**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-K**

 

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

 

**For the fiscal year ended December 31, 2002**

 

**Commission file number: 0-30391**

 

**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  registered pursuant to Section 12(b) of the Act: |
|--------------------------------------------------------------|
|                                                         |
| **None**                                                     |   |
|                                                         |
| Securities  registered pursuant to Section 12(g) of the Act: |
|                                                         |
| **Common Stock, par value $.01 per share**                   |   |
|                                                              |  |  |

 

**Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) had been subject to such filing requirements for the past 90days.     Yes  ****ý    No  ****o**

 

**Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K.  ****o**

 

**Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2).Yes  ****ý    No  ****o**

 

**As of June 28, 2002, the aggregatemarket value of the registrant’s  commonstock held by non-affiliates of the registrant was approximately $90,000,000.**

 

**Asof March 15, 2003, there were outstanding 23,432,721 shares of theregistrant’s common stock.**

** **

 

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**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions ofthe Registrant’s Proxy Statement for the 2003 Annual Meeting of Stockholdersare incorporated by reference into Items 10, 11,12 and 13 of Part III.

 

**TABLE OF CONTENTS**

** **
| **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 and Related Stockholder Matters** |
| **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** |
|          |   |
| **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.**  | **Controls and  Procedures** |
|          |   |
| **PART IV**   |
|          |
| **Item 15.**  | **Exhibits, Financial Statement  Schedules, and Reports on Form 8-K** |

 

References inthis Annual Report to “we,” “us,” or “our” are to Medis Technologies Ltd. andits direct and indirect subsidiaries, unless the context specifies or requiresotherwise.

 

 

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**PART I**

**Item 1.    Business**

** **

**Introduction**

 

Our businessstrategy is to acquire and exploit new technologies developed in Israel,particularly those developed by former citizens of the Soviet Union whoemigrated to Israel. We continuously review each acquired technology todetermine whether the state of each technology warrants a larger scalecommitment on our part or, alternatively, if we reach the conclusion that aparticular technology will not offer the investment benefits that we areseeking, we discontinue or curtail our investment of time and funding for thattechnology. As a result of that process, the primary focus of our efforts andfunding has become the development and commercialization of our direct liquidfuel cell technologies for portable electronic devices. A discussion of ourdirect liquid fuel cell technology and of our other technologies, including ourhighly conductive polymers, CellScan, stirling cycle system, toroidaltechnologies and rankin cycle liner compressor, are described below.

 

We are aDelaware corporation organized in April 1992. Our executive offices arelocated at 805 Third Avenue, New York, New York 10022. Our telephone number is(212) 935-8484. Our website is located at www.medistechnologies.com.  We make available free of charge through ourwebsite our annual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to those reports as soon as reasonablypracticable after we filed such material with, or furnished it to theSecurities and Exchange Commission.  Theinformation on our website is not part of this Annual Report.

 

**RecentDevelopments**

 

*Exercise of Options*.  On March 14, 2003, we exercised our option,pursuant to an existing option agreement, as amended, to purchase the remaining7% interest of More Energy Ltd. that we did not already own from GennadiFinkelshtain, the General Manager of More Energy, for an aggregate purchaseprice of 120,000 shares of our common stock. More Energy is our fuel cell subsidiary.

 

*Rights Offering*.  On March 11, 2003, we completed a rightsoffering in which we offered to our existing stockholders subscription rightsto purchase an aggregate of 2,325,600 shares of our common stock at a purchaseprice of $2.15 per share. We received gross proceeds of $5,000,040 from therights offering which, after deducting related expenses, will be used forworking capital, particularly for continued development of our fuel celltechnology, and selling, general and administrative expenses.

** **

**FuelCells**

 

***Introduction***

 

Our primarybusiness focus is on the development and commercialization of direct liquidfuel cells and attendant refueling cartridges for use as primary and auxiliarypower sources for portable electronic devices that currently use rechargeableor disposable batteries as their power source. These devices include a broadarray of products, such as cell phones, personal digital assistants (PDAs),other portable hand sets, laptop and pocket computers, computer peripherals andcertain military devices. Our first fuel cell product is expected to be a powerpack—a portable auxiliary power source which provides power to cell phones andPDAs by way of charging the batteries of such devices even while the device isbeing used.

 

 

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We expect thatas portable electronic devices become more advanced and offer greatercapabilities, manufacturers of those devices and consumers who use them willseek significantly increased power and longer lasting power. We believe thatour direct liquid fuel cell technology, the key proprietary components of whichare our fuel, electrodes, and catalysts for anodes and cathodes, will enable usto meet these demands. We also believe that our fuel cells can be responsive todevice manufacturers’ requirements for reduced size and weight and competitivepricing. Additionally, we believe that our fuel cell technologies haveadvantages over other micro fuel cell technologies currently being developedwhich use proton exchange membrane (PEM) technologies, including our fuel cell’sgreater power relative to size, increased length of operating time, ability tooperate without generating excess heat and particularly, its lower cost tomanufacture.

 

A fuel cell isan electro-chemical device that converts the chemical energy of a fuel, such ashydrogen, ethanol or methanol, into electrical energy. There are a number ofdifferent types of fuel cells being developed for commercial applications, manyof which are intended for large scale applications such as automobiles andstationary power generation. By contrast, our fuel cells are being developedfor small scale applications, and in particular for use in portable electronicdevices.

 

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

 

Fuel cells forsmall-scale applications have many of the characteristics of rechargeablebatteries and would compete with them. A key distinguishing feature betweenfuel cells and rechargeable batteries is that a fuel cell transforms its fueldirectly into electrical power and produces power as long as the fuel issupplied. Batteries are energy storage devices which release power until thechemical reactant stored in the battery is depleted. Once the chemical reactantis depleted, the battery must be recharged.

 

Becauseethanol and other alcohol-based fuels used in our direct liquid fuel cells havemany times the energy capacity as the operative components in rechargeablebatteries, our fuel cells have the potential for delivering far longeroperating time than any of today’s rechargeable batteries. Moreover, the fuelsupply of our direct liquid fuel cells can be replaced in a matter of seconds,unlike a rechargeable battery which undergoes a recharging process, that in thecase of lithium ion batteries—the most advanced rechargeable battery commonlyavailable—is approximately three hours. We believe an additional benefit of ourfuel cells over rechargeable batteries is that that our direct liquid fuelcells are much safer than batteries that contain lithium, a substance that canbe explosive and creates flames that are difficult to extinguish under certainconditions. Finally, from an environmental perspective, our direct liquid fuelcells are far easier and less costly to dispose of than batteries since, unlikebatteries, they have minimal heavy metal components.

 

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

 

Much of theother fuel cell development for the portable electronic device market centersaround direct methanol fuel cells using a solid polymer membrane (protonexchange membrane, or PEM) unlike our use of a liquid electrolyte. Although theproton exchange membrane, itself, requires less space than a liquidelectrolyte, we believe that the use of PEM technology makes it more difficultto reduce the overall size of the fuel cell and increase the power densities toan amount needed for portable electronic devices at commercially acceptabletemperature levels. Furthermore, in a direct methanol fuel cell with a PEM, theconcentration of methanol is generally limited to 3% to 6%, reducing theperformance of the fuel cell. As a result, some direct methanol fuel cells areconstructed with an external delivery system to feed the methanol into the fuelcell and a regulator to control the flow of methanol. Other direct methanolfuel cell external support systems may include a water management system, atemperature control system and where fuel cells are arranged in a stack, aforced air system. Such direct methanol fuel cells involve

 

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greater size, complexity andcost. Direct methanol fuel cells generally also use platinum or other expensivenoble metals.

 

Some companieshave announced plans to use highly concentrated methanol which is then dilutedinside the fuel cell. We believe that high concentrations of methanol raiseissues of consumer health and safety and issues of transportability. Othercompanies have announced their use of reformers inside their fuel cells toconvert methanol into hydrogen which is then used to create power. The publicannouncements thus far suggest the presence of heat of over 200 degrees Celsiusin these products. Other announcements have suggested the planned use ofnanotechnology methods to create fuel cells. We are not aware of any concreteevidence of successful development of fuel cells using nanotechnology. Itshould be noted, however, that considerable resources are being applied todevelop fuel cells using all of these, as well as other methods, and we cangive no assurance that a fuel cell product will not be developed using highly concentratedmethanol, reformers, nanotechnology or other approaches that would becompetitive to our products.

 

We havedeveloped a fuel cell that we believe has obviated many of the problems thathave traditionally affected PEM-based fuel cells. Our fuel cell technologyenables us to use a safer alcohol-based fuel instead of methanol, thus avoidingmethanol’s levels of toxicity and flammability. We have increased theconcentration of our proprietary fuel, which increases the performance of ourfuel cell. Additionally, our fuel cell is self-regulating, meaning it providessufficient power to meet the draw-down of power as needed and it does notrequire an external fuel delivery or regulating system. Furthermore, our fuelcell does not require a water management system, a forced air system, a heatcontrol system, a reformer or other complex system. Instead, our fuel cell hasa very simple design and architecture, consisting of an anode, a cathode, achamber for the liquid electrolyte and a fuel chamber. We have also eliminatedthe use of platinum on the cathode, and aim by the end of 2003 to eliminate theuse of platinum on the anode, thereby eliminating all platinum and other noblemetals in our fuel cells. In addition, the cost of the liquid electrolyte in ourfuel cell is substantially lower than the cost of a PEM. Eliminating complexsystems, using a low cost electrolyte and reducing or eliminating platinum fromour fuel cells enables us to lower the component costs of our productsignificantly. Finally, our fuel cell technology has allowed us to improve ourfuel cell’s performance in power output and operating time relative to size andweight.

 

***State Of Our FuelCell Products***

 

*Micro Fuel Cells; Power Pack*

 

The focus ofour current fuel cell efforts is in product development while continuing toseek to improve performance characteristics. We expect that the first of ourfuel cell products to come to the market will be auxiliary power sources—PowerPacks—used to provide uninterrupted power to the user of a portable electronicdevice. When a device’s battery is running low or is discharged, the Power Packwill allow the consumer to continue to use the device while at the same timecharging the battery. This cycle can be repeated a number of times or, at theconsumer’s option, the Power Pack can be used to maintain the full charge ofthe battery for the life of the fuel cell, itself. After the fuel in the PowerPack is depleted, it is contemplated that the Power Pack can be refueled bypressing a small, lightweight, and inexpensive refueling cartridge against thePower Pack for a few seconds. This process transfers the fuel and electrolytecontained in the refueling cartridge into the Power Pack and transfers anyremaining fuel, electrolyte and the by-product of water from the Power Packinto the refueling cartridge, which can then be discarded. The Power Pack canbe repeatedly refueled this way.

 

We aredeveloping Power Packs for cell phones and slightly larger versions to chargePDAs and laptop computers. We expect that users of electronic devices willperceive value in a fuel cell charger

 

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that is easily portable andwill provide much longer lasting operating power than batteries without theinconvenient need to recharge at an external power support system, such as awall socket.

 

As cell phonesadd additional functions and require more power and longer lasting power, weexpect that the convenience of having our Power Pack will spur a greater demandfor this product. Electronic device manufacturers could benefit by having afuel cell power source actually operating in the market place that they canimmediately offer to their customers. Furthermore, service providers can helpcreate longer use and increased average return per user by having theircustomers able to run their hand sets longer. We also expect to find a largemarket for our Power Pack in countries like China where cell phone use is broadbased and expanding but where many people ride bicycles and electricalconnections may be less readily available than in the United States and othercountries. As our Power Pack gains greater acceptance, we expect thatelectronic device manufacturers will want to incorporate our fuel cells as theprimary power source of the devices.

 

In laboratorytests, our Power Pack is capable of delivering up to three watts of power,enough to provide auxiliary power for cell phones and PDAs. By the middle of2003, we expect that our Power Pack will be able to deliver approximately fivewatts, enough to provide auxiliary power for certain smart phones or smallportable computers and other portable hand sets.

 

We aredesigning and developing a Power Pack capable of providing auxiliary power to aPDA being developed by General Dynamics to meet military specifications. Inlaboratory tests, this PDA Power Pack already provides approximately 12 hoursof operating time with each refueling cartridge and is expected to provideapproximately 72 hours of operating time with the use of four to five refuelingcartridges. We are also developing a Power Pack pursuant to third-partyspecifications for a cell phone product which we expect could provideapproximately 9 hours of talk time with each refueling cartridge. Our target isto have fuel cell products in the production process in 2004. In parallel, weexpect to be testing the military products in a military environment in 2004.We have recently designed a solution to the issue of allowing our fuel cell tooperate in any orientation and are working with a major chemical company tocomplete that solution. Finally, we have completed design of our fuel cartridgeand our goal is to be ready for production in 2004.

 

We continue towork towards substantial advances in the development of our technology to enhancethe commercial value of our Power Pack and of our fuel cell as a primary powersource. These advances include the following:

 

•                       **Supplyingincreased energy while also reducing size and weight.** We are workingto increase the power density of our fuel cells, which helps determine theability to supply more energy in relation to the size of the electrodes.Currently, our fuel cells are capable of maintaining a maximum power density ofover 90mW/cm2 (90mW/0.155in2) on a consistent basis atroom temperature. Furthermore, in laboratory tests, our fuel cells havedemonstrated an ability to deliver power in relation to its weight of 200Wh/kg,or watt hours per kilogram (watt hours per 2.20 pounds), and we are seeking toincrease that to 250Wh/kg by the beginning of 2004, with a next stage target of350Wh/kg.

 

•                       **Perfectingthe discharge characteristics and the length of operating time.**Discharge characteristics determine how much power the fuel cell can deliverover a period of time before refueling. We have developed a test unitindividual fuel cell with a volume of 20 cubic centimeters (1.22 cubic inches)that can provide a total of 12,000 mA (milliamperes) hours over 40 hours ofoperation in laboratory tests.

 

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•                       **Improvingthe engineering design.** Currently, our fuel cells are producedprimarily by hand and are not yet designed to achieve maximum efficiency. Weexpect to design a final product that will benefit from modern industrialproduction techniques, which will allow us to achieve greater efficiency forour fuel cells and have begun studying submissions from independent contractorsthat will address matters of industrial production. We are beginning to set upsmall production lines for electrode components of our fuel cells to gain theexperience of production which we can deliver as part of any future technologytransfer.

 

•                       **Reducing theinternal and external temperature during operation.** The internal andexternal temperature of our fuel cell is related to its efficiency. We expectthat improving the power density and longevity of our fuel cells will allow thefuel cells to operate more efficiently, thus lowering the internal and externaltemperature of the fuel cells. We are also developing ways to make our fuelcells resistant to outside weather conditions. For example, fuel cells used inmilitary products may be required to operate in very cold or very hotenvironments. Meeting these conditions may require changes in the fuel andelectrolytes which we are currently evaluating. We are also studying the issueof supplementary battery systems to meet specific weather conditions.

 

•                       **Integratingour individual fuel cells into a seamless power source.** Our fuelcell system integrates each fuel cell through the use of a DC to DC converter,which increases the voltage without having to connect a number of fuel cells ina series. We have designed a DC to DC converter that is now in the form of a“bread board,” or experimental model, which is 88% efficient. We have contractedwith Flextronics International Ltd. to develop a DC to DC converter with anefficiency of over 90% and a size of approximately one-quarter of the“bread-board” converter.

 

*Large Fuel Cells*

 

While ourmajor focus is on our direct liquid fuel cells for portable electronic devices,we believe that certain technologies used in our fuel cells can be appliedtowards the development of larger fuel cells delivering up to 5 kilowatts ofpower, which might be superior to fuel cell technologies for other larger fuelcells currently under development by others. A major advantage of a large fuelcell developed with our technology relates to reducing the fuel cell costs.Moreover, although comparative figures for other larger fuel cells are notwidely available, we believe that we may be able to improve upon the powerdensity, the catalytic performance and the electrode life of such other largerfuel cells. Although we have no current intention to divert resources or fundsto manufacture larger fuel cells, we would consider joining with or licensingour technology to a strategic partner to develop such technology.

 

***Market Opportunities***

 

*Portable Electronic Device Market*

 

It has beenwidely reported that over $100 billion has been committed bytelecommunications companies to license radio spectrum space for thedevelopment of wireless networks and equal amounts are estimated as the cost ofbuilding out these wireless systems. Furthermore, recent announcements by largehandset manufacturers reflect the fact that the available demand for presentstate-of-the-art cell phones is increasingly being satisfied. To justify thesehuge investments and in order for the cell phone companies to significantlyincrease sales of handsets, these companies are expected to offer much more advancedproducts, commonly referred to as second or third generation or 2G or 3G cellphones, with greater capabilities, i.e., many more applications, such as e-mailand internet availability, shopping, banking and stock purchasing capabilities,games, taking and transferring photographs, music, movies,

 

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messaging and the like. Whetheroffered on a next-generation cell phone, a currently available cell phone withadded capabilities or some other hand set such as a combination of a PDA and acell phone or so-called communicators, smart phones or pocket computers, suchcapabilities will require greater power than that possessed by currentlyavailable devices, as well as much longer-lasting power to extend use time, ifthe consumer expectation regarding the availability of those applications is tobe fully satisfied. There is an increasing recognition of the value of fuelcells for these small applications since they have the potential to delivermore lasting power in smaller sizes and weights than the equivalent batteries.Fuel cells can also be an important source of greater and longer operatingpower for other portable electronic devices, such as laptop computers, digitalcameras, various wireless products and power tools, that currently useconventional rechargeable batteries as their power source. We believe that ourfuel cells can be an attractive source of more power and longer lasting powereither as primary power sources included inside or as part of the originalequipment electronic device or as auxiliary power sources, for example, as inour Power Pack.

 

*Military Applications*

 

The U.S.Department of Defense has stated that it has a pressing need for lighter andmore compact electrical power sources as the modern soldier is increasinglyequipped with many new portable electronic devices. As with the latest portableelectronics for consumers, these devices require significant power sources andare currently dependent on batteries that are heavy and expensive and must berecharged frequently at a central charging source. We are working to developfuel cells to satisfy these power needs. We have entered into a mutuallyexclusive agreement with General Dynamics Corporation to develop micro fuelcell products for the U.S. military. One of our first efforts is working withGeneral Dynamics to develop a Power Pack capable of charging the batteries thatpower the PDA’s carried by soldiers. Pursuant to the agreement, in May 2002 wereceived a $75,000 order from General Dynamics towards development of thisproduct. Together with General Dynamics we are also evaluating other militaryproducts where micro fuel cells would be valuable, including products carriedby foot soldiers in the Land Warrior program of the U.S. Department of Defense,with the aim of eventually replacing the batteries themselves with fuel cells.The Land Warrior program is designed to make each individual soldier functionas a complete weapon system, integrating small arms with high-tech equipment suchas special communications devices, weapons imaging systems, video, and globalpositioning systems.

 

In January2002, we received a $75,000 purchase order from an Israeli electronicsmanufacturer to define a specification and carry out the preliminary design ofa direct liquid fuel cell for a new energy pack for infantry soldiers, which wecompleted. At this time, the Israeli military has suspended funding for theprogram. However, we believe that our successful execution of this order maylead to add-on orders if and when this program is continued.

 

***Business Strategy***

 

Our businessstrategy with respect to our fuel cell technology is to translate our advancedfuel cell technology into commercially viable products. We are in discussionswith a number of companies who are original equipment manufacturers (OEMs) ofportable electronic devices about developing fuel cell products that willprovide auxiliary or primary power sources for their devices. Each of the fuelcell products we are working to develop can also be a generic product that canbe applicable to similar devices made by other OEMs and used by consumers. Ouraim is to develop a core business with an OEM customer based around thoseproducts. For example, the Power Pack we are developing for the PDA to beoffered by General Dynamics may be able to be used for a number of PDA’s madefor the civilian market. The power pack we are making for a cell phone could beused in connection with many other cell phones, hand sets or other portabledevices.

 

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At the sametime we are planning to offer our Power Pack directly to the consumer. We willseek to offer that product through distribution channels that reach as many aspossible of the estimated 1.2 billion people who already are using cell phones,PDAs and other portable electronic devices.

#### ** **

#### *Strategic Alliances*

 

We are seekingstrategic alliances of different kinds. We are in discussions with OEMs so thattogether we can develop fuel cell products for use with existing and futureportable electronic devices made by these OEMs and ultimately develop devicesincorporating our fuel cell technology as their energy source. Furthermore, weare in discussions with multinational companies capable of large scale, world-wideproduction, marketing and distribution of our fuel cell products. We also willbe looking to these alliances and joint ventures to help us determine how bestto design products incorporating our fuel cells that are attractive to theconsumer, as well as to determine how to connect our fuel cells as the originalpower source to the circuitry inside the phones and other electronic devices.This includes such decisions as the best way to package and market therefueling cartridges to satisfy consumer demands.

 

To date, wehave entered into the following arrangements:

 

•                       We haveentered into an exclusive agreement with General Dynamics Government SystemsCorporation, a unit of General Dynamics Corporation, to develop and market ourfuel cells and fuel cell-powered portable electronic devices for the UnitedStates Department of Defense. As part of such agreement, among other things,General Dynamics agrees to market our fuel cells to the Department of Defense.

 

•                       We haveentered into an agreement with an Israeli electronics manufacturer to define aspecification and carry out the preliminary design of a fuel cell for a newenergy pack for infantry soldiers, as part of the first phase of an Israelisponsored military development program. Further funding for that program hasbeen delayed because of a reallocation of resources by the Israeli military.

 

•                       We haveentered into a non-exclusive cooperative agreement with France-based Sagem, SA,to develop a cell phone charger. Currently, neither we nor Sagem are activelypursuing this relationship.

 

*Production*

 

*Power Pack Charger.*  Our target is to have our Power Pack in theproduction process in 2004. Based on assumptions we have made concerningestimated component, manufacturing and distribution costs and sales prices, ourpreliminary estimates are that the Power Pack could be manufactured incommercial quantities at a cost of $9.00, and could be sold to the ultimateconsumer at a price of approximately $15.00 - $20.00. Since we have not beguncommercial production or distribution of this product, we can give you noassurance that the assumptions and estimates will prove to be accurate if andwhen our products are commercially successful.

 

*Refill Cartridges.*  We also intend to separately offerproprietary refueling cartridges to power our Power Pack and fuel cells oncethe fuel has been depleted. We have completed the design of our cartridge andour target is to be ready for production in 2004.

 

We see ourrefueling cartridge as a “razorblade” equivalent, holding out the prospect ofrepeated sales. Based on assumptions we have made concerning estimatedcomponent, manufacturing and distribution costs and sales prices, ourpreliminary estimates are that we will be able to manufacture in commercialquantities each refueling cartridge at a cost of $0.20. Our current plan isthat refueling

 

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cartridge for a cell phone sizePower Pack will be sold to the consumer for $1.00. Assuming that a consumerusing a next generation cell phone or other form of portable electronic devicewould use on average two fuel cartridges a month and would pay a price of $1.00per cartridge, that would result in a gross profit from refill cartridgespurchased by that consumer of $1.60 per month before distribution and othercosts. Since we have not manufactured or distributed refueling cartridges incommercial quantities, we can give no assurance that these assumptions andestimates will prove to be accurate if and when our products are commercially successful.

 

*Manufacturing Facilities.*At present, we have no plans to manufacture our fuel cell products but ratherto satisfy demand for our fuel cell products, if and when developed, byentering into license, joint venture or other arrangements with a company orcompanies that are capable of worldwide mass production of our products.

 

***Competition***

 

We expect tocompete against other fuel cell developers as well as against other advancedbattery technologies.

 

Our primarydirect competitors are companies developing small fuel cells for the portableelectronics market. These include Manhattan Scientifics Inc., which hasreported that it is developing a fuel cell to provide auxiliary power tocellular phones and pagers. Motorola, along with the Los Alamos NationalLaboratory in New Mexico, is also developing a direct methanol fuel cell formobile phones that it expects to run up to ten times longer than existingbatteries. Motorola has announced it expects to have a commercially viableproduct in 3-5 years. 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. and Neah Powers Systems, Inc., in which it has beenannounced that Intel has invested, and Smart Fuel Cell GmbH.

 

We believeother large cell phone and portable electronic device companies may also bedeveloping fuel cells for the portable electronics market. Some of suchcompanies providing public information about their fuel cell developmentprograms include Toshiba Corporation, NEC Corporation, Hitachi, Ltd., CasioComputer Co. Ltd., Samsung Electronics Co. Ltd. and Sony Corporation. Toshiba,Hitachi and other Japanese corporations have recently announced their intentionto unify the technical standards for micro fuel cells powered by methanol theyare each developing, in the hope of boosting the market for such fuel cells. Webelieve that there are other companies that we may not know of that aredeveloping fuel cells for portable electronic devices.

 

In addition,there are other fuel cell companies focusing on different markets than theportable electronic device market that we are targeting. These companies,including Plug Power, Avista Systems Inc., Fuel Cell Energy Inc. andH Power, are not primarily targeting the portable electronics market, althoughat any time these companies could introduce new products that compete directlyin the markets we are targeting. Ballard Power Inc., a recognized leaderin PEM fuel cell technology, has announced it is developing a direct methanolfuel cell for transportation and portable applications, however, we do not knowif this is intended for the portable electronic device market.

 

Additionally,we expect to compete with companies that develop, manufacture, and sellbattery-operated chargers for portable electronic devices, including zinc-airbatteries offered as chargers

 

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for cell phones, PDAs and otherportable electronic devices that target many of the same markets we intend totarget with our Power Pack.

 

We also expectindirect competition from battery manufacturers who utilize existing batterytechnologies (both chargeable and rechargeable). Existing battery technologieshave the significant advantage of having commercially available products today,and are backed by companies who are continuously investing in marketing andfurther research and development to improve their existing products and explorealternative technologies.

 

We expect ourfuel cell products to compete on the bases of size and weight, length ofoperating time, ease of use and cost.

 

**OurOther Technologies**

 

Starting withour formation in 1992, we have been working to develop and commercialize newtechnologies. The first of these technologies, the CellScan, was the primaryproduct of our indirect subsidiary, Medis El Ltd., through 1996. At the time ofour formation, Medis El granted us distribution rights to the CellScan in theUnited States and its territories and possessions. In 1994, Medis El acquiredits stirling cycle linear technologies and over the ensuing years, acquiredadditional technologies, including our direct liquid fuel cell technology andthe other technologies listed below. In 1998, we became Medis El’s exclusiveagent in North America for coordinating licensing arrangements with respect tothe stirling cycle and other technologies. In 2000, Medis El became ourindirect, wholly-owned subsidiary. With the exception of our highly conductivepolymers and our CellScan system, all of such technologies are in thedevelopment stage and no successful commercial prototypes have as yet beendeveloped, nor can we assure you that any such prototypes will be developed or,if developed, commercialized.

 

***Highly ConductivePolymers***

 

Our highlyconductive polymers, or HECPs, have electrical properties that can be changedover the full range of conductivity from insulators to metallic conductors andhave the non-corrosive properties, superior flexibility and durability ofplastics. Thus, they have a wide and diverse range of commercial uses,including uses for civilian and military products, particularly in electronicproducts such as sensors and capacitors. We believe that our advances in thefield of HECPs give us important advantages over conductive polymers we wouldcompete with, and we intend to manufacture and market our HECPs for sale tothird parties. To this end, we have established a small pilot facility tomanufacture HECPs in Or-Yehuda, Israel.

 

We havedemonstrated our HECPs and their potential applications to prospectivecustomers who have expressed interest in them. As a result, in January 2002, weentered into an agreement with a U.S. company to develop a new application forthe use of our HECPs in a PEM fuel cell component which could advance thedevelopment of such fuel cells for automobile, home and stationary power uses.The agreement provides for the payment to us over time of $300,000, of which wehave recognized $138,000 through December 31, 2002.

 

***CellScan***

 

The CellScanis a static cytometer—an instrument for measuring reactions of living cellswhile the cells are in a static state. A key element of the CellScan is itspatented cell carrier which can accommodate up to 10,000 cells in a study. TheCellScan can repeatedly and continuously monitor the

 

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intensity and polarization ofliving cells for purposes of cell research, disease diagnostics and determiningthe optimal chemotherapy to be given to a specific patient.

 

We havedeveloped a much smaller and less expensive version of our original CellScansystem with improved performance characteristics, including the number of cellsthat can be screened and analyzed per hour and the number of individual teststhat can be completed per hour. We are continuing to collaborate withthird-party researchers and institutions in the study and development ofpotential applications for the CellScan, including determining the efficacy ofchemotherapy drugs for specific tumors, the early detection of breast cancer,atherosclerosis, lupus and tuberculosis, and drug allergy detection.

 

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

 

•                       *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. The sensitivity and specificity levels achieved in suchstudies were promising, leading us to believe that the CellScan test may beuniquely suitable for testing high risk populations for early detection ofbreast cancer. As a result, we have established a CellScan laboratory inTashkent, Uzbekistan to perform multi-patient breast cancer studies incollaboration with the Uzbekistan Health Ministry, using a tetramer enhancedMUC-1antigen, which is a new biological reagent that we expect will furtherenhance the CellScan results. We are planning to send a team to Tashkent totrain local personnel in the use of the CellScan, and we expect that thestudies will be underway by the third quarter of 2003.

 

•                       *Chemosensitivity. *We have an on-going study in ourlaboratory in Israel to determine whether the CellScan could be used as a toolin determining the efficacy of chemotherapy drugs for specific tumors. Thepreliminary results of the study are promising, leading us to believe that theCellScan could serve as the basis for assessing drug sensitivity or resistanceof cancer cells derived from true-cut needle biopsies of human tumors, thusavoiding the use of toxic and inefficient drugs. In order to further study andcorroborate our earlier finding, we have entered into a contract with theInstitutul Oncologic in Romania to perform a multi-patient study utilizing theCellScan as a tool in determining the efficacy of chemotherapy drugs forspecific tumors.

 

•                       *OvarianCancer.*  We are indiscussions with Carmel Hospital in Israel to enter into a multi-patient studyto determine whether the CellScan can be used for early detection of ovariancancer. We are hopeful that such study will be underway shortly and that itwill utilize both conventional and tetrameric antigens.

 

•                       *Tuberculosis.*  In a study to determine whether the CellScancould be used in the diagnosis of tuberculosis, it was found that the CellScanwas more sensitive than the conventional Mantoux test for tuberculosis.Consequently, we are evaluating whether to commence a multi-patient study inorder to further determine the usefulness of the CellScan as a tool in thedetection of tuberculosis.

 

•                       *Lupus.*  In a recent mini-study performed in ourlaboratory in Israel to determine whether the CellScan can be used in thedetection of lupus disease, we found that the CellScan, used in conjunctionwith a new antigen, could be an efficient tool in the diagnosis and monitoringof lupus patients.

 

10

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•                       *DrugAllergy.*  A mini-study wasrecently performed in our laboratory in Israel to determine whether theCellScan can be used in a new method of diagnosing adverse reactions to drugs.This study compared several conventional clinical and laboratory methods forthe diagnosis of allergic reactions to drugs with a new method of diagnosingdrug reactions using the CellScan. The results indicated that the CellScan is apromising tool for detection of drug allergies.

 

Havingcompleted the development of the CellScan, we are ready to begincommercialization of the product. As part of the commercialization process, weare seeking to enter into distribution agreements with entities that havestrong marketing and distribution capabilities in various parts of the world.At the same time, we are interested in a program that would enable us tospin-off the assets relating to the CellScan and transfer the personnel to asubsidiary that has been formed for the commercialization of the CellScan. Aspart of such a program, we would seek private venture financing for thesubsidiary or seek to enter into a transaction with a company in thebiotechnology field whereby that company would acquire all or part of ourinterest in the CellScan. We can give no assurance that such a program can becarried out successfully. Additionally, depending on the level of ordersgarnered for the CellScan and any non-recourse financing available from theIsraeli government or otherwise, we may establish a facility to manufacture theCellScan.

 

***Stirling CycleSystem***

 

Our stirlingcycle system is a refrigeration system using our stirling cycle technologiesand a compressor powered by two of our linear reciprocating motors. Thestirling cycle is based upon a century-old technique that harnesses energy fromthe expansion and contraction of a gas forced between separate chambers and ourlinear reciprocating motor is based on our reciprocating electricaltechnologies. We believe that our stirling cycle system can offer advantagesfor certain applications over conventional refrigeration systems, includinggreater energy efficiency and being more environmentally friendly due to theuse of helium as its working gas instead of freon or freon compounds, which arecommonly believed to be depleting the earth’s ozone layer and contributing tothe “greenhouse effect” and global warming.

 

We havedeveloped a demonstration stirling cycle system that achieved in our laboratorytests a 130 watt cooling capacity, similar in power to the cooling capacity ofa 14 cubic foot beverage cooler, at a coefficient of performance of 1.7. Acoefficient of performance is a measurement of energy efficiency. We areplanning to present the results achieved to date with the demonstrationstirling cycle system we have developed to large companies capable of utilizingthis system and to seek to license the technology to and to join forces withsuch companies for further development of this technology.

 

***Toroidal Engine***

 

Our toroidalengine uses a rotary motion as contrasted with the up and down motion ofpistons in a conventional internal combustion engine. We believe that if we areable to successfully develop our toroidal engine, it could offers advantagesover a conventional internal combustion engine, including a simple design withfewer moving parts, better mechanical and thermal efficiency and a favorableweight to power ratio and volume to power ratio.

 

We havedeveloped and have recently completed testing of an approximately 61 cubic inchdemonstration engine based upon our toroidal technologies. Utilizing theinformation gained from our testing, we may build a new demonstrator whichcould be completed at a later date. However, we are reviewing the state of thedevelopment of our toroidal engine to decide at what level we allocate to ittime and funding going forward. We have decided to suspend the developmentprogram of our toroidal compressor and reallocate any resources originallyallocated to our other technologies.

 

11

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***Rankin Cycle LinearCompressor***

 

Our rankincycle linear compressor, which, using our linear reciprocating motor togetherwith a conventional compressor, is intended to replace the rotational electricmotor now powering conventional compressors for refrigeration and other coolingsystems. To date we have not succeeded in successfully developing thistechnology and we have decided to suspend its development program andreallocate any resources originally allocated to our other technologies.

 

**ResearchAnd Development**

 

Our researchand development programs are generally pursued by scientists employed by us inIsrael on a full-time basis or hired as per diem consultants. Most of thescientists working in the fuel cell field are emigres from the former SovietUnion where they worked on developing fuel cells for as much as fifteen years.We are also working with subcontractors in developing specific components ofour technologies.

 

Currently, ourmajor focus is on integrating our existing fuel cell technology as part ofproducts that require fuel cells while continuing to improve power output,carry out designs to resolve issues of orientation, complete development of therefueling cartridge and extend the length of use time for our direct liquidfuel cells. Another objective of our research and development programs is tofind new applications for our HECPs and catalysts. We also continue to carry onresearch related to expanding applications of the CellScan and completingdevelopment of certain of our other products.

 

We haveincurred research and development costs of approximately $4,493,000 for theyear ended December 31, 2000, $4,251,000 for the year ended December31, 2001 and $4,161,000 for the year ended December 31, 2002.

 

**Government Regulation**

 

Currently, theonly regulations we encounter are the regulations that are common to allbusinesses, such as employment legislation, implied warranty laws, andenvironmental, health and safety standards, both in the United States andIsrael, to the extent applicable. It is likely we will encounter industryspecific government regulations in the future in the jurisdictions in which weoperate. It may become the case that regulatory approvals will be required forthe design and manufacture of our fuel cells and the use of our proprietaryfuel, and other components of the fuel cell such as the electrolyte.Furthermore, we must obtain from the State of Israel permits to work withcertain chemicals used to make our fuel cells. To the extent that there aredelays in gaining regulatory approval, our development and growth may beconstrained.

 

**IntellectualProperty**

 

We rely on acombination of patent, copyright, trademark, trade secret and contract laws, aswell as international treaties, to protect our proprietary rights to ourintellectual property which includes technical know-how, designs, specialmaterials, manufacturing techniques, test equipment and procedures for fuelcells, fuel cell components and fuel cell systems, as well as our othertechnologies. Our policy is to secure, directly or through licensingarrangements, patent protection for significant innovations to the fullestextent practicable.

 

We have beenissued two U.S. patents and have received Notices of Allowance from the U.S.Patent Office relating to two additional patents for our fuel cell technology.We expect these patents to be issued in the second and fourth quarter quartersof 2003. Furthermore, we have seven other patents

 

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pending which we are pursuingand we are preparing new patent applications with respect to our fuel celltechnology in the United States. Corresponding applications have been filed orare intended to be filed under the Patent Cooperation Treaty, which allows us limitedprotection in all of its 45 member countries for periods ranging from24-30 months, during which time patent applications can be filed in suchcountries. We recently received a favorable opinion under the PatentCooperation Treaty relating to the catalyst and electrode components of ourfuel cell technology. Although we expect to file patent applications in most ofthe larger markets that are member countries, we have not yet ascertained whichof these jurisdictions we will file in. Patent applications filed in foreigncountries are subject to laws, rules and procedures which differ from those ofthe United States, and even if foreign patent applications issue, some foreigncountries provide significantly less patent protection than the United States. Weare contemplating filing a number of additional patents in the United Statesand elsewhere covering other of our fuel cell technologies.

 

We have beengranted two patents relating to our stirling cycle system, four patentsrelating to our toroidal technologies (one of which is owned by a 75% indirectsubsidiary), one patent relating to our reciprocating electrical machine andone patent relating to our direct current regulating device (which is owned bya 75% indirect subsidiary). We also have one patent pending each relating toour highly conductive polymers and our stirling cycle system, and two patentspending each relating to our toroidal compressor and our reciprocatingelectrical technologies. Each of such patents expires 17 years from the issue dateof such patent, the earliest of which will be in 2014.

 

Furthermore,we are the exclusive worldwide licensee of Bar-Ilan University’s patents,patent applications and any other proprietary rights relating to the CellScan.Bar-Ilan owns, or has applied for, corresponding patents in Europe, Japan,Israel, Canada and various other countries, of which we are the licensees. Weare required to pay Bar-Ilan a royalty through 2005 at the rate of 6.5% ofproceeds of sales, after deducting sales commissions and other customarycharges, and 4.5% of any fees received on account of the grant of territorialrights, and for the ensuing ten years a royalty of 3.5% of all revenues,whether from sales or fees. In addition, we are required to pay $100,000 toBar-Ilan during the first year in which our post-tax profits relating to theCellScan exceed $300,000. The license contains provisions relating to the jointprotection of the licensed patent rights and other provisions customary in suchinstruments. We have also been issue a patent relating to our CellScan CellCarrier.

 

In addition topatent protection, we rely on the laws of unfair competition and trade secretsto protect our licensed or proprietary rights. We attempt to protect our tradesecrets and other proprietary information through agreements with ourcollaborators, through confidentiality agreements with employees, consultants,potential joint ventures and licensees and other security measures.

 

**Employees**

 

As of December31, 2002, in addition to our chief executive officer and our president, we had45 full time employees, of which approximately 41 were engineers, scientistsand degreed professionals and 4 were technical, administrative andmanufacturing support personnel. There are also approximately 18 engineers, scientistsand degreed professionals who work with us as consultants researching anddeveloping our technologies on a part time basis. We consider relations withour employees to be satisfactory.

 

**Item 2.    Properties**

 

We presentlymaintain our U.S. executive offices in premises of approximately 3,000 squarefeet at 805 Third Avenue, New York, New York 10022 under a sublease from theStanoff Corporation, which

 

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is controlled by Robert K.Lifton, our chairman and chief executive officer, and Howard Weingrow, ourpresident. We pay approximately $112,000 for rent per year. The sublease is ona month to month basis.

 

Our researchlaboratory and technology center and Israel-based executive offices and backoffice functions are located at a leased facility of approximately 12,700square feet in Yehud, Israel. The rental expense for this lease, which has aterm until December 2003 with a one-year option extending toDecember 2004, is approximately $194,000 per year. We also lease amanufacturing facility of approximately 2,000 square feet in Or-Yehuda, Israelrelating to the HECPs. The Or-Yehuda lease expires on December 31, 2003and has a one-year options extending to December 31, 2004. The annualaggregate rent is approximately $14,000. We believe our facilities are adequatefor our present purposes; however, if there are orders to purchase our HECPs inexcess of that facility’s current capacity, we will be required to expand thatfacility as necessary to meet such increased demand.

** **

**Item 3.    LegalProceedings**

 

We are notparty to any material litigation, and we are not aware of any threatenedlitigation that would have a material adverse effect on us or our business.

 

**Item4.    Submission of Matters to a Vote ofSecurity Holders**

 

No matterswere submitted to a vote of securityholders during the fourth quarter of thefiscal year ended December 31, 2002.

 

**PART II**

 

**Item5.    Market For Registrant’s CommonEquity and Related Stockholder Matters**

 

Our commonstock has traded on the Nasdaq National Market under the symbol “MDTL” sinceOctober 3, 2000. Between June 6, 2000 and October 2, 2000, our commonstock was traded on the Nasdaq SmallCap Market under the same symbol. Prior toJune 6, 2000, there was no public market for our common stock. The closing highand low sales prices of our common stock, as reported by the Nasdaq NationalMarket, for the quarters indicated are as follows:

 

|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| **2001:**      |   |     |   |    |   |
| First Quarter  |   | 23.875   |   | 13.250  |   |
| Second Quarter |   | 19.700   |   | 11.000  |   |
| Third Quarter  |   | 12.930   |   | 4.010   |   |
| Fourth Quarter |   | 9.239    |   | 5.640   |   |
|           |   |     |   |    |   |
| **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   |   |

 

As ofMarch 19, 2003, there were approximately 726 stockholders of record of ourcommon stock. Such number does not include beneficial owners holding sharesthrough nominee names.

 

We have neverdeclared or paid any dividends on our common stock. We currently anticipatethat we will retain all of our future earnings for use in the expansion andoperation of our business. Thus, we

 

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do not anticipate paying anycash dividends on our common stock in the foreseeable future. Our futuredividend policy will be determined by our board of directors and will depend onvarious factors, including our results of operations, financial condition,capital requirements and investment opportunities. In addition, the terms ofour credit facility restrict our ability to pay dividends on our common stock.

 

In February2002, six of our Israeli employees and officers exercised options to purchasean aggregate of 66,180 shares of our common stock. We received gross proceedsof $309,000 as a result of such exercises, which we used for general corporatepurposes.

 

Exemption fromregistration under the Securities Act of 1933, as amended, in connection withthe foregoing transactions, is claimed under Section 4(2) of the Securities Actas a transaction by the issuer not involving a public offering.

** **

**Item6.    Selected Financial Data**

 

The selectedconsolidated statement of operations data for the years ended December 31,1998 and 1999 and the selected consolidated balance sheet data as ofDecember 31, 1998, 1999 and 2000 have been derived from audited financialstatements not included in this report. The selected consolidated statement ofoperations data for the years ended December 31, 2000, 2001, and 2002 and theselected consolidated balance sheet data as of December 31, 2002 and 2001 havebeen derived from our audited financial statements included elsewhere in thisreport. Such consolidated financial statements include the financial statementsof all of our direct and indirect subsidiaries. The data should be read in conjunctionwith the consolidated financial statements and the notes to such statements and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” included elsewhere in this report.

** **

**Statementof Operations Data**

** **
|                                          |   | **For the  Year Ended December 31,** |       |
|-----------------------------------------------|--------|--------------------------------------|------------|
|                                          |   | **1998**                             | ** ** | **1999** | ** ** | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** |
| Sales                                         |   | $                                    | 8,000      |   | $ | — |   | $ | — |   | $ | — |   | $ | 192,000 |   |
| Cost of sales                                 |   | 3,000                                |       | — |   | — |   | — |   | 130,000 |   |
| Gross profit                                  |   | 5,000                                |       | — |   | — |   | — |   | 62,000 |   |
| Operating expenses:                           |   |                                 |       |   |   |   |   |   |   |   |   |
| Research and development costs, net           |   | 1,646,000                            |       | 2,749,000 |   | 4,493,000 |   | 4,251,000 |   | 4,161,000 |   |
| Selling, general and administrative  expenses |   | 1,399,000                            |       | 2,467,000 |   | 5,405,000 |   | 6,297,000 |   | 3,642,000 |   |
| Amortization of intangible assets             |   | 2,445,000                            |       | 2,574,000 |   | 13,668,000 |   | 21,129,000 |   | 2,633,000 |   |
| Total operating expenses                      |   | 5,490,000                            |       | 7,790,000 |   | 23,566,000 |   | 31,677,000 |   | 10,436,000 |   |
| Loss from operations                          |   | (5,485,000                           | )          | (7,790,000 | ) | (23,566,000 | ) | (31,677,000 | ) | (10,374,000 | ) |
| Other income (expenses):                      |   |                                 |       |   |   |   |   |   |   |   |   |
| Interest and other income                     |   | 63,000                               |       | 150,000 |   | 214,000 |   | 178,000 |   | 151,000 |   |
| Interest expense                              |   | (101,000                             | )          | (22,000 | ) | (13,000 | ) | (63,000 | ) | (82,000 | ) |
| Loss before minority interest                 |   | (5,523,000                           | )          | (7,662,000 | ) | (23,365,000 | ) | (31,562,000 | ) | (10,305,000 | ) |
| Minority interest in loss of subsidiaries     |   | 1,105,000                            |       | 1,697,000 |   | 873,000 |   | — |   | — |   |
| Net loss                                      |   | (4,418,000                           | )          | (5,965,000 | ) | (22,492,000 | ) | (31,562,000 | ) | (10,305,000 | ) |
| Value of warrants                             |   | —                               |       | — |   | (2,971,000 | ) | (3,204,000 | ) | (2,241,000 | ) |
| Net loss attributable to common stockholders  |   | $                                    | (4,418,000 | ) | $ | (5,965,000 | ) | $ | (25,463,000 | ) | $ | (34,766,000 | ) | $ | (12,546,000 | ) |
| Basic and diluted net loss per share          |   | $                                    | (0.45)     | (1) | $ | (0.53) | (1) | $ | (1.56 | )(1) | $ | (1.76) | (1) | $ | (0.60 | ) |
| Weighted average shares outstanding           |   | 9,843,295                            | (1)        | 11,248,745 | (1) | 16,331,105 | (1) | 19,771,338 | (1) | 20,894,915 |   |

 

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**BalanceSheet Data:**

** **
|                                          |   | **As of  December 31,** |      |
|-----------------------------------------------|--------|-------------------------|-----------|
|                                          |   | **1998**                |      | **1999** |   | **2000** |   | **2001** |   | **2002** |   |
| Working capital                               |   | $                       | 3,536,000 |   | $ | 1,083,000 |   | $ | 2,522,000 |   | $ | 5,489,000 |   | $ | 5,037,000 |   |
| Total assets                                  |   | 14,755,000              |      | 10,226,000 |   | 87,202,000 |   | 69,894,000 |   | 66,894,000 |   |
| Long-term debt, excluding current  maturities |   | 96,000                  |      | 11,000 |   | — |   | — |   | — |   |
| Accumulated deficit                           |   | (17,650,000             | )         | (23,615,000 | ) | (49,078,000 | ) | (83,844,000 | ) | (96,390,000 | ) |
| Total stockholders’ equity               |   | 12,406,000              |      | 8,561,000 |   | 86,142,000 |   | 68,634,000 |   | 65,405,000 |   |
|                                               |        |                         |           |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| (1) | In  accordance with Statement of Financial Accounting Standards No. 128,  “Earnings Per Share,” the weighted average shares used in computing basic and  diluted net loss per share, and the basic and diluted net loss per share,  have been adjusted to give retroactive effect to shares issued in our March  18, 2002 rights offering. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 

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**Item 7.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

**Introduction**

 

Thispresentation includes the operations of our wholly and majority ownedsubsidiaries, unless we tell you otherwise.

 

**Resultsof Operations**

 

From ourinception in April 1992 through December 31, 2002 we have generated anaccumulated deficit of approximately $96,390,000, including approximately$42,390,000 from amortization expense. We expect to incur additional operatinglosses during 2003 and possibly thereafter, principally as a result of ourcontinuing anticipated research and development costs, selling, general andadministrative expenses and the uncertainty of bringing our fuel celltechnology or any of our other technologies to commercial success.

 

Our researchand development costs have increased from approximately $2,749,000 in 1999 toapproximately $4,161,000 in 2002; however, we anticipate that our failure tosuccessfully commercially develop our fuel cell technology or any of our othertechnologies will force us to curtail our spending levels until such time, ifever, as we generate revenues or otherwise receive funds from third partysources. If we begin to market and sell any of our technologies, we willincrease such expenses to the extent necessary, which we expect to fund out ofrevenues.

 

***Year ended December31, 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 $62,000 duringthe year ended December 31, 2002, compared to none during the same periods in2001. An aggregate of $138,000 of such revenues are attributable to a January2002 agreement to develop for a third party an application for the use of ourHECPs in its fuel cell products. The remaining $54,000 of such revenues areattributable to work performed under a completed January 2002 purchase order inwhich we designed a direct liquid fuel cell for use in a new energy pack forinfantry soldiers.  All of such revenuesare 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:

 

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•                       *Fuel CellTechnologies*. We incurred costs relating to our fuel cell technologiesof approximately $2,280,000 during the year ended December 31, 2002, comparedto costs of approximately $1,673,000 during the year ended December 31, 2001.This increases in our research and development expenses relating to our fuelcell technologies of approximately $607,000 during the year ended December 31,2002 reflect management’s decision to continue to devote substantial resourcesto the development of our fuel cell technologies.

 

•                       *CellScan*.We incurred costs relating to the refinement of the next generation CellScansystem and on various CellScan research activities of approximately $1,235,000during the year ended December 31, 2002, compared to costs of approximately$1,870,000 during the year ended December 31, 2001. The decrease can be primarilyattributed to lower labor, materials and depreciation costs, somewhat offset byincreases in costs incurred related to the retention of third party researchersin the development and testing of new CellScan applications.

 

•                       *ToroidalTechnologies, Stirling Cycle System and Linear* Compressor. Weincurred costs relating to our toroidal engine and compressor, stirling cyclesystem and linear compressor of approximately $625,000 during the year endedDecember 31, 2002, compared to costs of approximately $692,000 during the yearended December 31, 2001. The decrease during the year ended December 31, 2002can be primarily attributed to decreases in costs incurred from the use ofconsultants and subcontractors, as well as decreases in labor costs, with respectto 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.

 

Managementbelieves that, as an additional operational measurement, earnings (loss) beforeinterest, taxes, depreciation, and amortization, or EBITDA, is useful andmeaningful to an understanding of our operating performance. EBITDA should notbe considered in isolation or as a substitution for net income (loss) or cashflow data or as a measure of our profitability or liquidity. Items excludedfrom EBITDA, such as depreciation and amortization, are significant componentsin understanding and assessing our financial performance.

 

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Thecomputation of EBITDA for the years ended December 31, 2001 and 2002 is setforth in the table below: 

 
|                                          |   | **Year Ended December 31,** |        |
|-----------------------------------------------|--------|-----------------------------|-------------|
|                                          |   | **2001**                    |        | **2002** |   |
| Net loss attributable to  common shareholders |   | $                           | (34,766,000 | ) | $ | (12,546,000 | ) |
| Add: interest expense                         |   | 59,000                      |        | 71,000 |   |
| Add: amortization                             |   | 21,129,000                  |        | 2,633,000 |   |
| Add: depreciation                             |   | 587,000                     |        | 256,000 |   |
| EBITDA                                        |   | $                           | (12,991,000 | ) | $ | (9,586,000 | ) |

 

The decreasein the loss before interest, taxes, depreciation, and amortization for the yearended December 31, 2002 as compared to the year ended December 31, 2001occurred primarily due to reasons discussed earlier in this section.

 

***Year ended December31, 2001 compared to year ended December 31, 2000***

 

We sustainednet losses of $31,562,000 during the year ended December 31, 2001, compared to$22,492,000 during the year ended December 31, 2000. The increase in net lossescan primarily be attributed to a substantial increase in amortization ofintangible assets acquired in connection with our acquisition of the minorityinterest of Medis El Ltd. in our June 2000 exchange offer for all of Medis El’sordinary shares not owned by us.

 

Research anddevelopment costs amounted to $4,251,000 for the year ended December 31, 2001,compared to $4,493,000 during the year ended December 31, 2000. Research anddevelopment costs incurred during 2001 compared to 2000 were lower as a resultof (i) non-recurring expenditures aggregating $320,000 during the yearended December 31, 2000 relating to the write-off of acquiredin-process research and development in connection with the acquisition ofadditional shares of More Energy Ltd., our majority-owned subsidiary forthe development of fuel cells, (ii) non-recurring charges of approximately$561,000 during the year ended December 31, 2000 relating to the write-off ofacquired in-process research and development incurred in connection with theMedis El exchange offer, allocated among the fuel cell, toroidal and stirlingcycle technologies and (iii) a decrease of approximately $278,000 in costsrelating to the CellScan during the year ended December 31, 2001 compared tothe same period in 2000. These factors, however, were somewhat offset by anincrease in spending on our fuel cell technologies during the year endedDecember 31, 2001 compared to the same period in 2000. The research anddevelopment activities for the periods presented include:

 

•                       *Fuel CellTechnologies.* We incurred costs relating to our fuel celltechnologies of approximately $1,673,000 during the year endedDecember 31, 2001, compared to costs of approximately $1,299,000 duringthe year ended December 31, 2000. As mentioned above, our costs relating to thefurther development of our fuel cell technologies increased substantially in2001, even though in 2000 we incurred non-recurring expenditures aggregating$320,000 relating to the acquisition of additional shares of More Energy and acharge of approximately $182,000 from the write-off of acquired in-processresearch and development in connection with the Medis El exchange offer.

 

•                       *CellScan*.We incurred costs relating to the refinement of the next generation CellScansystem of approximately $1,870,000 during the year ended December 31, 2001,compared to costs of approximately $2,148,000 during the year ended December31, 2000. The decrease is mainly due to less funds being devoted tocollaborative research programs with third parties and procurement of materialsfor the CellScan. These factors were partially offset by increases in salaryand other related costs for research and development personnel and depreciationexpense incurred in 2001.

 

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•                       *ToroidalTechnologies and Stirling Cycle System*. We incurred costs relatingto our toroidal engine and compressor and the stirling cycle linear system ofapproximately $692,000 during year ended December 31, 2001, compared to costsof approximately $1,011,000 during the year ended December 31, 2000. Asdescribed above, costs incurred in 2000 were higher than those in 2001primarily due to non-recurring charges during the year ended December 31, 2000of approximately $379,000 from the write-off of acquired in-process researchand development in connection with the Medis El exchange offer, partiallyoffset by increases in salary and related costs and other expenses in 2001.

 

Selling,general and administrative expenses for the year ended December 31, 2001amounted to approximately $6,297,000, compared to approximately $5,405,000 forthe year ended December 31, 2000. The increase can be primarily attributed tonon-cash charges of approximately $3,334,000 relating to stock options andwarrants issued to officers, directors, employees and consultants for the yearended December 31, 2001 (approximately half of such charges relating to theextension of the expiration date of outstanding options and certain warrants),compared to $2,789,000 during the same period in 2000, as well as increases insalary and related costs and other expenses.

 

Amortizationof intangible assets amounted to $21,129,000 during the year ended December 31,2001, compared to $13,668,000 for the year ended December 31, 2000. Theincrease during year ended December 31, 2001 compared to the same period in2000 was primarily due to amortization expense of approximately $18,397,000during the year ended December 31, 2001 compared to $11,013,000 for the sameperiod in 2000 relating to goodwill of approximately $81,867,000 and acquiredtechnology assets of approximately $6,071,000, which was acquired upon thecompletion of the Medis El exchange offer.

 

Managementbelieves that, as an additional operational measurement, earnings (loss) beforeinterest, taxes, depreciation, and amortization, or EBITDA, is useful andmeaningful to an understanding of our operating performance. EBITDA should notbe considered in isolation or as a substitution for net income (loss) or cashflow data or as a measure of our profitability or liquidity. Items excludedfrom EBITDA, such as depreciation and amortization, are significant componentsin understanding and assessing our financial performance.

 

Thecomputation of EBITDA for the year ended December 31, 2000 and 2001 is setforth in the table below: 

 
|                                          |   | **Year Ended December 31,** |        |
|-----------------------------------------------|--------|-----------------------------|-------------|
|                                          |   | **2000**                    |        | **2001** |   |
| Net loss attributable to  common shareholders |   | $                           | (25,463,000 | ) | $ | (34,766,000 | ) |
| Add: interest expense                         |   | 13,000                      |        | 59,000 |   |
| Add: amortization                             |   | 13,668,000                  |        | 21,129,000 |   |
| Add: depreciation                             |   | 363,000                     |        | 587,000 |   |
| EBITDA                                        |   | $                           | (11,419,000 | ) | $ | (12,991,000 | ) |

 

The increasein the loss before interest, taxes, depreciation, and amortization for the yearended December 31, 2001 as compared to the year ended December 31, 2000occurred primarily due to reasons discussed earlier in this section, as well asthe minority interest share in the losses of Medis El of $873,000 for the yearended December 31, 2000 as compared to none in 2001.

 

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**LiquidityAnd Capital Resources**

** **

We have historicallyfinanced our operations primarily through the proceeds of investor equityfinancing, long-term bank loans to Medis El guaranteed by the State of Israel,grants to Medis El from the State of Israel, initial sales of our products andfees from the granting of exclusive distribution rights. Furthermore, wecurrently have available a credit line which has not been drawn upon.

 

In May andJune 2001, we issued in private placements a total of 660,688 shares ofour common stock and warrants to purchase 660,688 shares of our common stock,for aggregate proceeds of $10,571,000, less issuance costs of approximately$331,000. Additionally, between July and November 2001, we issued 41,100shares of our common stock upon the exercise of outstanding warrants, foraggregate cash proceeds of approximately $150,000. The net proceeds of suchissuances are being used for research and development projects with respect toour products and technologies and selling, general and administrative expenses.

 

On March 18,2002, we completed a rights offering in which we offered to our existingstockholders subscription rights to purchase an aggregate of 3,500,000 sharesof our common stock at a purchase price of $2.00 per share. We received grossproceeds of $7,000,000 from the rights offering, which proceeds, afterdeducting related expenses of approximately $461,000, are being used forworking capital, including for the continued development of our direct liquidfuel cell technology, as well as for selling, general and administrativeexpenses. Furthermore, pursuant to our shareholder loyalty program, inSeptember and October 2002, we issued warrants to purchase an aggregate of856,021 shares of our common stock, of which warrants to purchase 8,162 shareshave been exercised through March 15, 2003, generating proceeds ofapproximately $36,000. We intend to use the proceeds from these exercises aswell as from any future exercises for working capital and selling, general andadministrative expenses.

 

On October 24,2002, we entered into an amendment to the agreement governing our existing$5,000,000 revolving credit line. Pursuant to the amendment, the terminationdate of the revolving credit line was extended from December 28, 2002 toDecember 26, 2003. Additionally, on February 20, 2003, we entered into a secondamendment to such agreement. Pursuant to the second amendment, the terminationdate of the revolving credit line was extended from December 26, 2003 to July1, 2004. No other terms of the agreement were amended by the amendment. We havenot borrowed any funds under this credit line to date.

 

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 $5,000,040 from the rights offering, which proceeds, afterdeducting related expenses of approximately $110,000, are being used forworking capital, including for the continued development of our direct liquidfuel cell technology, as well as for selling, general and administrativeexpenses.

 

For the yearended December 31, 2002, net cash used in operating activities was $6,782,000,as compared to $5,788,000 for year ended December 31, 2001. The increase wasprimarily attributable to increases in levels of spending on research anddevelopment and selling, general and administrative expenses, during the yearended December 31, 2002 compared to the year ended December 31, 2001, for thereasons discussed above.

 

For the yearended December 31, 2002, net cash used in investing activities was $238,000,which represented purchases of property and equipment of $263,000, partiallyoffset by proceeds from disposals of property and equipment of $25,000. This iscompared to $1,294,000 for the year ended December 31, 2001, which represented$520,000 used to acquire an option to purchase the remaining 7% of More

 

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Energy we did not own and$799,000 for the purchase of property and equipment, partially offset byproceeds of $25,000 from the disposal of property and equipment.

 

For the yearended December 31, 2002, cash aggregating $7,057,000 was provided by financingactivities, compared to $10,196,000 for the year ended December 31, 2001. Thecash provided 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 of warrants to purchase our common stock issued pursuant to our shareholderloyalty program, which generated gross proceeds of approximately $15,000. Thecash provided by financing activities during the year ended December 31, 2001related to our sale in private placements of 660,688 shares of our common stockand warrants to purchase 660,688 shares of our common stock, for aggregateproceeds of $10,571,000, less issuance costs of approximately $331,000.Additionally, between July and November 2001, we issued pursuant to theexercise of warrants 41,100 shares of our common stock, for aggregate proceedsof approximately $150,000. Additionally, we incurred issuances costs in 2001related to our March 2002 rights offering of $194,000.

 

As of December31, 2002, we had approximately $6,036,000 in cash and cash equivalents, as wellas an unused $5,000,000 revolving credit line which terminates in accordancewith its terms on July 1, 2004. Our working capital and capital requirements atany given time depend upon numerous factors, including, but not limited to:

 

•                  the progress ofresearch and development programs;

•                  the status ofour technologies; and

•                  thelevel of resources that we devote to the development of our technologies,patents, marketing and sales capabilities.

 

Anothercontributing factor is the status of collaborative arrangements with businessesand institutes for research and development and companies participating in thedevelopment of our technologies. Since January 2002, we have entered into threecollaborative arrangements with third parties, in which we realized revenues of$192,000 on costs of sales of $130,000. There can be no assurance that we willrealize additional revenue from such collaborative arrangements or that we willenter into additional collaborative arrangements in the future. Additionally,we are considering various financing approaches, including the sale of oursecurities, in order to strengthen our balance sheet so as to better negotiatesuch additional collaborative arrangements, if any, from a more advantageousfinancial position. There can be no assurance that we will raise additionalfunds through any financing approach implemented by us.

 

As of December31, 2002, we believe that our cash resources, since augmented by the netproceeds from our March 2003 rights offering, and monies available to us fromour credit facility, will be sufficient to support our operating anddevelopmental activities for at least the next 25 months. Beyond suchtime, we may require capital infusions of cash to continue our operations,whether through debt financing, issuance of shares or from companies or otherorganizations participating in the development of our technologies. However, tothe extent we are unable to raise or acquire additional other funds, we willcurtail research and development of one or more technologies until such time aswe acquire additional funds.

 

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**TaxMatters**

 

As ofDecember 31, 2002, for U.S. federal income tax purposes, we have netoperating loss carry-forwards of approximately $7,982,000. For Israeli incometax purposes, we have net operating loss carry-forwards of approximately$37,624,000. Since our inception, we have not had any taxable income. Also,neither we nor any of our subsidiaries have ever been audited by the UnitedStates or Israeli tax authorities since incorporation.

 

Theavailability of our U.S. net operating loss carry-forwards may be reduced tothe extent one or more direct or indirect holders of 5% or greater amount ofour common stock increases their equity interest in us by more than 50% in theaggregate.

 

**GrantsObtained From The State Of Israel**

 

Medis El, ourindirect wholly-owned subsidiary, received approximately $1,800,000 in researchand development grants from the Office of the Chief Scientist of the Ministryof Commerce and Industry of the State of Israel from its inception to 1997.This is based upon a policy of the government of Israel to provide grants ofbetween 50% and 66% of qualifying approved research and developmentexpenditures to promote research and development by Israeli companies. Medis Elreceived 50% of qualifying approved research and development expenditures, with$1,629,000 of such funds being allotted for the CellScan and $167,000 allottedfor the neuritor. Pursuant to the grant arrangement, Medis El is required topay 3% of its sales of CellScan and neuritor products developed with the grantfunds until the grant amounts are paid in full. There is no requirement torepay the grants if the products developed with the grant funds are not sold. IfMedis El sells the underlying technology prior to repaying the grant funds, itmust first seek permission from the Israeli government for such sale. Prior toMedis El 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, 2002, 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.

 

**ApprovedEnterprise**

 

Under theIsraeli Law for the Encouragement of Capital Investments, 1959, Medis El wasissued a certificate of approval as an “Approved Enterprise.” Under the law,Medis El elected the “combined path,” pursuant to which Medis El had the rightto receive a government guaranteed bank loan of 66% of the amount of theapproved investment. In addition, Medis El had the right to receive a grant of 25%of the approved investment, in which case the loan would be reduced by theamount of the grant. Medis El received investment grants of approximately$97,000 and loans of approximately $893,000. The investment grants were used toinvest in equipment, furniture and fixtures and commercial vehicles. The loanproceeds were used for the above as well as to acquire know-how, leaseholdimprovements, marketing and working capital. The loans were paid-off in fullduring the year ended December 31, 2000. Additionally, the tax liabilityin respect of Medis El’s income deriving from its Approved Enterpriseactivities is calculated at a rate of 20% of income for a ten-year period, withtax on dividends distributed of 15%, instead of 25%. These tax benefits expirein 2006.

 

In September2001, More Energy, our fuel cell subsidiary, was granted Approved Enterprisestatus totaling $5,300,000. More Energy is entitled to a tax benefit period of10 years on income derived from this program, as follows: a full income taxexemption for the first six years and a reduced income tax rate of 25% (insteadof the regular rate of 36%) for the remaining four year period. If More Energydistributes a cash dividend out of retained earnings which were tax exempt dueto its approved enterprise

 

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status, it would be required topay a 25% corporate tax on the amount distributed and a further 15% withholdingtax would be deducted from the amount distributed to the recipients. ShouldMore Energy derive income from sources other than the approved enterpriseprograms during the relevant period of benefits, this income would be taxableat the regular corporate tax rate of 36%. The benefits from the approvedenterprise programs depend upon More Energy fulfilling the conditions under thegrant and the laws governing the grant. If More Energy does not comply withthese conditions, the tax benefits may be canceled, and it may be required torefund the amount of the canceled benefit, with the addition of linkagedifference and interest.

 

**CriticalAccounting Policies**

 

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

 

***Goodwill and OtherIntangible 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, 2002, the net book value of ourgoodwill and other intangible assets totaled $59,037,000. Our goodwill andother intangible assets arose primarily as a result of two purchase accountingtransactions: our acquisition of the minority interest in Medis Inc. in 1997and our exchange of our shares for the minority interest in Medis El in 2000.In amortizing our goodwill through December 31, 2001 and our other intangibleassets through December 31, 2002, we made estimates and assumptions regarding theuseful lives of such assets. If our estimates and assumptions change, theuseful lives and resulting charges to operations for amortization of suchassets would also change.

 

Additionally,with respect to our goodwill and intangible assets, as of January 1, 2002, weadopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which was issuedby the Financial Accounting Standards Board in June 2001. SFAS No. 142requires goodwill be subject to at least an annual assessment for impairmentwith amortization over its estimated useful life to be discontinued effectiveJanuary 1, 2002. As part of our initial evaluation of our goodwill andother intangible assets for any possible impairment, as of January 1, 2002, wewere required to use estimates and assumptions with respect to future cashflows, discount rates and timing of commercialization of our technologies indetermining the fair value of our reporting units. We have also carried forwardour initial evaluation in performing our annual test for impairment of ourgoodwill. If these estimates and/or assumptions change, we may, in the future,be required to record charges to operations for impairment of our goodwilland/or other intangible assets. 

 

***Stock Options andWarrants***

 

We alsoconsider accounting policies related to stock options and warrants to becritical due to the estimation process involved. We utilize stock options as animportant means of compensation for employees, directors and consultants andwarrants as an instrument in our fundraising process. Accounting for suchoptions and warrants, in some circumstances, results in significant non-cashcharges to operations or accumulated loss. There are assumptions and estimatesinvolved in determining the value of such stock options and warrants and thetiming of related charges to our operations or accumulated loss. Theseestimates and assumptions include the expected term of the option, volatilityof our stock and

 

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interest rates. The marketprice of our stock also has a significant impact on charges we incur fromperiod to period related to stock options and warrants. If these estimates andassumptions change or if our stock price changes, the charges to operationsand/or accumulated loss would also change.

 

***Deferred IncomeTaxes***

 

We record avaluation allowance to reduce our deferred tax assets to zero. In the eventthat we were to determine that we would be able to realize all or part of ourdeferred tax assets in the future, an adjustment to the deferred tax assetswould be credited to operations in the period such determination was made.

 

**RecentAccounting Pronouncements**

 

In June 2001,the Financial Accounting Standards Board (FASB) issued SFAS No. 141, “BusinessCombinations,” and No. 142, “Goodwill and Other Intangible Assets,” effectivefor fiscal years beginning after December 15, 2001. Under the new rules,goodwill and intangible assets deemed to have indefinite lives are no longeramortized, but are subject to annual impairment tests in accordance with thestatements. Other intangible assets continue to be amortized over their usefullives. We applied the new rules on accounting for goodwill and other intangibleassets as of January 1, 2002 and have performed the required tests of goodwilland indefinite lived intangible assets. Based on the results, we have notrecorded any charges related to the adoption of and subsequent conformity withSFAS No. 142.

 

In August2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” effective for fiscal years beginning after December 15,2001. This standard superceded Statement of Financial Accounting Standard No.121, Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to Be Disposed Of, and provided a single accounting model for long-livedassets to be disposed of. SFAS No. 144 was effective for us beginning with thefirst quarter of 2002 and its adoption did not have a material impact on ourresults of operations or financial position.

 

In December2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting forStock-Based Compensation” to provide alternative methods of transition for avoluntary change to the fair value based methods of accounting for stock-basedemployee compensation. In addition, SFAS No. 148 amends the disclosurerequirements of SFAS No. 123 to require more prominent disclosures in bothannual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults. The additional disclosure requirements of SFAS No. 148 are effectivefor fiscal years ending after December 15, 2002. As provided for in SFAS No.148, we have elected to continue to follow the intrinsic value method ofaccounting as prescribed by APB Opinion No. 25, Accounting for Stock Issued toEmployees, to account for stock options granted to employees.

 

In June 2001,the FASB issued SFAS No. 143 “Accounting for Asset Retirement Obligations.”SFAS No. 143 addresses accounting and reporting for obligations associatedwith the retirement of tangible long-lived assets and the associated retirementcosts. This statement is effective for fiscal years beginning after June 15,2002. We are currently assessing the impact of the adoption of this newstandard, although we do not expect it to affect our consolidated financialstatements.

 

In April 2002,the FASB issued SFAS No. 145, “Rescission of SFAS Nos. 4, 44 and 64, Amendmentof SFAS No. 13, and Technical Corrections as of April 2000.” SFAS No. 145revises the criteria for classifying the extinguishment of debt asextraordinary and the accounting treatment of certain

 

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lease modifications. SFAS No.145 is effective in fiscal 2003 and is not expected to have a material impacton our consolidated financial statements.

 

In July 2002,the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities.” SFAS No. 146 provides guidance on the timing of therecognition of costs associated with exit or disposal activities. The newguidance requires costs associated with exit or disposal activities to berecognized when incurred. Previous guidance required recognition of costs atthe date of commitment to an exit or disposal plan. The provisions of thestatement are to be adopted prospectively for exit activities after December31, 2002. Although SFAS No. 146 may impact the accounting for costs related toexit or disposal activities we may enter into in the future, particularly thetiming of recognition of these costs, the adoption of the statement is notexpected to have a material impact on our consolidated financial statements.

 

**RiskFactors**

** **

**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 1998 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, 2002, we had an accumulated deficit of approximately$96,390,000.

 

**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 seamless power sourcewhich can power various portable electronic devices, before we are able toproduce a commercially viable product. Additionally, we must improve theconverter used in our power pack charger to step up voltage. Failure to improveon our fuel cell technologies, including the failure of any of the above, coulddelay or prevent the successful development of commercially viable fuel cellproducts for any of our target markets.

 

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.

 

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**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 direct liquid fuel cells. These milestones relate totechnology and design improvements as well as to dates for achieving developmentgoals. If our products exhibit technical defects or are unable to meet cost orperformance goals, including levels and stability of power output, useful lifeand reliability, our commercialization schedule could be delayed and thirdparties who are collaborating with us to develop our fuel cell technology, aswell as potential 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 direct liquid fuel cells, including the level ofpower density and longevity of use obtained. We can give no assurance that ourcommercialization schedule will continue to be met as we further develop ourdirect liquid fuel cells, or any of our other products.

 

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

 

To date, wehave focused primarily on research and development of our fuel cell technology.Consequently, we have no experience in manufacturing direct liquid fuel cellsor refill cartridges on a commercial basis. We plan to manufacture our directliquid fuel cells and refill cartridges primarily through joint venturearrangements with third parties. We can offer no assurance that either we orour joint venture partners will develop efficient, automated, low-costmanufacturing capabilities and processes to meet the quality, price,engineering, design and production standards or production volumes required tosuccessfully mass market our direct liquid fuel cells and refill cartridges.Even if we or our joint venture partners are successful in developing suchmanufacturing capability and processes, we do not know whether we or they willbe timely in meeting our product commercialization schedule or the productionand delivery requirements of potential customers. A failure to develop suchmanufacturing processes and capabilities could have a material adverse effecton our business and financial results.

 

The price ofdirect liquid fuel cells and refill cartridges is dependent largely on materialand other manufacturing costs. We are unable to offer any assurance that eitherwe or our joint venture partners will be able to reduce costs to a level whichwill allow production of a competitive product or that any product producedusing lower cost materials and manufacturing processes will not suffer from areduction in performance, reliability and longevity. Furthermore, although wehave estimated a pricing structure for both our proposed power pack charger andour refueling cartridges, we can give no assurance that these estimates will becorrect in light of any manufacturing process we adopt or distribution channelswe use.

** **

**A mass market for our direct liquid fuelcells may never develop or may take longer to develop than we anticipate.**

 

A mass marketmay never develop for our direct liquid fuel cells or any of our othertechnologies, or may develop more slowly than we anticipate. Direct liquid fuelcells represent an emerging market, and we do not know whether end-users willwant to use them. The development of a mass market for our direct liquid fuelcells may be affected by many factors, some of which are out of our control,including:

 

•                    the level to which the technology of our direct liquidfuel cells has advanced;

 

•                    the emergence of newer, more competitive technologiesand products;

 

•                    improvements to existing technologies, includingexisting rechargeable battery technology;

 

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•                    the future cost of ethanol, or any otherhydrogen-based fuels powering our fuel cells;

 

•                    regulations that affect or limit the use of thecomponents in our fuel cells or our fuel cells in general;

 

•                    consumer perceptions of the safety of our products;and

 

•                    consumer reluctance to try a new product.

 

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 ourdirect liquid fuel cell technology or any of our other technologies if we areunsuccessful in entering into alliances, joint ventures or licensing agreementswith 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 direct liquidfuel cell technologies or any of our other technologies is wholly dependent onour entry into strategic alliances, joint ventures or licensing agreements withthird parties possessing such capabilities. We can offer no assurance that wewill be successful in entering into such alliances, joint ventures oragreements. Furthermore, we may enter into agreements the terms of which maynot be entirely beneficial to us.

 

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

 

We haveentered into agreements with third parties who have agreed to assist us indeveloping or marketing our fuel cell technologies. We are in discussions withother third parties and intend to enter into similar agreements with such otherparties or others in the future, of which we can give no assurances of success.These collaboration agreements contemplate that these third parties will workwith our scientists to test various aspects of our direct liquid fuel cells.Such tests may encounter problems and delays for a number of reasons,including, without limitation, the failure of our technology, the failure ofthe technology of others, the failure to combine these technologies properlyand the failure to maintain and service any test prototypes properly. Many ofthese potential problems and delays are beyond our control. In addition,collaborative efforts, by their nature, often create problems due tomiscommunications and disparate expectations and priorities among the partiesinvolved and may result in unexpected modifications and delays in developing ormarketing our fuel cell technologies. Any such problems or perceived problemswith these collaborative efforts could hurt our reputation and the reputationof our products and technologies.

** **

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

 

We regard ourpatents, trade secrets, copyrights and similar intellectual property rights asessential to our growth and success. We rely upon a combination of patent,copyright and trademark laws, trade secret protection, confidentiality andnon-disclosure agreements and contractual provisions with employees and with thirdparties to establish and protect our proprietary rights. We own, directly orindirectly through subsidiaries or companies in which we have an interest,patents for certain technologies and are currently applying for additionalpatents. We can offer no assurance that we will succeed in receiving patent andother proprietary protection in all markets we enter, or, if successful, thatsuch protection will be sufficient. If we successfully develop and market anyor all of our technologies, we expect to face efforts by larger companies andother organizations or authorities to undermine our patents

 

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by challenging or copying ourintellectual property. Moreover, intellectual property rights are not protectedin certain parts of the world. We intend to vigorously defend our intellectualproperty against any challenges that may arise. However, any infringementaction initiated by us may be very costly and require the diversion ofsubstantial funds from our operations and may require management to expendefforts that might otherwise be devoted 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 donot believe our business activities infringe upon the rights of others, nor arewe aware of any pending or contemplated actions to such effect, we can give noassurance that our business activities will not infringe upon the proprietaryrights of others, or that other parties will not assert infringement claimsagainst 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, 2002, we believe that our cashresources, since augmented by the net proceeds from our March 2003 rightsoffering, and monies available to us from our credit facility, will besufficient to support our operating and developmental activities for at leastthe next 25 months. After such time, we may need to raise additional fundsthrough public or private debt or equity financing in order to be competitive,to accelerate our sales and marketing programs, to establish a strongerfinancial position and to continue our operations. We can offer no assurancethat we will be able to secure additional funding, or funding on termsacceptable to us, to meet our financial obligations, if necessary, or that athird party will be willing to make such funds available. Our failure to raiseadditional funds could require us to delay our research and product developmentefforts or cause us to default under the repayment terms of our revolving creditfacility, if we were to borrow funds under that facility and we are unable torepay such borrowings. Furthermore, our failure to successfully develop ormarket our direct liquid fuel cell technologies or any of our othertechnologies may materially adversely affect our ability to raise additionalfunds. In any event, it is not possible to make any reliable estimate of thefunds required to complete the development of our direct liquid fuel celltechnology or any of our other technologies.

 

**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 the otherscientists, engineers and technicians that seek out, recognize and develop ourtechnologies, as well as our highly skilled and experienced management,including Robert K. Lifton, our chief executive officer, and Howard Weingrow,our president. The loss of the services of Messrs. Rehavi and Finkelshtain, ofany of our other technical talent or of Messrs. Lifton and Weingrow could havea material adverse effect on our ability to develop our direct liquid fuelcells into commercial products or any of our other technologies into commercialproducts. We possess key-person life insurance of $245,000 on Mr. Rehavi.Although to date we have been successful in recruiting and retaining executive,managerial and technical personnel, we can offer no assurance that we willcontinue to attract and retain the qualified personnel needed for our business.The failure to attract or retain qualified personnel could have a materialadverse effect on our business.

** **

**29**

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** **

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

 

At December31, 2002, our consolidated balance sheet showed approximately $59,037,000 ofgoodwill and intangible assets, with estimated original useful lives of up tofive years. Commencing January 1, 2002, in accordance with the recently-enactedStatement of Financial Accounting Standards No. 142 “Goodwill and OtherIntangible Assets,” such goodwill is no longer being charged ratably to expensebut is subject to at least an annual assessment for impairment. Our adoption ofSFAS 142 has resulted in the discontinuation as of January 1, 2002 ofamortization of the remaining goodwill balance of approximately $58,205,000,which has 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$832,000 at December 31, 2002.

 

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

 

Our researchand development facilities and our pilot HECP manufacturing facility, as wellas some of our executive offices and back-office functions, are located in theState of Israel. We are, therefore, directly affected by the political,economic and military conditions in Israel. Any major hostilities involvingIsrael or the interruption or curtailment of trade between Israel and any othercountry, whether due to the Israeli-Palestinian conflict, America’s war againstterrorism or against Iraq, among others, could have a material adverse effecton our ability to complete the development of any of our technologies or ourability to supply our technology to development partners 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 44 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.

 

**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 ofprocess upon our directors and officers, many of whom reside outside the UnitedStates, may be difficult to obtain within the United States. Furthermore, anyjudgment obtained in the United States against us may not be collectible withinthe United States to the extent our assets are located outside the UnitedStates. This could limit the ability of our stockholders to sue us based uponan alleged breach of duty or other cause of action. We have been informed byour Israeli legal counsel that there is doubt as to the enforceability of civilliabilities under the Securities Act of 1933 and the Securities Exchange Act of1934 in original actions instituted in Israel. However, subject to limitation,Israeli courts may enforce United States final executory judgments forliquidated amounts in civil matters, obtained after a trial before a court ofcompetent jurisdiction, according to the rules of private international lawcurrently prevailing in Israel, which enforce similar Israeli judgments,provided that:

 

30

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•                    due service of process has been effected and thedefendant was given a reasonable opportunity to defend;

 

•                    the obligation imposed by the judgment isexecutionable according to the laws relating to the enforceability of judgmentsin Israel, such judgment is not contrary to public policy, security orsovereignty of the State of Israel and such judgment is executionable in thestate in which it was given;

 

•                    such judgments were not obtained by fraud and do notconflict with any other valid judgments in the same manner between the sameparties; and

 

•                    an action between the same parties in the same matteris not pending in any Israeli court at the time the lawsuit is instituted inthe 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 directliquid fuel cells face and will continue to face significant competition. Alarge number of corporations, national laboratories and universities in theUnited States, Canada, Europe, Japan and elsewhere are actively engaged in thedevelopment and manufacture of power sources, including batteries and fuelcells, both for portable electronic devices and other uses. Each of thesecompetitors has the potential to capture market share in various markets, whichwould have a material adverse effect on our position in the industry and ourfinancial results.

 

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 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 strategic alliance or joint venture partners commenceproduction of our fuel cells, of which there can be no assurance, we expect torely upon third party suppliers to provide requisite materials and components.A supplier’s failure to supply materials or components in a timely manner, orto supply materials and components that meet our quality, quantity or costrequirements, or our inability to obtain substitute sources for these materialsand components in a timely manner or on terms acceptable to us, could harm ourability to manufacture our direct liquid fuel cells. We or our strategicalliance or joint venture partners may be unable to obtain comparable materialsor components

 

31

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from alternative suppliers, andthat could adversely affect our ability to produce viable direct liquid fuelcells or significantly raise the cost of producing direct liquid fuel cells.

 

In addition,platinum is a component of our direct liquid fuel cells. Platinum is a scarcenatural resource and we are dependent upon a sufficient supply of thiscommodity. While we do not anticipate significant near or long-term shortagesin the supply of platinum, such shortages could adversely affect our ability toproduce commercially viable direct liquid fuel cells or significantly raise ourcost of producing direct liquid fuel 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 andachievements. We have tried, wherever possible, to identify theseforward-looking statements by using words such as “anticipates,” “believes,”“estimates,” “expects,” “plans,” “intends” and similar expressions. Thesestatements reflect our current beliefs and are based on information currently availableto us. Accordingly, these statements are subject to certain risks,uncertainties and contingencies, including the factors set forth under “RiskFactors,” which could cause our actual results, performance or achievements todiffer materially from those expressed in, or implied by, any of thesestatements. You should not place undue reliance on any forward-lookingstatements. Except as otherwise required by federal securities laws, weundertake no obligation to release publicly the results of any revisions to anysuch forward-looking statements that may be made to reflect events orcircumstances after the date of this Annual Report or to reflect the occurrenceof unanticipated events.

 

**Item7A.**Quantitative and QualitativeDisclosures About Market Risk

 

**ImpactOf Inflation And Devaluation On Results 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 all monetaryassets and all monetary liabilities are linked to the same base in the sameamount 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.

 

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 in 1985,inflation, while continuing, has been significantly reduced and the rate ofdevaluation has been substantially diminished. However, Israel effecteddevaluations of the NIS against the dollar as follows: 

 

| 1998 |   | 17.6  | %      |
|------|--------|-------|--------|
| 1999 |   | (0.17 | )      |
| 2000 |   | (2.7  | )      |
| 2001 |   | 9.2   |   |
| 2002 |   | 7.3   |   |

 

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 2002,the rate of inflation in Israel was 6.5% and the rate of

 

32

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devaluation of the NIS was 7.3%against the dollar. Additionally, in 2003, through February 28, the rate ofinflation in Israel was 0.6% and the rate of devaluation of the NIS was 1.5%against the dollar.

 

**ImpactOf 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.    FinancialStatements 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.

** **

**Item9.    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.

 

**PARTIII**

 

**Item 10. Directorsand Executive Officers of the Registrant**

 

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

 

**Item11. Executive Compensation**

 

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

 

**Item 12.****                                 SecurityOwnership of 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. CertainRelationships and Related Transactions**

 

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

 

**Item14. Controls and Procedures**

 

Within the 90days prior to the date of this report, under the supervision and with theparticipation of management, including our Chief Executive Officer and ourChief Financial Officer, we have evaluated the effectiveness of the design andoperation of our disclosure controls and procedures pursuant to Exchange ActRule 13a-14. Based upon that evaluation, our Chief Executive Officer and ourChief Financial Officer have concluded that our disclosure controls andprocedures are effective in timely alerting them to material informationrelating to us (including our consolidated subsidiaries) required to

 

33

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be included in our periodic SECfilings. There have been no significant changes in our internal controls or inother factors that could significantly affect internal controls subsequent tothe date of their evaluation.

 

**PARTIV**

 

**Item 15. Exhibits****, Financial Statement Schedules, and Reports on Form8-K**

 

(a)           Financial Statements.

 

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(6)                                                                       |
| 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.                                    |
| 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   | Cooperation  Agreement dated February 6, 2001 by and between Sagem SA and Medis  Technologies Ltd.(2)                                                                                                                        |
| 10.9   | Strategic  Agreement dated April 5, 2001 by and between General Dynamics Government  Systems Corporation and Medis Technologies Ltd.(2)                                                                                      |
| 10.10  | Option  Agreement dated November 9, 2000, by and between Medis Technologies Ltd. and  Gennadi Finkelstain, and amendment thereto(2)                                                                                          |
| 10.11  | 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.      |
| 10.12  | 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(3)                                            |
| 10.13  | Agreement  dated October 17, 1991 between Bar-Ilan University and Israel Aircraft  Industries Ltd.(3)                                                                                                                        |
| 10.14  | Amendment of  License dated August 8, 1992 between Bar-Ilan University and Israel Aircraft  Industries Ltd. and Medis El(3)                                                                                                  |
| 10.15  | 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.(3) |
| 10.16  | Letter  Agreement dated July 18, 1996 between Medis El Ltd. and Bar-Ilan  University(3)                                                                                                                                      |
| 10.17  | Agreement to  Employ a Subcontractor dated as of December 11, 2001 between Elbit Systems                                                                                                                                     |

 

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|   | Ltd. and  More Energy Ltd.(3)                                                                                                       |
|--------|-------------------------------------------------------------------------------------------------------------------------------------|
| 10.18* | Consultancy  Agreement dated as of January 2, 2000 between Medis Technologies Ltd.  and Robert K. Lifton(4)                    |
| 10.19* | Consultancy  Agreement dated as of January 2, 2000 between Medis Technologies Ltd.  and Howard Weingrow(4)                     |
| 17.1   | Letter from  Grant Thornton LLP to the Securities and Exchange Commission, dated October  5, 2000(5)                                |
| 21.1   | Subsidiaries  of the Registrant(3)                                                                                                  |
| 23.1   | Consent of  Arthur Andersen, LLP(7)                                                                                                 |
| 23.2   | Consent of  Ernst & Young LLP                                                                                                   |
| 99.1   | Letter from  Arthur Andersen LLP to the Securities and Exchange Commission Pursuant to  Temporary Note 3T of Regulation S-X(4) |

 

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* Management contract orcompensatory plan

 

(1)                      Filed as an exhibit to theRegistration Statement on Form S-1, as amended (FileNo.:  333-83945), of Medis Technologies Ltd. and incorporated hereinby reference.

(2)                      Filed as an exhibit to the AnnualReport on Form 10-K for the year ended December 31, 2000 of Medis TechnologiesLtd. and incorporated herein by reference.

(3)                      Filed as an exhibit to theRegistration Statement on Form S-1, as amended (File No.: 333-73276), of MedisTechnologies Ltd. and incorporated herein by reference.

(4)                      Filed as an exhibit to the AnnualReport on Form 10-K for the year ended December 31, 2001 of MedisTechnologies Ltd. and incorporated herein by reference.

(5)                      Filed as an exhibit to theCurrent Report on Form 8-K dated October 6, 2000 of Medis TechnologiesLtd. and incorporated herein by reference.

(6)                      Filed as an exhibit to theQuarterly Report on Form 10-Q for the quarter ended September 30, 2002 ofMedis Technologies Ltd. and incorporated herein by reference.

(7)                      The consolidated financialstatements of the Registrant as of December 31, 2001 and 2000 and for the yearsthen ended included in this Annual Report on Form 10-K which are incorporatedby reference into the Registrant’s Registration Statement on Form S-3(Registration No.: 333-63874), have been audited by Arthur Andersen LLP,independent public accountants (“AA”). However, after reasonable efforts, theRegistrant has been unable to obtain the written consent of AA with respect tothe incorporation by reference of such financial statements in the RegistrationStatement. Therefore, the Registrant has dispensed with the requirement to filethe written consent of AA in reliance upon Rule 437a of the Securities Act of1933, as amended. As a result, you may not be able to recover damages from AAunder Section 11 of the Securities Act of 1933, as amended, for any untruestatements of material fact or any omissions to state a material fact, if any,contained in the aforementioned financial statements of the Registrant whichare incorporated in the Registration Statement by reference.

 

(c)           Reports on Form 8-K:

 
| **Date of  Report** |   | **Date  Report Filed with SEC** |   | **Items Reported**                                |
|---------------------|--------|---------------------------------|--------|---------------------------------------------------|
|                |   |                            |   |                                              |
| November 12, 2002   |   | November 12, 2002               |   | Item  9   Regulation FD Disclosure |

 

35

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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 26, 2003 | **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                       |   | March 26, 2003 |
| Robert K. Lifton      |   | Chief Executive Officer,           |   |                |
|                  |   | Secretary and Director             |   |                |
|                  |   |                               |   |                |
| /s/ HOWARD WEINGROW   |   | President, Treasurer and  Director |   | March 26, 2003 |
| Howard Weingrow       |   |                               |   |                |
|                  |   |                               |   |                |
| /s/ ISRAEL FISHER     |   | Vice President-Finance             |   | March 26, 2003 |
| Israel Fisher         |   | (Principal Financial  Officer)     |   |                |
|                  |   |                               |   |                |
| /s/ JACOB WEISS       |   | Senior Vice  President-Business    |   | March 26, 2003 |
| Jacob Weiss           |   | Development and Director           |   |                |
|                  |   |                               |   |                |
| /s/ AMOS EIRAN        |   | Director                           |   | March 26, 2003 |
| Amos Eiran            |   |                               |   |                |
|                  |   |                               |   |                |
| /s/ ZEEV NAHMONI      |   | Director                           |   | March 26, 2003 |
| Zeev Nahmoni          |   |                               |   |                |
|                  |   |                               |   |                |
| /s/ JACOB E. GOLDMAN  |   | Director                           |   | March 26, 2003 |
| Jacob E. Goldman      |   |                               |   |                |
|                  |   |                               |   |                |
| /s/ SEYMOUR HEINBERG  |   | Director                           |   | March 26, 2003 |
| Seymour Heinberg      |   |                               |   |                |
|                  |   |                               |   |                |
| /s/ PHILLIP WEISSER   |   | Director                           |   | March 26, 2003 |
| Phillip Weisser       |   |                               |   |                |

 

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I, Robert K. Lifton, certifythat:

 

1.             I have reviewed this annual report on Form 10-K of MedisTechnologies Ltd.;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and wehave:

 

a)             Designed such disclosure controlsand procedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

b)            Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

c)             Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a)             All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

b)            Any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this annual report whether or not there were significant changesin internal controls or in other factors that could significantly affectinternal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date: March 26, 2003 |                     |
|----------------------|--------------------------|
|                 | /s/ ROBERT  K. LIFTON    |
|                 | Robert K.  Lifton        |
|                 | Chief  Executive Officer |

 

37

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I, Israel Fisher, certify that:

 

1.             I have reviewed this annual report on Form 10-K of MedisTechnologies Ltd.;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and wehave:

 

a)             Designed such disclosure controlsand procedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

b)            Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

c)             Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a)             All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

b)            Any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this annual report whether or not there were significant changesin internal controls or in other factors that could significantly affectinternal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date: March 26, 2003 |                     |
|----------------------|--------------------------|
|                 | /s/ ISRAEL  FISHER       |
|                 | Israel  Fisher           |
|                 | Chief  Financial Officer |

 

38

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**INDEX**

 
| Medis  Technologies Ltd. Financial Statements                                                               |
|-------------------------------------------------------------------------------------------------------------|
|                                                                                                        |
| Report of Independent Auditors                                                                              |
|                                                                                                        |
| Report of Independent Public Accountants                                                                    |
|                                                                                                        |
| Consolidated  Financial Statements                                                                          |
|                                                                                                        |
| Consolidated  Balance Sheets as of December 31, 2001 and 2002                                               |
|                                                                                                        |
| Consolidated  Statements of Operations for the years ended December 31, 2000, 2001 and 2002                 |
|                                                                                                        |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2000,  2001 and 2002 |
|                                                                                                        |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2000, 2001 and 2002                 |
|                                                                                                        |
| Notes to Consolidated Financial Statements                                                                  |

 

F-1

----

 

**REPORT OF INDEPENDENT AUDITORS**

 

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

 

We haveaudited 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 conductedour audit in accordance with auditing standards generally accepted in theUnited States. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso 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 ouropinion, the financial statements referred to above present fairly, in allmaterial 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 discussedabove, the consolidated balance sheet as of December 31, 2001 and the relatedconsolidated statements of operations, stockholders’ equity and cash flows forthe years ended December 31, 2001 and 2000, were audited by other auditors whohave ceased operation. As described in Note G-1, on March 18, 2002 the Companycompleted a rights offering to all of its existing stockholders. As a result ofthis transaction, earning-per-share information in the financial statements hasbeen adjusted to reflect the transaction on a retroactive basis. We audited theadjustments that were applied to restate the number of shares and per shareinformation reflected in the 2001 and 2000 financial statements. Our proceduresincluded (a) agreeing the data used in the restated computation of number ofshares and loss per share to documents and underlying records obtained frommanagement, and (b) testing the mathematical accuracy of the restated number ofshares, and loss per share. In our opinion, such adjustments are appropriateand have been properly applied. In addition, as described in Note E, theseconsolidated financial statements have been revised to include the transitionaldisclosures required by Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets,” which was adopted by the Company as ofJanuary 1, 2002. Our audit procedures with respect to the disclosures in Note Ewith respect to 2001 and 2000 included (a) agreeing the previously reported netloss to the previously issued financial statements and the adjustments toreported net loss representing amortization expense recognized in those periodsrelated to goodwill, as a result of initially applying Statement No. 142 to theCompany’s underlying records obtained from management, and (b) testing themathematical accuracy of the reconciliation of adjusted net loss to reportednet loss, and the related earnings-per-share amounts. In our opinion, thedisclosures for 2001 and 2000 in Note E are appropriate.

 

F-2

----

 

However, wewere not engaged to audit, review, or apply any procedures to the 2001 or 2000financial statements of the Company other than with respect to such adjustmentsand disclosures and, accordingly, we do not express an opinion or any otherform of assurance on the 2001 and 2000 financial statements taken as a whole.

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

 

F-3

----

 

**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 Board of Directors and Stockholders of**Medis Technologies Ltd.**

 

We haveaudited 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.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Medis Technologies Ltd. andsubsidiaries as of December 31, 2001 and 2000, and the results of theiroperations and their cash flows for the years then ended in conformity withaccounting principles generally accepted in the United States.

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

 

F-4

----

 

**Medis Technologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED BALANCESHEETS**

** **

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

 
|                                                                                                                                                                                                                                |   | **December  31,** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                                                                                                                                |   | **2001**          |       | **2002** |   |
| **ASSETS**                                                                                                                                                                                                                          |   |              | ** ** |   | ** ** |
| Current assets                                                                                                                                                                                                                      |   |              | ** ** |   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                           |   | $                 | 5,999,000  | ** ** | **$** | **6,036,000** | ** ** |
| Accounts receivable-other                                                                                                                                                                                                           |   | 74,000            | ** ** | **50,000** | ** ** |
| Prepaid expenses and other current assets                                                                                                                                                                                           |   | 403,000           | ** ** | **52,000** | ** ** |
| Total current assets                                                                                                                                                                                                                |   | 6,476,000         | ** ** | **6,138,000** | ** ** |
| Property and equipment, net (Note D)                                                                                                                                                                                                |   | 1,228,000         | ** ** | **1,199,000** | ** ** |
| Goodwill, net (Note E)                                                                                                                                                                                                              |   | 58,205,000        | ** ** | **58,205,000** | ** ** |
| Intangible assets, net (Note E)                                                                                                                                                                                                     |   | 3,465,000         | ** ** | **832,000** | ** ** |
| Other assets (Note C)                                                                                                                                                                                                               |   | 520,000           | ** ** | **520,000** | ** ** |
| Total assets                                                                                                                                                                                                                        |   | $                 | 69,894,000 | ** ** | **$** | **66,894,000** | ** ** |
|                                                                                                                                                                                                                                |   |              |       |   |   |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                      |   |              | ** ** |   | ** ** |
| Current liabilities                                                                                                                                                                                                                 |   |              | ** ** |   | ** ** |
| Accounts payable                                                                                                                                                                                                                    |   | $                 | 165,000    | ** ** | **$** | **128,000** | ** ** |
| Accrued expenses and other current  liabilities (Note F)                                                                                                                                                                            |   | 822,000           | ** ** | **973,000** | ** ** |
| Total current liabilities                                                                                                                                                                                                           |   | 987,000           | ** ** | **1,101,000** | ** ** |
| Accrued severance pay                                                                                                                                                                                                               |   | 273,000           | ** ** | **388,000** | ** ** |
| Commitments and contingencies (Note H)                                                                                                                                                                                              |   |              | ** ** |   | ** ** |
| Stockholders’ equity (Note G)                                                                                                                                                                                                  |   |              | ** ** |   | ** ** |
| Preferred stock, $.01 par value; 10,000  shares authorized; none issued                                                                                                                                                             |   | *—*          | * *   | *—* | * * |
| Common stock, $.01 par value; 25,000,000  and 35,000,000 shares authorized at December 31, 2001 and 2002, respectively;  17,532,779 and 21,102,301 shares issued and outstanding, at December 31,  2001 and 2002, respectively |   | 175,000           | ** ** | **211,000** | ** ** |
| Additional paid-in capital                                                                                                                                                                                                          |   | 152,425,000       | ** ** | **161,584,000** | ** ** |
| Accumulated deficit                                                                                                                                                                                                                 |   | (83,844,000       | )          | **(96,390,000** | **)** |
| Deferred compensation costs                                                                                                                                                                                                         |   | (122,000          | )          | *—* | * * |
| Total stockholders’ equity                                                                                                                                                                                                     |   | 68,634,000        | ** ** | **65,405,000** | ** ** |
| Total liabilities and stockholders’ equity                                                                                                                                                                                     |   | $                 | 69,894,000 | ** ** | **$** | **66,894,000** | ** ** |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-5

----

 

**Medis Technologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED STATEMENTS OF OPERATIONS**

** **

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

 
|                                                                                     |   | **Year ended  December 31,** |        |
|------------------------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                                     |   | **2000**                     |        | **2001** |   | **2002** |   |
|                                                                                     |   |                         |        |   |   |   |   |
| Sales                                                                                    |   | $                            | —      |   | $ | — |   | $ | 192,000 |   |
| Cost of sales                                                                            |   | —                       |        | — |   | 130,000 |   |
|                                                                                     |   |                         |        |   |   |   |   |
| Gross profit                                                                             |   | —                       |        | — |   | 62,000 |   |
| Operating expenses                                                                       |   |                         |        |   |   |   |   |
| Research and development costs, net                                                      |   | $                            | 4,493,000   |   | $ | 4,251,000 |   | $ | 4,161,000 |   |
| Selling, general and administrative  expenses                                            |   | 5,405,000                    |        | 6,297,000 |   | 3,642,000 |   |
| Amortization of intangible assets                                                        |   | 13,668,000                   |        | 21,129,000 |   | 2,633,000 |   |
| Total operating expenses                                                                 |   | 23,566,000                   |        | 31,677,000 |   | 10,436,000 |   |
| Loss from operations                                                                     |   | (23,566,000                  | )           | (31,677,000 | ) | (10,374,000 | ) |
| Other income (expenses)                                                                  |   |                         |        |   |   |   |   |
| Interest income                                                                          |   | 214,000                      |        | 178,000 |   | 151,000 |   |
| Interest and other expense                                                               |   | (13,000                      | )           | (63,000 | ) | (82,000 | ) |
|                                                                                     |   | 201,000                      |        | 115,000 |   | 69,000 |   |
| Loss before minority interest                                                            |   | (23,365,000                  | )           | (31,562,000 | ) | (10,305,000 | ) |
| Minority interest in loss of subsidiary                                                  |   | 873,000                      |        | — |   | — |   |
| NET LOSS                                                                                 |   | (22,492,000                  | )           | (31,562,000 | ) | (10,305,000 | ) |
| Value of warrants (Note G)                                                               |   | (2,971,000                   | )           | (3,204,000 | ) | (2,241,000 | ) |
| Net loss attributable to common  stockholders                                            |   | $                            | (25,463,000 | ) | $ | (34,766,000 | ) | $ | (12,546,000 | ) |
|                                                                                     |   |                         |        |   |   |   |   |
| Basic and diluted net loss per share (Note  B)                                           |   | $                            | (1.56       | ) | $ | (1.76 | ) | $ | (.60 | ) |
| Weighted-average shares used in computing  basic and diluted net loss per share (Note B) |   | 16,331,105                   |        | 19,771,338 |   | 20,894,915 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-6

----

 

**Medis Technologies Ltd. and Subsidiaries**

** **

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

** **

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

 
|                                                                             |   | **Common  Stock** |       | **Additional  Paid-in  Capital** |        | **Accumulated  Deficit** |   | **Deferred  Compensation  Costs** |       | **Total  Stockholders’ Equity** |            |
|----------------------------------------------------------------------------------|--------|-------------------|------------|----------------------------------|-------------|--------------------------|--------|-----------------------------------|------------|--------------------------------------|-----------------|
| **Shares**                                                                       |   | **Amount**        |
| Balance at January 1, 2000                                                       |   | 9,988,619         |       | $                                | 100,000     |                     | $      | 32,450,000                        |       | $                                    | (23,615,000     | ) | $ | (374,000 | ) | $ | 8,561,000 |   |
| Net loss                                                                         |   | —            |       | —                           |        | —                   |   | (22,492,000                       | )          | —                               |            | (22,492,000 | ) |
| Issuance of common stock                                                         |   | 1,598,811         |       | 16,000                           |        | 7,742,000                |   | —                            |       | —                               |            | 7,758,000 |   |
| Issuance of common stock in exchange for  minority interest in a subsidiary      |   | 5,243,561         |       | 52,000                           |        | 88,946,000               |   | —                            |       | —                               |            | 88,998,000 |   |
| Stock options granted to employees and  directors                                |   |              |       | —                           |        | 2,629,000                |   | —                            |       | (2,629,000                           | )               | — |   |
| Amortization of deferred compensation                                            |   | —            |       | —                           |        | —                   |   | —                            |       | 1,236,000                            |            | 1,236,000 |   |
| Stock options and warrants granted to consultants                                |   | —            |       | —                           |        | 1,892,000                |   |                              |       | —                               |            | 1,892,000 |   |
| Value of warrants issued to exercising  stockholders                             |   | —            |       | —                           |        | 2,971,000                |   | (2,971,000                        | )          | —                               |            | — |   |
| Increase attributable to equity  transactions of a subsidiary                    |   | —            |       | —                           |        | 189,000                  |   | —                            |       | —                               |            | 189,000 |   |
| 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 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 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** | ** ** |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-7

----

 

**Medis Technologies Ltd. and Subsidiarie**

** **

**CONSOLIDATED STATEMENTS OF CASHFLOW**

** **

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

 
|                                                                                                        |   | **Year ended  December 31,** |        |
|-------------------------------------------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                                                        |   | **2000**                     |        | **2001** |   | **2002** |   |
| Cash flows from operating activities                                                                        |   |                         | ** **  |   | ** ** |   | ** ** |
| Net loss                                                                                                    |   | $                            | (22,492,000 | ) | $ | (31,562,000 | ) | **$** | **(10,305,000** | **)** |
| Adjustments to reconcile net loss to net  cash used in operating activities                                 |   |                         | ** **  |   | ** ** |   | ** ** |
| Depreciation and amortization of property  and equipment                                                    |   | 363,000                      |        | 587,000 | ** ** | **256,000** | ** ** |
| Amortization of intangible assets                                                                           |   | 13,668,000                   |        | 21,129,000 | ** ** | **2,633,000** | ** ** |
| Losses of minority interest                                                                                 |   | (873,000                     | )           | — | ** ** | **—** | ** ** |
| Non-cash compensation expense                                                                               |   | 3,229,000                    |        | 3,664,000 | ** ** | **213,000** | ** ** |
| (Gain) loss from sale of property and  equipment                                                            |   | (2,000                       | )           | 4,000 | ** ** | **11,000** | ** ** |
| Write-off of acquired in-process research  and development                                                  |   | 884,000                      |        | — |   | — |   |
| Changes in operating assets and liabilities                                                                 |   |                         | ** **  |   | ** ** |   | ** ** |
| Accounts receivable-other                                                                                   |   | (170,000                     | )           | 154,000 | ** ** | **24,000** | ** ** |
| Prepaid expenses and other current assets                                                                   |   | (144,000                     | )           | 36,000 | ** ** | **157,000** | ** ** |
| Accounts payable                                                                                            |   | 37,000                       |        | 26,000 | ** ** | **(37,000** | **)** |
| Accrued expenses and other current  liabilities                                                             |   | (33,000                      | )           | 125,000 | ** ** | **151,000** | ** ** |
| Accrued severance payable                                                                                   |   | 115,000                      |        | 49,000 | ** ** | **115,000** | ** ** |
| Net cash used in operating activities                                                                       |   | (5,418,000                   | )           | (5,788,000 | ) | **(6,782,000** | **)** |
| Cash flows from investing activities                                                                        |   |                         | ** **  |   | ** ** |   | ** ** |
| Capital expenditures                                                                                        |   | (487,000                     | )           | (799,000 | ) | **(263,000** | **)** |
| Proceeds from disposition of property and  equipment                                                        |   | 64,000                       |        | 25,000 | ** ** | **25,000** | ** ** |
| Acquisition of option to acquire shares of  a majority-owned subsidiary                                     |   | —                       |        | (520,000 | ) | **—** |   |
| Acquisition by a subsidiary of additional  shares of a majority-owned subsidiary.                           |   | (320,000                     | )           | — | ** ** | **—** | ** ** |
| Acquisition of shares of a majority-owned  subsidiary                                                       |   | (398,000                     | )           | — | ** ** | **—** | ** ** |
| Net cash used in investing activities                                                                       |   | (1,141,000                   | )           | (1,294,000 | ) | **(238,000** | **)** |
| Cash flows from financing activities                                                                        |   |                         | ** **  |   | ** ** |   | ** ** |
| Repayment of long-term debt                                                                                 |   | (97,000                      | )           | — | ** ** | **—** | ** ** |
| Proceeds from issuance of common stock and  exercise of stock options of a majority-owned subsidiary        |   | 336,000                      |        | — | ** ** | **—** | ** ** |
| Proceeds from issuance of common stock                                                                      |   | 7,758,000                    |        | 10,390,000 | ** ** | **7,057,000** | ** ** |
| Deferred common stock issuance costs                                                                        |   | —                       |        | (194,000 | ) | — |   |
| Direct costs of exchange of shares                                                                          |   | (395,000                     | )           | — | ** ** | **—** | ** ** |
| Net cash provided by financing activities                                                                   |   | 7,602,000                    |        | 10,196,000 | ** ** | **7,057,000** | ** ** |
| Net increase in cash and cash equivalents                                                                   |   | 1,043,000                    |        | 3,114,000 | ** ** | **37,000** | ** ** |
| Cash and cash equivalents at beginning of  year                                                             |   | 1,842,000                    |        | 2,885,000 | ** ** | **5,999,000** | ** ** |
| Cash and cash equivalents at end of year                                                                    |   | $                            | 2,885,000   |   | $ | 5,999,000 | ** ** | **$** | **6,036,000** | ** ** |
|                                                                                                        |   |                         |        |   |   |   |   |
| Supplemental disclosures of cash flow  information:                                                         |   |                         | ** **  |   | ** ** |   | ** ** |
| Cash paid during the year for:                                                                              |   |                         | ** **  |   | ** ** |   | ** ** |
| Interest                                                                                                    |   | $                            | 13,000      |   | $ | 24,000 | ** ** | **$** | **24,000** | ** ** |
| Non-cash investing and financing  activities:                                                               |   |                         | ** **  |   | ** ** |   | ** ** |
| Acquisition of minority interest through  exchange of shares (see Note C), comprised of the following: |   | 89,393,000                   |        | — | ** ** | **—** | ** ** |
| Goodwill                                                                                                    |   | 81,867,000                   |        | — | ** ** | **—** | ** ** |
| Acquired technology assets                                                                                  |   | 6,071,000                    |        | — | ** ** | **—** | ** ** |
| In-process research and development                                                                         |   | 561,000                      |        | — | ** ** | **—** | ** ** |
| Value of net tangible assets acquired                                                                       |   | 894,000                      |        | — | ** ** | **—** | ** ** |
| Value of warrants issued to exercising  stockholders (see Note G)                                           |   | 2,971,000                    |        | — | ** ** | **—** | ** ** |
| 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** | ** ** |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

F-8

----

 

**Medis Technologies Ltd and Subsidiaries**

** **

**NOTES****TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**December 31, 2001 and 2002**

 

**NOTEA—NATURE OF BUSINESS AND GENERAL MATTERS**

 

MedisTechnologies Ltd. (“MTL”), a Delaware corporation, is a holding company,which through its wholly-owned subsidiary, Medis El Ltd. (“Medis El”) andmajority-owned subsidiary, More Energy Ltd. (“More Energy”), engages inresearch and development of technology products to license, sell, or enter intojoint ventures with large corporations. The Company’s primary business focus ison the development and commercialization of direct liquid fuel cells andattendant refueling cartridges for use as primary and auxiliary power sourcesfor portable electronic devices which currently use rechargeable or disposablebatteries as their power source. These devices include cell phones, personaldigital assistants (PDAs), laptop computers and certain military devices.  The Company’s other technologies, which arein various stages of development, include highly electrically conductivepolymers, the CellScan, the toroidal engine, stirling cycle system, and theRankin cycle linear compressor.

 

Sinceinception, the Company has incurred operating losses and has used cash in itsoperations. Accordingly, the Company has relied on external financing,principally through the sale of its stock, to fund its research and developmentactivities. The Company believes this dependence will continue unless it isable to successfully develop and market its technologies. On December 29,2000, the Company entered into a $5,000,000 revolving credit line loan agreementwith a bank. The loan agreement, which bears interest on the outstandingbalances based on either the LIBOR or Prime Rate and terminates on July 1,2004, is collateralized by all cash and other assets on deposits with the bankat any time and the mortgage and assignment of certain leases owned by apartnership in which the Company’s chairman and chief executive officer and itspresident and treasurer are partners. The Company believes its cash resources,together with financing available by the line of credit, will be sufficient tomeet the Company’s needs past year end 2003.

 

**NOTEB—SIGNIFICANT ACCOUNTING POLICIES**

 

*1. Principles of Consolidation*

 

Theconsolidated financial statements include the accounts of MTL and itswholly-owned and majority-owned subsidiaries from their dates of acquisition(collectively, the “Company”). All significant intercompany transactions andbalances have been eliminated. Minority interest represents the minorityshareholders’ proportionate share in the equity or income of Medis El prior tothe completion of the Company’s exchange offer of June 5, 2000 (seeNote C).

 

*2. Cash and Cash Equivalents*

 

Cash and cashequivalents consist of cash and highly liquid investments with a maturity ofthree months or less when purchased.

 

*3. Research and Development Costs*

 

Research anddevelopment costs are charged to operations as incurred.

 

F-9

----

 

*4. Use of Estimates*

 

In preparingthe Company’s consolidated financial statements in conformity with accountingprinciples generally accepted in the United States, management is required tomake estimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

*5. Fair Value of Financial Instruments*

 

The carryingvalue of all financial instruments potentially subject to valuation risk(principally consisting of cash and cash equivalents) approximates their fairvalue.

 

*6. Translation of Foreign Currencies*

 

The financialstatements of subsidiaries have been prepared in U.S. dollars, as the dollar istheir functional currency.

 

Non-dollartransactions and balances were remeasured into dollars in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 52 , “ForeignCurrency Translation.”  Translationgains and losses for all period presented were immaterial.

 

*7. Property and Equipment*

 

Property andequipment are stated at cost, net of accumulated depreciation and amortization,and net of investment grants from the state of Israel. Depreciation is providedon the straight-line basis over the estimated useful lives of such assets.Leasehold improvements are amortized over the lives of the respective leases oruseful lives of the improvements, whichever is shorter. The Company reviewsproperty and equipment for impairment whenever events and circumstances indicatethat carrying amounts may not be recoverable through undiscounted projectedcash flows, excluding interest costs.

 

The estimateduseful lives 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                       |   |

 

F-10

----

 

*8. Stock-based Compensation*

 

In December2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No.148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to providealternative methods of transition for a voluntary change to the fair valuebased methods of accounting for stock-based employee compensation. In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require moreprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. The additional disclosure requirements ofSFAS No. 148 are effective for fiscal years ending after December 15, 2002.

 

As providedfor in SFAS No. 148, the Company has elected to continue to follow AccountingPrinciples Board Opinion No. 25 (“APB No. 25”), “Accounting for StockIssued to Employees,” and related interpretations in accounting for itsemployee stock options, under which compensation expense, if any, is generallybased on the difference between the exercise price of an option or the amountpaid for the award and the market price or fair value of the underlying commonstock at the date of the grant. To the extent that compensation expense isrecognized with respect to stock options issued to employees or directors, suchexpense is amortized over the vesting period of such options. Stock-basedcompensation arrangements involving non-employees or non-directors areaccounted for under SFAS No. 123, under which such arrangements are accountedfor based on the fair value of the option or award.

 

Hadcompensation cost for the Company’s stock option plans been determined based onthe fair value at the grant dates for all awards, the Company’s net lossattributable to common stockholders and basic and diluted net loss per sharewould have been the pro forma amounts indicated below:

 
|                                                                                              |   | **Year ended  December 31,** |        |
|---------------------------------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                                              |   | **2000**                     |        | **2001** |   | **2002** |   |
| Net loss attributable to common  stockholders for the year as reported                            |   | $                            | (25,463,000 | ) | $ | (34,766,000 | ) | **$** | **(12,546,000** | **)** |
| Add: Total stock-based employee  compensation expense included in the reported loss               |   | 1,236,000                    |        | 3,171,000 |   | **122,000** | ** ** |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method |   | (1,555,000                   | )           | (6,157,000 | ) | **(4,976,000** | **)** |
| Pro forma net loss attributable to common  shareholders                                           |   | $                            | (25,782,000 | ) | $ | (37,752,000 | ) | **$** | **(17,400,000** | **)** |
| Basic and diluted net loss per share as  reported (Note B)                                        |   | $                            | (1.56       | ) | $ | (1.76 | ) | **$** | **(.60** | **)** |
| Pro forma net loss per share                                                                      |   | $                            | (1.58       | ) | $ | (1.91 | ) | **$** | **(.83** | **)** |

 

 

 

F-11

----

 

The fair valueof each option granted is estimated on the date of the grant using theBlack-Scholes option pricing model with the following weighted averageassumptions:

 
|                    |   | **2000** |   | **2001** |   | **2002** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
| Dividend yield          |   | 0        | %      | 0        | %      | 0        | %      |
| Risk-free interest rate |   | 6.00     | %      | 2.50     | %      | 2.50     | %      |
| Expected life in years  |   | 1-2      |   | 1-2      |   | 1-2      |   |
| Volatility              |   | 95       | %      | 95       | %      | 94       | %      |

 

The averagefair value of each option granted in 2000, 2001 and 2002 was $9.67, $7.30 and$3.06, respectively.

 

*9. Intangible Assets*

 

In June 2001,the FASB issued SFAS No. 141, “Business Combinations,” and No. 142, “Goodwilland Other Intangible Assets,” effective for fiscal years beginning afterDecember 15, 2001.  Under the new rules,goodwill and intangible assets deemed to have indefinite lives are no longeramortized, but are subject to annual impairment tests in accordance with thestatements.  Other intangible assetscontinue to be amortized over their useful lives.  The Company applied the new rules on accounting for goodwill andother intangible assets as of January 1, 2002. The Company has performed therequired tests of impairment of goodwill and, based on the results, has notrecorded any charges related to the adoption of and subsequent conformity withSFAS No. 142 (see Note E).

 

*10. Impairment of Long-Lived Assets*

 

In August2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” effective for fiscal years beginning after December 15,2001.  This standard supercededStatement of Financial Accounting Standard No. 121, Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,and provided a single accounting model for long-lived assets to be disposed of.  SFAS No. 144 was effective for the Companybeginning with the first quarter of 2002 and its adoption did not have amaterial impact on the Company’s results of operations or financial position.

 

*11. Revenue Recognition*

 

Revenuesrelating to development cooperation agreements are recognized ratably over theterm of the agreement. Revenues from products are recognized upon deliveryprovided there is persuasive evidence of an agreement, the amount is fixed ordeterminable and collection of the related receivable is probable. Amountsbilled and/or received where revenue recognition criteria have not been fullymet, and thus the revenue is not yet earned, are reflected as liabilities andare offset against the related receivable.

 

F-12

----

 

*12. Net Loss Per Share*

 

The Companycomputes net loss per share in accordance with SFAS No. 128, “Earnings PerShare.” Under the provisions of SFAS No. 128, basic net loss per share iscomputed by dividing the net loss for the period by the weighted-average numberof common shares outstanding during the period. Diluted net loss per share iscomputed by dividing the net loss for the period by the weighted-average numberof common and common equivalent shares outstanding during the period. However, asthe Company generated net losses in all periods presented, potentially dilutedsecurities, composed of incremental common shares issuable upon the exercise ofwarrants and stock options, are not reflected in diluted net loss per sharebecause such shares are antidilutive. The total number of shares related to theoutstanding options and warrants excluded from the calculation of diluted netloss per share was 2,626,530, 3,715,618 and 5,111,097 at December 31, 2000,2001 and 2002, respectively.

 

In accordancewith SFAS No. 128, the Company has adjusted its net loss per share foryears ended December 31, 2000 and 2001 to give retroactive effect to sharesissued in its March 18, 2002 rights offering (see Note G-1). Accordingly, as aresult of such retroactive adjustment, for the years ended December 31, 2000and 2001, the net loss per share decreased from $(1.79) to $(1.56), or $(.23)per share, and from $(2.02) to $(1.76), or $(.26) per share, respectively (seeNote G-1).

 

*13. Other Comprehensive Income*

 

The Companyhas adopted SFAS No. 130, “Reporting Comprehensive Income.” SFASNo. 130 establishes standards for reporting comprehensive income and itscomponents in financial statements. Other comprehensive income, as defined,includes all changes in equity during a period from non-owner sources. To date,the Company has not had any material transactions that are required to bereported as other comprehensive income.

 

*14. Segment Information*

 

The Companyhas adopted SFAS No. 131, “Disclosures About Segments of an Enterprise andRelated Information,” which establishes standards for the way companies reportinformation about operating segments in annual financial statements. It alsoestablishes standards for related disclosures about products and services,geographic areas and major customers. The Company has determined that it doesnot have any separately reportable business segments, but does operate in twogeographic areas, the United States and Israel.

 

MTL’s foreignsubsidiaries had net losses of approximately $5,247,000, $7,191,000 and$6,201,000 for the years ended December 31, 2000, 2001 and 2002, respectively.MTL’s foreign subsidiaries had total assets of approximately $1,814,000 and$1,603,000 at December 31, 2001 and 2002, respectively.

 

F-13

----

 

*15. Income Taxes*

 

Deferredincome taxes are provided for differences between financial statement andincome tax basis of assets and liabilities using enacted tax rates in effect inthe years in which the differences are expected to reverse. The Companyprovides a valuation allowance on net deferred tax assets when it is morelikely than not that such assets will not be realized.

 

*16. Concentration of Credit Risk*

 

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist principally of cash and cash equivalents. Cash equivalents areprimarily invested in bank short-term investments, on-demand insurancecontracts and money market funds. Management believes that the institutions thathold the Company’s cash and cash equivalents are financially sound and,accordingly, minimal credit risk exists with respect to these investments.

 

Sales to twocustomers during 2002 were in excess of 10% (approximately 72% and 28%) of theCompany’s revenue and in the aggregate amounted to 100% of total revenue in2002.

 

17. Recent Pronouncements

 

In June 2001,the FASB issued SFAS No. 143 “Accounting for Asset Retirement Obligations.”SFAS No. 143 addresses accounting and reporting for obligations associatedwith the retirement of tangible long-lived assets and the associated retirementcosts.  This statement is effective forfiscal years beginning after June 15, 2002. The Company is currently assessing the impact of the adoption of thisnew standard, although it does not expect it to affect its consolidatedfinancial statements.

 

In April 2002,the FASB issued SFAS No. 145, “Rescission of SFAS Nos. 4, 44 and 64, Amendmentof SFAS No. 13, and Technical Corrections as of April 2000.”  SFAS No. 145 revises the criteria forclassifying the extinguishment of debt as extraordinary and the accountingtreatment of certain lease modifications. SFAS No. 145 is effective in fiscal 2003 and is not expected to have amaterial impact on the Company’s consolidated financial statements.

 

In July 2002,the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities.”  SFAS No. 146provides guidance on the timing of the recognition of costs associated withexit or disposal activities.  The newguidance requires costs associated with exit or disposal activities to berecognized when incurred. Previous guidance required recognition of costs atthe date of commitment to an exit or disposal plan.  The provisions of the statement are to be adopted prospectivelyfor exit activities after December 31, 2002. Although SFAS No. 146 may impact the accounting for costs related toexit or disposal activities the Company may enter into in the future,particularly the timing of recognition of these costs, the adoption of thestatement is not expected to have a material impact on the Company’sconsolidated financial statements.

 

F-14

----

 

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

 

OnApril 24, 2000, MTL commenced an offer for the approximately 36% of MedisEl it did not already beneficially own, offering 1.37 of its shares of commonstock for each ordinary share tendered (the “Exchange Offer”). The consummationof the Exchange Offer depended upon enough ordinary shares of Medis El beingtendered in the Exchange Offer such that the Company would beneficially own atleast 80% of Medis El’s ordinary shares after completion of the Exchange Offer.At the expiration of the offer on June 5, 2000, shareholders of Medis Eltendered an aggregate of 3,643,241 ordinary shares, giving MTL ownership ofapproximately 98% of Medis El’s outstanding ordinary shares. The remaining182,669 shares passed to MTL by operation of Israeli law upon the expiration ofthe exchange offer. In accordance with Accounting Principles Board Opinion(“APB”) No. 16 and Emerging Issues Task Force Issue No. 99-12, the Companyaccounted for the exchange using the purchase method and used as themeasurement date May 25, 2000, which is the date that the number of sharestendered by Medis El shareholders would have provided the Company withownership of 80% of Medis El’s ordinary shares had the Exchange Offer closed onthat day. The Company used the market price of Medis El’s ordinary shares fordetermining the purchase price as such shares were publicly traded on TheNasdaq SmallCap Market at the time of the Exchange Offer and, therefore, weremore clearly evident of the fair value of the transaction than the Company’scommon stock, which was not publicly traded at such time. Accordingly, theCompany calculated the purchase price of the 3,825,910 shares and 184,000options of Medis El not owned by it based on the market price of Medis Elordinary shares. Such purchase price was $89,393,000. The Company allocated theexcess of purchase price over net assets acquired to goodwill ($81,867,000),CellScan technology assets ($6,071,000) and in-process research and developmentfor the fuel cells, stirling cycle andtoroidal engine projects, which was charged to research and development expenseon the acquisition date ($561,000). Such allocation was based on a valuationusing the cost method, which represents the fair value of the assets underlyingeach project.

 

The followingdescribes the valuable elements, the fair value assigned and the stage ofdevelopment or significant target date for the CellScan, fuel cells, stirlingcycle and toroidal engine projects, at or around the closing of the ExchangeOffer:

 

*CellScan*.  The valuable elements of the CellScanproject were: (i) unique technology allowing for non-invasive repetitiveexamination and monitoring of thousands of living cells; (ii) proprietaryscientific, technological and engineering knowledge; (iii) patents;(iv) scientific, technological and engineering know-how; and(v) drawings and designs. The fair value assigned to the CellScan projectwas approximately $16,800,000, of which $6,071,000, or 36%, represented theportion acquired in the Exchange Offer. The CellScan was in late stages of developmentwith a short expected time and small expected investment to completion andaccordingly was allocated as acquired technology assets.

 

*Fuel Cells*.  The valuable elements of the fuel cellproject were: (i) the expectation of fuel cells, utilizing the Company’shighly electrically conductive polymers, which are expected to be long lasting,more efficient and cost less than traditional fuel cells; (ii) fundamentalinnovation supported by a substantial degree of proprietary scientific,technical and engineering knowledge; (iii) patents pending; and(iv) drawings and designs. The fair value assigned to the fuel cellproject was approximately $500,000. The Company expected to reach fulltechnical feasibility by the end of 2000. The expected aggregate cost of completionwas not projected.

 

F-15

----

 

*Stirling Cycle*.  The valuable elements of the stirling cycleproject were: (i) the expectation of a refrigeration and air-conditioningsystem that would provide greater efficiency than current systems, which wouldresult in lower average consumption and reduced emissions that are believed tobe harmful; (ii) proprietary scientific, technical and engineeringknowledge; (iii) patents; and (iv) drawings and designs. The fairvalue assigned to the stirling cycle project was approximately $600,000. At thetime of the Exchange Offer, this project was in progress. Expected aggregatecosts of completion were not projected at that time.

 

*Toroidal Engine*.  The valuable elements of the toroidal engineprojects were: (i) the expectation of an engine that would be moreefficient than an internal combustion or diesel engine, have reduced fuelconsumption, have reduced pollution and have lower manufacturing costs;(ii) proprietary scientific, technical and engineering knowledge;(iii) patents; and (iv) drawings and designs. The fair value assignedto the toroidal engine product was approximately $400,000. At the time of theExchange Offer, this project was in progress. Expected aggregate costs ofcompletion were not projected at that time.

 

In accordancewith the above, the fuel cells, stirling cycle and toroidal engine projectswere allocated as in-process research and development and charged to researchand development expense. The aggregate charge of $561,000 represents the 36%portion of the aggregate fair value of such projects acquired in the ExchangeOffer.

 

The Companyamortizes the acquired technology assets over their remaining useful lives ofthree years, and, through December 31, 2001, the Company had amortized itsgoodwill over five years. In accordance with SFAS 142 “Goodwill and OtherIntangible Assets,” the Company discontinued amortization of its goodwillbeginning on January 1, 2002. Furthermore, in accordance with SFAS 142, the Companyperforms an annual assessment for impairment of its goodwill (see Note E).During the years ended December 31, 2000, 2001 and 2002, the Companyrecorded amortization expense aggregating approximately $11,013,000,$18,397,000 and $2,024,000 respectively, related to this transaction. Thefollowing unaudited pro-forma information gives effect to the Exchange Offer asif it had occurred at the beginning of the year ended December 31, 2000: 

 
|                                          |   | **Year ended  December 31,  2000** |            |
|-----------------------------------------------|--------|------------------------------------|-----------------|
|                                          |   |                               |            |
| Net loss                                      |   | **$**                              | **(30,749,000** | **)** |
| Net loss attributable to common  shareholders |   | **$**                              | **(33,720,000** | **)** |
| Net loss per common share (Note B)            |   | **$**                              | **(1.81**       | **)** |

 

 

 

F-16

----

 

OnFebruary 23, 2000, Medis El issued to MTL 107,759 ordinary shares foraggregate cash consideration of $2,500,000. The Company accounted for theacquisition using the purchase method. The Company allocated the excess of thepurchase price over net assets acquired to goodwill ($810,000) and CellScantechnology assets ($99,000). The Company amortizes the acquired technologyassets over their useful lives of three years and had amortized the goodwillthrough December 31, 2001 based on a five year useful live.

 

During theyear ended December 31, 2000, the Company purchased an aggregate of 60,000shares of Medis El from the designee of an Argentinean company, pursuant to theterms of a settlement agreement entered into in November 1999 (“NovemberSettlement”). On June 8, 2000, the Company commenced an action entitledMedis Technologies Ltd. v. CellScan Argentina, S.A., in the Supreme Courtof the State of New York, County of New York, upon CellScan Argentina’s refusalto transfer 18,000 of such shares. The June 8, 2000 action alleged thatthe failure to transfer the 18,000 shares was a material breach of the NovemberSettlement. In August 2000, the parties entered into a stipulation andorder of settlement (the “Stipulation”), dismissing with prejudice the action.Pursuant to the Stipulation, the Company purchased the remaining 18,000 sharespursuant to the terms of the November Settlement and granted certain“piggy-back” registration rights to CellScan Argentina with respect to 30,000shares of the Company’s common stock underlying warrants issued to CellScanArgentina pursuant to the November Settlement. The Company paid aggregate cashconsideration of approximately $398,000 in exchange for the 60,000 ordinaryshares of Medis El. The excess of purchase price over net assets acquired onthese acquisitions was approximately $383,000, which was allocated to CellScantechnology assets ($92,000), in-process R&D for the fuel cell, stirlingcycle and toroidal engine projects ($4,000), and goodwill ($287,000).

 

From Januaryto June 2000, Medis El purchased an additional 11.5% of the outstandingshares of More Energy Ltd., a subsidiary of Medis El, giving Medis El a93% interest in such company, for an aggregate purchase price of $320,000.Medis El accounted for these acquisitions of minority interests using purchaseaccounting. The excess of purchase price over the book value of the net assetsacquired aggregated $320,000. This excess purchase price was allocated toin-process research and development and, therefore, was charged to research anddevelopment costs as of the dates of the acquisitions. Additionally, theCompany has an option expiring in November 2004 to acquire the remaining 7% ofthe outstanding shares of More Energy Ltd., held by its general manager anddirector, for 120,000 shares of the Company’s common stock. The purchase priceof the option, which was paid in full in June 2001, was $520,000, which isreported as other assets on the consolidated balance sheets.  Subject to a termination provision, theCompany has the right to exercise the option to acquire a maximum of 25% ofMore Energy’s shares not yet beneficially owned by Medis El in each of the four12 month periods following the date of the agreement, with any unexercisedamount being carried over to the following twelve month period until theexpiration of the option in November 2004 (see Note L -Subsequent Events).

 

F-17

----

 

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 andequipment consists of the following: 

 
|                                            |   | **December  31,** |       |
|-------------------------------------------------|--------|-------------------|------------|
|                                            |   | **2001**          |       | **2002** |   |
|                                            |   |              |       |   |   |
| Machinery and equipment                         |   | $                 | 1,823,000  | ** ** | **$** | **1,674,000** | ** ** |
| Computers                                       |   | 317,000           | ** ** | **376,000** | ** ** |
| Furniture and office equipment                  |   | 157,000           | ** ** | **162,000** | ** ** |
| Vehicles                                        |   | 94,000            | ** ** | **47,000** | ** ** |
| Land                                            |   | 110,000           | ** ** | **110,000** | ** ** |
| Leasehold improvements                          |   | 350,000           | ** ** | **385,000** | ** ** |
|                                            |   | 2,851,000         |       | **2,754,000** | ** ** |
| Less accumulated depreciation and  amortization |   | 1,623,000         | ** ** | **1,555,000** | ** ** |
| Property and equipment, net                     |   | $                 | 1,228,000  | ** ** | **$** | **1,199,000** | ** ** |

 

Depreciationand amortization expense on property and equipment  for the years ended December 31, 2000, 2001 and 2002 amounted to$363,000, $587,000 and $256,000, respectively.

 

During theyear ended December 31, 2002, the Company reduced its machinery and equipmentand corresponding accumulated depreciation balances for certain fullydepreciated equipment that is no longer in service.

 

F-18

----

 

**NOTEE—GOODWILL AND INTANGIBLE ASSETS**

 

As of December 31, 2001 and 2002, the Company’s intangible assetsconsisted of Goodwill and CellScan technology assets.****The following tablesummarizes the cost and related accumulated amortization for intangible assetsthat are subject to amortization.

 
|                          |   | **December  31,** |       |
|-------------------------------|--------|-------------------|------------|
|                          |   | **2001**          |       | **2002** |   |
|                          |   |              |       |   |   |
| CellScan technology assets    |   | $                 | 9,113,000  | ** ** | **$** | **9,113,000** | ** ** |
| Less accumulated amortization |   | 5,648,000         | ** ** | **8,281,000** | ** ** |
|                          |   | $                 | 3,465,000  |   | **$** | **832,000** | ** ** |

 

The Company recordedamortization expense of $1,808,000, $2,661,000 and $2,633,000 for the yearsended December 31, 2000, 2001 and 2002, respectively. Based on the currentamount of intangible assets subject to amortization, the estimated amortizationexpense for the year ended December 31, 2003 is $832,000.

 

The following table summarizes the activity in goodwill for the periodsindicated:

 
|                 |   | **December  31,** |       |
|----------------------|--------|-------------------|------------|
|                 |   | **2001**          |       | **2002** |   |
|                 |   |              |       |   |   |
| Beginning balance    |   | $                 | 76,673,000 | ** ** | **$** | **58,205,000** | ** ** |
| Amortization expense |   | 18,468,000        | ** ** | **—** | ** ** |
|                 |   | $                 | 58,205,000 |   | **$** | **58,205,000** | ** ** |

 

F-19

----

 

The followingtable reflects pro forma results of operations of the Company, giving effect toSFAS no. 142 as if it were adopted on January 1, 2000:

 
|                                                                |   | **Years  Ended December 31,** |        |
|---------------------------------------------------------------------|--------|-------------------------------|-------------|
|                                                                |   | **2000**                      |        | **2001** |   | **2002** |   |
|                                                                |   |                          |        |   |   |   |   |
| Net loss attributable to common  stockholders as reported           |   | $                             | (25,463,000 | ) | $ | (34,766,000 | ) | **$** | **(12,546,000** | **)** |
| Add back: goodwill amortization                                     |   | 11,860,000                    |        | 18,468,000 |   | **—** | ** ** |
| Pro forma net loss attributable to common  stockholders as reported |   | $                             | (13,603,000 | ) | $ | (16,298,000 | ) | **$** | **(12,546,000** | **)** |
| Basic and diluted loss per share:                                   |   |                          |        |   |   |   |   |
| Reported net loss per share (Note B)                                |   | $                             | (1.56       | ) | $ | (1.76 | ) | **$** | **(.60** | **)** |
| Goodwill amortization                                               |   | .73                           |        | .94 |   | **—** | ** ** |
| Pro forma net loss per share                                        |   | $                             | (.83        | ) | $ | (.82 | ) | **$** | **(.60** | **)** |

 

 

In accordancewith SFAS 142, the Company has performed an initial detailed evaluation of itsgoodwill as of January 1, 2002 for any possible impairment and has alsosubsequently tested its goodwill for impairment as of December 31, 2002. Noimpairment was found at either date. In performing such initial evaluation asof January 1, 2002, the Company first determined its reporting units. Once thereporting units were established and goodwill was allocated to such reportingunits, the Company compared the estimated fair value of each reporting unit tothe carrying amount of the units’ assets and liabilities, including itsgoodwill and other intangible assets. Since the fair value of its reporting unitsexceeded the carrying amount, the second step of the impairment test, in whichthe current fair market value of the units’ assets and liabilities woulddetermine the current implied fair value of the units’ goodwill, was notperformed. The Company has also reassessed the useful lives of its otherintangible assets previously recorded in connection with earlier purchaseacquisitions.

 

F-20

----

 

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

 

Accrued expenses and other current liabilities consist of thefollowing:

 
|                                                  |   | **December  31,** |       |
|-------------------------------------------------------|--------|-------------------|------------|
|                                                  |   | **2001**          |       | **2002** |   |
|                                                  |   |              |       |   |   |
| Employees and related liabilities                     |   | $                 | 485,000    | ** ** | **$** | **522,000** | ** ** |
| Professional services                                 |   |              | 152,000    |   |   | **60,000** |   |
| Related parties                                       |   | 6,000             | ** ** | **139,000** | ** ** |
| Other                                                 |   | 179,000           | ** ** | **252,000** | ** ** |
| Total accrued expenses and other current  liabilities |   | $                 | 822,000    | ** ** | **$** | **973,000** | ** ** |

 

**NOTEG—STOCKHOLDERS’ EQUITY**

 

*1. Medis Technologies Ltd. Common Stock*

 

Eachstockholder is entitled to one vote for each share of common stock owned bythat stockholder on all matters properly submitted to the stockholders fortheir vote. Stockholders owning or controlling more than 50% of the shares canelect all of the directors. Subject to the dividend rights of holders ofpreferred stock, if any, holders of common stock are entitled to receivedividends when, as and if declared by the board of directors out of fundslegally available for this purpose. In the event of liquidation, dissolution orwinding up, the holders of common stock are entitled to receive on a pro ratabasis any assets remaining available for distribution after payment ofliabilities and after provision has been made for payment of liquidationpreferences to all holders of preferred stock. Holders of common stock have noconversion or redemption provisions or preemptive or other subscription rights.

 

In January andFebruary 2000, the Company completed a private placement of units, eachunit consisting of 66,000 shares of its common stock and 25,000 warrants (ofwhich one unit was purchased by IAI). Each warrant is exercisable into oneshare of common stock and has an exercise price of $5.75 per share. Anaggregate of 637,000 shares and 240,833 warrants were issued for aggregate cashproceeds of approximately $2,895,000. On November 12, 2001, the Company extended the expiration date of suchwarrants through December 31, 2004 (see Note G-2).

 

InJune 2000, the Company issued 5,243,561 shares of its common stock(including 1,712,500 to IAI) in connection with the Exchange Offer.

 

F-21

----

 

InJune 2000, the Company issued 859,544 shares of its common stock and429,781 warrants (the “June Warrants”) (including 50,000 shares and 25,000warrants to IAI) upon exercise of existing warrants for an aggregate exerciseprice of approximately $4,441,000. The June Warrants were issued as aninducement to the Company’s existing warrant holders to exercise theirrespective then outstanding warrants, at the rate of one June Warrant for everytwo then outstanding warrants exercised. The June Warrants are exercisable at$16.42 per share until June 15, 2002. The Company estimated the fair valueof the June Warrants to be $2,887,000 using the Black-Scholes option pricingmodel. Such warrants were accounted for as a preferred dividend. InJuly 2000, the Company issued an additional 19,500 shares of its commonstock and 9,750 warrants pursuant to the same offering for an aggregateexercise price of approximately $98,000. The Company estimated the value ofsuch warrants issued in July 2000 to be $84,000 using the Black-Scholesoption pricing model. Such warrants were accounted for as a preferred dividend.Also in July 2000, the Company issued an additional 33,000 shares of itscommon stock upon the exercise of a like number of then outstanding warrants,for an aggregate exercise price of approximately $165,000. On November 12,2001, the Company extended the expiration date of all of such warrants throughDecember 31, 2004 (see Note G-2).

 

InOctober 2000, warrant holders exercised warrants to purchase 8,667 sharesof the Company’s common stock, for an aggregate exercise price of approximately$142,000. Also in October 2000, certain officers of the Company’sexercised options to purchase a total of 41,100 shares of the Company’s commonstock, for an aggregate exercise price of approximately $16,900. Such options,which were contemplated as part of the Exchange Offer (see Note C), wereissued in October 1999 in substitution for certain options to purchaseordinary shares of Medis El held by such officers (See Note G-3).

 

In May andJune 2001, the Company sold in private placements to accredited investors anaggregate of 660,688 units, each unit consisting of one share of the Company’scommon stock and a warrant to purchase one share of common stock, at a price of$16.00 per unit, for aggregate gross proceeds of approximately $10,571,000.Issuance costs aggregated approximately $331,000. Warrants issued with 413,500units have an exercise price of $18.00 per share and warrants issued with 247,188units have an exercise price of $19.00 per share. All of such warrants areexercisable for two years from their respective issue date. The Company’s chiefexecutive officer and its president each purchased 15,625 units and IAI, theCompany’s largest stockholder, purchased 12,500 units. On November 12, 2001,the Company extended the expiration date of such warrants through December 31,2004 (see Note G-2).

 

Between Julyand November 2001, an existing warrant holder exercised warrants to purchase41,100 shares of the Company’s common stock, for an aggregate cash exerciseprice of $150,000.

 

In Februaryand March 2002, certain officers and employees of the Company exercised optionsto acquire an aggregate of 66,180 shares of the Company’s common stock, for anaggregate exercise price of approximately $309,000.

 

F-22

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On March 18,2002, the Company completed a rights offering and initiated a shareholderloyalty program.  Pursuant to the rightsoffering,  it offered to its existingstockholders subscription rights to purchase an aggregate of 3,500,000 sharesof its common stock at a purchase price of $2.00 per share. The Companyreceived gross proceeds of $7,000,000 from the rights offering, which proceeds,after deducting related expenses of approximately $461,000, are being used forworking capital, including for the continued development of its direct liquidfuel cell technology, as well as for selling, general and administrativeexpenses.

 

Additionally,pursuant to the Company’s shareholder loyalty program, all stockholders whopurchased shares in the rights offering and who have met other specifiedrequirements, have received at no cost one-tenth of a warrant for each share ofcommon stock owned in such stockholder’s name on February 13, 2002.Accordingly, as of September 18, 2002 and October 1, 2002, the Companyissued  an aggregate of 856,021 warrantsto stockholders in the shareholder loyalty program. Each full warrant entitlesthe holder 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. Through December 31, 2002, stockholders have exercisedwarrants to acquire an aggregate of 3,342 shares of the Company’s common stock,pursuant to the shareholder loyalty program, for aggregate proceeds of $14,800.

 

In accordancewith SFAS No. 128, the Company has adjusted its net loss per share foryears ended December 31, 2000 and 2001 to give retroactive effect to sharesissued in its March 18, 2002 rights offering. Accordingly, as a result of suchretroactive adjustment, for the years ended December 31, 2000 and 2001, the netloss per share decreased from $(1.79) to $(1.56), or $(.23) per share, and from$(2.02) to $(1.76), or $(.26) per share, respectively

 

*2.  Medis Technologies Ltd. Warrants*

 

MTL warrantsoutstanding are summarized below: 

 
|                             |   | **Shares**    |       | **Weighted  Average  Exercise Price** |       |
|----------------------------------|--------|---------------|------------|---------------------------------------|------------|
|                             |   |          |       |                                  |       |
| Balance at January 1, 2000       |   | 1,204,765     |       | $                                     | 5.00       |   |
| Granted                          |   | 946,976       |       | 13.90                                 |       |
| Exercised                        |   | (920,711      | )          | 5.26                                  |       |
| Balance at December 31, 2000     |   | 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**                             | ** ** |
|                                  |        |               |            |                                       |            |  |

 

F-23

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OnJuly 15, 2000, the Company issued a five-year warrant, which vestsimmediately, to purchase an aggregate of 100,000 shares of common stock at anexercise price of $20.48 per share, as payment under the terms of aJune 12, 2000 agreement with CIBC World Markets Corp. (“CIBC”) for capitalmarkets and financial and strategic advisory services. Also, onOctober 15, 2000, pursuant to the terms of said agreement, the Companyissued a five-year warrant to purchase 50,000 shares of common stock at anexercise price of $20.62 per share. The agreement, which commenced onJuly 15, 2000 (the “Commencement Date”) and was subsequently amended, hada term of one year and provided for termination by either party upon30 days written notice. Additionally, if the Company requested CIBC topursue a financing transaction, an additional fee would have been paid based ona schedule included in such agreement. The Company has estimated the fair valueof such warrants issued on July 15, 2000 and October 15, 2000 to be$581,000 and $257,000, respectively. The Company accounted for such warrants inaccordance with SFAS No. 123 and estimated their fair value using theBlack-Scholes option pricing model.

 

OnJuly 12, 2000, the Company issued a warrant to purchase an aggregate of25,000 shares of its common stock to each of the three members of its corporateadvisory board, which the Company appointed on the same date to assist it withits business strategy and to build relationships with third parties to assistin the development of its technologies. The warrants may be exercised at $20.00per share, vest immediately and expire after three years. The Company hasestimated the fair value of such warrants to be $526,000. The Company accountedfor such warrants in accordance with SFAS No. 123 and estimated their fairvalue using the Black-Scholes option pricing model. On November 12, 2001, theCompany extended the expiration date of such warrants through December 31, 2004(see below).

 

OnJuly 2, 2001, the Company issued a warrant to purchase an aggregate of25,000 shares of its common stock to a new appointee to its corporate advisoryboard. The warrant vested upon issuance, expires in July 2003, and has anexercise price of $20.00 per share. The Company has estimated the value of suchwarrant to be approximately $48,000. The Company accounted for such warrant inaccordance with SFAS No. 123 and estimated their fair value using theBlack Scholes option pricing model. On November 12, 2001, the Company extendedthe expiration date of such warrants through December 31, 2004 (see below).

 

On July 2,2001, the Company issued warrants to purchase an aggregate of 18,000 shares ofits common stock pursuant to the terms of existing consulting agreements withthird parties. The warrants vested upon issuance and had an exercise price of$20.00 per share. Such warrants expired in June 2002. In accordance withSFAS No. 123, the Company estimated the value of such warrants to beapproximately $34,000, using the Black-Scholes option pricing model.

 

F-24

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On November12, 2001, the Company extended through December 31, 2004 the expiration date ofits outstanding warrants that were issued to stockholders of the Company andmembers of its corporate advisory board. Such warrants had original expiration dates between June 2002 and July2003. The Company has estimated the fair value of the extension of theexpiration date of such warrants that were issued to stockholders to be$3,204,000 and has accounted for such amount as a preferred dividend. TheCompany has estimated the fair value of the extension of the expiration date ofsuch warrants that were issued to advisory board members to be $168,000 and hasaccounted for such amount as a compensation expense during the year endedDecember 31, 2001. The Company accounted for the extension of the expirationdate of such warrants in accordance with SFAS No. 123 and estimated theirfair value using the Black-Scholes option pricing model.

 

See Note G-1for a discussion of warrants issued in connection with the issuance of theCompany’s common stock and in connection with the Company’s loyalty program.

 

*3.  Medis Technologies Ltd. Stock Options*

 

OnJuly 13, 1999, the Company’s Board of Directors approved the 1999 StockOption Plan, and reserved 1,000,000 shares of common stock for issuance asstock options or stock appreciation rights pursuant to the plan. The planprovides for the issuance of both incentive and nonqualified stock options. OnOctober 11, 2000, the Company’s Board of Directors increased the number ofshares of its common stock reserved under the 1999 Stock Option Plan to2,000,000, 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.

 

OnNovember 2, 1999, the Company granted to officers and a consultant of theCompany options to purchase 450,000 shares of common stock at $2.93 per share,which is the Company’s good faith determination of 80% of the fair market valueon the date of grant. Such options have a four-year life, and vest after twoyears. In August 2000, the consultant became an officer of the Company. OnNovember 12, 2001, the Company extended the expiration date of such optionsthrough December 31, 2004 (see below).

 

F-25

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OnFebruary 21, 2000, the Board of Directors of the Company granted optionsto purchase an aggregate of 165,000 shares of common stock under its 1999 StockOption Plan to employees, officers and consultants of the Company. The options,which may be exercised at $5.00 per share, vest after two years and expireafter four years. Deferred compensation of approximately $1,468,000, which hasbeen charged to expense ratably over the vesting period, was recorded for suchoptions issued to employees and officers. As of December 31, 2000, theCompany estimated the fair value of such options issued to consultants to beapproximately $527,000. In June 2000, the Company cancelled options issuedto consultants to purchase an aggregate of 8,000 shares of common stock. TheCompany accounted for those options issued to employees and officers in accordancewith APB No. 25 and those issued to consultants in accordance with SFASNo. 123 using the Black-Scholes option pricing model to estimate theirfair value.  On November 12, 2001, theCompany extended the expiration date of such options through December 31, 2004(see below).

 

InOctober 2000, as contemplated as part of the Exchange Offer (SeeNote C), the Board of Directors of the Company granted under its 1999Stock Option Plan options to purchase 41,100 shares of common stock to certainofficers of the Company, in substitution for certain options to purchaseordinary shares of Medis El held by such officers. Such options, which arevested and have an exercise price of $.4106, were on terms consistent with theExchange Offer. Accordingly, new options to purchase 1.37 shares of theCompany’s common stock were granted for each option to purchase an ordinaryshare of Medis El held by such officer. Additionally, in October 2000, theBoard of Directors of the Company granted under its 1999 Stock Option Plan optionsto purchase 68,500 shares of common stock to its chairman and chief executiveofficer in substitution for certain additional options to purchase ordinaryshares of Medis El granted to such officer prior to the Exchange Offer. Suchoptions, which are vested and have an exercise price of $5.26, were alsogranted on terms consistent with the Exchange Offer. Since such options werevested, their fair value was included in the Exchange Offer purchase price andaccounted for in accordance with APB 16.

 

On October 15,2000, the Board of Directors of the Company granted, under the 1999 StockOption Plan, options to purchase 200,000 shares of common stock to certainofficers of the Company. Such stock options vest on June 15, 2001, and maybe exercised at a price of $16.42 per share until June 15, 2002. Deferredcompensation of approximately $366,000, which was charged to expense ratablyover the vesting period, was recorded for such options. Also onOctober 15, 2000, the Board of Directors of the Company granted, under the1999 Stock Option Plan, options to purchase 10,000 shares of common stock toeach of the two new members of its Board of Directors. These options vest onSeptember 1, 2002 and may be exercised at $20.50 until September 1,2004. On November 12, 2001, the Company extended the expiration date of suchoptions through December 31, 2004 (see below).

 

F-26

----

 

OnDecember 22, 2000, the Board of Directors of the Company granted, underthe 1999 Stock Option Plan, options to purchase 500,000 shares of common stockto certain officers of the Company. Such stock options vest onDecember 22, 2002 and may be exercised at a price of $16.42 per shareuntil December 22, 2004. On November 12, 2001, the Company extended theexpiration date of such options through December 31, 2004 (see below).

 

Ascontemplated as part of the Exchange Offer, the Company sought and, inJuly 2001, received approval from the Israeli tax authorities tosubstitute outstanding Medis El stock options held by employees of Medis Elprior to the Exchange Offer for options to purchase shares of the Company’scommon stock. Consequently, the Company issued options to purchase 128,780shares of its common stock (including 109,600 and 13,700 to its executive vicepresident and its vice president-finance, respectively) in substitution ofoutstanding options to purchase 94,000 ordinary shares of Medis El. The ratioof 1.37 used to determine the number of shares underlying such options of theCompany to be issued was the same exchange ratio used in the Exchange Offer.Since such options were vested, their fair value was included in the ExchangeOffer purchase price and accounted for in accordance with APB No. 16.  On November 12, 2001, the Company extendedthe expiration date of such options through December 31, 2004 (see below).

 

In July andAugust 2001, the Board of Directors of the Company granted options to purchasean aggregate of 299,700 shares of common stock under its 1999 Stock OptionPlan, 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).

 

F-27

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•                                          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, APB No. 25 and FASB Interpretation No. 44, the Companyhas estimated the value of the extension of the expiration date of such optionsto 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 those issued to consultants in accordancewith SFAS No. 123 using the Black-Scholes option pricing model to estimatetheir fair value.

 

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.

 

During the years ended December 31, 2000, 2001 and 2002, the chiefexecutive officer of the Company received options to purchase 300,000, 75,000and 100,000 shares of the Company’s common stock, respectively, in his capacityas a director.

 

F-28

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

 
|                                         |   | **Options**   |       |
|----------------------------------------------|--------|---------------|------------|
|                                         |   | **Shares**    |       | **Weighted  average  exercise price** |   |
| Options outstanding at January 1, 2000       |   | 450,000       |       | 2.93 |   |
| Granted                                      |   | 994,600       |       | 11.71 |   |
| Exercised                                    |   | (41,100       | )          | 0.41 |   |
| Forfeited                                    |   | (8,000        | )          | 5.00 |   |
| Options outstanding at December 31, 2000     |   | 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** | ** ** |
|                                         |   |          |       |   |   |
| **Exercisable December 31, 2002**            |   | **1,454,800** | ** ** | **8.84** | ** ** |
|                                         |   |          |       |   |   |
| Exercisable December 31, 2001                |   | 864,000       |       | 6.52 |   |
|                                         |   |          |       |   |   |
| Exercisable December 31, 2000                |   | —        | ** ** | — | ** ** |

 
| **Options  Outstanding** |   | **Options  Exercisable**                      |   |
|--------------------------|--------|-----------------------------------------------|--------|
| **Exercise  Price**      |   | **Number  outstanding at  December 31, 2002** |   | **Weighted  average  remaining  contractual life** |   | **Weighted  average  exercise prices** |   | **Number  Exercisable at  December 31, 2002** |   | **Weighted  average  exercise prices** |   |
|                     |   |                                          |   |   |   |   |   |   |   |   |   |
| $                        | 0.41   |                                          | 13,700 |   | 2.00 |   | $ | 0.41 |   | 13,700 |   | $ | 0.41 |   |
| 2.93                     |   | 450,000                                       |   | 2.00 |   | 2.93 |   | 450,000 |   | 2.93 |   |
| 5-5.26                   |   | 388,100                                       |   | 2.20 |   | 5.13 |   | 288,100 |   | 5.13 |   |
| 6.75                     |   | 34,000                                        |   | 2.40 |   | 6.75 |   | 3,000 |   | 6.75 |   |
| 8.75                     |   | 647,000                                       |   | 2.00 |   | 8.75 |   | — |   | — |   |
| 10.50                    |   | 150,000                                       |   | 2.60 |   | 10.50 |   | — |   | — |   |
| 13.5                     |   | 500,000                                       |   | 2.00 |   | 13.50 |   | 500,000 |   | 13.50 |   |
| 16.42                    |   | 200,000                                       |   | 2.00 |   | 16.42 |   | 200,000 |   | 16.42 |   |
|                     |   | 2,382,800                                     |   |   |   |   |   | 1,454,800 |   |   |   |
|                          |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |

 

F-29

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As of December 31, 2002, approximately 510,000 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$3,229,000, $3,664,000 and $213,000 in 2000, 2001 and 2002, respectively.

 

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

 

*4. Medis El Share Option Plan*

 

In October 1993, the Board of Directors of Medis El adopted ashare option plan (the “Share Option Plan”) pursuant to which 500,000 shareswere reserved for issuance upon the exercise of options to be granted to keyemployees and consultants of Medis El. The Share Option Plan is administered bythe Board of Directors, which designates the quantities, dates and prices ofthe options granted. Unless otherwise determined by the Board of Directors, theexercise price of options will be the market price of the Ordinary Shares onthe date of grant. As of June 5, 2000 (the date of the completion of theExchange Offer), Medis El no longer granted options under its Share OptionPlan.

 

Options granted under the Share Option Plan would expire after afour-year period, but would be exercisable only after the second anniversary ofthe grant date and then only if the option holder is still an employee orconsultant of Medis El. As of December 31, 2001, there are no outstandingoptions under the Share Option Plan.

 

In January and February 2000, certain employees and a director of MedisEl, exercised options to purchase an aggregate of 66,100 ordinary shares ofMedis El. Such exercise generated aggregate cash proceeds to Medis El ofapproximately $336,000. The Company recorded a credit of approximately $189,000to additional paid in capital, representing the increase in Medis El’s bookvalue attributable to the Company from the exercise of the options.

 

Deferred loan feesSee Note G-3 for discussion of substitution ofoutstanding Medis El stock options held by employees of Medis El prior to theExchange Offer for options to purchase shares of the Company’s common stock.

 

F-30

----

 

The following table summarizes Medis El’s option plan activity for thethree years ended December 31, 2001: 

 
|                                                   |   | **Number of Options** |       | **Weighted average  exercise price** |       |
|--------------------------------------------------------|--------|-----------------------|------------|--------------------------------------|------------|
|                                                   |   |                  |       |                                 |       |
| **Balance at January 1, 2000**                         |   | **255,100**           | ** ** | **5.47**                             | ** ** |
| Granted                                                |   | —                |       | —                               |       |
| Exercised                                              |   | (66,100               | )          | 5.09                                 |       |
| Cancelled                                              |   | (45,000               | )          | 1.30                                 |       |
|                                                   |   |                  |       |                                 |       |
| **Balance at December 31, 2000**                       |   | **144,000**           | ** ** | **6.95**                             | ** ** |
| Granted                                                |   | —                |       | —                               |       |
| Exercised                                              |   | —                |       | —                               |       |
| Cancelled or forfeited                                 |   | (144,000              | )          | 6.95                                 |       |
|                                                   |   |                  |       |                                 |       |
| **Balance at December 31, 2001**                       |   | —                |       | —                               |       |
|                                                   |   |                  |       |                                 |       |
| **Balance at December 31, 2002 (no activity in 2002)** |   | —                |       | —                               |       |

 

Compensation costs charged to operations which Medis El recorded forMedis El stock options granted below the fair market value at the date of grantwere $65,000 in 2000 and none in 2001 and 2002. Compensation expense wasdetermined by calculating the difference between the exercise price and thefair market value of such options on the date of grant. The expense is chargedto operations over the vesting period of such options.

 

**NOTEH—COMMITMENTS AND CONTINGENCIES**

 

*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 granting territorialrights. The royalty for the second ten-year period is 3.5% on all revenueswhether from sales or fees. In addition to such royalty payments, the Companyis required to grant $100,000 to the University during the first year that theCompany’s after-tax profits exceed $300,000. No royalties were required to bepaid during the three years ended December 31, 2002.

 

F-31

----

 

*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.

 

*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, 2002.

 

*4.  Lease Commitments*—MTL’s office space is provided to MTLfor an annual rental fee of approximately $112,000, by a company which iscontrolled by the chairman and chief executive officer and the president andtreasurer of MTL.  The sublease is on amonth to month basis.

 

Medis El is committed under leases at two locations for office space,laboratory and manufacturing facilities, as well as its pilot production plant.Its corporate headquarters and technology center facility lease, which has aterm until December 31, 2003 and a one-year option on the facility, providesfor annual aggregate rental of approximately $194,000. Additionally, its pilotproduction plant lease has an initial term until December 31, 2003, aone-year options extending to December 31, 2004, and provides for anannual aggregate rental of approximately $14,000. During the years endedDecember 31, 2000, 2001 and 2002, the Company incurred expenses under itsfacility lease commitments aggregating approximately $155,000, $270,000 and$293,000 respectively.

 

The Company is committed under vehicle leases with various terminationdates in 2003 through 2006.  TheCompany’s annual aggregate commitment under such leases for the years endingDecember 31, 2003, 2004, 2005 and 2006 is approximately $138,000, $101,000, and$49,000 and $2,000, respectively.

 

5.  *Agreement with Peruvian Company*—In April and May 2000, theCompany transferred payments aggregating $110,000 to a Peruvian company (“Peru”)for the repurchase of a CellScan machine. In June 1999, Medis El reachedan agreement with Peru which owned a CellScan machine, whereby, inconsideration of Medis El upgrading the CellScan system at its cost, Perurelinquished any future claims against Medis El, except for an option torequire Medis El to repurchase the CellScan system for $100,000. Such optionexpired on January 14, 2000. In February 2000, Medis El granted Perua new option to require Medis El to repurchase the CellScan machine for$110,000 which was exercised by Peru, via a letter dated February 23,2000.

 

F-32

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6.  *Revolving Credit Line* -As ofDecember 31, 2002, the Company had available the entire $5 million ofcredit under its December 29, 2000 revolving credit line loan agreementwith Fleet National Bank, which to date it has not drawn upon. The loanagreement, which bears interest on the outstanding balances based on either theLIBOR or Prime Rate and terminates on July 1, 2004, is collateralized by allcash and other assets on deposit with the bank at any time and an assignment ofcertain leases owned by a partnership in which the Company’s chief executiveofficer and its president are partners.

 

7.  *Fuel Cell Technology Cooperation Agreements*—InApril 2001, the Company entered into a mutually exclusive agreement withGeneral Dynamics Government Systems Corporation, a unit of General DynamicsCorporation (“GD”), to develop and market fuel cells and fuel cell-poweredportable electronic devices for the United States Department of Defense (the“DOD”). As part of such agreement, among other things, GD agreed to market theCompany’s fuel cell products to the DOD. In May 2002, the Company received a$75,000 purchase order from GD to develop an initial prototype of such a fuelcell charger. As of December 31, 2002, the Company had not recognized any ofthe proceeds pursuant to such purchase order.

 

8.  *Polymer Agreement* — In January 2002, the Company enteredinto an agreement with a U.S. company to develop a new application for the useof its highly electrically conductive polymers (HECPs) in a proton exchangemembrane fuel cell component which could advance the development of such fuelcells for automobile, home and stationary power uses. The agreement providesfor the Company to receive payments aggregating $300,000 over time. The Companyrecognized revenues of approximately $138,000 during the year ended December31, 2002, with respect to such agreement.

 

9.  *Military Application Order* - In January 2002, the Companyreceived a purchase order from an Israeli electronics manufacturer to define aspecification and carry out the preliminary design of a direct liquid fuel cellfor a new energy pack for infantry soldiers. Upon completion of the servicesunder such purchase order, the Company recognized revenue of approximately$54,000 during the year ended December 31, 2002 with respect to such purchaseorder.

 

10. *Option to Acquire RemainingInterest in Subsidiary* - The Company, through Medis El, owns93% of the outstanding ordinary shares of More Energy. Additionally, theCompany has an option expiring in November 2004 to acquire the remaining 7% ofthe outstanding shares of More Energy, which are held by its general manager,for 120,000 shares of the Company’s common stock. The purchase price of theoption, which was paid in full in June 2001, was $520,000, which is reported asother assets on the consolidated balance sheets. Subject to a terminationprovision, the Company has the right to exercise the option to acquire amaximum of 25% of More Energy’s shares not yet beneficially owned by Medis Elin each of the four 12 month periods following the date of the agreement, withany unexercised amount being carried over to the following twelve month perioduntil the expiration of the option in November 2004. The Company plans toexercise the option to acquire the entire remaining 7% of the outstandingshares of More Energy prior to the expiration of such option. (see Note L –Subsequent Events).

 

F-33

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**NOTEI—RELATED PARTY TRANSACTIONS**

 

*1.  Insurance***—**MedisEl is presently included as an additional insured party on IAI’s product,casualty, and third party liability coverage. During the year ended December 31,2001 and 2002, IAI charged Medis El approximately $5,000 for insurancepremiums. Additionally, during the year ended December 31, 2000, Medis Elcharged IAI approximately $64,000 relating to property loss insurance claims.

 

2.  *Consulting Agreements—*TheCompany has entered into consulting agreements with its chief executive officerand with its president. Such agreements have initial terms through December 31,2001 and provide for automatic extension on a year to year basis. During theyear ended December 31, 2000, the Company incurred fees relating to itsagreements with its chief executive officer and president of approximately$183,000 and $45,000, respectively, $240,000 and $145,000 during the year endedDecember 31, 2001, respectively, and $296,000 and $244,000 during the yearended December 31, 2002, respectively, as compensation for their services asofficers of the Company. Additionally, during the year ended December 31, 2002,the Company entered into a consulting agreement with a corporation wholly ownedby its senior vice president of business development (the “Corporation”). Suchagreement has an initial term through December 31, 2003 and provides forautomatic extension on a year to year basis. During the year ended December 31, 2002, the Company incurred fees ofapproximately $72,000, as compensation for consulting services under suchagreement.

 

**NOTEJ—INCOME TAXES**

 

The following represents the components of the Company’s pre-tax lossesfor each of the three years in the period ended December 31, 2001. 

 
|     |   | **Year ended  December 31,** |        |
|----------|--------|------------------------------|-------------|
|     |   | **2000**                     |        | **2001** |   | **2002** |   |
| Domestic |   | $                            | (17,245,000 | ) | **$** | **(24,371,000** | **)** | **$** | **(4,104,000** | **)** |
| Foreign  |   | (5,247,000                   | )           | **(7,191,000** | **)** | **(6,201,000** | **)** |
|     |   | $                            | (22,492,000 | ) | **$** | **(31,562,000** | **)** | **$** | **(10,305,000** | **)** |

 

The Company files a consolidated Federal income tax return, whichincludes MTL, Medis Inc., and Toroidal Products Inc. At December 31,2002, the Company has a net operating loss (“NOL”) carryforward for UnitedStates Federal income tax purposes of approximately $7,982,000, expiring through2022.

 

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 $37,624,000, as of December 31, 2002,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.

 

F-34

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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. Medis Elmust continue to fulfill the Approved Enterprise requirements to receive suchtax benefits.

 

More Energy’s investment program totaling $5,300,000 has been granted“Approved Enterprise” status under the Law for Encouragement of CapitalInvestments, 1959.  The Company isentitled to a tax benefit period of 10 years on income derived from theseprograms, as follows: a full income tax exemption for the first six years and areduced income tax rate of 10% to 25% (instead of the regular rate of 36% forthe remaining four year period).

 

If the Company distributes a cash dividend from retained earning whichwere tax exempt due to its approved enter purse 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 the Company’s Subsidiaries’ approved enterpriseprograms are dependent upon the Company Subsidiaries fulfilling he conditionsstipulated by the Laws for Encouragement of Capital Investments, 1959 and theregulations published under this law, as well as the criteria in the approvalfor the specific investment in the Company’s Subsidiaries’ approved enterpriseprograms.  If the Company’s  Subsidiaries do not comply with theseconditions, the tax benefits may be canceled, and the Company’s Subsidiariesmay be required to refund the amount of the canceled benefit, with the additionof linkage difference and interest.  Asof the date of these financial statements, the Company believes that it hascomplied with these conditions.

 

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.

 

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Temporary differences that give rise to deferred tax assets are as follows

 
|                                             |   | **December  31,** |      |
|--------------------------------------------------|--------|-------------------|-----------|
|                                             |   | **2001**          |      | **2002** |   |
|                                             |   |              |      |   |   |
| Net operating loss carryforward-United  States   |   | $                 | 2,643,000 |   | **$** | **3,397,000** | ** ** |
| Net operating loss carryforward-Israel           |   | 11,941,000        |      | **13,545,000** | ** ** |
| Other differences                                |   | (425,000          | )         | **(104,000** | **)** |
|                                             |   | 14,159,000        |      | **16,838,000** | ** ** |
| Valuation allowance                              |   | (14,159,000       | )         | **(16,838,000** | **)** |
| 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 financial statementsis as follows:

 
|                                                         |   | **Year ended  December 31,** |       |
|--------------------------------------------------------------|--------|------------------------------|------------|
|                                                         |   | **2000**                     |       | **2001** |   | **2002** |   |
|                                                         |   |                         |       |   |   |   |   |
| Income tax benefit computed at Federal  statutory rate (34%) |   | $                            | (7,647,000 | ) | $ | (10,731,000 | ) | **$** | **(3,504,000** | **)** |
| Other                                                        |   | (105,000                     | )          | 506,000 |   | **(143,000** | **)** |
| Effect of permanent differences                              |   | 4,842,000                    |       | 7,225,000 |   | **968,000** | ** ** |
| Valuation allowance                                          |   | 2,910,000                    |       | 3,000,000 |   | **2,679,000** | ** ** |
|                                                         |   | $                            | —     |   | $ | — |   | **$** | **—** | ** ** |

 

F-36

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

 
| **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                                            |   | $            | (.13       | )           | $      | (.12                | )      | $                | (.22       | ) | $ | (.13 | ) |
|                                                                            |   |         |       |        |   |                |   |             |       |
| Weighted-average shares used in computing  basic and diluted net loss per share |   | 20,278,876   |       | 21,098,959  |   | 21,098,959          |   | 21,100,417       |       |

 
| **Quarter ended**                                                               |   | **March 31*** |       | **June 30*** |   | **September 30*** |   | **December 31*** | ** ** |
|---------------------------------------------------------------------------------|--------|---------------|------------|--------------|--------|-------------------|--------|------------------|------------|
|                                                                            |   |          |       |         |   |              |   |             |       |
| Fiscal 2001                                                                     |   |          |       |         |   |              |   |             |       |
| Loss from operations                                                            |   | $             | (7,587,000 | )            | $      | (7,463,000        | )      | $                | (7,396,000 | ) | $ | (9,231,000 | ) |
| Net loss                                                                        |   | $             | (7,568,000 | )            | $      | (7,440,000        | )      | $                | (7,334,000 | ) | $ | (9,220,000 | ) |
| Net loss attributable to  common stockholders                                   |   | $             | (7,568,000 | )            | $      | (7,440,000        | )      | $                | (7,334,000 | ) | $ | (12,424,000 | ) |
| Basic and diluted net loss per  share                                           |   | $             | (.39       | )            | $      | (.38              | )      | $                | (.37       | ) | $ | (.62 | ) |
|                                                                            |   |          |       |         |   |              |   |             |       |
| Weighted-average shares used  in computing basic and diluted net loss per share |   | 19,305,147    |       | 19,594,657   |   | 20,070,248        |   | 20,100,106       |       |

 

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(*) reflects adjustment to giveretroactive effect to the Company’s March 18, 2002 rights offering.****(seeNote B)

 

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**NOTEL—SUBSEQUENT EVENTS (UNAUDITED)**

 

*1. Rights Offering –* On March 11, 2003, theCompany completed a rights offering in which it offered to its existingstockholders subscription rights to purchase an aggregate of 2,325,600 sharesor its common stock at a purchase price of $2.15 per share. The Companyreceived gross proceeds of $5,000,040 from the rights offering.

 

*2. Option to Acquire Remaining Interest in Subsidiary –* On March 14, 2003, the Company entered into anagreement with the General Manager of More Energy to amend the terms of theCompany’s existing option agreement, pursuant to which the Company had the rightto purchase the remaining 7% interest of More Energy it did not already own.Pursuant to the amendment, the vesting schedule of the option was acceleratedso that the Company can immediately exercise the option in full. Concurrently,the Company exercised the option in full and agreed to issue to the GeneralManager 120,000 shares of its common stock as payment in full for the remaining7% interest. Such payment was in addition to the initial purchase price of theoption of $520,000, which the Company paid in full in June 2001.

 

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