SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-KSB ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended December 31, 2000 Commission File Number: 0-31641 SUPERCONDUCTIVE COMPONENTS, INC. (Name of small business issuer in its charter) OHIO 31-0121318 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1145 CHESAPEAKE AVENUE COLUMBUS, OHIO 43212 (Address of principal executive offices, including zip code) (614) 486-0261 (Issuer's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, without par value (Title of Class) Check whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. Yes X No ---- ---- Check if there is no disclosure of delinquent filers pursuant to Item 405 of Regulation S-B contained in this form, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] The issuer's revenues for the fiscal year ended December 31, 2000, were $3,205,163. The aggregate market value of the Registrant's common equity held by non-affiliates of the Registrant was approximately $1,636,973 on March 23, 2001. There were 1,802,043 shares of the Registrant's Common Stock outstanding on March 23, 2001. Transitional Small Business Disclosure Format (check one): Yes No X --- --- DOCUMENTS INCORPORATED BY REFERENCE Portions of our Proxy Statement for the 2001 Annual Meeting of Stockholders are incorporated by reference in Part III. TABLE OF CONTENTS ----------------- Page ---- PART I Item 1. Description of Business................................................................. 3 Item 2. Description of Property................................................................. 25 Item 3. Legal Proceedings....................................................................... 26 Item 4. Submission of Matters to a Vote of Security Holders..................................... 26 PART II Item 5. Market for Common Equity and Related Stockholder Matters................................ 26 Item 6. Management's Discussion and Analysis or Plan of Operation............................... 27 Item 7. Financial Statements.................................................................... 31 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................................................... 55 PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act............................................................... 55 Item 10. Executive Compensation.................................................................. 55 Item 11. Security Ownership of Certain Beneficial Owners and Management.......................... 55 Item 12. Certain Relationships and Related Transactions.......................................... 55 Item 13. Exhibits and Reports on Form 8-K........................................................ 55 Signatures.......................................................................................... 57 NOTE REGARDING FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 26A of the Securities Act of 1933, as amended. The words "anticipate," "believe," "expect," "estimate," and "project" and similar words and expressions identify forward-looking statements which speak only as of the date hereof. Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors, including, but not limited to, the factors discussed in "Description of Business - Risk Factors." The Company undertakes no obligation to publicly update or revise any forward-looking statements. -2- PART I ITEM 1 DESCRIPTION OF BUSINESS. INTRODUCTION Superconductive Components, Inc. ("SCI" or the "Company"), an Ohio corporation, was incorporated on May 29, 1987, to develop, manufacture and market products based on or incorporating high temperature superconductive ("HTS") materials. HTS materials are complex metal oxides - ceramics - of certain stoichiometries (chemical mixture ratios) which exhibit superconducting phenomena when cooled to at least -196(degree)Centigrade. These complex metal oxides are identified as members of the Perovskite family of ceramic materials. Perovskites are a large family of crystalline ceramics that derive their name from the perovskite mineral. The perovskite minerals are the most abundant minerals on earth and have approximately a 2:3 metal-to-oxygen ratio. Copper-oxide superconductors are layered perovskites. The strategy of the Company has been to find commercially viable applications for HTS materials and, subsequently, other ceramic and metal materials. The Company's objective has been to stay intellectually current with the advancing technology in HTS materials, and search out commercially viable applications by being in the market place. This objective has been widened to include other perovskites, as well as other metals and alloys, in materials other than HTS materials. Until 1998, the Company relied primarily on its own resources for the research and development necessary to stay current with HTS technology and also to develop products for other applications. In 1998, the Company engaged in sponsored research for Nanophase Technology Corporation, Inc. and also received several awards for research from two United States government agencies, the National Aeronautics and Space Administration and the National Science Foundation. The Company's sponsored research programs are discussed more fully at Pages 12 through 14 of this Report with respect to their revenues and time lines. The following table summarizes this information: SPONSOR PROGRAM TYPE AWARD START DATE END DATE National Aeronautics and SBIR Phase II $585,000 4/1/99 3/31/01 Space Administration National Science SBIR Phase II $399,000 9/1/99 8/31/01 Foundation National Science STTR Phase I $100,000 7/1/99 6/30/00 Foundation National Science SBIR Phase I $100,000 1/1/01 6/31/01 Foundation Cambridge Research and Private Contract $25,000 9/1/99 12/31/00 Instrumentation Ceramphysics, Inc. Private Contract $20,500 9/1/99 12/31/00 TOTAL: $1,229,500 The Company intends to continue to seek such funding because this funding maintains and expands the technical understanding within the Company. With the exception of processes and devices being developed under federal or private research grants (which are discussed more fully in "The SCI Division - Sensors in Development" and "- Sponsored Product Development Programs within the SCI Division"), the Company's products are fully developed and currently are being sold in the marketplace. The Company supplies materials to customers who are engaged in product or process development themselves, but such customers purchase the Company's products based on clear specifications for a fixed price. The Company currently does not have any export restrictions on foreign sales of its products. -3- As of December 31, 2000, the total amount of accumulated deficit the Company has generated since its inception in 1987 was $5,660,276. BACKGROUND OF SUPERCONDUCTIVITY AND ADVANTAGES OF HIGH TEMPERATURE SUPERCONDUCTIVITY A superconductor is an element, inert-metallic alloy, or compound that will conduct electricity without resistance when cooled below a certain critical temperature. For the types of superconductors that the Company manufactures, this critical temperature is -196(degree) Centigrade. This phenomenon was discovered in 1911 in the metal Mercury when it was cooled with liquid Helium to -273(degree) Centigrade. This cooling enables the material to carry electrical currents without loss of energy and, due to the increased current the metals can carry, be used to generate very large magnetic fields. Scientists realized that the phenomenon of superconductivity raised the possibility of less expensive electrical generation and transmission, powerful magnets and levitation. In the past, the only way to achieve this phenomenon was to submerge the metals in liquid Helium. Because of Helium's inherent instability in liquid form and cost issues, the wide spread use of superconductors in commercial applications was impractical. These metals, now known as Low Temperature Superconductors ("LTS"), are superconductive at temperatures from absolute zero up to as high as 23(degree) Kelvin. Kelvin is the temperature scale used to identify the extremely cold conditions required for superconductivity. The Kelvin scale starts at "absolute zero," which is the equivalent of -273(degree) Centigrade, and is the coldest theoretical temperature attainable. The unit of measure on this temperature scale is called a Kelvin ("K") and is equal to a single degree on the Centigrade scale ("C"). With the discovery of new ceramic compounds in 1986, superconductivity can now be accomplished at higher temperatures by using liquid Nitrogen for cooling. The boiling point of Liquid Nitrogen is 77(degree) K, which is equivalent to -196o C. These new ceramics bring superconductivity into the realm of the practical since liquid Nitrogen is inexpensive, stable, long-lasting, and the largest component in our atmosphere and environmentally friendly. These materials are known as HTS materials. HTS materials provide the potential for significant increases in performance of electrical systems. Every electrical application delivers electricity from its source to a user through the use of "conductors." However, conventional conductors, such as Copper, exhibit some performance disadvantages. These performance disadvantages include resistance to electric current, causing power loss, heat generation, interference and noise, each of which can significantly decrease the performance of electrical systems. Additionally, the ceramic superconductors manufactured by the Company must overcome several hurdles if they are to gain wide spread commercial application. These include problems associated with making flexible structures such as wire from brittle materials such as ceramics, the limited performance of these materials at what are considered practical temperatures, such as the boiling point of liquid Nitrogen (77(degree) K), and the cost of any device based on these materials. The scientific community has been working on these and other difficulties with HTS materials since 1987. There is no assurance that all of these difficulties can be overcome. Superconductors have the ability to conduct electrical current with zero resistance, no power loss, and no generation of heat below some critical current. The performance advantages of HTS materials in electronics applications include reduced component size and weight, increased operating speeds and, in transmission applications, include lower line losses. HTS materials exhibit these properties when cooled to 77(degree) K, a process easily obtainable with inexpensive liquid Nitrogen. LTS materials require cooling to as cold as 4(degree) K or -269(degree) C , with the use of the more expensive liquid Helium. The problem of system-wide cooling is being addressed by various of the Company's customers and others. While this problem must be solved for the success of large area applications, such as power transmission lines, high performance applications such as superconductive magnets for medical applications have been widely demonstrated. The required use of liquid Helium has made wide spread applications of LTS superconductors impractical in many applications. The higher operating temperatures of HTS superconductors have reduced the operating costs for HTS products since the required liquid Nitrogen is inexpensive and readily available. However, the HTS material itself, as a ceramic, is more difficult to form into products than the metallic LTS materials. For example, with wire and cables, the HTS material requires considerably more processing steps and possibly a higher degree of processing precision -4- in order to manufacture a useful product. In many respects these processes are still in development by the Company's customers and others. Because of these difficulties, it has been necessary to develop a number of new or modified processes to achieve satisfactory results with the HTS materials. The Company's process development in this area is being sponsored by the National Science Foundation through a Phase II SBIR grant. This two year program is intended to produce a fine grained superconductive powder which can be manufactured in large batches. The Company is on schedule with its development plans and continues to make sales based on the enhanced powder products that have resulted from this research. HISTORY OF THE COMPANY The Company was founded in 1987 by Dr. Edward R. Funk and his wife Ingeborg Funk to develop, manufacture, and market HTS materials for commercial applications of the newly-discovered superconducting ceramics. The Company's initial efforts were directed toward mastering the manufacturing process for making high temperature superconducting ceramic powders, as discussed in further detail below. During this period, the market for high temperature superconductors was very small, estimated at $1 million a year or less, consisting primarily of demonstration kits and small amounts of HTS powder for research purposes. Sales, though relatively small, covered a wide range of superconducting products, including ceramic powders. The Company sold ceramic powders as finished products and in other forms such as pressed pills or pellets, which were achieved by sintering the ceramic powders, and solid shapes. Ceramic powders sold in such forms were used primarily in research applications. Subsequently, the Company began to develop other forms of HTS materials. A broad commercial market for products using HTS superconducting materials has not yet developed, although small niche markets had emerged for some products. In the second half of 1989, the Company began to focus on the market for superconducting thin-film materials, made from the Company's sputtering targets. A sputtering target is a pressed and sintered ceramic pellet which has been sized to fit into a special coating device called a sputtering system. These HTS sputtering targets are used by customers of the Company in a vapor deposition process to make thin films of the target material. This process operates in vacuum, hence, the frequently heard term, vacuum deposition or Physical Vapor Deposition ("PVD"). HTS thin films are then patterned, using techniques similar to those in the semiconductor industry, to manufacture sensors, circuits and other devices, which in turn can be used in medical diagnostics, geological exploration, advanced radar, wireless communication and other niche applications. The Company's HTS products are produced and marketed by its SCI Division. Additionally, the Target Markets, Inc. ("TMI") Division of the Company is marketing some of the non-superconducting products that the Company has developed. The Company established the TMI Division in 1992 and began to market sputtering targets of materials other than superconductors for thin film deposition. This division is located within the headquarters of the Company in Columbus, Ohio and shares facilities and staff with the SCI Division. For additional information, see "The TMI Division." The following chart summarizes the annual revenues and percentage of total consolidated sales for the fiscal years ended December 31, 1998, 1999, and 2000 respectively, for each class of products that the Company produces. -5- 12/31/98 12/31/99 12/31/00 -------- -------- -------- Annual % of Total Annual % of Total Annual % of Total PRODUCT CLASS Revenue Sales Revenue Sales Revenue Sales ------------- ------- ----- ------- ----- ------- ----- Superconductive Powders $ 73,959 2.96% $ 107,277 4.01% 47,886 1.49% Nonsuperconductive Powders 8,456 0.34% 18,003 0.67% 24,698 0.77% Superconductive Targets 52,899 2.12% 85,386 3.19% 55,981 1.75% Nonsuperconductive Targets(1) 1,035,725 41.46% 1,079,133 40.29% 1,340,411 41.82% Buy & Resell(2) 435,119 17.42% 552,663 20.63% 781,377 24.38% Bonding and Backing Plates(3) 142,161 5.69% 163,200 6.09% 210,474 6.57% Demonstration Kits 21,644 0.87% 15,141 0.57% 20,961 0.65% Levitators 21,182 0.85% 1,245 0.42% 26,000 0.81% Contract Research 470,552 18.84% 425,153 15.87% 525,566 16.40% Other(4) 236,465 9.45% 221,161 8.26% 171,809 5.36% ---------- ---------- ---------- $2,498,162 $2,678,362 $3,206,163 ========== ========== ========== ---------- (1) Includes nonsuperconductive targets from the SCI division and ceramic and metal targets from the TMI Division. (2) Includes buy and resell of precious metals, buy/resell targets and other miscellaneous items. (3) Includes sales from the SCI and TMI divisions. (4) Includes scrap inventory sales, as well as shipping and packaging charges on the Company's products. Original Company Focus in HTS Products The Company's original focus was to offer HTS powders in various chemical mixture ratios and bulk solid state forms of HTS materials, including: o sputtering targets; o Levitators(R), which produce a large oriented grain useful for its high levitation forces, ability to trap magnetic flux, and carry large currents; o magnetic shields; and o various kits, support equipment and other materials. Superconductors can be used as magnetic shields because of their unique diamagnetic properties. Diamagnetism is the ability of a material to repel a magnetic field. Many naturally-occurring substances, such as water, wood, and paraffin, exhibit weak diamagnetism. Superconductors exhibit strong diamagnetism below their Tc, which represents the critical transition temperature below which a material begins to superconduct. The sudden loss of resistance in a superconductive medium may occur across a range as small as twenty millionths of a degree Centigrade. The market for all HTS products, although small, has historically been represented by groups seeking to establish a fundamental understanding of the properties, principles and theory of these materials and also groups focused on applications of high temperature superconductivity. The ratio of fundamental to applications research continues to shift toward commercialization of the technology as demonstrated by the increasing number of "beta prototype" programs in the industry. A beta prototype is a device or system in a pre-commercial stage of development, which has been tested in a laboratory as an alpha prototype, and then further developed to be tested in an actual customer site in a typical operating environment. Operating experience and customer feedback in the beta test phase can be used in the design of an initial commercial product. -6- The Company provides the basic building blocks for many HTS products, since nearly all applications of HTS start with powder that is subsequently processed into products such as wire, sputtering targets, or large single crystals, which, in turn, can be used to manufacture transmission cables, superconductive magnets, sensors, radio frequency ("Rf") filters for wireless communications, and frictionless bearing systems for linear or rotating system applications. A frictionless bearing system is a non-contact device that utilizes the diamagnetic characteristics of a superconductor to stably levitate or suspend a load which may be in rotational or linear motion. The system overcomes normal frictions which limit conventional mechanical bearings by eliminating physical contact between the components. This bearing design has been used in energy storage systems under development by Boeing, among others. The Company has a suite of proprietary processes that are utilized in the production of its products. As discussed later, the Company also has licenses of patents and its own patent and patent applications in this field. See the section of this document entitled "Intellectual Property" for additional information. The Company's proprietary ceramic powder and powder densification processes have been successfully adapted to other electronic ceramics that exhibit unique, non-superconductive characteristics. Some of these materials are also in transition from fundamental to applications oriented development and may be the source of significant revenues in the Company's future. These materials can be categorized as ionic or electronic conductors and materials with unique magnetic properties such as the ceramics used in non-volatile computer memories. Expansion into Other Materials and the Creation of the TMI Division By early 1990, it was clear to the Company that the market for HTS superconducting powder, targets and other HTS products was still too small (about $1 to $2 million annually) to assure survival and growth of the Company. Accordingly, the Company expanded its product line to include sputtering targets made of non-superconducting ceramics, metals and metal alloys. As the demand for these products grew it became evident that this new product line could expand more rapidly if it were managed as a focused, non-superconductive, effort. The metal, metals alloy and simple ceramic sputtering targets were then packaged into the newly created TMI Division. The Company's non-superconductive products are marketed and identified under the TMI name. The total market for non-superconducting metal, metal alloy and simple ceramic targets for the thin film industry is estimated at $720 million globally based on a Business Communications Company ("BCC") report dated August 26, 1999. The Company, through its TMI Division, also embarked on a program to move selected products developed for research and development applications into production applications. Through continuing relationships with equipment manufacturers and potential customers, TMI is able to compete in the production markets with existing products both on a technical and price basis. There are new materials being continuously investigated, and these new ceramics and metal alloys sometimes develop rapidly into significant markets. The Company believes that it has positioned itself well in the marketplace to move quickly as these materials move from research and development into production usage. In 2000, approximately 60% of the Company's target shipments were classified by the Company as production, and 40% were classified as research and development. This is a marked change from 100% classification as research and development shipments in 1995. The Company's objective is to achieve an 80% to 20% ratio of production to research and development shipments. The Company has continually added production processes and testing equipment for the many product compositions that can be used as sputtering targets. The TMI Division standard products, as listed in its catalogue, now include nearly 200 items of ceramic materials and metals and alloys available in various sizes and shapes. TMI shipments were 64.6% of total Company revenues in 2000. The Company offers a wide range of HTS products to the marketplace. The Company has competitors for all of its various products. In general, the Company's HTS products are distinct in the marketplace due to the molecular level mixing achieved through the Company's patented and proprietary chemical precipitation processes for ceramic powders, the chemical purity achievable by these processes, and the high level of characterization and customization the Company performs for each client. Accordingly, the Company intends to be price competitive on its products but not the low price leader. -7- THE SCI DIVISION The SCI Division primarily produces and markets the Company's various HTS products, which include both superconducting and non-superconducting products. The most significant of the Company's HTS products are discussed below. Superconducting Products High Temperature Superconductive Powders. HTS powders are the building blocks for most applications of high temperature superconductivity. The Company offers a wide variety of HTS powders. Powders are manufactured using conventional solid state and wet chemistry, as well as proprietary processes developed or licensed by the Company. Wet chemistry refers to a mixing technique using liquid precursors from the Company's processes which utilize dry blending of chemical precursors. Superconducting powders represented approximately 1.5% of Company revenues in 2000, 4.0% in 1999, and 3.0% in 1998. The Company's HTS powder production is also used internally to make Levitators(R), HTS sputtering targets and other ceramic components. Customers in the SCI Division have included several manufacturers of superconducting wire, wherein the powder is put into a tube and drawn and redrawn to very fine size. Such wire is now available from our customers and others in lengths sufficient to make superconducting magnets, motors, and power transmission lines. This market for the Company's HTS powder is expected to grow as these applications transition from research to prototype to production use. Some of these applications are now in the engineering-prototype stage, and are being evaluated with respect to their conventional counterparts. There currently are several highly-publicized prototype devices or systems based on HTS materials, most of which in the United States are sponsored by the Department of Energy through its Strategic Partnership Initiatives, including: o Fault Current Limiter o Transformer o Transmission Line o Flywheel Energy Storage System The purpose of the engineering prototypes now in evaluation is to determine the technical and economic feasibility of the specific applications. Although it is unlikely that all of the initially configured prototypes now in testing will be economically viable, there are a number of applications being tested, and the Company believes that some of these will move into production in the next several years, although in most cases the time lines for development are unclear. Specifically, the development of Ittrium Barium Copper Oxide ("YBCO") wires based on the coated conductor approach still has several technical and financial hurdles to overcome, and at this time it is unclear when such wires will move into production phase. The Company is particularly optimistic about cables, where the use of superconductors may reduce power transmission losses. In addition, because much higher currents can be carried in HTS cables for a given volume, there may be savings realized through the minimization of the disruption to dense cityscapes as the transmission and distribution grid is refitted to accommodate the increase in demand for electric power. Encouraging results are also being shown by companies other than SCI that make superconductive Rf filters for the distributed base stations which support the national wireless communication network. Rf filters are used in wireless communication systems to enable the selection of desired radio frequencies and the exclusion of undesired signals. Such applications of HTS promise to reduce noise level, decrease signal interference, and reduce the number of dropped calls. Additionally, some HTS equipped cellular base stations extend the range of the station. Another promising application of HTS is fast response fuses, sometimes called fault current limiters. In this case, the very short (fraction of a cycle) response time of HTS material to voltage surges on electric transmission and distribution networks may reduce downtime and capital expenditures for utilities. HTS fault current limiters are self-resetting and, unlike conventional fuses, are not destroyed by a voltage surge. The Company currently has an alliance with Argonne National Laboratory in the development of this device. This product has not yet reached the prototype test stage. The major market for LTS wire is in magnets for medical Magnetic Resonance Imaging ("MRI") systems. Recent tests conducted by Siemens show that HTS wire may have an economic and technical advantage for this -8- application. Cost advantages may be achieved in new systems by the elimination of liquid Helium cooling. Technical advantages may be achieved through the higher fields obtainable by using HTS materials at very low temperatures. The Siemens tests were not conducted with wire containing the Company's HTS materials, but with wire of similar composition produced by the Company's competitors. At this time, the Company's HTS products have not been tested in an MRI system. The Company makes the raw materials that are used by the manufacturers of the above mentioned products, and actively solicits the business of those making such products. Superconducting Sputtering Targets. The Company converts its powders into dense, precisely machined ceramic components which are used as sputtering targets by its customers for the manufacture of superconductive thin films. These thin films can then be etched in patterns to produce electrical devices such as superconductive quantum interference devices that are extremely sensitive to small electric and magnet fields, such as brain waves, a passing submarine, or certain electric and magnetic signatures of ore or oil deposits. This market was 1.7% of Company revenues in 2000, 3.2% in 1999 and 2.1% in 1998. HTS materials, as thin and thick films both as sputtering targets and powder are currently used in Rf filters microwave applications such as in cellular base stations. At this time, there are several companies whose superconductive Rf filters are going into limited production. These companies include: Superconductor Technologies, Inc., Conductus, Inc., and Illinois Superconductor Corp. Other companies are thought to be developing such products based on HTS materials. The Company is a potential supplier to these producers for both HTS powder and sputtering targets, although it has not sold these products to such producers as of yet. The "next generation" of HTS wires and cables is expected to be based on a structure called a "coated conductor." In this case the conductor, YBCO, is deposited using a thin film technique onto a metal tape or foil which has been modified so that the area receiving the superconductor is specifically aligned or "textured" to promote optimal performance of the coating. Thin film deposition is a method of fabricating ceramic superconductors to more precisely control the growth of the crystalline structure to eliminate grain boundaries and achieve a desired Tc. The deposition of the YBCO conductor is being pursued in the United States and Japan by use of the Company's sputtering targets. While this application is expected to take several years to develop, for now it enables the Company to participate in near term applications of HTS wire through its Bismuth, Strontium, Calcium, Copper and Oxygen ("BSCCO") materials, and future requirements through its YBCO ceramic components. "Levitators(R)." The Company has a non-exclusive license from Argonne National Laboratories for producing seeded and melt textured YBCO large single domains for which the Company has been issued the trademark "Levitators(R)." In a typical melt processing method, YBCO is heated above its peritectic point where it melts incongruently into Y2BaCuO5 and a Ba- and Cu- rich liquid. The semi-solid melt is cooled slowly to obtain aligned grains of YBCO or domains. In order to achieve high levitation forces, large domain size and high critical current density ("Jc,") are desirable. One way to increase the domain size is by initiating grain growth by using a seed crystal. In the presence of a favorable temperature gradient, the seed not only ensures a single nucleation site but also permits controlled orientation of the grains. The seeding technique along with a controlled temperature gradient enable growth of YBCO domains as large as that of the sample size. A superconducting Levitator(R) is a compact of the Company's superconductive powders which have been processed to form a large C-axis oriented grain that exhibits a high critical current density and considerable diamagnetism. The Company has advanced its technology well beyond the original Argonne licenses, and has applied for and expects to be issued a patent for its own proprietary processes to manufacture Levitators(R). At this time, the Company's large domain Levitators(R) ("LDL"), made from its superconducting powders, exceed 30 Newtons of separating force when used with certain magnets. This value is high enough to make practical several applications, including near frictionless bearing systems, flywheels energy storage devices (so called frictionless flywheels), and linear transportation devices (e.g., Maglev trains). In 1996 the Company supplied approximately 1,600 Levitators(R) to Commonwealth Edison for a prototype frictionless flywheel energy storage ("FFES") device. The FFES device is a flywheel that rotates in an evacuated chamber and is supported by HTS Levitators(R) so that there are no mechanical bearings. The friction factor is more than -9- 1,000,000 times less than the best mechanical bearings. Under these conditions, very little energy is lost to friction. Energy is applied to the flywheel to spin it up, and energy is withdrawn at nearly 90.0% efficiency as needed. At this time, Commonwealth Edison has placed the development of FFES units on hold. The prototype for which the Company supplied for the Levitators(R) is said to have demonstrated the feasibility of HTS levitated frictionless bearings for this application. The Levitators(R) supplied by the Company for this program were tested by Argonne National Laboratory. The Company has engaged in further research and development on its Levitators(R), with a view toward enhancing their performance capability and reducing the costs of production. The Company has focused its efforts on identifying a suitable replacement for Platinum Oxide, which is one of the most expensive components of its basic powder mix for Levitators(R). If successful, levitator production costs will be substantially reduced. Currently the Company is exploring the use of Cerium as a substitute for Platinum Oxide with some success. The Company continues to collaborate with Argonne National Laboratory through a Creative Research and Development Agreement in order to advance the technology and broaden the range of applications for which Levitators(R) are applicable. Improvements in performance, combined with a significant reduction in manufacturing costs, are expected to result from this multi-year, cost sharing program. The United States electric power industry is scheduled for deregulation in the very near future. This will force competition to occur between power providers well beyond their current regional boundaries. Commonwealth Edison, which purchased the Company's LDLs in 1996, at that time supplied approximately 5% of the electrical power used in the United States. Officials at the utility have advised the Company that they view the development of the FFES system as a key component of their competitive strategy. Other utilities may also use these systems in their competitive strategies. There are also programs to develop similar energy storage devices in Japan, the United Kingdom, Korea and Germany. Currently Boeing Corporation, which is one of the Company's competitors, is developing a competitive FFES system that uses HTS materials as an enabling component of the bearing system. Superconducting Accessories. The Company provides certain accessory superconducting products that are needed, in addition to the Company's core HTS materials, to support its customers' research or manufacturing programs. The Company does not manufacture accessory superconducting products, but rather it purchases such products for resale to the Company's customers. Demonstration Kits, Instrumentation Accessories for Superconductivity Education. Demonstration kits were the first products sold by the Company in significant volume. Packaged for the educational community, the Company continues to manufacture a family of laboratory demonstration kits designed to exhibit the key features of perfect conduction, diamagnetism and flux trapping that are unique to HTS materials. These kits are marketed directly by the Company and also through a network of educational product distributors which include Edmund Scientific, Arbor Scientific, Beckly Cardy and others. The instrumentation and accessories offered by the Company include a wide range of discs, dies, rare earth magnets, vacuum jars, box furnaces, digital volt meters, dewars and flasks, and related items. These combined categories represented approximately 0.7% of Company revenues in 2000, 0.6% in 1999 and 0.9% in 1998. Non-Superconducting Products Beginning in 1996, the SCI Division of the Company manufactured and sold non-superconducting, as well as HTS products for commercial use which can be categorized as engineered powders, engineered parts, and engineered components. Engineered Ceramic Powders. The Company has adapted its proprietary Ceramic Oxide powder production processes for the manufacture of fine, ultra-fine and nano-crystalline powders of non-superconductive materials to support a variety of expanding applications requiring electronic ceramics. These powders are used by customers of the Company in the development or manufacture of: -10- o solid oxide fuel cells; o ceramic membranes for the separation of natural gas from its contaminants; o Lithium ion batteries; o ceramic electrodes for harsh environments; o ceramic electrodes as a replacement for precious metals; and o capacitors. Engineered ceramic powders were 0.8% of Company revenues in 2000, 0.7% in 1999 and 0.3% in 1998. Ceramic Sputtering Targets. The Company has adapted its proprietary ceramic powder densification processes to manufacture a variety of sputtering targets from its line of electronic ceramic powders. The energy storage and optical industries are working to utilize the unique properties of electronic ceramics to enhance the performance or reduce the cost of their products. Sputtering targets composed of complex ceramic oxides for applications such as non-volatile memory, thin film capacitors, thin film electrodes, and transparent electronic conductors are an emerging product line for the SCI Division, comprising 10.2% of the SCI Division's revenues in 2000, 5.9% in 1999 and 5.8% in 1998. The hope of the Company is that materials developed to supply customers' research requirements will grow into large scale production orders with the commercial success of the next generation of thin-film-based electronic devices. The Company has certain proprietary knowledge and trade secrets related to the manufacturing of these non-superconductive ceramic oxide sputtering targets. Sensors in Development by SCI Division The SCI Division was awarded a Phase I SBIR contract by the National Science Foundation to develop a sensor for oxides of Nitrogen gas ("NOx") and to be used in harsh environments. The Company has also been given a purchase order by Cambridge Research Instruments to develop a temperature sensor, based on a thin film superconductor, for use at or slightly above the boiling point of liquid Nitrogen. These two development contracts were 1.2% of Company revenues in 1999. The Company was not in this field of sensors prior to 1999. Sensors for Harsh Environments- Gaseous Oxides of Nitrogen. For automobiles, public utilities, and other generators of NOx, currently no low cost detection system exists. The harmful effects of NOx are a well known component of the green house gases that are damaging to the environment. The United States and other foreign governments continue to fund the development of solutions to reduce green house gasses in which sensors are a part of the detection and correction system. Once developed, these solutions may be legislated upon the marketplace. The low-cost NOx sensor market is global and may be expected to exceed several million dollars in the next decade. The Company has recently completed a Phase I Small Business Innovative Research ("SBIR) feasibility study of the design, development and manufacture of a sensor for NOx to be used in harsh environments, such as the exhaust stream of internal combustion engines. This program consists of three phases: (1) Phase I, which is the feasibility study, (2) Phase II, in which a prototype is developed, and (3) Phase III, which includes the realization of a commercial product, backed by private funds. The Company is currently preparing a Phase II proposal for this sensor. The goal of the program, funded through a competitive award in the amount of $399,000 by the National Science Foundation, is to build on the Company's strengths in ceramic fabrication and to devise a device that is both low in cost and also highly sensitive to NOx in the range required for future automobiles. The development of a NOx sensor, suitable for use in next generation spark-ignition direct injection engines, has been given the highest priority by stakeholders in the industry, including major automobile and engine manufacturers. New, lean-burn engine technologies are nearing commercial reality, but they lack adequate sensors to monitor and control the quality of exhaust in order to operate within federally mandated pollution guidelines. Sensors for Cryogenic Temperatures - YBCO Based. Sensors based on the superconductor YBCO are being developed for the temperature range of 77-92(degree) K. The skill set developed to perfect these devices will serve the Company in the manufacture of all of its planned sensors. While temperature sensors for the broad range of 4.2(degree) K to 300(degree) K are well understood, and available from reputable commercial enterprises, a greater accuracy over a limited -11- temperature range may be a competitive advantage for YBCO based sensors in new and dynamic applications such as magnetic levitation ("MAGLEV") and flywheel energy storage, where very small temperature excursions may be used as the predictors of system disruptions or failure. In this effort the Company currently has an alliance with Cambridge Research and Instrumentation. Strategic Alliances, Major Suppliers and Customers The Company attempts to do most development work in the SCI Division in cooperation with partners who will ultimately consume, or may serve as a channel to market, the Company's products and technology. In this way, the Company remains focused on providing value-added materials solutions for a range of commercial applications. Most of the Company's products are manufactured from component chemicals and metals supplied by various vendors. The SCI Division is dependent upon ultra high purity Yttrium to manufacture its superconducting products. Several suppliers currently satisfy the Company's requirements for this material. If the Company suddenly lost the services of such suppliers, there could be a disruption in its manufacturing process until the suppliers were replaced, but the Company has identified several other firms as potential back-up suppliers who would be capable of supplying this material to the Company as necessary. To date, the Company has not experienced an interruption of raw material supplies. The top five suppliers to the SCI Division in 2000 were, in descending order: Argonne National Laboratories, Noah Technology Corp., MTI Corp., Cerac Corp., and Praxair Corp. In every case, the Company believes that suitable substitute vendors could be found. Also, as the Company's volume grows, the Company may make alliances or purchasing contracts with these or other vendors. No customers in the SCI Division accounted for 10.0% or more of the total SCI revenue in 2000. Research and Development The Company focuses its research and development efforts in areas that build on its expertise in multi-component ceramic oxides. These efforts currently include optimization and scale up efforts for BSCCO 2-2-1-2 powders sponsored by the National Science Foundation, large and specially formulated YBCO discs and rotation/levitation apparatus for gravity modification research sponsored by NASA, and a sensing device based on the Company's ceramic products which identify the presence of NOx gases in harsh environments which is also sponsored by the National Science Foundation. The Company's initial focus on HTS was shifted upon the realization that the market for that technology would take several years to develop, and that the Company's talents and capital base could also be used to provide materials solutions in a wide range of other industries. While according to a study commissioned by the United States Department of Energy, HTS is expected to develop into a multi-billion dollar industry in the first decade of this century, the Company has diversified its efforts to concurrently participate in other materials markets. The emphasis of the SCI Division's research has been broadened to include engineered ceramic oxide materials. The SCI Division of the Company remains focused on the development of materials, processes and devices based on its core skills in: o ceramic powder fabrication; o powder densification; o thin film technology, a device fabrication technique where individual layers of the device are less than one micron thick and are typically constructed using specialized coating techniques that can utilize the Company's sputtering targets; and o thick film technology, a device fabrication technique where individual layers of the device are more than one micron thick and are typically constructed using specialized coating processes like tape casting, which can utilize the Company's ceramic powders. These developments are realized through partnerships with the Company's many customer collaborators. The Company's reliance on a commercial customer collaborator optimizes its development expenditures by focusing on the -12- projects where customers have identified markets and agree to provide future revenue streams based on the successful completion of the project. Company Sponsored Research and Development. The Company often undertakes commitments in the ordinary course of business that require the Company to develop methods or processes that expand the Company's skill set. In general, the Company does not initiate a formal development program to accomplish these tasks, but does absorb any expenses which may exceed the revenues provided by clients, as part of its internal development costs. Sponsored Product Development Programs within the SCI Division The Company has a number of research programs, including two Phase II SBIRs that are sponsored by government agencies. These programs are being conducted within the SCI Division. These programs are all believed to have significant commercial potential if the respective technologies can be fully developed. The research program sponsored by NASA involved various experiments to determine the proper composition and crystal structure of a specialized ceramic material which, when used in conjunction with a superconductive YBCO layer, and the assembly is both cooled and rotated at high speeds, may shield the effects of gravity. Another research program sponsored by the National Science Foundation as a Phase II SBIR involves the automation of the chemical precipitation and also the scale up and automation of the low pressure calcination process for the Company's BSCCO 2-2-1-2 superconductor powder. Experiments are being performed to determine the reliability of the automated process, and the effects of the larger batch size on quality in the calcination step. The Company's subcontractor, Intermagnetics General Corporation, Advanced Superconductor Division, was also using selected powder samples to make multi-filament superconductive wire and also developing a process for the continuous heat treatment of long lengths of HTS wire. The Phase I STTR program, also sponsored by NSF, included experiments using various combinations of the Company's ceramic substrates and powders to determine which pairing showed the most sensitivity to NOx gases at temperatures in the range of 700-1000(degree) C. SBIRs and sponsored research and development contracts accounted for 16.4% of Company revenues in 2000, 15.9% in 1999 and 18.8% in 1998. Several public and privately funded programs currently support continued product, process and component development within the SCI Division. Sponsored programs include: o National Aeronautics and Space Administration ("NASA"), beginning on April 1, 1999, funded a Phase II SBIR for a $580,000 program over two years to demonstrate the feasibility of manufacturing a large, bi-layered superconductive toroid (ring) and related levitation/rotation system for gravity modification experiment in cooperation with Argonne National Laboratories and Wright State University. The Company's share for in-house work on this project is $310,000 over two years. The contract may be cancelled at any time and the two year duration expires on May, 2001. o The National Science Foundation ("NSF"), beginning on September 1, 1999, funded a Phase II SBIR program over two years for $400,000 for advanced manufacturing of BSCCO superconductive powders for low cost, continuous HTS wire fabrication, with partner Intermagnetics General Corporation, Advanced Superconductor Division. Pursuant to the terms of an award letter from NSF dated August 26, 1999, the Company's share of this funding is $200,000 over two years and the contract may be cancelled at any time. The grant is subject to the NSF SBIR Phase II grant general conditions and to the NSF SBIR/STTR Phase I Program Solicitation and Phase II Instructions. These conditions require, among other things, that the Company submit semiannual progress reports and a final report to NSF as a condition to payment of the award amounts. The Company may subcontract portions of the work to be performed under the grant, although the Company itself must perform at least one-half of the research and analytical effort. The Company may retain rights in technical data developed under the grant, except that the U.S. federal government will have the right to use such data for government purposes. The Company may also retain all rights, title and interest in any patentable invention or discovery conceived or reduced to practice in performance of work under the grant, provided that it discloses the invention or discovery to NSF, notifies NSF in writing of its intent to retain title to the invention or discovery, and takes appropriate action under applicable U.S. federal patent laws. If the Company fails to follow these procedures, it may lose title -13- and rights to the invention or discovery to the U.S. federal government. This program expires on August 31, 2001. o NSF, beginning on July 1, 1999, funded a Phase I Small Business Technology Transfer Program ("STTR") for $100,000 for the development and technology transfer of a sensor for oxides of Nitrogen gas to be used in harsh environments, i.e. an automobile exhaust stream, with the Center for Industrial Sensors and Measurement at The Ohio State University as a partner. Pursuant to the terms of an award letter from NSF dated June 25, 1999, the grant is a fixed amount grant. The Company's in-house share of this funding is $50,000. This program expired on June 30, 2000, although work continues on the device in preparation of a Phase II grant application which will be submitted in the first quarter of 2001. o NSF, beginning on January 1, 2001, funded a Phase I SBIR for $100,000 for a project entitled "New Coordination Complexes for the Synthesis of Nanocrystalline SrRuO3," with Oklahoma State University as a partner. Pursuant to the terms of an award letter from NSF dated November 27, 2000, the grant is a fixed amount grant that will expire on June 30, 2001. The Company must file a Phase I Final Report within 15 days of the date the grant expires. The grant is subject to the NSF SBIR/STTR Programs FY-2000 and Phase I Grant General Conditions, which require, among other things, that the Company timely submit the final report to NSF to receive full payment of the grant. The Company may subcontract portions of the work to be performed under the grant, although it must perform at least two-thirds of the research and analytical effort itself. The Company may retain rights in technical data developed under the grant, except that the U.S. federal government will have the right to use such data for government purposes. The Company may also retain all rights, title and interest in any patentable invention or discovery conceived or reduced to practice in performance of work under the grant, provided that it discloses the invention or discovery to NSF, notifies NSF in writing of its intent to retain title to the invention or discovery, and takes appropriate action under applicable U.S. federal patent laws. If the Company fails to follow these procedures, it may lose title and rights to the invention to the U.S. federal government. o Cambridge Research and Instrumentation, funded by a Phase II SBIR subcontracted with the Company pursuant to a purchase order dated September 27, 1999, for $25,000 for the development of a superconductive temperature sensor tunable for a specific 2(degree) K region around the boiling point of liquid Nitrogen (77(degree) K) for use in a unique geological instrument. This program began on September 1, 1999, and ended on September 30, 2000. o Ceramphysics, Inc., which has a funded Phase II SBIR, subcontracted with the Company for the development of HTS electrodes to replace Platinum in a Department of Defense application of cryogenic capacitance energy storage. This subcontract is for $20,500 and ends on September 1, 2001. A second phase of the program has been funded outside the government for a 13 month period beginning October 1, 2000. All of the sponsored research and development contracts can be cancelled at the sponsor's option, with accrued costs being paid. The Company currently has $364,753 of funding from government sponsored research and development programs that could be cancelled at any time. To date, federal funding has been directly or indirectly responsible for an estimated 80.0% of the developmental funding of the HTS industry. Such funding plummeted in 1992 and 1993 when the Supercollider project was terminated. Federal funding has rebounded somewhat in recent years. Management of the Company anticipates that any increase in funding for superconductivity research may benefit the Company indirectly, since many of its customers' research and development efforts receive government funding. However, while the Company continues to submit proposals to federal and private funding organizations, there is no assurance that the Company will be awarded similar contracts in the future. Competition in the HTS Industry The Company has a number of domestic and international competitors in the HTS field, many of whom have resources far in excess of the Company's resources. After more than a decade of intensive development work, -14- commercial prototypes of various large scale HTS applications are now reaching prototype test stage. It is anticipated that as commercial devices based on HTS technology begin to gain wide spread acceptance, and the attractiveness of the industry improves, new competitors for powders, sputtering targets and large superconductive single crystals will emerge. A major United States competitor of the SCI Division is The Surface Science Division of Praxair Corporation. In Europe, the SCI Division competes principally with a spin-off of Aventis (f.k.a., Hoechst), a division of Aliatec Corporation of France. In Japan, the SCI Division's principal competitor is the DOWA Chemical Company. Some of the developers of HTS based products, such as American Superconductor Corporation, have also chosen to internally manufacture the HTS powders that they require, and therefore compete with the Company in some cases, or foreclose themselves as potential customers of the Company. Marketing and Sales The SCI Division markets its products by direct sale in the United States. Most of the Division's orders are in response to requests for quotations. The SCI Division distributes a catalogue of its products, exhibits at the several relevant tradeshows, and engages in direct mailings. The Company also has an operating website: www.superconductivecomp.com. The Company intends to intensify its marketing efforts in the future. The SCI Division also sells its products through distributors in some foreign markets. On March 2, 2000, the Company announced that Earth Chemicals in Japan was selected as the exclusive distributor for Japan. The Company has non-exclusive distributors in Europe, Korea, Taiwan, Israel and Singapore. The global acceptance of the Internet has greatly increased the SCI Division's ability to promote itself to the entire scientific community, and thereby facilitated direct sales, engineering and customer support from the Company's Columbus, Ohio facility. Notwithstanding an increasing number of distributors, more than 75% of the SCI Division's international sales are handled directly by the Company's in-house sales staff. In addition to distributors and representatives around the world and its Internet website, the Company maintains a modest print advertising program, which includes the magazines Physics Today, Superconductor, Cryo-electronics and the Thomas Register of Manufacturers. The Company publishes technical articles in scientific journals and presents technical papers at technology-based conferences, workshops and symposia. The Company has sold HTS products to customers in 42 countries worldwide. The total number of customers served by the Company was 235 in 2000, 185 in 1999 and 129 in 1998. No single customer accounts for more than 10.0% of total SCI Division sales. Production Capacity The SCI Division has a current HTS powder production capacity of approximately 700 kilograms per year, but is expected to increase to 1,200 kilograms per year in the year 2001. The Company was able to increase its production capacity in the year 2000 to keep pace with customer demand. The cost of this expansion was supported by grants from NSF and by additional investment in equipment by the Company. Currently, the Company is on track to meet future demand. Generally, the Company has not had instances where it was unable to meet demand, although delivery times have been extended by a few weeks in some cases without any loss of sales. Increasingly, however, the customers of the SCI Division are inquiring about the production capacity of the Company for their future production requirements. Based on this experience and occasional loss of customers to larger competitors, management views the expansion of HTS capacity in the SCI Division as a primary objective in the near future. Quality Control The Company uses a network of trusted and qualified suppliers, backed up by the Company's internal and contracted analytical capabilities. Incoming raw materials are tested, when required, for suitability using techniques such as X-ray diffraction ("XRD"), inductivity coupled plasma ("ICP") spectrometry, particle size analysis, and other methods. In addition to these tests, sample lots of the Company's complex ceramics are often fabricated to determine if a new supplier and/or new lot of input materials can be used to make a product to specification. -15- The quality assurance processes for Company products include critical temperature, carbon content, or packing density. The Company certifies its products for phase purity by XRD, for major and trace elemental composition by ICP, and mechanical tolerances using certified calipers and micrometers. The amount of rejected product during internal processing was 1.5% of revenues in 2000, 4.5% in 1999 and 3.0% in 1998. Customer returns of SCI Division products were 1.5% of revenues in 2000, 0.1% in 1999 and 0.5% in 1998. The Company owns its quality control equipment and also selectively contracts with a network of domestic vendors for additional analytical capabilities. The Company's in-house analytical instruments include: o ICP manufactured by Leeman Laboratories, Inc.; o particle size analyzer manufactured by Toshiba Corporation.; o XRD manufactured by Rigaku Corporation; o electronic dispersive X-ray spectrometer manufactured by Edax; o differential thermal analyzer manufactured by Perkin Elmer Corporation; o scanning electron microscope manufactured by ISI Corporation; o various digital calipers, analog calipers, digital and analog micrometers, routinely calibrated against National Institute of Standards ("NIST") traceable standards; and o various digital weight scales that are routinely calibrated against NIST traccable standards. Intellectual Property The Company has developed or acquired intellectual property in the form of patents, patent applications, and licenses on patents. The Company currently is not aware of any litigation involving its products or processes, nor has the Company been contacted by any potential litigants regarding the same. Patents and Patent Applications. The Company has applied for and received from the United States Patent and Trademark Office patent # 5,863,867 dated January 26, 1999, for Fine-Particle Bi-Sr-Ca-Cu-O Having High Phase Purity made by a Chemical Precipitation and Low-Pressure Calcination method. This patent will expire on October 28, 2016. This material is used to make HTS powder at this time. Several other patents have been or may be filed covering various aspects of the HTS field, including the basic concepts, the powder composition, processing, and products. The Company has applied to the United States Patent and Trademark Office for a patent number covering Large, Strongly-Linked Superconducting Monoliths and Process for Making Same. The application date is July 1, 1998. Notice of allowance for this patent application has been received and the Company expects a patent to issue in the near future. Industry wide, it has been reported that over 4,000 applications exist for HTS materials, processes and applications. The Company does not have a license or patents covering all products that it makes and markets in the HTS field. The Company may not be able to obtain licenses for manufacturing from the patent holders. Furthermore, the Company may have a liability, which cannot be determined at this time, for products produced prior to the issuance of the patents. The Company may not have the resources to defend itself in the event of a patent lawsuit, although the Company is not currently a party to any ongoing patent dispute or litigation and knows of no circumstances at this time that would give rise to such a dispute or litigation. The Company's patent attorneys are Hudak and Shunk of Akron, Ohio. Ms. Laura Shunk, a partner in that firm, is the daughter of Dr. Edward R. Funk, President and Chief Executive Officer of the Company. Trademarks. The Company has a federally registered trademark on the word "Levitator(R)," which is used to describe the SCI Division's line of large domain YBCO seeded and melt-textured monoliths. -16- Non-Exclusive Licenses. The Company has the following non-exclusive licenses: o Sandia National Laboratories - Sandia Chemical Prep Process for line YBCO superconductive powders, license #95-000131, based on U.S. patent #4,839,339, dated June 13, 1989. The Company's license to use this patent is governed by the terms of a Nonexclusive License Agreement between the Company and Sandia Corporation, which operates Sandia National Laboratories, effective February 26, 1996. Pursuant to this Agreement, the Company has a non-transferable, non-exclusive right and license to make, sell, lease and transfer products that are operated under any claim of Sandia patent rights for patent # 4,439,339. In exchange therefor, and in addition to an initial fee paid on the effective date of the Agreement, the Company currently pays Sandia a royalty equal to 5% of the net sales price of the licensed product sold, leased or transferred. The Nonexclusive License Agreement is effective until the earliest to occur of: (1) January 1, 2015, (2) expiration of the subject patent rights, or (3) a default by the Company on a royalty payment or other breach by the Company of the Agreement that is not cured within 60 days after written notice from Sandia of such default. Sandia may also terminate the Agreement upon the Company's dissolution, insolvency, bankruptcy, or similar event. o Argonne National Laboratory Low Pressure Calcination process for low Carbon HTS material. License # ANL-IN-89-030, based on U.S. patent #5,086,034. This license is subject to the terms of a Nonexclusive License Agreement between the Company and The University of Chicago as operator of Argonne National Laboratory, effective as of October 12, 1995. Pursuant to this Agreement, the Company has a nonexclusive license to use U.S. patent #5,086,034 and all extensions thereof in the processing of HTS powders. In exchange therefor, and in addition to an initial non-refundable license fee, the Company currently pays a royalty equal to 1.25% of its gross sales of products made within the scope of any claim of the subject patent. The Agreement is effective for as long as the patent is effective, except that the Company may terminate at any time, with or without cause, upon written notice to the University, and the University may terminate if the Company has breached a material term of the Agreement and has failed to cure the same within 90 days of receiving written notice of such breach from the University. The Company may assign the Agreement only with the University's consent, which the University may not unreasonably withhold. o Argonne National Laboratory Levitator Package. Licenses # ANL-IN-93-008, ANL-IN-93-130, ANL-IN-93-134 based on U.S. patents #5,504,060 (Method of Harvesting Rare Earth Barium Copper Oxide Single Crystals), #5,549,748 (Method of Harvesting Single Crystals from a Peritectic Melt), and #5776,864 (Large Domain 123 Material Produced by Seeding with Single Crystal Rare Earth Barium Copper Oxide Single Crystals). This license is subject to the terms of a Nonexclusive License Agreement between the Company and The University of Chicago as operator of the Argonne National Laboratory, effective as of October 12, 1995. Pursuant to this Agreement, the Company has a nonexclusive license to use the foregoing patents in levitator materials and seeds for inducing phase control in levitator materials during melt processing. In exchange therefor, and in addition to non-refundable license fees already paid, the Company currently pays a royalty equal to 5.0% of its gross sales of products made within the scope of any claim of the subject patents. The Agreement is effective for as long as the patents are effective, except that the Company may terminate at any time, with or without cause, upon written notice to the University, and the University may terminate if the Company has breached a material term of the Agreement and has failed to cure the same within 90 days of receiving written notice of such breach from the University. The Company may assign the Agreement only with the University's consent, which the University may not unreasonably withhold. The Company's license agreements with Argonne and Sandia National Laboratories form the core of its technology base in HTS powder and device fabrication. The Company acquired these licenses for less cost than it could have developed similar technology internally, and was able, based on the speed at which the Company was able to commercialize the resulting HTS products, to create a revenue stream within a few months of license acquisition dates. Subsequently, the Company has built on these licenses to create its own intellectual property in the form of patents, patent applications, and industrial knowledge. Licensed Powder Processing Technologies. The processes used by the Company to manufacture high temperature ceramic (superconductive) powder were invented at various national research laboratories operated by the -17- Department of Energy. The Company has licensed these processes from the Department of Energy, which gives the Company the legal right to practice the technology in exchange for a small royalty on sales. The powders are then used to make pressed shapes which can become sputtering targets or Levitators(R) or they can be sold without further processing to customers who will combine them with other materials to make superconductive wire and cable. Trade Secrets. The Company uses the following trade secrets in the manufacture of its SCI Division products: o powder fabrication in non-SC powders; o powder densification in YBCO and non-SC material; o fabrication of BI-layer structure of YBCO for use in gravity modification; and o fabrication of nano-materials. THE TMI DIVISION The TMI Division manufactures and markets source materials, both ceramics and metals, for the thin film physical vacuum deposition industry. The TMI Division has served over 950 customers worldwide in 40 foreign countries over the past five years. While serving as critical raw materials for the fabrication of a variety of highly engineered thin film products -- from integrated circuits to window coatings -- sputtering targets are themselves high-value-added advanced materials. The Sputtering Targets Industry A number of technological changes are occurring within the sputtering industry. For example, higher purity sputtering targets and new target materials are emerging to improve the performance of thin film products for certain applications. Also, sputtering target fabrication methods and cathode designs are being refined and optimized to improve target material utilization and process efficiency. A Business Communications, Inc. Report, dated August 26, 1999, summarizes sputtering target consumption as follows: SPUTTERED FILMS AND SPUTTERING TARGETS ----------------------------------------------------------------------- AAGR* WORLD MARKET 1999 2004 (%) EST'D EST'D EST'D ----------------------------------------------------------------------- Total film area (in million s of meters squared) 363 764 16.0 Target consumption (in millions of kilograms) 2.9 3.9 6.0 Target consumption (in millions of pounds) 6.4 8.5 6.0 Approx. target units consumed (in thousands) 374 510 6.4 Value of material consumed (in millions of dollars) 720 1100 8.8 Source: Business Communications Co. Inc., Norwalk, Connecticut * Average Annual Growth Rate An estimated 2.9 million kilograms (6.4 million pounds) of sputtering target material will be consumed in 1999 to sputter-deposit 363 million square meters of thin films for microelectronics, data storage, advanced display and optical coating applications. This projection shows that, worldwide, the production of sputtered films will increase at an average annual growth rate ("AAGR") of 16.0% from 1999 to 2004, reaching 764 million square meters of sputter-deposited films in 2004. -18- Applications of sputtering targets include the following products: o optical filters; o flat panel displays; o photovoltaic cells; o electronic switches; o thin film resistors; o decorative coatings; o thin film batteries; and o tool coating for wear resistance, non-glare glass and mirrors and semi-conductors. TMI Division Products Sputtering Targets. The Company has chosen to focus on production applications in industries other than the semi-conductor industry. Thus, the focus of the Company is on the use of sputtering targets in industrial applications. Sputtering targets are offered in an extensive line of materials, including most ceramic materials and various metals and alloys. Customers in the solar panel, tool coating, decorative coating, electronic, optical and research industries use these targets. Non-superconducting targets (including buy/resell targets, buy/resell of precious metals, and other miscellaneous items) represented approximately 66.2% of Company revenues in 2000, 60.9% in 1999 and 58.9% in 1998. In addition to the TMI Division, the SCI Division of the Company also makes and markets sputtering targets. The SCI Division sputtering targets, however, are made of more complex ceramics which require specialized processing. Bonding and Backing Plates. Bonding is the process of adhering a sputtering target to a backing plate to prepare the target for use in the physical vapor deposition process. Physical vapor deposition processes are coating techniques that deposit thin metal, ceramic or other materials onto a substrate, and include sputtering, laser ablation, evaporation, and ion beam deposition. The Company offers bonding on its own, or customer supplied, backing plates with metallic solder or silver epoxy. High purity copper backing plates can also be used in thicknesses ranging from .125" to 1" on sizes from 1" to 12" and rectangles to 72" long. Bonding services generated approximately 6.6% of Company revenues in 2000 and 6.1% in 1999. In earlier years, TMI had the bonding done through an outside source. Process Knowledge Since its inception, the TMI Division has invested heavily in practical in-house research and development. Each item of the nearly 200 items now offered in the TMI Division's catalogue has required some degree of development, including finding vendors, developing the manufacturing processes and methods of control and standardization. The process knowledge is captured in written specifications, process set cards, logs, operating procedures and other means. Competition The market for sputtering targets is very competitive. The Company has numerous competitors, most of which are larger and have greater financial resources than the Company. Domestically, the Company views Puretech, Inc., a division of Williams Advanced Materials, itself a division of Wellman Corporation, and Cerac Corporation as primary competitors over the entire line of manufactured products, although as many as 30 competitors exist and compete for different portions of the sputtering target market. Further, some primary metal suppliers also produce sputtering targets. Additionally, the Company competes with several other companies producing sputtering targets and thin-film deposition materials for foreign markets. Management believes that Tosoh Corp. has the largest worldwide market share, followed by MRC Corporation (a division of Praxair Corp.), VMC Corporation, Johnson Mathey Corporation, Nippon Mining Corporation, Puretech Inc., and Cerac Inc. All enjoy vastly superior resources than those possessed by the Company. However, few of these competitors focus their marketing efforts on the research segment of the market, due to the low volumes that characterize this market niche. The Company believes that the principal competitive factors in this market are price, service, quality, reliability, reproducibility, availability of technical information, and timely deliveries. -19- The Company strives to differentiate itself from its competitors by providing a full line of manufacturing capabilities, maintaining an excellent quality rating by achieving quick turnaround on manufactured orders, and by providing personalized customer service. Although TMI's objective is to achieve an 80.0% to 20.0% ratio of shipments for production to research and development, at this time, the ratio is approximately 60.0% production to 40.0% research and development. Obtaining production business requires submitting samples, meeting the customer specifications, and developing the confidence of the customer for reliability and reproducibility. Management believes that the needs of its customers generally progress from research and development quantities to pilot production to full scale production. The length of time this cycle requires varies widely. The TMI Division now has the equipment and capacity to supply production quantities to customers who have moved out of the development phase to the production of any new product. Management believes that it will be able to capture a larger portion of production type orders in the future from these customers based on on-going sales and marketing programs and long-term relationships that have been developed with current and prospective customers. Marketing and Sales The TMI Division markets and sells its products worldwide, concentrating on the research and development and industrial production markets. Domestic sales account for approximately 70% of the Company's sales, compared to 30% export sales. All sales are conducted in United States dollars. In the United States, the TMI Division markets and sells through its internal sales staff, and through independent manufacturer's representative groups located strategically around the country. Either party may terminate the Company's contracts with its representatives on 60 days notice. Commission rates vary according to materials and other factors. A typical commission rate is 8% of gross sales dollars. In Asia, the TMI division markets and sells through several non-exclusive distributors. Sales in this region consist primarily of research and development accounts. TMI currently is seeking representation in the European market. Production Capacity In the TMI Division, the production equipment currently on hand will accommodate a throughput of $4.0 million or greater per year, depending on product mix and the addition of a second shift operation. In order to enter production accounts requiring larger, more complex targets, the Company intends to acquire a larger machine center in 2001. The new center will cost approximately $150,000 and will be financed through a leasing program. This additional center will increase the TMI Division production capacity by approximately 25%. With those measures taken, the production capability of the TMI Division is expected to be approximately $6.0 million per year revenue. Major Suppliers and Customers The TMI Division buys raw materials, components and chemicals used in the manufacture and assembly of the Company's products. If these materials are not received in a timely manner, it may seriously affect the Company's production schedule. The Company, however, has designed its products using widely-available standard items and components, and has identified alternative vendors it may use in order to avoid production delays. The Company is not experiencing difficulty in maintaining its inventory of such components, although purchase commitments are, at times, limited by cash flow. The TMI Division purchases various types of ceramic powder as well as metal for the production of ceramic or metal sputtering targets. These materials are purchased to Company specifications. In such cases, the price per unit of weight of the material depends primarily on the volumes purchased. In some cases, the materials are very costly. The quantities purchased and price per unit weight paid by the Company varies widely, based upon cash flow considerations and inventory levels. -20- The Company has established supplier relations with a number of companies, some of which are importers of metals from other countries, including China and Russia. Delivery schedules are often unpredictable for these supplies, requiring the Company to maintain considerable inventory levels to avoid shortages. The Company does not manufacture sputtering targets made from gold, platinum, palladium or other materials considered in the market as precious metals. As a service to its customers who require such materials, TMI buys finished targets from one of several suppliers and resells these targets at a markup. The approximate percent of the Company's overall revenues consisting of precious metals targets was 5.3% in 1998, 7.9% in 1999, and 10.9% in 2000. The Company maintains a letter of credit with one precious metal supplier to cover the purchases. The Company sells precious metals on a net-10 day basis, while all other sales are net-30 days. The Company also purchases other finished sputtering targets made with unique compositions of common materials from outside sources for resale at a markup to its customers as a service. The approximate percent of the Company's overall revenues consisting of these "buy/re-sell" items was 12.1% in 1998, 12.7% in 1999, and 10.9% in 2000. The Company has appropriate purchase specifications, and performs its own receiving, inspection and quality control on these products prior to shipment to its customers. The top five suppliers to the TMI Division in 2000 were, in descending order: Williams Advanced Materials, Inc., Standard Resources, Inc., ACI Alloys Inc., Noah, Inc. and Alta, Inc. In every case, the Company believes that suitable substitute vendors could be found. The Company buys primarily based on quality, price and delivery to its specifications factors. No customers in the TMI Division accounted for 10.0% or more of the total TMI revenue in 2000. Research and Development The TMI Division has no government support, preferring to invest in and control its research and development program in a commercial market-oriented customer-driven manner. Quality Control The Company strives for world class quality in its products. The Company has experienced quality control problems in the past. Consequently, the Company in recent years has invested funds in the development and implementation of a quality assurance program to insure that each process in the manufacturing, materials purchasing and order-entry functions are more tightly controlled. The Company has also invested in quality control equipment. The Company is currently able to perform in-house testing of its ceramic products and metals and alloys via scanning electron microscopy, Edax, differential thermal analysis, electrical resistivity, particle size analysis, ICP, spectagraph equipment and XRD. The quality control efforts have included preparation for certification for ISO 9000, the international standard of quality performance, as well as investment in training of personnel, preparation of specifications, purchasing and installation of equipment, purchasing of software, on-going calibration and maintenance of advanced measuring and composition analysis equipment. These efforts have produced a significant improvement in the product produced by the Company, as shown by customer returns, which were under 2.2% overall in 2000, 1.7% in 1999 and 2.0% in 1998. The Company has not requested the required examination by the controlling authorities for ISO 9000 and does not plan to do so in fiscal year 2001. EMPLOYEES The Company currently has 23 full-time and 4 part-time employees. Three of the Company's employees have a Ph.D. in Chemistry or Materials Science. Ten employees work primarily for the TMI Division of the Company, while the remainder work primarily for the SCI Division. In the case of shared employees, charges are assigned in accordance with the ratio of shipped dollars. -21- The Company has never experienced work stoppage and considers its relations with employees to be good. The employees do not have a bargaining unit. ENVIRONMENTAL MATTERS The Company generates small quantities of ceramic dust from grinding or machining and has approval from the Ohio EPA for the emission of the exhaust from these materials, which are primarily Zinc Oxide. The Company maintains filters and dust collectors that it believes are in accordance with all EPA regulations. The Company has been inspected from time to time by local EPA authorities and the few noted deficiencies have been corrected. To date, the Company is not under any EPA strictures. The Company does not handle "hazardous materials" as defined on the Materials Safety and Data Sheets ("MSDS"). The Company supplies MSDS sheets to its customers with all shipments as a routine procedure. The TMI Division also does not offer products made from "hazardous materials" (as defined by the MSDS, for the materials). COLLECTIONS AND WRITE-OFFS The Company collected its receivables in an average of 44 days in 2000. The Company has occasionally been forced to write-off a few small invoices as uncollectible. The Company considers credit management critical to its success. SEASONAL TRENDS The Company has not experienced and does not in the future expect to experience seasonal trends in its business operations. RISK FACTORS The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The following factors have affected or could affect the Company's actual results and could cause such results to differ materially from those expressed in any forward-looking statements made by the Company. Investors should consider carefully the following risks and speculative factors inherent in and affecting the business of the Company and an investment in the Company's common stock. WE HAVE EXPERIENCED SIGNIFICANT OPERATING LOSSES IN THE PAST AND MAY CONTINUE TO DO SO IN THE FUTURE. We commenced business in May of 1987 and have never been profitable on an annual basis. We have reported net losses for each of the years ended December 31, 2000, 1999, and 1998, respectively, as detailed below. Research and Period Sales Development Loss --------------- -------------- --------------- ------------ 12/31/00 3,205,163 17,623 (153,694) 12/31/99 2,678,362 15,392 (138,420) 12/31/98 2,498,162 41,421 (232,887) We have financed these losses primarily from: (i) several private offerings of debt and equity securities; (ii) additional investments and loans by our major shareholders; and (iii) a private offering of common stock and warrants to purchase common stock in October 2000. We can not assure you, however, that we will be able to raise additional capital in the future to fund our operations. -22- WE HAVE LIMITED MARKETING AND SALES CAPABILITIES. To successfully market our products, we must continue to develop appropriate marketing, sales, technical, customer service and distribution capabilities, or enter into agreements with third parties to provide these services. Our failure to develop these capabilities or obtain third-party agreements could adversely affect us. OUR SUCCESS DEPENDS ON OUR ABILITY TO RETAIN KEY MANAGEMENT PERSONNEL, INCLUDING OUR CURRENT PRESIDENT AND CHIEF EXECUTIVE OFFICER. Our success depends in large part on our ability to attract and retain highly qualified management, administrative, manufacturing, sales, and research and development personnel. Due to the specialized nature of the our business, it may be difficult to locate and hire qualified personnel. The loss of services of one our executive officers or other key personnel, or our failure to attract and retain other executive officers or key personnel, could have a material adverse effect on our business, operating results and financial condition. Our success also depends substantially on the knowledge, expertise, and continued financial contributions of our President, Chief Executive Officer and major shareholder, Dr. Edward R. Funk. The loss of the services of Dr. Funk would likely have a material adverse effect on our operations, especially if we cannot find a qualified replacement. WE MAY NEED TO SEEK ADDITIONAL CAPITAL IN THE FUTURE, WHICH MAY REDUCE THE VALUE OF OUR COMMON STOCK. The Company has incurred substantial operating losses, and numerous factors could require that the Company seek additional capital in the future. Unless the Company increases sales in the near future, additional capital may be needed, and there is no assurance that the it will be available or that it will be available on the terms that will not result in substantial dilution or reduction in value of the Company's common stock. OUR COMPETITORS HAVE FAR GREATER FINANCIAL AND OTHER RESOURCES THAN WE HAVE. The superconductive industry is in its early formative state and there is substantial competition in the current market for superconductors, including superconductive ceramic materials and related products. While we believe that our superconductive products enjoy certain competitive advantages in design, function, quality, and availability, considerable competition exists from well-established firms such as a division of Praxair's Surface Science Technology group as well as MCR, Johnson Matthey, Pure Tech and CERAC, all of which have more resources than we have. In addition, a significant portion of our business is in the very competitive market for sputtering targets made of ceramics, metals, and alloys. We face substantial competition in this area from companies with far greater financial and other resources than we have. We cannot assure you that developments by others will not render our products or technologies obsolete or less competitive. WE DEPEND ON GOVERNMENT SPONSORED RESEARCH AND DEVELOPMENT CONTRACTS FOR A SIGNIFICANT AMOUNT OF REVENUE. We are, and expect to continue to be in the near term, dependent on government funding for our research and development projects. Government contracts may be reduced or eliminated at any time, and receipt of all or any part of the funds under any of our existing government contracts not yet performed is not guaranteed. If we fail to increase revenues from commercial sales, a significant loss of government funding would severally harm us. GOVERNMENT CONTRACTS MAY BE TERMINATED OR SUSPENDED FOR NONCOMPLIANCE OR OTHER EVENTS BEYOND OUR CONTROL. The government may cancel virtually all of our government contracts and are terminable at the option of the government. While we have complied with applicable government rules and regulations and contract provisions in the past, we could fail to comply in the future. Noncompliance with government procurement regulations or contract provisions could result in the termination of government contracts. The termination of our significant government contracts or the adoption of new or modified procurement regulations or practices could adversely affect us. -23- Inventions conceived or actually reduced to practice under a government contract generally result in the government obtaining a royalty-free, non-exclusive license to practice the invention. Similarly, technologies developed in whole or in part at government expense generally result in the government obtaining unlimited rights to use, duplicate or disclose technical data produced under the contract. These licenses and rights may result in a loss of potential revenues or the disclosure of our proprietary information, either of which could adversely affect us. OUR REVENUES DEPEND ON PATENTS AND PROPRIETARY RIGHTS WHICH MAY NOT BE ENFORCEABLE. We rely on a combination of patent and trademark law, license agreements, internal procedures and nondisclosure agreements to protect our intellectual property. These may be invalidated, circumvented or challenged. In addition, the laws of some foreign countries in which our products may be produced or sold do not protect our intellectual property rights to the same extent as the laws of the United States. Our failure to protect our proprietary information could adversely affect us. RIGHTS WE HAVE TO PATENTS AND PENDING PATENT APPLICATIONS MAY BE CHALLENGED. We have received from the United States Patent and Trademark Office a patent for Fine-Particle Bi-Sr-Ca-Cu-O Having High Phase Purity made by a Chemical Precipitation and Low-Pressure Calcination method, and have also applied for a patent covering Large Weld-Connected Superconducting Monoliths and Process for Making the Same. In addition, in the future we may submit additional patent applications covering various aspects of the HTS field. The patent application we filed and patent applications that we may file in the future may not result in patents being issued, and any patents issued may not afford meaningful protection against competitors with similar technology, and may be challenged by third parties. Because U.S. patent applications are maintained in secret until patents are issued, and because publications of discoveries in the scientific or patent literature tend to lag behind actual discoveries by several months, we may not be the first creator of inventions covered by issued patents or pending patent applications or the first to file patent applications for such inventions. Moreover, other parties may independently develop similar technologies, duplicate our technologies or, if patents are issued to us or rights licensed by us, design around the patented aspects of any technologies we developed or licensed. We may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office to determine the priority of inventions, which could result in substantial costs. Litigation may also be necessary to enforce any patents held by or issued to us or to determine the scope and validity of others' proprietary rights, which could result in substantial costs. THE RAPID RATE OF INVENTIONS AND DISCOVERIES IN THE SUPERCONDUCTIVITY FIELD HAS RAISED MANY UNRESOLVED PATENT ISSUES THAT MAY NEGATIVELY AFFECT OUR BUSINESS. The claims in granted patents often overlap and there are disputes involving rights to inventions claimed in pending patent applications. As a result, the patent situation in the high temperature superconductor field is unusually complex. It is possible that there will be patents held by third parties relating to our products or technology. We may need to acquire licenses to design around or successfully contest the validity or enforceability of those patents. It is also possible that because of the number and scope of patents pending or issued, we may be required to obtain multiple licenses in order to use a single material. If we are required to obtain multiple licenses, our costs will increase. Furthermore, licenses may not be available on commercially reasonable terms or at all. The likelihood of successfully contesting the validity or enforceability of those patents is also uncertain; and, in any event, we could incur substantial costs in defending the validity or scope of our patents or challenging the patents of others. THE RAPID TECHNOLOGICAL CHANGES OF OUR INDUSTRY MAY ADVERSELY AFFECT US IF WE DO NOT KEEP PACE WITH ADVANCING TECHNOLOGY. The field of superconductivity is characterized by rapidly advancing technology. Our success depends on our ability to keep pace with advancing superconductor technology, including superconducting materials and processes and industry standards. To date, we have focused our development efforts on HTS superconducting powders and targets, as well as sputtering targets made of non-superconducting ceramics, metals and metal alloys. We intend to continue to develop and integrate advances in the thin film coatings industry. However, our development efforts may be rendered obsolete by research efforts and technological advances made by others, and materials other -24- than those we currently use may prove more advantageous for the commercialization of high-temperature superconductor products. THE MARKET FOR OUR COMMON STOCK IS LIMITED. There is presently only a limited public market for shares of our common stock. Our common stock currently is traded over the counter through the National Quotation Bureau (a.k.a. - the "pink sheets"). While we are applying to have our shares re-listed on the OTC Bulletin Board, there is no guarantee that our application will be approved. Even if our common stock is re-listed on the OTC Bulletin Board, we cannot assure you that market makers will continue to buy and sell our securities. Further, even if these market makers continue to buy and sell our securities, we cannot assure you that one of our shareholders who desires to sell a specified number of shares will be able to all such shares at the price quoted by the market maker. The market prices for securities of superconductive material companies have been volatile throughout the Company's existence. Most of the companies are traded over the counter through the National Quotation Bureau or National Association of Securities Dealers Automated Quotation System. Historical trading characteristics for public companies in this industry include limited market support, low trading volume, and wide spreads (on a percentage basis) between the bid and ask prices. Announcements regarding product developments, technological advances, significant customer orders, and financial results significantly influence per share prices. OUR COMMON STOCK IS SUBJECT TO THE SECURITIES AND EXCHANGE COMMISSION'S "PENNY STOCK" REGULATIONS, WHICH LIMITS THE LIQUIDITY OF COMMON STOCK HELD BY OUR SHAREHOLDERS. Based on its trading price, our common stock is considered a "penny stock" for purposes of federal securities laws, and therefore is subject to regulations which affect the ability of broker-dealers to sell the Company's securities. Broker-dealers who recommend a "penny stock" to persons (other than established customers and accredited investors) must make a special written suitability determination and receive the purchaser's written agreement to a transaction prior to sale. As long as the penny stock regulations apply to our common stock, it may be difficult to trade such stock because compliance with the regulations can delay and/or preclude certain trading transactions. Brokers-dealers may be discouraged from effecting transactions in our common stock because of the sales practice and disclosure requirements for penny stock. This could adversely effect the liquidity and/or price of our common stock, and impede the sale of our common stock in the secondary market. WE HAVE NOT PAID DIVIDENDS ON OUR COMMON STOCK IN THE PAST AND DO NOT EXPECT TO DO SO IN THE FUTURE. We cannot assure you that our operations will result in sufficient revenues to enable us to operate at profitable levels or to generate positive cash flow sufficient to pay dividends. We have never paid dividends on our common shares in the past and do not expect to do so in the foreseeable future. ITEM 2. DESCRIPTION OF PROPERTY. The Company's office and manufacturing facilities are located at 1145 Chesapeake Avenue, Columbus, Ohio, where it occupies about 20,000 square feet. Additional space of 10,000 square feet is currently sub-leased by the Company and can be reclaimed for Company use on three months notice. The Company's lease on the property currently is month-to-month, and negotiations for a longer term lease are pending. There is adequate power running to several locations in the building and other utilities are adequate for the projected growth. The Company is current on all operating lease liabilities. -25- ITEM 3. LEGAL PROCEEDINGS. There are no known legal proceedings against the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. MARKET FOR COMMON STOCK The Company's common stock traded on the OTC Bulletin Board under the symbol "SCCI" until April 2000, at which time it began to trade over the counter through the National Quotation Bureau. The following table sets forth for the periods indicated the high and low bid quotations for the Company's common stock as reported on the OTC Bulletin Board, except for the Quarters ended June 30, 2000, September 30, 2000, and December 31, 2000, which set forth the high and low bid quotations for the Company's common stock on the National Quotation Bureau. HIGH LOW ---- --- FISCAL 1999 Quarter ended March 30, 1999 4 1/4 3/4 Quarter ended June 30, 1999 3 1/4 1 1/2 Quarter ended September 30, 1999 2 1/2 1 1/4 Quarter ended December 31, 1999 2 3/4 1 1/2 FISCAL 2000 Quarter Ended March 31, 2000 29 1 1/2 Quarter Ended June 30, 2000 5 2 Quarter Ended September 30, 2000 3 3/5 1 3/4 Quarter Ended December 31, 2000 3 3/4 1 The quotations provided herein may reflect inter-dealer prices without retail mark-up, markdown, or commissions, and may not represent actual transactions. As discussed above, at the present time, the Company's common stock is not listed on The Nasdaq SmallCap Stock Market or on any stock exchange, but trades over the counter through the National Quotation Bureau. Based on its trading price, the Company's common stock is considered a "penny stock" for purposes of federal securities laws, and therefore is subject to certain regulations which are summarized below. The Securities Enforcement and Penny Stock Reform Act of 1990 requires special disclosure relating to the market for penny stocks in connection with trades in any stock defined as a "penny stock." Specifically, Rules 15g-1 through 15g-9 under the Securities Exchange Act of 1934 (the "Exchange Act") impose sales practice and -26- disclosure requirements on NASD brokers-dealers who make a market in a "penny stock." Securities and Exchange Commission regulations generally define a penny stock to be an equity security that has a market price of less than $5.00 per share and that is not listed on The Nasdaq SmallCap Stock Market or a major stock exchange. These regulations affect the ability of broker-dealers to sell the Company's securities and also may affect the ability of purchasers of the Company's common stock to sell their shares in the secondary market. Under the penny stock regulations, a broker-dealer selling penny stock to anyone other than an established customer or "accredited investor," generally, an individual with net worth in excess of $1,000,000 or an annual income exceeding $200,000, or $300,000 together with his or her spouse, must make a special suitability determination for the purchaser and must receive the purchaser's written consent to the transaction prior to sale, unless the broker-dealer or the transaction is otherwise exempt. In addition, the penny stock regulations require the broker-dealer to deliver, prior to any transaction involving a penny stock, a disclosure schedule prepared by the Commission relating to the penny stock market, unless the broker-dealer or the transaction is otherwise exempt. A broker-dealer is also required to disclose commissions payable to the broker-dealer and the registered representative and current quotations for the securities. Finally, a broker-dealer is required to send monthly statements disclosing recent price information with respect to the penny stock held in a customer's account and information with respect to the limited market in penny stocks. As long as the penny stock regulations apply to the Company's stock, it may be difficult to trade such stock because compliance with the regulations can delay and/or preclude certain trading transactions. Brokers-dealers may be discouraged from effecting transactions in the Company's stock because of the sales practice and disclosure requirements for penny stock. This could adversely effect the liquidity and/or price of the Company's common stock, and impede the sale of the Company's stock in the secondary market. HOLDERS OF RECORD As of December 31, 2000, there were approximately 762 holders of record of the common stock of the Company and 1,816,977 shares outstanding, and approximately 69 holders of Series B Preferred and one holder of Series A Preferred stock. The Company has come to have approximately 762 registered holders of common stock as a result of various unregistered exempt private offerings of its common stock since the Company's inception in 1987, including issuances of stock options to employees and to members of the Company's board of directors, and subsequent trading of the common stock on the OTC Bulletin Board and over the counter through the National Quotation Bureau. The number of holders of common stock has also increased due to conversions of Series B preferred shares into shares of common stock. There is no public market for the Series A and B preferred shares. The Company's 69 Series B Preferred holders acquired their Series B Preferred Stock in an private offering by the Company that was completed in 1996. The total amount of this offering was $700,000. The Company issued the Series B Preferred Shares in reliance on an exemption pursuant to Rule 504 of Regulation D under the Securities Act of 1933, and the offering was registered by qualification in the State of Ohio under Section 1707.09 of the Ohio Revised Code. As of December 31, 2000, there were 99 shares of Series A Preferred outstanding and 26,648 Series B Preferred Shares outstanding. DIVIDENDS The Company has never paid cash dividends on its common stock and does not expect to pay any dividends in the foreseeable future. Furthermore, the Company's bank loan prohibits it from paying cash dividends. The Company intends to retain future earnings, if any, for use in the business. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS. RESULTS OF OPERATIONS To date, the Company has received revenue predominantly from commercial sales, government research contracts and non-government research contracts. The Company has incurred cumulative losses of $5,660,276 from inception to December 31, 2000. -27- Fiscal Year 2000 As Compared to Fiscal Year 1999 Revenues Revenues in fiscal 2000 increased by 19.6% to $3,205,163 from the fiscal 1999 level of $2,678,362. Contract research revenue in fiscal 2000 was $525,566 compared to $425,153 in fiscal 1999, an increase of 23.6%. TMI Division sales increased to $2,069,895 in 2000 from $1,779,519 in 1999 or an increase of 16.3%. SCI Division sales for product sales increased to $609,702 from $473,690 or an increase of 28.7%. Increase in sales is credited to increased sales of existing customers and efforts by management to expand into additional markets creating new customers. In 2000, total contract research revenues were $525,566 as compared to $425,153 in 1999. Government development contract revenue was $494,373, or 15.4% of total revenues in 2000 and $392,617 or 14.7% of total revenues in 1999. NASA has been, and is expected in the near term to continue to be, the Company's largest customer, accounting for 8.3% and 8.1% of the Company's revenues in fiscal 2000 and 1999, respectively. Significant loss of government funding would have a material adverse effect on the Company's financial condition and results of operations. Gross Margin Total gross margin in 2000 was $771,745 or 24.1% of total revenue as compared to $477,179 or 17.8% in 1999. Gross margin on sales revenue for the TMI Division was 27.5% in 2000 versus 23.3% in 1999. The improvement in gross margin is due primarily to increased sales as the gross margin is impacted by utilization of production capacity. Gross margin on sales revenue for the SCI Division product sales was 16.5% for 2000 compared to 13.9% in 1999. The gross margin on product sales has improved as a result of improved manufacturing processes. Gross margins on the Company's products vary widely and are impacted from period to period by sales mix and utilization of production capacity. The gross margin on the contract research is generally lower than the other products. The Company expects that gross margins will improve as sales grow. Inventory reserves are established for obsolete inventory and excess inventory quantities based on management's estimate of net realizable value. Changes in this reserve are expensed to cost of goods sold or reduce inventory and approximated $122,500 and $9,000 for the years ended December 31, 2000, and 1999, respectively. During 2000, management completed a review of inventory for both divisions in an effort to identify obsolete inventory. As a result of this detailed analysis, management has valued the obsolete inventory at zero for the TMI and SCI division of $73,553 and $31,522, respectively. Inventory and the inventory reserve accounts were reduced by the same dollar amounts. Management has segregated the inventory and is identifying methods to dispose of the inventory in compliance with all regulatory agencies. Management believes the total cost to dispose, net of scrap values, will be insignificant. Additionally, management reviewed the inventory reserve and determined that the reserve should be increased by approximately $17,000 which was expensed to cost of goods sold. During 1999, changes in the reserve were expensed to cost of goods sold and totaled $9,000 and $6,000 for the TMI and SCI Divisions, respectively. Management deems the inventory reserve, after its assessment of obsolete inventory, at December 31, 2000,of $61,000 to be adequate for excess inventory and a lower of cost-or-market analysis. Gross margin on contract research revenue reported in the SCI Division in segment reporting was 31.1% for 2000 compared to 13.9%. The increase in gross margin on contract research revenue of 17.2% was due primarily to a $100,000 credit obtained from a third party subcontractor in 2000 which resulted in the higher margins. -28- Selling Expense Selling expense in fiscal 2000 increased to $309,969 from $265,631 in fiscal 1999, a increase of $44,338, or 16.7%. This increase is primarily a result of increased staffing for an additional sales representative for the SCI Division, and a more aggressive sales and marketing campaign related to the TMI Division. General and Administrative Expense General and Administrative expense in fiscal 2000 increased to $560,653, from $325,195 in fiscal 1999, an increase of $235,458, or 72.4%. The increase in these costs related to the expansion of the Company infrastructure. Legal and accounting increased $127,000 related to the audit of financial statements and preparation for regulatory filings. Research and Development Expenses. Internal research and development costs are expensed as incurred. Research and development costs, including testing, for 2000 was $17,623 compared to $15,392 in 1999. Internal research and development costs decrease when government funded projects are available. Interest Expense. Interest expense was $57,901, or 1.8% of Company revenues in fiscal 2000, up 30.1% from $44,473 in fiscal 1999. Subordinated notes payable to shareholders increased by $89,408 during 2000. Additional borrowings of $75,000 on a bank line of credit also occurred throughout the year, with all balances repaid by year end. LOSS APPLICABLE TO COMMON SHARES Net loss per common share based on the loss applicable to common shares was $(0.15) and $(0.20) per common share for the years ended December 31, 2000 and 1999, respectively. The loss applicable to common shares includes the net loss from operations, Series A and B preferred stock dividends and the accretion of Series A and B preferred stock. The net loss per common share from operations was $(0.10) and $.011), respectively. The difference between the net loss from operations and the loss applicable to common shares of $(0.05) and $(0.09), respectively, is a result of the preferred position that the preferred shareholders have in comparison to the common shareholders. Dividends on the Series A and B preferred stock accrue at 10% annually on the outstanding shares. Dividends on the Series A preferred stock totaled $8,668 and $14,716, respectively. Dividends on the Series B preferred stock totaled $76,637 and $76,637, respectively. The accretion of Series A preferred stock represents issue costs of $70,277 that were netted against the proceeds of Series A preferred stock. The issue costs are being amortized on a straight-line basis over the payout period of seven years to loss applicable to common shares and additional paid-in capital. The annual accretion totaled $11,713 and $11,713, respectively. The Series B preferred stock accretion represents a discount of $5.00 per share at the time of issuance of these shares. The original discount totaled $350,000. The discount is being accreted to loss applicable to common shares and additional paid-in capital through the period that the Series B preferred stock can be converted to common stock which is after the third anniversary. The discount was fully amortized at December 31, 1998. LIQUIDITY AND WORKING CAPITAL At December 31, 2000, working capital was $760,595 compared to $57,991 at December 31, 1999. The increase in working capital of $702,604 was due mainly to the proceeds of sales of common stock and warrants totaling $528,000 and accounts payable paid by a shareholder which increased long-term subordinated notes payable. The Company provided (used) cash from operations for the years ended December 31, 2000, and 1999 of $(95,370) and $107,633, respectively. Significant non-cash expenses included depreciation, amortization and inventory reserve on excess and obsolete inventory approximate $281,000 and $274,000, respectively, for the years ended December 31, 2000, and 1999. Overall, accounts receivable, inventory and prepaids increased in excess of increases in accounts payable and accrued expenses by approximately $226,000 and $27,000, respectively. The overall change between years was due to the ability to make payments on accrued expenses with the cash available from the common stock and warrant sales and the purchase of additional inventory to restore inventory levels. For investing activities, the Company used cash of approximately $107,000 and $66,000 for the years ended December 31, 2000, and 1999, respectively. The amounts invested in 2000 and 1999 were used to purchase machinery and equipment for increased production capacity. For financing activities for the year ended December 31, 2000, the Company provided cash of approximately $405,000. Cash payments to third parties for debt and capital lease obligations approximated $106,000. Cash payments for accrued cumulative dividends on Series A and B preferred stock approximated $27,000. Proceeds from the sale of common stock and warrants totaled $528,000. Proceeds from the exercise of common stock options totaled $80,000. The proceeds from these were used to redeem $70,000 of Series A preferred stock and accrued dividends. For financing activities for the year ended December 31, 1999, the Company used cash of approximately $46,000. Due to tight cash flow, cash was overdrawn by approximately $31,000. Cash payments to third parties for debt and capital lease obligations approximated $73,000. Proceeds from issuance of subordinated notes payable of approximately $80,000 to a shareholder were used to pay accrued cumulative dividends approximating $84,000 on Series A and B preferred stock. -29- During fourth quarter 2000, the Company received proceeds from the sale of common stock totaling $500,000 for 200,000 shares of common stock and $28,000 for the sale of warrants to purchase 140,000 shares of common stock at $3.50 per share. Additionally, the Company has available $100,000 on a bank line of credit. In conjunction with the sale of common stock and common stock warrants, Dr. and Mrs. Funk converted approximately $506,000 to common stock. Bank debt is guaranteed by the Dr. Funk, President and majority shareholder of the Company. Subordinated notes payable are payable to majority shareholders. During fourth quarter 2000, the subordinated debt was converted to equity. Dr. Funk held all of the outstanding Series A preferred stock as of December 31, 2000. Additionally, Dr. and Mrs. Funk have pledged collateral as security for the payment of Series B preferred stock dividends, which is held by a third party. The Series B preferred shareholders have the option to force the sale of the secured collateral. While officers of the Company have advanced funds in the form of su