Fuel Cell Works Supplemental News Page
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following risks and uncertainties could cause actual results, and actual events that occur, to differ materially from those contemplated by the forward-looking statements:
? our revenues are derived primarily from General Motors and our business depends to a great extent on our relationship with General Motors;
? our second stage assembly agreements and our bi-fuel and compressed natural gas fuel systems agreement with General Motors extend through July 2006. If General Motors were to cease doing business with us or significantly reduce or delay its purchases from us, and we are unable to replace the potential lost sales with agreements with other Original Equipment Manufactures ("OEMs"), our business, financial condition and results of operations could be materially adversely affected;
? General Motors has publicized its interest to put significant pressures on its suppliers to reduce costs, including General Motors' intention to change suppliers if suppliers do not comply;
? we have a history of operating losses and negative cash flow that may continue into the foreseeable future without growth in the hydrogen economy and growth in our TAG business;
? we expect our merger with TAG to result in benefits to the combined company, but we may not realize those benefits due to challenges associated with integrating the operations and employees of the companies, which potentially could lead to an impairment of goodwill;
? we may not be able to achieve profitability of the combined company;
? our financial results could suffer if the goodwill and other intangible assets acquired in our merger with TAG become impaired, or as a result of costs associated with our merger with TAG;
? we could become subject to stockholder litigation associated with our merger with TAG;
? our second stage vehicle assembly operations are primarily focused on SUV and pick up truck vehicles which are dependent on the automotive and specialty vehicle markets in the United States. These markets are influenced by and our sales may be negatively impacted by a number of factors including the level of disposable consumer income, OEM plant shutdowns, model year changeovers, atypical weather for any sales region, interest rates, gasoline prices, and OEM programs affecting price and supply;
? our business depends on the growth of the hydrogen economy and the fuel cell market, which in turn is dependent on government regulations, hydrogen availability, consumer adoption of our technologies, and refueling technology advancements;
? our business depends upon General Motors' and other OEMs' commitment to the commercialization of fuel cell vehicles;
? the cyclical nature of automotive production and sales, particularly those of General Motors, could adversely affect our TAG business;
? variability in our operating performance may impact our ability to meet certain financial covenants required by our Amended and Restated Credit Agreement with our financial institution;
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? we may never be able to introduce commercially viable hydrogen products and systems;
? a mass market for hydrogen fuel cell products and systems may never develop or may take longer to develop than anticipated;
? users of gaseous alternative fueled or fuel cell powered vehicles may not be able to obtain fuel conveniently and affordably, which may adversely affect the demand for our products;
? our ability to design and manufacture fuel systems for fuel cell, hydrogen and hybrid electric vehicle applications that can be integrated into the products of OEMs will be critical to our business;
? our financial results can be impacted by our ability to estimate engineering and material costs associated with development programs;
? we depend on third-party suppliers for the supply of materials and components for our products;
? we may experience delays in the delivery of high-strength fiber from our suppliers due to shortages of this material;
? evolving customer design requirements, product specifications and testing procedures could cause order delays or cancellations;
? we depend on relationships with strategic partners, and the terms and enforceability of many of these relationships are not certain;
? the market for fuel cell vehicles, hybrids and other alternative fuel vehicles may be sensitive to general economic conditions or consumer preferences;
? we currently face and will continue to face significant competition;
? we depend on our intellectual property, and our failure to obtain, protect, and maintain the right to use certain intellectual property could adversely affect our future growth and success;
? we have limited experience manufacturing fuel systems for fuel cell and hybrid on a commercial basis, and as a result, we may experience process and technical difficulties that cause product shipments to be delayed;
? we may need to raise additional capital in the future to achieve commercialization of our products and technologies and to develop facilities for mass production of our products and systems, and to take advantage of strategic opportunities;
? our ability to raise capital in the future may be difficult due to operating losses;
? we may not meet our product development and commercialization milestones;
? our business could suffer if we fail to attract and maintain key personnel;
? we may be affected by skilled labor shortages and labor disputes at OEM facilities;
? we may be subject to warranty claims, and our provision for warranty costs may not be sufficient;
? our insurance may not be sufficient;
? our business may be subject to product liability claims or product recalls, which could be expensive and could result in a diversion of management's attention;
? our business may become subject to future product certification regulations, which may impair our ability to market our products;
? new technologies could render our existing products obsolete;
? failure to comply with OEM vehicle requirements, safety standards and applicable environmental and other laws and regulations could adversely affect our business and harm our results of operations;
? changes in environmental policies could hurt the market for our products;
? the development of uniform codes and standards for hydrogen fuel cell vehicles and related hydrogen refueling infrastructure may not develop in a timely fashion;
? future sales of substantial amounts of our common stock could affect its market price;
? our future operating results may fluctuate, which could result in a lower price for our common stock;
? if we fail to maintain adequate internal controls we may not be able to produce reliable financial reports in a timely manner or prevent financial fraud;
? the market price and trading volume of our common stock may be volatile;
? provisions of Delaware law and of our amended and restated certificate of incorporation and amended and restated bylaws may make a takeover or change in control more difficult.
This list of factors above is not intended to be exhaustive. Reference should also be made to the factors set forth from time to time in our SEC reports, including but not limited to those set forth in the section entitled "Risk Factors" in our Annual Report on Form 10-K for the year ended April 30, 2005. All forward-looking statements in this report are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update or revise any of these forward-looking statements even if experience or future changes show that the indicated results or events will not be realized.
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We provide powertrain engineering, system integration, manufacturing and assembly of packaged fuel systems and specialty equipment for automotive applications including fuel cells, hybrids, alternative fuels, hydrogen refueling, new body styles, mid-cycle vehicle product enhancements and high performance engines and drive trains for OEMs and OEM dealer networks. We believe we are well positioned to integrate advanced fuel system and electric drive system technologies for fuel cell and hybrid vehicles based on our years of experience in vehicle-level design, vehicle electronics and system integration. We also design, engineer and manufacture hybrid and fuel cell vehicles.
We classify our business operations into three reporting segments: Quantum Fuel Systems, Tecstar Automotive Group, and Corporate. The reportable segments other than Corporate represent strategic businesses that are managed separately and offer products and services that can be differentiated. Corporate consists of general and administrative expense incurred at the corporate level that is not directly attributable to any of the other operating segments.
The Quantum Fuel Systems business operations primarily consist of design, manufacture and supply of packaged fuel systems for use in fuel cell, hydrogen and alternative fuel vehicles. This segment generates product revenues through the sale of fuel cell-related fuel storage, fuel delivery, and electronic control systems to OEMs, and the installation of its fuel cell products into OEM vehicles. Product revenues are also generated through the sale of compressed natural gas (CNG), and hydrogen fuel storage, fuel delivery, and electronic control systems for internal combustion engine applications. In addition to product sales, the Quantum Fuel Systems segment generates contract revenue by providing engineering design and support to OEMs so that its fuel storage, fuel delivery, and electronic control systems integrate and operate with their fuel cell and alternative fuel applications. Prior to the acquisition of TAG, the Quantum Fuel Systems business was reported in three separate segments that were aligned consistent with how previous operating performance was tracked. The segment disclosure amounts reported for the first six months of fiscal 2005 have been restated to reflect the new presentation.
The Tecstar Automotive Group segment is comprised of virtually all of the business activities acquired via the merger with TAG, which was completed in March 2005, and primarily consist of second stage manufacturing of specialty equipment for General Motors' pick-up trucks and SUVs, engineering and design capabilities for concept vehicles, and distribution of automotive accessories through OEM dealer networks. This segment engineers and validates appearance items and performance packages to OEM standards and completed systems carry the full OEM warranty and are distributed directly by the OEM to automotive dealerships.
The merger with TAG expands Quantum's OEM 'one-stop-shop' capability with expanded resources in terms of vehicle system design, powertrain engineering, systems integration, validation, and second stage manufacturing and assembly for all future fuel cell, hybrid and alternative fuel vehicle programs. Our expanded OEM capabilities facilitates our participation in early stage development, production and second stage assembly of fuel systems and performance packages for fuel cell, hybrid and alternative fuel vehicles. Through the integration of the two companies, we are starting to use Tecstar Automotive Group's second stage assembly capabilities in several of Quantum Fuel System's programs involving assembly and production.
The Tecstar Automotive Group product portfolio coupled with its service and assembly capabilities positions Quantum as a specialty vehicle designer, integrator and assembler for low-volume programs with the military and public and private fleet operators. We have existing programs with the military and other government agencies wherein we are providing specialty and hydrogen-hybrid vehicles using our expanded resources to design, integrate and assemble the vehicles and fuel systems in a more cost-effective, efficient and timely manner.
The merger has allowed us to strengthen our customer relationships as well as to build new OEM relationships within the combined business as a result of a heightened profile as a leader in the specialty vehicle design and assembly industry coupled with our technology in the hydrogen vehicle industry.
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The chief operating decision maker allocates resources and tracks performance by the three reporting segments, and evaluates performance based on profit or loss from operations before interest and income taxes.
Quantum Fuel Systems Segment
Our Quantum Fuel Systems segment supplies our advanced gaseous fuel systems for alternative fuel vehicles to OEM customers for use by consumers and for commercial and government fleets. Since 1997, we have sold approximately 18,500 fuel systems for alternative fuel vehicles, primarily to General Motors, which in turn have sold substantially all of these vehicles to its customers. We also provide our gaseous fuel systems and hydrogen refueling products for fuel cell applications to major OEMs through funded research and development contracts and on a prototype and production intent basis. These fuel cell and hydrogen refueling products are not currently manufactured in high volumes and will require additional product development; however, we believe that a commercial market will begin to develop for these products over the next five years. We believe that these systems will reach production volumes only if OEMs produce fuel cell applications and hydrogen refueling products using our systems on a commercial basis.
A number of automotive and industrial manufacturers are developing alternative clean power systems using fuel cells or clean burning gaseous fuels in order to decrease fuel costs, lessen dependence on crude oil and reduce harmful emissions. Our products for these markets consist primarily of fuel storage, fuel delivery and electronic control systems, as well as system integration of our products into fuel cell, hybrid, and alternative fuel vehicles, and hydrogen refueling products, which includes the complete design of fuel cell and hybrid vehicles to demonstrate our advanced fuel systems expertise.
Our Quantum Fuel Systems segment revenues and cash flows are dependent on the advancement of OEM fuel cell technologies and our OEM customers' internal plans, spending levels and timing for pre-production development programs and commercial production. This segment depends on the industry-wide growth of the fuel cell and alternative fuel markets, which in turn is dependent on regulations, laws, hydrogen availability and refueling, technology advancements, and consumer adoption of alternative fuel and fuel cell technologies on a commercial scale.
Our fuel storage systems must be able to withstand rigorous testing as individual components and as part of the fuel system on the vehicle. The fuel system as a whole, including the tank, regulator and fuel lines, need to comply with OEM vehicle requirements and applicable safety standards. Our systems are generally designed, validated and certified for short-term life, approximately three years, and are produced in accordance with requirements specified by our OEM customers. We currently have programs with OEMs to design, validate and certify systems for longer durability and for vehicles designed for commercialization. Our hydrogen storage and delivery systems may encounter technology and design challenges, durability constraints and issues with technology application into the vehicles. In early September 2005, Toyota Motor Company announced a grounding of 14 fuel cell prototype vehicles containing our hydrogen fuel storage systems due to the discovery of a hydrogen leak in the system in one prototype vehicle. We worked with Toyota to evaluate these systems and have determined that the subject system had leaked hydrogen as a result of a combination of certain manufacturing process conditions coupled with isolated operating conditions. Overall, the design and validation of these prototype systems met the OEM and certification requirements, but the systems for these 14 prototype vehicles were approaching their three-year service life and were scheduled for replacement in the near future. Toyota has elected to begin phasing in their next generation fuel cell prototype vehicles to replace the 14 initial prototype vehicles and has equipped the new prototype vehicles with Toyota designed and produced hydrogen fuel storage systems.
A significant portion of our Quantum Fuel Systems business is generally related to fuel cell, hybrid and alternative fuel vehicle development programs and product sales, which vary directly with the program timing and production schedules of our OEM customers. The market for these vehicles is sensitive to general economic conditions, government agency and commercial fleet spending and consumer preferences. The rate at which our customers sell fuel cell or alternative fuel vehicles depends on their marketing strategy, as well as company specific inventory and incentive programs. Any significant reduction or increase in production of these vehicles by our OEM customers may have a material effect on our business. Our CNG program with General Motors extends through July 2006 and may not be renewed by General Motors as a second stage General Motors-marketed program. If not renewed under its current contractual structure, we would plan on continuing this program under a dual-invoice program. A dual-invoice structure would allow us to assemble the CNG fuel system and directly sell our systems in conjunction with the General Motors vehicle to General Motors' customers under a QVM-Quality Vehicle Manufacturing arrangement without utilizing their marketing network.
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Our industry is also dependent upon a limited number of third party suppliers of materials and components for our products. Any quality problems or supply shortages with respect to these components could negatively impact our business. In the past year, we have experienced pressure on the availability of high-strength fiber from our primary supplier, and we are looking for alternative suppliers to fulfill our needs in the event of any potential shortages. Any issues with respect to the availability of raw materials such as high-strength fiber could negatively impact our ability to develop and manufacture fuel storage systems for our customers.
Tecstar Automotive Group Segment
Our Tecstar Automotive Group segment engineers and integrates specialty equipment products into motor vehicle applications, primarily pick-up trucks and sport utility vehicles. Our accessory packages are typically designed for new OEM body styles, mid-cycle enhancements, specialty products, and high-performance engines and drivetrains. We also have engineering and design capabilities focused on powertrain projects and complete vehicle concepts, such as high-performance and racing engines for cars, boats and motorcycles, and complete race cars.
We engineer and validate certain appearance items to OEM standards, primarily for pick-up trucks and sport utility vehicles. We receive vehicle chassis from the OEM and add these parts through a process called "second stage manufacturing." The chassis are provided by the OEM on a drop-ship basis and are not included as part of our product sales. After completing the final appearance assembly work, the vehicles are placed back into the normal OEM distribution stream. The vehicles carry the full OEM warranty and are marketed directly by the OEM through its dealerships. We engineer and design concept vehicles and distribute automotive parts and OEM-quality automotive accessories through a dealer network.
The sales of specialty equipment and second stage manufacturing services are directly impacted by the size of the automotive industry and the relative market share of the major OEMs. Second stage assembly programs typically range from two to five years over the life of the OEM chassis and are fulfilled under short-term purchase orders, as is standard in the industry. We provide a limited product warranty to the OEM, which is substantially the same as the OEM warranty provided to the OEM's retail customers. OEMs periodically reduce production or close plants for model changeovers that adversely affect operating results of industry participants. Sales may be adversely affected if OEMs perform such second stage manufacturing programs themselves and do not outsource the business. Approximately 90.4% of Tecstar Automotive Group's sales for the first six months of fiscal 2006 was made to General Motors.
Most of our second stage assembly programs with General Motors extend through April 2006 for model year 2006. The 2007 model year vehicles produced by General Motors represent a model changeover and may not include our specialty equipment products until future model years. We are in discussions with General Motors on targeted second stage vehicle platforms, programs and introductory timing. Any discontinuance of a specialty vehicle program or an extended transitional period in redesigning a performance package for these new model year vehicles by General Motors would likely have a material adverse effect on our business if not replaced with other OEM programs or revenues from aftermarket programs, dealer network programs, dual-invoice programs or other strategic initiatives. We are in discussions with other OEMs for OEM-level second stage assembly programs and have initiated several aftermarket and dealer network programs. We are currently evaluating the feasibility of initiating certain dual-invoice programs enabling us to assemble a specialty equipment package on a new vehicle and directly sell our system in conjunction with a vehicle sale from the OEM to high-volume customers or dealerships under a QVM-Quality Vehicle Manufacturing arrangement but without utilizing the OEM marketing network.
In September 2005, we acquired a 51% interest in Empire Coach Enterprises, LLC ("Empire Coach"), a second stage limousine manufacturer, for $600,000 cash. Among other business opportunities, Empire Coach will pursue "qualified vehicle modifier" status with Ford Motor Company ("Ford QVM") in order to modify Lincoln Town Cars to limousines. Empire Coach will also be able to offer alternative fuel limousines using Quantum's advanced fuel system technologies for compressed natural gas, propane, and hydrogen applications.
The Tecstar Automotive Group is also involved in other special programs such as designing and constructing second stage production and assembly operations for other companies involved in non-traditional consumer automotive markets. In August 2005, we were contracted by Force Protection Industries to assist in a second stage assembly program for special military vehicle assembly.
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In September 2005, we sold substantially all the assets of our production paint facility, Tarxien Automotive Products Ltd., to Concord Coatings, Inc. in exchange for a 20% equity interest in Concord Coatings, $250,000 in cash, and a promissory note with a principal amount of approximately $1.2 million. Our investment in Concord Coatings is included in the Tecstar Automotive Group segment and accounted for under the equity method.
Financial Operations Overview
In managing our business, our management uses several non-financial factors to analyze our performance. For example, we assess the extent to which current programs are progressing in terms of timing and deliverables and the success to which our systems are interfacing with our customers' applications. We also assess the degree to which we secure additional programs or new programs from our current or new OEM customers and the level of government funding we receive for hydrogen-based systems and storage solutions. We also evaluate the number of new second stage manufacturing programs we obtain and the units shipped as part of current and new programs.
For the second quarters of fiscal 2005 and 2006, consolidated revenue related to sales of our products to and contracts with General Motors represented 58.3% and 90.0%, respectively, of our total revenue for these periods. For the second quarters of fiscal years 2005 and 2006, revenue related to sales of our products to and contracts with Toyota represented 18.6% and 0.6%, respectively, of our total revenue for those periods. For the first half of fiscal 2005 and 2006, consolidated revenue related to sales of our products to and contracts with General Motors represented 56.6% and 88.7%, respectively, of our total revenue for these periods. For the second quarters of fiscal years 2005 and 2006, revenue related to sales of our products to and contracts with Toyota represented 19.9% and 0.4%, respectively, of our total revenue for those periods.
We recognize revenue for product sales when goods and systems are assembled on the vehicles and prepared and deliverable to our customers in accordance with our contract terms and collectability is reasonably assured. Contract revenue is recognized based on the percentage of completion method.
We expense all research and development when incurred. Research and development expense includes both customer-funded research and development and company-sponsored research and development. Customer-funded research and development consists primarily of expenses associated with contract revenue. These expenses include application development costs we funded under customer contracts. We will continue to require significant research and development expenditures over the next several years in order to commercialize our products for fuel cell applications.
General Motors Relationship
Our strategic alliance with General Motors became effective upon our spin-off . . .