SUPERCONDUCTOR TECHNOLOGIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[August 14, 2012]

SUPERCONDUCTOR TECHNOLOGIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) General We are a leading company in developing and commercializing high temperature superconductor ("HTS") materials and related technologies. Superconductivity is the unique ability to conduct various signals or energy (e.g., electrical current or radio frequency ("RF") signals) with little or no resistance when cooled to "critical" temperatures. HTS materials are a family of elements that demonstrate superconducting properties at temperatures significantly warmer than previous superconducting materials. Electric currents that flow through conventional conductors encounter resistance that requires power to overcome and generates heat. HTS materials can substantially improve the performance characteristics of electrical systems, reducing power loss, lowering heat generation, and decreasing electrical noise.

Commercialization Our development efforts over the last 25 years have yielded an extensive patent portfolio as well as critical trade secrets, unpatented technology and proprietary knowledge. We have commercialized wireless products using our proprietary technology and are currently focusing our efforts on commercializing this technology in superconducting power applications, RF filters and cryocoolers.

16 -------------------------------------------------------------------------------- Table of Contents • Wireless Networks. Our current commercial products help maximize the performance of wireless telecommunications networks byimproving 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 for the carrier.

• Superconducting Power Applications. We are adapting our unique HTS materials deposition techniques to deliver energy efficient, cost-effective and high performance 2G HTS wire technology for next generation power applications. We have identified several large initial target markets for our 2G HTS wire including energy (wind turbines, smart grid) and industrial (motors, generators) applications. To accelerate development and manufacturing processes for our 2G HTS wire, we are partnering with HTS industry leaders and the United States National Labs. In July 2011, we renewed our three year Cooperative Research and Development Agreement with Los Alamos National Laboratory. These technological interchanges will help us meet the technical challenges and performance metrics for both high performance and cost effective 2G HTS wire.

• RF Filters. Our RF filter structures resemble a circuit on a semiconductor using a circuit that is etched into HTSmaterials that are deposited on a wafer. Our unique and innovative circuits allow us to utilize the characteristics of the HTS materials for this application, and we have developed unique tuning methods that allow us to produce a frequency specific filter. We are also leveraging our unique technology to design advanced reconfigurable filters, which have the potential to drastically reduce the size and cost of mobile devices.

• Cryocoolers. We developed a unique cryocooler that can efficiently and reliably cool HTS circuits to the critical temperature (77 degrees Kelvin), and as a result, our wireless products are maintenance free and reliable enough to be deployed for many years.

Our development efforts can take a significant number of years to commercialize, and we must overcome significant technical barriers and deal with other significant risks.

Our Wireless Business Our current revenue comes from the design, manufacture, and sale of high performance infrastructure products for wireless communication applications. We have three current product lines all of which relate to wireless base stations: • SuperLink®, a highly compact and reliable receiver front-end HTS wireless filter system to eliminate out-of-bandinterference for wireless base stations, combining filters with a proprietary cryogenic cooler and a cooled low-noise amplifier; • AmpLink®, a ground-mounted unit for wireless base stations that includes a high-performance amplifier and up to six dual duplexers; and • SuperPlex, a high-performance multiplexer that provides extremely low insertion loss and excellent cross-band isolation designed to eliminate the need for additional base station antennas and reduce infrastructure costs.

We sell most of our current commercial products to a small number of wireless carriers in the United States, including AT&T and Verizon Wireless. Verizon Wireless and AT&T each accounted for more than 10% of our commercial revenues in each of the last three years. Demand for wireless communications equipment fluctuates dramatically and unpredictably and recently has been trending downward. 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 expect these trends to continue and they may cause significant fluctuations in our quarterly and annual revenues.

Our Strategic Initiatives In addition to our ongoing sale of products for wireless applications described above, we have created several unique capabilities and an HTS manufacturing system related to a new HTS wire platform, RF filters and cryocoolers that we are seeking to commercially deploy by leveraging our leadership in superconducting technologies, extensive intellectual property, and HTS manufacturing expertise.

HTS Wire Platform Our 2G HTS wire product development is focused on large markets where the advantages of HTS wire are recognized by the industry. Our initial product roadmap targets three important applications: superconducting high power transmission cable, superconducting fault current limiters (SFCL) and superconducting rotating machines such as motors and generators.

17-------------------------------------------------------------------------------- Table of Contents Superconducting High Power Transmission Cable: Superconducting high power transmission and distribution cable transmit 5 to 10 times the electrical current of traditional copper or aluminum cables with significantly improved efficiency. HTS power cable systems consist of the cable, which is comprised of hundreds of strands of HTS wire wrapped around a copper core, and the cryogenic cooling system to maintain proper operating conditions.

HTS superconducting cables offer solutions for utilities facing challenges that include: substation footprint availability, lack of available rights of way, and high load connections between substations. HTS power cables are particularly suited to high load areas such as the dense urban business districts of large cities, where purchases of easements and construction costs for traditional low capacity cables may be cost prohibitive.

Superconducting Fault Current Limiter (SFCL): With power demand on the rise and new power generation sources being added, the grid has become overcrowded and vulnerable to catastrophic faults. Faults are abnormal flows of electrical current like a short circuit. As the grid is stressed, faults and power blackouts increase in frequency and severity. SFCLs act like powerful surge protectors, preventing harmful faults from taking down substation equipment by reducing the fault current to a safer level (20 - 50% reduction) so that the existing switchgear can still protect the grid. SFCLs protect against damaging fault currents and blackouts while enhancing system safety, stability, and efficiency. A critical benefit for new build outs is the improved system reliability when renewables, like solar and wind, are added.

When compared to a complete substation upgrade, SFCLs are a significantly lower capital investment.

Superconducting Rotating Machines - Motors and Generators: Superconducting motors, generators, turbines and other rotating machines are expected to generate large future demand for 2G HTS wire. Coils utilizing HTS wire will enable electric motors and generators to operate at much higher power densities. When compared to a copper wire based electric machine with equivalent output power, future superconducting motors and generators will enable significant size reductions for the motors with higher efficiency. One potential application for high-powered HTS generators is expected to be 10+ megawatt offshore wind turbines. Offshore superconducting wind turbines promise to capture clean energy at a lower cost than competing renewables, while delivering power directly to growing coastal cities. Offshore superconducting wind turbines are a long-term initiative for HTS technologies. Wind energy is taking shape as a critical world resource for electric power. Today, wind energy is primarily land based. The expected future trend is to exploit a largely untapped supply of offshore wind energy. However, it will take time to build enough infrastructure for offshore wind power to significantly contribute to the power grid.

Superconducting wind turbines are expected to play a unique role offshore since conventional technology cannot achieve the necessary "power per tower". The increase in power density provided by superconducting turbines significantly reduces generator weight and maximizes power per tower, turning wind power into an economically viable alternative. Size reduction translates directly to cost savings by greatly reducing the amount of magnetic steel and structural steel required. Superior 2G HTS wire power handling performance at a lower cost will enable superconducting wire to replace incumbent and competing technologies.

RF Filters Conventional RF filters are fabricated primarily from aluminum blocks with hollow cavities, resonators, and tuning elements incorporated to make a frequency specific filter. Our filter structures resemble a circuit on a semiconductor using a circuit that is etched into HTS materials that are deposited on a wafer. Our unique and innovative circuits allow us to utilize the characteristics of the HTS materials for this application. We have also developed unique tuning methods that allow us to produce a frequency specific filter.

In July 2012 we announced we were contributing 14 patents regarding our innovative Reconfigurable Resonance™ (RcR) technology, experienced executive leadership and technical expertise as our minority investment in Resonant LLC. Resonant intends to commercialize RcR for the mobile communication products industry. The contributed patents do not relate to either our current wireless business nor to our 2G HTS wire initiative.

18-------------------------------------------------------------------------------- Table of Contents Cryocoolers HTS circuits need to be cooled to the critical temperature that enables the superconducting properties of the materials to be utilized. To meet this need, we developed a unique cryocooler that can efficiently and reliably cool the circuit to the critical temperature (77 degrees Kelvin). As a result, our wireless products are maintenance free and reliable enough to be deployed for many years.

Results of Operations Quarter and six months ended June 30, 2012 compared to the quarter and six months ended July 2, 2011 Net revenues decreased by $520,000 or 47%, to $596,000 in the second quarter of 2012 from $1.1 million in the second quarter of 2011. Total net revenues decreased by $1.7 million, or 64%, to $995,000 in the first six months of 2012 from $2.7 million in the same period of 2011. Net revenues consist primarily of commercial product revenues and government contract revenues.

Net commercial product revenues decreased by $572,000, or 52%, to $529,000 in the second quarter of 2012 from $1.1 million in the second quarter of 2011. The decrease is the result of lower sales volume for our SuperLink products. For the first six months of 2012, net commercial revenue decreased to $873,000 from $2.7 million in the same period of 2011, a decrease of $1.8 million, or 68%. The decrease in the six month period was the result of lower sales of both our SuperLink and AmpLink products. We sell our SuperLink and other performance enhancement products to large North American wireless operators. As our customers continue to invest in 4G networks, spending on 3G data networks, where our products are deployed, has become a secondary priority. This market dynamic has impacted and we believe will continue to impact our commercial revenue. The average sales prices for our products were unchanged. Our three largest customers accounted for 95% of our total net commercial product revenues in the first six months of 2012 and 99% in the same period of 2011. These customers generally purchase products through non-binding commitments with minimal lead-times. We also continue to experience challenges to revenue growth in the commercial wireless market. Consequently, our commercial product revenues can fluctuate dramatically from quarter to quarter based on changes in our customers' capital spending patterns, and revenues may continue to be impacted by such challenges.

Government contract and other revenues increased by $52,000 from $15,000 in the second quarter of 2011 to $67,000 in the second quarter of 2012. For the first six months of 2012, government contract revenues increased to $122,000 from $32,000, an increase of $90,000, or 281%. This increase is attributable to the addition of two small government contracts procured in early 2012.

Cost of commercial product revenues includes all direct costs, manufacturing overhead and provision for excess and obsolete inventories. The cost of commercial product revenues decreased to $1.1 million in the second quarter of 2012 compared to $1.3 million for the second quarter of 2011, a decrease of $187,000 or 15%. For the first six months of 2012, the cost of commercial product revenues totaled $1.9 million compared with $2.9 million for the first six months of 2011, a decrease of $1.0 million, or 34%. The lower costs resulted principally from lower production as a result of lower sales. We had an expense provision for obsolete inventories in the first half of 2012 of $182,000 compared to no expense provision in the first half of 2011.

Our cost of commercial 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 against which to absorb our overhead costs.

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 against which to absorb our overhead costs. 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.

19-------------------------------------------------------------------------------- Table of Contents The following is an analysis of our commercial product gross loss: Dollars in thousands Three Months Ended Six Months Ended June 30, 2012 July 2, 2011 June 30, 2012 July 2, 2011 Net commercial product sales $ 529 100 % $ 1,101 100 % $ 873 100 % $ 2,704 100 % Cost of commercial product sales 1,078 204 % 1,265 115 % 1,922 220 % 2,934 109 % Gross loss $ (549 ) (104 )% $ (164 ) (15 )% $ (1,049 ) (110 )% $ (230 ) (9 )% We had a gross loss of $549,000 in the second quarter of 2012 from the sale of our commercial products compared to a gross loss of $164,000 in the second quarter of 2011. We experienced a gross loss in the second quarters of 2012 and 2011 because the level of commercial sales was insufficient to cover our fixed manufacturing overhead costs. 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. Gross margin in the second quarters and first six months of 2012 and 2011 was not impacted by the sale of previously written-off inventory.

Cost of government and other contract revenues totaled $43,000 in the second quarter of 2012 compared to $15,000 in the second quarter of 2011 and $95,000 in the first half of 2012 compared to $30,000 in the first half of 2011. This increase was the result of higher expenses associated with more revenue from government contracts. Because these contracts are generally priced on a "cost plus" basis, increases in revenue generally result in increases in associated costs. As a percentage of government and other contract revenues, these costs decreased to 78% in the first half of 2012 compared to 99% in the first half of 2011 because of the cost plus nature of the contracts.

Research and development expenses relate principally to development of our HTS wire products and other products related to our expertise. These expenses totaled $1.3 million and $2.5 million, respectively, in the three and six months ended June 30, 2012 compared to $1.4 million and $3.3 million in the three and six month period ended July 2, 2011. These expenses were $0.8 million higher in the prior six month period when we voluntarily terminated a patent license we had with a third party along with certain other related intangible assets. As a result, capitalized cost was charged to expense during the six months ended July 2, 2011.

Selling, general and administrative expenses totaled $1.6 million and $3.0 million, respectively, in the three and six months ended June 30, 2012 compared to $1.7 million and $3.3 million in the three and six months ended July 2, 2011.

The reduction was primarily from lower sales expenses.

Interest income for the three and six months ended June 30, 2012 was $3,000 and $5,000 respectively compared to $2,000 and $4,000, respectively, in the three and six months ended July 2, 2011. The increases resulted from higher interest rates in the 2012 periods.

There was no interest expense for the three and six months ended June 30, 2012.

Interest expense for the three and six months ended July 2, 2011 was $7,000 and $14,000, respectively, and was the result of our line of credit with a bank. We had not used the line of credit in a number of years and allowed it to expire in 2011.

We had a net loss of $3.4 million for the quarter ended June 30, 2012, compared to a net loss of $3.2 million in the same period of 2011. For the six months ended June 30, 2012 our loss totaled $6.4 million compared to a net loss of $6.9 million for the six months ended July 2, 2011.

The net loss available to common stockholders totaled $0.09 per common share in the second quarter of 2012, compared to a net loss of $0.10 per common share in the same period of 2011. The net loss available to common stockholders totaled $0.17 per common share in the first half of 2012 compared to $0.22 per common share in the first half of 2011.

Liquidity and Capital Resources Cash Flow Analysis As of June 30, 2012, we had working capital of $5.6 million, including $5.4 million in cash and cash equivalents, compared to working capital of $7.2 million at December 31, 2011, which included $6.2 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.

Cash and cash equivalents decreased by $0.8 million from $6.2 million at December 31, 2011 to $5.4 million at June 30, 2012. Cash was provided by financing activities offset by uses in operations and by purchases of property and equipment.

20 -------------------------------------------------------------------------------- Table of Contents Cash used in operations totaled $5.5 million in the first six months of 2012. We used $5.4 million to fund the cash portion of our net loss. We also used cash to fund a $337,000 increase in accounts receivable and patents, offset by cash provided by a $420,000 decrease in inventory and other assets, as well as an increase in accounts payable and accrued expenses.

Net cash used in investing activities totaled $1.8 million in the first six months of 2012. Purchases of equipment for our HTS wire initiative were $1.8 million and $37,000 was provided by equipment sales. In the first six months of 2011, we used $647,000 to purchase property and equipment and there were no equipment sales.

We used $134,000 in financing activities in the first six months of 2012 compared to $303,000 in the first six months of 2011 to repurchase common shares from our employees to satisfy tax withholding obligations that arose upon the vesting of restricted stock awards.

Financing Activities 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.

Net cash provided by financing activities through June 30, 2012 totaled $6.6 million, net of $582,000 in expenses. The financing was from two activities: the registered direct sale of 6,711,219 shares of common stock at $1.05 per share in February 2012 and at-the-market sales to or through Citadel Securities of 97,372 shares of common stock at an average price of $1.60 per share in January and early February 2012. These financing activities were slightly offset in the first six months of 2012 by the $134,000 used to repurchase shares from our employees to satisfy tax withholding obligations mentioned above.

Contractual Obligations and Commercial Commitments We have not had any material changes outside of the ordinary course of business in our contractual obligations as disclosed in our Annual Report on Form 10-K for 2011.

Capital Expenditures We plan to invest approximately $2.1 million in fixed assets during the remainder of 2012. This $2.1 million and the $1.9 million already spent in the first six months of 2012 are for the purchase of equipment and facilities improvements for our HTS wire initiative. There have been no fixed asset expenditures in the six months ended June 30, 2012, and we do not plan any additional fixed asset expenditures in 2012 for our existing wireless business.

Future Liquidity For the first six months of 2012, we incurred a net loss of $6.4 million and had negative cash flows from operations of $5.5 million. In the full 2011 year, we incurred a net loss of $13.4 million and had negative cash flows from operations of $10 million. Our independent registered public accounting firm has included in their audit reports for 2011 and 2010 an explanatory paragraph expressing doubt about our ability to continue as a going concern.

At June 30, 2012, we had $5.4 million in cash and cash equivalents. We believe our cash resources will not be sufficient to fund our business for at least the next twelve months. We believe the key factors to our liquidity will be our ability to successfully use our expertise and our technology to generate revenues in various ways, including commercial operations, government contracts, joint ventures and licenses and we plan to leverage our leadership in superconducting technologies, extensive intellectual property, and HTS manufacturing expertise to develop and produce HTS wire. Because of the uncertainty of these factors, we will need to raise funds to meet our working capital needs. If we require additional financing, 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, 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.

Net Operating Loss Carryforward As of December 31, 2011, we had net operating loss carryforwards for federal and state income tax purposes of approximately $308.4 million and $181.5 million, respectively, which expire in the years 2012 through 2031. However, during 2011 we concluded that under the Internal Revenue Code change of control limitations, a maximum of $94.4 million and $70.2 million, respectively, would be available for reduction of taxable income and reduced both the deferred tax asset and valuation allowance accordingly. 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 condensed consolidated balance sheets.

21-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Our discussion and analysis of our historical financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements in conformity with those principles requires us to make estimates of certain items and judgments as to certain future events including, for example, those related to bad debts, inventories, recovery of long-lived assets (including intangible assets), income taxes, warranty obligations, and contingencies. These determinations, even though inherently subjective and subject to change, affect the reported amounts of our assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. While we believe that our estimates are based on reasonable assumptions and judgments at the time they are made, some of our assumptions, estimates and judgments will inevitably prove to be incorrect. As a result, actual outcomes will likely differ from our accruals, and those differences - positive or negative - could be material. Some of our accruals are subject to adjustment, as we believe appropriate, based on revised estimates and reconciliation to the actual results when available.

In addition, we identified certain critical accounting policies which affect certain of our more significant estimates and assumptions used in preparing our consolidated financial statements in our Annual Report on Form 10-K for 2011. We have not made any material changes to these policies.

Backlog Our commercial backlog consists of accepted product purchase orders with scheduled delivery dates during the next twelve months. We had commercial backlog of $231,000 at June 30, 2012, compared to $13,000 at December 31, 2011.

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