|
ITEM
1.
|
FINANCIAL
STATEMENTS (UNAUDITED)
|
(U.S.
Dollars)
|
|
|
|
June
30, 2006
|
|
|
December
31, 2005
|
|
|
ASSETS
|
|
|
(Unaudited)
|
|
|
|
|
|
CURRENT
ASSETS:
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
4,565,725
|
|
$
|
6,150,652
|
|
|
Restricted
collateral deposits
|
|
|
8,283,905
|
|
|
3,897,113
|
|
|
Available-for-sale
marketable securities
|
|
|
38,172
|
|
|
35,984
|
|
|
Trade
receivables (net of allowance for doubtful accounts in the amount
of
$159,349 and $176,180 as of June 30, 2006 and December 31, 2005,
respectively)
|
|
|
7,766,761
|
|
|
11,747,876
|
|
|
Unbilled
receivables
|
|
|
4,871,255
|
|
|
5,228,504
|
|
|
Other
accounts receivable and prepaid expenses
|
|
|
1,545,059
|
|
|
2,114,331
|
|
|
Inventories
|
|
|
8,724,101
|
|
|
7,815,806
|
|
|
Total
current assets
|
|
|
35,794,978
|
|
|
36,990,266
|
|
|
SEVERANCE
PAY FUND
|
|
|
2,109,660
|
|
|
2,072,034
|
|
|
RESTRICTED
DEPOSITS
|
|
|
21,571
|
|
|
779,286
|
|
|
PROPERTY
AND EQUIPMENT, NET
|
|
|
4,025,999
|
|
|
4,252,931
|
|
|
INVESTMENT
IN AFFILIATED COMPANY
|
|
|
175,530
|
|
|
37,500
|
|
|
OTHER
INTANGIBLE ASSETS, NET
|
|
|
10,468,321
|
|
|
11,027,499
|
|
|
GOODWILL
|
|
|
29,774,878
|
|
|
29,559,157
|
|
|
|
|
$
|
82,370,937
|
|
$
|
84,718,673
|
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
3
CONDENSED
CONSOLIDATED BALANCE SHEETS
(U.S.
Dollars, except share data)
|
|
|
|
June
30, 2006
|
|
|
December
31, 2005
|
|
|
|
|
|
(Unaudited)
|
|
|
|
|
|
LIABILITIES
AND SHAREHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
|
CURRENT
LIABILITIES:
|
|
|
|
|
|
|
|
|
Trade
payables
|
|
$
|
2,708,730
|
|
$
|
5,830,820
|
|
|
Other
accounts payable and accrued expenses
|
|
|
6,009,805
|
|
|
5,586,061
|
|
|
Current
portion of promissory notes due to purchase of
subsidiaries
|
|
|
208,581
|
|
|
453,764
|
|
|
Short-term
bank loans and current portion of long-term loans
|
|
|
3,093,829
|
|
|
2,036,977
|
|
|
Deferred
revenues
|
|
|
1,709,350
|
|
|
603,022
|
|
|
Convertible
debenture
|
|
|
11,367,231
|
|
|
11,492,238
|
|
|
Liability
in connection with warrants issuance
|
|
|
--
|
|
|
44,047
|
|
|
Liabilities
of discontinued operation
|
|
|
--
|
|
|
120,000
|
|
|
Total
current liabilities
|
|
|
25,097,526
|
|
|
26,166,929
|
|
|
LONG
TERM LIABILITIES
|
|
|
|
|
|
|
|
|
Accrued
severance pay
|
|
|
3,900,072
|
|
|
3,657,328
|
|
|
Convertible
debenture
|
|
|
1,142,763
|
|
|
8,590,233
|
|
|
Total
long-term liabilities
|
|
|
5,042,835
|
|
|
12,247,561
|
|
|
MINORITY
INTEREST
|
|
|
--
|
|
|
38,927
|
|
|
SHAREHOLDERS’
EQUITY:
|
|
|
|
|
|
|
|
|
Share
capital -
|
|
|
|
|
|
|
|
|
Common
stock - $0.01 par value each;
|
|
|
|
|
|
|
|
|
Authorized:
250,000,000 shares as of June 30, 2006 and December 31, 2005; Issued:
8,508,623 shares as of June 30, 2006 and
6,221,193
shares as of December 31, 2005; Outstanding:
8,468,957
shares as of June 30, 2006 and
6,181,527
shares as of December 31, 2005
|
|
|
1,191,230
|
|
|
870,969
|
|
|
Preferred
shares - $0.01 par value each;
|
|
|
|
|
|
|
|
|
Authorized:
1,000,000 shares as of
June
30, 2006
and December 31, 2005; No shares issued and outstanding as of
June
30, 2006
and December 31, 2005
|
|
|
--
|
|
|
--
|
|
|
Additional
paid-in capital
|
|
|
211,277,011
|
|
|
193,560,579
|
|
|
Accumulated
deficit
|
|
|
(155,425,747
|
)
|
|
(142,996,964
|
)
|
|
Treasury
stock, at cost (common stock - 39,666 shares as of
June
30, 2006
and December 31, 2005)
|
|
|
(3,537,106
|
)
|
|
(3,537,106
|
)
|
|
Notes
receivable from shareholders
|
|
|
(1,280,768
|
)
|
|
(1,256,777
|
)
|
|
Accumulated
other comprehensive loss
|
|
|
5,956
|
|
|
(375,445
|
)
|
|
Total
shareholders’ equity
|
|
|
52,230,576
|
|
|
46,265,256
|
|
|
|
|
$
|
82,370,937
|
|
$
|
84,718,673
|
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
4
(U.S.
Dollars, except share data)
|
|
|
Six
months ended June 30,
|
Three
months ended June 30,
|
|
|
|
|
2006
|
|
|
2005
|
|
|
2006
|
|
|
2005
|
|
|
Revenues
|
|
$
|
16,310,747
|
|
$
|
22,624,355
|
|
$
|
7,414,335
|
|
$
|
12,236,910
|
|
|
Cost
of revenues
|
|
|
12,742,129
|
|
|
14,981,150
|
|
|
6,089,377
|
|
|
8,609,276
|
|
|
Gross
profit
|
|
|
3,568,618
|
|
|
7,643,205
|
|
|
1,324,958
|
|
|
3,627,634
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Research
and development
|
|
|
520,629
|
|
|
898,504
|
|
|
216,017
|
|
|
483,826
|
|
|
Selling
and marketing
|
|
|
1,748,132
|
|
|
2,222,692
|
|
|
848,864
|
|
|
1,063,873
|
|
|
General
and administrative
|
|
|
6,240,808
|
|
|
6,720,816
|
|
|
3,138,272
|
|
|
3,364,406
|
|
|
Amortization
of intangible assets
|
|
|
970,885
|
|
|
1,646,241
|
|
|
460,193
|
|
|
823,153
|
|
|
Impairment
of goodwill and other intangible assets
|
|
|
204,059
|
|
|
2,389,129
|
|
|
--
|
|
|
2,389,129
|
|
|
Total
operating costs and expenses
|
|
|
9,684,513
|
|
|
13,877,382
|
|
|
4,663,346
|
|
|
8,124,387
|
|
|
Operating
loss
|
|
|
(6,115,895
|
)
|
|
(6,234,177
|
)
|
|
(3,338,388
|
)
|
|
(4,496,753
|
)
|
|
Other
income
|
|
|
35,988
|
|
|
--
|
|
|
18,482
|
|
|
--
|
|
|
Financial
expenses, net
|
|
|
(6,458,796
|
)
|
|
(1,306,466
|
)
|
|
(4,997,660
|
)
|
|
(837,608
|
)
|
|
Loss
before minority interest in (loss) earnings of subsidiaries, earnings
from
affiliated company and tax expenses
|
|
|
(12,538,703
|
)
|
|
(7,540,643
|
)
|
|
(8,317,566
|
)
|
|
(5,334,315
|
)
|
|
Income
tax expenses
|
|
|
(54,053
|
)
|
|
(267,218
|
)
|
|
(14,081
|
)
|
|
(49,954
|
)
|
|
Minority
interest in (loss) earnings of subsidiaries
|
|
|
25,943
|
|
|
(71,153
|
)
|
|
16,754
|
|
|
(38,199
|
)
|
|
Earnings
from affiliated company
|
|
|
138,030
|
|
|
--
|
|
|
99,558
|
|
|
--
|
|
|
Loss
from continuing operations
|
|
|
(12,428,783
|
)
|
|
(7,879,014
|
)
|
|
(8,215,335
|
)
|
|
(5,422,514
|
)
|
|
Loss
from discontinued operations
|
|
|
--
|
|
|
(200,000
|
)
|
|
--
|
|
|
(200,000
|
)
|
|
Net
loss
|
|
|
(12,428,783
|
)
|
|
(8,079,014
|
)
|
|
(8,215,335
|
)
|
|
(5,622,514
|
)
|
|
Deemed
dividend to certain shareholders
|
|
|
(434,185
|
)
|
|
--
|
|
|
(116,978
|
)
|
|
--
|
|
|
Net
loss attributable to common shareholders
|
|
$
|
(12,862,968
|
)
|
$
|
(8,079,014
|
)
|
$
|
(8,332,313
|
)
|
$
|
(5,622,514
|
)
|
|
Basic
and diluted net loss per share from continuing operations
|
|
$
|
(1.67
|
)
|
$
|
(1.37
|
)
|
$
|
(0.98
|
)
|
$
|
(0.94
|
)
|
|
Basic
and diluted net loss per share from discontinued operation
|
|
$
|
0.00
|
|
$
|
(0.03
|
)
|
$
|
0.00
|
|
$
|
(0.03
|
)
|
|
Basic
and diluted net loss per share
1
|
|
$
|
(1.73
|
)
|
$
|
(1.41
|
)
|
$
|
(0.99
|
)
|
$
|
(0.97
|
)
|
|
Weighted
average number of shares used in computing basic and diluted net
loss per
share
|
|
|
7,438,333
|
|
|
5,745,826
|
|
|
8,384,433
|
|
|
5,770,009
|
|
_______________________
1
Includes $434,185 and $116,978 deemed dividend in the calculation of the
loss
per share for the respective six-months ended 6/30/06 and three-months ended
6/30/06.
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
5
|
(U.S.
Dollars, except share data)
|
|
|
|
Common
Stock
|
|
Additional
paid-in
capital
|
|
|
Accumulated
deficit
|
|
|
Treasury
stock
|
|
|
Notes
receivable
from
shareholders
|
|
|
|
|
|
Accumulated
other
comprehensive
income
(loss)
|
|
|
|
|
|
Total
comprehensive
loss
|
|
|
|
|
|
Total
|
|
|
|
|
|
Shares
|
|
|
Amount
|
|
|
|
|
|
|
|
|
|
|
|
BALANCE
AT JANUARY 1, 2006 - NOTE 1
|
|
|
6,221,193
|
|
$
|
870,969
|
|
$
|
193,560,579
|
|
$
|
(142,996,964
|
)
|
$
|
(3,537,106
|
)
|
$
|
(1,256,777
|
)
|
|
|
|
$
|
(375,445
|
)
|
|
|
|
$
|
--
|
|
|
|
|
$
|
46,265,256
|
|
|
CHANGES
DURING THE SIX
-MONTH
PERIOD ENDED JUNE 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Principal
installment of convertible debenture payment in shares
|
|
|
1,542,023
|
|
|
215,884
|
|
|
13,136,089
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
13,351,973
|
|
|
Warrants
exercise
|
|
|
745,549
|
|
|
104,377
|
|
|
4,246,258
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
4,350,635
|
|
|
Amortization
of deferred stock compensation
|
|
|
--
|
|
|
--
|
|
|
310,094
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
310,094
|
|
|
Interest
accrued on notes receivable from shareholders
|
|
|
--
|
|
|
--
|
|
|
23,991
|
|
|
--
|
|
|
--
|
|
|
(23,991
|
)
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
Other
comprehensive loss - foreign currency translation
adjustment
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
380,534
|
|
|
|
|
|
380,534
|
|
|
|
|
|
380,534
|
|
|
Other
comprehensive loss - unrealized gain on available for sale marketable
securities
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
867
|
|
|
|
|
|
867
|
|
|
|
|
|
867
|
|
|
Adjustment
of fractional shares due to reverse split
|
|
|
(142
|
)
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
--
|
|
|
Net
loss
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
(12,428,783
|
)
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
|
(12,428,783
|
)
|
|
|
|
|
(12,428,783
|
)
|
|
Total
comprehensive loss
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
|
|
|
--
|
|
|
|
|
$
|
(12,047,382
|
)
|
|
|
|
|
--
|
|
|
BALANCE
AT
JUNE
30, 2006
- UNAUDITED
|
|
|
8,508,623
|
|
$
|
1,191,230
|
|
$
|
211,277,011
|
|
$
|
(155,425,747
|
)
|
$
|
(3,537,106
|
)
|
$
|
(1,280,768
|
)
|
|
|
|
$
|
5,956
|
|
|
|
|
|
|
|
|
|
|
$
|
52,230,576
|
|
|
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
6
|
|
|
|
|
Six
months ended June 30,
|
|
|
|
|
2006
|
|
2005
|
|
CASH
FLOWS FROM OPERATING ACTIVITIES:
|
|
|
|
|
|
|
Net
loss for the period before deemed dividend to certain shareholders
of
common stock
|
|
$
|
(12,428,783
|
)
|
$
(8,079,014)
|
|
Less
loss for the period from discontinued operations
|
|
|
--
|
|
200,000
|
|
Adjustments
required to reconcile net loss to net cash used in operating
activities:
|
|
|
|
|
|
|
Depreciation
|
|
|
733,426
|
|
613,368
|
|
Amortization
of intangible assets, capitalized software costs and impairment
of
intangible assets
|
|
|
1,236,497
|
|
4,099,454
|
|
Amortization
of compensation related to warrants issued to the holders of convertible
debentures and beneficial conversion feature
|
|
|
1,040,041
|
|
789,448
|
|
Amortization
of deferred stock based compensation due to shares issued to
employees
|
|
|
224,864
|
|
270,738
|
|
Financial
expenses in connection with convertible debenture principal
repayment
|
|
|
5,395,338
|
|
--
|
|
Amortization
of deferred expenses related to convertible debenture
issuance
|
|
|
659,140
|
|
24,256
|
|
Remeasurement
of liability in connection with warrants granted
|
|
|
(700,113
|
)
|
--
|
|
Stock-based
compensation due to shares granted and to be granted to consultants
and
shares granted as a donation
|
|
|
--
|
|
98,010
|
|
Stock
based compensation due to options and shares granted to
employees
|
|
|
85,230
|
|
177,633
|
|
Adjustment
of stock based compensation related to non-recourse note granted
to
shareholder
|
|
|
--
|
|
(28,500)
|
|
(Earnings)
loss to minority
|
|
|
(25,943
|
)
|
71,153
|
|
Share
in earnings of affiliated company
|
|
|
(138,030
|
)
|
--
|
|
Interest
expenses accrued on promissory notes issued to purchase of
subsidiary
|
|
|
--
|
|
284,140
|
|
Amortization
of premium related to restricted securities
|
|
|
--
|
|
42,234
|
|
Liability
for employee rights upon retirement, net
|
|
|
157,243
|
|
10,711
|
|
Capital
gain from sale of marketable securities
|
|
|
--
|
|
2,693
|
|
Write-off
of inventory
|
|
|
272,650
|
|
--
|
|
Impairment
of fixed assets
|
|
|
16,672
|
|
--
|
|
Decrease
in deferred tax assets
|
|
|
15,830
|
|
64,595
|
|
Changes
in operating asset and liability items:
|
|
|
|
|
|
|
Decrease
in trade receivables and notes receivable
|
|
|
4,044,450
|
|
694,803
|
|
Decrease
in unbilled receivables
|
|
|
357,249
|
|
485,390
|
|
Increase
in other accounts receivable and prepaid expenses
|
|
|
(88,544
|
)
|
(184,965)
|
|
Increase
in inventories
|
|
|
(1,131,729
|
)
|
(1,230,866)
|
|
Decrease
in trade payables
|
|
|
(3,177,065
|
)
|
(1,676,572)
|
|
Increase
in deferred revenues
|
|
|
1,106,328
|
|
549,474
|
|
Increase
(decrease) in accounts payable and accruals
|
|
|
425,130
|
|
(1,209,465)
|
|
Net
cash used in operating activities from continuing
operations
|
|
|
(1,920,119
|
)
|
(3,931,282)
|
|
Net
cash used in operating activities from discontinuing
operations
|
|
|
(120,000
|
)
|
--
|
|
Net
cash used in operating activities
|
|
|
(2,040,119
|
)
|
(3,931,282)
|
|
CASH
FLOWS FROM INVESTING ACTIVITIES:
|
|
|
|
|
|
|
Repayment
of promissory note related to purchase of subsidiary
|
|
|
(245,183
|
)
|
(7,055,937)
|
|
Purchase
of property and equipment
|
|
|
(493,347
|
)
|
(534,678)
|
|
Proceeds
from sale of marketable securities
|
|
|
--
|
|
92,519
|
|
Payment
of transactions expenses in relation to previous year investment
in
subsidiary
|
|
|
--
|
|
(12,945)
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
7
|
|
|
|
|
|
Six
months ended June 30,
|
|
|
|
|
2006
|
|
2005
|
|
Investment
in affiliated company
|
|
|
--
|
|
(112,500)
|
|
Increase
in capitalized research and development projects
|
|
|
(325,877
|
)
|
(56,109)
|
|
Increase
in restricted securities and deposits, net
|
|
|
(3,828,124
|
)
|
6,667,886
|
|
Net
cash used in investing activities
|
|
|
(4,892,531
|
)
|
(1,011,764)
|
|
FORWARD
|
|
$
|
(6,932,650
|
)
|
$
(4,943,046)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
8
CONDENSED
CONSOLIDATED STATEMENT OF CASH FLOWS (
UNAUDITED
)
(U.S. Dollars)
|
|
|
Six
months ended June 30,
|
|
|
|
|
2006
|
|
|
2005
|
|
|
FORWARD
|
|
$
|
(6,932,650
|
)
|
$
|
(4,943,046
|
)
|
|
CASH
FLOWS FROM FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
|
Increase
in short-term credit from banks
|
|
|
1,074,877
|
|
|
1,117,477
|
|
|
Proceeds
from exercise of options
|
|
|
--
|
|
|
17,192
|
|
|
Proceeds
from issuance of share capital, net
|
|
|
--
|
|
|
1,275,325
|
|
|
Proceeds
from exercise of warrants
|
|
|
4,350,634
|
|
|
--
|
|
|
Repayment
of long-term loans
|
|
|
(19,552
|
)
|
|
(44,471
|
)
|
|
Net
cash provided by financing activities
|
|
|
5,405,959
|
|
|
2,365,523
|
|
|
DECREASE
IN CASH AND CASH EQUIVALENTS
|
|
|
(1,526,691
|
)
|
|
(2,577,523
|
)
|
|
CASH
EROSION (ACCRETION) DUE TO EXCHANGE RATE
DIFFERENCES
|
|
|
(58,236
|
)
|
|
36,935
|
|
|
BALANCE
OF CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE
PERIOD
|
|
|
6,150,652
|
|
|
6,734,512
|
|
|
BALANCE
OF CASH AND CASH EQUIVALENTS AT THE END OF THE
PERIOD
|
|
$
|
4,565,725
|
|
$
|
4,193,924
|
|
|
SUPPLEMENTARY
INFORMATION ON NON-CASH TRANSACTIONS:
|
|
|
|
|
|
|
|
|
Payment
of principal installment of convertible debenture in
shares
|
|
$
|
8,612,518
|
|
$
|
--
|
|
|
Issuance
of shares and warrants against accrued expenses
|
|
|
--
|
|
|
56,577
|
|
|
Accrual
for earnout in respect of subsidiary acquisition
|
|
|
--
|
|
|
152,973
|
|
|
Shares
issuance in regard to subsidiary acquisition
|
|
|
--
|
|
|
82,645
|
|
|
|
|
|
|
|
|
|
|
The
accompanying notes are an integral part of the Condensed Consolidated
Financial
Statements.
9
NOTE
1:
BASIS
OF PRESENTATION
a.
Company:
Arotech
Corporation (“Arotech” or the “Company”), and its subsidiaries
provide
defense and security products for the military, law enforcement and homeland
security markets, including advanced zinc-air and lithium batteries and
chargers, multimedia interactive simulators/trainers and lightweight vehicle
armoring
.
The
Company is primarily operating through
FAAC
Corporation, a wholly-owned subsidiary based in Ann Arbor, Michigan, and
FAAC’s
80%-owned United Kingdom subsidiary FAAC Limited
;
IES
Interactive Training, Inc. (“IES”), a wholly-owned subsidiary
based in
Ann Arbor, Michigan;
Electric
Fuel Battery Corporation, a wholly-owned subsidiary based in Auburn, Alabama;
Electric Fuel Ltd. (“EFL”) a wholly-owned subsidiary based in Beit Shemesh,
Israel;
Epsilor
Electronic Industries, Ltd., a wholly-owned subsidiary located in Dimona,
Israel;
MDT
Protective Industries, Ltd. (“MDT”),
a
majority-owned subsidiary based in Lod, Israel; MDT Armor Corporation, a
majority-owned subsidiary based in Auburn, Alabama; and Armour of America,
Incorporated, a wholly-owned subsidiary based in Auburn, Alabama
.
b.
Basis
of
presentation:
The
accompanying interim condensed consolidated financial statements have been
prepared by Arotech Corporation in accordance with generally accepted accounting
principles for interim financial information, with the instructions to Form
10-Q
and with Article 10 of Regulation S-X, and include the accounts of Arotech
Corporation and its subsidiaries. Certain information and footnote disclosures,
normally included in complete financial statements prepared in accordance
with
generally accepted accounting principles, have been condensed or omitted.
In the
opinion of the Company, the unaudited financial statements reflect all
adjustments (consisting only of normal recurring adjustments) necessary for
a
fair presentation of its financial position at June 30, 2006, its operating
results for the three- and six-month periods ended June 30, 2006 and 2005,
its
changes in shareholders’ equity for the six-month period ended June 30, 2006,
and its cash flow for the three- and six-month periods ended June 30, 2006
and
2005.
The
results of operations for the six months ended June 30, 2006 are not necessarily
indicative of results that may be expected for any other interim period or
for
the full fiscal year ending December 31, 2006.
The
balance sheet at December 31, 2005 has been derived from the audited financial
statements at that date but does not include all the information and footnotes
required by generally accepted accounting principles for complete financial
statements. These condensed consolidated financial statements should be read
in
conjunction with the audited financial statements included in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2005.
c.
Accounting
for stock-based compensation:
In
December 2004, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
Payments” (“SFAS No. 123(R)”), which is a revision of FASB No. 123, “Accounting
for Stock-Based Compensation” (“SFAS No. 123”). Generally, the approach in SFAS
No. 123(R) is similar to the approach described in Statement 123. However,
SFAS
No. 123 permitted, but did not require, share-based payments to employees
to
be
recognized based on their fair values, while SFAS No. 123(R) requires all
share-based payments to employees to be recognized based on their fair values.
SFAS No. 123(R) also revises, clarifies and expands guidance in several areas,
including measuring fair value, classifying an award as equity or as a liability
and attributing compensation cost to reporting periods.
On
December 29, 2005, the Company accelerated vesting of 39,810 of its outstanding
unvested stock options to make such options immediately vested and exercisable.
The Company’s decision to accelerate the vesting of those options and to grant
fully vested options was based primarily upon the issuance of SFAS No. 123(R),
which will require the Company to treat all unvested stock options as
compensation expense effective January 1, 2006. The Company believes that
the
acceleration of vesting of those options will enable the Company to avoid
recognizing stock-based compensation expense associated with these options
in
future periods. Additional reasons for the fully vested grant and for the
acceleration were to make the options more attractive to the recipients,
and to
avoid discrimination between groups of option holders.
The
Company has adopted the following stock option plans, whereby options and
restricted shares may be granted for purchase of shares of the Company’s common
stock. Under the terms of the employee plans, the Board of Directors or the
designated committee grants options and determines the vesting period and
the
exercise terms. Typically options under the plan are granted with an exercise
price equal to the fair value of common stock on the date of the
grant.
1)
1998
Employee Option Plan - as amended, 339,286 shares reserved for issuance,
of
which 60,711 were available for future grants to employees and consultants
as of
June 30, 2006.
2) 1995
Non-Employee Director Plan - 71,429 shares reserved for issuance, of which
no
stock options were available for future grants to non-employee directors
as of
June 30, 2006.
3) 2004
Employee Option Plan - 535,714 shares reserved for issuance, of which 317,891
were available for future grants to employees and consultants as of June
30,
2006.
Under
these plans, options generally expire no later than 5-10 years from the date
of
grant. Each option can be exercised to purchase one share, conferring the
same
rights as the other common shares. Options that are cancelled or forfeited
before expiration become available for future grants. The options generally
vest
over a three-year period (33.3% per annum) and restricted shares vest after
two
years; in the event that employment is terminated for cause within that period,
restricted shares revert back to the Company. The Company uses the Black-Scholes
model to determine fair value. Results for prior periods have not been
restated.
The
fair
value for the options to employees was estimated at the date of grant, using
the
Black-Scholes option valuation model, with the following weighted-average
assumptions: risk-free interest rates of 5.09% and 4.28% for 2006 and 2005,
respectively; a dividend yield of 0.0% for each of those years; a volatility
factor of the expected market price of the common stock of 0.76 for 2006
and
2005; and a weighted-average expected life of the option of three years for
2006
and 2005.
Application
of the Black-Scholes option pricing model involves assumptions that are
judgmental and affect compensation expense. Historical information was the
primary basis for the selection
of
expected volatility, expected option life and expected dividend yield. The
risk
free interest rate was based on yields of U.S. Treasury issues.
As
a
result of adopting Statement 123(R) on January 1, 2006, income tax expense
was
not impacted since the Company is in a net operating loss position and does
not
record income tax expense.
The
Company has elected the modified prospective application method and is expensing
all unvested stock options outstanding as of January 1, 2006. The compensation
expense is recognized over the requisite service period that still has not
been
rendered and is based upon the original grant date fair value of the award
as
calculated for recognition of the pro forma disclosure under SFAS No. 123.
For
the three and six months ended June 30, 2006 the compensation expense recorded
related to stock options and restricted shares was $79,154 and $310,094,
respectively, and has been included in reported net income for the three
and six
months ended June 30, 2006.
The
remaining total compensation cost related to non-vested stock options and
restricted share awards not yet recognized in the income statement as of
June
30, 2006 was $214,859, of which $102,180 was for stock options and $112,679
was
for restricted shares. The weighted average period over which this compensation
cost is expected to be recognized is approximately one year.
Per
the
requirements of SFAS No. 123(R) the balance of deferred stock compensation
in
shareholders’ equity arising from the issuance of restricted stock has been
reclassified as paid-in-capital as of June 30, 2006 and as of December 31,
2005.
Pro
forma
information under SFAS No. 123:
|
|
|
|
Six
months ended
June
30,
2006
|
|
|
Three
months ended
June
30,
2006
|
|
|
|
|
|
Unaudited
|
|
|
Unaudited
|
|
|
Net
loss as reported
|
|
$
|
(8,079,014
|
)
|
$
|
(5,622,514
|
)
|
|
Add
- stock-based compensation expense determined under APB 25
|
|
|
448,371
|
|
|
232,739
|
|
|
Deduct
- stock based compensation expense determined under fair value
method for
all awards
|
|
|
(851,391
|
)
|
|
(401,799
|
)
|
|
|
|
|
|
|
|
|
|
|
Pro
forma net loss
|
|
$
|
(8,482,034
|
)
|
$
|
(5,791,574
|
)
|
|
Loss
per share:
|
|
|
|
|
|
|
|
|
Basic
and diluted, as reported
|
|
$
|
(1.41
|
)
|
$
|
(0.97
|
)
|
|
Pro
forma basic and diluted
|
|
$
|
(1.48
|
)
|
$
|
(1.00
|
)
|
A
summary
of the status of the Company’s plans and other share options to employees and
restricted shares (except for options granted to consultants) granted as
of June
30, 2006, and changes during the six months then ended, is presented
below:
|
|
|
2006
|
|
|
|
|
Amount
|
|
|
Weighted
average
exercise
price
|
|
|
|
|
|
|
|
|
$
|
|
|
Options
outstanding at beginning of quarter
|
|
|
660,354
|
|
$
|
9.38
|
|
|
Changes
during quarter:
|
|
|
|
|
|
|
|
|
Granted
|
|
|
12,500
|
|
|
3.64
|
|
|
Exercised
|
|
|
--
|
|
|
--
|
|
|
Forfeited
|
|
|
(16,078
|
)
|
|
6.02
|
|
|
Options
outstanding at June 30, 2006
|
|
|
656,776
|
|
$
|
9.36
|
|
|
Options
exercisable at end of quarter
|
|
|
577,612
|
|
$
|
10.02
|
|
The
weighted-average remaining contractual term of the outstanding options at
June
30, 2006 was 4.54 years.
The
Company applies SFAS No. 123 and Emerging Issues Task Force No. 96-18,
“Accounting for Equity Instruments That Are Issued to Other Than Employees
for
Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”),
with respect to options and warrants issued to non-employees. SFAS No. 123
and
EITF 96-18 require the use of option valuation models to measure the fair
value
of the options and warrants at the measurement date.
d.
Reclassification:
Certain
comparative data in these financial statements have been reclassified to
conform
with the current year’s presentation.
The
Company’s shareholders approved a one-for-fourteen reverse stock split of the
Company’s common stock on June 19, 2006, which was effected on June 21, 2006. As
a result of the reverse stock split, every fourteen shares of Arotech common
stock were combined into one share of common stock; any fractional shares
created by the reverse stock split were eliminated. The reverse stock split
affected all of Arotech’s common stock, stock options, warrants and convertible
debt outstanding immediately prior to the effective date of the reverse stock
split. All shares of common stock, options, warrants, option and warrant
exercise prices, convertible debt conversion prices and per share data included
in these financial statements for all periods prior to June 21, 2006 presented
have been retroactively adjusted to reflect this one-for-fourteen reverse
split.
NOTE
2:
INVENTORIES
Inventories
are stated at the lower of cost or market value. Cost is determined using
the
average cost method. The Company periodically evaluates the quantities on
hand
relative to current and historical selling prices and historical and projected
sales volume. Based on these evaluations, provisions are made in each period
to
write down inventory to its net realizable value. Inventory write-offs are
provided to cover risks arising from slow-moving items, technological
obsolescence, excess inventories, and for market prices lower than cost.
In the
three and six months ended June 30, 2006, the Company wrote off and wrote
down
inventory in the amount of $202,073 and $272,650, respectively. Inventories
are
composed of the following:
|
|
|
|
June
30, 2006
|
|
|
December
31, 2005
|
|
|
|
|
(Unaudited)
|
|
|
|
|
Raw
and packaging materials
|
|
$
|
3,720,031
|
|
$
|
3,296,453
|
|
Work-in-progress
|
|
|
3,885,419
|
|
|
3,697,361
|
|
Finished
goods
|
|
|
1,118,651
|
|
|
821,992
|
|
|
|
$
|
8,724,101
|
|
$
|
7,815,806
|
NOTE
3:
IMPACT
OF RECENTLY ISSUED ACCOUNTING STANDARDS
In
February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
Financial Instruments” (“SFAS No. 155”), which amends SFAS No. 133, “Accounting
for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) and SFAS No.
140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities” (“SFAS No. 140”). SFAS No. 155 provides guidance
to simplify the accounting for certain hybrid instruments by permitting fair
value remeasurement for any hybrid financial instrument that contains an
embedded derivative, as well as clarifying that beneficial interests in
securitized financial assets are subject to SFAS 133. In addition, SFAS No.
155
eliminates a restriction on the passive derivative instruments that a qualifying
special-purpose entity may hold under SFAS No. 140. SFAS No. 155 is effective
for all financial instruments acquired, issued or subject to a new basis
occurring after the beginning of an entity’s first fiscal year that begins after
September 15, 2006. The Company believes that the adoption of this statement
will not have a material effect on its financial condition or results of
operations.
In
March
2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial
Assets” (“SFAS No. 156”), which amends SFAS No. 140. SFAS No. 156 provides
guidance addressing the recognition and measurement of separately recognized
servicing assets and liabilities, common with mortgage securitization
activities, and provides an approach to simplify efforts to obtain hedge
accounting treatment. SFAS No. 156 is effective for all separately recognized
servicing assets and liabilities acquired or issued after the beginning of
an
entity’s fiscal year that begins after September 15, 2006, with early adoption
being permitted. The Company believes that the adoption of this statement
will
not have a material effect on its financial condition or results of
operations.
In
June
2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes,” which clarifies the accounting for uncertainty in income taxes
recognized in the Company's financial statements in accordance with FAS 109,
“Accounting for Income Taxes.” The interpretation prescribes a recognition
threshold and measurement attribute for the financial statement recognition
and
measurement of a tax position taken or expected to be taken in a tax return.
The
Company is required to adopt the provisions of the Interpretation effective
January 1, 2007. The Company has not yet completed its assessment of the
affect
of adoption of the Interpretation on the Company’s financial
statements.
NOTE
4:
SEGMENT
INFORMATION
a.
General:
The
Company and its subsidiaries operate primarily in three business segments
and
follow the requirements of SFAS No. 131.
The
Company’s reportable operating segments have been determined in accordance with
the Company’s internal management structure, which is organized based on
operating activities. The accounting policies of the operating segments are
the
same as those used by the Company in the preparation of its annual financial
statement. The Company evaluates performance based upon two primary factors,
one
is the segment’s operating income and the other is the segment’s contribution to
the Company’s future strategic growth.
b.
The
following is information about reported segment revenues, income (losses)
and
assets for the six and three months ended June 30, 2006 and 2005:
|
|
|
|
Simulation
and Training
|
|
|
Battery
and
Power
Systems
|
|
|
Armor
|
|
|
All
Others
|
|
|
Total
|
|
|
Six
months ended
June
30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
from outside customers
|
|
$
|
9,444,801
|
|
$
|
4,140,654
|
|
$
|
2,725,292
|
|
$
|
--
|
|
$
|
16,310,747
|
|
|
Depreciation,
amortization and impairment expenses
(1)
|
|
|
(778,981
|
)
|
|
(466,438
|
)
|
|
(596,911
|
)
|
|
(127,593
|
)
|
|
(1,969,923
|
)
|
|
Direct
expenses
(2)
|
|
|
(8,383,310
|
)
|
|
(4,230,119
|
)
|
|
(4,123,123
|
)
|
|
(3,574,259
|
)
|
|
(20,310,811
|
)
|
|
Segment
income (loss)
|
|
$
|
282,510
|
|
$
|
(555,903
|
)
|
$
|
(1,994,742
|
)
|
$
|
(3,701,894
|
)
|
|
(5,969,987
|
)
|
|
Financial
expenses (after deduction of minority interest)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(6,458,796
|
)
|
|
Loss
from continuing operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
(12,428,783
|
)
|
|
Segment
assets
(3), (4)
|
|
$
|
32,885,330
|
|
$
|
12,432,232
|
|
$
|
7,031,686
|
|
$
|
644,050
|
|
$
|
52,993,298
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six
months ended
June
30, 2005
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
from outside customers
|
|
$
|
9,639,071
|
|
$
|
5,060,971
|
|
$
|
7,924,313
|
|
$
|
--
|
|
$
|
22,624,355
|
|
|
Depreciation
expenses and amortization
(1)
|
|
|
(806,350
|
)
|
|
(454,840
|
)
|
|
(3,378,631
|
)
|
|
(73,000
|
)
|
|
(4,712,821
|
)
|
|
Direct
expenses
(2)
|
|
|
(8,491,590
|
)
|
|
(5,062,577
|
)
|
|
(7,750,259
|
)
|
|
(3,178,029
|
)
|
|
(24,482,455
|
)
|
|
Segment
income (loss)
|
|
$
|
341,131
|
|
$
|
(456,446
|
)
|
$
|
(3,204,577
|
)
|
$
|
(3,251,029
|
)
|
|
(6,570,921
|
)
|
|
Financial
expenses (after deduction of minority interest)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1,308,093
|
)
|
|
Loss
from continuing operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
(7,879,014
|
)
|
|
Segment
assets
(3)
|
|
|
32,558,188
|
|
|
12,567,167
|
|
|
16,582,452
|
|
|
763,148
|
|
|
62,470,955
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
months ended
June
30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
from outside customers
|
|
$
|
4,508,236
|
|
$
|
2,098,712
|
|
$
|
807,387
|
|
$
|
--
|
|
$
|
7,414,335
|
|
|
Depreciation
, amortization and impairment expenses
(1)
|
|
|
(345,272
|
)
|
|
(234,241
|
)
|
|
(197,038
|
)
|
|
(67,767
|
)
|
|
(844,318
|
)
|
|
Direct
expenses
(2)
|
|
|
(4,187,962
|
)
|
|
(2,078,857
|
)
|
|
(1,766,918
|
)
|
|
(1,753,955
|
)
|
|
(9,787,692
|
)
|
|
Segment
income (loss)
|
|
$
|
(24,998
|
)
|
$
|
(214,386
|
)
|
$
|
(1,156,569
|
)
|
$
|
(1,821,722
|
)
|
|
(3,217,675
|
)
|
|
Financial
expenses (after deduction of minority interest)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(4,997,660
|
)
|
|
Loss
from continuing operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
(8,215,335
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
months ended
June
30, 2005
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenues
from outside customers
|
|
$
|
5,523,421
|
|
$
|
2,054,832
|
|
$
|
4,658,657
|
|
$
|
--
|
|
$
|
12,236,910
|
|
|
Depreciation
, amortization and impairment expenses
(1)
|
|
|
(403,690
|
)
|
|
(232,140
|
)
|
|
(2,887,083
|
)
|
|
(38,000
|
)
|
|
(3,560,913
|
)
|
|
Direct
expenses
(2)
|
|
|
(4,983,466
|
)
|
|
(2,305,587
|
)
|
|
(4,434,210
|
)
|
|
(1,536,132
|
)
|
|
(13,259,395
|
)
|
|
Segment
income (loss)
|
|
$
|
136,265
|
|
$
|
(482,895
|
)
|
$
|
(2,662,636
|
)
|
$
|
(1,574,132
|
)
|
|
(4,583,398
|
)
|
|
Financial
expenses (after deduction of minority interest)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(839,116
|
)
|
|
Loss
from continuing operations
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$
|
(5,422,514
|
)
|
|
|
_______________________________
(1)
Includes
depreciation of property and equipment, amortization expenses of intangible
assets and impairment of goodwill and other intangible assets.
(2)
Including,
inter
alia
,
sales
and marketing, general and administrative and tax expenses.
(3)
Consisting
of property and equipment, inventory and intangible assets.
(4)
Out
of
those amounts, goodwill in our Simulation and Training, Battery and Power
Systems and Armor divisions stood at $23,605,069, $5,151,084 and $1,018,725
as
of June 30, 2006, respectively, and $23,001,305, $5,000,178 and $9,501,699
as of
June 30, 2005, respectively.
NOTE
5:
CONVERTIBLE
DEBENTURES AND DETACHABLE WARRANTS
a.
8%
Secured Convertible Debentures due September 30, 2006 and issued in September
2003:
Pursuant
to the terms of a Securities Purchase Agreement dated September 30, 2003,
the
Company, in September 2003, issued and sold to a group of institutional
investors an aggregate principal amount of 8% secured convertible debentures
in
the amount of $5.0 million due September 30, 2006. These debentures are
convertible at any time prior to September 30, 2006 at a conversion price
of
$16.10 per share.
As
part
of the Securities Purchase Agreement dated September 30, 2003, the Company
issued to the purchasers of its 8% secured convertible debentures due September
30, 2006, warrants to purchase an aggregate of 89,286 shares of common stock
at
any time prior to September 30, 2006 at a price of $20.125 per
share.
As
of
June 30, 2006, principal amount of $150,000 remained outstanding under these
convertible debentures.
This
transaction was accounted according to APB No. 14 “Accounting for Convertible
Debt and Debt Issued with Stock Purchase Warrants” (“APB No. 14”) and Emerging
Issue Task Force No. 00-27 “Application of Issue No. 98-5 to Certain Convertible
Instruments” (“EITF 00-27”). The fair value of these warrants was determined
using the Black-Scholes pricing model, assuming a risk-free interest rate
of
1.95%, a volatility factor 98%, dividend yields of 0% and a contractual life
of
three years.
In
connection with these convertible debentures, the Company will recognize
financial expenses of $2,963,043 with respect to the beneficial conversion
feature, which is being amortized from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.
During
the six months ended June 30, 2006, the Company recorded an expense of $14,680,
which was attributable to amortization of debt discount and beneficial
conversion feature related to the convertible debenture over its term. These
expenses were included in the financial expenses. See also Note
6.b.
b.
8%
Secured Convertible Debentures due September 30, 2006 and issued in December
2003:
Pursuant
to the terms of a Securities Purchase Agreement dated September 30, 2003,
the
Company, in December 2003, issued and sold to a group of institutional investors
an aggregate principal amount of 8% secured convertible debentures in the
amount
of $6.0 million due September 30, 2006. These debentures are convertible
at any
time prior to September 30, 2006 at a conversion price of $20.30 per
share.
As
of
June 30, 2006, principal amount of $4,387,500 remained outstanding under
these
convertible debentures.
As
a
further part of the Securities Purchase Agreement dated December 31, 2003,
the
Company issued to the purchasers of its 8% secured convertible debentures
due
September 30, 2006, warrants to purchase an aggregate of 107,143 shares of
common stock at any time prior to December 31, 2006 at a price of $25.375
per
share. Additionally, the Company issued to the investors supplemental warrants
to purchase an aggregate of 74,143 shares of common stock at any time prior
to
June 18, 2009 at a price of $30.80 per share. See also Note 6.c.
This
transaction was accounted according to APB No. 14 and EITF 00-27. The fair
value
of the warrants granted in respect of convertible debentures was determined
using the Black-Scholes pricing model, assuming a risk-free interest rate
of
2.45%, a volatility factor 98%, dividend yields of 0% and a contractual life
of
three years.
In
connection with these convertible debentures, the Company will recognize
financial expenses of $6,000,000 with respect to the beneficial conversion
feature, which is being amortized from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.
During
the six months ended June 30, 2006, the Company recorded an expense of $774,768,
which was attributable to amortization of the beneficial conversion feature
of
the convertible debenture over its term. These expenses were included in
the
financial expenses.
c.
Senior
Secured Convertible Notes due March 31, 2008:
Pursuant
to the terms of a Securities Purchase Agreement dated September 29, 2005
(the
“Purchase Agreement”) by and between the Company and certain institutional
investors, the Company issued and sold to the investors an aggregate of $17.5
million principal amount of senior secured notes (“Notes”) having a final
maturity date of March 31, 2008.
Under
the
terms of the Purchase Agreement, the Company granted the investors (i) a
second
position security interest in the stock of MDT Armor Corporation, IES
Interactive Training, Inc. and M.D.T. Protective Industries, Ltd. (junior
to the
security interest of the holders of the Company’s 8% secured convertible
debentures due September 30, 2006) and in the assets of FAAC Incorporated
(junior to a bank that extends to FAAC Incorporated a $5 million line of
credit)
and in any stock that the Company acquires in future acquisitions, and (ii)
a
first position security interest in the assets of all of the Company’s other
active United States subsidiaries. The Company’s active United States
subsidiaries are also acting as guarantors of the Company’s obligations under
the Notes.
On
April
7
,
2006,
the Company and each investor entered into conversion agreements
dated
April
7,
2006 (collectively, the “Conversion Agreements”) pursuant to which an aggregate
of $6,148,904 principal amount of the Notes
was
converted into 1,098,019 shares of the Company’s common stock. The amount
converted eliminated the Company’s obligation to make the installment payments
under the Notes on each of March 31, 2008, January 31, 2008, November 30,
2007
and September 30, 2007 (aggregating a total of $5,833,333). In addition,
as a
result of the conversion an additional $315,570 was applied against part
of the
installment payment due July 31, 2007. After giving effect to the conversion,
$8,434,430 of principal remained outstanding
under
the
Notes. Each Investor also agreed, among other things, to defer the installment
payment due on May 31, 2006 to July 31, 2006 or, in certain circumstances,
August 31, 2006.
As
of
June 30, 2006, principal amount of $8.4 million remained outstanding under
these
convertible notes.
The
Notes
are convertible at the investors’ option at a fixed conversion price of $14.00.
The Notes bear interest at a rate equal to six month LIBOR plus 6% per annum,
subject to a floor of 10% and a cap of 12.5%. The Company will repay the
principal amount of the Notes over a period of two and one-half years, with
the
principal amount being amortized in twelve payments payable at the Company’s
option in cash and/or stock, provided certain conditions are met. In the
event
the Company elects to make such payments in stock, the price used to determine
the number of shares to be issued will be calculated using an 8% discount
to the
average trading price of our common stock during 17 of the 20 consecutive
trading days ending two days before the payment date.
As
a
further part of the Securities Purchase Agreement dated September 29, 2005,
the
Company issued warrants, which are not exercisable for the six month period
following closing, to purchase up to 375,000 shares of common stock (30%
warrant
coverage) at an exercise price of $15.40 per share. These warrants are
exercisable until the one-year anniversary of the effective date of the
registration statement registering the shares of common stock underlying
the
warrants.
This
transaction was accounted according to APB No. 14 and EITF 00-27. The fair
value
of the warrants granted in respect of convertible debentures was determined
using the Black-Scholes pricing model, assuming a risk-free interest rate
of
3.87%, a volatility factor 53%, dividend yields of 0% and a contractual life
of
one year.
In
connection with these convertible notes, the Company will recognize financial
expenses of $422,034 with respect to assigning fair value to the warrants
issued
to the holders of the convertible debenture, which is being amortized from
the
date of issuance to the stated redemption date - March 31, 2008 - as financial
expenses.
The
Company has also considered EITF No. 05-2, “The Meaning of ‘Conventional
Convertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock.’” Accordingly, the Company has concluded that these convertible notes
would be considered as conventional convertible debt and therefore EITF 00-19
does not apply to them.
During
the six months ended June 30, 2006, the Company recorded an expense of $250,594,
which was attributable to amortization of the beneficial conversion feature
of
the convertible notes over their term. These expenses were included in the
financial expenses.
NOTE
6:
WARRANTS
|
a.
|
Warrants
issued in June 2003:
|
In
June
2003, warrants to purchase a total of 29,437 shares of common stock, having
an
aggregate exercise price of $337,940, were exercised. These warrants had
originally been issued in May 2001 at an exercise price of $45.08 per share,
but
were repriced immediately prior to exer-
cise
to
$11.48 per share. In connection with this repricing, the holder of these
29,437
warrants received an aggregate of 19,625 new five-year warrants to purchase
shares at an exercise price of $20.30 per share and exercisable after January
1,
2004. In March 2006, these new warrants were repriced to an exercise price
of
$5.60 per share and exercised. In connection with this repricing, the holder
of
these warrants received new warrants to purchase 7,850 shares at an exercise
price of $8.316. As a result of this repricing of the existing warrants and
the
issuance of these new warrants, the Company recorded a deemed dividend in
the
amount of $28,369 in the six months ended June 30, 2006.
|
b.
|
Warrants
issued in September 2003:
|
In
connection with the transactions described in Note 5.a., the Company, in
September 2003, issued warrants to purchase an aggregate of 89,286 shares
of
common stock at any time prior to September 30, 2006 at a price of $20.125
per
share. In March 2006, 8,929 of these warrants were repriced to an exercise
price
of $5.60 per share and exercised. In connection with this repricing, the
holder
of these warrants received a new warrant to purchase 3,571 shares at an exercise
price of $8.316. As a result of this repricing of the existing warrants and
the
issuance of these new warrants, the Company recorded a deemed dividend in
the
amount of $24,531 in the six months ended June 30, 2006.
|
c.
|
Warrants
issued in December 2003:
|
In
connection with the transactions described in Note 5.b., the Company, in
December 2003, issued supplemental warrants to purchase an aggregate of 74,143
shares of common stock at any time prior to June 18, 2009 at a price of $30.80
per share. In February and March 2006, an aggregate of 55,607 of these warrants
were repriced to an exercise price of $5.60 per share and exercised. In
connection with this repricing, the holders of these warrants received new
warrants to purchase an aggregate of 22,244 shares at an exercise price of
$8.316. In April 2006, 11,121 of these warrants were repriced to an exercise
price of $5.60 per share and exercised. In connection with this repricing,
the
holder of these warrants received a new warrant to purchase 4,449 shares
at an
exercise price of $8.316. As a result of these repricings of the existing
warrants and the issuance of these new warrants, the Company recorded a deemed
dividend in the amount of $39,221 in the six months ended June 30,
2006.
|
d.
|
Warrants
issued in September 2003:
|
Pursuant
to the terms of a Securities Purchase Agreement dated January 7, 2004 by
and
between the Company and several institutional investors, the Company issued
and
sold (i) an aggregate of 702,888 shares of the Company’s common stock at a
purchase price of $26.32 per share, and (ii) three-year warrants to purchase
up
to an aggregate of 702,888 shares of the Company’s common stock at any time
beginning six months after closing at an exercise price per share of $26.32.
In
March 2006, 56,991 of these warrants were repriced to an exercise price of
$5.60
per share and exercised. In connection with this repricing, the holder of
these
warrants received a new warrant to purchase an aggregate of 22,796 shares
at an
exercise price of $8.316. In April 2006, an additional 75,988 of these warrants
were repriced to an exercise price of $5.60 per share and exercised. In
connection with this repricing, the holder of these warrants received a new
warrant to purchase 30,395 shares at an exercise price of $8.316. As a result
of
these repricings of the existing warrants and the issuance of these new
warrants, the Company recorded a deemed dividend in the amount of $270,336
in
the six months ended June 30, 2006.
e.
Warrants
issued in July 2004:
On
July
14, 2004, warrants to purchase 629,588 shares of common stock were exercised.
In
connection with this transaction, the Company issued to the holders of those
exercising warrants an aggregate of 622,662 new five-year warrants to purchase
shares of common stock at an exercise price of $19.32 per share. In February
and
March 2006, an aggregate of 501,216 of these warrants were repriced to an
exercise price of $5.60 per share and exercised. In connection with this
repricing, the holders of these warrants received new warrants to purchase
an
aggregate of 200,487 shares at an exercise price of $8.316. In April 2006,
an
additional 16,071 of these warrants were repriced to an exercise price of
$5.60
per share and exercised. In connection with this repricing, the holder of
these
warrants received a new warrant to purchase 6,429 shares at an exercise price
of
$8.316. As a result of these repricings of the existing warrants and the
issuance of these new warrants, the Company recorded a deemed dividend in
the
amount of $71,728 in the six months ended June 30, 2006.
f.
As
to
EITF 00-19, since the terms of the new warrants referred to above provided
that
the
warrants were exercisable subject to the Company obtaining shareholder
approval
,
in
accordance with Emerging Issues Task Force No 00-19 “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock,” their fair value was recorded as a liability at the closing date. Such
fair value was remeasured at each subsequent cut-off date until obtaining
shareholder approval. The fair value of these warrants was remeasured as
at June
19, 2006 (the date of the shareholder approval), using the Black-Scholes
pricing
model assuming a risk free interest rate of 5.00%, a volatility factor of
72%,
dividend yields of 0% and a contractual life of approximately 1.78 years.
The
change in the fair value of the warrants between the date of the grant and
June
19, 2006 in the amount of $739,520 has been recorded as finance
income.
NOTE
7:
IMPAIRMENT
OF GOODWILL
Goodwill
is tested for impairment at least annually, and between annual tests in certain
circumstances, and written down when impaired, rather than being amortized
as
previous accounting standards required. Goodwill is tested for impairment
by
comparing the fair value of the Company’s reportable units with their carrying
value. Fair value is determined using discounted cash flows. Significant
estimates used in the methodologies include estimates of future cash flows,
future short-term and long-term growth rates, weighted average cost of capital
and estimates of market multiples for the reportable units.
During
2005, the Company performed impairment test of goodwill, based on management’s
projections and using expected future discounted operating cash flows and
as
response to several factors. As of December 31, 2005, as a result of this
impairment test, the Company identified in AoA an impairment of goodwill
in the
amount of $11,757,812.
In
connection with the Company’s acquisition of AoA, the Company accrued during the
six months ended June 30, 2006 an amount of $204,059 for an earnout obligation,
which was charged as an impairment of goodwill (see Note 8).
NOTE
8:
CONTINGENT
LIABILITIES
In
connection with the Company’s acquisition of FAAC, the Company has a contingent
earnout obligation in an amount equal to the net income realized by the Company
from certain specific programs that were identified by the Company and the
former shareholders of FAAC as appropriate targets for revenue increases
in
2005. Through June 30, 2006, the Company had accrued an amount of $603,764
in
respect of such earnout obligation against FAAC’s goodwill. Although the former
shareholders of FAAC have initiated an arbitration action against the Company
based on their belief that the specific programs identified include more
orders
than those with respect to which the Company has made accrual in respect
of this
earnout obligation, the Company believes there is no basis for this
claim.
In
connection with the Company’s acquisition of AoA, the Company has a contingent
earnout obligation in an amount equal to the revenues realized by the Company
from certain specific programs that were identified by the Company and the
former shareholder of AoA as appropriate targets for revenue increases. The
earnout provides that if AoA receives certain types of orders from certain
specific customers prior to December 31, 2006 (“Additional Orders”), then upon
shipment of goods in connection with such Additional Orders, the former
shareholder of AoA will be paid an earnout based on revenues, up to a maximum
of
an additional $6.0 million. Through June 30, 2006 the Company had accrued
an
amount of $1.4 million in respect of such earnout obligation (see Note
7).
This
report contains forward-looking statements made pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. These
statements involve inherent risks and uncertainties. When used in this
discussion, the words “believes,” “anticipated,” “expects,” “estimates” and
similar expressions are intended to identify such forward-looking statements.
Such statements are subject to certain risks and uncertainties. Readers are
cautioned not to place undue reliance on these forward-looking statements,
which
speak only as of the date hereof. We undertake no obligation to publicly
release
the result of any revisions to these forward-looking statements that may
be made
to reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events. Our actual results could differ materially
from those anticipated in these forward-looking statements as a result of
certain factors including, but not limited to, those set forth elsewhere
in this
report. Please see “Risk Factors,” below, and in our other filings with the
Securities and Exchange Commission.
Arotech™
is a trademark and Electric Fuel
®
is a
registered trademark of Arotech Corporation. All company and product names
mentioned may be trademarks or registered trademarks of their respective
holders. Unless the context requires otherwise, all references to us refer
collectively to Arotech Corporation and its subsidiaries.
We
make available through our internet website free of charge our annual report
on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K,
amendments to such reports and other filings made by us with the SEC, as
soon as
practicable after we electronically file such reports and filings with the
SEC.
Our website address is www.arotech.com. The information contained in this
website is not incorporated by reference in this report.
The
following discussion and analysis should be read in conjunction with the
interim
financial statements and notes thereto appearing elsewhere in this Quarterly
Report. We have rounded amounts reported here to the nearest thousand, unless
such amounts are more than 1.0 million, in which event we have rounded such
amounts to the nearest hundred thousand.
Executive
Summary
Divisions
and Subsidiaries
We
operate primarily as a holding company, through our various subsidiaries,
which
we have organized into three divisions. Our divisions and subsidiaries (all
100%
owned, unless otherwise noted) are as follows:
|
|
Ø
|
Our
Simulation
and Training Division
,
consisting of:
|
|
|
·
|
FAAC
Incorporated, located in Ann Arbor, Michigan, which provides
simulators,
systems engineering and software products to the United States
military,
government and private industry (“FAAC”);
and
|
|
|
·
|
IES
Interactive Training, Inc., located in Ann Arbor, Michigan,
which provides
specialized “use of force” training for police, security personnel and the
military (“IES”).
|
|
|
Ø
|
Our
Armor
Division
,
consisting of:
|
|
|
·
|
Armour
of America, located in Auburn, Alabama, which manufactures ballistic
and
fragmentation armor kits for rotary and fixed wing aircraft,
marine armor,
personnel armor, military vehicles and architectural applications,
including both the LEGUARD Tactical Leg Armor and the Armourfloat
Ballistic Floatation Device, which is a unique vest that is certified
by
the U.S. Coast Guard (“AoA”)
;
|
|
|
·
|
MDT
Protective Industries, Ltd., located in Lod, Israel, which
specializes
in using state-of-the-art lightweight ceramic materials, special
ballistic
glass and advanced engineering processes to fully armor vans and
SUVs, and
is a leading supplier to the Israeli military, Israeli special
forces and
special services (“MDT”) (75.5% owned)
;
and
|
|
|
·
|
MDT
Armor Corporation, located in Auburn, Alabama, which conducts
MDT’s United
States activities (“MDT Armor”)
(88% owned)
.
|
|
|
Ø
|
Our
Battery
and Power Systems Division
,
consisting of:
|
|
|
·
|
Epsilor
Electronic Industries, Ltd., located in Dimona, Israel (in Israel’s Negev
desert area), which develops and sells rechargeable and primary
lithium
batteries and smart chargers to the military and to private industry
in
the Middle East, Europe and Asia (“Epsilor”);
|
|
|
·
|
Electric
Fuel Battery Corporation, located in Auburn, Alabama, which manufactures
and sells Zinc-Air fuel sells, batteries and chargers for the military,
focusing on applications that demand high energy and light weight
(“EFB”);
and
|
|
|
·
|
Electric
Fuel (E.F.L.) Ltd., located in Beit Shemesh, Israel, which produces
water-activated battery (“WAB”) lifejacket lights for commercial aviation
and marine applications, and which conducts our Electric Vehicle
effort,
focusing on obtaining and implementing demonstration projects
in the U.S.
and Europe, and on building broad industry partnerships that
can lead to
eventual commercialization of our Zinc-Air energy system for
electric
vehicles (“EFL”).
|
Overview
of Results of Operations
We
incurred significant operating losses for the years ended December 31, 2004
and
2005 and for the first six months of 2006. While we expect to continue to
derive
revenues from the
sale
of
products that our subsidiaries manufacture and the services that they provide,
there can be no assurance that we will be able to achieve or maintain
profitability on a consistent basis.
During
2003 and 2004, we substantially increased our revenues and reduced our net
loss,
from $18.5 million in 2002 to $9.2 million in 2003 to $9.0 million in 2004.
This
was achieved through a combination of cost-cutting measures and increased
revenues, particularly from the sale of Zinc-Air batteries to the military
and
from sales of products manufactured by the subsidiaries we acquired in 2002
and
2004. However, in 2005 our net loss increased to $23.9 million on revenues
of
$49.0 million, and in the first six months of 2006 we had a net loss of $12.4
million on revenues of $16.3 million.
A
portion
of our operating loss during the first six months of 2006 arose as a result
of
non-cash charges. In addition to the charges in respect of the write-off
of
goodwill described in Note 7 of the financial statements, these charges were
primarily related to our acquisitions and financings. Because we anticipate
continuing certain of these activities during the remainder of 2006, we expect
to continue to incur such non-cash charges in the future.
Acquisitions
In
acquisitions of subsidiaries, part of the purchase price is allocated to
intangible assets and goodwill. Amortization of intangible assets related
to
acquisition of subsidiaries is recorded based on the estimated expected life
of
the assets. Accordingly, for a period of time following an acquisition, we
incur
a non-cash charge related to amortization of intangible assets in the amount
of
a fraction (based on the useful life of the intangible assets) of the amount
recorded as intangible assets. Such amortization charges will continue during
2006. We are required to review intangible assets for impairment whenever
events
or changes in circumstances indicate that carrying amount of the assets may
not
be recoverable. If we determine, through the impairment review process, that
intangible asset has been impaired, we must record the impairment charge
in our
statement of operations.
In
the
case of goodwill, the assets recorded as goodwill are not amortized; instead,
we
are required to perform an annual impairment review. If we determine, through
the impairment review process, that goodwill has been impaired, we must record
the impairment charge in our statement of operations.
As
a
result of the application of the above accounting rules, we incurred non-cash
charges for amortization of intangible assets in the amount of $971,000 during
the first six months of 2006. In addition, we incurred non-cash charges for
impairment of goodwill in the amount of $204,000 during the first six months
of
2006 in respect of our subsidiary AoA.
Financings
The
non-cash charges that relate to our financings occurred in connection with
our
issuance of convertible debentures with warrants, and in connection with
our
repricing of certain warrants and grants of new warrants. When we issue
convertible debentures, we record a discount for a beneficial conversion
feature
that is amortized ratably over the life of the debenture. When a debenture
is
converted, however, the entire remaining unamortized beneficial
conversion
feature
expense is immediately recognized in the quarter in which the debenture is
converted. Similarly, when we issue warrants in connection with convertible
debentures, we record debt discount for financial expenses that is amortized
ratably over the term of the convertible debentures; when the convertible
debentures are converted, the entire remaining unamortized debt discount
is
immediately recognized in the quarter in which the convertible debentures
are
converted. As and to the extent that our remaining convertible debentures
are
converted, we would incur similar non-cash charges going forward.
As
a
result of the application of the above accounting rule, we incurred non-cash
charges related to amortization of debt discount attributable to beneficial
conversion feature in the amount of $1.0 million during the first six months
of
2006.
Issuances
of Restricted Shares, Options and Warrants
During
2004 and 2005, we issued restricted
shares to certain of our employees. These shares were issued as stock bonuses,
and are restricted for a period of two years from the date of issuance. Relevant
accounting rules provide that the aggregate amount of the difference between
the
purchase price of the restricted shares (in this case, generally zero) and
the
market price of the shares on the date of grant is taken as a general and
administrative expense, amortized over the life of the period of the
restriction.
As
a
result of the application of the above accounting rules, we incurred non-cash
charges related to stock-based compensation in the amount of $225,000 during
the
first six months of 2006.
As
a
result of stock options granted to employees and directors and the adoption
of
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
Payments,” we incurred non-cash charges related to stock-based compensation in
the amount of $85,000 during the first six months of 2006.
As
part
of the repricings and exercises of warrants described in Note 6 to the financial
statements, we issued warrants to purchase up to 298,221 shares of common
stock.
Since the terms of these warrants provided that
the
warrants were exercisable subject to the Company obtaining shareholder
approval
,
in
accordance with Emerging Issues Task Force No 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock,” the fair value of the warrants was recorded as a liability at the
closing date. Such fair value was remeasured at each subsequent cut-off date
until we obtained shareholders approval. The fair value of these warrants
was
remeasured as at June 19, 2006 (the date of the shareholders approval) using
the
Black-Scholes pricing model assuming a risk free interest rate of 5.00%,
a
volatility factor of 72%, dividend yields of 0% and a contractual life of
approximately 1.78 years. The change in the fair value of the warrants between
the date of the grant and June 19, 2006 in the amount of $739,000 has been
recorded as finance income.
Under
the
terms of our convertible notes, we have the option in respect of scheduled
principal repayments to force conversion of the payment amount at a conversion
price based upon the weighted average trading price of our common stock during
the 20 trading days prior to the conversion, less a discount of 8%. Because
of
this discount and the use in a conversion price that is based on the weighted
average trading price of our common stock during the 20 trading
days
prior
to
the conversion, we incurred a financial expense during the first six months
of
2006 of $507,000, which represents the shares issued multiplied by the
difference between the share price that was used for the conversion and the
share price at the day of the conversion.
On
April
7
,
2006, we
and each holder of our convertible notes agreed that we would force immediate
conversion of an aggregate of $6,148,904 principal amount of the convertible
notes into 1,098,019 shares of our common stock. The amount converted eliminated
our obligation to make the installment payments under the convertible notes
on
each of March 31, 2008, January 31, 2008, November 30, 2007 and September
30,
2007 (aggregating a total of $5,833,333). In addition, as a result of the
conversion an additional $315,570 was applied against part of the installment
payment due July 31, 2007. After giving effect to the conversion, $8,434,430
of
principal remained outstanding under the convertible notes. As a result of
this
transaction, we incurred a financial expense during the first six months
of 2006
of $4.9 million.
Additionally,
in an effort to improve our cash situation and our shareholders’ equity, we have
periodically induced holders of certain of our warrants to exercise their
warrants by lowering the exercise price of the warrants in exchange for
immediate exercise of such warrants, and by issuing to such investors new
warrants. Under such circumstances, we record a deemed dividend in an amount
determined based upon the fair value of the new warrants (using the
Black-Scholes pricing model). As and to the extent that we engage in similar
warrant repricings and issuances in the future, we would incur similar non-cash
charges.
As
a
result of the application of the above accounting rule we recorded a deemed
dividend related to repricing of warrants and the grant of new warrants in
the
amount of $434,000 during the first six months of 2006.
Overview
of Operating Performance and Backlog
In
our
Simulation and Training Division, revenues decreased from approximately $9.6
million in the first six months of 2005 to $9.4 million in the first six
months
of 2006. As of June 30, 2006, our backlog for our Simulation and Training
Division totaled $10.2 million.
In
our
Battery and Power Systems Division, revenues decreased from approximately
$5.1
million in the first six months of 2005 to approximately $4.1 million in
the
first six months of 2006. As of June 30, 2006, our backlog for our Battery
and
Power Systems Division totaled $5.8 million.
In
our
Armor Division, revenues decreased from $7.9 million during the first six
months
of 2005 to $2.7 million during the first six months of 2006. As of June 30,
2006, our backlog for our Armor Division totaled $25.3 million.
Functional
Currency
We
consider the United States dollar to be the currency of the primary economic
environment in which we and our Israeli subsidiary EFL operate and, therefore,
both we and EFL have adopted and are using the United States dollar as our
functional currency. Transactions and
balances
originally denominated in U.S. dollars are presented at the original amounts.
Gains and losses arising from non-dollar transactions and balances are included
in net income.
The
majority of financial transactions of our Israeli subsidiaries MDT and Epsilor,
are in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and
Epsilor’s costs is incurred in NIS. Management believes that the NIS is the
functional currency of MDT and Epsilor. Accordingly, the financial statements
of
MDT and Epsilor have been translated into U.S. dollars. All balance sheet
accounts have been translated using the exchange rates in effect at the balance
sheet date. Statement of operations amounts have been translated using the
average exchange rate for the period. The resulting translation adjustments
are
reported as a component of accumulated other comprehensive loss in shareholders’
equity.
Results
of Operations
Three
months ended June 30, 2006 compared to the three months ended June 30,
2005.
Revenues
.
During
the three months ended June 30, 2006, we (through our subsidiaries) recognized
revenues as follows:
Ø
IES
and
FAAC recognized revenues from the sale of interactive use-of-force training
systems and from the provision of maintenance services in connection with
such
systems.
Ø
MDT,
MDT
Armor and AoA recognized revenues from payments under vehicle armoring
contracts, for service and repair of armored vehicles, and on sale of armoring
products.
Ø
EFB
and
Epsilor recognized revenues from the sale of batteries, chargers and adapters
to
the military, and under certain development contracts with the U.S.
Army.
Ø
EFL
recognized revenues from the sale of water-activated battery (WAB) lifejacket
lights.
Revenues
for the three months ended June 30, 2006 totaled $7.4 million, compared to
$12.2
million in the comparable period in 2005, a decrease of $4.8 million, or
39.4%.
This decrease was primarily attributable to the following factors:
Ø
Decreased
revenues from our Armor Division ($3.9 million less in the three months ended
June 30, 2006 versus the three months ended June 30, 2005).
Ø
Decreased
revenues from our Simulation and Training Division, particularly FAAC ($1.0
million less in the three months ended June 30, 2006 versus the three months
ended June 30, 2005).
In
the
second quarter of 2006, revenues were $4.5 million for the Simulation and
Training Division (compared to $5.5 million in the second quarter of
2005,
a
decrease of $1.0 million, or 18.4%,
due
primarily to decreased sales of FAAC); $2.1 million for the Battery and Power
Systems Division (compared to $2.1 million in the second quarter of
2005,
an
increase of $44,000,
or
2.1%,
due primarily to increased sales of Epsilor, offset to some extent by decreased
CECOM revenues from our EFB subsidiary); and $807,000 for the Armor Division
(compared to $4.7 million in the second quarter of 2005,
a
decrease of $3.9 million, or 82.7%,
due
primarily to decreased revenues from MDT and AoA).
Cost
of revenues and gross profit.
Cost
of
revenues totaled $6.1 million during the second quarter of 2006, compared
to
$8.6 million in the second quarter of 2005,
a
decrease of $2.5 million, or 29.3%,
due
primarily to decreased sales in our Simulation and Training Division and
Armor
Division and the decrease in margins due to change in the mix of products
and
customers in 2006 in comparison to 2005. In addition, we incurred substantial
expenses in respect of production of a new product in our Armor
Division.
Direct
expenses for our three divisions during the second quarter of 2006 were $4.2
million for the Simulation and Training Division (compared to $5.0 million
in
the second quarter of 2005,
a
decrease of $796,000, or 16.0%,
due
primarily to decreased sales of FAAC); $2.1 million for the Battery and Power
Systems Division (compared to $2.3 million in the second quarter of
2005,
a
decrease of $227,000, or 9.8%, due primarily to the decreased CECOM revenues
from our EFB subsidiary); and $1.8 million for the Armor Division (compared
to
$4.4 million in the second quarter of 2005,
a
decrease of $2.7 million, or 60.2%,
due
primarily to decreased revenues from MDT and AoA).
Gross
profit was $1.3 million during the second quarter of 2006, compared to $3.6
million during the second quarter of 2005, a decrease of $2.3 million, or
63.5%.
This decrease was the direct result of all factors presented above, most
notably
the decrease in our Armor Division and Simulation and Training Division revenues
and the decrease in margins due to change in the mix of products and customers
in 2006 in comparison to 2005. In addition, we updated the accrual for loss
for
one of the projects in our Simulation and Training Division.
Research
and development expenses
.
Research
and development expenses for the second quarter of 2006 were $216,000, compared
to $484,000 during the second quarter of 2005, a decrease of $268,000, or
55.4%.
This decrease was primarily attributable to the consolidation of IES’s and
FAAC’s research and development operations
,
the
decrease in research and development capitalization in FAAC and allocation
of
research and development costs in EFB to cost of good sold due to revenues
from
research and development projects
.
Selling
and marketing expenses
.
Selling
and marketing expenses for the second quarter of 2006 were $849,000, compared
to
$1.1 million the second quarter of 2005, a decrease of $215,000, or 20.2%.
This
decrease was primarily attributable to the overall decrease in revenues and
their associated sales and marketing expenses.
General
and administrative expenses
.
General
and administrative expenses for the second quarter of 2006 were $3.1 million
compared to $3.4 million in the second quarter of 2005, a decrease of $226,000,
or 6.7%. This decrease was primarily attributable to the following
factors:
Ø
Decreases
in certain general and administrative expenses in comparison to 2005, such
as
auditing, legal expenses and travel expenses, as a result of cost-cutting
programs implemented by management.
Ø
Decrease
in general and administrative expenses related to our Simulation and Training
Division (payroll, legal and other expenses).
Financial
expenses, net
.
Financial expenses totaled
approximately $5.0 million in the second quarter of 2006 compared to $838,000
in
the second quarter of 2005, an increase of $4.2 million, or 496.7%. The
difference was due primarily to interest related to our convertible notes
that
were issued in September 30, 2005, and financial expenses related to repayment
by forced conversion of our convertible notes at an 8% discount to average
market price as provided under the terms of the convertible notes
,
particularly the April 2006 transaction described in “Overview of Results of
Operations – Financings,” above
.
Income
taxes.
We
and
certain of our subsidiaries incurred net operating losses during the three
months ended June 30, 2006 and accordingly, no provision for income taxes
was
recorded. With respect to some of our subsidiaries that operated at a net
profit
during 2006, we were able to offset federal taxes against our accumulated
loss
carry forward. We recorded a total of $14,000 in tax expenses in the second
quarter of 2006, compared to $50,000 in tax expenses in the second quarter
of
2005, mainly concerning state taxes.
Amortization
of intangible assets
.
Amortization of intangible assets totaled $460,000 in the second quarter
of
2006, compared to $823,000 in the second quarter of 2005, a decrease of
$363,000, or 44.1%, due primarily to a decrease in amortization of intangible
assets related to our subsidiary AoA.
Impairment
of goodwill and other intangible assets
.
Current
accounting standards require us to test goodwill for impairment at least
annually, and between annual tests in certain circumstances; when we determine
goodwill is impaired, it must be written down, rather than being amortized
as
previous accounting standards required. Goodwill is tested for impairment
by
comparing the fair value of our reportable units with their carrying value.
Fair
value is determined using discounted cash flows. Significant estimates used
in
the methodologies include estimates of future cash flows, future short-term
and
long-term growth rates, weighted average cost of capital and estimates of
market
multiples for the reportable units. We performed the required annual impairment
test of goodwill, based on our management’s projections and using expected
future discounted operating cash flows. We did not identify any impairment
of
goodwill during the second quarter of 2006. In the corresponding period of
2005,
we identified in AoA an impairment of goodwill in the amount of
$2,043,129.
Our
and
our subsidiaries’ long-lived assets and certain identifiable intangibles are
reviewed for impairment in accordance with current accounting standards whenever
events or changes in circumstances indicate that the carrying amount of an
asset
may not be recoverable. Recoverability of the carrying amount of assets to
be
held and used is measured by a comparison of the carrying amount of the assets
to the future undiscounted cash flows expected to be generated by the assets.
If
such assets are considered to be impaired, the impairment to be recognized
is
measured by the amount by which the carrying amount of the assets exceeds
the
fair value of the assets. We did not identify any impairment of backlog during
the second quarter of 2006. In the corresponding period of 2005, we identified
an impairment of backlog previously identified with the AoA acquisition and
as a
result we recorded an impairment loss in the amount of $346,000
.
Net
loss.
Due
to
the factors cited above
,
net
loss attributable to common shareholders increased from $5.6 million to $8.2
million, an increase of $2.6 million, or 46.1%.
Net
loss attributable to common shareholders.
Due to
deemed dividend that was recorded in the amount of $117,000 in the second
quarter of 2006 due to the repricing of existing warrants and the issuance
of
new warrants (see Note 6 to the financial statements), net loss attributable
to
common shareholders was $8.3 million in the second quarter of 2006, compared
to
$5.6 million in the second quarter of 2005, an increase of $2.7 million,
or
48.2%.
Six
months
ended June 30, 2006 compared to the six months ended June 30,
2005.
Revenues
.
During
the six months ended June 30, 2006, we (through our subsidiaries) recognized
revenues as follows:
Ø
IES
and
FAAC recognized revenues from the sale of interactive use-of-force training
systems and from the provision of maintenance services in connection with
such
systems.
Ø
MDT,
MDT
Armor and AoA recognized revenues from payments under vehicle armoring
contracts, for service and repair of armored vehicles, and on sale of armoring
products.
Ø
EFB
and
Epsilor recognized revenues from the sale of batteries, chargers and adapters
to
the military, and under certain development contracts with the U.S.
Army.
Ø
EFL
recognized revenues from the sale of water-activated battery (WAB) lifejacket
lights.
Revenues
for the six months ended June 30, 2006 totaled $16.3 million, compared to
$22.6
million in the comparable period in 2005, a decrease of $6.3 million, or
27.9%.
This decrease was primarily attributable to the following factors:
Ø
Decreased
revenues from our Armor Division ($5.2 million less in the first six months
of
2006 versus the first six months of 2005).
Ø
Decreased
revenues from our Battery and Power Systems Division, particularly Epsilor
($920,000 less in the first six months of 2006 versus the first six months
of
2005).
In
the
six months ended June 30, 2006, revenues were $9.4 million for the Simulation
and Training Division (compared to $9.6 million in the six months ended June
30,
2005,
a
decrease of $194,000, or 2.0%,
due
primarily to decreased sales of IES, offset to some extent by increased revenues
from FAAC); $4.1 million for the Battery and Power Systems Division (compared
to
$5.1 million in the six months ended June 30, 2005,
a
decrease of $920,000, or 18.2%, due primarily to decreased sales of Epsilor
and
CECOM from our EFB subsidiary, offset to some extent by increased WAB revenues
from our EFL subsidiary); and $2.7 million for the Armor Division (compared
to
$7.9 million in the six months ended June 30, 2005,
a
decrease of $5.2 million, or 65.6%,
due
primarily to decreased revenues from MDT and AoA).
Cost
of revenues and gross profit.
Cost
of
revenues totaled $12.7 million during the six months ended June 30, 2006,
compared to $15.0 million in the six months ended June 30, 2005,
a
decrease of $2.2 million, or 14.9%,
due
primarily to decreased sales in our Battery and Power Systems division and
Armor
Division and the decrease in margins due to change in the mix of products
and
customers in 2006 in comparison to 2005. In addition, we incurred substantial
expenses in respect of production of a new product in our Armor Division,
and we
updated our accrual for loss from one of our simulation projects.
Direct
expenses for our three divisions during the six months ended June 30, 2006
were
$8.4 million for the Simulation and Training Division (compared to $8.5 million
in the six months ended June 30, 2005,
a
decrease of $108,000, or 1.3%; $4.2 million for the Battery and Power Systems
Division (compared to $5.1 million in the six months ended June 30,
2005,
a
decrease of $832,000, or 16.4%, due primarily to decreased sales of Epsilor,
offset to some extent by increased WAB revenues from our EFL subsidiary);
and
$4.1 million for the Armor Division (compared to $7.8 million in the six
months
ended June 30, 2005,
a
decrease of $3.6 million, or 46.8%,
due
primarily to decreased revenues from MDT and AoA).
Gross
profit was $3.6 million during the six months ended June 30, 2006, compared
to
$7.6 million during the six months ended June 30, 2005, a decrease of $4.1
million, or 53.3%. This decrease was the direct result of all factors presented
above, most notably the decrease in our Armor Division revenues, the decrease
in
our Battery and Power Systems Division revenue, the decrease in margins due
to
change in the mix of products and customers in 2006 in comparison to 2005
and
the update of our accrual for loss from one of our simulation
projects.
Research
and development expenses
.
Research
and development expenses for the six months ended June 30, 2006 were $521,000,
compared to $899,000 during the second half of 2005, a decrease of $378,000,
or
42.1%. This decrease was primarily attributable to the consolidation of IES’s
and FAAC’s research and development operations
,
the
decrease in research and development capitalization in FAAC and allocation
of
research and development costs in EFB to cost of good sold due to revenues
from
research and development projects
.
Selling
and marketing expenses
.
Selling
and marketing expenses for the six months ended June 30, 2006 were $1.7 million,
compared to $2.2 million the six months ended June 30, 2005, a decrease of
$475,000, or 21.4%. This decrease was primarily attributable to the overall
decrease in revenues and their associated sales and marketing
expenses.
General
and administrative expenses
.
General
and administrative expenses for the six months ended June 30, 2006 were $6.2
million compared to $6.7 million in the six months ended June 30, 2005, a
decrease of $480,000, or 7.1%. This decrease was primarily attributable to
the
following factors:
Ø
Decreases
in certain general and administrative expenses in comparison to 2005, such
as
auditing, legal expenses and travel expenses, as a result of cost-cutting
programs implemented by management ($366,000).
Ø
Decrease
in general and administrative expenses related to FAAC, primarily payroll,
legal
and other expenses ($350,000).
Ø
Decrease
in general and administrative expenses related to IES as a result of the
consolidation of IES and FAAC operations ($106,000).
Ø
Decrease
in general and administrative expenses related to AoA due to decrease in
operations, employees and the relocation of AoA to Alabama
($248,000).
This
decrease
wase offset to some extent by an increase in expenses related to the
amortization of convertible debentures ($659,000).
Financial
expenses, net
.
Financial expenses totaled approximately $6.5 million in the six months ended
June 30, 2006 compared to $1.3 million in the six months ended June 30, 2005,
an
increase of $5.2 million, or 394.4%. The difference was due primarily to
interest related to our convertible notes that were issued in September 30,
2005, and financial expenses related to repayment by forced conversion of
our
convertible notes at an 8% discount to average market price as provided under
the terms of the convertible notes
,
particularly the April 2006 transaction described in “Overview of Results of
Operations – Financings,” above
.
Income
taxes.
We
and
certain of our subsidiaries incurred net operating losses during the six
months
ended June 30, 2006 and, accordingly, no provision for income taxes was
recorded. With respect to some of our subsidiaries that operated at a net
profit
during 2006, we were able to offset federal taxes against our accumulated
loss
carry forward. We recorded a total of $54,000 in tax expenses in the six
months
ended June 30, 2006, compared to $267,000 in tax expenses in the six months
ended June 30, 2005, mainly due to state taxes.
Amortization
of intangible assets
.
Amortization of intangible assets totaled $971,000 in the six months ended
June
30, 2006, compared to $1.6 million in the six months ended June 30, 2005,
a
decrease of $675,000, or 41.0%, due primarily to a decrease in amortization
of
intangible assets related to our subsidiary AoA.
Impairment
of goodwill and other intangible assets
.
Current
accounting standards require us to test goodwill for impairment at least
annually, and between annual tests in certain circumstances; when we determine
goodwill is impaired, it must be written down, rather than being amortized
as
previous accounting standards required. Goodwill is tested for impairment
by
comparing the fair value of our reportable units with their carrying value.
Fair
value is determined using discounted cash flows. Significant estimates used
in
the methodologies include estimates of future cash flows, future short-term
and
long-term growth rates, weighted average cost of capital and estimates of
market
multiples for the reportable units. We performed the required annual impairment
test of goodwill, based on our management’s projections and using expected
future discounted operating cash flows. We did not identify any impairment
of
goodwill during the six months ended June 30, 2006. In the corresponding
period
of 2005, we identified in AoA an impairment of goodwill in the amount of
$2,043,129.
Our
and
our subsidiaries’ long-lived assets and certain identifiable intangibles are
reviewed for impairment in accordance with current accounting standards whenever
events or changes in circumstances indicate that the carrying amount of an
asset
may not be recoverable. Recoverability of the carrying amount of assets to
be
held and used is measured by a comparison of the carrying amount of the assets
to the future undiscounted cash flows expected to be generated by the assets.
If
such assets are considered to be impaired, the impairment to be recognized
is
measured by the amount by which the carrying amount of the assets exceeds
the
fair value of the assets. We did not identify any impairment of backlog during
the six months ended June 30,
2006.
In
the corresponding period of 2005, we identified an impairment of backlog
previously identified with the AoA acquisition and as a result we recorded
an
impairment loss in the amount of $346,000
.
Net
loss.
Due
to
the factors cited above
,
net
loss attributable to common shareholders increased from $8.1 million to $12.4
million, an increase of $4.3 million, or 53.8%.
Net
loss attributable to common shareholders.
Due to
deemed dividend that was recorded in the amount of $434,000 in the six months
ended June 30, 2006 due to the repricing of existing warrants and the issuance
of new warrants (see Note 6 to the financial statements), net loss attributable
to common shareholders was $12.9 million in the six months ended June 30,
2006,
compared to $8.1 million in the six months ended June 30, 2005, an increase
of
$4.8 million, or 59.2%.
Liquidity
and Capital Resources
As
of
June 30, 2006, we had $4.6 million in cash, $8.3 million in restricted
collateral securities and cash deposits due within one year, $22,000 in
long-term restricted securities and deposits, and $38,000 in available-for-sale
marketable securities, as compared to at December 31, 2005, when we had $6.2
million in cash, $3.9 million in restricted collateral securities and restricted
held-to-maturity securities due within one year, $779,000 in long-term
restricted deposits, and $36,000 in available-for-sale marketable securities.
The increase in restricted collateral securities and cash deposits was primarily
the result of warrant exercises in February, March and April of 2006 (see
Note 6
to the financial statements).
We
used
available funds in the six months ended June 30, 2006 primarily for sales
and
marketing, continued research and development expenditures, and other working
capital needs. We increased our investment in fixed assets during the six
months
ended June 30, 2006 by $493,000 over the investment as at December 31, 2005,
primarily in the Battery and Power Systems and Armor Divisions. Our net fixed
assets amounted to $4.0 million at quarter end.
Net
cash
used in operating activities from continuing operations for the six months
ended
June 30, 2006 and 2005 was $2.0 million and $3.9 million, respectively, a
decrease of $1.9 million. This decrease was primarily the result of a decrease
in trade receivables in comparison to the six months ended June 30, 2005
offset
by a decrease in trade payables in 2005 in comparison to the six months ended
June 30, 2006.
Net
cash
used in investing activities for the six months ended June 30, 2006 and 2005
was
$4.9 million and $1.0 million, an increase of $3.9 million. This increase
was
primarily the result of warrant exercises during the six months ended June
30,
2006, the proceeds of which were deposited in restricted accounts for the
payment of our convertible debentures due in September 2006, resulting in
an
increase in restricted securities and deposits.
Net
cash
provided by (used in) financing activities for the three months ended June
30,
2006 and 2005 was $5.4 million and $2.4 million, respectively. This increase
was
primarily the result of warrant exercises in February, March and April of
2006
(see Note 6 to the financial statements).
As
of
June 30, 2006, we had (based on the contractual amount of the debt and not
on
the accounting valuation of the debt, not taking into consideration trade
payables, other accounts payables and accrued severance pay) approximately
$1.1
million in long term bank and certificated debt outstanding, all of which
was
convertible debt, and approximately $15.1 million in short-term debt (which
included short-term bank credit and convertible debentures in an amount of
$11.8
million, and liability due to acquisition of subsidiary in the amount of
$208,000).
Based
on
our internal forecasts, which are subject to all of the reservations regarding
“forward-looking statements” set forth above, we believe that our present cash
position, anticipated cash flows from operations, lines of credit and
anticipated additions to paid-in capital should be sufficient to satisfy
our
current estimated cash requirements through the remainder of the year. This
belief is based on certain earnout and other assumptions that our management
and
our subsidiaries managers believe to be reasonable, some of which are subject
to
the risk factors detailed under “Risk Factors” in Item IA of Part II, below,
including without limitation (i) that we will be able to refinance, restructure
or convert to equity our $10.3 million in convertible debt (debentures and
notes) that is due in 2006 (which does not include $3.1 million short-term
bank
credit), (ii) that our dispute with the former shareholders of FAAC will
ultimately be decided substantially in our favor, (iii) that the severance
and
retirement benefits that we owe to certain of our senior executives will
not
have to be paid ahead of their anticipated schedule, and (iv) that no other
earnout payments to the former shareholder of AoA will be required in excess
of
the funds being held by him in escrow to secure such earnout obligations.
In
this connection, we note that from time to time our working capital needs
are
partially dependent on our subsidiaries’ lines of credit. In the event that we
are unable to continue to make use of our subsidiaries’ lines of credit for
working capital on economically feasible terms, our business, operating results
and financial condition could be adversely affected.
Over
the
long term, we will need to become profitable, at least on a cash-flow basis,
and
maintain that profitability in order to avoid future capital requirements.
Additionally, we would need to raise additional capital in order to fund
any
future acquisitions.
Evaluation
of Disclosure Controls and Procedures
As
of
June 30, 2006, our management, including the principal executive officer
and
principal financial officer, evaluated our disclosure controls and procedures
related to the recording, processing, summarization, and reporting of
information in our periodic reports that we file with the SEC. These disclosure
controls and procedures are intended to ensure that material information
relating to us, including our subsidiaries, is made known to our management,
including these officers, by other of our employees, and that this information
is recorded, processed, summarized, evaluated, and reported, as applicable,
within the time periods specified in the SEC’s rules and forms. Due to the
inherent limitations of control systems, not all misstatements may be detected.
These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Any system of controls and procedures, no matter how well
designed and operated, can at best provide only reasonable assurance that
the
objective of the system are met and management necessarily is required to
apply
its judgment in evaluating the cost benefit relationship of possible controls
and procedures. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control. Our controls and procedures are intended to provide
only reasonable, not absolute, assurance that the above objectives have been
met.
Based
on
their evaluations, our principal executive officer and principal financial
officer were able to conclude that our disclosure controls and procedures
(as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934) were not effective as of June 30, 2006 to ensure that the information
required to be disclosed by us in the reports that we file or submit under
the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in SEC rules and forms.
Our
management has not completed implementation of the changes it believes are
required to remediate the previously reported material weakness for inadequate
controls related to revenue recognition at our FAAC subsidiary. The material
weakness arises from
revenue
recognition calculations at FAAC not being reviewed by appropriate accounting
personnel to determine that revenue is recognized in accordance with company
policy and generally accepted accounting principles
.
Management has identified that due to the reasons described above; we did
not
consistently follow established internal control over financial reporting
procedures related to revenue recognition at our FAAC subsidiary. Because
of
this material weakness, we have concluded that we did not maintain effective
internal control over financial reporting as of June 30, 2006, based on the
criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the
Treadway Commission in
Internal
Control - Integrated Framework
.
In
light
of the material weakness described above, our management performed additional
analyses and other post-closing procedures to ensure our condensed consolidated
financial statements are prepared in accordance with generally accepted
accounting principles in the United States (U.S. GAAP). Accordingly, management
believes that the condensed consolidated financial statements included in
this
report fairly present in all material respects our financial position, results
of operations and cash flows for the periods presented.
Management’s
Response to the Material Weaknesses
In
response to the material weakness described above, we have undertaken the
following initiatives with respect to our internal controls and procedures
that
we believe are reasonably likely to improve and materially affect our internal
control over financial reporting. We anticipate that remediation will be
continuing throughout fiscal 2006, during which we expect to continue pursuing
appropriate corrective actions at FAAC, including the following:
|
|
Ø
|
Revenue
recognition
.
We will institute procedures at FAAC to determine that revenue
recognition
calculations are reviewed by an appropriate accounting
person.
|
Our
management and Audit Committee have monitored and will continue to monitor
closely the implementation of our remediation plan. The effectiveness of
the
steps we intend to implement is subject to continued management review, as
well
as Audit Committee oversight, and we may make additional changes to our internal
control over financial reporting.
Changes
in Internal Controls Over Financial Reporting
Except
as
noted above, there have been no changes in our internal control over financial
reporting that occurred during our last fiscal quarter to which this Quarterly
Report on Form 10-Q relates that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.
PART
II
The
following factors, among others, which contain changes from risk factors
as
previously disclosed in our Form 10-K for the year ended December 31, 2005,
could cause actual results to differ materially from those contained in
forward-looking statements made in this report and presented elsewhere by
management from time to time. We specifically refer you to the section entitled
“Risk Factors” in our Form 10-K for the year ended December 31, 2005 for other
risk factors, which have not changed since the date our Form 10-K was filed,
which continue to apply to us.
Business-Related
Risks
We
have had a history of losses and may incur future
losses.
We
were
incorporated in 1990 and began our operations in 1991. We have funded our
operations principally from funds raised in each of the initial public offering
of our common stock in February 1994; through subsequent public and private
offerings of our common stock and equity and debt securities convertible
or
exercisable into shares of our common stock; research contracts and supply
contracts; funds received under research and development grants from the
Government of Israel; and sales of products that we and our subsidiaries
manufacture. We have incurred significant net losses since our inception.
Additionally, as of June 30, 2006, we had an accumulated deficit of
approximately $155.4 million. In an effort to reduce operating expenses and
maximize available resources, we intend to consolidate certain of our
subsidiaries, shift personnel and reassign responsibilities. We have also
substantially reduced certain senior employee salaries during 2005, cut
directors’ fees, and taken a variety of other measures to limit spending and
will continue to assess our internal processes to seek additional cost-structure
improvements. Although we believe that such steps will help to reduce our
operating expenses and maximize our available resources, there can be no
assurance that we will ever be able to achieve or maintain profitability
consistently or that our business will continue to exist.
Our
existing indebtedness may adversely affect our ability to obtain additional
funds and may increase our vulnerability to economic or business
downturns.
Our
bank
and certificated indebtedness (short and long term) aggregated approximately
$16.3 million principal amount as of June 30, 2006 (not including trade
payables, other account payables and accrued severance pay), of which $10.6
million is due in 2006 (not including $3.1 million short-term bank credit).
In
addition, we may incur additional indebtedness in the future. Accordingly,
we
are subject to the risks associated with significant indebtedness,
including:
|
|
·
|
we
must dedicate a portion of our cash flows from operations to pay
principal
and interest and, as a result, we may have less funds available
for
operations and other purposes;
|
|
|
·
|
it
may be more difficult and expensive to obtain additional funds
through
financings, if available at all;
|
|
|
·
|
we
are more vulnerable to economic downturns and fluctuations in interest
rates, less able to withstand competitive pressures and less flexible
in
reacting to changes in our industry and general economic conditions;
and
|
|
|
·
|
if
we default under any of our existing debt instruments, including
paying
the outstanding principal when due, and if our creditors demand
payment of
a portion or all of our indebtedness, we may not have sufficient
funds to
make such payments.
|
The
occurrence of any of these events could materially adversely affect our results
of operations and financial condition and adversely affect our stock
price.
The
agreements governing the terms of our debentures and notes contain numerous
affirmative and negative covenants that limit the discretion of our management
with respect to certain business matters and place restrictions on us, including
obligations on our part to preserve and maintain our assets and restrictions
on
our ability to incur or guarantee debt, to merge with or sell our assets
to
another company, and to make significant capital expenditures without the
consent of the debenture holders. Our ability to comply with these and other
provisions of such agreements may be affected by changes in economic or business
conditions or other events beyond our control.
The
payment by us of our secured convertible notes in stock or the conversion
of
such notes by the holders could result in substantial numbers of additional
shares being issued, with the number of such shares increasing if and to
the
extent our market price declines, diluting the ownership percentage of our
existing shareholders.
In
September 2005, we issued $17.5 million in secured convertible notes due
March
31, 2008. The Notes are convertible at the option of the holders at a fixed
conversion price of $14.00. We will repay the principal amount of the notes
over
the next two and one-half years, with the principal amount being amortized
in
twelve payments payable at our option in cash and/or stock, by requiring
the
holders to convert a portion of their Notes into shares of our common stock,
provided certain conditions are met. The failure to meet such conditions
could
make us unable to pay our notes, causing us to default. If the price of our
common stock is above $14.00, the holders of our notes will presumably convert
their notes to stock when payments are due, or before, resulting in the issuance
of additional shares of our common stock.
One-twelfth
of the principal amount of the Notes is payable on each of January 31, 2006,
March 31, 2006, May 31, 2006, July 31, 2006, September 30, 2006, November
30,
2006, May 31, 2007, July 31, 2007, September 30, 2007, November 30, 2007,
January 31, 2008, and March 31, 2008. We paid the January 31, 2006 and March
31,
2006 payments in stock by requiring the holders to convert a portion of their
Notes. Additionally, with the agreement of the holders of our Notes, we prepaid
the payments of September 30, 2007, November 30, 2007, January 31, 2008,
and
March 31, 2008, as well as a small portion of the payment due July 31, 2007,
in
stock by requiring the holders to convert a portion of their Notes. In the
event
we continue to elect to make payments of principal on our convertible notes
in
stock by requiring the holders to convert a portion of their Notes, either
because our cash position at the time makes it necessary or we
other-
wise
deem
it advisable, the price used to determine the number of shares to be issued
on
conversion will be calculated using an 8% discount to the average trading
price
of our common stock during 17 of the 20 consecutive trading days ending two
days
before the payment date. Accordingly, the lower the market price of our common
stock at the time at which we make payments of principal in stock, the greater
the number of shares we will be obliged to issue and the greater the dilution
to
our existing shareholders.
In
either
case, the issuance of the additional shares of our common stock could adversely
affect the market price of our common stock.
We
can
require the holder of our Notes to convert a portion of their Notes into
shares
of our common stock at the time principal payments are due only if such shares
are registered for resale and certain other conditions are met. If our stock
price were to decline, we might not have a sufficient number of shares of
our
stock registered for resale in order to continue requiring the holders to
convert a portion of their Notes. As a result, we would need to file an
additional registration statement with the SEC to register for resale more
shares of our common stock in order to continue requiring conversion of our
Notes upon principal payment becoming due. Any delay in the registration
process, including through routine SEC review of our registration statement
or
other filings with the SEC, could result in our having to pay scheduled
principal repayments on our Notes in cash, which would negatively impact
our
cash position and, if we do not have sufficient cash to make such payments
in
cash, could cause us to default on our Notes.
Our
earnings will decline if we write off additional goodwill and other intangible
assets.
As
of
December 31, 2004, we had recorded goodwill of $39.7 million. On January
1,
2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No.
142 requires goodwill to be tested for impairment on adoption of the Statement,
at least annually thereafter, and between annual tests in certain circumstances,
and written down when impaired, rather than being amortized as previous
accounting standards required. Goodwill is tested for impairment by comparing
the fair value of our reportable units with their carrying value. Fair value
is
determined using discounted cash flows. Significant estimates used in the
methodologies include estimates of future cash flows, future short-term and
long-term growth rates, weighted average cost of capital and estimates of
market
multiples for the reportable units. We performed the required annual impairment
test of goodwill, based on our projections and using expected future discounted
operating cash flows. As of December 31, 2005, we identified in AoA an
impairment of goodwill in the amount of $11.8 million. As of June 30, 2006,
we
identified in AoA an additional impairment of goodwill in the amount of
$204,000.
Our
and
our subsidiaries’ long-lived assets and certain identifiable intangibles are
reviewed for impairment in accordance with Statement of Financial Accounting
Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived
Assets,” whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. Recoverability of the carrying
amount
of assets to be held and used is measured by a comparison of the carrying
amount
of the assets to the future undiscounted cash flows expected to be generated
by
the assets. If such assets are considered to be impaired, the impairment
to be
recognized is measured by the amount by which the carrying amount of the
assets
exceeds the fair value of
the
assets. As of December 31, 2004, we identified an impairment of other intangible
assets identified with the IES acquisition and, as a result, we recorded
an
impairment loss in the amount of $320,000. As of December 31, 2005, we
identified an impairment of other intangible assets identified with the AoA
acquisition and, as a result, we recorded an impairment loss in the amount
of
$499,000.
We
will
continue to assess the fair value of our goodwill annually or earlier if
events
occur or circumstances change that would more likely than not reduce the
fair
value of our goodwill below its carrying value. These events or circumstances
would include a significant change in business climate, including a significant,
sustained decline in an entity’s market value, legal factors, operating
performance indicators, competition, sale or disposition of a significant
portion of the business, or other factors. If we determine that significant
impairment
has
occurred, we would be required to write off the impaired portion of goodwill.
Impairment
charges
could have a material adverse effect on our financial condition and
results.
Failure
to comply with the earnout provisions of our acquisition agreements could
have
material adverse consequences for us.
A
failure
to comply with the obligations contained in our acquisition agreements to
make
the earnout payments required under such agreements as ultimately determined
in
arbitration or litigation could result in actions for damages, a possible
right
of rescission on the part of the sellers, and the acceleration of debt under
instruments evidencing indebtedness that may contain cross-acceleration or
cross-default provisions. If we are unable to raise capital in order to pay
the
earnout provisions of our acquisition agreements, there can be no assurance
that
our future cash flow or assets would be sufficient to pay such
obligations.
In
this
connection, we note that we have received a demand for arbitration in respect
of
the amount that we owe the former shareholders of FAAC Incorporated in respect
of their earnout for 2005. Pursuant to the purchase agreement and a side
letter,
we are obligated to pay the former shareholders of FAAC an amount equal to
“the
net income realized by FAAC Incorporated from the Stryker Driver Simulator
Program with the U.S. Army.” Subsequently, the U.S. Army added additional
programs, all of which it classified generally as the “Common Driver Training
Program” (CDT). The former shareholders of FAAC have claimed that the 2005
earnout is due on the entire CDT program, which would equal to an additional
amount of $3.5 million. We have taken the position that the 2005 earnout
is due
only on the Stryker part of the CDT program, relying on the specific language
of
the side letter, and that we therefore owe an additional amount of only
$604,000. If this issue is ultimately decided in favor of the former
shareholders of FAAC, the need to pay additional earnout sums to them could
have
a material adverse effect on our cash flows and financial
condition.
Our
management has determined that we have material weaknesses in our internal
controls. If we fail to achieve and maintain effective internal controls
in
accordance with Section 404 of the Sarbanes-Oxley Act, we may not be able
to
accurately report our financial results.
Section
404 of the Sarbanes-Oxley Act of 2002 requires us to include an internal
control
report of management in our Annual Report on Form 10-K. Our management
acknowledges its responsibility for internal controls over financial reporting
and seeks to continually improve
those
controls. In addition, in order to achieve compliance with Section 404 within
the prescribed period, we have been engaged in a process to document and
evaluate our internal controls over financial reporting. In this regard,
management has dedicated internal resources, engaged outside consultants
and
adopted a work plan to (i) assess and document the adequacy of internal control
over financial reporting, (ii) take steps to improve control processes where
appropriate, (iii) validate through testing that controls are functioning
as
documented and (iv) implement a continuous reporting and improvement process
for
internal control over financial reporting. We believe our process for
documenting, evaluating and monitoring our internal control over financial
reporting is consistent with the objectives of Section 404 of
Sarbanes-Oxley.
We
have,
with our auditors’ concurrence, identified a material weakness under standards
established by the Public Company Accounting Oversight Board (PCAOB) related
to
our FAAC subsidiary. A material weakness is a condition in which the design
or
operation of one or more of the internal control components does not reduce
to a
relatively low level the risk that misstatements caused by error or fraud
in
amounts that would be material in relation to the financial statements being
audited may occur and not be detected within a timely period by employees
in the
normal course of performing their assigned functions. Our auditors have reported
to us that at December 31, 2005, we had a material weakness for inadequate
controls related to our FAAC subsidiary, in that we did not maintain effective
controls over the monitoring, review and approval of revenue recognition
calculations at FAAC.
As
a
public company, we have significant requirements for enhanced financial
reporting and internal controls. The process of designing and implementing
effective internal controls is a continuous effort that requires us to
anticipate and react to changes in our business and the economic and regulatory
environments and to expend significant resources to maintain a system of
internal controls that is adequate to satisfy our reporting obligations as
a
public company. We cannot assure you that the measures we have taken or will
take to remediate any material weaknesses or that we will implement and maintain
adequate controls over our financial processes and reporting in the future
as we
continue our rapid growth. If we are unable to establish appropriate internal
financial reporting controls and procedures, it could cause us to fail to
meet
our reporting obligations, result in material misstatements in our financial
statements, harm our operating results, cause investors to lose confidence
in
our reported financial information and have a negative effect on the market
price for shares of our common stock.
Market-Related
Risks
If
our shares were to be delisted, our stock price might decline further and
we
might be unable to raise additional capital.
One
of
the continued listing standards for our stock on the Nasdaq Stock Market
(both
the Nasdaq Global Market (formerly known as the Nasdaq National Market),
on
which our stock is currently listed, and the Nasdaq Capital Market (formerly
known as the Nasdaq SmallCap Market)) is the maintenance of a $1.00 bid price.
Our stock price was below $1.00 between August 15, 2005 and June 20, 2006;
however, on June 21, 2006, we effected a one-for-fourteen reverse stock split,
which brought the bid price of our common stock back over $1.00. If our bid
price were to go and remain below $1.00 for 30 consecutive business days,
Nasdaq
could notify us of our failure to meet the continued listing standards, after
which we would have 180 calendar days
to
correct such failure or be delisted from the Nasdaq Global Market. In addition,
we may be unable to satisfy the other continued listing
requirements.
Although
we would have the opportunity to appeal any potential delisting, there can
be no
assurances that this appeal would be resolved favorably. As a result, there
can
be no assurance that our common stock will remain listed on the Nasdaq Global
Market. If our common stock were to be delisted from the Nasdaq Global Market,
we might apply to be listed on the Nasdaq Capital Market if we then met the
initial listing standards of the Nasdaq Capital Market (other than the $1.00
minimum bid standard). If we were to move to the Nasdaq Capital Market, current
Nasdaq regulations would give us the opportunity to obtain an additional
180-day
grace period if we meet certain net income, shareholders’ equity or market
capitalization criteria; if at the end of that period we had not yet achieved
compliance with the minimum bid price rule, we would be subject to delisting
from the Nasdaq Capital Market. Although we would have the opportunity to
appeal
any potential delisting, there can be no assurances that this appeal would
be
resolved favorably. As a result, there can be no assurance that our common
stock
will remain listed on the Nasdaq Stock Market.
While
our
stock would continue to trade on the over-the-counter bulletin board following
any delisting from the Nasdaq, any such delisting of our common stock could
have
an adverse effect on the market price of, and the efficiency of the trading
market for, our common stock. Trading volume of over-the-counter bulletin
board
stocks has been historically lower and more volatile than stocks traded on
an
exchange or the Nasdaq Stock Market. As a result, holders of our securities
could find it more difficult to sell their securities. Also, if in the future
we
were to determine that we need to seek additional equity capital, it could
have
an adverse effect on our ability to raise capital in the public equity
markets.
In
addition, if we fail to maintain Nasdaq listing for our securities, and no
other
exclusion from the definition of a “penny stock” under the Securities Exchange
Act of 1934, as amended, is available, then any broker engaging in a transaction
in our securities would be required to provide any customer with a risk
disclosure document, disclosure of market quotations, if any, disclosure
of the
compensation of the broker-dealer and its salesperson in the transaction
and
monthly account statements showing the market values of our securities held
in
the customer’s account. The bid and offer quotation and compensation information
must be provided prior to effecting the transaction and must be contained
on the
customer’s confirmation. If brokers become subject to the “penny stock” rules
when engaging in transactions in our securities, they would become less willing
to engage in transactions, thereby making it more difficult for our shareholders
to dispose of their shares.
Additionally,
delisting from the Nasdaq Stock Market would constitute an event of default
under our debentures due in September 2006, which could result in acceleration
of debt under other instruments evidencing other indebtedness that may contain
cross-acceleration or cross-default provisions, even if the delisting were
not
an event of default under those other instruments.
A
substantial number of our shares are available for sale in the public market
and
sales of those shares could adversely affect our stock
price.
Sales
of
a substantial number of shares of common stock into the public market, or
the
perception that those sales could occur, could adversely affect our stock
price
or could impair our ability to obtain capital through an offering of equity
securities. As of June 30, 2006, we had 8,468,957 shares of common stock
issued
and outstanding. Of these shares, most are freely transferable without
restriction under the Securities Act of 1933 or pursuant to effective resale
registration statements, and a substantial portion of the remaining shares
may
be sold subject to the volume restrictions, manner-of-sale provisions and
other
conditions of Rule 144 under the Securities Act of 1933.
Exercise
of our warrants, options and convertible debt could adversely affect our
stock
price and will be dilutive.
As
of
June 30, 2006, there were outstanding warrants to purchase a total of 1,068,924
shares of our common stock at a weighted average exercise price of $14.27
per
share, options to purchase a total of 616,511 shares of our common stock
at a
weighted average exercise price of $11.00 per share, of which 589,490 were
vested, at a weighted average exercise price of $10.68 per share, and
outstanding debentures and notes convertible into a total of 827,909 shares
of
our common stock at a weighted average conversion price of $15.68 per share.
Holders of our options, warrants and convertible debt will probably exercise
or
convert them only at a time when the price of our common stock is higher
than
their respective exercise or conversion prices. Accordingly, we may be required
to issue shares of our common stock at a price substantially lower than the
market price of our stock. This could adversely affect our stock price. In
addition, if and when these shares are issued, the percentage of our common
stock that existing shareholders own will be diluted.
Israel-Related
Risks
A
significant portion of our operations takes place in Israel, and we could
be
adversely affected by the economic, political and military conditions in
that
region.
The
offices and facilities of three of our subsidiaries, EFL, MDT and Epsilor,
are
located in Israel (in Beit Shemesh, Lod and Dimona, respectively, all of
which
are within Israel’s pre-1967 borders). Most of our senior management is located
at EFL’s facilities. Although we expect that most of our sales will be made to
customers outside Israel, we are nonetheless directly affected by economic,
political and military conditions in that country. Accordingly, any major
hostilities involving Israel or the interruption or curtailment of trade
between
Israel and its present trading partners could have a material adverse effect
on
our operations. Since the establishment of the State of Israel in 1948, a
number
of armed conflicts have taken place between Israel and its Arab neighbors
and a
state of hostility, varying in degree and intensity, has led to security
and
economic problems for Israel.
Historically,
Arab states have boycotted any direct trade with Israel and to varying degrees
have imposed a secondary boycott on any company carrying on trade with or
doing
business in Israel. Although in October 1994, the states comprising the Gulf
Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai,
Bahrain and Oman) announced that they would no
longer
adhere to the secondary boycott against Israel, and Israel has entered into
certain agreements with Egypt, Jordan, the Palestine Liberation Organization
and
the Palestinian Authority, Israel has not entered into any peace arrangement
with Syria or Lebanon. Moreover, since September 2000, there has been a
significant deterioration in Israel’s relationship with the Palestinian
Authority, and a significant increase in terror and violence. Israel recently
withdrew unilaterally from the Gaza Strip and certain areas in northern Samaria.
It is unclear what the long-term effects of such disengagement plan will
be.
Efforts to resolve the problem have failed to result in an agreeable solution.
The
election of representatives of the Hamas movement to a majority of seats
in the
Palestinian Legislative Council has created additional unrest and uncertainty.
Recently, there has been a sharp increase in hostilities along Israel’s northern
border with Lebanon and to a lesser extent in the Gaza Strip. There can be
no
assurance that such hostilities will not intensify.
Continued
hostilities between the Palestinian community and Israel and any failure
to
settle the conflict may have a material adverse effect on our business and
us.
Moreover, the current political and security situation in the region has
already
had an adverse effect on the economy of Israel, which in turn may have an
adverse effect on us.
Reference
is made to the Current Report on Form 8-K that we filed with the Securities
and
Exchange Commission on June 19, 2006.
The
following documents are filed as exhibits to this report:
|
Exhibit
Number
|
|
Description
|
|
3.1
|
|
Amendment
to the Company’s Amended and Restated Certificate of Incorporation filed
on June 20, 2006 and effective on June 21, 2006
|
|
31.1
|
|
Certification
of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
|
|
31.2
|
|
Certification
of Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
|
|
32.1
|
|
Certification
of Chief Executive Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
|
|
32.2
|
|
Certification
of Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
|
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
Dated:
August
14, 2006
|
|
AROTECH
CORPORATION
|
|
|
|
By:
|
/s/
Robert S. Ehrlich
|
|
|
|
Name:
|
Robert
S. Ehrlich
|
|
|
|
Title:
|
Chairman
and CEO
|
|
|
|
|
(Principal
Executive Officer)
|
|
|
By:
|
/s/
Thomas J. Paup
|
|
|
|
Name:
|
Thomas
J. Paup
|
|
|
|
Title:
|
Vice
President - Finance and CFO
|
|
|
|
|
(Principal
Financial Officer)
|