|                                                                        |   | **Year ended December 31,** |        |
|-----------------------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                                        |   | **2001**                    |        | **2002** |   | **2003** |   |
| Cash flows from operating activities                                        |   |                        | ** **  |   |   |   | ** ** |
| Net loss                                                                    |   | $                           | (31,562,000 | ) | $ | (10,305,000 | ) | **$** | **(9,837,000** | **)** |
| Adjustments to reconcile net loss to net cash used in operating  activities |   |                        | ** **  |   |   |   | ** ** |
| Depreciation and amortization of property and equipment                     |   | 587,000                     |        | 256,000 |   | **305,000** | ** ** |
| Amortization of intangible assets                                           |   | 21,129,000                  |        | 2,633,000 |   | **997,000** | ** ** |
| Non-cash compensation expense                                               |   | 3,664,000                   |        | 213,000 |   | **592,000** | ** ** |
| Loss from sale of property and equipment                                    |   | 4,000                       |        | 11,000 |   | — |   |
| Changes in operating assets and liabilities                                 |   |                        | ** **  |   |   |   | ** ** |
| Accounts receivable—trade                                              |   | —                      |        | — |   | **(74,000** | **)** |
| Accounts receivable—other                                              |   | 154,000                     |        | 24,000 |   | **(187,000** | **)** |
| Prepaid expenses and other current assets                                   |   | 36,000                      |        | 157,000 |   | **(58,000** | **)** |
| Accounts payable                                                            |   | 26,000                      |        | (37,000 | ) | **195,000** | ** ** |
| Accrued expenses and other current liabilities                              |   | 125,000                     |        | 151,000 |   | **(15,000** | **)** |
| Accrued severance pay, net                                                  |   | 49,000                      |        | 115,000 |   | **108,000** | ** ** |
|                                                                        |   |                        |        |   |   |   |   |
| Net cash used in operating activities                                       |   | (5,788,000                  | )           | (6,782,000 | ) | **(7,974,000** | **)** |
|                                                                        |   |                        |        |   |   |   |   |
| Cash flows from investing activities                                        |   |                        | ** **  |   |   |   | ** ** |
| Capital expenditures                                                        |   | (799,000                    | )           | (263,000 | ) | **(576,000** | **)** |
| Acquisition of option to acquire shares of a majority-owned  subsidiary     |   | (520,000                    | )           | — |   | — |   |
| Proceeds from disposition of property and equipment                         |   | 25,000                      |        | 25,000 |   | — |   |
| Long-term note.                                                             |   | —                      |        | — |   | **(158,000** | **)** |
|                                                                        |   |                        |        |   |   |   |   |
| Net cash used in investing activities                                       |   | (1,294,000                  | )           | (238,000 | ) | **(734,000** | **)** |
| Cash flows from financing activities                                        |   |                        | ** **  |   |   |   | ** ** |
| Proceeds from issuance of common stock, net                                 |   | 10,390,000                  |        | 7,057,000 |   | **9,292,000** | ** ** |
| Deferred costs related to issuance common stock                             |   | (194,000                    | )           | — |   | — |   |
|                                                                        |   |                        |        |   |   |   |   |
| Net cash provided by financing activities                                   |   | 10,196,000                  |        | 7,057,000 |   | **9,292,000** | ** ** |
|                                                                        |   |                        |        |   |   |   |   |
| Net increase in cash and cash equivalents                                   |   | 3,114,000                   |        | 37,000 |   | **584,000** | ** ** |
|                                                                        |   |                        |        |   |   |   |   |
| Cash and cash equivalents at beginning of year                              |   | 2,885,000                   |        | 5,999,000 |   | **6,036,000** | ** ** |
|                                                                        |   |                        |        |   |   |   |   |
| Cash and cash equivalents at end of year                                    |   | $                           | 5,999,000   |   | $ | 6,036,000 |   | **$** | **6,620,000** | ** ** |

 

F - 9

----

 
|                                                                                                                  |   | **Year ended December 31,** |       |
|-----------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                                                  |   | **2001**                    |       | **2002** |   | **2003** |   |
| Supplemental disclosures of cash flow information:                                                                    |   |                        | ** ** |   | ** ** |   | ** ** |
| Cash paid during the year for:                                                                                        |   |                        | ** ** |   | ** ** |   | ** ** |
| Interest                                                                                                              |   | $                           | 24,000     |   | $ | 24,000 | ** ** | **$** | **32,000** | ** ** |
| Non-cash investing and financing activities:                                                                          |   |                        | ** ** |   | ** ** |   | ** ** |
| Acquisition of shares of majority-owned   purchase price allocated to intangible assets (see  Note C): |   | —                      |       | — | ** ** | **$** | **1,045,000** | ** ** |
| Financed as follows:                                                                                                  |   |                        | ** ** |   | ** ** |   | ** ** |
| Issuance of Common Stock                                                                                              |   | —                      |       | — | ** ** | **$** | **525,000** | ** ** |
| Cost of option purchased in prior period                                                                              |   | —                      |       | — | ** ** | **$** | **520,000** | ** ** |
| Value of extension of stockholder warrants  (see Note G)                                                         |   | $                           | 3,204,000  |   | — |   | — |   |
| Value of warrants issued pursuant to shareholder loyalty program (see  Note G)                                        |   | —                      |       | $ | 2,241,000 |   | — |   |
| Value of warrants issued pursuant offer to exchange and exercise (see  Note G)                                        |   | —                      |       | — | ** ** | **$** | **1,226,000** | ** ** |

 

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F - 10

----

 

**Medis Technologies Ltd. and Subsidiaries**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**December 31, 2001, 2002 and 2003**

 

# **NOTE A—NATUREOF BUSINESS AND GENERAL MATTERS**

# ** **

Medis Technologies Ltd. (“MTL”), a Delaware corporation, is aholding company, which through its wholly-owned subsidiaries, MedisEl Ltd. (“Medis El”) and More Energy Ltd. (“More Energy”) (collectively,the “Company”), engages in research and development of technology products tolicense, sell, or enter into joint ventures with large corporations. The Company’sprimary business focus is on the advanced development, manufacturing, marketingand distribution of direct liquid fuel cell products for portable electronicdevices. Included in this category are the most modern cell phones with afull range of functionality, digital cameras, PDAs, MP3 players, other deviceswith similar power requirements and a broad array of military devices. The Company’s other technologies, which are in various stages of development,include the CellScan, inherently conductive polymers, the toroidal engine,stirling cycle system, and the Rankin cycle linear compressor.

 

Since inception, the Company has incurred operating losses and has usedcash in its operations. Accordingly, the Company has relied on externalfinancing, principally through the sale of its stock, to fund its research anddevelopment activities. The Company believes this dependence will continueunless it is able to successfully develop and market its technologies. OnSeptember 30, 2003, the Company entered into a third amendment to the agreementgoverning its existing $5,000,000 revolving credit line. Pursuant to theamendment, the termination date of the revolving credit line was extended fromJuly 1, 2004 to July 1, 2005. No other terms of the agreement were amended bythe amendment. Any outstanding balances would be collateralized by all depositswith the bank and an assignment of certain leases owned by a partnership inwhich the Company’s chief executive officer and its president are partners.  Additionally, the Company’s chief executiveofficer and its president have personally guaranteed any amounts due under suchcredit line. As of December 31, 2003, the Company had not borrowed any fundsunder this credit line.

 

In January2004, the Company issued 1,425,000 shares of its common stock in private salesto institutional investors, for gross proceeds aggregating $14,588,000, lessrelated costs of approximately $257,000.

 

See Note C for discussion of acquisitions of minority interests.

 

# **NOTEB—SIGNIFICANT ACCOUNTING POLICIES**

# ** **

The Company’s consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The significant accountingpolicies followed in the preparation of the consolidated financial statements,applied on a consistent basis, are as follows:

 

## *1. Principles of Consolidation*

## * *

The consolidated financial statements include the accounts of MTL andits wholly-owned subsidiaries. All significant intercompany transactionsand balances have been eliminated.

 

## *2. Cash and Cash Equivalents*

## * *

Cash and cash equivalents consist of cash and highly liquid investmentswith a maturity of three months or less when purchased.

 

F - 11

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## *3. Research and Development Costs*

## * *

Research and development costs are charged to operations as incurred.Amounts funded to the Company under Federal Government contractor-related fixedprice, best efforts, research and development arrangements are recognized asoffsets to research and development expense.

 

## *4. Use of Estimates*

## * *

In preparing the Company’s consolidated financial statements inconformity with accounting principles generally accepted in the United States,management is required to make estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingent assetsand liabilities at the date of the financial statements, and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.

 

## *5. Fair Value of Financial Instruments*

## * *

The carrying value of all financial instruments potentially subject tovaluation risk (principally consisting of cash and cash equivalents, accountsreceivable, accounts payable and accrued expenses and other currentliabilities) approximates their fair value.

 

## *6. Translation of Foreign Currencies*

## * *

The financial statements of foreign subsidiaries have been prepared inU.S. dollars, as the dollar is their functional currency. Most of the Company’srevenues are generated in U.S. dollars. Additionally, a substantial portion ofthe Company’s costs are incurred in dollars. The Company’s management believesthat the dollar is the primary currency of the economic environment in whichthe Company operates.

 

Accordingly, monetary accounts maintained in currencies other than thedollar are remeasured into U.S. dollars in accordance with Statement of theFinancial Accounting Standards (“SFAS”) No. 52 “Foreign Currency Translation”(“SFAS No. 52”). All transaction gains and losses of the remeasured, monetarybalance sheet items are reflected in the statement of operations as financialincome or expense, as appropriate.

 

*7. Property and Equipment*

 

Property and equipment are stated at cost, net of accumulated depreciationand amortization, and net of investment grants from the State of Israel.Depreciation is provided on the straight-line basis over the estimated usefullives of such assets. The Company periodically assesses the recoverability ofthe carrying amount of property and equipment in accordance with SFAS No. 144,Accounting for Impairment or Disposal of Long-Lived Assets, and provides forany possible impairment loss based upon the difference between the carryingamount and fair value of such assets. As of December 31, 2002 and 2003 noimpairment losses have been identified.

 

F - 12

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The estimated useful lives of property and equipment are as follows: 

 
|                           |   | **Useful Lives  In Years** |   |
|--------------------------------|--------|----------------------------|--------|
|                           |   |                       |   |
| Machinery and equipment        |   | 3-10                       |   |   |
| Computers                      |   | 3-5                        |   |   |
| Furniture and office equipment |   | 7-15                       |   |   |
| Vehicles                       |   | 7                          |   |   |
| Leasehold improvements         |   | 2-10                       |   |   |

## * *

## *8. Stock-based Compensation*

## * *

SFAS No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure” (“SFAS No. 148”) amends SFAS No. 123, “Accounting for Stock-BasedCompensation” (“SFAS No.123”) to provide alternative methods of transition fora voluntary change to the fair value based methods of accounting forstock-based employee compensation. In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require more prominent disclosuresin both annual and interim financial statements about the method of accountingfor stock-based employee compensation and the effect of the method used onreported results.

 

As provided for in SFAS No. 148, the Company has elected to continue tofollow Accounting Principles Board Opinion No. 25 (“APB No. 25”),“Accounting for Stock Issued to Employees,” and FASB Interpretation No. 44,“Accounting for Certain Transactions Involving Stock Compensation” inaccounting for its employee stock options, under which compensation expense, ifany, is generally based on the difference between the exercise price of anoption or the amount paid for the award and the market price or fair value ofthe underlying common stock at the date of the grant. To the extent thatcompensation expense is recognized with respect to stock options issued toemployees or directors, such expense is amortized over the vesting period ofsuch options. Stock-based compensation arrangements involving non-employees ornon-directors are accounted for under SFAS No. 123 and Emerging Issues TaskForce No. 96-18, “Accounting for Equity Instruments That Are Issued to OtherThan Employees for Acquiring, or in Conjunction with Selling, Goods orServices” (“EITF No. 96-18”), under which such arrangements are accounted forbased on the fair value of the option or award.

 

F - 13

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Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant dates for all awards, theCompany’s net loss attributable to common stockholders and basic and dilutednet loss per share would have been the pro forma amounts indicated below:

 
|                                                                                        |   | **Year ended December 31,** |        |
|---------------------------------------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                                                        |   | **2001**                    |        | **2002** |   | **2003** |   |
| Net loss attributable to common stockholders for the year as reported                       |   | $                           | (34,766,000 | ) | $ | (12,546,000 | ) | **$** | **(11,063,000** | **)** |
| Add: Stock-based employee compensation expense included in the  reported loss               |   | 3,171,000                   |        | 122,000 |   | **131,000** | ** ** |
| Deduct: Stock-based employee compensation expense determined under  fair value based method |   | (6,157,000                  | )           | (4,976,000 | ) | **(1,150,000** | **)** |
| Pro forma net loss attributable to common shareholders                                      |   | $                           | (37,752,000 | ) | $ | (17,400,000 | ) | **$** | **(12,082,000** | **)** |
| Basic and diluted net loss per share as reported (Note B)                                   |   | $                           | (1.68       | ) | $ | (.57 | ) | **$** | **(.47** | **)** |
| Pro forma net loss per share                                                                |   | $                           | (1.82       | ) | $ | (.80 | ) | **$** | **(.52** | **)** |

 

The fair value of each option granted is estimated on the date of thegrant using the Black-Scholes option pricing model with the following weightedaverage assumptions:

 
|                    |   | **2001** |   | **2002** |   | **2003** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
|                    |   |     |   |     |   |     |   |
| Dividend yield          |   | 0        | %      | 0        | %      | 0        | %      |
| Risk-free interest rate |   | 2.50     | %      | 2.50     | %      | 2.50     | %      |
| Expected life in years  |   | 1-2      |   | 1-2      |   | 1-2      |   |
| Volatility              |   | 95       | %      | 94       | %      | 82-95    | %      |

 

The average fair value of each option granted in 2001, 2002 and 2003was $7.30, $3.06 and $1.82, respectively.

 

F - 14

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## *9. Goodwill*

## * *

SFAS No. 142, “Goodwill and Other IntangibleAssets” (“SFAS No. 142”) provides that goodwill acquired in a businesscombination on or after July 1, 2001 not be amortized and goodwill arising fromacquisitions prior to July 1, 2001 be amortized until December 31, 2001, on astraight-line basis. Rather than amortizing goodwill, SFAS No. 142 requires thatgoodwill be tested for impairment on adoption of the pronouncement and at leastannually thereafter, or more often in certain circumstances. Any impairmentfound in such tests would result in a write-down of the goodwill balance.Goodwill that has been attributed to reporting units is tested for impairmentby comparing the fair value of each reporting unit with its carrying value.Fair values are determined using discounted cash flows, market multiples andmarket capitalization. Significant estimates used in the methodologies includeestimates of future cash flows, future short-term and long-term growth rates,weighted average cost of capital and estimates of market multiples for each ofthe reportable units. As of December 31, 2003, the Company has not identifiedany goodwill impairment losses (see Note E).

 

*10. Intangible Assets*

 

Intangible assets subject to amortizationarising from acquisitions prior to July 1, 2001 are being amortized on astraight-line over their useful lives, in accordance with APB Opinion No. 17,“Intangible Assets.” Intangible assets acquired on or after July 1, 2001, arebeing amortized over their useful lives using a method of amortization thatreflects the pattern in which the economic benefits of the intangible assetsare consumed or otherwise used up, in accordance with SFAS No. 142. The Companyamortizes its intangible technology assets on a straight-line basis overperiods of three to five years.

 

*11. Impairment of Long-Lived Assets*

 

The Company periodically assesses the recoverabilityof the carrying amounts of property and equipment in accordance with SFAS No.144, “Accounting for Impairment or Disposal of Long-Lived Assets,” and providesfor any possible impairment loss based upon the difference between the carryingamount and fair value of such assets. As of December 31, 2002 and 2003, noimpairment losses have been identified.

 

*12. Revenue Recognition*

 

Revenues relating to development servicesagreements are recognized as services are rendered over the term of theagreement. Revenues from products are recognized upon delivery provided thereis persuasive evidence of an agreement, the amount is fixed or determinable andcollection of the related receivable is probable. Amounts billed and/orreceived where revenue recognition criteria have not been fully met, and thusthe revenue is not yet earned, are reflected as liabilities and are offsetagainst the related receivable.

 

F - 15

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## *13. Net Loss Per Share*

## * *

The Company computes net loss per share in accordance with SFASNo. 128, “Earnings Per Share” (“SFAS No. 128”). Under the provisions ofSFAS No. 128, basic net loss per share is computed by dividing the netloss for the period by the weighted-average number of common shares outstandingduring the period. Diluted net loss per share is computed by dividing the netloss for the period by the weighted-average number of common shares andcommon equivalent shares outstanding during the period. However, as the Companygenerated net losses in all periods presented, potentially diluted securities,composed of incremental common shares issuable upon the exercise of warrantsand stock options, are not reflected in diluted net loss per share because suchshares are antidilutive. The total number of shares related to the outstandingoptions and warrants excluded from the calculation of diluted net loss pershare was 3,715,618,  5,111,097 and5,038,271 as of December 31,  2001, 2003and 2003, respectively.

 

In accordance with SFAS No. 128, the Company has adjusted its netloss per share for the year ended December 31, 2001 to give retroactive effectto shares issued in its March 18, 2002 and March 11, 2003 rights offerings (seeNote G-1) and has adjusted its net loss per share for years ended December 31,2002 to give retroactive effect to shares issued in its March 11, 2003 rightsoffering (see Note G-1). Accordingly, as a result of such retroactiveadjustments, the net loss per share decreased from $(2.02) to $(1.68), or$(.34) per share, and from $(.60) to $(.57), or $(.03) per share, for the yearsended December 31, 2001 and 2002, respectively (see Note G-1).

 

## *14. Severance Pay*

## * *

The liability of the Company’s subsidiaries in Israel for severancepay, which comprises the Company’s entire severance pay obligation, iscalculated pursuant to Israeli severance pay law based on the most recentsalary of the employees multiplied by the number of years of employment, as ofthe balance sheet date. Employees are entitled to one month’s salary for eachyear of employment or a portion thereof. The liability for all of its employeesin Israel is fully provided by monthly deposits with insurance companies andother financial institutions and by an accrual. The deposited funds includeprofits accumulated up to the balance sheet date. The deposited funds may bewithdrawn only upon the fulfillment of the obligation pursuant to Israeliseverance pay law or labor agreements. The value of these deposited funds isrecorded as an asset in the Company’s consolidated balance sheets.

 

Severance expenses for the years ended December 31, 2001, 2002 and 2003amounted to approximately $293,000, $261,000 and $290,000 respectively.

 

Comparative data in these financial statements has been reclassified toconform with current year’s presentation.

 

F - 16

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* 15.Segment Information*

 

The Company has adopted SFAS No. 131, “Disclosures About Segmentsof an Enterprise and Related Information,” which establishes standards for theway companies report information about operating segments in annual financialstatements. It also establishes standards for related disclosures aboutproducts and services, geographic areas and major customers. The Company hasdetermined that it does not have any separately reportable business segments,but does operate in two geographic areas, the United States and Israel.

 

MTL’s foreign subsidiaries had net losses of approximately $7,191,000,$6,201,000 and $7,018,000 for the years ended December 31, 2001, 2002 and 2003,respectively. MTL’s foreign subsidiaries had total assets of approximately$1,603,000 and $2,127,000 at December 31, 2002 and 2003, respectively.

 

## *16. Income Taxes*

## * *

Deferred income taxes are provided for differences between financialstatement and income tax basis of assets and liabilities using enacted taxrates in effect in the years in which the differences are expected to reverse.The Company provides a valuation allowance on net deferred tax assets when itis more likely than not that such assets will not be realized.

 

## *17. Concentration of Credit Risk*

## * *

Financial instruments that potentially subject the Company toconcentrations of credit risk consist principally of cash and cash equivalents.Cash equivalents are primarily invested in bank short-term investments,on-demand insurance contracts and money market funds. Management believes thatthe institutions that hold the Company’s cash and cash equivalents arefinancially sound and, accordingly, minimal credit risk exists with respect tothese investments.

 

Sales to two customers during 2002 were in excess of 10% (approximately72% and 28%) of the Company’s revenue and in the aggregate amounted to 100% oftotal revenue in 2002. In 2003, sales to one customer amounted to 100% of totalrevenues.

 

F - 17

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*18. RecentPronouncements*

 

In January 2003, the Financial Accounting Standards Board (FASB) issuedInterpretation 46, Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51 (FIN 46). In December 2003, the FASB modified FIN46 to make certain technical corrections and address certain implementationissues that had arisen. FIN 46 provides a new framework for identifyingvariable interest entities (VIEs) and determining when a company should includethe assets, liabilities, noncontrolling interests and results of activities ofa VIE in its consolidated financial statements.

 

In general, a VIE is a corporation, partnership, limited-liabilitycorporation, trust or any other legal structure used to conduct activities orhold assets that either (1) has an insufficient amount of equity to carry outits principal activities without additional subordinated financial support, (2)has a group of equity owners that are unable to make significant decisionsabout its activities, or (3) has a group of equity owners that do not have theobligations to absorb losses or the right to receive returns generated by itsoperations.

 

FIN 46 requires a VIE to be consolidated if a party with an ownership,contractual or other financial interest in the VIE (a variable interest holder)is obligated to absorb a majority of the risk of loss from the VIE’sactivities, is entitled to receive a majority of the VIE’s residual returns (ifno party absorbs a majority of the VIE’s losses) or both. A variable interestholder that consolidates the VIE is called the primary beneficiary. Uponconsolidation, the primary beneficiary generally must initially record all ofthe VIE’s assets, liabilities and noncontrolling interests at fair value andsubsequently account for the VIE as if it were consolidated based on a majorityvoting interest. FIN 46 also requires disclosures about VIEs that the variableinterest holder is not required to consolidate but in which it has asignificant variable interest.

 

The Company does not believe that it has any interests in any variableinterest entities.

 

# **NOTEC—EXCHANGE OFFER AND ACQUISITION OF MINORITY INTERESTS**

# ** **

On April 24, 2000, MTL commenced an offer for the approximately36% of Medis El it did not already beneficially own, offering 1.37 of itsshares of common stock for each ordinary share tendered (the “Exchange Offer”).In accordance with Accounting Principles Board Opinion (“APB”) No. 16 andEmerging Issues Task Force Issue No. 99-12, the Company accounted for theexchange using the purchase method. Accordingly, the Company calculated thepurchase price of the 3,825,910 shares and 184,000 options of Medis El notowned by it based on the market price of Medis El ordinary shares. Such purchaseprice was $89,393,000. The Company allocated the excess of purchase price overnet assets acquired to goodwill ($81,867,000), CellScan technology assets($6,071,000) and in-process research and development for the fuel cells,stirling cycle and toroidal engine projects, which was charged to research anddevelopment expense on the acquisition date ($561,000). Such allocation wasbased on a valuation using the cost method, which represents the fair value ofthe assets underlying each project.

 

F - 18

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The Company amortizes the acquired technology assets over theirremaining useful lives of three years, and, through December 31, 2001, theCompany had amortized its goodwill over five years. In accordance with SFAS 142“Goodwill and Other Intangible Assets,” the Company discontinued amortizationof its goodwill beginning on January 1, 2002. Furthermore, in accordance withSFAS 142, the Company performs an annual assessment for impairment of itsgoodwill (see Note E). During the years ended December 31, 2001, 2002 and2003, the Company recorded amortization expense aggregating approximately$18,397,000, $2,024,000 and $812,000, respectively, related to thistransaction.

 

From January to June 2000, Medis El purchased an additional 11.5%of the outstanding shares of More Energy, giving Medis El a 93% interest insuch company, for an aggregate purchase price of $320,000. Medis El accountedfor these acquisitions of minority interests using purchase accounting. The excessof purchase price over the book value of the net assets acquired aggregated$320,000. This excess purchase price was allocated to in-process research anddevelopment and, therefore, was charged to research and development costs as ofthe dates of the acquisitions.

 

On March 14, 2003, MTL acquired the remaining 7%, or 70 shares, of MoreEnergy that it did not already own. Such acquisition was pursuant to anagreement dated March 14, 2003 with the General Manager of More Energy andowner of the remaining 7% interest of More Energy (the “Seller”), which amendedthe terms of the MTL’s existing option agreement to acquire such interest.Pursuant to the amendment, the vesting schedule of the option was acceleratedsuch that the MTL could immediately exercise its option in full to acquire theremaining 7% interest. Such acquisition was undertaken in order to make MoreEnergy a wholly-owned subsidiary of the Company.

 

The acquisition was accounted for under the purchase method ofaccounting. The total purchase price of $1,045,000 was comprised of $520,000paid in full in June 2001 for the purchase of the original option to acquiresuch interest in More Energy and the issuance as of March 14, 2003 of 120,000shares of MTL’s common stock. The common stock was valued at $4.374 per share,representing the average closing price of MTL’s common stock for three daysbefore and after March 14, 2003 - the date of the acquisition agreement, or anaggregate of approximately $525,000.

 

Based on a purchase price allocation analysis performed by the Company,the entire purchase price of $1,045,000 was allocated to intangible fuel celltechnology assets of More Energy. No goodwill was generated in the transaction.Such intangible assets acquired are being amortized over five year usefullives. During the year ended December, 2003, the Company recorded amortizationexpense of approximately $165,000 related to such intangible assets acquired.

 

As of the date of the acquisition, More Energy’s total stockholder’sequity reflected a deficit. Since the Company, from More Energy’s inception,has consolidated in its financial statements 100% of the losses of More Energy,such deficit is already included in the Company’s accumulated deficit as ofdate of the acquisition and was not reflected in the purchase price allocation.

 

F - 19

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In April 2003, the MTL loaned approximately $158,000, including accruedinterest through December 31, 2003, to the Seller, to enable the Seller to paycertain tax obligations arising from the sale of his interest to MTL. TheSeller has executed a non-recourse, interest bearing, secured promissory note(the “Note”) in favor of the MTL evidencing such loan and any additional loanswhich may be made by MTL to the Seller up to an aggregate principal amount of$258,000. The interest rate under the Note is equal to the applicable federalrate for mid-term loans in effect on the borrowing date which, for purposes ofthe amount borrowed to date, equals a rate of 2.94% per annum. Principal of,and accrued interest on, the Note must be paid in full by the December 31, 2006maturity date of the Note. The Seller has also entered into a pledge agreementwith the Company under which he has pledged as collateral for the payment in fullof his obligations under the Note 120,000 shares of the Company’s common stockowned by him.

 

As of December 15, 1997, MTL acquired Israel Aircraft IndustriesLtd.’s (“IAI”) 40% interest in Medis Inc., for aggregate consideration of3,600,457 shares of MTL stock. As this was an acquisition of a minorityinterest, the Company accounted for this transaction using purchase accounting.The purchase price was valued based on the value of Medis Inc.’sinvestment in Medis El, using the quoted market price of Medis El shares as ofDecember 15, 1997. The aggregate purchase price was valued at $13,125,000.Acquired intangible technology assets, consisting primarily of patents,know-how and other technology-related assets, aggregated $2,975,000, of which$2,814,000 related to the CellScan technology. Goodwill, which represented theexcess of the purchase price over the value of the acquired tangible andintangible technology assets, aggregated $9,252,000. Intangible technologyassets have been amortized over a five-year period and goodwill had beenamortized through December 31, 2001 based on a five year useful live (see NoteB).

 

**NOTED—PROPERTY AND EQUIPMENT, NET**

 

Property and equipment consists of the following: 

 
|                                           |   | **December 31,** |       |
|------------------------------------------------|--------|------------------|------------|
|                                           |   | **2002**         |       | **2003** |   |
|                                           |   |             |       |   |   |
| Machinery and equipment                        |   | $                | 1,674,000  | ** ** | **$** | **2,115,000** | ** ** |
| Computers                                      |   | 376,000          | ** ** | **443,000** | ** ** |
| Furniture and office equipment                 |   | 162,000          | ** ** | **173,000** | ** ** |
| Vehicles                                       |   | 47,000           | ** ** | **47,000** | ** ** |
| Land                                           |   | 110,000          | ** ** | **110,000** | ** ** |
| Leasehold improvements                         |   | 385,000          | ** ** | **442,000** | ** ** |
|                                           |   | 2,754,000        |       | **3,330,000** | ** ** |
| Less accumulated depreciation and amortization |   | 1,555,000        | ** ** | **1,860,000** | ** ** |
| Property and equipment, net                    |   | $                | 1,199,000  | ** ** | **$** | **1,470,000** | ** ** |

 

Depreciationand amortization expense on property and equipment for the years ended December31, 2001, 2002 and 2003 amounted to $587,000, $256,000 and $305,000,respectively.**** During the year endedDecember 31, 2002, the Company reduced its machinery and equipment andcorresponding accumulated depreciation balances for certain fully depreciatedequipment that is no longer in service

 

F - 20

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# **NOTEE—GOODWILL AND INTANGIBLE ASSETS**

# ** **

As of December31, 2003, the Company’s intangible assets consisted of Goodwill and fuel celltechnology assets.****As of December 31, 2002, the Company’s intangibleassets consisted of Goodwill and CellScan technology assets.

 

## *Intangible Assets*

## * *

The followingtable summarizes the cost and related accumulated amortization for intangibleassets that are subject to amortization.

** **
|                        |   | **December 31,** |       |
|-----------------------------|--------|------------------|------------|
|                        |   | **2002**         |       | **2003** |   |
|                        |   |             |       |   |   |
| Cost:                       |   |             |       |   |   |
| CellScan technology assets  |   | $                | 9,113,000  | ** ** | **$** | **9,113,000** | ** ** |
| Fuel Cell technology assets |   | —           | ** ** | **1,045,000** | ** ** |
| Total intangible assets     |   | 9,113,000        | ** ** | **10,158,000** | ** ** |
| Accumulated amortization:   |   |             | ** ** |   | ** ** |
| CellScan technology assets  |   | 8,281,000        | ** ** | **9,113,000** | ** ** |
| Fuel Cell technology assets |   | —           | ** ** | **165,000** | ** ** |
|                        |   | $                | 832,000    |   | **$** | **880,000** | ** ** |

 

 

The Company recordedamortization expense of $2,661,000, $2,633,000 and $997,000 for the years endedDecember 31, 2001, 2002 and 2003, respectively. Based on the current amount ofintangible assets subject to amortization, the estimated amortization expensefor each of the years ending December 31, 2004 through 2007 is $209,000 and$44,000 for the year ending December 31, 2008.

 

## *Goodwill*

## * *

The followingtable summarizes the activity in goodwill for the periods indicated:

 
|                 |   | **December 31,** |       |
|----------------------|--------|------------------|------------|
|                 |   | **2002**         |       | **2003** |   |
|                 |   |             |       |   |   |
| Beginning balance    |   | $                | 58,205,000 | ** ** | **$** | **58,205,000** | ** ** |
| Amortization expense |   | —           | ** ** | **—** | ** ** |
|                 |   | $                | 58,205,000 |   | **$** | **58,205,000** | ** ** |

 

F - 21

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The followingtable reflects pro forma results of operations of the Company, giving effect toSFAS No. 142 as if it were adopted on January 1, 2001:

 
|                                                               |   | **Years  Ended December 31,** |        |
|--------------------------------------------------------------------|--------|-------------------------------|-------------|
|                                                               |   | **2001**                      |        | **2002** |   | **2003** |   |
| Net loss attributable to common stockholders as reported           |   | $                             | (34,766,000 | ) | $ | (12,546,000 | ) | **$** | **(11,063,000** | **)** |
|                                                               |   |                          |        |   |   |   |   |
| Add back: goodwill amortization                                    |   | 18,468,000                    |        | — | ** ** | **—** | ** ** |
|                                                               |   |                          |        |   |   |   |   |
| Pro forma net loss attributable to common stockholders as reported |   | $                             | (16,298,000 | ) | $ | (12,546,000 | ) | **$** | **(11,063,000** | **)** |
|                                                               |   |                          |        |   |   |   |   |
| Basic and diluted loss per share:                                  |   |                          |        |   |   |   |   |
|                                                               |   |                          |        |   |   |   |   |
| Reported net loss per share (Note B)                               |   | $                             | (1.68       | ) | $ | (.57 | ) | **$** | **(.47** | **)** |
|                                                               |   |                          |        |   |   |   |   |
| Goodwill amortization                                              |   | .89                           |        | — | ** ** | **—** | ** ** |
|                                                               |   |                          |        |   |   |   |   |
| Pro forma net loss per share                                       |   | $                             | (.79        | ) | $ | (.57 | ) | **$** | **(.47** | **)** |

 

In accordance with SFAS 142, the Company hasperformed an initial detailed evaluation of its goodwill as of January 1, 2002for any possible impairment and has also subsequently tested its goodwill forimpairment as of December 31, 2002 and 2003, with no impairment being found. Inperforming such initial evaluation as of January 1, 2002, the Company firstdetermined its reporting units. Once the reporting units were established andgoodwill was allocated to such reporting units, the Company compared theestimated fair value of each reporting unit to the carrying amount of theunits’ assets and liabilities, including its goodwill and other intangibleassets. Since the fair value of its reporting units exceeded the carryingamount, the second step of the impairment test, in which the current fairmarket value of the units’ assets and liabilities would determine the currentimplied fair value of the units’ goodwill, was not performed. The Company hasalso reassessed the useful lives of its other intangible assets previouslyrecorded in connection with earlier purchase acquisitions.

 

**NOTEF— ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES**

 

Accruedexpenses and other current liabilities consist of the following:

 
|                                                 |   | **December 31,** |       |
|------------------------------------------------------|--------|------------------|------------|
|                                                 |   | **2002**         |       | **2003** |   |
|                                                 |   |             |       |   |   |
| Employees and related liabilities                    |   | $                | 522,000    | ** ** | **$** | **599,000** | ** ** |
| Professional services                                |   | 87,000           | ** ** | **90,000** | ** ** |
| Related parties                                      |   | 139,000          | ** ** | **82,000** | ** ** |
| Subcontractors and consultants                       |   | 73,000           | ** ** | **89,000** | ** ** |
| Others                                               |   | 152,000          | ** ** | **98,000** | ** ** |
| Total accrued expenses and other current liabilities |   | $                | 973,000    | ** ** | **$** | **958,000** | ** ** |

 

F - 22

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**NOTEG—STOCKHOLDERS’ EQUITY**

 

## *1. Medis Technologies Ltd. Common Stock*

## * *

Each stockholder is entitled to one vote for each share of common stockowned by that stockholder on all matters properly submitted to the stockholdersfor their vote. Stockholders owning or controlling more than 50% of the sharescan elect all of the directors. Subject to the dividend rights of holders ofpreferred stock, if any, holders of common stock are entitled to receive dividendswhen, as and if declared by the board of directors out of funds legallyavailable for this purpose. In the event of liquidation, dissolution or windingup, the holders of common stock are entitled to receive on a pro rata basis anyassets remaining available for distribution after payment of liabilities andafter provision has been made for payment of liquidation preferences to allholders of preferred stock. Holders of common stock have no conversion orredemption provisions or preemptive or other subscription rights.

 

In May and June 2001, the Company sold in private placements toaccredited investors an aggregate of 660,688 units, each unit consisting of oneshare of the Company’s common stock and a warrant to purchase one share ofcommon stock, at a price of $16.00 per unit, for aggregate gross proceeds ofapproximately $10,571,000. Issuance costs aggregated approximately $331,000.Warrants issued with 413,500 units have an exercise price of $18.00 per shareand warrants issued with 247,188 units have an exercise price of $19.00 pershare. All of such warrants are exercisable for two years from their respectiveissue date. The Company’s chief executive officer and its president eachpurchased 15,625 units and IAI, the Company’s largest stockholder, purchased12,500 units. On November 12, 2001, the Company extended the expiration date ofsuch warrants through December 31, 2004 (see Note G-2).

 

Between July and November 2001, an existing warrant holder exercisedwarrants to purchase 41,100 shares of the Company’s common stock, for anaggregate cash exercise price of $150,000.

 

In February and March 2002, certain officers and employees of theCompany exercised options to acquire an aggregate of 66,180 shares of theCompany’s common stock, for an aggregate exercise price of approximately$309,000.

 

On March 18, 2002, the Company completed arights offering and initiated a shareholder loyalty program.  Pursuant to the rights offering, it offeredto its existing stockholders subscription rights to purchase an aggregate of3,500,000 shares of its common stock at a purchase price of $2.00 per share.The Company received gross proceeds of $7,000,000 from the rights offering,which proceeds, after deducting related expenses of approximately $461,000,have been used for working capital, including for the continued development ofits direct liquid fuel cell technology, as well as for selling, general andadministrative expenses.

 

F - 23

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Additionally, pursuant to the Company’sshareholder loyalty program, all stockholders who purchased shares in therights offering and who have met other specified requirements, have received atno cost one-tenth of a warrant for each share of common stock owned in suchstockholder’s name on February 13, 2002. Accordingly, as of December 31,2003, the Company issued an aggregate of approximately 865,000 warrants tostockholders in the shareholder loyalty program. Each full warrant entitles theholder to purchase one share of the Company’s common stock at a price of $4.43,increasing to $4.92 on September 18, 2003 and to $5.41 on September 18,2004.  Such warrants expire on September18, 2005. The Company has estimated the fair value of such warrants to beapproximately $2,241,000, using the Black-Scholes option pricing model, and hasaccounted for such amount as a preferred dividend during the year endedDecember 31, 2002. During the years ended December 31, 2002 and 2003 throughthe commencement of the offer to exchange and exercise on September 3, 2003(see below), stockholders exercised loyalty program warrants at an exerciseprice of $4.43 per share to acquire an aggregate of 3,342 shares of theCompany’s common stock for aggregate proceeds of approximately $15,000 and12,542 shares of the Company’s common stock for aggregate proceeds ofapproximately $56,000, respectively. See the discussion below regarding the Company’s offer to exchange andexercise such loyalty program warrants.

 

On March 11, 2003, the Company completed arights offering in which it offered to its existing stockholders subscriptionrights to purchase an aggregate of 2,325,600 shares of its common stock at apurchase price of $2.15 per share. The Company received gross proceeds ofapproximately $5,000,000 from the rights offering, which proceeds, afterdeducting related expenses of approximately $122,000, are being used forworking capital, including for the continued development of its direct liquidfuel cell technology, as well as for selling, general and administrativeexpenses.

 

In accordance with SFAS No. 128, the Company has adjusted its netloss per share for years ended December 31, 2001 to give retroactive effect toshares issued in its March 18, 2002 and March 11, 2003 rights offerings, andhas adjusted its net loss per share for years ended December 31, 2002 to giveretroactive effect to shares issued in its March 11, 2003 rights offering (seeNote G-1). Accordingly, as a result of such retroactive adjustments, the netloss per share decreased from $(2.02) to $(1.68), or $(.34) per share and from$(.60) to $(.57), or $(.03) per share, for the years ended December 31, 2001and 2002, respectively

 

On November 13, 2003, the Company completedan offer to exchange and exercise to holders of its approximately 848,000outstanding warrants issued pursuant to its 2002 shareholder loyalty program(the “Offer”).  In order to participatein the Offer, holders of loyalty program warrants who exchanged such warrantsfor new warrants exercisable at $4.43 per share were also required to exercisethe new warrants at the time of the exchange. Each holder of a new warrant, upon its exercise, received one share ofcommon stock and a one-year warrant to purchase an additional share of commonstock at $9.60 for every two new warrants exercised. Pursuant to the Offer, theCompany issued 839,966 shares of its common stock for gross proceeds ofapproximately $3,721,000, less related costs of approximately $112,000, uponthe exchange and exercise of 839,966 warrants at a price of $4.43 per share.The Company has estimated the fair value of the approximately 420,000 one-yearwarrants issued pursuant to the Offer using the Black-Scholes option pricingmodel - assuming a 2.5% risk free interest rate, 0% dividend yield, expectedlife of one year and 76% volatility - to be approximately $1,226,000 and hasaccounted for such amount as a preferred dividend for the year ended December31, 2003.

 

F - 24

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During the year ended December 31, 2003, warrantholders exercised outstanding warrants to acquire 25,509 shares of theCompany’s common stock, at an exercise price of $5.00 per share, for aggregategross proceeds of approximately $128,000.

 

During the year ended December 31, 2003, anofficer, a director, employees and consultants of the Company exercised optionsto acquire an aggregate of 112,350 shares of its common stock, for an aggregateexercise price of approximately $621,000.

 

See Note C for a discussion of shares of theCompany’s common stock issued in connection with the acquisition of theremaining interest in a subsidiary.

 

## *2.  Medis Technologies Ltd. Warrants*

## * *

MTL warrants outstanding are summarized below: 

 
|                             |   | **Warrants**  |       | **Weighted  Average  Exercise Price** |       |
|----------------------------------|--------|---------------|------------|---------------------------------------|------------|
| Balance at January 1, 2001       |   | 1,231,030     |       | 11.65                                 |       |
| Granted                          |   | 703,688       |       | 18.47                                 |       |
| Exercised                        |   | (41,100       | )          | 3.65                                  |       |
| Balance at December 31, 2001     |   | 1,893,618     |       | 14.26                                 |       |
| Granted                          |   | 856,021       |       | 4.43                                  |       |
| Exercised                        |   | (3,342        | )          | 4.43                                  |       |
| Cancelled or Forfeited           |   | (18,000       | )          | 20.00                                 |       |
| Balance at December 31, 2002     |   | 2,728,297     |       | 11.15                                 |       |
| Granted                          |   | 1,318,457     |       | 6.11                                  |       |
| Exercised                        |   | (878,017      | )          | 4.45                                  |       |
| Exchanged  (see Note G-1)        |   | (839,966      | )          | 4.43                                  |       |
| **Balance at December 31, 2003** |   | **2,328,771** | ** ** | **13.25**                             | ** ** |

 

On July 2, 2001, the Company issued a warrant to purchase anaggregate of 25,000 shares of its common stock to a new appointee to itscorporate advisory board. The warrant vested upon issuance, expires inJuly 2003, and has an exercise price of $20.00 per share. The Company hasestimated the value of such warrant to be approximately $48,000. The Companyaccounted for such warrant in accordance with SFAS No. 123 and EITF No.96-18, and estimated their fair value using the Black Scholes option pricingmodel. On November 12, 2001, the Company extended the expiration date of suchwarrants through December 31, 2004 (see below).

 

F - 25

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On July 2, 2001, the Company issued warrants to purchase an aggregateof 18,000 shares of its common stock pursuant to the terms of existingconsulting agreements with third parties. The warrants vested upon issuance andhad an exercise price of $20.00 per share. Such warrants expired inJune 2002. In accordance with SFAS No. 123 and EITF No. 96-18, theCompany estimated the value of such warrants to be approximately $34,000, usingthe Black-Scholes option pricing model.

 

On November 12, 2001, the Company extended through December 31, 2004the expiration date of its outstanding warrants that were issued tostockholders of the Company and members of its corporate advisory board.  Such warrants had original expiration datesbetween June 2002 and July 2003. The Company has estimated the fair value ofthe extension of the expiration date of such warrants that were issued tostockholders to be $3,204,000 and has accounted for such amount as a preferreddividend. The Company has estimated the fair value of the extension of theexpiration date of such warrants that were issued to advisory board members tobe $168,000 and has accounted for such amount as a compensation expense duringthe year ended December 31, 2001. The Company accounted for the extension ofthe expiration date of such warrants in accordance with SFAS No. 123 andEITF 96-18 and estimated their fair value using the Black-Scholes optionpricing model.

 

On April 1, 2003, the Company granted to a consultant warrants topurchase an aggregate of 50,000 shares of the Company’s common stock, inconnection with a consulting agreement of the same date. Such warrants providefor an exercise price of $5.35 per share, the market price on the date of thegrant, and expire three years from the date of the grant. Warrants to purchase25,000 shares vest one year from the date of the grant and warrants to purchasethe remaining 25,000 shares vest two years from the date of the grant; providedthat if the Company does not extend the term of the consulting agreement for asecond twelve month period, all of the warrants shall vest one year from thedate of the grant. The Company accounted for such warrant in accordance withSFAS No. 123 and EITF No. 96-18. Using the Black-Scholes option pricingmodel assuming a 2.5% risk free interest rate, 0% dividend yield, expected lifeof 2.5 years and 87% volatility, the Company has estimated the fair value ofsuch warrants at December 31, 2003 to be approximately $358,000, and hasrecorded expense of approximately $268,000 for the year ended December 31,2003.

 

See Note G-1 for a discussion of warrants issued in connection with theissuance of the Company’s common stock, the Company’s loyalty program and theCompany’s offer to exchange and exercise.

 

F - 26

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*3.  Medis Technologies Ltd. Stock Options*

 

On July 13, 1999, the Company’s Board of Directors approved the1999 Stock Option Plan, and reserved 1,000,000 shares of common stock forissuance as stock options or stock appreciation rights pursuant to the plan.The plan provides for the issuance of both incentive and nonqualified stockoptions. On October 11, 2000, the Company’s Board of Directors increasedthe number of shares of its common stock reserved under the 1999 Stock OptionPlan to 2,000,000, subject to stockholder approval. At the Annual Meeting ofStockholders held on June 21, 2001, the Company’s stockholders approved theincrease in the number of shares of common stock reserved under the 1999 StockOption Plan. On April 25, 2002, the Company’s Board of directors increased thenumber of shares of its common stock reserved under the 1999 Stock Option Planto 3,000,000, subject to stockholder approval. At the Annual Meeting ofStockholders held on June 12, 2002, the Company’s stockholders approved theincrease in the number of shares of common stock reserved under the 1999 StockOption Plan. On April 28, 2003, the Company’s Board of directors increased thenumber of shares of its common stock reserved under the 1999 Stock Option Planto 3,300,000, subject to stockholder approval. At the Annual Meeting ofStockholders held on June 24, 2003, the Company’s stockholders approved theincrease in the number of shares of common stock reserved under the 1999 StockOption Plan.

 

As contemplated as part of the Exchange Offer (see Note C), the Companysought and, in July 2001, received approval from the Israeli taxauthorities to substitute outstanding Medis El stock options held by employeesof Medis El prior to the Exchange Offer for options to purchase shares of theCompany’s common stock. Consequently, the Company issued options to purchase128,780 shares of its common stock (including 109,600 and 13,700 to itsexecutive vice president and its vice president-finance, respectively) insubstitution of outstanding options to purchase 94,000 ordinary shares of MedisEl. The ratio of 1.37 used to determine the number of shares underlying suchoptions of the Company to be issued was the same exchange ratio used in theExchange Offer. Since such options were vested, their fair value was includedin the Exchange Offer purchase price and accounted for in accordance with APBNo. 16.  On November 12, 2001, theCompany extended the expiration date of such options through December 31, 2004(see below).

 

F - 27

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In July and August 2001, the Board of Directors of the Company grantedoptions to purchase an aggregate of 297,700 shares of common stock under its1999 Stock Option Plan, as amended, as follows:

 

•                  Optionsto its chief executive officer to purchase an aggregate of 75,000 shares of theCompany’s common stock, exercisable at $10.50 per share (the market price onthe date of the grant). The options vest after two years and expire after fouryears.

 

•                  Optionsto its president to purchase an aggregate of 75,000 shares of the Company’scommon stock, exercisable at $10.50 per share (the market price on the date ofthe grant). The options vest after two years and expire after four years.

 

•                  Optionsto its executive vice president to purchase an aggregate of 100,000 shares ofthe Company’s common stock, exercisable at $5.16 per share (the market price onthe date of the grant). The options vest after two years and expire after fouryears.

 

•                  Optionsto a director to purchase an aggregate of 13,700 shares of the Company’s commonstock, exercisable at $.4106 per share. The options vested upon issuance andexpire after one year. The Company has estimated the value of such options tobe approximately $138,000. On November 12, 2001, the Company extended theexpiration date of such options through December 31, 2004 (see below).

 

•                  Optionsto purchase an aggregate of 34,000 shares of its common stock under its 1999Stock Option Plan, as amended, to employees and a consultant of More Energy.Such options are exercisable at $6.75 per share (the market price on the dateof the grant), vest after two years and expire after four years. The Companyestimates the value of such options issued to the consultant to beapproximately $8,000.

 

On November 12, 2001, the Company extended through December 31, 2004the expiration date of its outstanding options that had expiration dates priorto such date.  In accordance with SFASNo. 123, EITF No. 96-18, APB No. 25 and FASB InterpretationNo. 44 (“FIN No. 44”), the Company has estimated the value of theextension of the expiration date of such options to be approximately$1,583,000.

 

On January 31, 2002, the Board of Directors of the Company grantedoptions to purchase an aggregate of 647,000 shares of common stock under its1999 Stock Option Plan to employees, officers, directors and consultants of theCompany.  Such options are exercisableat $8.75 (the market price on the grant date), vest after one year and expireafter three years.  The Companyaccounted for those options issued to employees, officers and directors inaccordance with APB No. 25 and FIN No. 44 and those issued to consultantsin accordance with SFAS No. 123 and EITF No. 96-18 using the Black-Scholesoption pricing model to estimate their fair value.

 

F - 28

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During the year ended December 31, 2003, the Company issued options topurchase an aggregate of  441,000 sharesof common stock under its 1999 Stock Option Plan, as follows:

 

•                  February 12,2003 - options to purchase an aggregate of 391,000 shares of common stock toemployees, officers, directors and consultants of the Company.  Such options are exercisable at $4.00 (themarket price on the grant date), vest after one year and expire after threeyears.  The Company accounted for thoseoptions issued to employees, officers and directors in accordance with APBNo. 25 and FIN No. 44 and those issued to consultants in accordance withSFAS No. 123 and EITF No. 96-18 using the Black-Scholes option pricingmodel to estimate their fair value.

 

•                  March 31, 2003 -options to purchase 5,000 shares of common stock to a director of theCompany.  Such options are exercisableat $5.12 (the market price on the grant date), vest after one year and expireafter three years.  The Companyaccounted for such options issued in accordance with APB No. 25 and FIN No.44.

 

•                  August11, 2003 - options to purchase an aggregate of 20,000 shares of common stock toa consultant of the Company.  Of suchoptions, 10,000 are exercisable at $5.00, vest upon issuance and expire onDecember 31, 2004. The other 10,000 of such options are exercisable at $8.75,vest upon issuance and expire on January 31, 2005. The Company accounted forall such options in accordance with SFAS No. 123 and EITF No. 96-18 usingthe Black-Scholes option pricing model to estimate their fair value.

 

•                  November6, 2003 - options to purchase an aggregate of 25,000 shares of common stock toa director of the Company.  Of suchoptions, (i) 10,000 are exercisable at $5.00, vest upon issuance and expire onDecember 31, 2004; (ii) 10,000 are exercisable at $8.75, vest upon issuance andexpire on January 31, 2005 and (iii) 5,000 are exercisable $4.00, vest onFebruary 12, 2004 and expire on February 12, 2006. The Company accounted forall such options in accordance with APB No. 25 and FIN No. 44.

 

During the years ended December 31, 2001, 2002 and 2003, the chiefexecutive officer of the Company received options to purchase 75,000, 100,000and 50,000 shares of the Company’s common stock, respectively, in his capacityas a director.

 

F - 29

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The Company’s option activity and options outstanding are summarized asfollows: 

 
|                                         |   | **Options**   |       |
|----------------------------------------------|--------|---------------|------------|
|                                         |   | **Options**   |       | **Weighted average  exercise price** |   |
| Options outstanding at January 1, 2001       |   | 1,395,500     |       | $ | 9.25 |   |
| Granted                                      |   | 426,500       |       | 6.96 |   |
| Options outstanding at December 31, 2001     |   | 1,822,000     |       | 8.72 |   |
| Granted                                      |   | 647,000       |       | 8.75 |   |
| Exercised                                    |   | (66,200       | )          | 4.67 |   |
| Cancelled or forfeited                       |   | (20,000       | )          | 20.50 |   |
| Options outstanding at December  31, 2002    |   | 2,382,800     |       | 8.74 |   |
| Granted                                      |   | 441,000       |       | 4.27 |   |
| Exercised                                    |   | (112,350      | )          | 5.52 |   |
| Cancelled or forfeited                       |   | (2,000        | )          | 6.75 |   |
| **Options outstanding at December 31, 2003** |   | **2,709,450** | ** ** | **8.15** | ** ** |
|                                         |   |          |       |   |   |
| **Exercisable December 31, 2003**            |   | **2,308,450** | ** ** | **8.86** | ** ** |
|                                         |   |          |       |   |   |
| Exercisable December 31, 2002                |   | 1,454,800     |       | 8.84 |   |
|                                         |   |          |       |   |   |
| Exercisable December 31, 2001                |   | 864,000       |       | 6.52 |   |
|                                              |        |               |            |  |  |  |

 
| **Options Outstanding** |   | **Options Exercisable**                       |   |
|-------------------------|--------|-----------------------------------------------|--------|
| **Exercise  Price**     |   | **Number  outstanding at  December 31, 2003** |   | **Weighted average  remaining  contractual life** |   | **Weighted average exercise prices** |   | **Number  Exercisable at  December 31, 2003** |   | **Weighted average  exercise prices** |   |
| $                       | 0.41   |                                          | 3,700  |   | 1.00 |   | $ | 0.41 |   | 3,700 |   | $ | 0.41 |   |
| 2.93                    |   | 450,000                                       |   | 1.00 |   | 2.93 |   | 450,000 |   | 2.93 |   |
| 4.00                    |   | 396,000                                       |   | 2.10 |   | 4.00 |   | — |   | — |   |
|                    |   |                                          |   |   |   |   |   |   |   |   |   |
| 5-5.26                  |   | 345,100                                       |   | 1.20 |   | 5.15 |   | 340,100 |   | 5.15 |   |
| 6.75                    |   | 19,950                                        |   | 1.60 |   | 6.75 |   | 19,950 |   | 6.75 |   |
| 8.75                    |   | 644,700                                       |   | 1.10 |   | 8.75 |   | 644,700 |   | 8.75 |   |
| 10.50                   |   | 150,000                                       |   | 1.60 |   | 10.50 |   | 150,000 |   | 10.50 |   |
|                    |   |                                          |   |   |   |   |   |   |   |   |   |
| 13.5                    |   | 500,000                                       |   | 1.00 |   | 13.50 |   | 500,000 |   | 13.50 |   |
| 16.42                   |   | 200,000                                       |   | 1.00 |   | 16.42 |   | 200,000 |   | 16.42 |   |
|                    |   | 2,709,450                                     |   |   |   |   |   | 2,308,450 |   |   |   |
|                         |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |

 

F - 30

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As of December 31, 2003, approximately 371,000 options wereavailable for grant pursuant to the plan.

 

Compensation costs charged to operations which the Company recorded foroptions granted to employees and directors at exercise prices below the fairmarket value at the date of grant and for options and warrants granted toconsultants, including the value of the extension of the expiration date in2001 of employee, director and consultant options and warrants, aggregated$3,664,000, $213,000 and $592,000 in 2001, 2002 and 2003, respectively.

 

See Note B-8 for discussion of pro forma effects of applying SFASNo. 123 to employee stock options.

 

# **NOTEH—COMMITMENTS AND CONTINGENT LIABILITIES**

# ** **

*1.  CellScan License*—MedisEl acquired the rights to the CellScan in August 1992 by assignment fromIAI of a license from Bar Ilan University (the “University”) to IAI.  Medis El paid IAI $1,000,000 inconsideration of the assignment of the license and for certain tooling andequipment. The license is a perpetual worldwide license to develop, manufactureand sell the CellScan, and to sublicense the right to manufacture and sell thedevice. The license includes all rights to the University’s CellScan patents,know-how and inventions including any subsequently acquired, and allimprovements thereto. Medis El is obligated to pay the University a royalty fora twenty-year period beginning in 1995. For the first ten years, the royalty isat the rate of 6.5% of proceeds of sales (after deducting sales commissions andother customary charges) and 4.5% on any fees received from grantingterritorial rights. The royalty for the second ten-year period is 3.5% on allrevenues whether from sales or fees. In addition to such royalty payments, theCompany is required to grant $100,000 to the University during the first yearthat the Company’s after-tax profits exceed $300,000. No royalties wererequired to be paid during the three years ended December 31, 2003.

 

*2.  Neuritor License—*Inconsideration of grants by the State of Israel, Medis El is obligated to payroyalties for a license from Imexco General Ltd. (“Imexco”), for whichassignment Medis El paid $500,000. An additional sum of $125,000 was paid inDecember 1995. In 1996, Medis El relinquished its exclusive right tomarket the Neuritor in consideration of relief of its obligation to pay minimumroyalties. Medis El has to pay Imexco royalties at rates ranging from 2% to 7%of the revenue generated by the sale of the Neuritor. No royalties were requiredto be paid during the three years ended December 31, 2003.

 

*3.  Other Royalties***—**Inconsideration of grants by the State of Israel, Medis El is obligated to payroyalties of 3% of sales of products developed with funds provided by the Stateof Israel until the dollar-linked amount equal to the grant payments receivedby Medis El is repaid in full. All grants received from the State of Israelrelated to the CellScan and Neuritor technologies. Total grants received, netof royalties paid as of December 31, 2002, aggregate $2,601,000, whichincludes those received by IAI relating to such technologies of $805,000. Noroyalties were required to be paid during the three years endedDecember 31, 2003.

 

F - 31

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*4.  Lease Commitments***—**MTL’soffice space is provided to MTL for an annual rental fee of approximately$115,000, by a company which is controlled by the chairman and chief executiveofficer and by the president of MTL. The sublease is on a month to month basis.

 

Medis El and More Energy are committed under leases at two locationsfor office space, laboratory and production facilities. The corporateheadquarters and technology center facility lease, which has a term untilDecember 31, 2004 and a two one-year option on the facility, provides forannual aggregate rental of approximately $199,000. Additionally, its pilotproduction plant lease has a term until December 31, 2008, with acondition permitting the Company to unilaterally terminate the lease, and providesfor an annual aggregate rental of approximately $30,000. During the years endedDecember 31, 2001, 2002 and 2003, the Company incurred expenses under itsfacility lease commitments aggregating approximately $270,000, $293,000 and341,000, respectively.

 

The Company is committed under vehicle leases with various terminationdates in 2004 through 2006.  TheCompany’s annual aggregate commitment under such leases for the years endingDecember 31, 2004, 2005 and 2006 is approximately $116,000, $64,000, and $22,000,respectively.

 

5.  *RevolvingCredit Line* - On September 30, 2003, the Company entered into athird amendment to the agreement governing its existing $5,000,000 revolvingcredit line. The loan agreement bears interest on any outstanding balancesbased on either the LIBOR or Prime Rate. Pursuant to the amendment, thetermination date of the revolving credit line was extended from July 1, 2004 toJuly 1, 2005. No other terms of the agreement were changed. Any outstandingbalances would be collateralized by all deposits with the bank and anassignment of certain leases owned by a partnership in which the Company’schairman and chief executive officer and its president are partners.  Additionally, the Company’s chairman andchief executive officer and its president have personally guaranteed anyamounts due under such credit line. As of December 31, 2003, the Company hadnot borrowed any funds under this credit line.

 

6.   *Fuel Cell Technology Cooperation Agreements*—In April 2001, the Company entered into a mutually exclusive agreementwith General Dynamics Government Systems Corporation, a unit of GeneralDynamics Corporation (“GD”), to develop and market fuel cells and fuelcell-powered portable electronic devices for the United States Department ofDefense (the “DOD”). As part of such agreement, among other things, GD agreedto market the Company’s fuel cell products to the DOD. In May 2002, the Companyreceived a $75,000 purchase order from GD to develop an initial prototype ofsuch a fuel cell charger. In March 2003, the Company developed, on schedule,the prototype designated under the May 2002 purchase order and recorded the$75,000 as a credit to research and development expense.

 

F - 32

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On May 5,2003, the Company announced that it had signed a second agreement with GD, todesign and develop on a best efforts basis a pre-production prototype of itsfuel cell Power Pack for the ruggedized personal digital assistant system thatGeneral Dynamics is developing for the military (the “Agreement”). The totalprice for the Company’s services provided for in the Agreement is $500,000,with an initial payment of $100,000 and the balance in accordance with thepayment and performance milestones established in the Agreement through January2005. The Company expects that it will benefit from the development effortbeyond the scope of the Agreement and anticipates that its development costswill exceed the $500,000 price. The Company is accounting for the Agreement as afixed priced, best efforts research and development arrangement and hasrecorded approximately $224,000 as credits to research and development expensefor the year ended December 31, 2003. The Company received payments aggregating$250,000 during the year ended December 31, 2003, pursuant to the agreement.

 

# **NOTE I—RELATEDPARTY TRANSACTIONS**

# ** **

*1.  Insurance***—**MedisEl is presently included as an additional insured party on IAI’s product,casualty, and third party liability coverage. During each of the years endedDecember 31, 2001, 2002 and 2003, IAI charged Medis El approximately$5,000 for insurance premiums.

 

2.  *Consulting Agreements—*TheCompany has entered into consulting agreements with its chairman and chiefexecutive officer and with its president. Such agreements have initial termsthrough December 31, 2001 and provide for automatic extension on a year to yearbasis. During the years ended December 31, 2001, 2002 and 2003, the Companyincurred fees relating to its agreement with its chairman and chief executiveofficer of approximately $240,000, $296,000 and $240,000, respectively, ascompensation for his services as an officer of the Company. During the yearsended December 31, 2001, 2002 and 2003, the Company incurred fees relating toits agreement with its president of approximately $145,000, $244,000 and$145,000, respectively, as compensation for his services as an officer of theCompany.

 

During the year ended December 31, 2002, theCompany entered into a consulting agreement with a corporation wholly owned byits senior vice president of business development. Such agreement has aninitial term through December 31, 2003 and provides for automatic extension ona year to year basis.  During the yearsended December 31, 2002 and 2003, the Company incurred fees of approximately$72,000 and $144,000, respectively, as compensation for consulting servicesunder such agreement.

 

3.  *Administrative Services**—*Secretarial and bookkeeping services are provided to MTL through a costssharing arrangement with a company that is controlled by the chairman and chiefexecutive officer and by the president of MTL. During the years ended December 31, 2001, 2002, and 2003, fees for suchservices amounted to approximately $32,000, $56,000 and $60,000, respectively.

 

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# **NOTE J—INCOMETAXES**

# ** **

The following represents the components of the Company’s pre-tax lossesfor each of the three years in the period ended December 31, 2003. 

 
|     |   | **Year ended December 31,** |        |
|----------|--------|-----------------------------|-------------|
|     |   | **2001**                    |        | **2002** |   | **2003** |   |
| Domestic |   | $                           | (24,371,000 | ) | $ | (4,104,000 | ) | **$** | **(7,017,000** | **)** |
| Foreign  |   | (7,191,000                  | )           | (6,201,000 | ) | **(2,820,000** | **)** |
|     |   | $                           | (31,562,000 | ) | $ | (10,305,000 | ) | **$** | **(9,837,000** | **)** |

 

The Company files a consolidated Federal income tax return, whichincludes MTL, Medis Inc., and Toroidal Products Inc. At December 31,2003, the Company has a net operating loss (“NOL”) carryforward for UnitedStates Federal income tax purposes of approximately $9,213,000, expiringthrough 2023.

 

Pursuant to United States Federal income tax regulations, the Company’sability to utilize this NOL may be limited due to changes in ownership, asdefined in the Internal Revenue Code.

 

The Company, through Medis El, has net operating losses, for Israelitax purposes, aggregating approximately $42,640,000 as of December 31, 2003,which, pursuant to Israeli tax law, do not expire.

 

Deferred income tax assets arising mainly from NOL carryforwards havebeen reduced to zero through a valuation allowance. The Company continuallyreviews the adequacy of the valuation allowance and will recognize deferred taxassets only if a reassessment indicates that it is more likely than not thatthe benefits will be realized.

 

Medis El is an Israeli corporation and is subject to income taxes underthe relevant Israeli tax law. Medis El has been issued a certificate ofapproval as an “Approved Enterprise,” which allows Medis El to have lower taxrates under Israeli tax law. Such rates include a corporate tax on incomederived from Approved Enterprise activities at a rate of 10% to 25% and a taxrate on distributed dividends of 15%. These benefits expire in 2006.

 

If the Company distributes a cash dividend from retained earning whichwere tax exempt due to its approved enterprise status, the Company would berequired to pay a 25% corporate tax on the amount distributed and a further 15%withholding tax would be deducted from the amount disturbed to the recipients.Should the Company derive income form sources other than the approvedenterprise programs during the relevant period of benefits, this income wouldbe taxable at the regular corporate tax rate of 36%.

 

The benefits from Medis El’s approved enterprise programs are dependentupon it fulfilling the conditions stipulated by the Laws for Encouragement ofCapital Investments, 1959 and the regulations published under this law, as wellas the criteria in the approval for the specific investment in Medis El’sapproved enterprise programs.  If MedisEl does not comply with these conditions, the tax benefits may be canceled, andit may be required to refund the amount of the canceled benefit, with theaddition of linkage difference and interest. As of the date of these financial statements, the Company believes thatMedis El has complied with these conditions.

 

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In September 2001, More Energy, the Company’s fuel cell subsidiary, wasgranted Approved Enterprise status. The benefits from the Approved Enterpriseprogram depend upon More Energy fulfilling the conditions under the grant andthe laws governing the grant. More Energy has chosen not to continue itsApproved Enterprise program and, thus, is not in compliance with theseconditions.  It does not expect to incurany costs relating to not participating in the program.

 

No tax expense on income has been recorded in the financial statementsof the Company, as the Company has a loss in the current year, in eachtax-paying jurisdiction.

 

Temporary differences that give rise to deferred tax assets are asfollows 

 
|                                               |   | **December 31,** |       |
|----------------------------------------------------|--------|------------------|------------|
|                                               |   | **2002**         |       | **2003** |   |
|                                               |   |             |       |   |   |
| Net operating loss carryforward—United States |   | $                | 3,397,000  | ** ** | **$** | **3,862,000** | ** ** |
| Net operating loss carryforward—Israel        |   | 13,545,000       | ** ** | **15,350,000** | ** ** |
| Other differences                                  |   | (104,000         | )          | **279,000** | ** ** |
|                                               |   | 16,838,000       |       | **19,491,000** | ** ** |
| Valuation allowance                                |   | (16,838,000      | )          | **(19,491,000** | **)** |
| Deferred tax assets, net of valuation allowance    |   | $                | —     | ** ** | **$** | **—** | ** ** |

 

A reconciliation of the income tax benefit computed at the UnitedStates Federal statutory rate to the amounts provided in the financialstatements is as follows: 

 
|                                                        |   | **Year ended December 31,** |        |
|-------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                        |   | **2001**                    |        | **2002** |   | **2003** |   |
|                                                        |   |                        |        |   |   |   |   |
| Income tax benefit computed at Federal statutory rate (34%) |   | $                           | (10,731,000 | ) | $ | (3,504,000 | ) | **$** | **(3,344,000** | **)** |
| Other                                                       |   | 506,000                     |        | (143,000 | ) | **46,000** | ** ** |
| Effect of permanent differences                             |   | 7,225,000                   |        | 968,000 |   | **645,000** | ** ** |
| Valuation allowance                                         |   | 3,000,000                   |        | 2,679,000 | ** ** | **2,653,000** | ** ** |
|                                                        |   | $                           | —      |   | $ | — | ** ** | **$** | **—** | ** ** |

 

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# **NOTEK—CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
| **Quarter  ended**                                                              |   | **March 31** |       | **June 30** |   | **September 30** |   | **December 31** |       |
|---------------------------------------------------------------------------------|--------|--------------|------------|-------------|--------|------------------|--------|-----------------|------------|
|                                                                            |   |         |       |        |   |             |   |            |       |
| Fiscal 2003                                                                     |   |         |       |        |   |             |   |            |       |
| Sales                                                                           |   | $            | 37,000     |        | $      | 38,000           |   | $               | 38,000     |   | $ | 18,000 |   |
| Gross profit                                                                    |   | $            | 19,000     |        | $      | 29,000           |   | $               | 22,000     |   | $ | 15,000 |   |
| Loss from operations                                                            |   | $            | (2,508,000 | )           | $      | (2,664,000       | )      | $               | (2,264,000 | ) | $ | (2,477,000 | ) |
| Net loss                                                                        |   | $            | (2,485,000 | )           | $      | (2,658,000       | )      | $               | (2,231,000 | ) | $ | (2,463,000 | ) |
| Net loss attributable to common stockholders                                    |   | $            | (2,485,000 | )           | $      | (2,658,000       | )      | $               | (3,457,000 | ) | $ | (2,463,000 | ) |
| Basic and diluted net loss per share                                            |   | $            | (.11       | )           | $      | (.11             | )      | $               | (.15       | ) | $ | (.10 | ) |
|                                                                            |   |         |       |        |   |             |   |            |       |
| Weighted-average shares used in computing basic and diluted net loss  per share |   | 22,446,271   |       | 23,562,873  |   | 23,591,557       |   | 24,106,764      |       |

 
| **Quarter  ended**                                                              |   | **March 31*** |       | **June 30*** |   | **September 30*** |   | **December 31*** |       |
|---------------------------------------------------------------------------------|--------|---------------|------------|--------------|--------|-------------------|--------|------------------|------------|
|                                                                            |   |          |       |         |   |              |   |             |       |
| Fiscal 2002                                                                     |   |          |       |         |   |              |   |             |       |
| Sales                                                                           |   | $             | 80,000     |         | $      | 36,000            |   | $                | 38,000     |   | $ | 38,000 |   |
| Gross profit                                                                    |   | $             | 29,000     |         | $      | 9,000             |   | $                | 6,000      |   | $ | 18,000 |   |
| Loss from operations                                                            |   | $             | (2,648,000 | )            | $      | (2,596,000        | )      | $                | (2,420,000 | ) | $ | (2,710,000 | ) |
| Net loss                                                                        |   | $             | (2,648,000 | )            | $      | (2,565,000        | )      | $                | (2,392,000 | ) | $ | (2,700,000 | ) |
| Net loss attributable to common stockholders                                    |   | $             | (2,648,000 | )            | $      | (2,565,000        | )      | $                | (4,633,000 | ) | $ | (2,700,000 | ) |
| Basic and diluted net loss per share                                            |   | $             | (.12       | )            | $      | (.12              | )      | $                | (.21       | ) | $ | (.12 | ) |
|                                                                            |   |          |       |         |   |              |   |             |       |
| Weighted-average shares used in computing basic and diluted net loss  per share |   | 21,248,566    |       | 22,107,863   |   | 22,107,863        |   | 22,113,237       |       |

 

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(*) Basic and diluted net loss per share and weighted-average common sharesused in computing basic and diluted net loss per share reflect adjustment togive retroactive effect to the Company’s March 11, 2003 rights offering (seeNote B)

 

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# **NOTEL—SUBSEQUENT EVENTS (UNAUDITED)**

# ** **

*1. Private Placements of Common Stock*— In January 2004, the Company issued1,425,000 shares of its common stock in private sales to institutionalinvestors, for gross proceeds aggregating approximately $14,588,000, lessrelated costs of approximately $257,000.

 

*2. Exercise of StockOptions -* From January 1 through March 3, 2004, theCompany issued approximately 192,600 shares of its common stock pursuant to theexercise of a like number of stock options granted under the Company’s 1999Stock Option Plan, as amended, for an aggregate exercise price of approximately$1,129,000.

 

********************************

 

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