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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
    For the fiscal year ended December 31, 2007
OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
    For the transition period from          to          
 
Commission File Number 0-21074
SUPERCONDUCTOR TECHNOLOGIES INC.
(Exact name of registrant as specified in its charter)
 
     
Delaware
  77-0158076
(State or other jurisdiction of
incorporation or organization)
  (IRS Employer
Identification No.)
460 Ward Drive, Santa Barbara, California 93111-2310
 
(Address of principal executive offices) (Zip Code)
 
Registrant’s telephone number, including area code: ( 805) 690-4500
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of each class
 
Name of each exchange on which registered
 
Common stock, $0.001 par value
  The NASDAQ Capital Market
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o or     No  þ
 
Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o or     No  þ
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  þ or     No  o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer, large accelerated filer, and smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large Accelerated Filer  o Accelerated Filer  o Non-Accelerated Filer  o Smaller reporting company  þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o or No  þ
 
The aggregate market value of the common stock held by non-affiliates was $15.9 million as of June 30, 2007 (the last business day of our most recently completed second fiscal quarter). The closing price of the common stock on that date was $1.49 as reported by the NASDAQ Capital Market. For purposes of this determination, we excluded the shares of common stock held by each officer and director and by each person who owns 5% or more of the outstanding common stock. The exclusion of shares owned by the aforementioned individuals and entities from this calculation does not constitute an admission by any of such individuals or entities that he or it was or is an affiliate of ours.
 
We had 15,612,775 shares of common stock outstanding as of the close of business on February 29, 2008.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Item 5 of Part II and Items 10, 11, 12, 13 and 14 of Part III incorporate information by reference from the definitive proxy statement for the Registrant’s 2008 Annual Meeting of Stockholders.
 


 

 
SUPERCONDUCTOR TECHNOLOGIES INC.
 
FORM 10-K ANNUAL REPORT
Year Ended December 31, 2007
 
Unless otherwise noted, the terms “we,” “us,” “our” and “STI” refer to the combined and ongoing business operations of Superconductor Technologies Inc. and its subsidiaries
 
                 
        Page
 
    1  
    1  
 
PART I
      Business     2  
      Risk Factors     8  
      Unresolved Staff Comments     17  
      Properties     17  
      Legal Proceedings     17  
      Submission of Matters to a Vote of Security Holders     18  
 
PART II
      Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     18  
      Selected Financial Data     21  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     22  
      Quantitative and Qualitative Disclosures about Market Risk     34  
      Financial Statements and Supplementary Data     34  
      Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     34  
      Controls and Procedures     35  
      Other Information     35  
 
PART III
      Directors, Executive Officers and Corporate Governance     35  
      Executive Compensation     36  
      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     36  
      Certain Relationships and Related Transactions, and Director Independence     36  
      Principal Accountant Fees and Services     36  
 
PART IV
      Exhibits and Financial Statement Schedules     36  
  EXHIBIT 10.21
  EXHIBIT 10.22
  EXHIBIT 10.23
  EXHIBIT 10.24
  EXHIBIT 10.25
  EXHIBIT 21
  EXHIBIT 23.1
  EXHIBIT 23.2
  EXHIBIT 31.1
  EXHIBIT 31.2
  EXHIBIT 32.1
  EXHIBIT 32.2


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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. You can find many (but not all) of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” or other similar expressions in this Report. We claim the protection of the safe harbor contained in the Private Securities Litigation Reform Act of 1995. We caution investors that any forward-looking statements presented in this Report, or which we may make orally or in writing from time to time, are based on the beliefs of, assumptions made by, and information currently available to, us. Such statements are based on assumptions and the actual outcome will be affected by known and unknown risks, trends, uncertainties and factors that are beyond our control or ability to predict. Although we believe that our assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect. As a result, our actual future results can be expected to differ from our expectations, and those differences may be material. Accordingly, investors should use caution in relying on past forward-looking statements, which are based on known results and trends at the time they are made, to anticipate future results or trends.
 
Some of the risks and uncertainties that may cause our actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements include the following: limited assets and a history of losses; limited number of potential customers; limited number of suppliers for some of our components; no significant backlog from quarter to quarter; our market is characterized by rapidly advancing technology. For further discussion of these and other factors see “Item 1A. Risk Factors” of this Report.
 
This Report and all subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to release publicly any revisions to our forward-looking statements to reflect events or circumstances after the date of this Report.
 
WHERE YOU CAN FIND MORE INFORMATION
 
As a public company, we are required to file annually, quarterly and special reports, proxy statements and other information with the SEC. You may read and copy any of our materials on file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Judiciary Plaza, Washington, DC 20549, as well as at the SEC’s regional office at 5757 Wilshire Boulevard, Suite 500, Los Angeles, California 90036. Our filings are available to the public over the Internet at the SEC’s website at http://www.sec.gov. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. We also provide copies of our Forms 8-K, 10-K, 10-Q, Proxy and Annual Report at no charge to investors upon request and make electronic copies of our most recently filed reports available through our website at www.suptech.com as soon as reasonably practicable after filing such material with the SEC.


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PART I
 
ITEM 1.    BUSINESS
 
Our Company
 
We design, manufacture, market and sell high performance infrastructure products for wireless voice and data applications. Our products are utilized in major wireless networks throughout the United States which support voice and data communications by use of cell phones and other wireless communication devices.
 
Our products help maximize the performance of wireless telecommunications networks by improving the quality of uplink signals from mobile wireless devices. Our products increase capacity utilization, lower dropped and blocked calls, extend coverage, and enable higher wireless data throughput — all while reducing capital and operating costs. Our SuperLink utilizes patented high-temperature superconductor (HTS) technology to create a receiver front-end that enhances network performance. Today, we are leveraging our expertise and proprietary technology in radio frequency (RF) engineering to expand our product line beyond HTS technology. We believe our RF engineering expertise provides us with a significant competitive advantage in the development of high performance, cost-effective solutions for wireless telecommunications networks.
 
We currently sell most of our commercial products directly to wireless network operators in the United States. Our customers to date include ALLTEL, AT&T, Sprint Nextel, T-Mobile, and Verizon Wireless. We have a concentrated customer base. Verizon Wireless and AT&T each accounted for more than 10% of our commercial revenues in 2007 and Verizon Wireless, ALLTEL, and T-Mobile each accounted for more than 10% of our commercial revenues in 2006. We plan to continue to expand our customer base by selling directly to other wireless network operators and manufacturers of base station equipment, including internationally. During 2007, we formed a joint venture to gain access to the Chinese market.
 
Industry Background.   The ability to provide high quality service to subscribers is becoming increasingly difficult for wireless operators as the number of users grows, minutes of use increase and the market for wireless data services expands. Wireless service providers in both rural and urban areas are encountering radio frequency interference due to greater subscriber density and a larger number of users on adjacent channels. This reduced signal quality and higher percentage of dropped calls can lead to lower system utilization, decreased revenue and, ultimately, higher rates of customer churn. Some service providers are also facing network capacity constraints.
 
As a result, wireless carriers are seeking to cost-effectively reduce interference, increase capacity, expand coverage to improve the quality of their systems and, utilize their spectrum in the most efficient manner possible.
 
Our Solution.   We leverage our expertise in RF technology to cost effectively deliver interference protection and increased sensitivity to our wireless carrier customers. Our solutions provide the following quality-of-service improvements:
 
  •  reduction of dropped calls and network access failures;
 
  •  elimination of interference from other sources such as specialized mobile radio handsets and other base stations;
 
  •  increased in-building penetration;
 
  •  reduction in base station noise figure; and
 
  •  improved handset power consumption
 
Our Products.   Our solutions consist of the following three product lines:
 
  •  SuperLink combines HTS filters with a proprietary cryogenic cooler and an ultra low-noise amplifier to create a highly compact and reliable receiver front-end that can simultaneously deliver both high selectivity (interference rejection) and high sensitivity (detection of low level signals).


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  •  AmpLink is a ground-mounted unit which includes a high-performance amplifier that provides increased sensitivity.
 
  •  SuperPlex is a line of multiplexers that provides extremely low insertion loss and excellent cross-band isolation.
 
Our Strategy.   Our objective is to provide a full range of performance improvement solutions to wireless carriers by offering our field-proven solutions, innovative duplexer designs for antenna sharing and network overlays, ground-based sensitivity improvement solutions and high-performance multiplexers. The primary elements of our strategy include:
 
  •  diversifying our customer base,
 
  •  expanding our current product offerings,
 
  •  enhancing our productivity and lowering our costs,
 
  •  maintaining our focus on technical excellence and innovation, and
 
  •  pursuing strategic partnerships, alliances and acquisitions.
 
Government Contracts.   We also generate significant revenues from government contracts. We primarily pursue government research and development contracts which complement our commercial product development, but we also pursue government product opportunities. We undertake government contract work which has the potential to add to or improve our commercial product line. These contracts often yield valuable intellectual property relevant to our commercial business. We typically own the intellectual property developed under these contracts, and the Federal Government receives a royalty-free, non-exclusive and nontransferable license to use the intellectual property in the United States.
 
Corporate Information.   Our facilities and executive offices are located at 460 Ward Drive, Santa Barbara, California 93111, and our telephone number is (805) 690-4500. We were incorporated in Delaware on May 11, 1987. Additional information about us is available on our website at www.suptech.com. The information on our web site is not incorporated herein by reference.
 
Our Wireless Products
 
Wireless service providers can use our solutions to keep pace with the growing demand for wireless communications. Wireless providers may deploy our products in connection with the installation of additional base stations in a network, as well as with the installation of an entirely new network. Wireless service providers can also improve the performance of existing base stations and networks by retrofitting their equipment with our link enhancement products.
 
Our performance improvement solutions fit into three product families: SuperLink, AmpLink and SuperPlex.
 
  •  SuperLink.   In order to receive uplink signals from wireless handsets, base stations require a filter system to eliminate out-of-band interference, and amplification to enhance the base station’s sensitivity. To address this need, we offer the SuperLink product line for the receiver front-end of base stations. These products combine specialized filters using HTS technology with a proprietary cryogenic cooler and ultra low-noise amplifiers. The result is a highly compact and reliable receiver front-end that can simultaneously deliver both high selectivity (interference rejection) and high sensitivity (detection of low level signals). SuperLink products offer significant performance advantages over conventional filter and amplifier systems.
 
  •  AmpLink.   AmpLink is designed to address the sensitivity requirements of wireless base stations. AmpLink is a ground-mounted unit which utilizes a high-performance amplifier. The enhanced uplink performance provided by AmpLink improves network coverage immediately and avoids the installation and maintenance costs associated with tower mounted alternatives.
 
  •  SuperPlex.   SuperPlex is our line of multiplexers that provides extremely low insertion loss and excellent cross-band isolation. Products in our SuperPlex family of high-performance multiplexers are designed to facilitate base station antenna sharing and reduce infrastructure costs. SuperPlex can be used in conjunction


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  with AmpLink and SuperLink products to optimize performance in networks where 1900 MHz EV-DO capabilities are added to existing 850 MHz networks. Relative to competing technologies, this portfolio of STI solutions offers increased transmit power delivered to the base station antenna, higher sensitivity to subscriber handset signals, interference rejection and fast and cost-effective network overlays.
 
Marketing and Sales
 
We sell solutions to wireless communication service providers in the United States and pursue selected international opportunities.
 
We have a concentrated customer base. Verizon Wireless and AT&T each accounted for more than 10% of our commercial revenues in 2007; Verizon Wireless, ALLTEL and T-Mobile each accounted for more than 10% of our commercial revenues in 2006 and 2005. We sell using a direct sales force in the U.S. to focus on the Tier I wireless carriers. We use indirect channels to market our products to select customers internationally.
 
We demonstrate our products at trade shows, and participate in industry conferences. Advertising, email campaigns, direct mailings, and contribution of technical and application reports to recognized trade journals, are all employed to communicate our solutions to potential customers. We also advertise our products through our website, brochures, data sheets, application notes, trade journal reports and press releases.
 
Our sales and marketing efforts are complemented by a team of sales applications engineers who manage field trials and initial installations, as well as provide ongoing pre- and post-sales support.
 
Our marketing efforts are focused on establishing and developing long-term relationships with potential customers. The initial sales cycle for our solutions can be lengthy, typically ranging from six months to twelve months. Our customers typically conduct significant technical evaluations of products before making purchase commitments. We typically negotiate general purchase agreements with our customers. These agreements specify the terms and conditions for the business relationship with our customers. Standard purchase orders are subject to cancellation, postponement or other types of delays.
 
We purchase inventory components and manufacture inventory based on sales forecasts.
 
Backlog
 
Our commercial backlog consists of accepted product purchase orders with scheduled delivery dates during the next twelve months. We had commercial backlog of $352,000 at December 31, 2007, as compared to $75,000 at December 31, 2006.
 
How We Use Government Contracts to Fund Technology Development
 
Our strategy is to continue to pursue government research and development contract awards which complement our commercial product and technology development and allow for commercialization of the underlying technology. Since our inception in 1987, a substantial part of our revenues have been from research and development contracts with the U.S. government or as a subcontractor to a supplier to the U.S. government. Nearly all of these revenues were paid under contracts with the U.S. Department of Defense. We interact with various government agencies to identify opportunities and actively solicit partners for product development proposals. Since 1988, we have successfully obtained a number of classified and non-classified government contracts for superconductor research, including one of the largest non-classified HTS awards from the Defense Advanced Research Projects Agency (DARPA) through the Office of Naval Research. In addition to actively soliciting government contracts, we have participated in the Small Business Innovative Research, (SBIR) and Small Business Technology Transfer (STTR) programs. We have been awarded 34 Phase I SBIR/STTR contracts, each of which typically generates up to $100,000 in revenues. We have been successful in converting nine of these Phase I contracts into Phase II programs, each of which typically generates up to $750,000 in revenues, and we converted one of these contracts into a Phase III program valued at $2.2 million. Since our formation, government contracts have provided us approximately $98 million of revenue and remain a significant source of revenue today. We also develop and sell RF transceiver front-end products that utilize our unique HTS filter and cryogenics technologies to the US Government and we intend to continue growing this government products business.


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Our Manufacturing Capabilities
 
Our manufacturing process involves the assembly of numerous individual components and precision tuning by production technicians. The parts and materials used by us and our contract manufacturers consist primarily of printed circuit boards, specialized subassemblies, fabricated housing, relays and small electric circuit components, such as integrated circuits, semiconductors, resistors and capacitors. Principal components of our AmpLink and SuperPlex products are produced by foreign manufacturers. We currently manufacture our SuperLink systems at our facilities in Santa Barbara, California.
 
In 1998, we opened a state-of-the-art manufacturing facility in Santa Barbara. We renovated these manufacturing areas in early 2003, the first in a series of moves that have enabled us to produce larger quantities of our SuperLink products. In 2003 and 2004, we expanded our controlled clean rooms, continued to develop and introduce new, state-of-the-art production and test equipment and processes, and implemented a continuous flow manufacturing strategy. In addition, performance testing and systems screening methods, along with optimized quality improvement techniques, have been instrumental in enabling our SuperLink units to reach Mean Time Between Failure (MTBF) levels of more than 500,000 hours.
 
We have the physical infrastructure to manufacture up to 2,800 SuperLink units per year. This capacity is unchanged from the prior year. We are holding physical capacity and staffing at their current levels to conserve cash resources. We could expand manufacturing capacity to approximately 5,000 units per year in our current facility with minor additional equipment purchases and staffing increases.
 
Our internal capabilities include a proprietary manufacturing process for thin-film materials that is scaleable for high volume production. In addition, we have established a production operation that we use to produce thin films on wafers for wireless applications. Our radio frequency circuitry is designed, modeled and tested by internal engineering resources. We have in-house capabilities to pattern the superconducting material and all other aspects of radio frequency component production, including packaging the filters. We also have in-house capabilities to manufacture our cryogenic coolers. We have refined our supplier base to improve the quality of received parts, while lowering the cost and decreasing lead-times.
 
In early 2006, we launched our high volume AmpLink assembly and distribution center within the existing Santa Barbara site. The 3,200 square foot production facility has the capacity to produce 10,000 AmpLink units annually which can be increased to 20,000 units with no additional capital expenditure. The production line is supported by a newly refurbished 8,000 square foot warehouse and distribution center. The manufacturing and distributions centers are tightly linked to provide the most efficient and rapid order fulfillment capabilities for up to 200 AmpLink units per week.
 
A number of the parts used in our products are available from only one or a limited number of outside suppliers due to unique component designs as well as certain quality and performance requirements.
 
Intellectual Property
 
We rely upon trade secrets and patents to protect our intellectual property. We execute confidentiality and non-disclosure agreements with our employees and suppliers and limit access to, and distribution of, our proprietary information. We have an on-going program to identify and file applications for both U.S. and international patents for various aspects of our technology. We regard our product designs, design tools, fabrication equipment and manufacturing processes as proprietary and seek to protect our rights in them through a combination of patent, trademark, trade secret and copyright law and internal procedures and non-disclosure agreements. We also seek licenses from third parties for HTS materials and processes used by us, which have been patented by other parties. We believe that our success will depend, in part, on the protection of our proprietary information, patents and the licensing of key technologies from third parties.


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We have an extensive patent portfolio for the technology relevant to our SuperLink products, government products and related business. As of December 31, 2007, we held 53 U.S. patents in the following categories which are currently relevant to this business:
 
  •  6 patents for technologies directed toward producing thin-film materials and structures expiring in 2010 to 2024;
 
  •  26 patents for cryogenic and non-microwave circuit designs expiring in 2010 to 2024;
 
  •  16 patents covering cryogenics, packaging and systems expiring in 2013 to 2024; and
 
  •  5 patents covering other superconducting technologies expiring in 2013 to 2015.
 
We also had 24 U.S. patent applications pending as of December 31, 2007 which are currently relevant to our business. As of that date, we held 14 foreign issued patents and 31 foreign patents pending.
 
We have trade secrets, unpatented technology and proprietary knowledge about the sale, promotion, operation, development and manufacturing of our products. We have confidentiality agreements with our employees and consultants to protect these rights.
 
We own federally registered trademarks to Superconductor Technologies, Conductus and Improving the Quality of Wireless and have several other trademark registrations pending. We own other registered and unregistered trademarks, and have certain trademark rights in foreign jurisdictions.
 
From time to time we grant licenses for our technology to other companies for fields of use that are not relevant to our business. Specifically, we have granted licenses to, among others, (1) Bruker for Nuclear Magnetic Resonance application, (2) General Dynamics for government applications and (3) Star Cryoelectronics for Superconducting Quantum Interference Device applications, among others.
 
We use superconducting technology in our SuperLink solution to improve both the selectivity (rejection of adjacent band interference) and the sensitivity (ability to “hear” signals better) of a base station receiver. Superconducting materials have the ability to conduct electrical energy with little or no resistance when cooled to “critical” temperatures. In contrast, electric currents that flow through conventional conductors encounter resistance that requires power to overcome and generates heat. Substantial improvement in the performance characteristics of electrical systems can be made with superconductors, including reduced power loss, lower heat generation and decreased electrical noise. As these properties have been applied to radio and microwave frequency applications, new products, such as wireless filters, have been developed that are extremely small, highly sensitive and highly frequency selective.
 
The discovery of superconductors was made in 1911. However, a fundamental understanding of the phenomenon of superconductivity eluded physicists until J. Robert Schrieffer (a former director and Chairman of our Technical Advisory Board), John Bardeen (co-inventor of the transistor) and Leon Cooper proposed a theory explaining superconductivity, for which they were awarded the Nobel Prize in Physics in 1972. Until 1986, all superconductor utilization was done at extremely low temperatures, below 23K (-250°C). Superconductors were not widely used in commercial applications because of the high cost and complexities associated with reaching and maintaining such low temperatures. In 1986, high temperature superconductors with critical temperatures greater than 30K (-243°C) were discovered. In early 1987, yttrium barium copper oxide (“YBCO”) was discovered, which has a critical temperature of 93K (-180°C). Shortly thereafter, thallium barium calcium copper oxide (“TBCCO”) was discovered, which has a critical temperature of 125K (-148°C). These discoveries were important because these high temperature superconductors allowed for operating temperatures higher than 77K (-196°C), or the point at which nitrogen liquefies at atmospheric pressure. These high critical temperatures allow superconductors to be cooled using less expensive and more efficient refrigeration processes. We were formed following this discovery for the initial purpose of developing and commercializing high temperature superconductors.
 
We have historically TBCCO as the primary HTS material in our SuperLink product line. In the fourth quarter of 2004, we shifted all of our production from TBCCO to YBCO to lower the product manufacturing cost of the SuperLink. We have a non-exclusive license in the U.S. and selected foreign countries to the primary patents on YBCO from Lucent and TBCCO from the University of Arkansas. We use HTS materials as the base material to


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produce “thin film” microelectronics, primarily RF filters, in our SuperLink product line. We manufacture YBCO using proprietary processes, including proprietary manufacturing techniques. We believe that the process technology we have developed produces state of the art HTS thin-films of the highest quality using YBCO.
 
As part of our strategy to maintain our technological leadership, we have focused our research and development activities on HTS materials, RF circuitry, cryogenic design and product application. We utilize a proprietary manufacturing process for HTS thin-film production, the base material for our filtering products. An in-house design team develops the filters, which are packaged into a vacuum-sealed container for thermal insulation. The filter package is integrated with our cryogenic cooler and the necessary control electronics into a complete system that is deployed in conjunction with new or existing wireless base stations.
 
We have devoted a significant portion of our engineering resources to design and model the complex RF circuitry that is basic to our products. The expertise of this highly qualified team has allowed us to design and fabricate very precise individual components, such as RF signal filters. We have developed computer simulation systems to design our products and this RF circuitry design capability has allowed us to produce extremely small, high-performance circuits. Some of our design and engineering innovations have been patented; others are the subjects of pending patent applications. We believe that our RF engineering expertise provides us with a unique competitive advantage. These capabilities also allow us to begin pursuing additional market segments, such as in the area of handset filters.
 
The availability of a low-cost, highly reliable, compact cooling technology is critical to the successful commercialization of our superconducting products. Prior to our efforts, no such cryogenic cooler had been commercially available. In response to this lack of availability, we developed a low-cost, highly reliable low-power cooler designed to cool to 77K (-196°C) with sufficient cooling capacity for our superconducting applications. Our SuperLink systems have logged in excess of 200 million hours of cumulative operation. The cryogenic coolers in our current models have demonstrated a “mean time between failure” (the industry standard measurement) of greater than one million hours. The design was based in part on patents licensed by us from Sunpower, Inc. We believe our internally developed cooler, which is both compact enough and reliable enough to meet the most demanding wireless industry standards, provides us with a significant and unique competitive advantage.
 
Cooling to cryogenic temperatures requires proper thermal isolation and packaging. Any superconducting or other cryogenically cooled device must be maintained at its optimal operating temperature, and its interaction with higher temperature components must be controlled. We have developed a variety of proprietary and patented cryogenic packaging innovations to satisfy this requirement.
 
Competition
 
The wireless communication market is intensely competitive. We face competition in various aspects of our technology and product development and in each of our target markets. Our products compete on the basis of performance, functionality, reliability, pricing, quality, and compliance with industry standards. Our current and potential competitors include conventional RF filter manufacturers and both established and newly emerging companies developing similar or competing HTS technologies. We also compete with companies that design, manufacture and sell antenna-optimizing multiplexers and companies that seek to enhance base station range and selectivity by means other than a superconducting filter. The primary competitors use tower mounted and ground mounted amplifiers, conventional filters, repeaters or “smart antenna” technologies. Tower mounted and ground mounted amplifiers pass an RF signal received by an antenna through a broad filter, followed by a low noise amplifier. These units are produced by a number of companies, which include most of the base station original equipment manufacturers (OEMs) such as Ericsson and Nokia. Filter manufacturers, including Andrew, Powerwave, and Radio Frequency Systems, also produce these units. Smart antennas allow base stations to focus energy more directly on individual wireless devices in order to improve capacity. Some competitors have significantly greater financial, technical, manufacturing, sales, marketing and other resources. Some competitors have achieved greater name recognition for their products and technologies.
 
In addition, we currently supply components and license technology to several companies that may eventually decide to manufacture or design their own HTS components, rather than purchasing or licensing our technology. With respect to our HTS materials, we compete with THEVA among others. In the government sector, we compete


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with universities, national laboratories and both large and small companies for research and development contracts, and with larger defense contractors, such as Raytheon and Northrop Grumman for government products.
 
Employees
 
We employed a total of 129 people as of December 31, 2007: 54 in manufacturing, 35 in research and development, 19 in sales and marketing and 21 in administration. Nine of our employees have Ph.D.s, and fourteen others hold advanced degrees in physics, materials science, electrical engineering and other fields. Our employees are not represented by a labor union and we believe that our employee relations are good.
 
Environmental Issues
 
We use certain hazardous materials in our research, development and manufacturing operations. As a result, we are subject to stringent federal, state and local regulations governing the storage, use and disposal of such materials. Current or future laws and regulations could require substantial expenditures for preventative or remedial action, reduction of chemical exposure, waste treatment or disposal. Although we believe that our safety procedures for the handling and disposing of hazardous materials comply with the standards prescribed by state and federal regulations, there is always the risk of accidental contamination or injury from these materials. To date, we have not incurred substantial expenditures for preventive action with respect to hazardous materials or for remedial action with respect to any hazardous materials accident, but the use and disposal of hazardous materials involves the risk that we could incur substantial expenditures for such preventive or remedial actions. If such an accident occurred, we could be held liable for resulting damages. The liability in the event of an accident or the costs of such remedial actions could exceed our resources or otherwise have a material adverse effect on our financial condition, results of operations or cash flows.
 
ITEM 1A.    RISK FACTORS
 
The following section includes some of the material factors that may adversely affect our business and operations. This is not an exhaustive list, and additional factors could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for us to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. This discussion of risk factors includes many forward-looking statements. For cautions about relying on such forward looking statements, please refer to the section entitled “Forward Looking Statements” at the beginning of this Report immediately prior to Item 1.
 
Risks Related to Our Business
 
We have a history of losses and may never become profitable.
 
In each of our last five years, we have experienced significant net losses and negative cash flows from operations. If we fail to increase our revenues, we may not achieve and maintain profitability and may not meet our expectations or the expectations of financial analysts who report on our stock.
 
We may need to raise additional capital, and if we are unable to raise capital our ability to implement our current business plan and ultimately our viability as a company could be adversely affected.
 
In 2007, we incurred a net loss of $9.1 million and had negative cash flows from operations of $5.4 million. In 2006, we incurred a net loss of $29.6 million and had negative cash flows from operations of $7.3 million. Our independent registered public accounting firm has included in their audit report for fiscal 2007 and 2006 an explanatory paragraph expressing doubt about our ability to continue as a going concern. Our prior independent registered public accounting firm included a similar explanatory paragraph in their audit report for 2005.
 
Our principal sources of liquidity consist of existing cash balances and funds expected to be generated from future operations. We believe one of the key factors to our liquidity will be our ability to successfully execute on our


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plans to increase sales levels in a highly concentrated industry where we experience significant fluctuations in sales from quarter to quarter. Our cash requirements will also depend on numerous other variable factors, including the rate of growth of sales, the timing and levels of products purchased, payment terms and credit limits from manufacturers, and the timing and level of accounts receivable collections.
 
At December 31, 2007 we had $3.9 million in cash and in January 2008 we received the remaining $11.0 million from our investment agreement with Hunchun BaoLi Communication Co. Ltd., or BAOLI, whereby in exchange for $15.0 million in cash we issued to BAOLI and two related purchasers a total of (a) 3,101,361 shares of our common stock and (b) 611,523 shares of our Series A Preferred Stock (convertible under certain conditions into 6,115,230 shares of our common stock). If actual cash flows deviate significantly from forecasted amounts or if we believe operations require additional funding we cannot assure you that additional financing will be available on acceptable terms or at all.
 
If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise any needed funds, it might be forced to make further substantial reductions in our operating expenses, which could adversely affect our ability to implement our current business plan and ultimately our viability as a company.
 
We rely on a small number of customers for the majority of our commercial revenues and the loss of any one of these customers, or a significant loss, reduction or rescheduling of orders from any of these customers, could have a material adverse effect on our business, results of operations and financial condition.
 
We sell most of our products to a small number of wireless carriers. We derived 75% of our commercial product revenues from Verizon Wireless and AT&T in 2007 and 96% of our commercial product revenues from ALLTEL, Verizon Wireless and T-Mobile in 2006. Our future success depends upon the wireless carriers continuing to purchase our products, and fluctuations in demand from such customers could negatively impact our results. Unanticipated demand fluctuations can have a negative impact on our revenues and business and an adverse effect on our results of operations and financial condition.
 
In addition, our dependence on a small number of major customers exposes us to numerous other risks, including:
 
  •  a slowdown or delay in the deployment, upgrading or improvement of wireless networks by any one customer could significantly reduce demand for our products;
 
  •  reductions in a single customer’s forecasts and demand could result in excess inventories;
 
  •  each of our customers have significant purchasing leverage over us to require changes in sales terms including pricing, payment terms and product delivery schedules; and
 
  •  concentration of accounts receivable credit risk, which could have a material adverse effect on our liquidity and financial condition if one of our major customers declared bankruptcy or delayed payment of their receivables.
 
Many of our customers also provide minimal lead-time prior to the release of their purchase orders and have non-binding commitments to purchase from us. If we fail to forecast our customer’s demands accurately, we could experience delays in manufacturing which could result in customer dissatisfaction. Additionally, these factors further impact our ability to forecast future revenue.
 
The wireless communication industry is highly concentrated, which limits the number of potential customers, and further industry consolidation could result in the loss of key customers.
 
The wireless communication industry is highly concentrated in nature and may become more concentrated due to anticipated industry consolidation. As a result, we believe that the number of potential customers for our products


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may be limited. We also face significant risks in the event any of our key customers is acquired by a company that has not adopted our technology or not adopted it to the same extent. In that event, we could face a significant decline in our sales to the acquired customer.
 
We experience significant fluctuations in sales and operating results from quarter to quarter.
 
Our quarterly results fluctuate due to a number of factors, including:
 
  •  the lack of any contractual obligation by our customers to purchase their forecasted demand for our products;
 
  •  variations in the timing, cancellation, or rescheduling of customer orders and shipments; and
 
  •  high fixed expenses that may disproportionately impact operating expenses, especially during a quarter with a sales shortfall.
 
The nature of our business requires that we promptly ship products after we receive orders. This means that we typically do not have a significant backlog of unfilled orders at the start of each quarter. We have also regularly generated a large percentage of our revenues in the last month of a quarter. Our major customers generally have no contractual obligation to purchase forecasted amounts and may cancel orders, change delivery schedules or change the mix of products ordered with minimal notice and minimal penalty. As a result of these factors, we may not be able to accurately predict our quarterly sales. Any shortfall in sales relative to our quarterly expectations or any delay of customer orders would adversely affect our revenues and results of operations.
 
Order deferrals and cancellations by our customers, declining average sales prices, changes in the mix of products sold, increases in inventory and finished goods, delays in the introduction of new products and longer than anticipated sales cycles for our products have, in the past, adversely affected our results of operations. Despite these factors, we maintain significant finished goods, work-in-progress and raw materials inventory to meet estimated order forecasts. If our customers purchase less than the forecasted amounts or cancel or delay existing purchase orders, there will be higher levels of inventory that face a greater risk of obsolescence. If our customers desire to purchase products in excess of the forecasted amounts or in a different product mix, there may not be enough inventory or manufacturing capacity to fill their orders.
 
Due to these and other factors, our past results may not be reliable indicators of our future performance. Future revenues and operating results may not meet the expectations of stock analysts and investors. In either case, the price of our common stock could be materially adversely affected.
 
Our sales cycles are unpredictable, making future performance uncertain.
 
The sales cycle for telecommunications products includes identification of decision makers within the customers’ organizations, development of an understanding of customer-specific performance and economic issues, convincing the customer through field trial reports of the benefits of systems offered, negotiation of purchase orders and deployment. Customers who purchase our systems must commit a significant amount of capital and other resources. Our customers must consider budgetary constraints, comply with internal procedures for approving large expenditures and complete whatever testing is necessary for them to integrate new technologies that will impact their key operations. Customer delays can lengthen the sales cycles and have a material adverse effect on our business.
 
We depend on the capital spending patterns of wireless network operators, and if capital spending is decreased or delayed, our business may be harmed.
 
Because we rely on wireless network operators for product purchases, any substantial decrease or delay in capital spending patterns in the wireless communication industry may harm our business. Demand from customers for our products depends to a significant degree upon the amount and timing of capital spending by these customers for constructing, rebuilding or upgrading their systems. The capital spending patterns of wireless network operators depend on a variety of factors, including access to financing, the status of federal, local and foreign government regulation and deregulation, changing standards for wireless technology, overall demand for wireless services, competitive pressures and general economic conditions. In addition, capital spending patterns in the wireless


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industry can be subject to some degree of seasonality, with lower levels of spending in the first and third calendar quarters, based on annual budget cycles.
 
Our reliance on a limited number of suppliers and the long lead time of components for our products could impair our ability to manufacture and deliver our systems on a timely basis.
 
A number of components used in our products are available from only one or a limited number of outside suppliers due to unique designs as well as certain quality and performance requirements. We currently purchase substrates for growth of high-temperature superconductor thin-films from a single supplier because of the quality of their substrates. A thin film is a thin layer of high-temperature superconductor material. There are additional components that we source from a single vendor due to the present volume. Key components of our conventional products are manufactured by sole foreign manufacturer. Our reliance on sole or limited source suppliers involves certain risks and uncertainties, many of which are beyond our control. These include the possibility of a shortage or the discontinuation of certain key components. Any reduced availability of these parts or components when required could impair our ability to manufacture and deliver our systems on a timely basis and result in the delay or cancellation of orders, which could harm our business.
 
In addition, the purchase of some of our key components involves long lead times and, in the event of unanticipated increases in demand for our solutions, we may be unable to obtain these components in sufficient quantities to meet our customers’ requirements. We do not have guaranteed supply arrangements with any of these suppliers, do not maintain an extensive inventory of parts or components and customarily purchase sole or limited source parts and components pursuant to purchase orders. Business disruptions, quality issues, production shortfalls or financial difficulties of a sole or limited source supplier could materially and adversely affect us by increasing product costs, or eliminating or delaying the availability of such parts or components. In such events, our inability to develop alternative sources of supply quickly and on a cost-effective basis could impair our ability to manufacture and deliver our systems on a timely basis and could harm our business.
 
Our reliance on a limited number of suppliers exposes us to quality control issues.
 
Our reliance on certain single-source and limited-source components exposes us to quality control issues if these suppliers experience a failure in their production process or otherwise fail to meet our quality requirements. A failure in single-source or limited-source components or products could force us to repair or replace a product utilizing replacement components. If we cannot obtain comparable replacements or effectively return or redesign our products, we could lose customer orders or incur additional costs, which could have a material adverse effect on our gross margins and results of operations.
 
We expect decreases in average selling prices, requiring us to reduce product costs in order to achieve and maintain profitability.
 
The average selling price of our products has decreased over the years. We anticipate customer pressure on our product pricing will continue for the foreseeable future. We have plans to further reduce the manufacturing cost of our products, but there is no assurance that our future cost reduction efforts will keep pace with price erosion. We will need to further reduce our manufacturing costs through engineering improvements and economies of scale in production and purchasing in order to achieve adequate gross margins. We may not be able to achieve the required product cost savings at a rate needed to keep pace with competitive pricing pressure. Additionally, we may be forced to discount future orders. If we fail to reach our cost saving objectives or we are required to offer future discounts, our business may be harmed.
 
Our ability to protect our patents and other proprietary rights is uncertain, exposing us to possible losses of competitive advantage.
 
Our efforts to protect our proprietary rights may not succeed in preventing infringement by others or ensure that these rights will provide us with a competitive advantage. Pending patent applications may not result in issued patents and the validity of issued patents may be subject to challenge. Third parties may also be able to design around the patented aspects of the products. Additionally, certain of the issued patents and patent applications are


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owned jointly with third parties. Because any owner or co-owner of a patent can license its rights under jointly-owned patents or applications, inventions made by us jointly with others are not subject to our exclusive control. Any of these possible events could result in losses of competitive advantage.
 
We depend on specific patents and licenses to technologies, and we will likely need additional technologies in the future that we may not be able to obtain.
 
We utilize technologies under licenses of patents from others for our products. These patents may be subject to challenge, which may result in significant litigation expense (which may or may not be recoverable against future royalty obligations). Additionally, we continually try to develop new products, and, in the course of doing so, we may be required to utilize intellectual property rights owned by others and may seek licenses to do so. Such licenses may not be obtainable on commercially reasonable terms, or at all. It is also possible that we may inadvertently utilize intellectual property rights held by others, which could result in substantial claims.
 
Intellectual property infringement claims against us could materially harm results of operations.
 
Our products incorporate a number of technologies, including high-temperature superconductor technology, technology related to other materials, and electronics technologies. Our patent positions, and that of other companies using high-temperature superconductor technology, is uncertain and there is significant risk that others, including our competitors or potential competitors, have obtained or will obtain patents relating to our products or technologies or products or technologies planned to be introduced by us.
 
We believe that patents may be or have been issued, or applications may be pending, claiming various compositions of matter used in our products. We may need to secure one or more licenses of these patents. There can be no assurances that such licenses could be obtained on commercially reasonable terms, or at all. We may be required to expend significant resources to develop alternatives that would not infringe such patents or to obtain licenses to the related technology. We may not be able to successfully design around these patents or obtain licenses to them and may have to defend ourselves at substantial cost against allegations of infringement of third party patents or other rights to intellectual property. In those circumstances, we could face significant liabilities and also be forced to cease the use of key technology.
 
We currently rely on specific technologies and may not successfully adapt to the rapidly changing wireless telecommunications equipment market.
 
Wireless telecommunication equipment is characterized by rapidly advancing technology. Our success depends upon our ability to keep pace with advancing wireless technology, including materials, processes and industry standards. For example, we had to redesign our SuperLink product to convert from thallium barium calcium copper oxide to yttrium barium copper oxide in order to reduce the product cost and compete with other technologies. However, even with the lower cost HTS material, SuperLink may not ultimately prove commercially competitive against other current technologies or those that may be discovered in the future.
 
We will have to continue to develop and integrate advances to our core technologies. We will also need to continue to develop and integrate advances in complementary technologies. We cannot guarantee that our development efforts will not be rendered obsolete by research efforts and technological advances made by others.
 
Other parties may have the right to utilize technology important to our business.
 
We utilize certain intellectual property rights under non-exclusive licenses or have granted to others the right to utilize certain intellectual property rights licensed from a third party. Because we may not have the exclusive rights to utilize such intellectual property, other parties may be able to compete with us, which may harm our business.
 
Our failure to anticipate and respond to developments in the wireless telecommunications market could substantially harm our business.
 
Our efforts are focused on the wireless telecommunications market, including the 2G, 2.5G and 3G markets. The dedication of our resources to the wireless telecommunications market makes us potentially vulnerable to


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changes in this market, such as new technologies like WIMAX, future competition, changes in availability of capital resources or regulatory changes that could affect the competitive position and rate of growth of the wireless industry.
 
We may not be able to compete effectively against alternative technologies.
 
Our products compete with a number of alternative approaches and technologies that increase the capacity and improve the quality of wireless networks. Some of these alternatives may be more cost effective or offer better performance than our products. Wireless network operators may opt to increase the number of transmission stations, increase tower heights, install filters and amplifiers at the top of towers or use advanced antenna technology in lieu of purchasing our products. We may not succeed in competing against these alternatives.
 
We depend upon government contracts for a substantial amount of revenue and our business may suffer if significant contracts are terminated, adversely modified, or we are unable to win new contracts.
 
We derive a portion of our revenue from a few large contracts with the U.S. government. As a result, a reduction in, or discontinuance of, the government’s commitment to current or future programs could materially reduce government contract revenue.
 
Contracts involving the U.S. government may include various risks, including:
 
  •  termination by the government;
 
  •  reduction or modification in the event of changes in the government’s requirements or budgetary constraints;
 
  •  increased or unexpected costs causing losses or reduced profits under contracts where prices are fixed or unallowable costs under contracts where the government reimburses for costs and pays an additional premium;
 
  •  risks of potential disclosure of confidential information to third parties;
 
  •  the failure or inability of the main contractor to perform its contract in circumstances where we are a subcontractor;
 
  •  the failure of the government to exercise options for additional work provided for in the contracts; and
 
  •  the government’s right in certain circumstances to freely use technology developed under these contracts.
 
The programs in which we participate may extend for several years, but are normally funded on an annual basis. The U.S. government may not continue to fund programs under which we have entered into contracts. Even if funding is continued, we may fail to compete successfully to obtain funding within such programs.
 
All costs for services under government contracts are subject to audit, and the acceptance of such costs as allowable and allocable is subject to federal regulatory guidelines. We record contract revenues in amounts which we expect to be realized upon final audit settlement. Any disallowance of costs by the government could have an adverse effect on our business, operating results and financial condition. Audits and adjustments may result in decreased revenues and net income for those years. Additionally, because of our participation in government contracts, we are subject to audit from time to time for our compliance with government regulations by various agencies. Government agencies may conduct inquiries or investigations that may cover a broad range of activity. Responding to any such audits, inquiries or investigations may involve significant expense and divert management’s attention. In addition, an adverse finding in any such audit, inquiry or investigation could involve penalties that may harm our business.
 
Because competition for target employees is intense, we may be subject to claims of unfair hiring practices, trade secret misappropriation or other related claims.
 
Companies in the wireless telecommunications industry whose employees accept positions with competitors frequently claim that competitors have engaged in unfair hiring practices, trade secret misappropriation or other related claims. We may be subject to such claims in the future as we seek to hire qualified personnel, and such


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claims may result in material litigation. If this should occur, we could incur substantial costs in defending against these claims, regardless of their merits.
 
If we are unable to forecast our inventory needs accurately, we may be unable to obtain sufficient manufacturing capacity or may incur unnecessary costs and produce excess inventory.
 
We forecast our inventory needs based on anticipated purchase orders to determine manufacturing requirements. If we overestimate demand, we may have excess inventory, and our suppliers may as well, which could increase our costs. If we underestimate our requirements, our suppliers may have inadequate inventory, which could interrupt manufacturing and result in delays in shipments and recognition of revenues. In addition, lead times for ordering materials and components vary significantly and depend on factors such as the specific supplier, contract terms and demand for any component at a given time. Accordingly, if we inaccurately forecast demand, we may be unable to obtain adequate manufacturing capacity from our suppliers to meet customers’ delivery requirements, which would harm our business.
 
Our success depends on the attraction and retention of senior management and technical personnel with relevant expertise.
 
As a competitor in a highly technical market, we depend heavily upon the efforts of our existing senior management and technical teams. The loss of the services of one or more members of these teams could slow product development and commercialization objectives. Due to the specialized nature of our products, we also depend upon our ability to attract and retain qualified technical personnel with substantial industry knowledge and expertise. Competition for qualified personnel is intense and we may not be able to continue to attract and retain qualified personnel necessary for the development of our business.
 
We have experienced difficulty recruiting senior management due to the high cost of living in the Santa Barbara area. We have a limited pool of qualified executives in Santa Barbara and may attempt to recruit qualified candidates from across the country. Some candidates have cited the high cost of housing in Santa Barbara as a significant negative factor when considering our employment offers. We have mitigated this problem to a limited extent by allowing some executives to maintain their existing residences in other parts of the country and effectively “commute” to our corporate headquarters in Santa Barbara as needed to perform their duties. Regardless, we expect the cost of housing in our area will continue to present a significant obstacle to recruiting senior executives.
 
Regulatory changes negatively affecting wireless communications companies could substantially harm our business.
 
The Federal Communications Commission strictly regulates the operation of wireless base stations in the United States. Other countries also regulate the operation of base stations within their territories. Base stations and equipment marketed for use in base stations must meet specific technical standards. Our ability to sell our high-temperature superconductor filter subsystems will depend upon the rate of deployment of other new wireless digital services, the ability of base station equipment manufacturers and of base station operators to obtain and retain the necessary approvals and licenses, and changes in regulations that may impact the product requirements. Any failure or delay of base station manufacturers or operators in obtaining necessary approvals could harm our business.
 
We may acquire or make investments in companies or technologies that could cause loss of value to stockholders and disruption of business.
 
We may explore opportunities to acquire companies or technologies in the future. Other than the acquisition of Conductus, Inc. in 2002, we have not made any such acquisitions or investments to date and, therefore, our ability as an organization to make acquisitions or investments is unproven. Entering into an acquisition entails many risks, any of which could adversely affect our business, including:
 
  •  failure to integrate operations, services and personnel;
 
  •  the price paid may exceed the value eventually realized;
 
  •  loss of share value to existing stockholders as a result of issuing equity securities to finance an acquisition;


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  •  potential loss of key employees from either our then current business or any acquired business;
 
  •  entering into markets in which we have little or no prior experience;
 
  •  diversion of financial resources and management’s attention from other business concerns;
 
  •  assumption of unanticipated liabilities related to the acquired assets; and
 
  •  the business or technologies acquired or invested in may have limited operating histories and may be subjected to many of the same risks to which we are exposed.
 
In addition, future acquisitions may result in potentially dilutive issuances of equity securities, or the incurrence of debt, contingent liabilities or amortization expenses or charges related to goodwill or other intangible assets, any of which could harm our business. As a result, if we fail to properly evaluate and execute acquisitions or investments, our business and prospects may be seriously harmed.
 
If we are unable to implement appropriate controls and procedures to manage our expected growth, we may not be able to successfully offer our products and implement our business plan.
 
Our ability to successfully offer our products and implement our business plan in a rapidly evolving market requires an effective planning and management process. Anticipated growth in future operations will continue to place a significant strain on management systems and resources. We expect that we will need to continue to improve our financial and managerial controls, reporting systems and procedures, and will need to continue to expand, train and manage our work force worldwide. Furthermore, we expect that we will be required to manage multiple relationships with various customers and other third parties.
 
Compliance with environmental regulations could be especially costly due to the hazardous materials used in the manufacturing process.
 
We are subject to a number of federal, state and local governmental regulations related to the use, storage, discharge and disposal of toxic, volatile or otherwise hazardous chemicals used in our business. Any failure to comply with present or future regulations could result in fines being imposed, suspension of production or interruption of operations. In addition, these regulations could restrict our ability to expand or could require us to acquire costly equipment or incur other significant expense to comply with environmental regulations or to clean up prior discharges.
 
The reliability of market data included in our public filings is uncertain.
 
Since we operate in a rapidly changing market, we have in the past, and may from time to time in the future, include market data from industry publications and our own internal estimates in some of the documents we file with the Securities Exchange Commission. The reliability of this data cannot be assured. Industry publications generally state that the information contained in these publications has been obtained from sources believed to be reliable, but that its accuracy and completeness is not guaranteed. Although we believe that the market data used in our SEC filings is and will be reliable, it has not been independently verified. Similarly, internal company estimates, while believed by us to be reliable, have not been verified by any independent sources.
 
Our international operations expose us to certain risks.
 
In November 2007, we signed a binding definitive agreement for a joint venture with BAOLI to manufacture and market our SuperLink ® interference elimination solution for the China market. In addition to facing many of the risks faced by our domestic business, if that joint venture or any other international operation we may have is to be successful, we (together with any joint venture partner) must recruit the necessary personnel and develop the facilities needed to manufacture and sell the products involved, must learn about the local market (which may significantly different from our domestic market), must build brand awareness among potential customers and must compete successfully with local organizations with greater market knowledge and potentially greater resources than we have. We must also obtain a number of critical governmental approvals from both the United States and the local country governments on a timely basis, including those related to any transfers of our technology. We must establish


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sufficient controls on any foreign operations to ensure that those operations are operated in accordance with our interests, that our intellectual property is protected and that our involvement does not inadvertently create potential competitors. There can be no assurance that these conditions will be met. Even if they are met, the process of building our international operations could divert financial resources and management attention from other business concerns. Finally, our international operations will also be subject to the general risks of international operations, such as:
 
  •  changes in exchange rates;
 
  •  international political and economic conditions;
 
  •  changes in government regulation in various countries;
 
  •  trade barriers;
 
  •  adverse tax consequences; and
 
  •  costs associated with expansion into new territories.
 
Risks Related to Our Common Stock
 
Our stock price is volatile.
 
The market price of our common stock has been, and we expect will continue to be, subject to significant volatility. The value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:
 
  •  our perceived prospects;
 
  •  variations in our operating results and whether we have achieved key business targets;
 
  •  changes in, or our failure to meet, earnings estimates;
 
  •  changes in securities analysts’ buy/sell recommendations;
 
  •  differences between our reported results and those expected by investors and securities analysts;
 
  •  announcements of new contracts by us or our competitors;
 
  •  market reaction to any acquisitions, joint ventures or strategic investments announced by us or our competitors; and
 
  •  general economic, political or stock market conditions.
 
Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the market price of our common stock are beyond our control. The market price of our common stock at any particular time may not remain the market price in the future.
 
We have a significant number of outstanding warrants and options, and future sales of these shares could adversely affect the market price of our common stock.
 
As of December 31, 2007, we had outstanding warrants and options exercisable for an aggregate of 1,210,603 shares of common stock at a weighted average exercise price of $25.92 per share. We have registered the issuance of all these shares, and they will be freely tradable by the exercising party upon issuance. The holders may sell these shares in the public markets from time to time, without limitations on the timing, amount or method of sale. As our stock price rises, the holders may exercise their warrants and options and sell a large number of shares. This could cause the market price of our common stock to decline.


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Our corporate governance structure may prevent our acquisition by another company at a premium over the public trading price of STI shares.
 
It is possible that the acquisition of a majority of our outstanding voting stock by another company could result in our stockholders receiving a premium over the public trading price for our shares. Provisions of our restated certificate of incorporation and bylaws and of Delaware corporate law could delay or make more difficult an acquisition of our company by merger, tender offer or proxy contest, even if it would create an immediate benefit to our stockholders. For example, our restated certificate of incorporation does not permit stockholders to act by written consent and our bylaws generally require ninety days advance notice of any matters to be brought before the stockholders at an annual or special meeting.
 
In addition, our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the terms, rights and preferences of this preferred stock, including voting rights of those shares, without any further vote or action by the stockholders. The rights of the holders of common stock may be subordinate to, and adversely affected by, the rights of holders of preferred sock that may be issued in the future. The issuance of preferred stock could also make it more difficult for a third party to acquire a majority of our outstanding voting stock, even at a premium over our public trading price.
 
Further, our certificate of incorporation also provides for a classified board of directors with directors divided into three classes serving staggered terms. These provisions may have the effect of delaying or preventing a change in control of STI without action by our stockholders and, therefore, could adversely affect the price of our stock or the possibility of sale of shares to an acquiring person.
 
We do not anticipate declaring any cash dividends on our common stock.
 
We have never declared or paid cash dividends on our common stock and do not plan to pay any cash dividends in the near future. Our current policy is to retain all funds and earnings for use in the operation and expansion of our business. In addition, our debt agreements prohibit the payment of cash dividends or other distributions on any of our capital stock except dividends payable in additional shares of capital stock.
 
ITEM 1B.    UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.    PROPERTIES
 
We lease all of our properties. All of our operations, including our manufacturing facility, are located in an industrial complex in Santa Barbara, California. We occupy approximately 71,000 square feet in this complex under a long-term lease that expires in 2011. We believe that our Santa Barbara facilities are adequate to meet current and reasonably anticipated needs for approximately the next two years.
 
ITEM 3.    LEGAL PROCEEDINGS
 
Settlement of Shalvoy Litigation
 
Mr. Shalvoy, a director and stockholder, executed two notes aggregating $820,244 in principal in connection with the exercise in December 2000 of two options to purchase Conductus, Inc. common stock prior our acquisition of Conductus, Inc. in December 2002. Through the third quarter of, 2005, we carried the principal (as “Notes Receivable from Stockholder”) and accrued interest (as “Prepaid Expenses and Other Current Assets”) for both notes as assets on our balance sheet.
 
We filed a lawsuit against Mr. Shalvoy on December 21, 2005 in the California Superior Court (Case No. 1186812) to collect both notes. In that same quarter, due to Mr. Shalvoy’s refusal to pay the notes voluntarily we recorded a reserve for the value of the notes (principal plus accrued interest) in excess of the market value of the collateral securing the notes.
 
On March 2, 2007, we entered into a Settlement Agreement and Mutual Release of All Claims with Mr. Shalvoy to settle the lawsuit. As per the agreement, we received a payment of $610,000 on April 2, 2007


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in payment of one note, including interest and attorneys’ fees, and the rescission of Mr. Shalvoy’s second purported option exercise including cancellation of the related note.
 
Routine Litigation
 
We may be involved in routine litigation arising in the ordinary course of our business, and, while the results of the proceedings cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our financial position, operating results or cash flow.
 
ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Our 2007 Annual Meeting of Shareholders was held on October 23, 2007. The following matters were submitted to a vote of our shareholders:
 
1. Election of two Class 3 Directors. The following directors were elected to hold office until the 2010 Annual Meeting or until their successors are elected and qualified:
 
                 
Directors
  Votes For     Votes Withheld  
 
John D. Lockton
    10,279,801       210,743  
David W. Vellequette
    10,287,800       202,744  
 
2. Approval to Amend the 2003 Equity Incentive Plan:
 
                 
In Favor Of
  Against     Abstain  
 
2,425,588
    148,018       18,737  
 
3. Ratification of the appointment of Stonefield Josephson, Inc. as the Company’s Independent Registered Public Accounting Firm for the year ending December 31, 2007.
 
                 
In Favor Of
  Against     Abstain  
 
10,277,793
    53,137       159,614  
 
PART II
 
ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Market for Common Stock
 
Our common stock is traded on the NASDAQ Capital Market under the symbol “SCON.” The following table shows the high and low intraday sales prices for our common stock as reported by NASDAQ for each calendar quarter in the last two fiscal years:
 
                         
    High     Low        
 
2007
                       
Quarter ended March 31, 2007
  $ 2.60     $ 1.60          
Quarter ended June 30, 2007
  $ 2.16     $ 1.40          
Quarter ended September 29, 2007
  $ 10.90     $ 1.38          
Quarter ended December 31, 2007
  $ 13.77     $ 5.50          
2006
                       
Quarter ended April 1, 2006
  $ 6.70     $ 3.21          
Quarter ended July 1, 2006
  $ 4.54     $ 1.90          
Quarter ended September 30, 2006
  $ 2.10     $ 1.30          
Quarter ended December 31, 2006
  $ 3.24     $ 1.43          


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Holders of Record
 
We had 123 holders of record of our common stock on February 29, 2008. This number does not include stockholders for whom shares were held in a “nominee” or “street” name. We estimate that there are more than 15,000 round lot beneficial owners of our common stock.
 
Dividends
 
We have never paid cash dividends and intend to employ all available funds in the development of our business. We have no plans to pay cash dividends in the near future, and our line of credit does not allow the payment of dividends.
 
Our ability to declare or pay dividends on shares of our common stock is subject to the requirement that we pay an equivalent dividend on each outstanding share of Series A Preferred (on an as converted basis).
 
Sales of Unregistered Securities
 
We did not conduct any offerings of equity securities during the fourth quarter of 2007 that were not registered under the Securities Act of 1933.
 
Repurchases of Equity Securities
 
We did not repurchase any shares of our common stock during the fourth quarter of 2007.
 
Securities Authorized for Issuance Under Equity Compensation Plans
 
                         
                Number of
 
                Securities
 
    Number of
          Remaining Available
 
    Securities to Be
          for Future Issuance
 
    Issued Upon
    Weighted-Average
    Under Equity
 
    Exercise of
    Exercise Price of
    Compensation Plans
 
    Outstanding
    Outstanding
    (Excluding
 
    Options, Warrants
    Options, Warrants
    Securities
 
Plan Category
  and Rights     and Rights     Reflected in Column(a))  
 
Equity compensation plans approved by security holders
    741,858     $ 34.24       1,575,397  
Equity compensation plans not approved by security holders
                 
                         
Total
    741,858     $ 34.24       1,575,397  
                         


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Stock Performance Graph
 
The graph and table below compare the cumulative total stockholders’ return on our common stock since December 31, 2002 with the Nasdaq Composite Index, and the Nasdaq Telecommunications Index over the same period (assuming the investment of $100 in our common stock and in the two other indices, and reinvestment of all dividends).
 
 
                                                             
      31-Dec-02     31-Dec-03     31-Dec-04     31-Dec-05     31-Dec-06     31-Dec-07
Superconductor Technologies
    $ 100.00       $ 591.49       $ 147.87       $ 45.74       $ 18.83       $ 59.04  
Nasdaq Composite
      100.00         150.01         162.89         165.13         180.85         198.60  
Nasdaq-Telecommunications
      100.00         168.74         182.23         169.09         216.03         235.85  
                                                             


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ITEM 6.    SELECTED FINANCIAL DATA
 
The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with our Financial Statements and Notes thereto appearing in Item 15 of Part IV of this Report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
 
                                         
    Year Ended December 31,  
    2003     2004     2005     2006     2007  
    (In thousands, except per share data)  
 
Statement of Operations Data:
                                       
Net revenues:
                                       
Net commercial product revenues
  $ 38,577     $ 16,787     $ 21,080     $ 17,697     $ 12,787  
Government contract revenues
    10,759       6,189       3,107       3,361       5,115  
Sub license royalties
    58       28       22       20        
                                         
Total net revenues
    49,394       23,004       24,209       21,078       17,902  
Costs and expenses:
                                       
Cost of commercial product revenues
    28,249       23,421       18,989       15,922       12,944  
Contract research and development
    6,899       4,465       2,806       2,407       2,906  
Other research and development
    4,697       5,036       4,214       3,488       3,172  
Selling, general and administrative
    20,567       16,051       11,442       9,086       8,123  
Restructuring expenses and impairment charges
          4,128       1,197       38        
Write off of Goodwill
                      20,107        
                                         
Total costs and expenses
    60,412       53,101       38,648       51,048       27,145  
                                         
Loss from operations
    (11,018 )     (30,097 )     (14,439 )     (29,970 )     (9,243 )
Other income (expense), net
    (327 )     (1,120 )     226       346       117  
                                         
Net loss
  $ (11,345 )   $ (31,217 )   $ (14,213 )   $ (29,624 )   $ (9,126 )
                                         
Basic and diluted net loss per share:
                                       
Net loss per common share
  $ (1.81 )   $ (3.71 )   $ (1.24 )   $ (2.37 )   $ (0.73 )
                                         
Weighted average number of shares Outstanding
    6,269       8,424       11,419       12,483       12,488  
 
                                         
    December 31,  
    2003     2004     2005     2006     2007  
 
Balance Sheet Data:
                                       
Cash and cash equivalents
  $ 11,144     $ 12,802     $ 13,018     $ 5,487     $ 3,939  
Working capital
    15,576       16,146       17,218       10,158       3,293  
Total assets
    68,123       62,358       52,045       21,904       16,625  
Long-term debt, including current portion
    721       76       33       618       563  
Total stockholders’ equity
    52,220       49,249       47,257       17,951       9,190  


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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes many forward-looking statements. For cautions about relying on such forward looking statements, please refer to the section entitled “Forward Looking Statements” at the beginning of this Report immediately prior to Item 1.
 
General
 
We design, manufacture, market and sell high performance infrastructure products for wireless voice and data applications. Our products are utilized in major wireless networks throughout the United States which support voice and data communications by use of cell phones and other wireless communication devices.
 
Our products help maximize the performance of wireless telecommunications networks by improving the quality of uplink signals from mobile wireless devices. Our products increase capacity utilization, lower dropped and blocked calls, extend coverage, and enable higher wireless data throughput — all while reducing capital and operating costs. Our SuperLink solution utilizes patented high-temperature superconductor (HTS) technology to create a receiver front-end that enhances network performance. Today, we are leveraging our expertise and proprietary technology in radio frequency (RF) engineering to continue to expand our product line beyond HTS technology. We believe our RF engineering expertise provides us with a significant competitive advantage in the development of high performance, cost-effective solutions for wireless telecommunications networks.
 
We have three product offerings:
 
  •  SuperLink .  In order to receive uplink signals from wireless handsets, base stations require a wireless filter system to eliminate out-of-band interference. SuperLink combines HTS filters with a proprietary cryogenic cooler and an ultra low-noise amplifier. The result is a highly compact and reliable receiver front-end that can simultaneously deliver both high selectivity (interference rejection) and high sensitivity (detection of low level signals). SuperLink delivers significant performance advantages over conventional filter systems.
 
  •  AmpLink .  AmpLink is designed to address the sensitivity requirements of wireless base stations. AmpLink is a ground-mounted unit which utilizes a high-performance amplifier. The enhanced uplink performance provided by AmpLink improves network coverage immediately and avoids the installation and maintenance costs associated with tower mounted alternatives.
 
  •  SuperPlex .   SuperPlex is our line of multiplexers that provides extremely low insertion loss and excellent cross-band isolation. SuperPlex high-performance multiplexers are designed to eliminate the need for additional base station antennas and reduce infrastructure costs. Relative to competing technologies, these products offer increased transmit power delivered to the base station antenna, higher sensitivity to subscriber handset signals, and fast and cost-effective network overlays.
 
We currently sell most of our commercial products directly to wireless network operators in the United States. Our customers to date include ALLTEL, Cingular, Sprint Nextel, T-Mobile, U.S. Cellular and Verizon Wireless. We have a concentrated customer base. Verizon Wireless and AT&T each accounted for more than 10% of our commercial revenues in 2007 and Verizon Wireless, ALLTEL, and T-Mobile each accounted for more than 10% of our commercial revenues in 2006. We plan to expand our customer base by selling directly to other wireless network operators and manufacturers of base station equipment, but we cannot assure that this effort will be successful.
 
We also generate significant revenues from government contracts. We primarily pursue government research and development contracts which compliment our commercial product development. We undertake government contract work which has the potential to improve our commercial product offering. These contracts often yield valuable intellectual property relevant to our commercial business. We typically own the intellectual property developed under these contracts, and the Federal Government receives a royalty-free, non-exclusive and nontransferable license to use the intellectual property for the United States.
 
We sell most of our products to a small number of wireless carriers, and their demand for wireless communications equipment fluctuates dramatically and unpredictably. We expect these trends to continue and may cause significant fluctuations in our quarterly and annual revenues.


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The wireless communications infrastructure equipment market is extremely competitive and is characterized by rapid technological change, new product development, product obsolescence, evolving industry standards and price erosion over the life of a product. We face constant pressures to reduce prices. Consequently, we expect the average selling prices of our products will continue decreasing over time. We have responded in the past by successfully reducing our product costs, and expect further cost reductions over the next twelve months. However, we cannot predict whether our costs will decline at a rate sufficient to keep pace with the competitive pricing pressures.
 
Recent Developments
 
BAOLI Investment.
 
Under a previously announced investment agreement with Hunchun BaoLi Communication Co. Ltd, or BAOLI, in August 2007, on February 27, 2008, we issued to BAOLI and two related purchasers a total of (a) 3,101,361 shares of our common stock (of which 953,065 must be voted in accordance with the votes of our other shares, effectively giving BAOLI no voting power over such shares) and (b) 611,523 shares of our Series A Convertible Preferred Stock, or Series A Preferred (convertible under certain conditions into 6,115,230 shares of our common stock). We received $15.0 million in cash, of which $4.0 million was funded in 2007 and the $11.0 million balance was funded in January 2008.
 
Subject to the terms and conditions of our Series A Preferred and to customary adjustments to the conversion rate, each share of our Series A Preferred is convertible into ten shares of our common stock so long as the number of shares of our common stock beneficially owned by BAOLI following such conversion does not exceed 9.9% of our outstanding common stock. Except for a preference on liquidation of $.01 per share, each share of Series A Preferred is the economic equivalent of the ten shares of common stock into which it is convertible. Except as required by law, the Series A Preferred will not have any voting rights. For a complete description of the terms of the Series A Preferred, please see the certificate of designations, a copy of which is available through our website at www.suptech.com or in our SEC filings available at the SEC’s website at http://www.sec.gov.
 
With the issuance of the Series A Preferred, our ability to declare or pay dividends on shares of our common stock will be subject to the requirement that we pay an equivalent dividend on each outstanding share of Series A Preferred (on an as converted basis).
 
BAOLI Joint Venture.
 
We and BAOLI continue to work on our recently established joint venture to manufacture and market our SuperLink ® interference elimination solution for the China market. As previously announced, our agreements provide that BAOLI will provide the manufacturing expertise and financing in exchange for 55 percent of the equity and we will provide an exclusive license in the China market of the enabling technology in exchange for 45 percent of the equity and a royalty on sales. We continue to work on preliminary matters relating to the joint venture, including administrative and logistical matters, exploratory marketing initiatives, technical and market analysis and discussions with governmental officials.
 
The commencement of manufacturing and any actual sales by the joint venture, and the transfer of our technology to the joint venture, remain subject to success in these efforts and to a number of other conditions including certain critical approvals from the Chinese and United States governments. In particular, we are in discussions with the Committee on Foreign Investment in the United States (or CFIUS), an inter-agency committee of the United States government that reviews the national security implications of foreign acquisitions of U.S. companies regarding our joint venture with and investment from BAOLI. There continues to be no assurance that these conditions will be met, or that all required approvals (if obtained) will be obtained on a timely basis. Even if these conditions are met and the approvals received, the results from our joint venture will be subject to a number of significant risks associated with international operations and new ventures (which are similar to those involved in acquisitions), some of which are set out in our public filings, including in particular the “Risk Factors” included in Item 1A of this document.


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Critical Accounting Policies and Estimates
 
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, warranty obligations, contract revenue and contingencies. We base our estimates on historical experience and on various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Any future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.
 
We believe the following critical accounting policies affect our significant judgments and estimates used in the preparation of the financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
 
Our inventory is valued at the lower of its actual cost or the current estimated market value of the inventory. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained or disposed. Our inventory reserves establish a new cost basis for inventory and are not reversed until the related inventory is sold or otherwise disposed. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements. Our business is characterized by rapid technological change, frequent new product development and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Demand for our products can fluctuate significantly. Our estimates of future product demand may prove to be inaccurate and we may understate or overstate the provision required for excess and obsolete inventory.
 
Our net sales consist of revenue from sales of products net of trade discounts and allowances. We recognize revenue when evidence of an arrangement exists, contractual obligations have been satisfied, title and risk of loss have been transferred to the customer and collection of the resulting receivable is reasonably assured. At the time revenue is recognized, we provide for the estimated cost of product warranties if allowed for under contractual arrangements and return products. Our warranty obligation is affected by product failure rates and service delivery costs incurred in correcting a product failure. Should such failure rates or costs differ from these estimates, accrued warranty costs would be adjusted.
 
We indemnify, without limit or term, our customers against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to our products or other claims arising from our products. We cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under our guarantees because of the uncertainty as to whether a claim might arise and how much it might total.
 
Contract revenues are principally generated under research and development contracts. Contract revenues are recognized utilizing the percentage-of-completion method measured by the relationship of costs incurred to total estimated contract costs. If the current contract estimate were to indicate a loss, utilizing the funded amount of the contract, a provision would be made for the total anticipated loss. Contract revenues are derived primarily from research contracts with agencies of the United States Government. Credit risk related to accounts receivable arising


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from such contracts is considered minimal. These contracts include cost-plus, fixed price and cost sharing arrangements and are generally short-term in nature.
 
All payments to us for work performed on contracts with agencies of the U.S. Government are subject to adjustment upon audit by the Defense Contract Audit Agency. Based on historical experience and review of current projects in process, we believe that the audits will not have a significant effect on our financial position, results of operations or cash flows. The Defense Contract Audit Agency has audited us through 2003.
 
In connection with the acquisition of Conductus we recognized $20.1 million of goodwill. At July 1, 2006, our market capitalization had declined to $25.5 million, an amount less than our total book value. We concluded that our declining stock price constituted an event under FAS 142 and required us to test for goodwill impairment as of July 1, 2006. We then proceeded with step two of the impairment analysis — determining the fair values of all our tangible and intangible assets and then aggregating and subtracting these values from our fair value. Our analysis led us to reasonably estimate at that time that our fair market value was less than our net assets excluding goodwill. Accordingly, we recorded a full write-down of the goodwill ($20.1 million) in the second quarter 2006.
 
We periodically evaluate the realizability of long-lived assets as events or circumstances indicate a possible inability to recover the carrying amount. Long-lived assets that will no longer be used in business are written off in the period identified since they will no longer generate any positive cash flows for us. Periodically, long-lived assets that will continue to be used by we need to be evaluated for recoverability. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses necessarily involve significant management judgment. In the event the projected undiscounted cash flows are less than net book value of the assets, the carrying value of the assets will be written down to their estimated fair value. Our future cash flows may vary from estimates.
 
Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). Under this provision, the share-based compensation cost recognized beginning January 1, 2006 includes compensation cost for (i) all share-based payments granted prior to, but not vested as of January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”) and (ii) all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost under SFAS No. 123(R) is recognized ratably using the straight-line attribution method over the expected vesting period. Prior periods are not restated under this transition method.
 
Prior to 2006, as permitted under Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation”, we elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for stock options and other stock-based employee awards. Pro forma information regarding net loss and loss per share, as calculated under the provisions of SFAS 123, are disclosed in the notes to the financial statements. We accounted for equity securities issued to non-employees in accordance with the provision of SFAS 123 and Emerging Issues Task Force 96-18.
 
Prior to 2006, we did not recognize compensation expense for issuance of stock options to employees. If we had elected to recognize compensation expense for employee awards prior to 2006 based upon the fair value at the


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grant date consistent with the methodology prescribed by SFAS 123, our net loss and net loss per share would have been increased to the pro forma amounts indicated below:
 
         
    For the Year Ended
 
    December 31, 2005  
    (In thousands, except
 
    per share data)  
 
Net loss:
       
As reported
  $ (14,213 )
Stock-based employee compensation included in net loss
     
Stock-based compensation expense determined under fair value method
    (6,459 )
         
Pro forma
    (20,672 )
         
Basic and Diluted Loss per Share:
       
As reported
  $ (1.24 )
Stock-based compensation expense determined under fair value method
    (0.57 )
         
Pro forma
  $ (1.81 )
         
 
On December 1, 2005, the Compensation Committee of our Board of Directors approved the accelerated vesting of all time-vested outstanding out-of-the-money stock options held by current employees or consultants. For this purpose, the Compensation Committee defined “out-of-the-money options” as options having an exercise price equal to or greater than $5.80 per share (the market price on the date of the committee’s decision to accelerate the vesting). If we had elected to recognize compensation expense for employee awards, the pro forma cost impact of these accelerated options in 2005 would have been $3.7 million.
 
Our valuation allowance against the deferred tax assets is based on our assessments of historical losses and projected operating results in future periods. If and when we generate future taxable income in the U.S. against which these tax assets may be applied, some portion or all of the valuation allowance would be reversed and an increase in net income would consequently be reported in future years.
 
We have a contract to deliver several custom products to a government contractor. We are unable to manufacture the products for technical reasons. We have discussed the problem with the contractor and its government customer. They are considering the problem, and we expect further discussions. We do not believe that a loss is reasonably estimable at this time and therefore have not recorded any liability relating to this matter. We will periodically reassess our potential liability as additional information becomes available. If we later determine that a loss is probable and the amount reasonably estimable, we would record a liability for the potential loss.
 
Backlog
 
Our commercial backlog consists of accepted product purchase orders with scheduled delivery dates during the next twelve months. We had commercial backlog of $352,000 at December 31, 2007, as compared to $75,000 at December 31, 2006.
 
Results of Operations
 
2007 Compared to 2006
 
Net revenues decreased by $3.2 million, or 15%, from $21.1 million in 2006 to $17.9 million in 2007. Net revenues consist primarily of commercial product revenues and government contract revenues. We also generate some additional revenues from sublicensing our technology.
 
Net commercial product revenues decreased by $4.9 million, or 28%, to $12.8 million in 2007 from $17.7 million in 2006. The decrease is primarily the result of lower sales volume for some or our products. Average sales prices for our products decreased only slightly in 2007. Our two largest customers accounted for 75% of our net commercial revenues in 2007, as compared to 76% in 2006. These customers generally purchase products


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through non-binding commitments with minimal lead-times. Consequently, our commercial product revenues can fluctuate dramatically from quarter to quarter based on changes in our customers’ capital spending patterns.
 
Government contract revenues increased to $5.1 million in 2007 from $3.4 million in 2006, an increase of $1.7 million, or 52%. This increase is primarily attributable to the addition of new or amended contracts in 2007.
 
Cost of commercial product revenues includes all direct costs, manufacturing overhead, provision for excess and obsolete inventories. The cost of commercial product revenues totaled $12.9 million for 2007 as compared to $15.9 million for 2006, a decrease of $3.0 million, or 19%. The lower costs resulted principally from lower production as a result of lower sales. There was also no restructuring expenses in 2007 and a lower provision for obsolete inventory. Our provision for obsolete inventories totaled $160,000 in 2007 as compared to $360,000 in 2006.
 
Our cost of sales includes both variable and fixed cost components. The variable component consists primarily of materials, assembly and test labor, overhead, which includes equipment and facility depreciation, transportation costs and warranty costs. The fixed component includes test equipment and facility depreciation, purchasing and procurement expenses and quality assurance costs. Given the fixed nature of such costs, the absorption of our production overhead costs into inventory decreases and the amount of production overhead variances expensed to cost of sales increases as production volumes decline since we have fewer units to absorb our overhead costs against. Conversely, the absorption of our production overhead costs into inventory increases and the amount of production overhead variances expensed to cost of sales decreases as production volumes increase since we have more units to absorb our overhead costs against. As a result, our gross profit margins generally decrease as revenue and production volumes decline due to lower sales volume and higher amounts of production overhead variances expensed to cost of sales; and our gross profit margins generally increase as our revenue and production volumes increase due to higher sales volume and lower amounts of production overhead variances expensed to cost of sales. Our inventory is valued at the lower of its actual cost or the current estimated market value of the inventory. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. If the results of the review determine that a write-down is necessary, we recognizes a loss in the period in which the loss is identified, whether or not the inventory is retained or disposed.
 
The following is an analysis of our commercial product gross profit margins for 2006 and 2007:
 
                                 
    For the Years Ended December 31,  
    2006     2007  
    Dollars in thousands  
 
Net commercial product sales
  $ 17,697       100.0 %   $ 12,787       100.0 %
Cost of commercial product sales
    15,922       90 %     12,944       101.2 %
                                 
Gross profit
  $ 1,775       10 %   $ (157 )     (1.2 )%
                                 
 
We had a negative gross margin of $157,000 in 2007 from the sale of our commercial products as compared to a positive gross margin of $1.8 million in 2006. We experienced negative gross profits in 2007 primarily because the reduced level of commercial sales was insufficient to cover our fixed manufacturing overhead costs. Our gross margins were also adversely impacted by a $160,000 charge for excess and obsolete inventory. Gross margins were favorably impacted by $195,000 in 2007 and $700,000 in 2006 by the sale of previously written-off inventory. We regularly review inventory quantities on hand and provide an allowance for excess and obsolete inventory based on numerous factors including sales backlog, historical inventory usage, forecasted product demand and production requirements for the next twelve months.
 
Contract research and development expenses totaled $2.9 million in 2007 as compared to $2.4 million in 2006, an increase of $499,000 or 20%. The increase was primarily the result of higher expenses associated with performing a greater number of government contracts.
 
Other research and development expenses relate to development of new wireless commercial products. We also incur design expenses associated with reducing the cost and improving the manufacturability of our existing products. These expenses totaled $3.2 million in 2007 as compared to $3.5 million in 2006, a decrease of $316,000,


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or 9%. The decrease is due to lower expenses associated with commercial products development and the result of our cost reduction efforts.
 
Selling, general and administrative expenses totaled $8.1 million in 2007 as compared to $9.1 million in 2006, a decrease of $1.0 million, or 11%. The lower expenses resulted primarily from $610,000 received from a settlement agreement with a former director and lower insurance premiums.
 
In connection with the acquisition of Conductus in December 2002 we recognized $20.1 million of goodwill. At July 1, 2006, we concluded that our declining stock price constituted an event under FAS 142 and required us to test for goodwill impairment. Our analysis led us to reasonably estimate at that time that our fair market value was less than our net assets excluding goodwill. Accordingly, we recorded a full write-down of the goodwill ($20.1 million) in the second quarter of 2006. We also recorded an impairment charge of $38,000 related to a note receivable from a Board member in 2006.
 
The following table summarizes our restructuring and impairment charges for 2006 and 2007:
 
                                                 
    For the Year Ended December 31,  
    Restructuring
    Impairment
          Restructuring
    Impairment
       
    Charges for
    Charges for
    Total for
    Charges for
    Charges for
    Total for
 
    2006     2006     2006     2007     2007     2007  
 
Severance costs
  $     $     $     $  —     $  —     $  —  
Fixed assets write offs
                                   
Facility consolidation costs
                                   
Employee relocation cost
                                   
Goodwill Write-off
          20,107,000       20,107,000                    
Impairment charge for notes receivable from shareholder and board member
          38,000       38,000                    
                                                 
Total
          20,145,000       20,145,000                    
Fixed Asset write off and severance costs included in cost of goods sold
                                   
                                                 
Expense included in operating expenses
  $     $ 20,145,000     $ 20,145,000     $     $     $  
                                                 
 
Interest income decreased to $156,000 in 2007, as compared to $391,000 in 2006, primarily because of lower cash balances in 2007.
 
Interest expense in 2007 amounted to $39,000, as compared to $45,000 in 2006, as a result of lower borrowing levels.
 
Our loss totaled $9.1 million in 2007 as compared to $29.6 million in 2006.
 
The net loss available to common shareholders totaled $0.73 per common share in 2007, as compared to $2.37 per common share in 2006.
 
2006 Compared to 2005
 
Net revenues decreased by $3.1 million, or 13%, from $24.2 million in 2005 to $21.1 million in 2006. Net revenues consist primarily of commercial product revenues and government contract revenues. We also generate some additional revenues from sublicensing our technology.
 
Net commercial product revenues decreased by $3.4 million, or 16%, to $17.7 million in 2006 from $21.1 million in 2005. The decrease is primarily the result of lower sales and lower average sale prices of our products. Our three largest customers accounted for 96% of our net commercial revenues in 2006, as compared to 95% in 2005. These customers generally purchase products through non-binding commitments with minimal lead-times. Consequently, our commercial product revenues can fluctuate dramatically from quarter to quarter based on changes in our customers’ capital spending patterns.


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Government contract revenues increased to $3.4 million in 2006 from $3.1 million in 2005, an increase of $254,000, or 8%. This increase is primarily attributable to the addition of new or amended contracts in 2006.
 
Cost of commercial product revenues includes all direct costs, manufacturing overhead, provision for excess and obsolete inventories. The cost of commercial product revenues totaled $15.9 million for 2006 as compared to $19.0 million for 2005, a decrease of $3.1 million, or 16%. The lower costs resulted from no restructuring expenses in 2006 and a lower provision for obsolete inventory. Restructuring and impairment expenses from severance and “fixed assets write off included in cost of goods sold” were zero in 2006 as compared to $109,000 in 2005. Our provision for obsolete inventories totaled $360,000 in 2006 as compared to $1.0 million in 2005.
 
Our cost of sales includes both variable and fixed cost components. The variable component consists primarily of materials, assembly and test labor, overhead, which includes equipment and facility depreciation, transportation costs and warranty costs. The fixed component includes test equipment and facility depreciation, purchasing and procurement expenses and quality assurance costs. Given the fixed nature of such costs, the absorption of our production overhead costs into inventory decreases and the amount of production overhead variances expensed to cost of sales increases as production volumes decline since we have fewer units to absorb our overhead costs against. Conversely, the absorption of our production overhead costs into inventory increases and the amount of production overhead variances expensed to cost of sales decreases as production volumes increase since we have more units to absorb our overhead costs against. As a result, our gross profit margins generally decrease as revenue and production volumes decline due to lower sales volume and higher amounts of production overhead variances expensed to cost of sales; and our gross profit margins generally increase as our revenue and production volumes increase due to higher sales volume and lower amounts of production overhead variances expensed to cost of sales. Our inventory is valued at the lower of its actual cost or the current estimated market value of the inventory. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. If the results of the review determine that a write-down is necessary, we recognizes a loss in the period in which the loss is identified, whether or not the inventory is retained or disposed.
 
The following is an analysis of our commercial product gross profit margins for 2005 and 2006:
 
                                 
    For the Years Ended December 31,  
    2005     2006  
    Dollars in thousands  
 
Net commercial product sales
  $ 21,080       100.0 %   $ 17,697       100.0 %
Cost of commercial product sales
    18,989       90.1 %     15,922       90 %
                                 
Gross profit
  $ 2,091       9.9 %   $ 1,775       10 %
                                 
 
We had a positive gross margin of $1.8 million in 2006 from the sale of our commercial products as compared to a positive gross margin of $2.1 million in 2005. The gross margin percentage improved slightly on lower sales volumes primarily due to lower restructuring expenses, a lower provision for obsolete inventory and the positive results of our cost reduction efforts. Gross margin was also favorably impacted $700,000 by the sale of previously written-off inventory. We regularly review inventory quantities on hand and provide an allowance for excess and obsolete inventory based on numerous factors including sales backlog, historical inventory usage, forecasted product demand and production requirements for the next twelve months.
 
Contract research and development expenses totaled $2.4 million in 2006 as compared to $2.8 million in 2005, a decrease of $399,000 or 14%. The decrease was primarily the result of 2005 expenses totaling $759,000 on a contract for which no revenue was recognized. See “ Contractual Contingency ” under the Contractual Guarantees and Indemnities Note to the Financial Statements for a description of the non-revenue generating contract.
 
Other research and development expenses relate to development of new wireless commercial products. We also incur design expenses associated with reducing the cost and improving the manufacturability of our existing products. These expenses totaled $3.5 million in 2006 as compared to $4.2 million in 2005, a decrease of $726,000, or 17%. The decrease is due to lower expenses associated with commercial products development and the result of our cost reduction efforts.


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Selling, general and administrative expenses totaled $9.1 million in 2006 as compared to $11.4 million in 2005, a decrease of $2.3 million, or 20%. The lower expenses resulted primarily from lower auditor fees, lower insurance premiums, lower legal expenses for other matters, no restructuring activities in 2006 and the payment in 2005 of retirement benefits for our previous Chief Executive Officer.
 
We implemented several restructuring programs since 2004. These activities were completed in 2005. In connection with the acquisition of Conductus in December 2002 we recognized $20.1 million of goodwill. At July 1, 2006, we concluded that our declining stock price constituted an event under FAS 142 and required us to test for goodwill impairment. Our analysis led us to reasonably estimate at that time that our fair market value was less than our net assets excluding goodwill. Accordingly, we recorded a full write-down of the goodwill ($20.1 million) in the second quarter. We also recorded an impairment charge of $38,000 related to a note receivable from a Board member.
 
The following table summarizes our restructuring and impairment charges for 2005 and 2006:
 
                                                 
    For the Year Ended December 31,  
    Restructuring
    Impairment
          Restructuring
    Impairment
       
    Charges for
    Charges for
    Total for
    Charges for
    Charges for
    Total for
 
    2005     2005     2005     2006     2006     2006  
 
Severance costs
  $ 178,000     $     $ 178,000     $     $     $  
Fixed assets write offs
    137,000             137,000                        
Facility consolidation costs
    6,000             6,000                        
Employee relocation cost
    16,000             16,000                      
Goodwill Write-off
                            20,107,000       20,107,000  
Impairment charge for notes receivable from shareholder and board member
          969,000       969,000             38,000       38,000  
                                                 
Total
  $ 337,000     $ 969,000     $ 1,306,000             20,145,000       20,145,000  
Fixed Asset write off and severance costs included in cost of goods sold
    (109,000 )           (109,000 )                  
                                                 
Expense included in operating expenses
  $ 228,000     $ 969,000     $ 1,197,000     $     $ 20,145,000     $ 20,145,000  
                                                 
 
Interest income increased to $391,000 in 2006, as compared to $342,000 in 2005, primarily because of increased interest rates.
 
Interest expense in 2006 amounted to $45,000, as compared to $116,000 in 2005, as a result of lower borrowing levels.
 
Our loss totaled $29.6 million in 2006 as compared to $14.2 in 2005.
 
The net loss available to common shareholders totaled $2.37 per common share in 2006, as compared to $1.24 per common share in 2005.
 
Liquidity and Capital Resources
 
Cash Flow Analysis
 
As of December 31, 2007, we had working capital of $3.3 million, including $3.9 million in cash and cash equivalents, as compared to working capital of $10.2 million at December 31, 2006, which included $5.5 million in cash and cash equivalents. We currently invest our excess cash in short-term, investment-grade, money-market instruments with maturities of three months or less. Our investments have zero exposure to the auction rate securities market. We believe that all of our cash investments would be readily available to us should the need arise.


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Cash and cash equivalents decreased by $1.6 million from $5.5 million at December 31, 2006 to $3.9 million at December 31, 2007. (In January 2008 we received the remaining $11.0 million from our investment agreement with BAOLI. See notes below in Financing Activities and Future Liquidity ). Cash was used principally in operations and to a lesser extent for the purchase of property and equipment and for the payment of short and long-term borrowings. Cash and cash equivalents decreased by $7.5 million from $13.0 million at December 31, 2005 to $5.5 million at December 31, 2006. Cash was used in operations, for the purchase of property and equipment, for the payment of short and long-term borrowings. These uses were offset by gross cash proceeds of $12.5 million received from the sale of common stock in a public offering during the third quarter of 2005.
 
Cash used in operations totaled $5.4 million in 2007. We used $9.1 million to fund the cash portion of our net loss. We also used cash to fund a $2.1 million increase in accounts payable payments, accounts receivable and patents and licenses. These uses were offset by cash generated from lower inventory, lower prepaid and other assets totaling $3.0 million. Cash used in operations totaled $7.3 million in 2006. In 2006 we used $6.2 million to fund the cash portion of our net loss. We also used cash to fund a $1.8 million increase in inventory and accounts payable payments. These uses were offset by cash generated from lower accounts receivables and prepaid balances totaling $746,000.
 
Net cash used in investing activities totaled $165,000 in 2007. In 2007, sales of fixed assets generated $26,000 and were offset by fixed asset purchases totaling $191,000. Net funds used in investing activities totaled $229,000 in 2006 and $45,000 in 2005. In 2006 we purchased $229,000 of fixed assets and there were no sales of fixed assets. In 2005, sales of fixed assets generated $216,000 and essentially offset purchases of property and equipment totaling $261,000.
 
Net cash provided by financing activities totaled $4.0 million in 2007. In 2007, $4.0 million was received from BAOLI as an installment toward completion of a $15.0 million financing which was completed in February 2008. Cash used to pay long term debt was $14,000 and was offset by $26,000 provided by the exercise of stock options. Net cash used in financing activities totaled $19,000 in 2006 and was used to pay long term debt. In 2005 gross cash received from the sale of common stock totaled $12.5 million and borrowings against our line of credit totaled $662,000, offset by cash used to pay down our line of credit and long term debt of $1.6 million. Cash was also used to pay $1.9 million of offering expenses related to the sale of common stock in November 2004 and August 2005.
 
Financing Activities
 
We have historically financed our operations through a combination of cash on hand, equipment lease financings, available borrowings under bank lines of credit and both private and public equity offerings. We have effective registration statements on file with the SEC covering the public resale by investors of all the common stock issued in our private placements, as well as any common stock acquired upon exercise of their warrants.
 
We have an existing line of credit from a bank. It is a material source of funds for our business. The line of credit expires in July 2008. The loan agreement is structured as a sale of our accounts receivable and provides for the sale of up to $5.0 million of eligible accounts receivable, with advances to us totaling 80% of the receivables sold. Advances bear interest at the prime rate (7.25% at December 31, 2007) plus 2.50% subject to a minimum monthly charge. Advances are collateralized by a lien on all of our assets. Under the terms of the agreement, we continue to service the sold receivables and are subject to recourse provisions. There was no amount outstanding under this borrowing facility at December 31, 2007.
 
In 2007 and 2006, we did not complete a financing transaction. However, on August 17, 2007, we entered into the previously noted investment agreement with BAOLI and on February 27, 2008, the transactions contemplated by this investment agreement closed and in exchange for $15.0 million in cash we issued to BAOLI and two related purchasers a total of (a) 3,101,361 shares of our common stock and (b) 611,523 shares of our Series A Preferred Stock (convertible under certain conditions into 6,115,230 shares of our common stock).


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Contractual Obligations and Commercial Commitments
 
We incur various contractual obligations and commercial commitments in our normal course of business. They consist of the following:
 
  •  Operating Lease Obligations
 
Our operating lease obligations consist of a facility lease in Santa Barbara, California and several copier leases.
 
  •  Patents and Licenses
 
We have entered into various licensing agreements requiring royalty payments ranging from 0.13% to 2.5% of specified product sales. Some of these agreements contain provisions for the payment of guaranteed or minimum royalty amounts. Typically, the licensor can terminate our license if we fail to pay minimum annual royalties.
 
  •  Purchase Commitments
 
In the normal course of business, we incur purchase obligations with vendors and suppliers for the purchase of inventory, as well as other goods and services. These obligations are generally evidenced by purchase orders that contain the terms and conditions associated with the purchase arrangements. We are committed to accept delivery of such material pursuant to the purchase orders subject to various contract provisions which allow us to delay receipt of such orders or cancel orders beyond certain agreed upon lead times. Cancellations may result in cancellation costs payable by us.
 
  •  Quantitative Summary of Contractual Obligations and Commercial Commitments
 
At December 31, 2007, we had the following contractual obligations and commercial commitments:
 
                                         
    Payments Due by Period  
          Less than
                After
 
Contractual Obligations
  Total     1 year     2-3 years     4-5 years     5 years  
 
Operating leases
    5,870,000       1,425,000       2,999,000       1,445,000       1,000  
Minimum license commitment
    1,800,000       150,000       300,000       300,000       1,050,000  
Fixed asset and inventory purchase commitments
    3,184,000       3,184,000                    
                                         
Total contractual cash obligations
  $ 10,854,000     $ 4,759,000     $ 3,299,000     $ 1,745,000     $ 1,051,000  
                                         
 
Capital Expenditures
 
We plan to invest approximately $700,000 in fixed assets during 2008.
 
Future Liquidity
 
Our principal sources of liquidity consist of existing cash balances and funds expected to be generated from future operations. We believe one of the key factors to our liquidity will be our ability to successfully execute on our plans to increase sales levels in a highly concentrated industry where we experience significant fluctuations in sales from quarter to quarter. Our cash requirements will also depend on numerous other variable factors, including the rate of growth of sales, the timing and levels of products purchased, payment terms and credit limits from manufacturers, and the timing and level of accounts receivable collections.
 
In 2007, we incurred a net loss of $9.1 million and had negative cash flows from operations of $5.4 million. In 2006, we incurred a net loss of $29.6 million and had negative cash flows from operations of $7.3 million. Our independent registered public accounting firm has included in their audit report for fiscal 2007 and 2006 an explanatory paragraph expressing doubt about our ability to continue as a going concern. Our prior independent registered public accounting firm included a similar explanatory paragraph in their audit report for 2005.
 
At December 31, 2007 we had $3.9 million in cash and in January 2008 we received the remaining $11.0 million from our previously noted investment agreement with BAOLI whereby in exchange for $15.0 million


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in cash we issued to BAOLI and two related purchasers a total of (a) 3,101,361 shares of our common stock and (b) 611,523 shares of our Series A Preferred Stock (convertible under certain conditions into 6,115,230 shares of our common stock). If actual cash flows deviate significantly from forecasted amounts or if we believe operations require additional funding we cannot assure you that additional financing will be available on acceptable terms or at all.
 
Net Operating Loss Carryforward
 
As of December 31, 2007, we had net operating loss carryforwards for federal and state income tax purposes of approximately $285.1 million and $154.7 million , respectively, which expire in the years 2008 through 2027. Of these amounts $88.3 million and $23.5 million, respectively, resulted from the acquisition of Conductus. Included in the net operating loss carryforwards are deductions related to stock options of approximately $24.1 million and $13.1 million for federal and California income tax purposes, respectively. To the extent net operating loss carryforwards are recognized for accounting purposes the resulting benefits related to the stock options will be credited to stockholders’ equity. In addition, we had research and development and other tax credits for federal and state income tax purposes of approximately $2.7 million and $1.3 million, respectively, which expire in the years 2008 through 2027. Of these amounts $661,000 and $736,000, respectively resulted from the acquisition of Conductus.
 
Due to the uncertainty surrounding their realization, we have recorded a full valuation allowance against our net deferred tax assets. Accordingly, no deferred tax asset has been recorded in the accompanying balance sheet.
 
Section 382 of the Internal Revenue Code imposes an annual limitation on the utilization of net operating loss carryforwards based on a statutory rate of return (usually the “applicable federal funds rate”, as defined in the Internal Revenue Code) and the value of the corporation at the time of a “change of ownership” as defined by Section 382. We had changes in ownership in August 1999 and December 2002. Therefore, the ability to utilize net operating loss carryforwards of $97.3 million incurred prior to the ownership changes will be subject in future periods to an annual limitation of $1.3 million. In addition, we acquired the right to Conductus’ net operating losses, which are also subject to the limitations imposed by Section 382. Conductus underwent three ownership changes, which occurred in February 1999, February 2001 and December 2002. Therefore, the ability to utilize Conductus’ net operating loss carryforwards of $88.3 million incurred prior to the ownership changes will be subject in future periods to annual limitation of $700,000. Net operating losses incurred by us subsequent to the ownership changes totaled $99.5 million and are not subject to this limitation. We are currently evaluating the potential limitations on our ability to utilize our net operating loss carryforwards as a result of the recent investment by BAOLI.
 
Future Accounting Requirements
 
In February 2008, the FASB issued FSP 157-2 “Partial Deferral of the Effective Date of Statement 157” (FSP 157-2). FSP 157-2 delays the effective date of SFAS No. 157, for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. We are currently assessing the impact of SFAS No. 157 for non-financial assets and non-financial liabilities on our consolidated financial position and results of operations. We do not expect that the implementation of this standard, for financial assets and financial liabilities, will have a material impact on our consolidated financial position and results of operations.
 
In December 2007 the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (FAS 141(R) and No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (FAS 160)”. FAS 141(R) will change how business acquisitions are accounted for and FAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. FAS 141(R) and FAS 160 are effective for fiscal years beginning on or after December 15, 2008 (January 1, 2009 for the Company). The adoption of FAS 141(R) and FAS 160 are not expected to have a material impact on the Company’s consolidated financial statements.
 
In June 2007 the FASB ratified EITF No. 07-3, or EITF 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities . EITF 07-3 requires non-refundable advance payments for goods and services to be used in future research and development activities to


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be recorded as an asset and the payments to be expensed when the research and development activities are performed. EITF 07-3 is effective for fiscal years beginning after December 15, 2007. We are currently evaluating the impact of adopting EITF 07-3 on our results of operations and financial condition.
 
In June 2007, the FASB ratified EITF 06-11 “Accounting for the Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF 06-11”). EITF 06-11 provides that tax benefits associated with dividends on share-based payment awards be recorded as a component of additional paid-in capital. EITF 06-11 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007. We are currently assessing the impact of EITF 06-11 on our consolidated financial position and results of operations.
 
In May 2007, the FASB issued FASB Staff Position (“FSP”) FIN 48-1 “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective retroactively to January 1, 2007. The implementation of this standard did not have a material impact on our consolidated financial position or results of operations.
 
In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS No. 159). SFAS No. 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We do not expect that the implementation of this standard will have a material impact on our consolidated financial position and results of operations.
 
Market Risk
 
We are exposed to various market risks, including changes in interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices. We do not enter into derivatives or other financial instruments for trading or speculation purposes. Our money market investments have zero exposure to the auction rate securities market.
 
At December 31, 2007, we had approximately $3.7 million invested in a money market account yielding approximately 4.63%. Assuming a 1% decrease in the yield on this money market account and no liquidation of principal for the year, our total interest income would decrease by approximately $37,000 per annum. Also, at December 31, 2007, we had no amounts outstanding under a $5.0 million bank borrowing arrangement bearing interest at the prime rate (7.25% at December 31, 2007) plus 2.50%. Assuming a 1% increase in the prime rate interest and that the entire line was used for the entire year, interest expense would increase approximately $40,000 per annum.
 
Inflation
 
We do not foresee any material impact on our operations from inflation.
 
ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
See “ Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk .”
 
ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
All information required by this item is listed in the Index to Financial Statements in Part IV, Item 15(a)1.
 
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
Not applicable.


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ITEM 9A.    CONTROLS AND PROCEDURES
 
Controls and Procedures
 
We have established disclosure controls and procedures to ensure that material information relating to us and our consolidated subsidiaries is made known to the officers who certify the Company’s financial reports, as well as other members of senior management and the Board of Directors, to allow timely decisions regarding required disclosures. As of the end of the period covered by this report we carried out an evaluation under the supervision and with the participation of our management, including the our Chief Executive Officer and Controller (“Principal Financial Officer”), of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities and Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Controller concluded that our disclosure controls and procedures are effective in timely alerting them to material information related to us that is required to be included in our annual and periodic SEC filings.
 
There were no changes in our internal controls over financial reporting during the fourth quarter of the year ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.
 
We do not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.
 
Management’s Report on Internal Control Over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal controls over financial reporting as of December 31, 2007. In making its assessment of the effectiveness of our internal controls over financial reporting, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on these criteria, our management has concluded that, as of December 31, 2007, our internal controls over financial reporting are effective. This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to temporary rules of the SEC that permit the company to provide only management’s report in this annual report.
 
ITEM 9B.   OTHER INFORMATION
 
We disclosed all the information required to be disclosed pursuant to Form 8-K during the fourth quarter of 2007.
 
PART III
 
ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
Information regarding our executive officers and directors is incorporated by reference to the information set forth under the caption “ Directors and Executive Officers ” in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of our year ended December 31, 2007.
 
We have a Code of Business Conduct and Ethics for all of our employees, including our Chief Executive Officer, Chief Financial Officer and Principal Accounting Officer. The purpose of the code is to ensure that our business is conducted in a consistently legal and ethical matter. We have posted the text of the code on our website at www.suptech.com. We will post any material amendments or waivers to the code on our website. We will provide a


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copy of our code free of charge to any person upon request by writing to us at the following address: Superconductor Technologies Inc., 460 Ward Drive, Santa Barbara, California 93111-2310, Attn: Corporate Secretary.
 
ITEM 11.    EXECUTIVE COMPENSATION
 
Information regarding executive compensation is incorporated by reference to the information set forth under the caption “ Executive Compensation ” in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of our year ended December 31, 2007.
 
ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
Information regarding security ownership of certain beneficial owners and management is incorporated by reference to the information set forth under the caption “Voting Securities and Principal Shareholders — Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of our year ended December 31, 2007.
 
ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
Information regarding certain relationships and related transactions is incorporated by reference to the information set forth under the caption “Transactions With Related Persons” and “Corporate Governance — Director Independence” in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of our year ended December 31, 2007.
 
ITEM 14.    PRINCIPAL ACCOUNTING FEES AND DISCLOSURES
 
Information regarding accounting fees and disclosures is incorporated by reference to the information set forth under the caption “Fees Paid to Independent Auditors” in our Proxy Statement for the Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of our year ended December 31, 2007.
 
PART IV
 
ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
(a) The following documents are filed as part of this Report:
 
1.  Index to Financial Statements .  Our financial statements and the Reports of Stonefield Josephson, Inc., Independent Registered Public Accounting Firm and PricewaterhouseCoopers LLP, our former Independent Registered Public Accounting Firm , are included in Part IV of this Report on the pages indicated:
 
         
    Page
 
    F-1  
    F-3  
    F-4  
    F-5  
    F-6  
    F-7  
 
2.  Financial Statement Schedule Covered by the Foregoing Report of Independent Registered Public Accounting Firms .


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    F-29  
 
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or the notes thereto.
 
3.  Exhibits
 
         
Number
 
Description of Document
 
  3 .1   Amended and Restated Certificate of Incorporation of the registrant(1)
  3 .2   Certificate of Amendment of Restated Certificate of Incorporation(2)
  3 .3   Certificate of Amendment of Restated Certificate of Incorporation(3)
  3 .4   Certificate of Designations of the Registrant relating to the Series A Preferred Stock(26)
  3 .5   Amended and Restated Bylaws of the Registrant(4)
  4 .1   Form of Common Stock Certificate(5)
  4 .2   Third Amended and Restated Stockholders Rights Agreement(6)
  4 .3   Form of Warrant to Purchase Common Stock dated March 28, 2003, issued to Silicon Valley Bank(8)
  4 .4   Form of Warrant(9)
  4 .5   Form of Registration Rights Agreement(9)
  4 .6   Silicon Valley Bank Warrant dated May 2004(10)
  4 .7   Form of Warrant dated August 2005(11)
  10 .1   Amended and Restated 1988 Stock Option Plan, as amended, with form of stock option agreement(12)
  10 .2   1999 Stock Option Agreement(7)***
  10 .3   1998 Stock Option Plan (13)***
  10 .4(a)   Form of Change of Control Agreement dated March 28, 2003 (14)***
  10 .4(b)   Form of Amendment to Change of Control Agreement dated as of May 24, 2005 (12)***
  10 .4(c)   Form of Amendment to Change of Control Agreement dated as of December 31, 2006 (23)***
  10 .5(a)   Accounts Receivable Purchase Agreement dated March 28, 2003 by and between Registrant and Silicon Valley Bank(14)
  10 .5(b)   Accounts Receivable Purchase Modification Agreement with Silicon Valley Bank dated March 17, 2004(15)
  10 .5(c)   Accounts Receivable Purchase Modification Agreement with Silicon Valley Bank dated March 29, 2005(16)
  10 .6   Unconditional Guaranty dated March 27, 2003 issued by Conductus, Inc. to Silicon Valley Bank(14)
  10 .7   Patent License Agreement between Telcordia Technologies, Inc. and Registrant dated July 13, 2002(14)
  10 .8(a)   Securities Purchase Agreement dated June 23, 2003(17)
  10 .8(b)   Form of Investor Warrant(17)
  10 .9   Form of Registration Rights Agreement(17)
  10 .10   Patent License Agreement by and between Lucent Technologies and the registrant**(18)
  10 .11   License Agreement with Sunpower**(23)
  10 .12(a)   Employment Agreement with Jeffrey Quiram (20)***
  10 .12(b)   Option Agreement with Jeffrey Quiram (20)***
  10 .12(c)   Amendment to Employment Agreement with Jeffrey Quiram dated as of December 31, 2006 (24)***
  10 .13(a)   2003 Equity Management Incentive Plan (as amended May 25, 2005)(4)***
  10 .13(b)   Form of Option Agreement for 2003 Equity Incentive Plan (20)***
  10 .13(c)   Management Incentive Plan (22)***
  10 .14(a)   Employment Agreement with Terry White (23)***
  10 .14(b)   Amendment to Employment Agreement with Terry White dated as of December 31, 2006 (24)***


37


Table of Contents

         
Number
 
Description of Document
 
  10 .15   Compensation Policy for Non-Employee Directors dated March 18, 2005 (23)***
  10 .15   Stipulation of Settlement to Class Action dated August 10, 2005(23)
  10 .16(a)   Placement Agency Agreement for August 2005(11)
  10 .16(b)   Form of Subscription Agreement for August 2005 offering(22)
  10 .17   Form of Director and Officer Indemnification Agreement(21)
  10 .18   Code of Business Conduct and Ethics(21)
  10 .19   Master Services Agreement dated as of September 8, 2006 with Cingular Wireless, LLC(24)
  10 .20   August 17, 2007 investment agreement with Hunchun BaoLi Communication Co. Ltd. (“BAOLI”)(25)
  10 .21   November 9, 2007 first amendment to investment agreement with BAOLI*
  10 .22   January 8, 2008 second amendment to investment agreement with BAOLI*
  10 .23   November 8, 2007 Framework Agreement with BAOLI*
  10 .24   December 8, 2007 Sino-Foreign Equity Joint Venture between the Registrant and BAOLI (Exhibit A to Framework Agreement with BAOLI)*
  10 .25   Form of License Agreement between the Registrant and BAOLI (Exhibit B to Framework Agreement with BAOLI)*
  21     List of Subsidiaries*
  23 .1   Consent of Stonefield Josephson Inc, Independent Registered Public Accounting Firm*
  23 .2   Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm*
  31 .1   Statement of CEO Pursuant to 302 of the Sarbanes-Oxley Act of 2002*
  31 .2   Statement of CFO Pursuant to 302 of the Sarbanes-Oxley Act of 2002*
  32 .1   Statement of CEO Pursuant to 906 of the Sarbanes-Oxley Act of 2002*
  32 .2   Statement of CFO Pursuant to 906 of the Sarbanes-Oxley Act of 2002*
 
 
(1) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q filed for the quarter ended April 3, 1999.
 
(2) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q filed for the quarter ended June 30, 2001.
 
(3) Incorporated by reference from Registrant’s Form 8-K dated March 13, 2006.
 
(4) Incorporated by reference from Registrant’s Form 8-K dated May 25, 2005.
 
(5) Incorporated by reference from the Registrant’s Registration Statement on Form S-1 (Reg. No. 33-56714).
 
(6) Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q filed for the quarter ended July 3, 1999.
 
(7) Incorporated by reference from the Registrant’s Registration Statement on Form S-8 (Reg. No. 333-90293).
 
(8) Incorporate by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 29, 2003.
 
(9) Incorporated by reference from Registrant’s Current Report on Form 8-K filed June 25, 2003.
 
(10) Incorporated by reference from Registrants’ Registration Statement of Form S-3 (Reg. 333-89184).
 
(11) Incorporated by reference from Registrant’s Form 8-K dated August 10, 2005.
 
(12) Incorporated by reference from the Registrant’s Annual Report on Form 10-K filed for the year ended December 31, 1994.
 
(13) Incorporated by reference from the Registrant’s Registration Statement on Form S-8 (Reg. No. 333-56606) filed March 6, 2001.
 
(14) Incorporate by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 29, 2003.

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(15) Incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended April 3, 2004.
 
(16) Incorporated by reference from Registrants’ Form 8-K dated March 29, 2005.
 
(17) Incorporated by reference from Registrants’ Form 8-K dated June 25, 2003.
 
(18) Incorporated by reference from Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003.
 
(19) Incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended October 2, 2004.
 
(20) Incorporated by reference from Registrant’s Annual Report on Form 10-K for the year ended December 31, 2004.
 
(21) Incorporated by reference from Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005
 
(22) Incorporated by reference from Registrant’s Form 8-K dated July 27, 2006.
 
(23) Incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended April 2, 2005.
 
(24) Incorporated by reference from Registrant’s Annual Report on Form 10-K for the year ended December 31, 2006.
 
(25) Incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 29, 2007.
 
(26) Incorporated by reference from Registrant’s Report on Form 8-K/A dated February 25, 2008.
 
Filed herewith.
 
** Confidential treatment has been previously granted for certain portions of these exhibits.
 
*** This exhibit is a management contract or compensatory plan or arrangement.
 
(b)  Exhibits .  See Item 15(a) above.


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Report of Independent Registered Public Accounting Firm
 
To: The Board of Directors and Stockholders of Superconductor Technologies, Inc.
Santa Barbara, California
 
We have audited the accompanying consolidated balance sheets of Superconductor Technologies, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2007. Our audits also included the consolidated financial statement schedule listed in the Index at Item 15(a)(2) as of and for the years ended December 31, 2007 and 2006. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Superconductor Technologies, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related consolidated financial statement schedules as of and for the years ended December 31, 2007 and 2006, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
 
The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the company as a going concern. As discussed in Note 2, the Company has incurred significant net losses since its inception and has an accumulated deficit of $199,985,000 and expects to incur substantial additional losses and costs. The foregoing matters raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are described in Note 2 of the accompanying financial statements. These financial statements do not include any adjustments that might result from the outcome of these uncertainties.
 
/s/   Stonefield Josephson, Inc.
 
Los Angeles, California
March 27, 2008


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Table of Contents

To the Board of Directors and Stockholders of
Superconductor Technologies Inc.
 
In our opinion, the consolidated statements of operations, stockholders’ equity and cash flows for the year ended December 31, 2005 present fairly, in all material respects, the results of operations and cash flows of Superconductor Technologies Inc. and its subsidiaries for the year ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for the year ended December 31, 2005 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
 
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has had recurring losses and used $9.4 million in cash for operations in 2005. These matters raise a substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
/s/   PricewaterhouseCoopers LLP
 
Los Angeles, California
March 3, 2006, except for effects of
the reverse stock split discussed in Note 2,
as to which the date is March 13, 2006


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Table of Contents

 
SUPERCONDUCTOR TECHNOLOGIES INC.
 
CONSOLIDATED BALANCE SHEETS
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
ASSETS
Current Assets:
               
Cash and cash equivalents
  $ 5,487,000     $ 3,939,000  
Accounts receivable, net
    1,535,000       2,413,000  
Inventory, net
    5,978,000       3,415,000  
Prepaid expenses and other current assets
    507,000       442,000  
                 
Total Current Assets
    13,507,000       10,209,000  
Property and equipment, net of accumulated depreciation of $18,599,000 and $19,129,000, respectively
    5,770,000       3,961,000  
Patents, licenses and purchased technology, net of accumulated amortization of $1,391,000 and $1,722,000, respectively
    2,409,000       2,236,000  
Other assets
    218,000       219,000  
                 
Total Assets
  $ 21,904,000     $ 16,625,000  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities :
               
Accounts payable
  $ 1,725,000     $ 1,467,000  
Accrued expenses
    1,610,000       1,405,000  
Proceeds for shares to be issued
          4,000,000  
Current portion of capitalized lease obligations and long term debt
    14,000       45,000  
                 
Total Current Liabilities
    3,349,000       6,917,000  
Other long term liabilities
    604,000       518,000  
                 
Total Liabilities
    3,953,000       7,435,000  
Commitments and contingencies (Notes 9, 10 and 11)
               
Stockholders’ Equity:
               
Preferred stock, $.001 par value, 2,000,000 shares authorized, none issued and outstanding
           
Common stock, $.001 par value, 250,000,000 shares authorized, 12,483,367 and 12,511,414 shares issued and outstanding, respectively
    12,000       12,000  
Capital in excess of par value
    208,825,000       209,163,000  
Notes receivable from stockholder and board member
    (27,000 )      
Accumulated deficit
    (190,859,000 )     (199,985,000 )
                 
Total Stockholders’ Equity
    17,951,000       9,190,000  
                 
Total Liabilities and Stockholders’ Equity
  $ 21,904,000     $ 16,625,000  
                 
 
See accompanying notes to the consolidated financial statements


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
CONSOLIDATED STATEMENT OF OPERATIONS
 
                         
    For the Year Ended December 31,  
    2005     2006     2007  
 
Net revenues:
                       
Net commercial product revenues
  $ 21,080,000     $ 17,697,000     $ 12,787,000  
Government and other contract revenues
    3,107,000       3,361,000       5,115,000  
Sub license royalties
    22,000       20,000        
                         
Total net revenues
    24,209,000       21,078,000       17,902,000  
Costs and expenses:
                       
Cost of commercial product revenues
    18,989,000       15,922,000       12,944,000  
Contract research and development
    2,806,000       2,407,000       2,906,000  
Other research and development
    4,214,000       3,488,000       3,172,000  
Selling, general and administrative
    11,442,000       9,086,000       8,123,000  
Restructuring expenses and impairment charges
    1,197,000       38,000        
Write off Goodwill
          20,107,000        
                         
Total costs and expenses
    38,648,000       51,048,000       27,145,000  
                         
Loss from operations
    (14,439,000 )     (29,970,000 )     (9,243,000 )
Interest income
    342,000       391,000       156,000  
Interest expense
    (116,000 )     (45,000 )     (39,000 )
                         
Net loss
  $ (14,213,000 )   $ (29,624,000 )   $ (9,126,000 )
                         
Basic and diluted net loss per common share
  $ (1.24 )   $ (2.37 )   $ (0.73 )
                         
Basic and diluted weighted average number of common shares outstanding
    11,418,504       12,483,367       12,487,593  
                         
 
See accompanying notes to the consolidated financial statements


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
 
                                                                 
    Convertible
                Capital in
    Receivable
             
    Preferred Stock     Common Stock     Excess of
    From
    Accumulated
       
    Shares     Amount     Shares     Amount     Par Value     Stockholder     Deficit     Total  
 
Balance at December 31, 2004
                10,771,103     $ 11,000     $ 197,080,000     $ (820,000 )   $ (147,022,000 )   $ 49,249,000  
Exercise of stock options Issuance of common stock
                    1,712,329       1,000       11,440,000                       11,441,000  
Issuance of options and warrants
                                    25,000                       25,000  
Reserve for impairment
                                            755,000               755,000  
Net loss
                                                    (14,213,000 )     (14,213,000 )
                                                                 
Balance at December 31, 2005
                12,483,431       12,000       208,545,000       (65,000 )     (161,235,000 )     47,257,000  
Issuance of common stock and warrants
                    (64 )                                        
Issuance of options
                                    280,000                       280,000  
Reserve for impairment
                                            38,000               38,000  
Net loss
                                                    (29,624,000 )     (29,624,000 )
                                                                 
Balance at December 31, 2006
                12,483,367       12,000       208,825,000       (27,000 )     (190,859,000 )     17,951,000  
Exercise of stock options
                    3,350               26,000                       26,000  
Issuance of common stock
                                    (27,000 )                     (27,000 )
Issuance of options and warrants
                    24,697               339,000                       339,000  
Reserve for impairment
                                            27,000               27,000  
Net loss
                                                    (9,126,000 )     (9,126,000 )
                                                                 
Balance at December 31, 2007
                12,511,414     $ 12,000     $ 209,163,000     $     $ (199,985,000 )   $ 9,190,000  
                                                                 
 
See accompanying notes to the consolidated financial statements.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
CONSOLIDATED STATEMENT OF CASH FLOWS
 
                         
    For the Year Ended December 31  
    2005     2006     2007  
 
CASH FLOWS FROM OPERATING ACTIVITIES:
                       
Net loss
  $ (14,213,000 )   $ (29,624,000 )   $ (9,126,000 )
Adjustments to reconcile net loss to net cash used for operating activities:
                       
Depreciation and amortization
    3,225,000       2,600,000       2,333,000  
Warrants and options charges
    25,000       280,000       339,000  
Provision for excess and obsolete inventories
    984,000       360,000       160,000  
Forgiveness of note receivable from former CEO
    150,000              
Reserve for impairment of note and interest receivable from stockholder
    924,000       38,000       (583,000 )
Write off Goodwill
          20,107,000        
Gain on disposal of property and equipment
    (138,000 )            
Changes in assets and liabilities:
                       
Accounts receivable
    (732,000 )     631,000       (877,000 )
Inventory
    2,979,000       (974,000 )     2,403,000  
Prepaid expenses and other current assets
    112,000       115,000       574,000  
Patents and licenses
    (154,000 )     (217,000 )     (169,000 )
Other assets
    (23,000 )     128,000       16,000  
Accounts payable and accrued expenses
    (2,543,000 )     (727,000 )     (465,000 )
                         
Net cash used in operating activities
    (9,404,000 )     (7,283,000 )     (5,395,000 )
CASH FLOWS FROM INVESTING ACTIVITIES:
                       
Proceeds from the sale of property and equipment
    216,000             26,000  
Purchase of property and equipment
    (261,000 )     (229,000 )     (191,000 )
                         
Net cash used in investing activities
    (45,000 )     (229,000 )     (165,000 )
CASH FLOW FROM FINANCING ACTIVITIES:
                       
Proceeds from Shares to be issued
                4,000,000  
Proceeds from short-term borrowings
    662,000              
Payments on short-term borrowings
    (1,600,000 )            
Payments on long-term obligations
    (43,000 )     (19,000 )     (14,000 )
Gross proceeds from sale of common stock and exercise of warrants and options
    12,500,000             26,000  
Payment of common stock issuance costs
    (1,854,000 )            
                         
Net cash provided by (used in) financing activities
    9,665,000       (19,000 )     4,012,000  
                         
Net increase (decrease) in cash and cash equivalents
    216,000       (7,531,000 )     (1,548,000 )
Cash and cash equivalents at beginning of year
    12,802,000       13,018,000       5,487,000  
                         
Cash and cash equivalents at end of year
  $ 13,018,000     $ 5,487,000     $ 3,939,000  
                         
 
See accompanying notes to the consolidated financial statements.


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Table of Contents

 
SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1 — The Company
 
Superconductor Technologies Inc. (together with our subsidiaries, “we” or “us”) was incorporated in Delaware on May 11, 1987 and maintains its headquarters in Santa Barbara, California. We operate in a single industry segment, the research, development, manufacture and marketing of high-performance infrastructure products for wireless voice and data applications. Our commercial products are divided into three product offerings: SuperLink (high-temperature superconducting filters), AmpLink (high performance, ground-mounted amplifiers) and SuperPlex (high performance multiplexers). Our research and development contracts are used as a source of funds for our commercial technology development. From 1987 to 1997, we were engaged primarily in research and development and generated revenues primarily from government research contracts.
 
We continue to be involved as either contractor or subcontractor on a number of contracts with the United States government. These contracts have been and continue to provide a significant source of revenues for us. For the years ended December 31, 2005, 2006, and 2007, government related contracts account for 13%, 16% and 29%, respectively, of our net revenues.
 
Note 2 — Summary of Significant Accounting Policies
 
Basis of Presentation
 
Our financial statements have been prepared assuming that it will continue as a going concern.
 
In 2007, we incurred a net loss of $9.1 million and negative cash flows from operations of $5.4 million. In 2006 and 2005 we incurred net losses of $29.6 million and $14.2 million, respectively, and negative cash flows from operations of $7.3 million and $9.4 million, respectively.
 
Our principal sources of liquidity consist of existing cash balances and funds expected to be generated from future operations. On August 17, 2007, we entered into an agreement with Hunchun BaoLi Communication Co. Ltd. (“BAOLI”). On February 27, 2008, the transactions contemplated by our investment agreement with BAOLI closed and in exchange for $15.0 million in cash we issued to BAOLI and two related purchasers a total of (a) 3,101,360 shares of our common stock and (b) 611,523 shares of our Series A Preferred Stock (convertible into 6,115,230 shares of our common stock).
 
We believe one of the key factors to our liquidity beyond 2008 will be our intention to successfully execute on our plans to increase sales levels. Our cash requirements will also depend on numerous other variable factors, including the rate of growth of sales, the timing and levels of products purchased, payment terms and credit limits from manufacturers, the timing and level of accounts receivable collections and the timing and levels of new product development.
 
There is no assurance that additional financing (public or private) will be available on acceptable terms or at all. If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise any needed funds, it might be forced to make further substantial reductions in our operating expenses, which could adversely affect our ability to implement our current business plan and ultimately our viability as a company.
 
The factors described above raise substantial doubt about our ability to continue as a going concern. These financial statements do not include any adjustments that might result from this uncertainty.
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of Superconductor Technologies Inc. and its wholly owned subsidiaries. All significant intercompany transactions have been eliminated from the consolidated financial statements.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Cash and Cash Equivalents
 
Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less. Cash and cash equivalents are maintained with quality financial institutions and from time to time exceed FDIC limits. Historically, we have not experienced any losses due to such concentration of credit risk.
 
Accounts Receivable
 
We sell predominantly to entities in the wireless communications industry and to entities of the United States government. We grant uncollateralized credit to our customers. We perform usual and customary credit evaluations of our customers before granting credit. Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience. Past due balances are reviewed for collectibility. Accounts balances are charged off against the allowance when we deem it is probable the receivable will not be recovered. We do not have any off balance sheet credit exposure related to our customers.
 
Revenue Recognition
 
Commercial revenues are principally derived from the sale of our SuperLink, AmpLink and SuperPlex family of products and are recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing, b) customer’s credit worthiness has been established, c) shipment of the product has occurred, d) title has transferred, and e) if stipulated by the contract, customer acceptance has occurred and all significant vendor obligations, if any, have been satisfied.
 
Contract revenues are principally generated under research and development contracts. If the current contract estimate were to indicate a loss, utilizing the funded amount of the contract, a provision would be made for the total anticipated loss. Revenues from research related activities are derived primarily from contracts with agencies of the United States Government. Credit risk related to accounts receivable arising from such contracts is considered minimal. These contracts include cost-plus, fixed price and cost sharing arrangements and are generally short-term in nature.
 
All payments to us for work performed on contracts with agencies of the U.S. Government are subject to adjustment upon audit by the Defense Contract Audit Agency. Contract audits through 2003 are closed. Based on historical experience and review of current projects in process, we believe that the audits will not have a significant effect on our financial position, results of operations or cash flows.
 
Gross versus Net Presentation
 
In accordance with EITF 06-03 “How Taxes Collected from Customers and Remitted to Governmental Authorities should be Presented in the Income Statement (Gross versus Net Presentation”, the Company collects sales tax on its sales to customers. These sales taxes are accounted for by the Company on a net basis and excluded from revenue. These amounts are included in both accounts receivable and accrued expenses.
 
Shipping and Handling Fees and Costs
 
Shipping and handling fees billed to customers are included in net commercial product revenues. Shipping and handling fees associated with freight are generally included in cost of commercial product revenues.
 
Warranties
 
We offer warranties generally ranging from one to five years, depending on the product and negotiated terms of purchase agreements with our customers. Such warranties require us to repair or replace defective product returned


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
to us during such warranty period at no cost to the customer. Our estimate for warranty related costs is recorded at the time of sale based on our actual historical product return rates and expected repair costs. Such costs have been within our expectations.
 
Guarantees
 
In connection with the sales and manufacturing of our commercial products, we indemnify, without limit or term, our customers and contract manufactures against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to our products or other claims arising from our products. We cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under our guarantee because of the uncertainty as to whether a claim might arise and how much it might total. Historically, we have not incurred any expenses related to these guarantees.
 
Research and Development Costs
 
Research and development costs are expensed as incurred and include salary, facility, depreciation and material expenses. Research and development costs incurred solely in connection with research and development contracts are charged to contract research and development expense. Other research and development costs are charged to other research and development expense.
 
Inventories
 
Inventories are stated at the lower of cost or market, with costs primarily determined using standard costs, which approximate actual costs utilizing the first-in, first-out method. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained or disposed. Our inventory reserves establish a new cost basis for inventory and are not reversed until the related inventory is sold or otherwise disposed. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements. Costs associated with idle capacity are expensed immediately.
 
Property and Equipment
 
Property and equipment are recorded at cost. Equipment is depreciated using the straight-line method over their estimated useful lives ranging from three to five years. Leasehold improvements and assets financed under capital leases are amortized over the shorter of their useful lives or the lease term. Furniture and fixtures are depreciated over seven years. Expenditures for additions and major improvements are capitalized. Expenditures for minor tooling, repairs and maintenance and minor improvements are charged to expense as incurred. When property or equipment is retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts. Gains or losses from retirements and disposals are recorded in selling, general and administration expenses. In 2007, we disposed of $1.3 million of older, fully depreciated equipment. There was no gain or loss on said disposition.
 
Patents, Licenses and Purchased Technology
 
Patents and licenses are recorded at cost and are amortized using the straight-line method over the shorter of their estimated useful lives or approximately seventeen years. Purchased technology acquired through the acquisition of Conductus, Inc. in 2002 was recorded at its estimated fair value and is amortized using the straight-line method over seven years.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Goodwill
 
Goodwill represents the excess of purchase price over fair value of net assets acquired in connection with the acquisition of Conductus in December 2002. Conductus was acquired primarily for the synergies the acquisition would bring to our existing business of developing, manufacturing and marketing products for the commercial wireless telecommunications business and for the synergies it would have on our fund raising abilities.
 
At July 2006, our market capitalization had declined to $25.5 million, an amount less than our total book value. We concluded that our declining stock price constituted an event under FAS 142 and required us to test for goodwill impairment as of July 2006. Our analysis led us to reasonably estimate at that time that our fair market value was less than our net assets excluding goodwill. Accordingly, we recorded a full write-down of the goodwill ($20.1 million) in the second quarter 2006.
 
Long-Lived Assets
 
The realizability of long-lived assets is evaluated periodically as events or circumstances indicate a possible inability to recover the carrying amount. Long-lived assets that will no longer be used in the business are written off in the period identified since they will no longer generate any positive cash flows for us. Periodically, long lived assets that will continue to be used by us will need to be evaluated for recoverability. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses necessarily involve significant management judgment. In the event the projected undiscounted cash flows are less than net book value of the assets, the carrying value of the assets will be written down to their estimated fair value. We tested our long lived assets for recoverability during fiscal 2007 and determined there was no impairment.
 
Restructuring Expenses
 
Liability for costs associated with an exit or disposal activity are recognized when the liability is incurred.
 
Loss Contingencies
 
In the normal course of our business we are subject to claims and litigation, including allegations of patent infringement. Liabilities relating to these claims are recorded when it is determined that a loss is probable and the amount of the loss can be reasonably estimated. The costs of our defense in such matters are expensed as incurred. Insurance proceeds recoverable are recorded when deemed probable.
 
Income Taxes
 
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“SFAS 109”), which requires that the Company recognize deferred tax liabilities and assets based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities, using enacted tax rates in effect in the years the differences are expected to reverse. Deferred income tax benefit (expense) results from the change in net deferred tax assets or deferred tax liabilities. A valuation allowance is recorded when it is more likely than not that some or all deferred tax assets will not be realized.
 
In July 2006, the FASB issued Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 provides detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with SFAS 109. Income tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. We adopted FIN 48 effective January 1, 2007, and the provisions of FIN 48 have been applied to all income tax positions commencing from that date. There was no material impact from this adoption. As of December 31, 2007, we had net operating loss carryforwards for federal and state income tax purposes of approximately $285.1 million and $154.7 million, respectively. We are currently evaluating the potential limitations on our ability to utilize our net


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
operating loss carryforwards as a result of the recent investment by BAOLI. Due to the uncertainty surrounding their realization, we recorded a full valuation allowance against our net deferred tax assets. Accordingly, no deferred tax asset has been recorded in the accompanying balance sheet.
 
Marketing Costs
 
All costs related to marketing and advertising our products are expensed as incurred or at the time the advertising takes place. Advertising costs were not material in each of the three years in the period ended December 31, 2007.
 
Net Loss Per Share
 
Basic and diluted net loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding in each year. Potential common shares are not included in the calculation of diluted loss per share because their effect is anti-dilutive.
 
Stock-based Compensation
 
Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). Under this provision, the share-based compensation cost recognized beginning January 1, 2006 includes compensation cost for (i) all share-based payments granted prior to, but not vested as of January 1, 2006, based on the grant date fair value originally estimated in accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”) and (ii) all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost under SFAS No. 123(R) is recognized ratably using the straight-line attribution method over the expected vesting period. Prior periods are not restated under this transition method.
 
As a result of adopting SFAS 123R, the impact to the Consolidated Statement of Operations for the years ended December 31, 2007 and 2006 on net income, for stock options and awards, was an expense of $339,000 and $280,000 and $0.03 and $0.02, respectively, on basic and diluted earnings per share. No stock compensation cost was capitalized during the period.
 
In the years prior to 2006, as permitted under Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation”, we elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for our stock options and other stock-based employee awards. Pro forma information regarding net loss and loss per share, as calculated under the provisions of SFAS 123, are disclosed in the notes to the financial statements. We accounted for equity securities issued to non-employees in accordance with the provision of SFAS 123 and Emerging Issues Task Force 96-18. If we had elected to recognize compensation expense for employee awards based upon the fair value at the grant date


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
consistent with the methodology prescribed by SFAS 123, our net loss and net loss per share in 2005 would have been increased to the pro forma amounts indicated below:
 
         
    For the Year Ended
 
    December 31,
 
    2005  
 
Net loss:
       
As reported
  $ (14,213,000 )
Stock-based employee compensation included in net loss
     
Stock-based compensation expense determined under fair value method
    (6,459,000 )
         
Pro forma
  $ (20,672,000 )
         
Basic and diluted loss per share
       
As reported
  $ (1.24 )
Stock-based compensation expense determined under fair value method
    (0.57 )
         
Pro forma
  $ (1.81 )
         
 
Use of Estimates
 
The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The significant estimates in the preparation of the financial statements relate to the assessment of the carrying amount of accounts receivable, inventory, fixed assets, intangibles, goodwill, estimated provisions for warranty costs, accruals for restructuring and lease abandonment costs, contract revenues, income taxes and disclosures related to the litigation. Actual results could differ from those estimates and such differences may be material to the financial statements. At December 31, 2007, we reversed $319,000 of product line exit cost accruals. This accrual was established in 2002 in the amount of $1,042,000 and represented the estimated costs to be incurred with a customer to support commercial product units previously purchased from Conductus for a period of five years.
 
Fair Value of Financial Instruments
 
The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term nature of these instruments. We estimate that the carrying amount of the debt approximates fair value based on our current incremental borrowing rates for similar types of borrowing arrangements.
 
Comprehensive Income
 
We have no items of other comprehensive income in any period and consequently do not report comprehensive income.
 
Segment Information
 
We operate in a single business segment, the research, development, manufacture and marketing of high performance products used in cellular base stations to maximize the performance of wireless telecommunications networks by improving the quality of uplink signals from mobile wireless devices. Net commercial product revenues are primarily derived from the sales of our SuperLink, AmpLink and SuperPlex products. We currently sell most of our products directly to wireless network operators in the United States. Net revenues derived


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
principally from government research and development contracts are presented separately on the statement of operations for all periods presented.
 
Reverse Stock Split
 
On March 13, 2006, we made a one-for-ten (1:10) reverse stock split effective as of the open of business. All results prior to that time have been adjusted to reflect the impact of that split.
 
Certain Risks and Uncertainties
 
Our long-term prospects are dependent upon the continued and increased market acceptance for our products.
 
We currently sell most of our products directly to wireless network operators in the United States and our product sales have historically been concentrated in a small number of customers. In 2007, we had three customers that represented 40%, 14% and 7% of total net revenues. At December 31, 2007, these three customers represented 26%, 15% and 2% of accounts receivable. In 2006, these three customers represented 44%, 20% and 16% of total net revenues and in 2005 we had three customers that represented 31%, 37% and 15% of total net revenues. The loss of or reduction in sales, or the inability to collect outstanding accounts receivable, from any of these customers could have a material adverse effect on our business, financial condition, results of operations and cash flows.
 
We currently rely on one supplier for purchase of high quality substrates for growth of high-temperature superconductor films and on a limited number of suppliers for other key components of our products. The loss of any of these suppliers could have material adverse effect on our business, financial condition, results of operations and cash flows.
 
In connection with the sales of our commercial products, we indemnify, without limit or term, our customers against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to our products or other claims arising from our products. We cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under our guarantee because of the uncertainty as to whether a claim might arise and how much it might total.
 
Recent Accounting Pronouncements
 
In February 2008, the FASB issued FSP 157-2 “Partial Deferral of the Effective Date of Statement 157” (FSP 157-2). FSP 157-2 delays the effective date of SFAS No. 157, for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. We are currently assessing the impact of SFAS No. 157 for non-financial assets and non-financial liabilities on our consolidated financial position and results of operations. We do not expect that the implementation of this standard, for financial assets and financial liabilities, will have a material impact on our consolidated financial position and results of operations.
 
In December 2007 the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (FAS 141(R)) and No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (FAS 160)”. FAS 141(R) will change how business acquisitions are accounted for and FAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. FAS 141(R) and FAS 160 are effective for fiscal years beginning on or after December 15, 2008 (January 1, 2009 for the Company). The adoption of FAS 141(R) and FAS 160 are not expected to have a material impact on the Company’s consolidated financial statements.
 
In June 2007 the FASB ratified EITF No. 07-3, or EITF 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities . EITF 07-3 requires


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
non-refundable advance payments for goods and services to be used in future research and development activities to be recorded as an asset and the payments to be expensed when the research and development activities are performed. EITF 07-3 is effective for fiscal years beginning after December 15, 2007. We are currently evaluating the impact of adopting EITF 07-3 on our results of operations and financial condition.
 
In June 2007, the FASB ratified EITF 06-11 “Accounting for the Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF 06-11”). EITF 06-11 provides that tax benefits associated with dividends on share-based payment awards be recorded as a component of additional paid-in capital. EITF 06-11 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007. We believe there will be no impact from EITF 06-11 on our consolidated financial position and results of operations.
 
In May 2007, the FASB issued FASB Staff Position (“FSP”) FIN 48-1 “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective retroactively to January 1, 2007. The implementation of this standard did not have a material impact on our consolidated financial position or results of operations.
 
In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS No. 159). SFAS No. 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We do not expect that the implementation of this standard will have a material impact on our consolidated financial position and results of operations.
 
Note 3 — Short Term Borrowings
 
We have a line of credit with a bank. The line of credit expires July 2008 and is structured as a sale of accounts receivable. The agreement provides for the sale of up to $5 million of eligible accounts receivable, with advances to us totaling 80% of the receivables sold. Advances under the agreement are collateralized by all of our assets. Under the terms of the agreement, we continue to service the sold receivables and are subject to recourse provisions.
 
Advances bear interest at the prime rate (7.25% at December 31, 2007) plus 2.50% subject to a minimum monthly charge. There was no amount outstanding under this borrowing facility at December 31, 2007.
 
The agreement contains representations and warranties, affirmative and negative covenants and events of default customary for financings of this type. The failure to comply with these provisions, or the occurrence of any one of the events of default, would prevent any further borrowings and would generally require the repayment of any outstanding borrowings. Such representations, warranties and events of default include (a) non-payment of debt and interest hereunder, (b) non-compliance with terms of the agreement covenants, (c) insolvency or bankruptcy, (d) material adverse change, (e) merger or consolidation where our shareholders do not hold a majority of the voting rights of the surviving entity, (f) transactions outside the normal course of business, or (g) payment of dividends.
 
Note 4 — Retirement of Company’s Chief Executive Officer
 
On March 15, 2005, our Chief Executive Officer and President retired. In connection with the retirement, we agreed to the continuation of his salary and benefits for one year and to immediately vest and extend all his outstanding stock options and the executive agreed to provide certain consulting services as requested by us. Also, in connection with the retirement, a $150,000 loan made to our Chief Executive Officer in 2001, and in accordance with the existing terms of a promissory note in effect prior to the adoption of the Sarbanes-Oxley Act of 2002, was forgiven. We recognized expense of $565,000 relating to the retirement of the CEO in 2005.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Note 5 — Notes Receivable From Stockholder
 
A former director and stockholder executed two notes aggregating $820,244 in principal in connection with the exercise in December 2000 of two options. Through the third quarter of, 2005, we carried the principal (as “Notes Receivable from Stockholder”) and accrued interest (as “Prepaid Expenses and Other Current Assets”) for both notes as assets on our balance sheet. In December 2005, we filed a lawsuit to collect both notes and recorded a reserve for the value of the notes (principal plus accrued interest) in excess of the market value of the collateral securing the notes. In 2007, we received $610,000 in full satisfaction of our claims including interest and attorneys’ fees, and the rescinded the second purported option exercise and canceled the related note.
 
Note 6 — Income Taxes
 
We incurred a net loss in each year of operation since inception resulting in no current or deferred tax expense for 2005, 2006 and 2007.
 
The benefit for income taxes differs from the amount obtained by applying the federal statutory income tax rate to loss before benefit for income taxes for the years ended December 31, 2005, 2006 and 2007 as follows:
 
                         
    For the Year Ending December 31  
    2005     2006     2007  
 
Tax benefit computed at Federal statutory rate
    34.0 %     34.0 %     34.0 %
Increase (decrease) in taxes due to:
                       
Change in valuation allowance
    (39.8 )     (16.7 )     (39.8 )
State taxes, net of federal benefit
    5.8       5.8       5.8  
Impairment of Goodwill (not deductible for tax)
          (23.1 )      
                         
      %     %     %
                         
 
The significant components of deferred tax assets (liabilities) at December 31 are as follows:
 
                 
    For the Year Ended
 
    December 31,  
    2006     2007  
 
Loss carryforwards
  $ 101,519,000     $ 105,460,000  
Capitalized research and development
    3,972,000       2,710,000  
Depreciation
    2,430,000       2,582,000  
Tax credits
    3,226,000       3,822,000  
Inventory
    559,000       415,000  
Purchase accounting adjustments
    93,000       46,000  
Acquired intellectual property
    (286,000 )     (190,000 )
Other
    640,000       437,000  
Less: valuation allowance
    (112,153,000 )     (115,282,000 )
                 
    $     $  
                 
 
The valuation allowance increased by $3,129,000 in 2007, increased by $5,854,000 in 2006 and decreased by $290,000 in 2005.
 
As of December 31, 2007, we had net operating loss carryforwards for federal and state income tax purposes of approximately $285.1 million and $154.7 million , respectively, which expire in the years 2008 through 2027. Of these amounts $88.3 million and $23.5 million, respectively, resulted from the acquisition of Conductus. Included in


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Table of Contents

 
SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
the net operating loss carryforwards are deductions related to stock options of approximately $24.1 million and $13.1 million for federal and California income tax purposes, respectively. To the extent net operating loss carryforwards are recognized for accounting purposes the resulting benefits related to the stock options will be credited to stockholders’ equity. In addition, we had research and development and other tax credits for federal and state income tax purposes of approximately $2.7 million and $1.3 million, respectively, which expire in the years 2008 through 2027. Of these amounts $661,000 and $736,000, respectively resulted from the acquisition of Conductus.
 
Due to the uncertainty surrounding their realization, we have recorded a full valuation allowance against our net deferred tax assets. Accordingly, no deferred tax asset has been recorded in the accompanying balance sheet.
 
Section 382 of the Internal Revenue Code imposes an annual limitation on the utilization of net operating loss carryforwards based on a statutory rate of return (usually the “applicable federal funds rate”, as defined in the Internal Revenue Code) and the value of the corporation at the time of a “change of ownership” as defined by Section 382. We had changes in ownership in August 1999 and December 2002. Therefore, the ability to utilize net operating loss carryforwards of $97.3 million incurred prior to the ownership changes will be subject in future periods to an annual limitation of $1.3 million. In addition, we acquired the right to Conductus’ net operating losses, which are also subject to the limitations imposed by Section 382. Conductus underwent three ownership changes, which occurred in February 1999, February 2001 and December 2002. Therefore, the ability to utilize Conductus’ net operating loss carryforwards of $88.3 million incurred prior to the ownership changes will be subject in future periods to annual limitation of $700,000. Net operating losses incurred by us subsequent to the ownership changes totaled $99.5 million and are not subject to this limitation. We are currently evaluating the potential limitations on our ability to utilize our net operating loss carryforwards as a result of the recent investment by BAOLI.
 
Note 7 — Stockholders’ Equity
 
Preferred Stock
 
Pursuant to our Certificate of Incorporation, the Board of Directors is authorized to issue up to 2,000,000 shares of preferred stock (par value $.001 per share) in one or more series and to fix the rights, preferences, privileges, and restrictions, including the dividend rights, conversion rights, voting rights, redemption price or prices, liquidation preferences, and the number of shares constituting any series or the designation of such series.
 
Common Stock
 
On August 17, 2007, we entered into an agreement with Hunchun BaoLi Communication Co. Ltd. under which on February 27, 2008 we issued to BAOLI and two related purchasers a total of (a) 3,101,360 shares of our common stock and (b) 611,523 shares of our Series A Preferred Stock (convertible under certain conditions into 6,115,230 shares of our common stock) in exchange for $15.0 million in cash. At December 31, 2007 we had received $4.0 million from BAOLI and in January 2008 we received the remaining $11.0 million. This transaction caused the exercise price and the number of shares of the warrants issued to a bridge lender under our 2004 bridge loan to be adjusted to $8.34 and 110,880, respectively, under the anti-dilution provisions of the warrants. In November 2007, the holder of these warrants elected the net exercise provision of this warrant, where by the holder received 24,697 shares. The BAOLI transaction also caused the exercise price of the warrants issued to lenders under our 2005 financing to be adjusted to $7.08 under the anti-dilution provisions of the warrants.
 
We raised no money from the sale of our common stock in 2006.
 
In August 2005, we raised net proceeds of $11,441,000, net of offering costs of $1,059,000, from the public sale of 1,712,329 shares of common stock at $7.30 per share and 5-year warrants to purchase an additional 342,466 shares of common stock exercisable at $11.10 per share. The warrants become exercisable on February 16, 2006. The warrant agreement also contains the following significant terms: (i) in the event of changes in our outstanding Common Stock, the number of shares and their price under the warrant shall be correspondingly


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
adjusted and (ii) if, at any time while the warrants are outstanding, we issue additional shares at an effective price less than the warrant price the number of shares and their price will be adjusted. This transaction caused the exercise price and the number of shares of the warrants issued to a bridge lender under our 2004 bridge loan to be adjusted to $13.30 and 69,549, respectively, under the anti-dilution provisions of the warrants.
 
Stock Options
 
We have five stock option plans, the 1992 Stock Option Plan, the nonstatutory 1992 Directors Stock Option Plan, 1998 and 1999 Stock Option Plans and the 2003 Equity Incentive Plan (collectively, the “Stock Option Plans”). The 1988 Stock Option Plan expired in 1998 and the 1992 Stock Option Plan and the nonstatutory 1992 Directors Stock Option Plan expired in 2002. During 2003, the 1998 and 1999 Stock Option Plans were replaced by the 2003 Equity Incentive Plan. Under the 2003 Equity Incentive Plan, stock awards may consist of stock options, stock appreciation rights, restricted stock awards, performance awards, and performance share awards. Stock awards may be made to our directors, key employees, consultants, and non-employee directors. Stock options granted under these plans must be granted at prices no less than 100% of the market value on the date of grant. Both stock options and restricted stock awards have been granted under these plans. Generally, stock options become exercisable in installments over a minimum of four years, beginning one year after the date of grant, and expire not more than ten years from the date of grant, with the exception of 10% or greater stockholders which may have options granted at prices no less than the market value on the date of grant, and expire not more than five years from the date of grant. There were no stock option exercises in 2006 and 3,350 shares were exercised in 2007.
 
At our 2007 Annual Meeting, the stockholders approved an increase in the total shares available for grants under the 2003 Equity Plan from 1,200,000 shares of common stock to 2,500,000 shares of common stock.
 
During 2005, our President and Chief Executive Officer, as well as another board member, retired. In connection with these retirements, we modified the terms of all the stock options held by these individuals to fully vest them and to extend the term until the earlier of the fifth anniversary of the retirement or the normal expiration date. Since these options had no intrinsic value at the date of modification, the modifications did not impact our statement of operations.
 
In 2005, the Compensation Committee of the Board of Directors made grants of performance based stock options totaling 40,816 to our officers and certain managers. The Compensation Committee determined that the financial performance criteria for these options were not met and therefore these options were canceled.
 
On December 1, 2005, the Compensation Committee of our Board of Directors approved the accelerated vesting of all time-vested outstanding out-of-the-money stock options held by current employees or consultants. For this purpose, the Compensation Committee defined “out-of-the-money options” as options having an exercise price equal to or greater than $5.80 per share (the market price on the date of the committee’s decision to accelerate the vesting). The acceleration of vesting increased the pro forma expense in 2005 by $3.7 million. We accelerated the vesting of these options in anticipation of the impact of Statement of Financial Accounting Standard No. 123R (“SFAS 123R”) Share-Based Payment. The primary purpose of the accelerated vesting was to minimize the amount of compensation expense recognized in relation to the underwater options in future periods following our adoption of SFAS 123R. In addition, because these options had exercise prices in excess of current market values and were not fully achieving their original objectives of incentive compensation and employee retention, we believe that the acceleration has had a positive effect on employee morale and retention.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
For the years ended December 31, 2006 and 2007, the weighted average fair value has been estimated at the date of the grant using the Black-Scholes option-pricing model. The following are the significant weighted average assumptions used for estimating the fair value under our stock option plans:
 
                 
    Year Ended December 31,  
    2006     2007  
 
Per share fair value at grant date
  $ 2.55     $ 2.15  
Risk free interest rate
    4.82 %     4.34 %
Expected volatility
    95 %     98 %
Dividend yield
    0 %     0 %
Expected life in years
    4.0       4.0  
 
The expected life was based on the contractual term of the options and the expected employee exercise behavior. Typically, options to our employees have a 4 year vesting term and a 10 year contractual term. Four year vesting term options vest at 25% after one year and ratably, on a monthly basis, thereafter. Options to Board Members have a 2 year vesting term and a 10 year contractual term. Two year vesting term options vest at 50% after one year and 50% after two years. The risk-free interest rate is based on the U.S. Treasury zero-coupon issues with a remaining term equal to the expected option life assumed at the grant date. The future volatility is based on our 4 year historical volatility. We used an expected dividend yield of 0% because we have never paid a dividend and do not anticipate paying dividends. We assumed a 10% forfeiture rate based on historical stock option cancellation rates over the last 4 years.
 
The impact of the stock options to the Consolidated Statement of Operations for the years ended December 31, 2007 and 2006 on net income was an expense of $115,000 and $187,000 and $0.01 and $0.01, respectively, on basic and diluted earnings per share. No stock compensation cost was capitalized during the periods. The total compensation cost related to non-vested awards not yet recognized is $175,000 and the weighted-average period over which the cost is expected to be recognized is 2.75 years. Prior to 2006, we did not recognize compensation expense for issuance of stock options.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
At December 31, 2007, 1,585,397 shares of common stock were available for future grant of options and 741,858 options had been granted but not yet exercised. Option activity during the three years ended December 31, 2007 was as follows:
 
                 
          Weighted
 
    Number
    Average
 
    of Shares     Exercise Price  
 
Outstanding at December 31, 2004
    946,725     $ 55.21  
Granted
    453,206       8.02  
Canceled
    (197,555 )     37.18  
Exercised
           
                 
Outstanding at December 31, 2005
    1,202,376       40.38  
Granted
    80,900       3.70  
Canceled
    (128,335 )     34.64  
Exercised
           
                 
Outstanding at December 31, 2006
    1,154,941       38.33  
Granted
    45,670       2.96  
Canceled
    (455,403 )     41.68  
Exercised
    (3,350 )     7.42  
                 
Outstanding at December 31, 2007
    741,858     $ 34.24  
                 
 
The following table summarizes information concerning currently outstanding and exercisable stock options at December 31, 2007:
 
                                         
          Weighted
          Exercisable  
          Average
    Weighted
          Weighted
 
Range of
  Number
    Remaining
    Average
    Number
    Average
 
Exercise Prices
  Outstanding     Contractual Life     Exercise Price     Exercisable     Exercise Price  
 
 $1.43 —   $5.90
    102,800       8.62     $ 3.28       35,367     $ 3.85  
 $6.10 —   $7.52
    248,670       7.50     $ 6.91       238,670     $ 6.89  
 $8.00 —  $10.40
    97,615       4.96     $ 9.66       96,364     $ 9.68  
$10.80 —  $38.75
    111,645       4.11     $ 28.06       111,645     $ 28.06  
$39.00 — $493.75
    181,128       2.67     $ 106.40       181,128     $ 106.40  
                                         
      741,858       5.64     $ 34.24       663,174     $ 37.87  
                                         
 
Our outstanding options expire by the end of December 2017. The weighted-average contractual term of stock options currently exercisable is slightly less than 5.6 years. At December 31, 2007, 100,400 shares of outstanding stock options and 32,967 exercisable options had an exercise price less than the current market value and had an intrinsic value of $235,000 and $61,000, respectively. The number of options exercisable and weighted average exercise price at December 31, 2005 and 2006 totaled 1,162,330 and $41.32 and 1,067,296 and $41.13, respectively.
 
Prior to 2006 we adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, (“SFAS 123”), “Accounting for Stock-Based Compensation.” Accordingly, no compensation cost had been recognized for the stock-based compensation other than for non-employees.
 
The fair value of the options granted in 2005 was estimated for purposes of the pro forma amounts in Note 2 as of the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for 2005: dividend yield of zero percent; expected volatilities of 93.85-95%; risk-free interest rates of 4.28-4.62%;


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
and expected life of 4.0 years. All options granted during 2005 were granted at the then fair market value of our common stock. The weighted average fair value of options granted in 2005 was $5.50.
 
Restricted Stock Awards
 
In July 2006, for the first time we issued restricted stock awards. A total of 331,000 shares were granted and will fully vest in one single installment on the second anniversary of the grant date in July 2008. The per share weighted average grant-date fair value was $1.50. A 10% forfeiture rate was assumed.
 
The impact to the Consolidated Statement of Operations for the year ended December 31, 2007 on net income was an expense of $223,000 and $0.02 on basic and diluted earnings per share. The 2006 impact on net income was an expense of $93,000 and $0.01 on basic and diluted earnings per share. No stock compensation cost was capitalized during either period. The total compensation cost related to non-vested awards not yet recognized is $130,000 and the weighted-average period over which the cost is expected to be recognized is seven months.
 
Warrants
 
The following is a summary of outstanding warrants at December 31, 2007:
 
                                 
    Common Shares  
          Currently
    Price per
       
    Total     Exercisable     Share     Expiration Date  
 
Warrants and options related to issuance of common stock
    342,466       342,466     $ 7.08       August 16, 2010 * **
      116,279       116,279       29.00       June 24, 2008 *
Warrants related to April 2004 Bridge Loans
    10,000       10,000       18.50       April 28, 2011 *
Total
    468,745       468,745                  
                                 
 
 
 * The terms of these warrants contain net exercise provisions, wherein instead of a cash exercise holders can elect to receive common stock equal to the difference between the exercise price and the average closing sale price for common shares over 10-30 days immediately preceding the exercise date.
 
** The terms of these warrants contain antidilution adjustment provisions related to issuances at certain prices.
 
No warrants were exercised during 2005 and 2006.
 
During 2007 the following warrants were exercised:
 
                                 
                Common Shares Issued  
    Warrants           In Accordance With
 
    Warrants
    Price per
          Net Exercise
 
    Exercised     Share     For Cash     Provisions  
 
Warrants related to issuance of common stock
    24,697     $ 10.73             24,697  
                                 
 
Note 8 — Employee Savings Plan
 
In December 1989, the Board of Directors approved a 401(k) savings plan (the “401(k) Plan”) for our employees that became effective in 1990. Eligible employees may elect to make contributions under the terms of the 401(k) Plan; however, contributions by us are made at the discretion of management. We made no contributions to the 401(k) Plan in 2007.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Note 9 — Commitments and Contingencies
 
Operating Leases
 
We lease our offices and production facilities under a non-cancelable operating lease that expires in four years. This lease contains a minimum rent escalation clause that requires additional rental amounts after the first year. Rent expense for this lease with minimum annual rent escalation is recognized on a straight line basis over the minimum lease term. This lease also requires us to pay utilities, insurance, taxes and other operating expenses and contains one five-year renewal option at 95% of the then current market rental value.
 
For 2005, 2006 and 2007, rent expense was $1,158,000, $1,152,000 and 1,104,000, respectively.
 
Capital Leases
 
Our property and equipment leases under a capital lease arrangement expired in 2007.
 
Patents and Licenses
 
We have entered into various licensing agreements requiring royalty payments ranging from 0.13% to 2.5% of specified product sales. Certain of these agreements contain provisions for the payment of guaranteed or minimum royalty amounts. In the event that we fail to pay minimum annual royalties, these licenses may automatically be terminated. These royalty obligations terminate in 2009 to 2020. Royalty expenses totaled $211,000 in 2005, $156,000 in 2006 and $172,000 in 2007. Under the terms of certain royalty agreements, royalty payments made may be subject to audit. There have been no audits to date and we do not expect any possible future audit adjustments to be significant.
 
The minimum lease payments under operating and capital leases and license obligations are as follows:
 
                 
          Operating
 
Year Ending December 31,
  Licenses     Leases  
 
2008
  $ 150,000     $ 1,425,000  
2009
    150,000       1,474,000  
2010
    150,000       1,525,000  
2011
    150,000       1,436,000  
2012
    150,000       9,000  
Thereafter
    1,050,000       1,000  
                 
Total payments
  $ 1,800,000     $ 5,870,000  
                 
 
Note 10 — Contractual Guarantees and Indemnities
 
During our normal course of business, we make certain contractual guarantees and indemnities pursuant to which we may be required to make future payments under specific circumstances. We have not recorded any liability for these contractual guarantees and indemnities in the accompanying consolidated financial statements.
 
Warranties
 
We establish reserves for future product warranty costs that are expected to be incurred pursuant to specific warranty provisions with our customers. Our warranty reserves are established at the time of sale and updated throughout the warranty period based upon numerous factors including historical warranty return rates and expenses over various warranty periods.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Intellectual Property Indemnities
 
We indemnify certain customers and our contract manufacturers against liability arising from third-party claims of intellectual property rights infringement related to our products. These indemnities appear in development and supply agreements with our customers as well as manufacturing service agreements with our contract manufacturers, are not limited in amount or duration and generally survive the expiration of the contract. Given that the amount of any potential liabilities related to such indemnities cannot be determined until an infringement claim has been made, we are unable to determine the maximum amount of losses that it could incur related to such indemnifications.
 
Director and Officer Indemnities and Contractual Guarantees
 
We have entered into indemnification agreements with our directors and executive officers, which require us to indemnify such individuals to the fullest extent permitted by Delaware law. Our indemnification obligations under such agreements are not limited in amount or duration. Certain costs incurred in connection with such indemnifications may be recovered under certain circumstances under various insurance policies. Given that the amount of any potential liabilities related to such indemnities cannot be determined until a lawsuit has been filed against a director or executive officer, we are unable to determine the maximum amount of losses that it could incur relating to such indemnifications. Historically, any amounts payable pursuant to such director and officer indemnifications have not had a material negative effect on our business, financial condition or results of operations.
 
We have also entered into severance and change in control agreements with certain of our executives. These agreements provide for the payment of specific compensation benefits to such executives upon the termination of their employment with us.
 
General Contractual Indemnities/Products Liability
 
During the normal course of business, we enter into contracts with customers where it agreed to indemnify the other party for personal injury or property damage caused by our products. Our indemnification obligations under such agreements are not generally limited in amount or duration. Given that the amount of any potential liabilities related to such indemnities cannot be determined until a lawsuit has been filed against a director or executive officer, we are unable to determine the maximum amount of losses that it could incur relating to such indemnifications. Historically, any amounts payable pursuant to such guarantees have not had a material negative effect our business, financial condition or results of operations. We maintain general and product liability insurance as well as errors and omissions insurance which may provide a source of recovery to us in the event of an indemnification claim.
 
Short Term Borrowings
 
We have a line of credit with a bank. The line of credit expires July 2008 and is structured as a sale of accounts receivable. The agreement provides for the sale of up to $5 million of eligible accounts receivable, with advances to us totaling 80% of the receivables sold. Advances under the agreement ( See Note 3)  are collateralized by all our assets. Under the terms of the agreement, we continue to service the sold receivables and are subject to recourse provisions. Under the terms of the agreement, if the bank determines that there is a material adverse change in our business, they can exercise all their rights and remedies under the agreement, including demanding immediate payment of outstanding amounts. There was no amount outstanding under this facility at December 31, 2007
 
Contractual Contingency
 
We have a contract to deliver several custom products to a government contractor. We are unable to manufacture the products for technical reasons. We have discussed the problem with the contractor and our government customer. They are considering the problem, and further discussions are expected. We do not believe that a loss, if any, is reasonably estimable at this time and therefore has not recorded any liability relating to this


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
matter. We will periodically reassess our potential liability as additional information becomes available. If we later determine that a loss is probable and the amount reasonably estimable, we will record a liability for the potential loss. All costs have been expensed and no revenues recognized on this contract.
 
Note 11 — Legal Proceedings
 
Settlement of Shalvoy Litigation
 
Mr. Shalvoy, a director and stockholder, executed two notes aggregating $820,244 in principal in connection with the exercise in December 2000 of two options to purchase Conductus, Inc. common stock prior our acquisition of Conductus, Inc. in December 2002. Through the third quarter of, 2005, we carried the principal (as “Notes Receivable from Stockholder”) and accrued interest (as “Prepaid Expenses and Other Current Assets”) for both notes as assets on our balance sheet.
 
We filed a lawsuit against Mr. Shalvoy on December 21, 2005 in the California Superior Court (Case No. 1186812) to collect both notes. In that same quarter, due to Mr. Shalvoy’s refusal to pay the notes voluntarily we recorded a reserve for the value of the notes (principal plus accrued interest) in excess of the market value of the collateral securing the notes.
 
On March 2, 2007, we entered into a Settlement Agreement and Mutual Release of All Claims with Mr. Shalvoy to settle the lawsuit. As per the agreement, we received a payment of $610,000 on April 2, 2007 in payment of one note, including interest and attorneys’ fees, and the rescission of Mr. Shalvoy’s second purported option exercise including cancellation of the related note.
 
Routine Litigation
 
We may be involved in routine litigation arising in the ordinary course of our business, and, while the results of the proceedings cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our financial position, operating results or cash flows.
 
Note 12 — Earnings Per Share
 
The computation of per share amounts for 2005, 2006 and 2007 is based on the average number of common shares outstanding for the period. Options and warrants to purchase 2,031,213, 1,983,779 and 1,210,603 shares of common stock during 2005, 2006 and 2007 respectively, were not considered in the computation of diluted earnings per share because their inclusion would have been antidilutive.
 
Note 13 — Restructuring Expenses and Impairment Charges
 
During the first quarter of 2005, we implemented another restructuring program and reduced our workforce by another 27 positions and vacated a portion of our leased facility in Santa Barbara.
 
As discussed in Notes Receivable from Stockholder we recorded an impairment charge of $969,000 related to certain notes in the fourth quarter of 2005. The impairment charge is included in Restructuring Expenses and Impairment Charges.


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The following summarizes the restructuring and impairment charges for the years ended December 31, 2005, 2006 and 2007:
 
                                                                         
    For the Years Ended December 31,  
    Restructuring
    Impairment
          Restructuring
    Impairment
          Restructuring
    Impairment
       
    Charges for
    Charges for
    Total for
    Charges for
    Charges for
    Total for
    Charges for
    Charges for
    Total for
 
    2005     2005     2005     2006     2006     2006     2007     2007     2007  
 
Severance costs
  $ 178,000     $     $ 178,000     $     $     $     $     $     $  
Fixed assets write-offs
    137,000             137,000                                      
Patent, licenses and purchased technology write-off
                                                       
Lease abandonment costs
                                                         
Facility consolidation costs
    6,000             6,000                                      
Employee relocation costs
    16,000             16,000                                      
Goodwill write-off
                              20,107,000       20,107,000                    
Impairment charge for notes receivable from shareholder and board member
          969,000       969,000             38,000       38,000                    
                                                                         
Total
    337,000       969,000       1,306,000             20,145,000       20,145,000                    
                                                                         
Fixed assets write-off and severance costs included in cost of goods sold
    109,000             109,000                                      
                                                                         
Expense included in operating expenses
  $ 228,000     $ 969,000     $ 1,197,000     $     $ 20,145,000     $ 20,145,000     $     $     $  
                                                                         
 
Note 14 — Details of Certain Financial Statement Components and Supplemental Disclosures of Cash Flow Information and Non-Cash Activities
 
Balance Sheet Data:
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
Accounts receivable:
               
Accounts receivable-trade
  $ 1,117,000     $ 1,242,000  
U.S. government accounts receivable-billed
    493,000       1,246,000  
Less: allowance for doubtful accounts
    (75,000 )     (75,000 )
                 
    $ 1,535,000     $ 2,413,000  
                 
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
Inventories:
               
Raw materials
  $ 2,242,000     $ 1,934,000  
Work-in-process
    569,000       679,000  
Finished goods
    4,534,000       1,817,000  
Less: inventory reserves
    (1,367,000 )     (1,015,000 )
                 
    $ 5,978,000     $ 3,415,000  
                 
 


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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
Property and Equipment:
               
Equipment
  $ 17,186,000     $ 15,951,000  
Leasehold improvements
    6,732,000       6,732,000  
Furniture and fixtures
    451,000       407,000  
                 
      24,369,000       23,090,000  
Less: accumulated depreciation and amortization
    (18,599,000 )     (19,129,000 )
                 
    $ 5,770,000     $ 3,961,000  
                 
 
At December 31, 2006 and December 31, 2007, equipment includes $237,000 of assets financed under capital lease arrangements, net of $226,000 and $237,000 of accumulated amortization, respectively. Depreciation expense amounted to $2,548,000, $2,277,000 and $1,877,000 respectively, in 2005, 2006 and 2007. At December 31, 2007 we disposed of $1,344,000 of older, fully depreciated equipment. There was no gain or loss on said disposition.
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
Patents and Licenses:
               
Patents pending
  $ 632,000     $ 705,000  
Patents issued
    899,000       983,000  
Less accumulated amortization
    (286,000 )     (345,000 )
                 
Net patents issued
    613,000       638,000  
Licenses
    563,000       563,000  
Less accumulated amortization
    (100,000 )     (134,000 )
                 
Net licenses
    463,000       429,000  
Purchased technology
    1,706,000       1,706,000  
Less accumulated amortization
    (1,005,000 )     (1,242,000 )
                 
Net purchased technology
    701,000       464,000  
                 
    $ 2,409,000     $ 2,236,000  
                 
 
Amortization expense related to these items totaled $329,000, $326,000 and $331,000 respectively in 2005, 2006 and 2007. Amortization expenses related to these items are expected to total $331,000 in 2008 and 2009 and approximately $95,000 in 2010 and 2011.
 

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SUPERCONDUCTOR TECHNOLOGIES INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
                 
    December 31,
    December 31,
 
    2006     2007  
 
Accrued Expenses and Other Long Term Liabilities:
               
Salaries payable
  $ 287,000       307,000  
Compensated absences
    379,000       371,000  
Compensation related
    299,000       369,000  
Warranty reserve
    428,000       380,000  
Lease abandonment costs
    8,000        
Product line exit costs
    319,000        
Deferred rent
    390,000       373,000  
Other
    104,000       123,000  
                 
      2,214,000       1,923,000  
Less current portion
    (1,610,000 )     (1,405,000 )
                 
Long term portion
  $ 604,000     $ 518,000  
                 
 
                         
    For the Year Ended  
    December 31,
    December 31,
    December 31,
 
    2005     2006     2007  
 
Warranty Reserve Activity:
                       
Beginning balance
  $ 419,000     $ 491,000     $ 428,000  
Additions
    204,000       140,000       75,000  
Deductions
    (273,000 )     (203,000 )     (123,000 )
Change in estimate relating to previous warranty accruals
    141,000              
                         
Ending balance
  $ 491,000     $ 428,000     $ 380,000  
                         
Lease Abandonment Costs:
                       
Beginning balance
  $ 1,336,000     $ 225,000     $ 8,000  
Additions
                 
Transfers from unfavorable lease costs
                 
Deductions
    (1,111,000 )     (217,000 )     (8,000 )
                         
Ending balance
  $ 225,000     $ 8,000     $  
                         
Product Line Exit Costs:
                       
Beginning balance
  $ 885,000     $ 402,000     $ 319,000  
Additions
                 
Deductions
    (483,000 )     (83,000 )     (319,000 )
Change in estimate relating to previous exit costs accrual
                 
                         
Ending balance
  $ 402,000     $ 319,000     $  
                         

F-26


Table of Contents

                         
    For the Year Ended  
    December 31,
    December 31,
    December 31,
 
    2005     2006     2007  
 
Severance Costs:
                       
Beginning balance
  $ 36,000     $ 32,000          
Additions
    218,000                
Deductions
    (222,000 )     (32,000 )        
                         
Ending balance
  $ 32,000     $     $  
                         
 
                         
    Dec. 31,
    Dec. 31,
    Dec. 31,
 
    2005     2006     2007  
 
Supplemental Cash Flow Information:
                       
Cash paid for interest
  $ 116,000     $ 45,000     $ 39,000  
Cash paid for taxes
  $ (5,190 )   $ 15,592     $ 183,249  
 
Note 15 — Subsequent Event
 
Unregistered Sales of Equity Securities
 
Under a previously announced investment agreement with Hunchun BaoLi Communication Co. Ltd, or BAOLI in August 2007, on February 27, 2008, we issued to BAOLI and two related purchasers a total of (a) 3,101,361 shares of our common stock (of which 953,065 must be voted in accordance with the votes of our other shares, effectively giving BAOLI no voting power over such shares) and (b) 611,523 shares of our Series A Convertible Preferred Stock, or Series A Preferred (convertible under certain conditions into 6,115,230 shares of our common stock). We received $15.0 million in cash, of which $4.0 million was funded in 2007 and the $11.0 million balance was funded in January 2008.
 
Subject to the terms and conditions of our Series A Preferred and to customary adjustments to the conversion rate, each share of our Series A Preferred is convertible into ten shares of our common stock so long as the number of shares of our common stock beneficially owned by BAOLI following such conversion does not exceed 9.9% of our outstanding common stock. Except for a preference on liquidation of $.01 per share, each share of Series A Preferred is the economic equivalent of the ten shares of common stock into which it is convertible. Except as required by law, the Series A Preferred will not have any voting rights and there is currently no dividend.
 
With the issuance of the Series A Preferred, our ability to declare or pay dividends on shares of our common stock will be subject to the requirement that we pay an equivalent dividend on each outstanding share of Series A Preferred (on an as converted basis).

F-27


Table of Contents

Quarterly Financial Data (Unaudited)
 
                                 
    First Quarter     Second Quarter     Third Quarter     Fourth Quarter  
 
2007
                               
Net revenues(1)
  $ 4,183,000     $ 4,685,000     $ 4,120,000     $ 4,914,000  
Loss from operations(2)(3)
    (2,977,000 )     (2,006,000 )     (2,040,000 )     (2,220,000 )
Net loss
    (2,937,000 )     (1,982,000 )     (2,020,000 )     (2,187,000 )
Basic and diluted loss per common share
  $ (0.24 )   $ (0.16 )   $ (0.16 )   $ (0.17 )
Weighted average number of shares outstanding
    12,483,367       12,483,367       12483,367       12,500,134  
2006
                               
Net revenues(1)
  $ 4,840,000     $ 5,021,000     $ 5,910,000     $ 5,307,000  
Loss from operations(4)(5)
    (3,340,000 )     (22,755,000 )     (2,164,000 )     (1,712,000 )
Net loss
    (3,226,000 )     (22,659,000 )     (2,092,000 )     (1,647,000 )
Basic and diluted loss per common share
  $ (0.26 )   $ (1.81 )   $ (0.17 )   $ (0.13 )
Weighted average number of shares outstanding
    12,483,367       12,483,367       12,483,367       12,483,367  
 
 
(1) Our revenues vary from quarter to quarter as our customers provide minimal lead-time prior to the release of their purchase orders and have non-binding commitments to purchase from us.
 
(2) Includes sale of previously written-off inventory of none, $138,000, $57,000 and none, respectively.
 
(3) Includes increased reserve for inventory obsolescence of $90,000, $70,000, none and none, respectively.
 
(4) Includes increased reserve for inventory obsolescence of $90,000, $90,000, $90,000 and $90,000, respectively.
 
(5) Includes sale of previously written-off inventory of $119,000, $273,000, $309,000 and none, respectively.


F-28


Table of Contents

SUPERCONDUCTOR TECHNOLOGIES INC.
 
Schedule II — Valuation and Qualifying Accounts
 
                                         
    Additions  
          Charge to
    Charge to
    Charge to
       
    Beginning
    Costs &
    Other
    Other
    Ending
 
    Balance     Expenses     Accounts     Deductions     Balance  
 
Year Ended December 31, 2007
                                       
Allowance for Uncollectible Accounts
  $ 75,000     $     $     $     $ 75,000  
Impairment for Notes Receivable from Stockholder
    1,007,000       (583,000 )           (424,000 )      
Reserve for Inventory Obsolescence
    1,367,000       (195,000 )           (157,000 )     1,015,000  
Reserve for Warranty
    428,000       75,000             (123,000 )     380,000  
Deferred Tax Asset Valuation Allowance
    112,153,000       3,129,000                   115,282,000  
Year Ended December 31, 2006
                                       
Allowance for Uncollectible Accounts
    75,000                         75,000  
Impairment for Notes Receivable from Stockholder
    969,000       38,000                   1,007,000  
Reserve for Inventory Obsolescence
            3,209,000       360,000       (2,202,000 )     1,367,000  
Reserve for Warranty
    491,000       140,000             (203,000 )     428,000  
Deferred Tax Asset Valuation Allowance
    106,299,000       5,854,000                   112,153,000  
Year Ended December 31, 2005
                                       
Allowance for Uncollectible Accounts
    77,000                   (2,000 )     75,000  
Impairment for Notes Receivable from Stockholder
          969,000                   969,000  
Reserve for Inventory Obsolescence
    5,402,000       984,000             (3,177,000 )     3,209,000  
Reserve for Warranty
    419,000       204,000             (132,000 )     491,000  
Deferred Tax Asset Valuation Allowance
  $ 106,589,000     $ (290,000 )   $     $     $ 106,299,000  


F-29


Table of Contents

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 27th day of March 2008.
 
SUPERCONDUCTOR TECHNOLOGIES INC.
 
  By: 
/s/  Jeffrey A. Quiram
Jeffrey A. Quiram
President and Chief Executive Officer
 
POWER OF ATTORNEY
 
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints William J. Buchanan, his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact or his substitute or substitutes, may do or cause to be done by virtue hereof.
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
 
             
Signature
 
Title
 
Date
 
         
/s/  Jeffrey A. Quiram

Jeffrey A. Quiram
  President, Chief Executive Officer and Director (Principal Executive Officer)   March 27, 2008
         
/s/  William J. Buchanan

William J. Buchanan
  Controller (Principal Accounting Officer) (Principal Financial Officer)   March 27, 2008
         
/s/  David W. Vellequette

David W. Vellequette
  Director   March 27, 2008
         
/s/  Lynn J. Davis

Lynn J. Davis
  Director   March 27, 2008
         
/s/  Dennis J. Horowitz

Dennis J. Horowitz
  Director   March 27, 2008
         
/s/  Martin A. Kaplan

Martin A. Kaplan
  Director   March 27, 2008
         
/s/  John D. Lockton

John D. Lockton
  Chairman of the Board   March 27, 2008


F-30

 

EXHIBIT 10.21
FIRST AMENDMENT TO AGREEMENT
     This First Amendment, dated as of November 1 st , 2007 (the “ Amendment ”), between Superconductor Technologies, Inc., a Delaware corporation (“ STI ”), and Hunchan BaoLi Communication Co., Ltd. (“ BAOLI ”) amends that certain Agreement, dated as of August 17, 2007 ( the " “Agreement ”), between STI and BAOLI.
RECITALS
A.   Pursuant to the Agreement, BAOLI agreed to purchase and STI agreed to sell $15,000,000 of shares of STFs Common. Stock, par value $0.001 per share (the “ Common Stock ”), at a per share price of $1.6275. The Agreement provides that it may be amended by the written agreement of STI and BAOLI, and STI and BAOLI agree to amend the Agreement as set forth below.
 
B.   This Amendment provides: (i) that upon full payment of the Purchase Price by BAOLI to STI, STI will instead be obligated to deliver 2,148,296 shares of Common Stock (the “Common Shares”) and 706,829 shares of newly created Series A Convertible Preferred Stock of the Corporation (the “ Preferred Shares" ) (with the rights and privileges set forth in the Certificate of Designations attached hereto as Exhibit B and convertible into 7,068,290 shares of Common Stock), and (ii) BAOLI with registration rights with respect to the Common Shares as set forth in Exhibit C .
1.   PURCHASE AND SALE .
     The Agreement is hereby amended so that the term “ Shares ” consists of the Common Shares and the Preferred Shares. The purchase price per Common Share is $1.6275 and the purchase price per Preferred Share Is $16.275, with the total purchase price for the Shares equal to $15,000,000. On a fully converted basis, BAOLI will receive the same number of Common Shares as under the Agreement,
2.   REGISTRATION RIGHTS
     STI hereby grants to BAOLI the registration rights related to the Common Shares set forth in Exhibit C,
3.   LEGALITY OF INVESTMENT
     3.1. Legal Consent to the Amendment, BAOLI and each Purchaser represents and warrants that the execution and performance of the Amendment are consented and approved by the Board of Directors of BAOLI and such Purchaser and that the Amendment is legally binding on BAOLI and such Purchaser. BAOLI and each Purchaser also make the representations and warranties set forth in Exhibit A .
     3.2. Legality of the Offer to Amend. STI represents and warrants that the execution and performance of the Amendment are for the corporate interest of SIT's development and STI has obtained all and any necessary internal approval and STI is legally bound by each of the Agreement and the Amendment, and in addition, subject to the representations and warranties of each Purchaser contained in Exhibit A upon which STI hereby relies complies with the

 


 

EXHIBIT 10.21
provisions of the laws and regulations of United States of America, including but not limited to the pertinent SEC requirements.
4.   TERMS AND EFFECT OF AMENDMENT
     Except as amended by this Amendment, the Agreement remains in full force and effect. Terms used in this Amendment that are not defined in this Amendment shall have the same meaning given to such terms in the Agreement. Terms defined in this Amendment shall be applicable to the Agreement, as amended hereby.
      IN WITNESS WHEREOF , the parties have executed this Amendment as of the date first written above.
         
  SUPERCONDUCTOR TECHNOLOGIES, INC
 
 
  By:   /s/ Jeffrey Quiram    
    Name:   Jeffrey Quiram   
    Title:   President & CEO   
 
         
  BAOLI COMMUNICATIONS CO. LTD
 
 
  By:   /s/ (Signature)    
    Name:      
    Title:      
 

2

 

EXHIBIT 10.22
SECOND AMENDMENT TO AGREEMENT
     This Second Amendment, dated as of January 7, 2008 (the “ Amendment ”) between Superconductor Technologies Inc. a Delaware corporation (“ STI ”). and Hunchun BaoLi Communication Co. Ltd, (“ BAOLI ”) amends that certain Agreement, dated as of August 17, 2007 and subsequently amended as of November 1st, 2007 (the “ Agreement ”), between STI and BAOLI.
RECITALS
A.   Pursuant to the Agreement, BAOLI agreed to purchase and STI agreed to sell 2,148,296 shares of STI's common stock, par value $0.001 per share (the Common Stock” ) and 706,829 shares of Series A Convertible Preferred Stock of STI (the “ Preferred Stock ”) in exchange for $15,000,000, of which a deposit of $4,000,000 has already been received by STI, The Agreement provides that it may be amended by the written agreement of STI and BAOLI and STI and BAOLI agree to amend the Agreement as set forth below.
 
B.   This Amendment provides that if full payment of the Purchase Price is actually received from BAOLI, STI will Instead be obligated to deliver 3,101361 shares of Common Stock
(the “ Common Shares ”) and 611,523 shares of Preferred Stock (the “ Preferred Shares ”) (convertible into 6,115,230 shares of Common Stock, for an aggregate of 9,216,519 shares of Common Stock including the Common Shares). As of the date hereof, STI has approximately 12,500,000 shares of common stock outstanding.
 
    NOW, THEREFORE, the parties hereby agree as follows:
      1.   PURCHASE AND SALE . The Agreement is hereby amended so that (i) term “ Shares ” consists of 3,101,361 shares of Common Stock and 611,523 shares of Preferred Stock; (ii) BOALI agrees to increase its deposit from $4,000,000 to $6,000,000 not later than 1 PM on January 8, 2008 (Los Angeles time); and (iii) BAOLI agrees to complete the purchase of all of the Shares by paying the remaining $9,000,000 of the $15,000,000 Purchase Price not later than 1 PM on January 21, 2008 (Los Angeles time). BAOLI represents that the additional $2,000,000 has been irrevocably wired to STI.
      2.   VOTING AGREEMENT . BAOLI agrees that 953,065 of the Common Shares (any and all other shares or securities of STI issued or issuable in respect thereof on or after the date hereof, the “ Non Voting Shares ”) shall be covered by the Irrevocable Proxy and Voting Agreement executed simultaneously herewith. Each certificate representing any Non Voting Shares shall be endorsed by the Company with a legend reading substantially as follows:
“THE SHARES EVIDENCED HEREBY ARE SUBJECT TO AN IRREVOCABLE PROXY AND VOTING AGREEMENT (A COPY OF WHICH MAY BE OBTAINED UPON WRITTEN REQUEST FROM THE COMPANY), AND BY ACCEPTING ANY INTEREST IN SUCH SHARES THE PERSON ACCEPTING SUCH INTEREST SHALL BE DEEMED TO AGREE TO AND SHALL BECOME BOUND BY ALL THE PROVISIONS OF THAT AGREEMENT.”
     Upon receipt by STI of reasonably acceptable evidence of bona fide transfer to a person not covered by the Irrevocable Proxy and Voting Agreement according to its terms, the legend

1


 

EXHIBIT 10.22
will be removed from the certificate representing such transferred shares.
      3.  EXCHANGE . STI has informed BAOLI that the issuance of additional Common Stock under the initial Agreement was not permitted by the NASDAQ Stock Market without a shareholder vote. Although NASDAQ has given preliminary approval of the issuance under Section 1, if final approval is denied, the parties will work together to overcome or respond to any objections. In addition if all necessary regulatory approvals, including the NASDAQ, can be obtained on or before February 15, 2008, the parties will take all steps needed to exchange the Preferred Shares for the Common Stock into which it would be convertible, provided that BAOLI signs the same form of Irrevocable Proxy and Voting Agreement with respect to all such shares of Common Stock issued in such exchange and such shares bear the same legend set forth in Section 2.
      4.  LEGALITY OF INVESTMENT .
          4.1. Legal Consent to the Amendment. BAOLI represents and warrants that the execution and performance of the Amendment are consented and approved by the Board of Directors of BAOLI and that the Amendment is legally binding on BAOLI. BAOLI also makes the representations and warranties set forth in, Exhibit A to the First Amendment.
          4.2. Legality of the Offer to Amend. STI represents and warrants that the execution and performance of the Amendment are for the corporate interest of STI’s development and STI has obtained all and any necessary internal approval and STI is legally bound by each of the Agreement and the Amendment, and in addition, subject to the representations and warranties of each Purchaser contained in Exhibit A to the First Amendment upon which STI hereby relies, complies with the provisions of the laws and regulations of United States of America, including but not limited to the pertinent SEC requirements.
      5. FUNDING OF JOINT VENTURE . Section 12 of the Sino-Foreign Equity Joint Venture Contract dated as of December 8, 2007 among BAOLI and Superconductor Investments (Mauritius) Ltd (the “ JV Contract ”) relating to BAOLI Superconductor Technology Co, Ltd (“ BSTC ”) is hereby amended to require the contributions of the parties be made not later than September 30, 2008; it being understood that the Effective Date under the STI Trademark and Technology License (when technology transfers can begin) is not until “ten days after the completion of the contribution to the capitalization of [BSTC] of [BAOLI] as contemplated by the [JV Contract].” Should BAOLI fail for any reason, including governmental decisions, to fully fund its contributions not later the date in the first sentence, (1) the Trademark and Technology License shall immediately terminate and neither BAOLI nor the BSTC shall have any rights to the technology or trademarks of STI, although both shall continue to bound by their obligations to maintain the confidentiality of all information provided by STI and its affiliates; (2) BAOLI shall be deemed to be in material breach under Article 15 of the JV Contract; (3) BSTC shall be immediately terminated and a liquidation application shall be submitted to the original Examination and Approval Authority for approval, with BAOLI agreeing to be responsible for promptly obtaining such approval and (4) STI and its affiliates shall be immediately relieved of all of its or their obligations under the JV Contract and the related Framework Agreement.
      6.  TERMS AND EFFECT OF AMENDMENT . Except as amended by this Amendment, the Agreement remains in full force and effect. Terms used in this Amendment that are not defined in this Amendment shall have the same meaning given to such terms in the

2


 

EXHIBIT 10.22
Agreement. Terms defined in this Amendment shall be applicable to the Agreement, as amended hereby.
     7.  TIME IS OF THE ESSENCE. TIME IS OF THE ESSENCE UNDER THIS AGREEMENT. THERE WILL BE NO FURTHER EXTENSIONS OF TIME OF ANY LENGTH OF THESE DEADLINES FOR ANY REASON, EVEN IF GOVERNMENTAL APPROVAL IS NOT RECEIVED BY BAOLI. BAOLI specifically agrees that, unless BOTH (1) the additional $2,000,000 deposit is actually RECEIVED by STI NO LATER THAN the date and time set forth in Section 1 AND (2) FULL payment is actually RECEIVED by STI NO LATER THAN the date and time set forth in Section 1, BAOLI will FORFEIT its entire deposit, which may be retained by STI without any further obligations to BAOLI. BAOLI acknowledges that (i) STI could have sold its stock at amounts far in excess of either the price in the Agreement of the current market price, but refrained form doing so based on BAOLI’s assurances that it would complete its obligations under the Agreement and (ii) STI will suffer significant damages as a results of any failure of BAOLI to complete the transactions contemplated by the Agreement. The parties have agreed that, under the circumstances, and in consideration of the additional extension of time for BAOLI to invest its money without increasing the price per share to reflect current market conditions, the current deposit is inadequate and that increasing it by an additional $2,000,000 to a total of $6,000,000 as contemplated by Section 1 is fair and reasonable in light of the repeated delays, and the significant benefits to BAOLI, and the risks to STI, of this extension. Accordingly, BAOLI agrees that STI retaining the full amount of its deposit in the event that either BAOLI fails to increase the deposit or fails to pay the full purchase price by the precise deadlines set forth above is fair and reasonable based on these and other factors.
      IN WITNESS WHEREOF , the parties have executed