Item 1. Business
Forward-Looking Information
Statements in this Report concerning expectations for the future constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are subject to a number of known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements of the Company to differ materially from those expressed or implied by such forward- looking statements. Relevant risks and uncertainties include, among others, those discussed in Item 1 of Part I under the heading "Risk Factors" and elsewhere in this Report and those described from time to time in the Company's other filings with the Securities and Exchange Commission, press releases and other communications.
Description of Business
Thermatrix Inc., a Delaware Corporation formed in 1992, (the "Company") is a global industrial technology company engaged in the development, manufacture and sale of industrial process equipment for the destruction of volatile organic compounds and hazardous air pollutants (collectively, "VOCs"). The core component of the Company's technology is its proprietary flameless thermal oxidizer ("FTO"), which is capable of treating virtually all VOCs while achieving destruction removal efficiency ("DRE") of 99.99% or higher with de minimis formation of hazardous by-products such as oxides of nitrogen ("NOX "), carbon monoxide ("CO") and products of incomplete combustion ("PICs"). The Company sells its flameless thermal oxidizer as a stand-alone unit or as an integrated system. In addition, the Company's product line also includes PADRE(R), a proprietary technology used to capture and recover very low concentration VOCs from low-to-medium vapor streams.
To date, the Company has focused on the industrial VOC market where it believes the Company's FTO system offers the greatest economic and environmental advantages over other treatment methods. These advantages include: (i) low operating and maintenance costs; (ii) product safety; (iii) application to a wide range of VOCs, including difficult-to-treat chlorinated, sulfonated and fluorinated compounds; (iv) the ability to economically treat fume streams with variable flows and concentrations; (v) high operating reliability; (vi) high DRE; and (vii) de minimis formation of hazardous by-products.
The Company's strategy is to expand the use and application of its proprietary FTO technology and to become a leading global supplier of industrial VOC treatment systems by: (i) increasing market penetration for established applications; (ii) broadening application of the Company's proprietary FTO technology for new industrial VOC applications; and (iii) expanding the Company's product line to include complementary technologies.
The Company has achieved a number of significant milestones in commercializing its technology in the industrial VOC market, including: (i) establishing the application of its proprietary FTO technology in the petroleum, chemical/petrochemical, pulp and paper, medical sterilization and pharmaceutical industries with "market leader" customers, and for soil and groundwater remediation; (ii) selling more than 80 commercial-scale systems; (iii) establishing a global sales and marketing organization; and (iv) the receipt of regulatory approvals by the Company's customers for the use of the Company's systems in the United States, Canada, England, Ireland, France and Taiwan. The Company's customers through 1998 included: Chesebrough-Pond's USA Co., Formosa Petrochemical Corporation, Mobil Chemical Company, PPG Industries, Inc., Bayer Corporation, Zeneca, Ltd., B.F. Goodrich, Marathon Oil, BASF, Shin Foong, Sorex Medical, Zeon Chemicals, Pfizer and Warner Lambert as well as the United States Departments of Defense and Energy (the "DOD" and the "DOE", respectively).
The Company is also pursuing a strategy to selectively provide complementary technologies in order to expand its presence in the VOC treatment market. In April 1996, the Company acquired all rights to the PADRE(R) VOC adsorption technology from Purus, Inc.
In addition to its core industrial VOC emissions control business, the Company has embarked on a strategy of working with strategic partners to evaluate the feasibility of applying the Company's FTO technology to other markets. In light of the recent technological advances in the diesel program and the significant amount of federal and international attention being focused on particulate matter ("PM") reductions from diesel engines, the Company is currently focusing its development activities on the application of the Company's FTO technology to the treatment of emissions from stationary and mobile diesel engines.
During 1998 the Company (i) entered into a Demonstration Project Partnership Agreement with the Massachusetts Executive Office of Environmental Affairs and the Massachusetts Executive Office of Transportation and Construction to demonstrate the application of the FTO technology to treat the exhaust of a diesel locomotive operated by the Massachusetts Bay Transportation Authority ("MBTA"); (ii) received a grant award of $1.65 million from the Advanced Technology Program ("ATP") of the National Institute of Standards and Technology, an agency of the U.S. Department of Commerce, for the development of a four-way diesel emissions treatment device; and (iii) entered into an agreement with the Diesel Emission Evaluation Program ("DEEP") to conduct a series of performance tests on an emissions control prototype for underground mining vehicles.
On January 13, 1999 the Company acquired all of the outstanding common shares of Wahlco Environmental Systems, Inc. ("Wahlco"), a Delaware corporation formerly traded on the NASDAQ bulletin board. Wahlco designs, manufactures, and sells combined cycle gas turbine products, metallic and fabric bellows, air pollution control equipment, and related products and services to electric utilities, independent power producers, co-generation plants, and industrial manufacturers worldwide. Wahlco also provides mechanical plant installation services and rents associated equipment to users in the U.K. Management believes that the business and market synergies between the Company and Wahlco in the air pollution control industry are excellent and the combination of the two firms will provide a more balanced business with global presence and performance.
Industrial VOC Emissions
VOCs are an unavoidable by-product of many manufacturing and process industries worldwide and must be controlled due to significant health, safety and environmental risks. The primary conventional industrial VOC treatment methods are flame-based thermal oxidation, activated carbon adsorption and scrubbing systems, which are installed in many industries, including petroleum, chemical/petrochemical, pulp and paper and pharmaceutical.
In the United States, the health, safety and environmental risks presented by VOCs have led to significant federal regulations, which are enforced by the Occupational Safety and Health Administration ("OSHA"), the United States Environmental Protection Agency ("U.S. EPA") and various state and local agencies. Non-compliance with these regulations carries substantial civil and criminal penalties. The United States Clean Air Act Amendments of 1990 (the "CAAA") significantly expanded the scope of air pollution regulations established in the 1970s, and required the reduction and control of a wide range of air pollutants, including 189 hazardous air pollutants ("HAPs"), most of which are VOCs. The CAAA also addressed for the first time the reduction of NO\x\ that, in combination with VOCs, produce smog. The CAAA introduced new regulatory requirements and timetables for the abatement of VOCs and NOX for most geographic areas that become progressively more stringent through the year 2010.
In addition, international demand for VOC control equipment is rapidly growing. While many European nations have comprehensive health, safety and environmental regulations in force, certain Asian and Latin American nations have only recently begun to recognize the need to more stringently control VOC emissions. In addition, many multinational companies have recognized the benefits of global health, safety and environmental standards and are collaborating in the development of comprehensive voluntary environmental performance standards such as ISO 14000.
The Thermatrix System for Industrial VOC Control
The core component of the Company's system is its proprietary FTO, a highly engineered, insulated vessel packed with ceramic material. Due to its flameless design and consistent temperature profile (between 1600(degree) and 1800(degree)F), the Company's FTO system achieves high destruction with very low energy usage and with de minimis formation of NO\\x\\ and CO. The FTO system can also be combined with an energy recovery system if the waste stream contains a surplus of energy over and above that required for VOC destruction. Recovery of usable materials from halogenated or sulfonated fume streams is also possible due to the high DRE of the FTO system.
The Thermatrix technology has the following attributes, which individually or in combination provide advantages over competing methods for industrial VOC treatment:
Energy Efficiency. The FTO system can operate effectively on VOC fume streams of moderate to high concentrations with less than 30% of the energy required for flame-based systems. The FTO's energy efficiency is particularly significant in geographic locations where the cost of energy is many times higher than in the United States.
Safety. The FTO is certified for use in flameproof areas where conventional flame-based systems are prohibited.
Flexibility. The FTO can process a broad range of VOCs, including difficult- to-treat compounds and those with variable flows and concentrations.
Reliability. The FTO operates within wide tolerance limits, is fully automatic, has no moving parts, no catalysts and requires little off-line maintenance.
High DRE. The Thermatrix system consistently achieves DRE of 99.99% or higher, which exceeds the DRE achieved by competing technologies. The high DRE of the Thermatrix system makes it particularly useful in applications involving the most highly toxic and complex VOCs.
De minimis By-products. The absence of a flame minimizes the formation of by- products generated by flame-based systems, including NO\\x\\, CO and PICs. The reduced energy requirement for the FTO system also results in a corresponding reduction in the formation of greenhouse gases.
Regulatory Advantages. The Company's systems often exceed regulatory performance requirements because of the high DRE and the de minimis formation of by-products.
In February 1998, the Company successfully completed six months of full-scale testing of a new FTO design. The oxidizer was reconfigured to create an almost spherical flameless reaction front within the reactor's ceramic matrix, as compared to the planar flameless reaction front, which until now was a signature feature of the Company's technology. The Company believes the new development will result in the following business advantages and design features:
. A greater than 60% reduction in the size of a typical non-recuperative flameless thermal oxidizer for the same processing capability.
. A hot-wall reactor with the ability to process chlorinated, sulfonated and fluorinated waste streams without the need for expensive and exotic materials of construction to prevent corrosion.
. The ability to use horizontal as well as vertical vessels, which will extend the applicable range of non-recuperative oxidizers to over 40,000 scfm.
. The incorporation of electric-assisted preheat, which will enable the Company to offer flameless startup and operation.
. The ability to offer, for the first time, a flameless thermal oxidizer for the destruction of hazardous liquids by direct injection into the oxidizer.
. The ability to offer, for the first time, a flameless oxidizer using liquid fuels such as diesel, kerosene or waste solvents rather than other fuels such as natural gas or propane, which are not available in all areas.
During 1998, the Company received one order totalling approximately $800,000 for the supply of the new FTO design. The Company is currently in the process of completing the delivery of this order.
VOC Business Strategy
The Company seeks to expand the use and application of its proprietary FTO technology and to become a leading global supplier of industrial VOC treatment systems. The Company's strategy in the industrial VOC market is to: (i) increase market penetration for established applications; (ii) broaden application of the Company's technology in the industrial VOC market; and (iii) selectively provide complementary technologies in order to expand its presence in the VOC treatment market. Key elements of the Company's industrial VOC strategy are as follows:
Increase Market Penetration for Established Applications. Thermatrix systems have now been successfully installed in the petroleum, chemical/petrochemical, pharmaceutical, medical sterilization, and pulp and paper industries, and for soil and groundwater remediation, at facilities operated by customers such as Chevron U.S.A. Inc., Dow Chemical Company, PPG Industries, Inc., Warner Lambert, Pfizer, Simpson Paper and Bayer Corporation, as well as facilities operated by the DOD and DOE. Many of these customers have already purchased multiple units. The Company is using these reference accounts to promote follow-on sales to the same customers and to expand sales within these industries, both in the United States and overseas.
Broaden Application of the Company's Technology in the Industrial VOC Market. The Company is continuing to identify new customers within industrial VOC applications not currently served by the Company, such as the electronics and semiconductor industries. In addition, there is an increasing demand from customers for the Company to supply turnkey systems that combine the Company's FTO technology with other technologies. These "hybrid" systems may provide energy recovery or product recovery, as well as treatment of the customer's fume stream.
Provide Complementary Technologies. Customers are increasingly seeking suppliers who can solve a wide range of VOC problems. To provide such solutions the Company continues to seek opportunities to expand its technology portfolio through joint ventures, selective marketing arrangements and acquisitions. In April 1996, the Company acquired all rights from Purus, Inc. to a VOC adsorption technology known as PADRE(R), which uses a regenerative synthetic adsorption resin to capture and recover very low concentration VOCs from low-to-medium flow vapor streams.
The Company believes that its installed base and proven applications provide a solid foundation for growth in both the United States and overseas. The Company received its first order from Europe in 1995. The percentage of sales to international customers increased to 14% in 1996, 35% in 1997 and 60% in 1998. The Company expects that sales from overseas installations will continue in 1999 at approximately the same level experienced during 1998. During 1997, the Company relocated its European operation from London to an expanded facility near Hull, England. The Company's United Kingdom capabilities now include sales, applications engineering, project management and service. The Company has established relationships with qualified subcontractors for fabrication and assembly in Europe and has agreements with engineering partners in Asia for construction and installation support.
Industrial VOC Control Competitive Environment
The industrial VOC control equipment market is mature and highly fragmented among a large number of competitors, none of whom have a significant industry- wide market share. The Company currently competes primarily with suppliers of flame-based thermal oxidation systems, carbon adsorption systems and scrubbing systems. Within each of these categories, the technologies are generally undifferentiated and characterized by commodity pricing. Since many of these technologies have been in use for over thirty years, these technologies are familiar and predictable to companies requiring VOC controls and to regulators, and are available from and
promoted by a large number of suppliers. In addition, some of the Company's competitors have substantially greater financial resources, operating experience and market presence than the Company. There can be no assurance that the Company's existing competitors or new market entrants will not develop new technologies or modifications to existing technologies that are superior to or more cost-effective than the Company's FTO technology. In addition, increased competition could result in price reductions and reduced gross margins and could limit the Company's market share.
Based on its sales experience, the Company believes that the major considerations in selecting industrial VOC control systems are safety; capital, operating and maintenance costs; high DRE; ease of permitting; process stream characteristics; unit location; and on-line reliability. The Company believes it competes favorably with respect to these factors.
Industrial VOC Regulatory Environment
VOCs are an unavoidable by-product of many manufacturing and process industries worldwide and must be controlled due to the significant health, safety and environmental risks. Many of these VOCs are flammable, explosive or highly toxic. To control these significant health and safety risks, regulations have been promulgated and enforced in the United States and overseas. These regulatory requirements are expanding globally into developing nations.
The United States Clean Air Act Amendments of 1990 (the "CAAA") significantly expanded the scope of air pollution regulations established in the 1970s, and required the reduction and control of a wide range of air pollutants, including 189 hazardous air pollutants, most of which are VOCs. The CAAA also addressed the reduction of NOX that, in combination with VOCs, produces smog. The CAAA introduced new regulatory requirements and timetables for the abatement of VOCs and NOX for most geographic areas that become progressively more stringent through the year 2010. Specifically, Title I and Title III of the CAAA address emissions of VOCs. Principal provisions of these titles are discussed below.
Title I establishes requirements for attaining and maintaining national ambient air quality standards ("NAAQS"). Key provisions of Title I are aimed at bringing cities and other areas which are not in attainment in line with NAAQS in most areas by the year 2000 and all cities by 2010. In addition, measures for all regions require the application of technological controls to reduce emissions of ozone precursors, such as VOCs, from a broad range of industrial activities, including chemicals production, petroleum refining, pharmaceutical production, gasoline distribution, wastewater treatment, solvent use, coating operations, hazardous waste treatment storage and disposal facilities, solid waste landfills and marine terminal loading and unloading.
Title III establishes a new program for the regulation of toxic air pollutants. The combined federal and state program provided for in the legislation creates a comprehensive and coordinated nationwide effort to deal with these pollutants. Title III specifically lists 189 substances as hazardous air pollutants, of which most are VOCs. Title III defines three significant programs that will require substantial pollution control expenditures by industry across the nation: (i) control of routine releases of air toxins from major industrial and commercial sources; (ii) control of air toxic releases from area sources, primarily in urban areas; and (iii) control of accidental releases of air toxins from industrial and commercial sources. To reduce emissions of the 189 listed toxic hazardous air pollutants, the application of the maximum achievable control technology at major air emitting sources may be required.
The Company works with regulatory agencies both domestically and overseas to inform these agencies about the Company's FTO technology in order to facilitate the permitting process for its customers. In England, Her Majesty's Inspectorate of Pollution has issued Technical Note ITN/IPCX/02 identifying the flameless oxidation process benefits of high destruction (greater than 99.99%) and low formation of NOX and CO. The Company's FTO system was selected for inclusion in the Texas Natural Resource Conservation Commission's list of innovative environmental technologies. Thermatrix is currently under review for certification by the California Environmental Protection Agency ("CalEPA") as a flameless thermal destruction technology. The CalEPA program is closed to incineration technologies. Also, the U.S. EPA and its equivalent agencies in the U.K., Ireland, Italy and the Netherlands have recognized the Company's FTO technology as being distinguishable from incineration.
During 1998, two regulatory events occurred in California that are significant to the Company's development activity relating to diesel emissions. First, the California Air Resources Board ("CARB") identified particulate emissions from diesel-fueled engines as a toxic air contaminant and initiated a process to implement new control strategies. Second, CARB approved the elimination of less stringent emission standards for light-duty trucks beginning in 2004 which, according to CARB, will likely preclude diesel engines without suitable pollution control devices in vehicles with a gross vehicle weight below 8500 pounds. In 1997, light trucks (including vans and sport utility vehicles) comprised 46% of all new car sales in California and an increasing proportion of these vehicles are being equipped with diesel engines because of the higher fuel economy.
Current Thermatrix Industrial VOC Customers
The Company has identified industries that are large generators of VOCs and where it believes its FTO technology provides significant competitive advantages over existing treatment methods. The Company has sought acceptance of its systems, in each of its initial target markets, through the utilization of "market leader" customers. To date, the Company has sold over 80 systems across a range of industries including petroleum, chemical/petrochemical, pharmaceutical, pulp and paper manufacturing, medical sterilization and for soil and groundwater remediation. The following table sets forth the Company's target markets, representative customers and the types of VOCs treated by its systems:
Sales and Marketing
The Company has experienced a shift in market demand for its products, both in terms of the geographic distribution of the orders it has received and the complexity of the systems ordered. During 1998, the Company continued to experience a high volume of orders from overseas installations. During 1999, the Company expects that sales from overseas installations will comprise 60% of total sales, which is similar to the percentage experienced in 1998.
In addition, the Company's clients have increasingly outsourced the process design of air pollution control systems. Instead of sourcing components individually, clients are seeking a design partner willing to provide an integrated system on a turnkey basis coupled with appropriate system performance guarantees. In response to this shift in demand, the Company restructured its sales organization in 1997 to replace most outside manufacturers' representatives with direct selling by the Company's process and application engineers in order to increase focus on marketing and account management.
Two sales directors manage the Company's sales efforts. Sales for North America are managed from Knoxville, Tennessee and those for Europe and Asia are managed from Hull, England. The sales directors hold engineering degrees and have an average of ten years of industrial selling experience.
In addition, where cost effective, the Company has selectively retained some of its independent commissioned sales representatives in the United States and Canada and currently has agreements with seven representative organizations with over 24 sales agents selling the Company's FTO system. In Asia, the Company has agreements with Cinchem Enterprise Limited for sales representation in Taiwan and the Peoples' Republic of China, with Toray Engineering Co. Limited and Nittetu Chemical Engineering Limited in Japan, and with Miju Plant Companies Limited in South Korea. All independent representatives are paid solely on commission, which is calculated on a sliding scale as a percentage of sales revenues. The Company retains responsibility for pricing and terms and conditions.
In April 1997, the Company entered into an Exclusive Sales and Marketing Agreement (the "White Horse Agreement") with White Horse Technologies Inc. ("White Horse") to facilitate penetration of the air pollution control market by offering potential customers a wider array of products. In July 1998, the Company declared White Horse to be in default of the White Horse Agreement and on August 25, 1998 suspended any further commercial dealings with the firm. In October 1998, the Company filed a claim against White Horse for damages related to the default and White Horse filed a bankruptcy petition in November 1998. The Company does not expect to recover the investment it made in White Horse and has provided in full against all White Horse investments and receivables.
Engineering and Manufacturing
The Company's Engineering group, located in Knoxville, Tennessee, provides global support to the Company's customers. The Company's project management and assembly operations for the United States and Asia are managed from Knoxville, Tennessee and those for Europe are based in Hull, England. In addition, the Company has agreements with engineering partners in Asia for construction and installation support of the Company's systems. These partners include Toray Engineering Co. Ltd. and Nittetu Chemical Engineering Ltd. in Japan and with Miju Plant Companies Ltd. in South Korea. The Company will continue to engineer and assemble the proprietary components of its FTO systems, but will utilize its Asian partners to supply the balance of plant.
The Company has focused on modularizing and standardizing components of its technology and utilizes sophisticated software to integrate these components into comprehensive air pollution control systems. This system's integration expertise allows the Company to provide comprehensive systems centered on the Company's FTO technology. The engineers utilize state-of-the-art, PC-based, computer-aided engineering and database management tools, including three- dimensional design tools.
The Company manufactures its systems to customer order. Qualified subcontractors specializing in the manufacture of the particular component carry out component fabrication. These specialized subcontractors adhere to and carry formal certification with national and international codes and standards for electrical and mechanical construction. The Company's subcontractors have been selected to allow the Company to expand its capacity to manufacture additional systems while minimizing the Company's investment in fixed costs. The Company uses qualified subcontractors throughout the United States and overseas and is not dependent on any one or subset of these subcontractors.
In the fabrication process, no one subcontractor is exposed to the entire technology package and final assembly of the systems is completed by a separate subcontractor. Throughout the delivery cycle, the manufacturing process is managed to conform to ISO 9001.
During the period that the technology was developed, an extensive empirical database of performance characteristics for waste flows of different volumes and compositions was compiled. The Company has used this database to develop a proprietary, software-based design tool. In the design process, the software tools analyze the characteristics of the customer's fume flow and determine the optimal system configuration and size. Not only does
this process specify the correct system characteristics, but also it automates the task of generating budget proposals. The Company is continuing to expand this database as new systems are installed.
Research and Development
The Company believes that its continued commitment to developing new applications and refining its technology is critical to remaining competitive in the industry. During 1998, the Company focused its technical resources on product development in the diesel emissions area while continuing to make product improvements in its core business of industrial air pollution control. The successful construction and testing of four diesel prototypes in 1998 led the Company to conclude that its FTO technology could efficiently destroy diesel particulate and odors. Based upon the success of these early initiatives, the business unit Thermatrix Diesel Systems was formed to focus internal resources on the diesel emissions market.
The Company's industrial VOC applications development efforts are managed by the Engineering group located in Knoxville, Tennessee. The group's primary mission is to optimize the Company's technology for new applications in the industrial VOC control market. The Company's research and development activities are now primarily focused on its diesel engine emission control program. The Technology Development group, located in San Jose, California, carries out these activities in conjunction with selected strategic partners. When areas of specialized expertise are required, the Company relies on consulting relationships with a number of top tier research institutes, including Lawrence Berkeley National Laboratory, Oak Ridge National Laboratory and Southwest Research Institute.
As announced in the 1997 Annual Report, the Company has successfully completed the dissolution of its joint venture arrangement with ThermoChem, Inc., which had been established for the processing of radioactive mixed waste. Any future projects for such processing will be undertaken on a teaming basis.
Potential Applications Under Development
During 1998, the Company began to focus development efforts on applications in two general market areas: Industrial and Diesel. The Company's strategy to expand its presence in these markets is to work with strategic partners to evaluate the feasibility of applying the Company's technology to other uses.
Industrial VOC Emission Control. The Company received its first orders for the reconfigured, reduced-cost version of its straight-through FTO in 1998, and will be commissioning them during 1999. The Company has also delivered the first two modified recuperative FTO systems into the pharmaceutical industry, where the featured range and operability improvements are vital. One benefit derived from the diesel development efforts is a newly designed recuperative FTO for small to medium industrial applications that will see its first trial at a large European plant where NOx minimization and VOC abatement are required simultaneously. A strategic partner and host site for the first flameless liquid waste FTO is currently being sought.
The Company has ceased to commercially offer the continuous bed improvement to its PADRE product line because of technical issues that arose during the fielding of a prototype of the improved system. In 1998, a significant R&D expense was incurred in responding to these technical issues and no timetable has been established for their resolution. The Company continues to successfully offer its commercially proven fixed bed system to the marketplace.
Diesel Engine Emission Control. An important stage in the diesel development program was a joint assessment the Company carried out with a major manufacturer of diesel fuel injection systems in 1998. The parties' intent at the onset of the program was to jointly develop a system comprising both parties' technologies in such a way that reductions in both PM and NOx emissions would occur in an energy-neutral system. Although the FTO was shown to reduce PM to non-detectable levels under many conditions during the course of that program, both parties concluded that fundamental market forces rendered no advantage to linking their technologies together and joint activity ended.
During 1998, several partnerships were formed with potential end users of diesel aftertreatment systems, and three agreements were concluded for prototype demonstration testing.
Locomotives. In the third quarter, the Company entered into a Demonstration Project Partnership Agreement with the Massachusetts Executive Office of Environmental Affairs working with the Massachusetts Executive Office of Transportation and Construction whose jurisdiction includes the MBTA. The goal of the project is to demonstrate the application of the FTO technology to treat the exhaust of a diesel locomotive owned and operated by the MBTA, to validate the performance of the technology on a locomotive, and to evaluate the cost effectiveness of this particular application. The program also includes demonstrating the integration of various NO\\x\\ reduction technologies to achieve as complete destruction as possible of all the undesirable components contained in this diesel engine emission exhaust.
Four-Way Converter. In the fourth quarter, the Company received a grant of $1.65 million from the ATP of the National Institute of Standards and Technology, an agency of the U.S. Department of Commerce for the development of a four-way diesel emissions treatment device. The grant will be received over a two-year period based on the level of research and development incurred by Thermatrix on this project and the availability of federal funding for year two. The project seeks to develop and test a device capable of reducing or eliminating all four key pollutants in diesel engine exhaust by combining the FTO technology for the reduction of PM, CO and HC with a proprietary Lean NO\\x\\ Catalyst developed by Southwest Research Institute of San Antonio, Texas. The ATP provides funding to industry for research and devlopement projects that have the potential to provide direct broad-based economic benefits to the United States. The initial market will be urban buses.
Mining Vehicles. In the fourth quarter, the Company also received approval from DEEP to demonstrate the FTO's ability to destroy PM and organic vapors from diesel vehicles in underground mines. DEEP is a consortium of Canadian and U.S. mining interests, whose mission is to reduce miners' exposure to diesel exhaust contaminants, particularly fine particles that are suspected carcinogens. The focus of the DEEP demonstration is to quantify the amount of particulate mass destroyed by the FTO and prove that the FTO eliminates "ultrafine" particles that have greater detrimental health consequences and are a by-product of some diesel oxidation catalysts and traps.
Intellectual Property
As of February 28, 1999, the Company owned 13 United States and 48 international patents, had received notice of allowance for two additional United States patent applications, and had a further 10 United States and 126 international patent applications pending relating to its thermal treatment technology. All issued United States patents expire during the period between August 17, 2003 and March 19, 2018.
The Company's 15 issued and allowed United States patents include several hundred claims of varying scope relating to many of the Company's inventive methods and apparatuses. These patents cover fundamental aspects of flameless thermal oxidation that are the bases of the Company's technology and their application. Aspects of the technology, including the use and maintenance of a "flameless reaction wave" of gases or vapors in a matrix of heat resistant materials, are covered under a variety of claiming formats.
In addition to patents, the Company relies on trade secrets and proprietary know-how, which it seeks to protect, in part, through appropriate confidentiality and proprietary information agreements. The confidentiality and proprietary information agreements generally provide that all confidential information developed or made known to individuals by the Company during the course of the relationship with the Company is to be kept confidential and not disclosed to third parties, except in specific circumstances. The agreements also generally provide that all inventions conceived by the individual in the course of rendering services to the Company shall be the exclusive property of the Company.
In addition to the foregoing patents and patent applications, the Company has four issued United States trademarks and five issued international trademarks, and has received notice of allowance for one additional United States trademark. The Company also has an additional eight international trademark applications pending for certain of the Company's tradenames and other intellectual property.
Employees
As of December 31, 1998, the Company had 57 full-time employees, 13 of whom hold advanced degrees. The Company believes that it has been successful in attracting experienced and capable engineering, operations and management personnel. As of December 31, 1998, none of the Company's permanent, full-time employees are covered by collective bargaining agreements.
Significant Subsequent Event
On January 13, 1999, pursuant to an Agreement and Plan of Merger, dated November 9, 1998 (the "Merger Agreement"), among Wahlco Environmental Systems, Inc., ("Wahlco"), the Company and TMX Acquisition Sub I, Inc., a wholly owned subsidiary of the Company ("Merger Sub"), Merger Sub merged with and into Wahlco (the "Merger"), and Wahlco became a wholly owned subsidiary of the Company at the effective time of the Merger.
The Company paid approximately $1.9 million in cash to acquire all of the common shares and warrants of Wahlco. The Wahlco shareholders are also entitled to receive certain Contingent Payments as defined in the Merger Agreement. The Contingent Payments are dependent upon the resolution of certain contingencies not relating to future operating results of the Company. The Company believes, but can provide no assurances, that the Contingent Payments will not exceed $2,000,000 in total and may be substantially less than that amount.
In connection with the Merger, the Company agreed to guaranty to Wexford Management LLC ("Wexford"), as Agent for certain lenders which are affiliates of Wexford (the "Lenders"), the obligations of Wahlco to the Lenders under an amended and restated credit agreement dated January 30, 1998 (the "1998 Credit Agreement") and to The Chase Manhattan Bank under a non-committed line of credit (the "Chase Facility") and to grant to the Lenders a security interest in all existing and future assets of the Company.
On February 25, 1999 the Company entered into the Second Amended and Restated Credit Agreement among Wahlco and the Company, as Borrowers, and the Lenders and Wexford as Agent for the Lenders (the "1999 Credit Agreement"). As of March 31, 1999, the debt amounts to slightly more than $5.7 million and bears interest at the rate of 13% per annum, payable monthly in advance. The debt matures on August 24, 1999, and may, with the payment of an additional fee of $100,000, be extended until November 22, 1999. As a further condition to the Lenders' execution and delivery of the 1999 Credit Agreement, the Company agreed to confirm its grant to the Lenders of a security interest in all existing and future assets and to cause all its significant subsidiaries to enter into guarantees and grant to the Lenders additional security interests and mortgages in all existing and future assets of the Borrowers and significant subsidiaries.
The Company believes this merger to be strategically significant. The business and market synergies between the Company and Wahlco in the air pollution control industry are excellent and the combination of the two firms will provide a more balanced business with a stable base, above-average growth, and global presence and performance.
In recent years the air pollution control and air- and gas-handling industries have been experiencing enormous change and consolidation. The biggest change has been that customers in all sectors, including industrial, energy and government, are increasingly purchasing complete turnkey systems from global vendors rather than
component equipment from regional suppliers. As a result, the number of original equipment manufacturers ("OEM's") has begun to decrease as those that have not been able to make the successful transformation to global system vendors have failed or are being acquired by others that can. In the past several years the Company has been able to successfully develop the capability to deliver complete systems on a global basis and began to seek targeted acquisitions such as Wahlco.
Currently, the air pollution control industry is structured into three discrete market segments: stationary sources, mobile sources and indoor air quality. In the stationary and mobile sources segments, the pollutants of concern are particulate matter ("PM"), volatile organic compounds and hazardous air pollutants (collectively, "VOCs"), oxides of nitrogen ("NO\\x\\"), and sulfur dioxide ("SO2"). The primary global sources of the foregoing emissions are industrial facilities, utilities and engines.
The Company is a system supplier and has a particular focus on VOCs and NO\\x\\ from industrial facilities. While the current business is 100% from the industrial sector, recent activities involving the destruction of emissions from diesel engines has begun to diversify the company into a larger segment of the air pollution control marketplace. Wahlco is primarily an OEM directed at handling flue gas and treating the emission of PM and NO\\x\\. Wahlco's market is approximately 70% from the utilities and energy sector and 30% from the industrial sector. A combination of the two companies would result in an enterprise with unaudited combined 1998 sales of approximately $50 million with approximately 55% being derived from the utilities and energy sector and approximately 45% from the industrial sector. Geographically, approximately 55% of the revenues will be derived from European operations and approximately 45% will be derived from North American operations.
Business activities of the two companies are similar except that the Company has not had a dedicated fabrication facility since the Knoxville, Tennessee plant was closed in December 1997. Both the Company and Wahlco have resources and facilities for engineering design and specification, purchasing, installation, commissioning and servicing. The Company employs 57 people and has 80 installations worldwide and Wahlco employs 354 people and has over 1,000 installations around the world. Of the Company's current business, 60% is derived from Europe and 40% is derived from North America while Wahlco's business is divided equally between Europe and North America.
Description of the Wahlco Business
Wahlco designs, manufactures, and sells combined cycle gas turbine products, metallic and fabric bellows, air pollution control equipment, and related products and services to electric utilities, independent power producers, co- generation plants, and industrial manufacturers worldwide. Wahlco also provides mechanical plant installation services and rents associated equipment to users in the U.K. Wahlco operates through several subsidiaries that focus on specific geographical regions or products.
Wahlco Engineered Products, Inc. (U.S.) designs, manufacturers and sells gas flow diverters, dampers and fabric and metallic expansion joints used by electric utilities and other industrial companies. Wahlco Inc. (U.S.) designs, manufactures, sells, leases and services equipment used by electric utilities and others to reduce and control air pollution. Products and services include flue gas conditioning systems, NO\\x\\ reduction systems and industrial electric heaters and thermocouples.
Wahlco Engineered Products, Ltd. (U.K.) designs and sells gas flow diverters which control and direct the flow of gases from a gas turbine exhaust to a waste heat recovery boiler in a gas-turbine combined-cycle power-generation plant. Pentney Engineering Ltd. (U.K.) provides mechanical pipework and plant installation, hydraulic equipment manufacture, and general fabrication to utilities and industrial companies. Teddington Bellows Ltd. (U.K.) designs, manufacturers and sells specialized high performance metallic expansion joints for industrial and utility applications. Treste Plant Hire, Ltd. (U.K.) rents mechanical equipment to the United Kingdom construction industry.
Products and Services
Wahlco's products and services are sold in the coal-fired utility after- boiler market, the gas-turbine power-generation market, the market for elimination of VOCs, and other industrial markets.
Dampers, Diverters, Expansion Joints, Piping Systems, Hydraulic Equipment and Other Services
Gas flow diverters divert the flow of exhaust gases from gas turbines either to the atmosphere via stacks or to boilers for steam production. The steam produced is principally used for power generation by combined cycle steam turbines. In some cases, the steam is used as process steam in district heating systems, water desalination, or operations such as liquefying oil to assist in its extraction from the ground (co-generation). Gas flow diverters are supplied to the power generation industry, industrial power plant systems, and similar process industries of gas type isolation equipment. Diverters are sold to customers in Europe, Southeast Asia, the Far East and to the United States.
Dampers control the flow of air and gas by directing, throttling and/or channeling air and gas through a single path. They are used by power generating utilities, petrochemical plants, refineries, chemical plants, cement plants, paper and steel mills, and other industrial companies.
Expansion joints are produced from various fabrics and metals, in a variety of configurations, and are used with diverters and other ducting systems. These products are provided to a wide range of industries.
Metallic expansion joints are installed in liquid and gas piping, pressure systems and exhaust systems in the chemical, petrochemical, utility power generation, aviation, nuclear, shipbuilding, heating and other general industries. Expansion joints are used primarily to counteract the negative effect of the expansion and contraction of pipes and ducts caused by extreme temperature changes from a production process such as electric power production and petroleum refining.
Only a small portion of these businesses are driven by environmental regulations.
Warranties for the foregoing products generally average from 12 to 24 months from the date of sale and provide for the repair or replacement, without charge, of any parts found to be defective in material or workmanship under normal and proper use (except wear and tear for abrasion or corrosion). The useful life for this group of products ranges from 3 to 20 years under normal and proper use.
FGC Systems, Heaters and Thermocouples, and Related Products and Services
Wahlco is the leading provider of flue gas conditioning ("FGC") systems worldwide. The FGC business is principally driven by environmental regulations that require electric utilities to meet certain emissions standards for particulate matter and sulfur oxides.
To comply with these regulations, many utilities previously burning high sulfur coal have switched to low sulfur coal. While the conversion from high sulfur to low sulfur coal enables utilities to meet existing sulfur oxide emissions standards, the conversion generally results in an increase in particulate emissions. FGC systems increase the collection efficiency of electrostatic precipitators ("ESPs"), which abate particulate (fly ash) emissions. Wahlco's FGC technologies include sulfur trioxide, ammonia and dual conditioning (both sulfur trioxide and ammonia conditioning). FGC systems may be installed on existing or new ESPs.
The ability of Wahlco's customers to purchase low sulfur coal economically is an important factor in the continuing demand for Wahlco's FGC business. Experts in the field of coal resources expect this trend to continue. Originally, low sulfur coal was thought to be more difficult to obtain and transport when planning for the Clean Air Act began in the early 1990's.
Wahlco's Staged NO\\x\\ Reduction System ("SNRS") relies on two NO\\x\\ reduction technologies: selective non-catalytic reduction ("SNCR") and selective catalytic reduction ("SCR"). The system uses the customer's
existing air heater to further reduce NOx emissions. The air heater SCR process is covered by U.S. and foreign patents owned by Wahlco.
Thermocouples are heat-sensing devices used in conjunction with a temperature controller or indicator to convert an electrical signal to a temperature readout. Wahlco's electrical heaters include: (1) tubular heaters for plastic injection molding and extrusion, pipe heating and die heating; (2) immersion heaters for heating liquids in the chemical and process industries; (3) duct heaters for heating large quantities of air or gas passing through ducts; (4) tubular elements for specialty heating applications; and (5) silicone rubber heaters for drum and tank heating used for food processing, medical equipment and other applications.
Warranties for FGC systems generally provide for the repair or replacement, without charge, of any parts found to be defective in material or workmanship under normal and proper use (excepting wear and tear from abrasion or corrosion) within 18 months from the date of shipment or 12 months from the date of initial operation, whichever occurs first. In addition, under certain circumstances, Wahlco guarantees that proper operation of its FGC systems will not exceed certain effluent opacity or emission levels over an initial acceptance period.
Warranties for heaters and thermocouples generally provide that Wahlco will repair or replace, without charge, any parts found to be defective in material or workmanship under normal and proper use (excepting wear and tear from abrasion or corrosion) within 12 months from the date of sale. Wahlco believes the useful life of each of these products exceeds five years under normal and proper use.
Patents and Trademarks ----------------------
As of December 31, 1998, Wahlco held 24 U.S. patents and corresponding foreign patents and/or applications. Existing patents expire between 1999 and 2015. Although initially enhanced by its patent rights, Wahlco believes its ability to compete effectively in the FGC market depends primarily upon its engineering, scientific and technological expertise and its reputation for successful installations. This includes a database of information relating to coal and ash analysis and precipitator size and operating conditions. In addition, Wahlco has competed successfully in the sale of its sulfur dioxide-based and ammonia conditioning systems, which are not protected by patents, and in the sale of its sulfur-burning FGC systems in foreign countries in which it does not have significant patent protection.
Marketing ---------
Wahlco markets its products, technologies and services to electric utilities and industrial customers worldwide. The principal export markets for Wahlco's products are Asia, Europe and Canada.
Wahlco has a dedicated sales force for each subsidiary. Coordination among these groups has aided the development of relationships and future business prospects for all products.
Wahlco's FGC sales organization is headquartered in Santa Ana, California. A sales manager oversees approximately 40 independent sales representative organizations in North America that sell to utility customers and industrial customers, primarily in the steel, cement, pulp and related process industries. The international sales function operates through a network of 42 representatives in 57 countries in Africa, Asia, the Pacific Rim, the Caribbean, Europe, the Middle East and Central and South America. In addition to this sales organization, Wahlco markets its products through sales and/or service offices located in California and Illinois.
Wahlco's FGC marketing efforts are targeted primarily at coal-fired power plants operated by electric utilities. Repeat business for FGC systems is limited because individual customers typically have a small number of electrostatic precipitators and because FGC systems operate for many years without the need for replacement.
In recent years, Wahlco has increased its international marketing efforts for FGC systems. While U.S. environmental regulations, mandating lower emissions levels for power generating plants, have been in place for
several years, many other countries have not yet adopted or enforced strict regulations aimed at reducing emissions from coal fired power plants. Asia, Europe, and Africa, may enact stricter regulations to control power plant emissions. It is impossible to predict with certainty, however, whether such regulations will be enacted or, if enacted, enforced, or the effect of such regulations upon Wahlco's business.
Marketing and sales for Wahlco Engineered Products, Inc. is based in Lewiston, Maine and focuses on customers in the power, pulp and paper, cement, metals, and petrochemical industries in North, Central and South America through a network of approximately 28 independent sales representative organizations. Wahlco Engineered Products, Inc. also markets dampers and expansion joints to customers in Europe and Asia through a network of 18 independent sales representative organizations in Europe and Asia. In addition, WEP, Inc. sells diverters to U.S. based customers for projects in Europe and Asia.
Wahlco Engineered Products, Ltd.'s products are marketed internationally by direct and independent sales representatives in 34 countries. Sales, engineering and technical support are performed from the Chesterfield, U.K. facility.
Teddington Bellows Ltd. uses a combination of its own and several of Wahlco's international sales and marketing representatives.
Customers ---------
No customer accounted for more than 10% of Wahlco's revenues in 1998.
Raw Materials -------------
The materials used in the production of Wahlco's product lines are generally available through a number of sources, and Wahlco does not anticipate difficulty in obtaining the materials and components used in its operations. Most of the materials used by Wahlco are ordered to a number of standards, including ASME, ASTM and DIN.
Certain materials and components must withstand extreme operating conditions and because only relatively few component suppliers consistently meet necessary specifications, Wahlco purchases from a limited number of suppliers. Generally, Wahlco has not experienced difficulty in obtaining the necessary materials and components and has several alternative sources of supply.
Pentney Engineering Ltd., Teddington Bellows Ltd., and Wahlco Engineered Products, Ltd. have achieved ISO 9000 standards. The remaining subsidiaries continue to work toward achieving ISO 9000 accreditation or equivalent standards.
Competition -----------
Wahlco, Inc. competes primarily on its engineering, scientific and technological expertise. Since 1990, Wahlco Inc.'s domestic FGC business has experienced increased price competition as domestic utilities attempted to reduce the overall costs of compliance with state and federal regulations. Several smaller domestic manufacturers including Chemithon, Inc. and Wilhelm Environmental Technologies, Inc., have been successful in securing some FGC contracts.
As a result of price competition, Wahlco Inc. has experienced a decline in market share and in overall FGC margins. Since 1993-1996, Wahlco Inc. confronted competitive pricing pressures by reducing certain engineering and manufacturing costs and by reconfiguring various products to better meet customer demand. Based upon internal market information, Wahlco Inc. believes that it still continues to be the leading provider for FGC systems in the United States and maintains a strong market position internationally.
Since there are several alternatives to FGC systems, Wahlco Inc. faces substantial competition from companies providing devices that reduce particulate emissions generally without the need for FGC systems. Examples of such devices are scrubbers, certain ESPs, and baghouses. Numerous factors may be considered by an electric utility in determining whether to install FGC systems or an alternative technology to achieve compliance. These include the amount of initial capital expenditures, issues and policies related to fuel sources, related on-going operating and maintenance costs, availability and associated costs of low and/or high sulfur coal, the particular emission standards applicable to the public utility, and the value of any credits or allowances which may be available.
One of the largest factors affecting the market and its competitive nature has been the electric utilities' strategy to postpone adding FGC and other compliance equipment by blending coals. Electric utilities have mixed high and low sulfur coal or burned low sulfur coal containing enough sulfur content to reduce sulfur emissions without impairing the effectiveness of the particulate control devices.
Wahlco Inc. faces substantial competition with respect to its thermocouple and electrical heater products and serves a relatively small portion of the total market. In addition to a few large companies that market such products nationally, there are also several regional suppliers that compete with Wahlco. In establishing a market niche, Wahlco targets customers requiring specially engineered and customized products.
Wahlco Engineered Products, Inc. faces significant competition in the sale of its dampers, diverters, and expansion joints. Although these products are differentiated by design, sophistication, reliability, and customer service, many purchasing decisions are made on the basis of price and delivery.
Wahlco Engineered Products, Ltd. continues to win a significant share of the international market for gas flow diverters. Pentney Engineering Ltd., Treste Plant Hire, Ltd. and Teddington Bellows Ltd. compete in the U.K. construction market. The recent strength of the U.K. pound has adversely affected the U.K. market. Recent problems in Southeast Asian markets have had a negative effect on sales of Wahlco's products to that region.
As a group, Wahlco Engineered Products, Inc. and Wahlco Engineered Products, Ltd. command a significant share of the global market for gas flow diverters and dampers. Significant competitors in this market include Rappold, Braden, Effox, and Stober & Morlock. Domestically, Wahlco Engineered Products, Inc. faces competition in the damper market from Effox, American Warming & Ventillating, ACDC, DDI, and others. In the expansion joint market, Wahlco Engineered Products, Inc. competes with Pathways, EJS, Senior Flexonics, Badger, and others.
Employees
On December 31, 1998, Wahlco employed a total of 354 persons.
Thermatrix Inc. Risk Factors
Operating Losses and Accumulated Deficit; Uncertainty of Future Profitability. The Company had a net loss of approximately $7.9 million in 1998 and an accumulated deficit of approximately $44.6 million at December 31, 1998. Since the Company restructured its operations in 1992, it has financed its operations primarily through private placements of equity securities totaling approximately $20.3 million and an initial public offering of its common stock with net proceeds totaling approximately $22.1 million. The Company does not expect to be profitable unless and until sales of its systems generate sufficient revenues with an appropriate gross margin to fund its operations. There can be no assurance that the Company will achieve such revenues or margins. See further discussion at Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations.
Ability to Compete Against Lower Cost Technologies. To date, FTO systems have been installed in an increasing number of industries. There can be no assurance that the Company's FTO technology will receive broad market acceptance as an economically and environmentally acceptable means of destroying VOCs. The Company's
ability to compete will depend upon the Company's ability to persuade potential customers to adopt its FTO technology in place of certain, more established, competing technologies, including flame-based destruction and carbon adsorption systems. The failure of the Company to persuade a significant number of potential customers to adopt its FTO technology would have a material adverse effect on the growth of the Company's business, results of operations and financial condition.
Sensitivity to Major Projects. In 1998, three projects for two customers accounted for 62% of the Company's revenues. In 1997, two projects accounted for 38% of the Company's revenues and in 1996, three projects accounted for 38% of the Company's revenues. Although the Company is expanding the number of its customers and installations, the average size and dollar volume of each installation has been increasing. The Company anticipates the size of turnkey projects in 1999 will continue to range from $1 million to $4 million. As a result, the Company's results of operations are likely to continue to be dependent on major projects. Such a reliance on major orders is likely to lead to fluctuations in, and to reduce the predictability of, quarterly results.
Larger projects also pose other challenges. The sales cycle for larger projects tends to be longer than for smaller projects, and, when orders are received, projects may be delayed by factors outside the Company's control, including customer budget decisions, design changes and delays in obtaining permits. Orders for large systems often have tight delivery schedules and the customer will often attempt to negotiate penalties for late delivery and/or the ability to assess liquidated damages for lost production if the delivery schedule is not met. Also, because the dollar volumes are larger, the costs of providing warranty services could increase. The Company's business, results of operations and financial condition could be materially adversely affected if the Company were to fail to obtain major project orders, if such orders were delayed, if installations of such systems were delayed, or if such installations encountered operating, warranty or other problems.
Management of Growth. Although it relies on subcontractors to fabricate subassemblies and to assemble and install completed systems, the Company uses its own employees to design, test and commission systems. The Company seeks to maintain engineering and design staffing levels adequate for current and near- term demand. During periods of rapid growth, such as that experienced by the Company during 1998, the Company's engineering and design personnel generally operate at full capacity. As a result, future growth, if any, is limited by the Company's ability to recruit and train additional engineering, design and project management personnel and by the ability and performance of the individual employees in managing more and larger projects. Furthermore, any failure to maintain quality or to meet customer installation schedules could damage relationships with important customers, damage the Company's reputation generally and result in contractual liabilities. There can be no assurance that the Company will be able to effectively manage an expansion of its operations or that the Company's systems or controls will be adequate to support the Company's operations if expansion occurs. In such event, any failure to manage growth effectively could have a material adverse effect on the Company's business, results of operations and financial condition.
Risks Associated with International Operations and Sales. In 1998, sales to international customers in Europe and Asia increased to 60%, up from 35% in 1997. The Company plans to increase its revenues, in part, through an expansion of its overseas operations. Expansion internationally encompasses the need to provide an infrastructure for operations, sales and administration. The Company's overseas growth has placed, and could continue to place, a significant strain on its managerial, operational and financial resources. There can be no assurance that the Company will be able to attract, hire and train personnel or to continue to develop the infrastructure needed on a timely basis which may have an adverse impact on the Company's business, results of operations and financial condition.
Additionally, the Company's business, results of operations and financial condition may be materially adversely affected by fluctuations in currency exchange rates and duty rates, and therefore its ability to maintain or increase prices due to competition. The Company denominates international sales either in United States dollars or local currencies. Sales in Europe have been primarily denominated in pounds sterling. Since some expenses in connection with international contracts are often incurred in United States dollars, there can be a short-term exchange risk created. If the Company has significant international sales in the future denominated in foreign currencies, the Company may purchase hedging instruments to mitigate the exchange risk on these contracts.
Risks Associated with Fixed Price Contracts. A majority of the Company's contracts are performed using "fixed-price" rather than "cost-plus" terms. Under fixed-price terms, the Company quotes firm prices to its customers and bears the full risk of cost overruns caused by estimates that differ from actual costs incurred or manufacturing delays during the course of the contract. Some costs, including component costs, are beyond the Company's control and may be difficult to predict. If manufacturing or installation costs for a particular project exceed anticipated levels, gross margins would be materially adversely affected, and the Company could experience losses. In addition, the manufacturing process may be subject to significant change orders. However, in some cases the cost of these change orders may not be negotiated until after the system is installed. The failure of the Company to recover the full cost of these change orders could materially adversely affect gross margins and also cause the Company to experience losses.
Dependence on Key Personnel. The Company's success depends to a significant extent upon its executive officers and key engineering, sales, marketing, financial and technical personnel, both in the United States and overseas. Employees may voluntarily terminate their employment with the Company at any time, and only one of the Company's employees is subject to a term employment contract with the Company which will expire April 30, 1999. The Company has limited personnel resources available to address the different activities in its business. The loss of the services of one or more of the Company's key employees could have a material adverse effect on the Company's business, results of operations and financial condition.
The Company also believes that its future success will depend in large part upon its ability to attract and retain additional highly skilled personnel, particularly design and process engineers. Because of the technical sophistication of the Company's systems and the sophisticated engineering software utilized by the Company, design and process engineers who join the Company generally are required to have advanced technical knowledge and significant training to perform efficiently and productively. The availability of such personnel is limited, and the Company has at times experienced difficulty in locating new employees with the requisite level of expertise and experience. In addition, the Company believes its ability to manage customer orders for the Company's products in Europe will depend in a large part on its success in attracting and retaining skilled engineers or project managers in Europe. There can be no assurance that the Company will be successful in retaining its existing key personnel or in attracting and retaining the personnel it requires in the future.
The Company maintains key employee life insurance on the life of its Chairman, President and Chief Executive Officer, John T. Schofield, in the amount of $2,000,000. There can be no assurance that such amount will be sufficient to compensate the Company for the unexpected loss of the services of Mr. Schofield.
Dependence on the Reliability and Performance of Subcontractors. The Company relies on subcontractors to build system components and to assemble and install systems, both in the United States and overseas. The Company's ability to deliver high quality systems on time will depend upon the reliability and performance of its subcontractors. The failure of a subcontractor to meet delivery schedules could cause the Company to default on its obligations to its customers, which could materially adversely affect the Company's reputation, business, results of operations and financial condition. In addition, the Company's reliance on subcontractors for manufacturing, assembly and installation places a significant part of the Company's quality control responsibilities on these subcontractors. There can be no assurance that the Company will be able to continue to contract for the level of quality control required by the Company's customers. The failure to provide such quality control could result in manufacturing and installation delays, which could have a material adverse effect on the Company's business, results of operations and financial condition.
The materials used in the production of the Company's product lines are generally available through a number of sources, and the Company does not anticipate difficulty in obtaining the materials and components used in its operations.
Dependence on Customer Information. The Company is highly dependent upon information provided by its customers concerning the type, volume and flow rate of VOC emissions to be treated by the Company's systems. If the customer's information is inaccurate or the customer operates the facility outside its design parameters, a malfunction in the Company's FTO system could occur, resulting in damage to the customer's facilities or personal injury. In addition, incorrect information could cause delays in the design, manufacture and installation of the
customer's system. The Company might then be held liable for damages resulting from such malfunction or delay beyond its control. Any of these factors could have a material adverse effect on the Company's business, results of operations and financial condition.
Fluctuations in Quarterly Operating Results. The Company's quarterly revenues and operating results have varied significantly in the past and may fluctuate significantly in the future as a result of a variety of factors, many of which are outside the Company's control. Such factors include the size and timing of individual orders, the timing and amount of project change orders, customer delays, order cancellations, general economic and industry conditions, the amount of first-time engineering needed, the introduction of new products or services by the Company or its competitors or the introduction of the Company's products to new markets, changes in the levels of operating expenses, including development costs, and the amount and timing of other costs relating to the expansion of the Company's operations.
Furthermore, the purchase of the Company's products, particularly for major projects, may involve a significant commitment of capital, with the attendant delays frequently associated with large capital expenditures and authorization procedures within its customers' organization. For these and other reasons, the sales cycle for the Company's products can be lengthy (up to two years) and subject to a number of significant risks over which the Company has little or no control, including customer budgetary constraints. The Company historically has operated with little backlog because most customer orders are placed with relatively short lead times, usually from four to thirty weeks. Variations in the timing of recognition of specific revenues due to changes in project scope and timing may adversely and disproportionately affect the Company's operating results for a quarter because the Company establishes its expenditure levels on the basis of expected future revenues, and a significant portion of the Company's expenses do not vary with current revenues.
Uncertain Regulatory Environment. The Company's customers are required to comply with environmental laws and regulations in the United States and elsewhere which limit the emission of VOCs and other chemicals. The level of enforcement activities by environmental protection agencies and changes in laws and regulations will affect demand for the Company's systems. To the extent that the burden of complying with such environmental laws and regulations may be eased, the demand for the Company's systems could be materially adversely affected.
Although the Company believes that its FTO technology does not come under the U.S. EPA's current definitions of incineration, there can be no assurance that the U.S. EPA will not classify the Company's FTO technology as an incineration technology in the future. Classification as an incineration technology could significantly increase the length of time and cost of the permitting process for customers because of the requirement for a public hearing, especially where community sentiment is opposed to incineration technology. A lengthier permitting process could reduce the competitive advantages of the Company's technology and materially adversely affect the Company's business, results of operations and financial condition. The Company has applied for certification of its FTO technology under the California Department of Toxic Substances Control. This certification is not available to incineration-based technologies. The Department's decision will be published in mid-April 1999.
Proprietary Technology and Unpredictability of Patent Protection. The Company relies on patents, trade secrets and proprietary know-how, which it seeks to protect, in part, through appropriate confidentiality and proprietary information agreements with its strategic partners, employees and consultants. There can be no assurance that the proprietary information or confidentiality agreements will not be breached, that the Company will have adequate remedies for any breach, or that the Company's trade secrets and proprietary know-how will not otherwise become known to or be independently developed by others.
Possible Product Liability. The Company's FTO systems are designed to destroy VOCs, which are highly toxic and flammable. If the Company's systems are improperly designed or operated outside of design parameters and operating instructions provided by the Company, there is a risk of system failure or release of VOCs, which could require the Company to defend itself against a product liability or personal injury claim. Although the Company has product liability and commercial general liability insurance in scope and amount that it believes to be sufficient for the conduct of its business, there can be no assurance that such insurance will cover or be adequate to cover such claims. In addition, the Company's general liability insurance is subject to coverage limits and excludes
coverage for losses or liabilities relating to environmental damage or pollution. Accordingly, the Company's efforts to defend itself against such claims could have a material adverse effect on the Company's business, results of operations and financial condition.
Potential Environmental Liability. Although the Company does not believe that its activities would directly expose it to liabilities under local, state or federal environmental laws and regulations, if the Company were to improperly design, manufacture or test its systems or fail to properly train its customer's employees in the operation of the systems, it could be exposed to possible liability for investigation and clean-up costs under such environmental laws.
Under some environmental laws and various theories of tort and contract law, it is also possible that the Company could be liable for damages to its customers and third parties resulting from the actions of its customers or arising from the failure or malfunction, or the design, construction or operation of, the Company's FTO systems or products, even if the Company were not directly at fault. The Company's general liability insurance is subject to coverage limits and generally excludes coverage for losses or liabilities relating to or arising out of environmental damage or pollution. The Company's business, results of operations and financial condition could be materially adversely affected by an uninsured or partially insured claim.
Risks Associated With the Diesel Engine Emission Control Development Program. The engineering challenges involved in treating diesel emissions are different in a number of respects from the conditions in which the Company's system has been used in the past, and there can be no assurance that the Company's technology will prove successful in this development area. Moreover, the Company's extensive database of test results that it uses to design systems for industrial installations may not be relevant to diesel engine emission control. Although pilot test results to date have been positive, the Company will need to engage in extensive and costly applications development and engineering in order to commercialize its system for such use, and there can be no assurance as to the success of any such effort.
Additional Risks Associated With the Acquisition of Wahlco
Debt. As a result of the acquisition of Wahlco, the Company agreed to become the co-obligor for the outstanding obligations of Wahlco. This debt is payable to Wexford Management LLC ("Wexford") and several lenders affiliated with Wexford. As of March 31, 1999, the debt amounts to slightly more than $5.7 million and bears interest at the rate of 13% per annum, payable monthly. The debt becomes due August 24, 1999 and can, with the payment of an additional fee of $100,000, be extended until November 22, 1999. A comprehensive security interest in all of the Company's existing and future assets (to include the assets of its significant direct and indirect subsidiaries in the US and UK) was granted in connection with this Agreement. Failure to repay the debt or to secure alternative financing would permit Wexford to assert its rights to the underlying assets. There can be no assurance that the Company will be successful in generating sufficient resources to repay the debt when it becomes due, or that it will be successful in finding long-term replacement financing.
Ability to Integrate the Two Businesses. The Company belives that effective integration of Wahlco's business with the Company's can yield significant synergies. Failure to realize the full potential of integration, or an unanticipated delay in the integration could have a significant adverse impact on the business, the results of operations and financial condition of the Company. There can be no guarantee that the potential will be fully or partially realized or that it will be realized in a timely manner.
Liquidity. As a result of the net losses incurred by the Company, the acquisition of Wahlco and the significant cash demands required to meet ongoing operational obligations (including certain restructuring events to be incurred related to obtaining synergies from the Wahlco acquisition), the Company continues to experience negative cash flow. The Company anticipates it will continue to experience negative cashflows from operations and will need to issue additional equity or debt to provide funds for operations and to repay debt obligations that will become due and payable in 1999. There can be no guarantee that sufficient funds will be generated to cover the negative cash flow position. Failure to correct the situation will directly impact the ability to secure new orders, the ability to attract and retain quality staff and the ability to meet all existing obligations, all of which will have serious negative consequences for the Company's business, results of operations and financial condition.
Performance Bonds. Wahlco has experienced operating losses for each of the past six years, and losses have continued in 1998. For 1998, unaudited losses totaled approximately $6.4 million. In 1996 and 1997, the independent public accountants of Wahlco qualified their report on the company's financial statements expressing the substantial doubt as to the company's ability to continue as a going concern. One result of these continued operating losses and the going concern opinion is that customers have required letters of credit or performance bonds prior to placing orders. There can be no guarantee that the Company will be able to secure such credit instruments sufficient to meet customer requirements and this can have a serious impact on winning new orders.
Potential Puerto Rican Tax Liability. The Company has determined that there may be a tax liability associated with Wahlco's past repatriation of capital from the Commonwealth of Puerto Rico. Wahlco has recorded a reserve of $1.1 million for this potential liability. The Company is attempting to resolve this potential tax liability and believes it will be able to settle this matter without additional commitment above what is currently reserved by Wahlco.
Item 2.
Item 2. Properties
The Company sub-leases approximately 4,464 square feet of office space in San Jose, California under a 27-month sublease terminating on October 31, 2000, which the Company uses as its registered, and research and development and Thermatrix Diesel Systems offices. The Company is in the final year of a lease for approximately 15,000 square feet of office space in Knoxville, Tennessee, which it primarily uses for corporate management and administration, design engineering, project management and accounting offices. The Company is currently investigating a renewal lease or leasing other premises.
In addition, the Company leases approximately 5,000 square feet of office space in Hull, England under a six-year lease expiring January 27, 2003, accommodating all European activities, including sales, operations and engineering. The Company also leases approximately 1,000 square feet of office space in London, England under a five-year lease expiring March 24, 1999, which the Company is currently subletting on a month-to-month basis.
In the United States, Wahlco owns two properties. The first, located in Lewiston Maine, is a 13.27 acre site with a 50,864 square foot manufacturing plant and offices. The second, located in Thornton, Illinois is a 32,000 square foot site with a 5,233 square foot office and storage building. The second site is currently for sale. In addition to the property it owns, Wahlco leases an approximately 46,000 square foot manufacturing and office facility in Santa Ana, California under a ten-year lease expiring on July 31, 2001.
In the United Kingdom, Wahlco owns a 4.25 acre facility in Pontardulais, South Wales with a 79,200 square foot manufacturing plant and office complex. In addition to the owned property, Wahlco leases two facilities in the Chesterfield area on 15 year leases that expire in August 2006 but each lease has a break clause in August 2001. The first facility is on a 1.5 acre site with 15,174 square feet of warehouse and office space. Approximately 6,294 square feet are subleased to a tenant. The sublease expires November 17, 2001 . The second facility is a 3.5 acre site with 98,826 square feet of manufacturing and office space.
Item 3.
Item 3. Legal Proceedings
The Company is involved in various routine legal proceedings incident to the ordinary course of its business. Management believes that the outcome of all pending legal proceedings in the aggregate will not have a material effect on the Company's business, financial condition or result of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of stockholders during the fourth quarter of the Company's fiscal year.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The common stock of the Company is traded on the NASDAQ National Market under the symbol "TMXI." The following table sets forth, for the periods indicated, the high and low sales prices, in U. S. dollars, of the common stock (as reported by NASDAQ):
As of February 28, 1999, there were over 1,000 holders of record of the Company's Common Stock. The Company has never declared or paid dividends on its stock. The Company currently intends to finance the growth and development of its business with retained earnings and does not anticipate paying dividends in the foreseeable future.
Item 6.
Item 6. Selected Consolidated Financial Data
The selected consolidated financial data set forth below with respect to the Company's statements of operations for each of the three years in the period ended December 31, 1998 and with respect to the Company's balance sheets as of December 31, 1998 and 1997 are derived from the consolidated financial statements included elsewhere in this report and should be read in conjunction with those financial statements and related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The statement of operations data for the years ended December 31, 1995 and 1994 and the balance sheet data as of December 31, 1996, 1995 and 1994 are derived from audited financial statements not included in this report.
- --------------- (1) See Note 2 of Notes to Consolidated Financial Statements - Summary of Significant Accounting Policies Basic Net Loss Per Share.
THERMATRIX INC.
SUPPLEMENTARY CONSOLIDATED FINANCIAL DATA (In thousands, except per share data)
Quarterly Financial Data (Unaudited)
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
General
Thermatrix Inc. is a global industrial technology company engaged in the development, manufacture and sale of industrial process equipment for the destruction of volatile organic compounds and hazardous air pollutants (collectively, "VOCs"). The core component of the Company's technology is its proprietary flameless thermal oxidizer ("FTO"). The Company's product line also includes PADRE(R), a proprietary technology used to capture and recover very low concentration VOCs from low-to-medium vapor streams.
The Company derives its revenues from contracts to design, develop, manufacture, and install systems for the treatment of VOCs. The Company uses the percentage-of-completion method of accounting to recognize contract revenues. Losses on contracts are charged to cost of revenues as soon as such losses become known.
The Company's core technology has been successfully commercialized in the industrial VOC control market for applications in the petroleum, chemical/petrochemical, pharmaceutical, medical sterilization and pulp and paper industries, and for soil and groundwater remediation, and the Company is continuing to expand into additional segments of the industrial VOC control market. Because the Company's technology has been commercialized, the Company does not expect that costs associated with further research and development of its core FTO technology for the industrial VOC control market will be material to the Company's results of operations.
In 1998, the Company continued to experience an increase in demand for its products overseas, primarily due to the continued globalization of the chemical and pharmaceutical industries, increased adoption of ISO 14000 standards, and capital expenditures by overseas companies. As a result of the collapse of the markets in Asia, the Company's primary focus on overseas markets was in Europe, primarily the United Kingdom.
In addition to its primary focus on the industrial VOC emission control market, the Company is currently working with strategic partners to evaluate the feasibility of applying the Company's technology to other markets. The strategic partners generally share some, but not all, of the evaluation costs. Expenses incurred by the Company, primarily labor and equipment operation costs, are generally recorded as research and development expenses. To the extent the strategic partner reimburses such research and development expenses, these amounts are reflected as a reduction of research and development expenses. If evaluation costs are reimbursed under the terms of a purchase contract, these amounts are reflected as cost of revenues. In addition, the Company, may provide an evaluation system as part of a joint development program. The capital cost of the evaluation system is amortized over the estimated useful life of the evaluation system. In 1998, expenses incurred by the Company for these development programs were not significant. There can be no assurance as to the outcome of such evaluation programs or, if initiated, the outcome of any such applications development and engineering effort.
The Company's quarterly revenues and operating results have varied significantly in the past and may fluctuate significantly in the future as a result of a variety of factors, many of which are outside the Company's control. Such factors include general economic and industry conditions, the size and timing of individual orders, the timing and amount of project change orders, the amount of first-time engineering needed, the introduction of new products or services by the Company or its competitors or the introduction of the Company's products to new markets, changes in the levels of operating expenses, including development costs, and the amount and timing of other costs relating to the expansion of the Company's operations.
Furthermore, the purchase of the Company's products, particularly for major projects, may involve a significant commitment of capital, with the attendant delays frequently associated with large capital expenditures and authorization procedures within its customers' organization. For these and other reasons, the sales cycle for the Company's products can be lengthy (up to two years) and subject to a number of significant risks over which the Company has little or no control, including customer budgetary constraints. The Company historically has operated with little backlog because most customer orders are placed with relatively short lead times, usually from four to thirty weeks. Variations in the timing of recognition of specific revenues due to changes in project scope and timing may adversely and disproportionately affect the Company's operating results for a quarter because the Company
establishes its expenditure levels on the basis of expected future revenues, and a significant portion of the Company's expenses do not vary with current revenues.
Although the Company is expanding the number of its customers and installations, the average size and dollar volume of each installation is increasing. As a result, the Company's results of operations are likely to continue to be dependent on major projects. Such a reliance on major orders is likely to lead to fluctuations in, and to reduce the predictability of, quarterly results. Larger projects also pose other challenges. The sales cycle for larger projects tends to be longer than for smaller projects, and, when orders are received, projects may be delayed by factors outside the Company's control, including customer budget decisions, design changes and delays in obtaining permits. Orders for large systems often have tight delivery schedules and the customer will often attempt to negotiate penalties for late delivery and/or the ability to assess liquidated damages for lost production if the delivery schedule is not met. Also, because the dollar volumes are larger, the costs of providing warranty services could increase. The Company's business, results of operations and financial condition could be materially adversely affected if the Company were to fail to obtain major project orders, if such orders were delayed, if installations of such systems were delayed, or if such installations encountered operating, warranty or other problems.
Results of Operations
Fiscal years Ended December 31, 1998 and 1997
Revenues. Revenues increased 94% to $13.6 million in 1998 from $7.0 million -------- in 1997. The increase in revenues reflects the Company's successful transformation to a supplier of turn key systems for VOC control on a worldwide basis, the receipt of a two large orders from a customer in Ireland, and the decision to focus sales and marketing attention on capital investment activity in Europe, especially Ireland. In 1998, two customers accounted for 51% and 11% of revenues, respectively. Sales to international customers increased to 60% of revenues in 1998, up from 35% in 1997.
Gross Margin. The Company had a gross margin contribution of $558,000 in 1998 ------------ versus a gross margin loss of $1.3 million in 1997. The increase in gross margin was primarily attributable to higher revenues, which were sufficient to absorb the fixed and semi-fixed costs of engineering and operations in the U.S. and Europe, and to a lesser extent, reduction in costs from repeat sales of systems for established applications.
The Company anticipates that gross margins will continue to be adversely affected by numerous factors including growth of the operations infrastructure, international expansion, initial systems addressing new industries or new applications, larger, more complex systems and the extent and timing of change orders. As the Company grows, the Company will need to hire additional design engineers, instrumentation and control engineers and project management personnel. Significant training and familiarization with the Company's FTO technology will result in these new individuals not being fully engaged in revenue producing activities which reduces gross margin percentages. As the Company grows internationally, operations infrastructure needs to be added to support the sales activities. New industry and/or fume characteristics require the Company to expend significantly greater engineering resources in process and system design. Also such new applications are usually sold at lower initial gross margins as the customer and the Company make investments in the development effort. As systems become larger and more complex with hybrid technologies and purchased components, overall gross margin percentages are affected by the Company's ability to mark up the purchased components in the final system. Project change orders can be nominal or can be significant. The Company does not recognize change orders as revenue until the customer accepts the implemented change order or acceptance is probable. Depending upon the magnitude of the change order, gross margins can also be affected.
Research and Development. Research and development expenses include ------------------------ applications engineering expenses not chargeable to specific customer projects, personnel costs related to patent activities, and the expenses incurred in connection with the Company's development programs to evaluate the feasibility of applying the Company's technology to markets other than industrial VOC emissions control. Research and development expenses during 1998 and 1997 were $1.7 million and $1.2 million, respectively. The increase in research and development expenses in 1998 is primarily attributable to expenditures for the development and testing of a
prototype system utilizing the Company's patented FTO technology for the treatment of diesel engine emissions from mobile sources, the development of a prototype of a new FTO configuration, and PADRE (R) product development.
Selling, General and Administrative. Selling, general and administrative ----------------------------------- expenses decreased 8% to $7.1 million in 1998 as compared with $7.7 million in 1997. The decrease in 1998 over 1997 is primarily attributable to reduced staffing and related costs, lower sales commissions and marketing expenses, and a decrease in travel expenses. The decrease was partially offset, however, by higher consulting and legal fees.
The total selling, general and administrative expenses also reflect $1.6 million recorded to write off accounts receivable amounts incurred in connection with certain project change orders and contracts, the majority of which relate to prior years, that had not been settled as of December 31, 1998, including amounts due from White Horse pursuant to the Exclusive Sales and Marketing Agreement. The Company is in various stages of negotiations and litigation with the parties to the respective contracts and will continue to pursue collection of such balances, including further legal action when necessary. Historically, the Company has been successful in recovering substantial portions of the charges incurred with respect to change orders. However, given the passage of time from the incurrence of the related costs, the Company felt it was prudent to write off the amounts at this time. The Company also included an amount in the write-off related to a reasonable estimate of the legal costs to be incurred to collect the amounts in dispute.
Interest Income. Interest income decreased to $413,000 in 1998 from $697,000 --------------- in 1997. The decrease primarily resulted from a decrease in the amount available for investment as investments were liquidated and used throughout 1998 for working capital purposes.
Income Taxes. As a result of recurring losses, the only income taxes provided ------------ for relate to certain state taxes not fully offset by net operating losses.
Fiscal years Ended December 31, 1997 and 1996
Revenues. Revenues decreased 49% to $7.0 million in 1997 from $13.6 million -------- in 1996. The decrease in revenues reflects the decline in the United States VOC market, as well as the cancellation of three orders in three different countries due to changing customer circumstances after engineering work had been completed. In 1997, two customers accounted for 28% and 10% of revenues, respectively. Sales to international customers increased to 35% of revenues in 1997, up from 14% in 1996.
Gross Margin. The Company had a gross margin loss of $1.3 million in 1997 ------------ versus a gross margin contribution of $1.6 million, or 11.8%, in 1996. The decrease in gross margin was primarily attributable to lower revenues, which were insufficient to absorb the ongoing fixed costs of engineering and operations in the United States and Europe. As of December 31, 1997, the Company also recorded a charge to cost of revenues of $500,000 to establish a reserve against the costs accumulated in connection with certain change orders and contracts. In addition, gross margin was also impacted by increased overhead costs incurred as the Company put infrastructure in place to increase its presence in Europe and to manage the anticipated increase in customer orders for the Company's products. Also, gross margin was impacted by first-time shipments to foreign countries, as the Company had to comply with the different construction and regulatory codes of those countries, the full design cost of which was charged to the first project in a given country.
The Company anticipates that gross margins will continue to be adversely affected by numerous factors including growth of the operations infrastructure, international expansion, initial systems addressing new industries or new applications, larger, more complex systems and the extent and timing of change orders. As the Company grows, the Company will need to hire additional design engineers, instrumentation and control engineers and project management personnel. Significant training and familiarization with the Company's FTO technology will result in these new individuals not being fully engaged in revenue producing activities which reduces gross margin percentages. As the Company grows internationally, operations infrastructure needs to be added to support the sales activities. New industry and/or fume characteristics require the Company to expend significantly greater engineering resources in process and system design. Also such new applications are usually sold at lower initial
gross margins as the customer and the Company make investments in the development effort. As systems get larger and more complex with hybrid technologies and purchased components, overall gross margin percentages are affected by the Company's ability to mark up the purchased components in the final system. Project change orders can be nominal or can be significant. The Company does not recognize change orders as revenue until the customer accepts the implemented change order or acceptance is probable. Depending upon the magnitude of the change order, gross margins can also be affected.
Research and Development. Research and development expenses include ------------------------ applications engineering expenses not chargeable to specific customer projects, personnel costs related to patent activities, and the expenses incurred in connection with the Company's development programs to evaluate the feasibility of applying the Company's technology to markets other than industrial VOC emissions control. Research and development expenses during 1997 and 1996 were $1.2 million and $748,000, respectively. The increase in research and development expenses in 1997 is attributable to a significant increase in product development activities in 1997. A modified recuperative oxidizer was designed and installed to improve the operability and increase the range of the FTO. A portion of the increase in research and development expenses is attributable to the design of a continuous PADRE(R) system. Also, the first test unit for the treatment of emissions from dry cleaning operations was completed and shipped. In addition, a new FTO design with an almost spherical flameless reaction front within the reactor's ceramic matrix was constructed and tested.
Selling, General and Administrative. Selling, general and administrative ----------------------------------- expenses increased 24.9% to $7.7 million in 1997 as compared with $6.2 million in 1996. The increase in 1997 over 1996 is primarily attributable to the 1997 fourth quarter charge of $891,000 recorded for certain nonrecurring items including $472,000 for the costs relating to (i) the move of the Company's administrative center from San Jose, California to Knoxville, Tennessee, (ii) the closure of the Knoxville fabrication and assembly facility, and (iii) the relocation of the Company's European operations from London to an expanded facility near Hull, England. The charge also includes severance and other related closure and relocation costs associated with these activities. Another component of the nonrecurring charges relates to the non-cash provision of approximately $390,000 recorded to write off the Company's minority interest position in the Formatrix, LLC joint venture with ThermoChem, Inc.
In addition to the nonrecurring charge taken in 1997, the increase in selling, general and administrative expenses reflects the impact of increased staffing and related costs incurred in Europe and Asia as a result of the higher level of sales activity in those regions, which was partially offset by the decrease in the Company's United States sales staff. The increase is also reflective of the full-year costs of being a public company. The Company's IPO was completed June 20, 1996.
Interest Income. Interest income increased to $697,000 in 1997, from $548,000 --------------- in 1996. The increase primarily resulted from the investment of the net proceeds from the Company's initial public offering completed in June 1996.
Income Taxes. As a result of recurring losses, the only income taxes provided ------------ for relate to certain state taxes not fully offset by net operating losses.
Liquidity and Capital Resources
In February 1996, the Company sold 284,594 shares of its Series D Preferrred Stock at $7.50 per share to existing investors for net cash of $2.1 million. In June 1996, the Company completed its initial public offering raising net proceeds of $22.1 million. In 1998, 1997 and 1996, the Company used the proceeds of these prior equity issuances to finance its cash used in operating activities of $4.1 million, $7.7 million and $7.9 million, respectively.
At December 31, 1998, the Company had an accumulated deficit of $44.6 million, cash and short-term investments aggregating $3.2 million, and working capital of $2.3 million. In addition, the Company incurred a net loss during 1998 of $7.9 million. On January 13, 1999, the Company paid approximately $1.9 million to acquire all of the common shares and warrants of Wahlco. In addition to the cash payments, the Company agreed at the time to guarantee certain Wahlco debts owed to, or guaranteed by, Wexford and several
lenders affiliated with Wexford and granted a security interest in all existing and future assets to Wexford and the lenders. In addition, under certain conditions, the Company may be required to make an additional payment of up to $2 million to Wahlco's former shareholders. On an unaudited combined basis, after this transaction, the Company has cash and cash equivalents of approximately $1.5 million and current liabilities of approximately $24.0 million, excluding severance and other costs that may be accrued relating to the transaction.
On February 25, 1999 the Company entered into the Second Amended and Restated Credit Agreement among Wahlco and the Company, as Borrowers, and certain Wexford affiliates as Lenders and Wexford as Agent for the Lenders (the "1999 Credit Agreement"). As of March 31, 1999, the debt amounts to slightly more than $5.7 million and bears interest at the rate of 13% per annum, payable monthly in advance. The debt matures on August 24, 1999, and may, with the payment of an additional fee of $100,000, be extended until November 22, 1999. As a further condition to the Lenders' execution and delivery of the 1999 Credit Agreement, the Company agreed to confirm its grant to the Lenders of a security interest in all existing and future assets and to cause all its significant subsidiaries to enter into guarantees and grant to the Lenders additional security interests and mortgages in all existing and future assets of the Borrowers and significant subsidiaries.
The Company expects to spend approximately $1 million in 1999 to fund additional research and development activities relating to the treatment of emissions from diesel engines. However, under the ATP grant award the Company expects to receive funding to cover a substantial portion of the expense that will be incurred and its actual research and development expenses could total less than the $1 million forcasted. For the first year of this grant award, the Company is obligated to contribute direct costs of approximately $85,000 to this program. The Company is not contractually obligated to provide any additional fixed level of funding for the diesel program and had no other capital commitments at December 31, 1998.
In February 1997, the Company entered into an Amended and Restated Loan and Security Agreement (the "1997 Agreement") which provided for a $4,000,000 accounts receivable line of credit and a $2,500,000 acquisition facility. In January 1998, the Company entered into an Amended and Restated Loan and Security Agreement (the "1998 Agreement") which replaced the 1997 Agreement and which provided for a $4,000,000 accounts receivable line of credit with a $2,000,000 letter of credit sub-limit. The 1998 Agreement was renegotiated in March 1998 when certain financial covenants were amended. No cash advances were ever made under either the 1997 Agreement or the 1998 Agreement. The 1998 Agreement was terminated on January 20, 1999 and the stand-by letter of credit in the amount of $280,000 that had been issued under the sub-facility was collateralized with cash at that time.
It has always been the Company's intention to obtain additional financing to carry out the acquisition of Wahlco. The Company intends to finance its ongoing operations, including the restructuring and integration of Wahlco, primarily by raising equity and debt in the second quarter of fiscal 1999. The Company has engaged an investment advisory firm as its exclusive agent to assist with the structure and placement of a $6 million to $8 million equity offering and a $10 million to $15 million senior term and revolving credit facility. In concert with this engagement, the investment advisory firm has committed to invest a minimum of $2 million in the equity offering contingent upon appropriate due diligence and legal review. As consideration to the Company, the investment advisory firm will provide its initial investment in the form of convertible debt prior to the equity offering in order to immediately improve the Company's working capital position. If necessary, the investment advisory firm will also provide and/or arrange additional debt or mezzanine financing. The Company's financing is dependent upon the ability to attract additional equity investors and to provide sufficient security for credit facilities. There can be no assurances as to the timing or ultimate outcome of this financing.
Management is currently evaluating the Company's alternatives to fund its fiscal 1999 cash requirements. Such alternatives include, among other things, consideration of (i) increased revenues and positive gross margin (ii) the timely collection of accounts receivable and, (iii) divesting a portion or portions of the Company's business. These strategies are dependent upon the Company's ability to meet its forecasts, to develop increased sales and generate positive gross margins, to achieve the timely collection of amounts due to the Company and to identify parties willing and able to purchase a portion or portions of the Company's business. There can be no assurances as to the timimg or ultimate outcome of any of these alternatives.
Year 2000 Compliance
The Year 2000 issue arises from computer programs that use two digits rather than four to define the applicable year. Such computer programs may cause computer systems to recognize a date using "00" as the calendar year 1900 rather than the calendar year 2000. Systems that do not properly recognize such information could generate erroneous dates or cause a system to fail.
The Company has conducted a preliminary review of its products and internal computer systems to identify the systems that could be affected by the Year 2000 issue. The Company believes its products and most of its management information systems are already Year 2000 compliant, however its existing accounting system is not. The Company plans to upgrade to a Year 2000 compliant version of its accounting system and does not anticipate that the cost of such a conversion will be material.
The Company's business may be disrupted in other ways by Year 2000 problems of third parties, which may affect, for example, the Company's ability to obtain needed materials or deliver its products. The Company is in the process of determining whether its key vendors are Year 2000 compliant and has requested that such vendors complete and return surveys with respect to their Year 2000 issues.
While the Company currently expects the Year 2000 issue will not pose significant operational problems, failure to fully identify all Year 2000 dependencies in the Company's systems could have a material adverse effect on the Company's business, results of operations and financial condition. In addition, the Company cannot be sure that systems of other companies on which the Company relies will be converted in a timely manner. The failure of other companies to convert systems on which the Company relies may have a material adverse effect on the Company's business, results of operations or financial condition.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Information regarding quantitative and qualitative disclosures about market risks is included in Item 1 - Description of Business, Item 7 - Management's Discussion and Analysis of financial Condition and Results of Operations, and in Note 2 to the Consolidated Financial Statements.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
See pages 32 through 51
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
As of December 31, 1998, the executive officers of the Company, who are elected by and serve at the discretion of the Board of Directors, are as follows:
John T. Schofield. Mr. Schofield has been President and Chief Executive Officer of the Company since April 1992, and Chairman of the Board since December 1993. From April 1981 to September 1991, Mr. Schofield served in various executive positions at International Technology Corporation, an environmental management company, where he directed technical services, business activities, strategic planning and development. Mr. Schofield holds a BSc Honours in Chemistry from the University of Manchester, England.
Daniel S. Tedone. Mr. Tedone joined the Company in April 1998 as Executive Vice President and assumed responsibility for the operation of the Company's core VOC business. In June 1998 Mr. Tedone assumed the additional responsibilities of Chief Financial Officer. Prior to joining the Company, Mr. Tedone was CEO of Pollution Control Technologies Inc., which was acquired by TRC Companies, Inc. in 1995 and where he served as President and CEO of TRC Process Engineering, Inc. Previously, Mr. Tedone served as President of Vericon Corporation and held positions at Connecticut Resources Recovery Authority and Hartford National Bank & Trust Company. Mr. Tedone holds a Bachelor of Arts degree and an M.B.A. in Finance from the University of Connecticut.
Edward E. Greene. Mr. Greene has been Vice President, Administration of Thermatrix Inc. since December 1998. He was appointed Secretary of the Company in July 1998 and has been Director of Administrative Services since June 1996. Between 1970 and 1996 Mr. Greene was a career Regular Army Officer. Mr. Greene holds a Bachelor of Science degree in Economics from Gannon College and a Master of Arts in Economics from the University of Oklahoma.
Richard J. Goodier. Mr. Goodier joined the Company as Director, European Engineering and Operations, in February 1997 and manages the European engineering and operations. Prior to joining Thermatrix, he held a variety of senior management positions in Hickson International PLC, A.H. Marks & Co. Ltd., AE&CI (South Africa), Amoco Europe and Shell Chemicals. Mr. Goodier holds a B.Sc. Honours in Mechanical Engineering and is a Chartered Engineer with the Institution of Mechanical Engineers in London.
Information concerning the Company's Directors and compliance with Section 16 of the Securities Exchange Act is incorporated herein by reference to the Company's definitive proxy statement for its Annual Meeting of Stockholders to be held on June 10, 1999, which is intended to be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 1998.
Items 11, 12 and 13
The information called for by Part III (Items 11, 12 and 13) is incorporated herein by reference to the Company's definitive proxy statement for its Annual Meeting of Stockholders to be held on June 10, 1999, which is intended to be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended December 31, 1998.
Report of Independent Public Accountants
To Thermatrix Inc.:
We have audited the accompanying consolidated balance sheets of Thermatrix Inc. (a Delaware corporation) and subsidiary as of December 31, 1998, and 1997, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1998. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Thermatrix Inc. and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has incurred significant operating losses and has negative working capital as a result of the acquisition of Wahlco Environmental Systems, Inc. ("Wahlco") in January 1999. These conditions raise substantial doubt about the Company's ability to continue as a going concern. As discussed in Note 1, as part of its plan for financing the Wahlco acquisition, the Company has engaged an investment advisory firm to raise equity and debt financing during the second quarter of fiscal 1999. There can be no assurances as to the timing or ultimate outcome of this financing. Refer to Note 1 for further discussion of the Company's 1999 financing plan. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed under Item 14(a) is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth in relation to the basic consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
San Jose, California March 30, 1999
THERMATRIX INC.
CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
The accompanying notes are an integral part of these consolidated balance sheets.
THERMATRIX INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
THERMATRIX INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
THERMATRIX INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Operations of the Company
Thermatrix Inc. (the "Company") is a global industrial technology company primarily engaged in the development, manufacture and sale of industrial process equipment for the destruction of volatile organic compounds and hazardous air pollutants (collectively, "VOCs"). The Company markets its products to a wide variety of industries, including petroleum, chemical/petrochemical, pharmaceutical, pulp and paper, and medical sterilization and for soil and groundwater remediation, throughout the world.
The Company is subject to certain risks that include, but are not limited to, the history of operating losses and uncertainty of future profitability; sensitivity to major projects; fixed price contracts; and dependence on a limited set of customers and key employees. At December 31, 1998, the Company had an accumulated deficit of approximately $44.6 million and expects to incur additional losses in the future. The Company does not expect to be profitable unless and until such time as sales of flameless thermal oxidation systems at appropriate gross margins generate sufficient revenue to fund its operations. There can be no assurance that the Company will achieve such revenues. The Company's operating results are sensitive to major projects such that results of operations and financial condition could be adversely affected if the Company failed to obtain major projects, if a major project order was delayed, if the Company was unable to complete the project within its cost estimate or if such installations encountered operating or warranty problems.
At December 31, 1998, the Company had an accumulated deficit of $44.6 million, cash and short-term investments aggregating $3.2 million, and working capital of $2.3 million. In addition, the Company incurred a net loss during 1998 of $7.9 million. As discussed in Note 10, on January 13, 1999, the Company paid approximately $1.9 million to acquire all of the outstanding common shares of Wahlco Environmental Systems, Inc ("Wahlco"). In addition to the cash payments, the Company agreed at the time to guarantee certain Wahlco debts owed to, or guaranteed by, Wexford management LLC ("Wexford") and several lenders affiliated with Wexford and granted a security interest in all existing and future assets to Wexford and the lenders. On an unaudited combined basis, after this transaction, the Company has cash and cash equivalents of approximately $1.5 million and current liabilities of approximately $24.0 million, excluding severance and other costs that may be accrued relating to the transaction.
It has always been the Company's intention to obtain additional financing to carry out the acquisition of Wahlco. The Company intends to finance its ongoing operations, including the restructuring and integration of Wahlco, primarily by raising equity and debt in the second quarter of fiscal 1999. The Company has engaged an investment advisory firm as its exclusive agent to assist with the structure and placement of a $6 million to $8 million equity offering and a $10 million to $15 million senior term and revolving credit facility. In concert with this engagement, the investment advisory firm has committed to invest a minimum of $2 million in the equity offering, contingent upon appropriate due diligence and legal review. As consideration to the Company, the investment advisory firm will provide its initial investment in the form of convertible debt prior to the equity offering in order to immediately improve the Company's working capital position. If necessary, the investment advisory firm will also provide and/or arrange additional debt or mezzanine financing. The Company's financing is dependent upon the ability to attract additional equity investors and to provide sufficient security for credit facilities. There can be no assurances as to the timing or ultimate outcome of this financing.
Management is also currently evaluating other Company alternatives to fund its fiscal 1999 cash requirements. Such alternatives include, among other things, (i) increased revenues and improved gross margins, (ii) the timely collection of accounts receivable and (iii) divesting a portion or portions of the Company's business. These strategies are dependent upon the Company's ability, to meet its forecasts, to develop increased sales and generate positive gross margins, to achieve the timely collection of amounts due to the Company and to identify parties willing and able to purchase a portion or portions of the Company's business. There can be no assurances as to the timing or ultimate outcome of any of these alternatives.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company's ability to continue as a going concern is dependent upon completing the contemplated equity and debt transactions in the second quarter of 1999. The accompanying financial statements do not include any adjustments that might result from the outcome of these uncertainties.
2. Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. The Company prepares and evaluates ongoing cost to complete estimates in order to monitor its project costs. These estimates form the basis for calculating revenues and gross margins for each project under the percentage-of-completion method of accounting. Due to uncertainties inherent in the estimation process, estimated total costs are subject to revision on an on-going basis as additional information becomes available. The estimates are subject to change and actual results could be materially different from these estimates.
Principles of Consolidation and Foreign Currency Translation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. The functional currency of the subsidiary is the British Pound Sterling. Accordingly, all translation gains and losses resulting from transactions denominated in currencies other than the U.S. dollar are included in shareholders' equity. To date, the translation gains and losses have not been material. All intercompany accounts and transactions have been eliminated.
Cash and Cash Equivalents and Short-term Investments
For purposes of the statements of cash flows, the Company considers all short- term investments purchased with a maturity of three months or less to be cash equivalents.
Under Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" the Company classifies its short-term investments as "held to maturity." Therefore all of these investments are carried at amortized cost. Unrealized holding gains or losses as of December 31, 1998 and December 31, 1997 were not material. As of December 31, 1998, short-term investments mature at various dates through April 1999.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The amortized cost, aggregate fair value and gross unrealized holding gains (losses) by major security type at December 31 were as follows (in thousands):
Revenue Recognition
The Company principally uses the percentage-of-completion method of accounting for contract revenues. The percentage-of-completion method is based on total costs incurred to date compared with estimated total costs upon completion of contracts. The completed contract method of accounting is used for certain contracts when the Company does not have sufficient historical data to enable it to prepare dependable cost estimates. Estimated losses on contracts are charged in full to cost of revenues as soon as such losses become known. Due to uncertainties inherent in the estimation process, estimated total costs are subject to revision on an ongoing basis as additional information becomes available. The Company recognizes revenue and costs attributable to priced and unpriced change orders when it is probable that the contract price will be adjusted and the amount of the change order can be reliably estimated. When acceptance of the contract change order is not probable or the amount of the change order cannot be reliably estimated, the Company treats the change order costs as work in progress inventory and defers revenue recognition until the change order is accepted or acceptance is probable. The Company generally warrants only new systems manufactured by the Company for defective workmanship and/or materials for a period of 12 months from initial operation of the system or 18 months after shipment or notification that the system is ready for shipment, whichever occurs first. A provision for estimated warranty costs is provided for each unit produced by the Company.
Warranty costs of approximately $324,000 were charged to cost of revenues for the year ended December 31, 1998. The Company charged $212,000 against the reserve for warranty costs and $6,000 directly to warranty costs during fiscal 1998. Accrued warranty obligation amounted to $171,000 and $65,000 as of December 31, 1998 and 1997, respectively, and are included in other accrued liabilities in the accompanying balance sheets.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Accounts Receivable
Accounts receivable consisted of the following (in thousands):
The unbilled amounts represent revenues recognized under the percentage-of- completion method of accounting which exceed the amounts that are billable according to contract terms. The unbilled amounts are generally billable as contract milestones and deliverables are accepted by the customer or as change orders are submitted and approved. As of December 31, 1998, accounts receivable did not include any unpriced change orders. As of December 31, 1997, accounts receivable included approximately $793,000 of unpriced change orders.
As of December 31, 1998, 61% of accounts receivable was concentrated with three customers. As of December 31, 1997, approximately 59% of accounts receivable was concentrated with eight customers.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of short-term cash investments and accounts receivable. The Company has cash investment policies that limit its investments to short-term, low risk investments. With respect to accounts receivable, the Company performs ongoing credit evaluations of its customers' financial condition. Additionally, the Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information.
Property and Equipment
Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated lives of the assets of three to five years. Leasehold improvements are amortized over the shorter of the related lease term or the estimated useful life of the asset. Betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Patent Costs
Direct costs incurred in connection with the filing of the Company's patent claims are capitalized as patent costs. Such amounts are amortized over the estimated economic useful lives of the patents (generally ten years). Accumulated amortization as of December 31, 1998 and 1997 was approximately $214,000 and $137,000, respectively.
Significant Customers
Sales to significant customers as a percentage of total revenues for the years ended December 31, 1998, 1997 and 1996 were as follows:
Revenues from government contracts as a percentage of total revenues was 6%, 10%, and 15% for the years ended December 31, 1998, 1997, and 1996, respectively. The principal government agencies to which the Company sells are the Department of Defense and the Department of Energy. Revenues from international customers as a percentage of total revenues were 60% for the year ended December 31, 1998, 35% for the year ended December 31, 1997 and 14% for the year ended December 31, 1996.
Basic Net Loss Per Share
Basic net loss per share is computed using the weighted average number of shares of common stock outstanding. No diluted loss per share information has been presented in the accompanying statements of operations since potential common shares from conversion of convertible preferred stock, stock options and warrants are antidilutive.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130 (SFAS 130), Reporting Comprehensive Income, which establishes standards for reporting and display of comprehensive income and its components (revenue, expenses, gains and losses) in a full set of general-purpose financial statements. The Company has integrated the presentation of comprehensive income (loss) with the Consolidated Statement of Stockholders' Equity (deficit).
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Effect of Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheets as either an asset or liability measured at its fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Statement 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect the adoption of Statement 133 to have a material effect on the financial statements.
3. Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
4. Commitments And Contingencies
The Company leases its facilities and certain equipment under operating leases that expire through January 2003. Rent expense was approximately $428,000, $492,000 and $338,000 for the years ended December 31, 1998, 1997 and 1996, respectively. As of December 31, 1998, future minimum payments are as follows (in thousands):
In April 1996, the Company purchased all of the respective assets, rights and properties of Purus Inc.'s VOC adsorption technology ("PADRE(R)"). Concurrent with the purchase, the Company entered into a License
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Agreement ("License") with Purus to manufacture, sell and distribute VOC treatment systems utilizing the PADRE(R) technology. Under this License the Company is required to make quarterly royalty payments of 7% on the aggregate net invoice value of all PADRE(R) VOC equipment sales. Royalty payments will continue until the earlier of (i) five years from the date of the License or (ii) such date that Purus has received $2.0 million in aggregate royalty payments. Royalties paid by the Company under the License totaled approximately $34,000 and $80,000 for the years ended December 31, 1998 and 1997, respectively.
5. Preferred Stock
Convertible Preferred Stock
Upon the closing of the Company's initial public offering in June 1996, each of the 2,554,631 shares of preferred stock then outstanding converted automatically into common stock.
Redeemable Convertible Preferred Stock
Redeemable convertible preferred stock outstanding as of December 31, 1995, consisted of 1,614,284 shares of Series D redeemable preferred stock. In February 1996, the Company sold 284,594 shares of Series D redeemable preferred stock at $7.50 per share.
Pursuant to the terms of the preferred stock agreement, the conversion price of Series D redeemable preferred stock was adjusted to $5.25 per share. The Series D preferred stock was automatically converted into 2,712,682 shares of common stock upon the closing of the Company's initial public offering.
In connection with a bridge financing in 1994, warrants to purchase 20,672 shares of convertible Series D redeemable preferred stock at $5.25 per share (as adjusted) were issued. Subsequent to the Company's initial public offering, these warrants were convertible into warrants to purchase common stock. The warrants are exercisable at any time and expire in 1999. Warrants to purchase 3,558 shares of common stock were exercised during 1996.
Preferred Stock
The Company is authorized to issue 5,000,000 shares of $.001 par value undesignated preferred stock. Upon issuance, the Board of Directors will have the authority to fix the rights, preferences, privileges and restrictions thereof.
6. Common Stock
As of December 31, 1998, the Company had remaining for issuance the following number of reserved shares of its common stock:
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In May 1996, the Board of Directors approved a one for three reverse stock split of all common stock and all designated series of preferred stock outstanding. The effect of the stock split has been retroactively applied in the consolidated financial statements.
*450,000 warrants to purchase common stock at $3.046875 were issued in conjunction with interim debt financing related to the Wahlco acquisition.
7. Stock Option Plans
1987 Stock Option Plan ("1987 Plan")
Under the 1987 Plan, the Board of Directors may grant to employees and consultants options to purchase the Company's common stock at terms and prices determined by the Board. Options granted under the 1987 Plan generally expire ten (10) years from the date of grant. During 1996, the Company adopted new stock plans (see below); accordingly, the Company does not plan to issue further options to purchase common stock under the 1987 Plan.
1996 Stock Plan ("1996 Plan")
A total of 333,334 shares of common stock has been reserved for issuance under the 1996 Plan. The 1996 Plan provides that options and stock purchase rights may be granted to employees and consultants to the Company. Options granted under the 1996 Plan may be either incentive stock options or non-statutory stock options. The Company may also grant stock purchase rights under the 1996 Plan. The exercise price and vesting of all grants are to be determined by the Board of Directors or its designee. Options granted under the 1996 Plan expire 10 years from the date of grant. The 1996 Plan will terminate in 2006.
The Board of Directors adopted a sub-plan of the 1996 Plan for the purpose of qualifying for preferred tax treatment under UK tax laws. The UK Inland Revenue approved the sub-plan effective January 30, 1998.
1996 Director Option Plan ("Directors Plan")
A total of 83,334 shares of common stock has been reserved for issuance under the Directors Plan. The Directors Plan provides for an automatic grant to each director of an initial option to purchase 6,667 shares of common stock ("First Option") upon the date on which such person becomes a non-employee director, and an additional option to purchase 1,667 shares of common stock ("Subsequent Option") each year, if the director has served on the Company's Board of Directors for at least six months. Options granted under the Directors Plan expire ten years after the date of grant. Twelve and one-half percent of the shares subject to a First Option will vest six months after its date of grant and an additional twelve and one-half percent will vest at the end of each six- month period thereafter. One-half of the shares subject to a Subsequent Option will vest six months after the date of the option grant and as to the remaining one-half, one year after the date of grant. The exercise price per share of all options shall be equal to the fair market value of the Company's common stock on the date of grant. The Directors Plan will terminate in 2006.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following option activity occurred in all stock option plans during the three years ended December 31, 1998:
As of December 31, 1997, the number of options exercisable and the weighted average exercise price were 377,835 and $2.10, respectively. As of December 1996, the number of options exercisable and the weighted average exercise price were 373,212 and $1.77, respectively.
Employee Stock Purchase Plan ("Purchase Plan")
A total of 116,667 shares of common stock were initially reserved for issuance under the Purchase Plan with an additional 100,000 being added as a result of the vote at the 1998 Annual Shareholders Meeting on June 11, 1998. The Purchase Plan enables eligible employees to purchase common stock at the lower of 85% of the fair market value of the Company's common stock on the first or last day of each six-month offering period. The first offering period began on June 19, 1996. The Purchase Plan will terminate in 2006. As of December 31, 1998, 99,110 shares of common stock had been issued under the Purchase Plan.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company applies Accounting Principles Board Opinion No. 25. "Accounting for Stock Issued to Employees" and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. Had compensation cost for the Company's plans been determined based on the fair value at the grant dates for awards under the plans consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation", the Company's net loss and net loss per share would have been changed to the pro forma amounts indicated below (in thousands):
For the purpose of SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes multiple option-pricing model with the following weighted-average assumptions used for grants in 1998, 1997, and 1996:
8. Income Taxes
The Company follows SFAS No. 109 which prescribes an asset and liability approach to income taxes under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which the taxes become payable.
The provision for income taxes differs from the statutory United States Federal income tax rate due to the following:
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The provision for income taxes for the years ended December 31, 1998 and 1997 relates to state taxes against which no net operating loss can be applied.
The net deferred income tax asset consisted of the following (in thousands):
As of December 31, 1998, the Company had net operating loss carryforwards for Federal and state income tax purposes of approximately $42.9 million and $23.2 million, respectively. The net operating loss carryforwards and tax credit carryforwards expire on various dates through 2018. The Internal Revenue Service Code contains provisions which may limit the net operating loss and tax credit carryforwards to be used in any given year upon the occurrence of certain events. Certain of the Company's net operating loss and tax credit carryforwards would be limited due to possible ownership changes. Cumulative temporary differences consist of reserves and accruals currently deductible for financial reporting purposes, but not for tax purposes. The Company believes sufficient uncertainty exists regarding the realizability of the operating loss and credit carryforwards and, accordingly, has continued to provide a valuation allowance against the deferred income tax asset.
9. Loan And Security Agreements
In December 1995, the Company entered into a Loan and Security Agreement ("Agreement") with a bank which provided for a $3,000,000 bridge loan, available in two equal parts of $1,500,000, and bore interest at the bank's prime interest rate plus 2.5%. The Agreement was extended past its original expiration date while new terms and conditions were negotiated. No amounts were outstanding under the Agreement as of December 31, 1997 and 1996.
In consideration for the Agreement, the Company granted the bank a warrant to purchase 28,571 shares of Series D redeemable convertible preferred stock at $5.25 per share (as adjusted). The fair value of the warrants at the date of issuance was not significant and, therefore, no value was assigned to the warrants for accounting purposes. Subsequent to the Company's initial public offering, these warrants were convertible into warrants to purchase common stock.
In February 1997, the Company entered into an Amended and Restated Loan and Security Agreement (the "1997 Agreement") with the same bank, which provides for a $4,000,000 accounts receivable line of credit and a $2,500,000 acquisition facility. The committed line bears interest at the prime interest rate plus 0.50% and will be subject to certain financial and non-financial covenants. Any borrowings under the acquisition facility bore interest at the prime interest rate plus 1.00%. No amounts were outstanding under the 1997 Agreement as of December 31, 1997.
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In January 1998, the Company entered into an Amended and Restated Loan and Security Agreement (the "1998 Agreement"), which replaced the 1997 Agreement and which provides for a $4,000,000 accounts receivable line of credit with a $2,000,000 letter of credit sub-limit. The 1998 Agreement was renegotiated in March 1998 when certain financial covenants were amended. The committed line will bear interest at the prime interest rate plus 0.50% and will be subject to certain financial and non-financial covenants. No amounts were outstanding under the 1998 Agreement as of December 31, 1998. The 1998 Agreement matured on January 20, 1999.
10. Subsequent Events
Acquisition of Wahlco Environmental Systems, Inc.
On January 13, 1999, the Company completed the acquisition of Wahlco Environmental Systems, Inc. ("Wahlco") for the payment of approximately $1.9 million in cash. If certain other conditions are met, the Company may be required to make additional payments of up to approximately $2 million to Wahlco shareholders. Also, in conjunction with the acquisition, the Company agreed to guarantee repayment by Wahlco of approximately $4.9 million owed to affiliates of Wexford, Wahlco's largest shareholder at the time of the acquisition, or guaranteed by Wexford to other parties. The Company has subsequently entered into a new credit agreement with Wexford as referred to below. The acquisition will be accounted for as a purchase in the first quarter of fiscal 1999. The Company has embarked on a plan to close duplicate and/or inefficient Wahlco facilities and is reducing headcount accordingly. The costs involved to close facilities and terminate employees will be recognized as liabilities assumed at the time of the Wahlco acquisition.
Wexford Credit Agreement
On February 25, 1999, the Company entered into the Second Amended and Restated Credit Agreement among Wahlco and the Company, as Borrowers, and certain Wexford affiliates as Lenders and Wexford as Agent for the Lenders (the "1999 Credit Agreement"). As of March 31, 1999, the debt amounts to slightly more than $5.7 million and bears interest at the rate of 13% per annum, payable monthly in advance. The debt matures on August 24, 1999, and may, with the payment of an additional fee of $100,000, be extended until November 22, 1999. As a condition to the Lenders' execution and delivery of the 1999 Credit Agreement, the Company agreed to confirm its grant to the Lenders of a security interest in all existing and future assets and to cause all its significant subsidiaries to enter into guarantees and grant to the Lenders additional security interests and mortgages in all existing and future assets of the Borrowers and significant subsidiaries.
As a further condition to the 1999 Credit Agreement, the Company issued to Wexford a warrant to acquire 450,000 shares of common stock. The warrants can be exercised at any time on or before February 25, 2004 at an exercise price equal to the lesser of (i) $3.875 per share and (ii) the average closing price of the Company's common stock for the ten trading days immediately following the issuing date. The fair value of the warrant at the date of issuance will be recorded as additional interest cost over the period that the Wexford debt is outstanding.
Thermatrix Inc. Notes to Consolidated Financial Statements -- (Continued)
11. Segments
During 1998, the Company adopted Statement of Financial Accounting Standards SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information." SFAS 131 requires a new basis of determining reportable business segments, i.e. the management approach. This approach requires that business segment information used by management to assess performance and manage company resources be the source for information disclosure. On this basis, the Company is organized and operates as one business segment, the development, manufacture and sale of proprietary industrial process equipment for the destruction of volatile organic compounds and hazardous air pollutants. As a result, the adoption of SFAS 131 had no impact on the Company's disclosures or financial statements. The Company incurred approximately $1 million in research and development expenses during 1998 relating to its diesel engine emission reduction technology.
The Company's operations by geographic area are as follows:
Prior to January 1, 1998, the Company had accounted for United Kingdom assets, liabilities and operations as a branch of the U.S. entity. Effective January 1 1998, the Company transferred the United Kingdom net assets to a United Kingdom subsidiary.
The Company's export revenues accounted for 2%, 35% and 14% of total revenues for the years ended December 31, 1998, 1997 and 1996, respectively. The Company's export revenue by geographic regions is as follows:
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as a part of this Report:
1. Financial Statements. The following Consolidated Independent Public Accountants are filed as a Financial Statements of Thermatrix Inc. and Report of part of this Report:
Page ---- Report of Independent Public Accountants............................. 32 Consolidated Balance Sheets -- As of December 31, 1998 and 1997...... 33 Consolidated Statements of Operations -- For the Three Years Ended December 31, 1998.................................................. 34 Consolidated Statements of Stockholders' Equity (Deficit) -- For the Three Years Ended December 31, 1998............................ 35 Consolidated Statements of Cash Flows -- For the Three Years Ended December 31, 1998.................................................. 36 Notes to Consolidated Financial Statements........................... 37-51
2. Financial Statement Schedules. For years ended December 31, 1998, 1997 and 1996:
Schedule II. Valuation and Qualifying Accounts and Reserves......... 52
All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.
3. Exhibits:
3.3 Restated Certificate of Incorporation of Registrant.(**)
3.4 Amended and Restated Bylaws of Registrant.(*)
4.2 Amended and Restated Investor Rights Agreement.(*)
10.1 Form of Indemnification Agreement between the Registrant and each of its directors and executive officers.(*)
10.2 1987 Incentive Stock Plan, as amended and related agreements.(*)
10.3 1996 Stock Plan and form of Stock Option Agreement thereunder.(*)
10.4 Employee Stock Purchase Plan and forms of agreement thereunder.(*)
10.5 1996 Director Option Plan and form of Director Stock Option Agreement thereunder.(*)
10.6 Asset Purchase Agreement between the registrant and Purus, Inc. dated January 4, 1996.(*)
10.7 Lease dated June 12,1995 between the Registrant and Spieker Properties, L.P., as amended.(*)
10.8 Lease dated June 24, 1995 between the Registrant and American General Life Insurance Company.(*)
THERMATRIX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
10.11 Amended and Restated Loan and Security Agreement between the Registrant and Venture Banking Group, a Division of Cupertino National Bank, dated January 21, 1998.
10.12 1996 Stock Plan: UK Rules for Employees.
10.13 First Amendment to the Amended and Restated Loan and Security Agreement between the Registrant and Venture Banking Group, a Division of Cupertino National Bank.
10.14 Sublease dated May 7, 1998 between Registrant and Clinimetrics Research Associates, Inc.
10.15 Form 8K with exhibits filed January 27, 1999 regarding the acquisition of Wahlco Environmental Systems, Inc.
10.16 Form 8K with exhibits filed March 12, 1999 regarding the Second Amended and Restated Credit Agreement related to interim debt financing arrangements with Wexford
10.17 Form 10K with exhibits filed March 30, 1998 by Wahlco Environmental Systems, Inc.
10.18 Form 8K/A filed March 27, 1999 regarding the acquisition of Wahlco Environmental Systems, Inc.
27.1 Financial Data Schedule.
(*) Incorporated by reference to exhibits filed with the Registrant's Registration Statement on Form S-1 (No. 333- 4370) which became effective June 19, 1996.
(**) Incorporated by reference to exhibits filed with the Registrant's Quarterly Report on Form 10-Q for the quarter ending September 30, 1997.
(b) Reports on Form 8-K
None
Trademark Acknowledgments
. Thermatrix and PADRE(R) are registered trademarks of the Company.
Schedule II
THERMATRIX INC.
VALUATION AND QUALIFYING ACCOUNTS (in thousands)
- -------- (1) Deductions represent accounts receivable and inventory amounts that were considered doubtful and previously reserved for that became uncollectible and were written off in the year.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
THERMATRIX INC.
By: /s/ John T. Schofield Date: March 30, 1999 --------------------- John T. Schofield Chairman of the Board President and CEO
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints John T. Schofield and Daniel S. Tedone, jointly and severally, their attorney-in-fact, each with full power of substitution, for him in any and all capacities, to sign on behalf of the undersigned any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and each of the undersigned does hereby ratifying and confirming all that each of said attorneys-in-fact, of his substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ John T. Schofield Chairman, President and March 30, 1999 - ---------------------------- Chief Executive Officer John T. Schofield (Principal Executive Officer)
/s/ Daniel S. Tedone Executive Vice President and March 30, 1999 - ---------------------------- Chief Financial Officer (Principal Daniel S. Tedone Financial and Accounting Officer)
/s/ Robi Blumenstein Director March 30, 1999 - ---------------------------- Robi Blumenstein
/s/ Harry J. Healer, Jr. Director March 30, 1999 - ---------------------------- Harry J. Healer, Jr.
/s/ Charles R. Kokesh Director March 30, 1999 - ---------------------------- Charles R. Kokesh
/s/ Frank R. Pope Director March 30, 1999 - ---------------------------- Frank R. Pope
/s/ James M. Strock Director March 30, 1999 - ---------------------------- James M. Strock
/s/ Joseph W. Sutton Director March 30, 1999 - ---------------------------- Joseph W. Sutton
/s/ John M. Toups Director March 30, 1999 - ---------------------------- John M. Toups