General

      We develop, manufacture and market 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. Our solutions leverage our expertise in high-temperature superconducting filters to “hear” wireless devices with the best possible clarity while rejecting interfering signals. We believe that this combination of interference rejection and receiver sensitivity is only possible using HTS technology. We sell our products directly to wireless carriers in the Americas, and we have plans to expand internationally. Our customers to date include ALLTELL, AT&T Wireless (now part of Cingular), U.S. Cellular, and Verizon Wireless.

      We derive our commercial revenues from three product lines:

      We began commercial production of the SuperFilter (the precursor to the SuperLink Rx) in 1997. Our initial commercial sales of our SuperLink products were to small rural providers who had the most immediate need for range extension and coverage enhancement. We sold our first systems in the fourth quarter of 1997. We sold 83 more systems in 1998, 123 systems in 1999, 393 systems in 2000, 438 systems in 2001, 927 systems

in 2002, 1,884 systems in 2003, and 697 systems in 2004. In 2002, U.S. Cellular accounted for 8% of our net commercial revenues and ALLTEL for 84% of our net commercial revenues. In 2003, ALLTEL accounted for 70% of our net commercial revenues and Verizon accounted for 15% of our net commercial revenues. In 2004, ALLTEL accounted for 63% of our net commercial revenues and Verizon Wireless accounted for 24% of our net commercial revenues

      In our business model, we use government contracts as a source of funds for our commercial technology development. We primarily pursue government research and development contracts which compliment our commercial product development. In other words, 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 for the United States.

      During 2002 and 2003, we were marketing a power amplifier product called the SuperLink Tx manufactured by another company. The SuperLink Tx was for wireless networks that suffer from insufficient transmit power on the downlink signal path. Our supplier for this product was acquired by a competitor in November 2003. We have not had significant sales of the SuperLink Tx product to date. We evaluated alternative sources of power amplifiers for our customers and concluded that suitable power amplifiers are readily available from other vendors. Therefore, we have no plans to resume marketing any power amplifier products.

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. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, warranty obligations, contingencies and our loss contract with U.S. Cellular. 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. Actual results may differ from these estimates under different assumptions or conditions.

      We believe the following critical accounting policies affect our more 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 actual cost or the current estimated market value of the inventory. We review inventory quantities on hand and on order and record a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. 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. As demonstrated in the past three years, 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. Our warranty obligation is effected 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.

      In connection with the sales of its commercial products, the Company indemnifies, without limit or term, its 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 its products or other claims arising from its products. The Company cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under its guarantee 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. 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. 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 2002.

      In connection with the acquisition of Conductus we recognized $20 million of goodwill. Goodwill is tested for impairment annually in the fourth quarter after the annual planning process, or earlier if events occur which require an impairment analysis be performed. We operate in a single business segment as a single reporting unit. The first step of the impairment test, used to identify potential impairment, compares the fair value based on market capitalization of the entire Company with the book value of its net assets, including goodwill. (The Company’s market capitalization is based the closing price of our common stock as traded on NASDAQ multiplied by our outstanding common shares.) If the fair value of the Company exceeds the book value of our net assets, our goodwill is not considered impaired. If the book value of our net assets exceeds our fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the goodwill with the book value of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. At December 31, 2004, we tested the goodwill for possible impairment and determined that there was no impairment. The fair value of the Company based on its market capitalization totaled $149.7 million which is in excess of the total book value of the Company. Therefore, our goodwill was not considered impaired. This goodwill will again be tested for impairment in the fourth quarter of 2005 or earlier if events occur which require an earlier assessment. If the carrying amount exceeds its implied fair value, an impairment loss will be recognized equal to the excess. Any future impairment of our goodwill could have a material adverse effect on our financial position and results of operations.

      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 the Company. Periodically, long-lived assets that will continue to be used by the Company 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 completed such an analysis as of the fourth quarter of 2004 and determined that

no write down was necessary. Our estimates of future cash flows may prove to be inaccurate and we may understate or overstate the write down of long lived assets.

      As permitted under Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation”, we have elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for its 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 account 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 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:

      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 are currently involved as a defendant in a securities class action lawsuit. This matter is discussed below in “Legal Proceedings.” We reached an agreement in principle with the lead plaintiffs appointed by the District Court to settle this matter. Under the terms of the proposed settlement, our insurers will pay $4.0 million into a settlement fund, and we will pay up to $50,000 of the costs of providing notice of the settlement to settlement class members. The agreement in principle remains subject to completion of mutually acceptable written settlement documents, approval by our Board of Directors, and approval by the District Court. We recorded an estimated liability of $4.0 million for the settlement and an estimated receivable of $4.0 million for the expected insurance proceeds. We periodically reassess our potential liability as additional information becomes available. If we later determine that the probable loss is greater than our reserve or expected insurance proceeds, we would record an additional reserve for the potential additional loss. The ultimate amount of further losses, if any, could materially impact our results of operations, financial condition or cash flows.

Backlog

      Our commercial backlog consists of accepted product purchase orders with scheduled delivery dates during the next twelve months. We had commercial backlog of $730,000 at December 31, 2004, as compared to $250,000 at December 31, 2003. We also had at December 31, 2004 minimum purchase commitments

totaling $7.2 million from one customer under a general purchase agreement. We expect to fulfill these commitments during 2005, but we did not include them in our backlog because the customer has not identified the product mix and/or scheduled delivery dates.

Results of Operations

      We acquired Conductus, Inc. on December 18, 2002. Conductus was located in Sunnyvale California and was a competing supplier of high-temperature superconducting technology for wireless networks. We discontinued their competing commercial product line (the ClearSite) and incorporated their technology into our commercial product line (the SuperLink). The results of Conductus are included in the consolidated financial statement for 13 days in 2002 following its acquisition and for all periods thereafter. The acquisition did not have a significant impact on the results of operations for the year ended December 31, 2002. Conductus contributed $4.6 million to our government revenues in 2003. We consolidated the Conductus operation into our Santa Barbara facilities in the second quarter of 2004.

      Net revenues decreased by $26.4 million, or 53%, from $49.4 million in 2003 to $23.0 million in 2004. 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 to $16.8 million in 2004 from $38.6 million in 2003, a decrease of $21.8 million, or 56%. The decrease is primarily the result of a $21.9 million decline in sales of our SuperLink Rx products. We experienced significant declines in sales of these products to our two largest customers. We anticipated some decline in sales to one of these customers and expected to offset it with the addition of another new major customer in 2004. Our sales efforts were adversely affected in 2004 by, among other things, changes in capital spending patterns and consolidation in the telecommunications industry. The average selling price of our SuperLink Rx product is comparable between the periods. Our two largest customers accounted for 87% of our net commercial revenues in 2004 and 85% in 2003. 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.

      Net commercial product revenue consists of gross commercial product sales proceeds less sales discounts and the allocation of certain sales proceeds to a warrant issued to one customer in 1999 under a long-term supply agreement. The following table summarizes the calculation of net commercial product revenue for 2004 and 2003:

      Government contract revenues decreased by $4.6 million, or 43%, from $10.8 million in 2003 to $6.2 million in 2004. This decrease is primarily attributable to the completion of contracts in 2003 and 2004 that have not been replaced.

      Cost of commercial product revenues includes all direct costs, manufacturing overhead, provision for excess and obsolete inventories and restructuring and impairment charges relating to the manufacturing operations. The cost of commercial product revenue totaled $23.4 million for 2004 and $28.2 million for 2003.

Decreased costs result primarily from decreased unit shipments partially offset by increased provision for excess and obsolete inventories and restructuring and impairment charges.

      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.

      The following is an analysis of our gross profit and margins:

      We had a negative gross profit of $6.6 million in 2004 from the sale of our commercial products as compared to positive gross profit of $10.3 million in 2003. We experienced negative gross profits in 2004 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 $4.8 million charge for excess and obsolete inventory and a $1.1 million charge for restructuring activities and fixed asset write downs. This compares to $719,000 for charge for excess and obsolete inventory in 2003. We regularly review inventory quantities on hand and provided 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 $4.5 million in 2004 as compared to $6.9 million in 2003. These decreases were the result of lower expenses associated with performing a fewer number of government contracts offset by higher expenses associated with completing a contract.

      Other research and development expenses relate to development of new and wireless commercial products. We also incur design expenses associated with reducing the cost and improving the manufacturability of our existing products. These expenses totaled $5.0 million in 2004 as compared to $4.7 million in the prior year. The increase is due to increased commercial products development efforts.

      Selling, general and administrative expenses totaled $16.1 million in 2004, as compared to $20.6 million in 2003. The decrease in 2004 results primarily from lower ISCO litigation expenses, the closure of our Sunnyvale facility, reduced payments under our management incentive program and restructuring activities. These decreases were partially offset by higher legal expenses associated with the class action lawsuit and higher expenses related to the documentation and testing of our internal controls as required by the Sarbanes Oxley Act of 2002.

      During 2004, we implemented several restructuring programs to streamline our operations and reduce our cost structure. We recorded cash and non-cash restructuring charges of $3.6 million for these activities. We consolidated our Sunnyvale operations into our Santa Barbara facility and reduced our total workforce. The workforce reduction included reductions associated with the Sunnyvale consolidation, as well as other strategic

reductions in the organization. In addition, as part of the consolidation, we accelerated a program to implement of a new, lower cost wafer deposition process called Reactive Co-Evaporation.

      As a result of all cost reduction initiatives, we saved approximately $2.4 million in the quarter ended December 31, 2004, as compared to the first quarter of 2004.

      In connection with our 2005 annual planning process performed in the fourth quarter of 2004, we concluded that we would no longer use our thallium high temperature superconducting related technology beyond 2005 because alternative technologies were determined to be more cost effective and we decided we no longer wanted to support two HTS material technologies. As a result, we recorded non-cash charges of $715,000 primarily relating to the write-off of thallium related manufacturing equipment, patents and licenses since they will not be recovered from future cash flows. Also, during our annual planning process we concluded that we would no longer continue to develop or maintain and would abandon certain other non core business patents and patents no longer considered blocking our business, and certain purchased technology. As a result of the abandonment of the purchased technology and patents, we recorded non-cash charges of $842,000 relating to the write-off of these patents and purchased technology since they will not be recovered from future cash flows.

      The following table summarizes our actual restructuring and impairment charges for 2004 and our estimated charges for 2005 relating to the actions taken in 2004:

      Interest income decreased in 2004 as compared to the prior year because we had less cash available for investment.

      Interest expense in 2004 totaled $1.2 million as compared to $504,000 in 2003. This increase is related primarily to an $802,000 non-cash charge for warrants issued to the lenders in connection with a bridge loan in April 2004 (discussed below).

      We were named as a defendant in several substantially identical class action lawsuits filed in the United States District Court for the Central District of California in April 2004. We recently reached an agreement in principle with the lead plaintiffs appointed by the District Court to settle this matter. Under the terms of the proposed settlement, our insurers will pay $4.0 million into a settlement fund, and we will pay up to $50,000 of the costs of providing notice of the settlement to settlement class members. The agreement in principle remains subject to completion of mutually acceptable written settlement documents, approval by our Board of Directors, and approval by the District Court. We recorded a liability at December 31, 2004 on our consolidated balance sheet for the proposed amount of the settlement of $4,050,000. In addition, because the insurance carrier involved in this suit agreed to pay $4.0 million of the settlement amount, and therefore, recovery from the insurance carrier is probable, we also recorded a receivable on our balance sheet for that amount. Accordingly, the settlement had a $50,000 impact on our statement of operations for the year ended December 31, 2004. We included this amount in our selling, general and administrative expenses.

      We had a net loss of $31.2 million for the year ended December 31, 2004 as compared to $11.3 million in the same period last year.

      The net loss available to common shareholders totaled $0.37 per common share in the 2004, as compared to $0.18 per common share in the same period last year.

      Total net revenues increased by $27.0 million, or more than 100%, from $22.4 million in 2002 to $49.4 million for 2003. This increase is primarily due to higher commercial product sales and government and other contract revenues, including the government contract and other revenue from our acquisition of Conductus in December 2002.

      Net commercial product revenues increased to $38.6 million in 2003 from $17.6 million in 2002, an increase of $21.0 million, or more than 100%. This increase is primarily the result of an increase in sales of our SuperLink Rx products of $17.2 million, increased sales of our multiplexer product of $1.2 million and a $2.3 million decrease in sales proceeds allocated to warrants issued to U.S. Cellular. The average selling price for the SuperLink Rx decreased 7% on our SIX-Pak units and increased 1% on our TWO-Pak units. Our two largest customers accounted for 85% of our net commercial revenues in 2003 and 92% in 2002.

      Net commercial product revenue consists of gross commercial product sales proceeds less sales discounts and the allocation of certain sales proceeds to a warrant issued to one customer in 1999 under a long-term supply agreement. The following table summarizes the calculation of net commercial product revenue for 2003 and 2002:

      Government contract revenues increased by $6.0 million, or more than 100%, from $4.8 million in 2002 to $10.8 million in 2003. This increase results primarily from the acquisition of Conductus which totaled $4.6 million and the remainder to a modest increase in other government contracts at our Santa Barbara facility.

      Cost of commercial product revenue includes all direct costs, manufacturing overhead and related start-up costs. The cost of commercial product revenues totaled $28.2 million for 2003. For 2002, cost of commercial products revenues totaled $19.3 million, and was reduced by amortization credits of $2.0 million for the accrual of a non-cash contract loss on the purchase order from U.S. Cellular. Please read the discussion under the caption “Non-Cash Charges for Warrants Issued to U.S. Cellular. ” For 2002, excluding these amortization credits, the cost of commercial revenues totaled $21.3 million compared to $28.2 million in 2003. Increased costs resulting from increased unit shipments and higher costs associated with ramping up our manufacturing capacity were offset by lower material and labor costs per unit and the effect of increased manufacturing efficiencies.

      The following is an analysis of our gross profit and margins for 2002 and 2003:

      We generated positive commercial gross margins of $10.3 million in 2003 from the sale of our commercial products, as compared to negative gross margins of $1.7 million for 2002. The improvement is due to increased commercial product revenues and decreased manufacturing cost per unit.

      Contract research and development expenses totaled $6.9 million in 2003 and $2.5 million in 2002. The increase is primarily from the acquisition of Conductus. The remainder is attributable to a modest increase in government contract revenues at our Santa Barbara facility.

      Other research and development expenses are for internally funded development of our commercial products. These expenses increased to $4.7 million in 2003, and are comparable to $4.5 million in 2002.

      Selling, general and administrative expenses totaled $20.6 million in 2003 as compared to $15.0 million in 2002. This increase results primarily from increased domestic and international marketing and sales efforts, higher expenses related to the acquired Conductus operations and higher ISCO litigation expenses. ISCO litigation expenses totaled $4.8 million in 2003, as compared to $3.1 million in 2002.

      Interest income decreased in 2003 as compared to 2002 due to decreased levels of cash available for investment and the decline in interest rates.

      Interest expense increased in 2003 as compared to 2002 and resulted from the increased debt incurred in the fourth quarter of 2002, from short-term borrowings in 2003 and accretion of long term liabilities recorded in the Conductus acquisition.

      We had a net loss of $11.3 million for 2003 as compared to $19.5 million in 2002.

      The net loss available to common shareholders totaled $11.3 million in 2003, or $0.18 per common share, as compared to $21.3 million, or $0.89 per common share, in 2002. The amounts for 2002 include a charge of $1.8 million for a non-cash deemed distribution on preferred stock.

Liquidity and Capital Resources

      As of December 31, 2004, we had working capital of $16.1 million, including $12.8 million in cash and cash equivalents, as compared to working capital of $15.6 million at December 31, 2003, which included $11.1 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. We believe that all of our cash investments would be readily available to us should the need arise.

      Cash and cash equivalents increased by $1.7 million from $11.1 million at December 31, 2003 to $12.8 million at December 31, 2004. Cash was used in operations for the purchase of property and equipment and for the payment of short and long-term borrowings. These expenditures were offset by cash received from the sale of common stock in two public offerings. Cash and cash equivalents decreased by $7.1 million from $18.2 million at December 31, 2002 to $11.1 million at December 31, 2003. Cash used in operations was partially offset by cash received from the sale of common stock and warrants in a private placement, exercises of warrants and options and a net increase in borrowings.

      Cash used in operations totaled $21.6 million in 2004. We used $18.3 million to fund the cash portion of our net loss. We also used cash to fund a $10.7 million increase in inventory, prepaid expenses and other

current assets, patents and licenses and accounts payable payments. Inventory increased during 2004 due to lower than expected sales. These uses were partially offset by cash generated from the collection of accounts receivable of $7.4 million. Cash used in operations totaled $18.5 million in 2003. We used $7.2 million to fund the cash portion of our net loss. We also used cash to fund an $11.2 million increase in accounts receivable, inventory, patents and licenses, other assets and accounts payable. Depreciation and amortization expense increased in the year ended December 31, 2003 due to increased amortization related to the acquired technology in the Conductus acquisition and increased fixed assets expenditures in the prior year. Cash used in operations totaled $20.0 million in 2002. We used $16.0 million to fund the cash portion of our net loss. We also used cash to fund a $3.9 million increase in inventory, accounts receivable, patents and licenses and reduction in accounts payable.

      Net cash used in investing activities totaled $5.5 million in 2002, $4.4 million in 2003 and $1.8 million in 2004. These expenditures all related primarily to purchases of manufacturing equipment and facilities improvements to increase our production capacity. In 2003, cash of $500,000 was used to pay upfront license fees for a new technology license. In 2002, cash of $429,000 was used in the acquisition of Conductus, Inc. and $374,000 was provided by the release of restrictions on $374,000 of cash obtained through the Conductus acquisition.

      Net cash provided by financing activities totaled $25.1 million in 2004. Cash received from the sale of common stock and exercise of options and warrants totaled $28.1 million and borrowings against our credit and bridge loan facilities totaled $5.6 million. These sources of cash were partially offset by payments against our credit and bridge loan facilities totaling $7.9 million and payments against our long-term debt totaling $645,000. Net cash provided by financing activities totaled $15.8 million in 2003. Cash received from the sale of common stock and warrants totaled $13.9 million and net borrowings against our credit facility totaled $3.3 million and was partially offset by the reduction in long-term borrowings of $1.4 million. Net cash provided by financing activities totaled $28.4 million in 2002. Cash received from the sale of common stock and warrants totaled $31.9 million, which was partially offset by a $3.0 million premium paid on conversion of the Series E Convertible Preferred Stock and payments against our long-term debt totaling $519,000.

      We have historically financed our operations through a combination of cash on hand, cash provided from operations, 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 March 17, 2005, and we expect to renew it for another year on substantially the same terms as currently in effect. 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 (5.25% at December 31, 2004) plus 2.50% subject to a minimum monthly charge. Outstanding amounts under this borrowing facility at December 31, 2004 totaled $938,000. The amount outstanding is repaid upon collection of the underlying accounts receivable. 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.

      We completed three financing transactions during 2004. First, in April 2004, we temporarily expanded our credit facility and secured a bridge loan to provide interim funding until we could complete a larger public offering. We temporarily amended our existing line of credit to increase borrowing capacity from 80% to 95% of eligible accounts receivable. We concurrently secured a commitment for a $2.0 million secured bridge loan from an investor. The investor subsequently funded $1.5 million of the bridge loan. We issued to the lenders warrants to purchase in the aggregate 600,000 shares of common stock at $1.85 per share. The bridge loan was subsequently paid in full on May 26, 2004. Upon repayment of the bridge loan, our credit facility reverted back to its original terms.

      Second, we completed a public offering of 23,000,000 shares of common stock at $0.80 per share during the second quarter of 2004 raising net proceeds of $16.7 million.

      Third, we completed a public offering of 15,600,000 shares of common stock at $0.70 per share during the fourth quarter of 2004 raising net proceeds of $10.1 million.

      We incur various contractual obligations and commercial commitments in our normal course of business. They consist of the following:

      Our capital lease obligations are for property and equipment and total $89,000.

      Our operating lease obligations consist of facility leases in Santa Barbara and Sunnyvale, California. We assumed the Sunnyvale leases in connection with our acquisition of Conductus, Inc. in 2002. The Sunnyvale lease obligations total $1,386,000 and are due in monthly installments through February 2006. We consolidated the Sunnyvale operations into our Santa Barbara facility in 2004 and recorded a liability for the present value of the remaining obligations under the Sunnyvale leases. We included these liabilities in the financial statements under Accrued Liabilities and Other Long Term Liabilities.

      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.

      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.

      At December 31, 2004, we had the following contractual obligations and commercial commitments:

      We plan to invest approximately $500,000 in fixed assets during 2005.

      Our principal sources of liquidity consist of existing cash balances and funds expected to be generated from future operations. We expect our existing cash resources, together with our line of credit and a planned inventory reduction, will be sufficient to fund our planned operations for at least the next twelve months. We have more inventory than required for current sales volumes and plan to use our excess inventory as a material source of funding in 2005. We believe the key factors to our liquidity in 2005 will be our ability to successfully execute on our plans to increase sales levels and to convert excess inventory to cash. 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.

      If actual cash flows deviate significantly from forecasted amounts, we may require additional financing in the next twelve months. We cannot assure you 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, we 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.

      In the last several years, we have raised money from investors to cover our operating losses through public and private offerings. Our ability to continue to raise funds using these methods may be adversely impacted by any future NASDAQ listing issues. Our continued NASDAQ listing requires us to maintain a minimum of $1 share price. Our stock has recently begun trading at levels significantly below $1 per share. Although NASDAQ de-listing would not be immediate, our lower share price could make capital raising more difficult.

      Our financial statements have been prepared assuming that the Company will continue as a going concern. The factors described above raise substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from this uncertainty.

      Our independent registered public accounting firm has included in their audit report for fiscal 2004 an explanatory paragraph expressing doubt about our ability to continue as a going concern. They included a similar explanatory paragraph in their audit report for 2002 and 2003. In 2004, we incurred a net loss of $31.2 million and had negative cash flows from operations of $21.6 million. In response, we reduced direct and indirect labor and continued to cut fixed costs. We also consolidated our Sunnyvale operations into our Santa Barbara facility and accelerated the implementation of a new, lower cost wafer deposition process.

Non-Cash Charges for Warrants Issued To U.S. Cellular

      In August 1999, we entered into a warrant agreement with United States Cellular Corporation (“U.S. Cellular”) where the exercise of a warrant to purchase up to 1,000,000 shares of common stock was conditioned upon future product purchases by U.S. Cellular. Under the terms of the warrant, U.S. Cellular vests in the right to purchase one share of common stock at $4 per share for every $25 of SuperFilter systems purchased. The warrant is immediately exercisable with respect to any vested shares and expires August  27, 2004. For accounting purposes, we are allocating proceeds from sales under this agreement between commercial product revenues and the estimated value of the warrants vesting in connection with those sales. The estimated fair value of the warrants in excess of the related sales, when applicable, is recorded in cost of commercial product revenues.

      In September 2000, we received a $7.8 million noncancelable purchase order from U.S. Cellular for SuperFilter® systems to be shipped over the next nine quarters. In consideration for the purchase order, we amended the August 1999 warrant agreement and vested 312,000 warrants to U.S. Cellular. The vested

warrants are immediately exercisable, not subject to forfeiture, and U.S. Cellular has no other purchase obligations.

      We estimated the fair value of the warrants vesting upon receipt of this order at $5,635,000 using the Black-Scholes option-pricing model and recorded this amount as a deferred warrant charge in the statement of stockholders’ equity. As SuperFilter systems are shipped under this purchase order, the related sales proceeds will be allocated between stockholders’ equity and commercial product revenue using the percentage relationship which existed between the fair value of the warrants as recorded in September 2000 and the amount of the non-cancelable purchase order. During 2001 and 2002 sales proceeds of $2,237,000 and $2,280,000, respectively, for shipments pursuant to this purchase order were allocated to the deferred warrant charge and proceeds of $879,000 and $967,000, respectively, were recorded as commercial product revenues under this purchase order.

      After the allocation of sales proceeds under the $7.8 million purchase order to the related warrants, the estimated cost of providing products under the purchase order exceeded related revenue by $5.3 million. The resulting loss was reflected in the results of operations for the year ended December 31, 2000. During the years ending December 31, 2001 and 2002, $2,243,000 and $1,998,000, respectively, of this reserve was reversed against the cost of product delivered under this purchase order.

      During the fourth quarter of 2002, deliveries under the $7.8 million purchase order were completed. For accounting purposes, proceeds from subsequent sales to U.S. Cellular under this agreement are again being allocated between commercial product revenue and the estimated value of the warrants vesting using the Black-Scholes option-pricing model. For subsequent product sales, in the fourth quarter of 2002, the year ended December 31, 2003 and December 31, 2004, U.S. Cellular vested in the right to exercise the warrant and purchase a total of 22,540, 38,088 and 7,024 shares of common stock, respectively. Sales proceeds allocated to warrants vesting in 2002, 2003 and 2004 totaled $3,000, $90,000 and less than $1,000, respectively.

      This warrant expired unexercised on August 27, 2004.

Net Operating Loss Carryforward

      As of December 31, 2004, we had net operating loss carryforwards for federal and state income tax purposes of approximately $244.6 million and $119.4 million, respectively, which expire in the years 2005 through 2024. Of these amounts $93.7 million and $30.2 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 have research and development and other tax credits for federal and state income tax purposes of approximately $2.6 million and $2.4 million, respectively, which expire in the years 2005 through 2024. Of these amounts $972,000 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 completed an analysis of our equity transactions and determined that we had a change in ownership in August 1999 and December 2002. Therefore, the ability to utilize net operating loss carryforwards incurred prior to the change of ownership totaling $101.6 million 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 $93.7 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 $51.4 million and are not subject to this limitation.

Future Accounting Requirements

      In December 2004, the Financial Accounting Standards Board issued SFAS No. 123® (revised 2004), “Share-Based Payment” which amends SFAS Statement 123 and will be effective for public companies for interim periods or annual periods beginning after June 15, 2005. The new standard will require us to recognize compensation costs in our financial statements in an amount equal to the fair value of share-based payments granted to employees and directors. We are currently evaluating how we will adopt the standard and evaluating the effect that the adoption of SFAS 123® will have on our financial position and results of operations.

      In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”, and amendment of ARB No. 43, Chapter 4. This statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB No. 43, Chapter 4, previously stated that “...under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges....” SFAS No. 151 requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overheads to the cost of conversion be based on the normal capacity of the production facilities. The provisions of SFAS 151 shall be applied prospectively and are effective for inventory costs incurred during fiscal years beginning after June 15, 2005, with earlier application permitted for inventory costs incurred during fiscal years beginning after the date this Statement was issued. We do not expect the adoption of SFAS No. 151 to have a material impact on our 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.

      At December 31, 2004, we had approximately $11.9 million invested in a money market account yielding approximately 2.013%. 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 $119,000 per annum. Also, at December 31, 2004 we had $938,000 outstanding under a bank borrowing arrangement bearing interest at the prime rate (5.25% at December 31, 2004) plus 2.50%. Assuming a 1% increase in the prime rate interest and that the amount was outstanding for the entire year, interest expense would increase approximately $9,000.

Forward-Looking Statements

      This report contains forward-looking statements that involve risks and uncertainties. We have made these statements in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Our forward-looking statements relate to future events or our future performance and include, but are not limited to, statements concerning our business strategy, future commercial revenues, market growth, capital requirements, new product introductions, expansion plans and the adequacy of our funding. Other statements contained in this report that are not historical facts are also forward-looking statements. We have tried, wherever possible, to identify forward-looking statements by terminology such as “may,” “will,” “could,” “should,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and other comparable terminology.

      Forward-looking statements are not guarantees of future performance and are subject to various risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from

those expressed in forward-looking statements. They can be affected by many factors, including, but not limited to the following:

      Please read the section in this report entitled “Business — Additional Factors That May Affect Our Future Results” for a description of additional uncertainties and factors that may affect our forward-looking statements. Forward-looking statements are based on information presently available to senior management, and we do not assume any duty to update our forward-looking statements.

Inflation

      We do not foresee any material impact on our operations from inflation.