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SUPERCONDUCTOR TECHNOLOGIES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[May 09, 2014]

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 27 years have yielded an extensive patent portfolio as well as critical trade secrets, unpatented technology and proprietary knowledge. We have commercialized wireless products and cryogenic coolers using our proprietary technology and are currently focusing our efforts on this technology in superconducting power applications.

• Wireless Communications. Our current commercial 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.

• 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.

• Electric Power Utilities. As discussed above, we are adapting our unique HTS materials deposition techniques to deliver energy efficient, cost-effective and high performance Conductus wire technology for next generation power applications. We have identified several large initial target markets for our Conductus wire including energy (wind turbines, cables, fault current limiters) and industrial (motors, generators) applications. We are partnering with HTS industry leaders to accelerate our development and manufacturing processes for our Conductus wire, which we expect to begin commercial production later this year.

Our development efforts (including those described under "Our Strategic Initiatives" below) can take a significant number of years to commercialize, and we must overcome significant technical barriers and deal with other significant risks, some of which are set out in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report.

Our Wireless Business Although our current efforts are focused on our strategic initiatives described below, substantially all 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-band interference 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. As a result of this downward trend, we have managed our inventory to historically low levels, which may result in longer delivery lead times, which may not be acceptable to our customers. If this downward trend continues we may be compelled to refocus our manufacturing away from wireless products altogether. We continue to evaluate the various options available for our wireless business as we transform ourselves into a Conductus wire manufacturer.

Our commercial operations are subject to a number of significant risks, some of which are set out in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report.

16 -------------------------------------------------------------------------------- Table of Contents Our Strategic Initiatives We have created several unique capabilities and a HTS manufacturing system related to our new Conductus wire platform, 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 Conductus 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.

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 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.

The primary application for HTS cables is medium voltage feeds to load pockets in dense urban areas. In these high demand zones the grid is often saturated with aging infrastructure. HTS technology brings a considerable amount of power to new locations where the construction of additional transmission to distribution substations, with major transformer assets, is not feasible.

Another potential use of HTS power cable is to improve grid power transmission by connecting two existing substations. In dense urban environments many substations often reach capacity limits and require redundant transformer capacity to improve reliability HTS cables can tie these existing stations together, avoiding very costly transformer upgrades and construction costs.

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.

Currently, electrical-utilities use massive 80kA circuit breakers, oversized transformers and fuses to prevent faults from damaging their equipment and protecting against surges. However, once a fault has occurred, standard circuit breakers suffer destructive failure and need to be replaced before service can be restored. In addition, Smart Grid and embedded alternative energy generation enhancements will increase the need for SCFLs. Grid operators face a major challenge in moving power safely and efficiently, from generators to consumers, through several stages of voltage transformation step downs and step ups. At each stage, valuable energy is lost in the form of waste heat. Moreover, while demands are continually rising, space for transformers and substations - especially in dense urban areas - is severely limited. Conventional oil-cooled transformers pose a fire and environmental hazard. Compact, efficient superconducting transformers, by contrast, are cooled by safe, abundant and environmentally benign liquid nitrogen. As an additional benefit, these actively-cooled devices will offer the capability of operating in overload, to twice the nameplate rating, without any loss of life to meet occasional utility peak load demands.

Superconducting Rotating Machines - Motors and Generators: Superconducting motors, generators, turbines and other rotating machines are expected to generate large future demand for our Conductus wire. Coils utilizing Conductus 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 a significant size reductions for the motors with higher efficiency. One potential application for high-powered superconducting 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. Superconducting wind turbines are expected to play a unique role offshore since conventional technology cannot achieve the "power per tower" requirement.

Superconducting High Field magnets: There are a variety of applications that utilize superconducting magnets in order to capitalize on their unique ability to create extremely high magnetic fields. The NMR (Nuclear Magnetic Resonance) and MRI (Magnetic Resonance Imaging) machines of today utilize such superconducting magnets for this very reason. Currently, high-field superconducting magnets 17 -------------------------------------------------------------------------------- Table of Contents are manufactured using commercially available superconducting wire such as niobium-titanium (NbTi) or niobium-tin (Nb3Sn). NMR and MRI device manufacturers look towards advances in superconducting technologies to improve the overall performance of their systems by dramatically increasing the magnetic fields while reducing size. High demand for a robust, high performance and low cost superconducting wire has spurred rapid development of a next generation alternative. In the last 10 years, new second generation (2G) Rare Earth, Barium, Copper Oxide (ReBCO) superconducting materials have been proven to drastically increase magnetic field strengths, especially at low temperatures.

These advanced ReBCO based superconductors now provide an excellent alternative to NbTi and Nb3Sn based materials.

Advanced RF Filters for mobile communications In February 2012 our newly formed subsidiary, Resonant LLC., entered into an agreement to develop its innovative Reconfigurable Resonance™ (RcR) technology in the rapidly growing mobile communications products industry. See further explanation below in Other Assets and Investments.

Other Assets and Investments From time to time we may pursue joint ventures with other entities to commercialize our technology. As mentioned above, in July 2012, we contributed 14 issued and pending patents regarding our innovative Reconfigurable Resonance™ (RcR) technology, limited use of our Santa Barbara facility, experienced executive leadership and technical expertise as our minority investment in Resonant LLC. As of December 31, 2012 and June 18, 2013, our interest in Resonant was 30%, and the net value of the assets contributed, estimated to approximate fair value, was $423,000 and $185,000, respectively. We had accounted for this investment using the equity method and included it in Other assets for both periods.

On June 18, 2013, we announced via a press release, that we exchanged our equity interest in Resonant LLC, a wholly owned subsidiary of Resonant Inc., for a $2.4 million subordinated convertible note receivable from the new Resonant Inc. No gain was recognized for the exchange of our net equity interest on the date of issuance for the note receivable due to uncertainties in connection with the collectability of this subordinated note receivable. Our note is subordinated to a third party lender and is only convertible in the event Resonant, Inc.

conducts an initial public offering and certain other conditions are met. We determined that our net equity interest of $185,000 approximated the fair value of the note receivable at December 31, 2013 and March 29, 2014, respectively.

Resonant Inc. filed a registration statement with the Securities and Exchange Commission in January 2014. Upon conversion of our note, we would own, before any such public offering, approximately 18.5% of Resonant Inc. We cannot estimate the value of such interest or predict the outcome of the offering by Resonant Inc.

In 2007, we formed a joint venture with Hunchun BaoLi Communication Co. Ltd.

("BAOLI") to manufacture and sell our SuperLink interference elimination solution in China. We use the equity method of accounting for our 45 percent joint venture interest. The joint venture agreement called for our joint venture partner to supply the capital and local expertise, and for us to provide a license of certain technology and supply key parts for manufacturing. Since 2007, we have been conducting lab and field trials in the existing China 2G market using our TD-SCDMA and SuperLink solutions. Although those activities continue, the parties have not completed their contributions to the joint venture, including most of the funding and our license, within the two year period specified by the agreement and Chinese law. The future of the joint venture, including any commencement of manufacturing and the transfer of our processes, will depend on product demand in China, completion of funding by our joint venture partner, as well as a number of other conditions, including certain critical approvals from the Chinese and United States governments. There continues to be no assurance that these conditions will be met and 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, some of which are set forth in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report.

Results of Operations Quarter Ended March 29, 2014 compared to the Quarter Ended March 30, 2013 Net revenues decreased by $387,000 to $389,000 in the first quarter of 2014 from $776,000 in the first quarter of 2013. Net revenues consist of commercial product revenues.

Net commercial product revenues decreased by $387,000, or 50%, to $389,000 in the first quarter of 2014 from $776,000 in the first quarter of 2013. The decrease is the result of lower sales volume for all of our wireless products.

Sales of our Conductus wire products are not yet significant. 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. As our sales have declined in the current period, we believe this market dynamic will continue to impact our commercial revenue. Sales prices for our products were essentially unchanged. Our three largest customers accounted for 99% of our total net commercial product revenues in the first quarter of both 2014 and 2013. These customers generally purchase 18 -------------------------------------------------------------------------------- Table of Contents 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. Sales of our Conductus wire products are not yet material.

Cost of commercial product revenues includes all direct costs, manufacturing overhead and provision for excess and obsolete inventories. The cost of commercial product revenues increased to $370,000 in the first quarter of 2014 compared to $226,000 for the first quarter of 2013, an increase of $144,000 or 64%. The lower 2013 costs were primarily the result of the sale of $300,000 of previously reserved inventory in the first quarter of 2013.

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 charged 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 commercial product gross profit and margins: For the quarters ended March 29, 2014 March 30, 2013 (Dollars in thousands) Net commercial product sales $ 389 100.0 % $ 776 100.0 % Total cost of commercial product sales 370 95 % 226 29 % Gross profit $ 19 5 % $ 550 71 % We had a gross profit of $19,000 in the first quarter of 2014 from the sale of our commercial products compared to a gross profit of $550,000 in the first quarter of 2013. We experienced a reduced gross profit in the first quarter of 2014 due to lower sales being insufficient to cover our overhead. The gross profit in 2013 was the result of higher sales, the reduction of warranty reserves, reduced manufacturing use of our facilities and the sale of $300,000 of previously reserved inventory mentioned above.

Research and development expenses relate to development of new Conductus wire products and new wire products manufacturing processes. Total expenses totaled $1,470,000 in the first quarter of 2014 compared to $1,438,000 in the same quarter of 2013, an increase of 2%. The increase is the result of our efforts for improving the manufacturability of our new Conductus wire products, which included increased use of our facilities and increases in depreciation from placing new equipment into service.

Selling, general and administrative expenses were $1.3 million in both the first quarter of 2014 and 2013.

We recognized an expense for an adjustment to the fair value of warrant derivatives of $232,000 in the first quarter of 2014. See Note 3 - Stockholder's Equity: Warrants. There was no such expense in the first quarter of 2013.

Other income from the sale of property and equipment was $96,000 in the first quarter of 2014 and $6,000 in the first quarter of 2013.

We had a net loss of $2.9 million for the quarter ended March 29, 2014, compared to a net loss of $2.4 million in the first quarter of 2013.

The net loss available to common stockholders totaled $0.25 per common share in the first quarter of 2014, compared to a net loss of $0.58 per common share in the first quarter of 2013. The reduction in net loss available to common stockholders is largely due to the difference in shares outstanding used in computing the net loss.

19 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Cash Flow Analysis As of March 29, 2014, we had working capital of $6.7 million, including $7.8 million in cash and cash equivalents, compared to working capital of $6.6 million at December 31, 2013, which included $7.5 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.

Cash and cash equivalents increased by $309,000 from $7.5 million at December 31, 2013 to $7.8 million at March 29, 2014. In the first quarter of 2014, cash was used principally in operations and for the purchase of equipment.

These uses were offset by net cash proceeds of $3.7 million provided by the sale of common stock from the exercise of outstanding warrants.

Cash used in operations totaled $2.0 million in the first quarter of 2014. We used $2.3 million to fund the cash portion of our net loss. We also used cash to fund a $0.3 million increase in accounts receivable, and a decrease in inventory and patents and licenses. These uses were offset by a $0.6 million decrease provided by a reduction in prepaid expenses and other assets, and increases in accounts payable, accrued expenses and other liabilities.

Net cash used in investing activities totaled $1.4 million in the first quarter of 2014. Purchases of equipment for our Conductus wire initiative were $1.5 million and $96,000 was provided by equipment sales. In the first quarter of 2013, $178,000 was used to purchase property and equipment and there were $6,000 in equipment sales.

Net cash provided by financing activities in the first quarter of 2014 was $3.7 million from the exercise of 1,459,398 outstanding warrants issued in connection with our August 2013 underwritten public offering. Since March 29, 2014, through May 2, 2014, there have been no additional warrant exercises.

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. During the first quarter ended March 29, 2014, we have received more than $3.7 million from the exercise of 1,459,398 outstanding warrants issued in connection with our August 2013 underwritten public offering.

Contractual Obligations and Commercial Commitments In April 2014 documents were signed to amend our Santa Barbara, CA building operating lease and reduced our lease commitment. Instead of leasing approximately 71,000 square feet and partially subleasing to other tenants, we will now lease approximately 35,000 square feet and our former principal tenant will lease their portion of the building directly from our landlord. Other terms and conditions of the lease remain the same. Our table of minimum operating lease payments listed above has not yet been updated to reflect this reduced commitment going forward. We have not had other material changes outside of the ordinary course of business in our contractual obligations as disclosed in our Annual Report on Form 10-K for 2013.

Capital Expenditures We invested $1.5 million for fixed assets in the first quarter of 2014 and we plan to invest approximately $2.1 million in fixed assets during the remainder of 2014. These amounts, and the amounts spent in 2013, are for the purchase of equipment and facilities improvements for our Conductus wire initiative. We do not plan any additional fixed asset expenditures in 2014 for our existing wireless business.

Future Liquidity For the quarter ended March 29, 2014, we incurred a net loss of $2.9 million and had negative cash flows from operations of $2.0 million. In the full 2013 year, we incurred a net loss of $12.2 million and had negative cash flows from operations of $8.3 million. Our independent registered public accounting firm has included in its audit reports for 2013 and 2012 an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern.

At March 29, 2014, we had $7.8 million in cash and cash equivalents. During the first quarter of 2014 we raised $3.7 million from the exercise of outstanding warrants. Since March 29, 2014, through May 2, 2014, there have been no additional warrant exercises. We believe our current cash resources and these recently raised proceeds will not be sufficient to fund our business for the next twelve months. We believe the key factors to our future liquidity will be our ability to successfully use our expertise and our technology to generate revenues in various ways, including commercial operations, joint ventures, licenses and we plan to leverage our leadership in superconducting technologies, extensive intellectual property, and HTS manufacturing expertise to develop and produce Conductus wire. Because of the expected timing and uncertainty of these factors, we may need to raise funds to meet our working capital needs.

20 -------------------------------------------------------------------------------- Table of Contents Additional financing may not 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, 2013, we had net operating loss carryforwards for federal and state income tax purposes of approximately $313.8 million and $160.6 million, respectively, which expire in the years 2014 through 2033. However, during 2013, we concluded that under the Internal Revenue Code change of control limitations, a maximum of $17.4 million and $16.8 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 balance sheets.

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 generally accepted accounting principles in the United States. 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 2013. 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 $26,000 at March 29, 2014, compared to $88,000 at December 31, 2013.

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