SCI ENGINEERED MATERIALS, INC.

(Exact name of small business issuer as specified in its charter)

Ohio	31-1210318
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

Table of Contents

			Page No.
PART I.       FINANCIAL INFORMATION
	Item 1.	Financial Statements.
		Balance Sheets as of September 30, 2008 (unaudited)
		and December 31, 2007	3
		Statements of Operations for the Three Months and Nine Months
		Ended September 30, 2008 and 2007 (unaudited)	5
		Statements of Cash Flows for the Nine Months
		Ended September 30, 2008 and 2007 (unaudited)	6
		Notes to Financial Statements (unaudited)	8
	Item 2.	Management's Discussion and Analysis of Financial Condition and
		Results of Operations.	14
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	N/A
	Item 4.	Controls and Procedures.	20
PART II.      OTHER INFORMATION
	Item 1.	Legal Proceedings.	N/A
	Item 1A.	Risk Factors	N/A
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.	N/A
	Item 3.	Defaults Upon Senior Securities.	N/A
	Item 4.	Submission of Matters to a Vote of Security Holders.	N/A
	Item 5.	Other Information.	N/A
	Item 6.	Exhibits.	21
	Signatures.		21

 

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SCI ENGINEERED MATERIALS, INC.

BALANCE SHEETS

 

ASSETS

		September 30,			December 31,
		2008			2007
		(UNAUDITED)
CURRENT ASSETS
Cash		$	906,409		$	1,182,086
Accounts receivable
Trade, less allowance for doubtful accounts of $24,700			605,061			219,222
Contract			78,137			65,954
Other			-			550
Inventories			1,513,458			756,999
Prepaid expenses			180,241			21,148
Total current assets			3,283,306			2,245,959
PROPERTY AND EQUIPMENT,   AT COST
Machinery and equipment			4,198,407			3,386,778
Furniture and fixtures			105,089			74,222
Leasehold improvements			313,951			301,551
Construction in progress			17,535			599,753
			4,634,982			4,362,304
Less accumulated depreciation			(2,380,180	)		(2,185,277	)
			2,254,802			2,177,027
OTHER ASSETS
Deposits			27,530			18,639
Intangibles			34,850			29,202
Total other assets			62,380			47,841
TOTAL ASSETS		$	5,600,488		$	4,470,827

The accompanying notes are an integral part of these financial statements.

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SCI ENGINEERED MATERIALS, INC.

BALANCE SHEETS

LIABILITIES AND SHAREHOLDERS' EQUITY

		September 30,			December 31,
		2008			2007
		(UNAUDITED)
CURRENT LIABILITIES
Capital lease obligation, current portion		$	272,530		$	259,714
Accounts payable			231,475			160,468
Accrued contract expenses			39,892			47,702
Customer deposits			806,618			19,483
Accrued compensation			83,941			138,190
Accrued expenses and other			100,861			100,184
Note payable, current portion			5,077			-
Total current liabilities			1,540,394			725,741
LONG TERM LIABILITIES
Capital lease obligation, net of current portion			628,649			846,433
Note payable, net of current portion			394,923			-
Total long term liabilities			1,023,572			846,433
COMMITMENTS AND CONTINGENCIES			-			-
SHAREHOLDERS' EQUITY
Convertible preferred stock, Series B, 10% cumulative, nonvoting, no par value, $10 stated value, optional redemption at 103%; 24,430 and 24,566 issued and outstanding respectively			367,675			375,861
Common stock, no par value, authorized 15,000,000 shares; 3,560,259 and 3,474,338 shares issued and outstanding respectively			9,180,183			9,061,378
Additional paid-in capital			985,298			987,840
Accumulated deficit			(7,496,634	)		(7,526,426	)
			3,036,522			2,898,653
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY		$	5,600,488		$	4,470,827

The accompanying notes are an integral part of these financial statements.

 

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SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

(UNAUDITED)

		THREE MONTHS ENDED SEPT. 30,						NINE MONTHS ENDED SEPT. 30,
		2008			2007			2008			2007
SALES REVENUE		$	4,008,635		$	2,589,938		$	7,240,088		$	8,447,689
COST OF SALES REVENUE			3,239,069			2,100,305			5,603,650			6,986,308
GROSS PROFIT			769,566			489,633			1,636,438			1,461,381
GENERAL AND ADMINISTRATIVE EXPENSE			241,101			213,111			751,562			669,423
RESEARCH AND DEVELOPMENT EXPENSE			133,066			108,943			355,785			253,980
MARKETING AND SALES EXPENSE			169,524			123,852			441,556			331,703
INCOME FROM OPERATIONS			225,875			43,727			87,535			206,275
OTHER INCOME (EXPENSE)
Interest income			5,569			21,733			19,744			48,721
Interest expense			(27,490	)		(32,317	)		(79,487	)		(56,433	)
Gain on disposal of equipment			800			3,570			2,000			8,352
Miscellaneous, net			-			(457	)		-			(1,372	)
			(21,121	)		(7,471	)		(57,743	)		(732	)
INCOME BEFORE PROVISION FOR INCOME TAX			204,754			36,256			29,792			205,543
INCOME TAX EXPENSE			-			-			-			-
NET INCOME			204,754			36,256			29,792			205,543
DIVIDENDS ON PREFERRED STOCK			(6,119	)		(6,245	)		(18,402	)		(18,837	)
INCOME APPLICABLE TO COMMON SHARES		$	198,635		$	30,011		$	11,390		$	186,706
EARNINGS PER SHARE - BASIC AND DILUTED (Note 6)
NET INCOME PER COMMON SHARE BEFORE DIVIDENDS ON PREFERRED STOCK
Basic		$	0.06		$	0.01		$	0.01		$	0.06
Diluted		$	0.05		$	0.01		$	0.01		$	0.05
NET INCOME PER COMMON SHARE AFTER DIVIDENDS ON PREFERRED STOCK
Basic		$	0.06		$	0.01		$	0.00		$	0.05
Diluted		$	0.05		$	0.01		$	0.00		$	0.04
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic			3,560,196			3,468,756			3,520,490			3,457,005
Diluted			4,086,906			4,216,320			4,122,439			4,224,899

 

The accompanying notes are an integral part of these financial statements.

 

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SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF CASH FLOWS

NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

(UNAUDITED)

		2008			2007
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	29,792		$	205,543
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and accretion			281,446			216,618
Amortization			2,316			2,316
Stock based compensation			45,873			42,938
Gain on sale of equipment			(2,000	)		(8,352	)
Inventory reserve			7,930			8,765
Provision for doubtful accounts			-			(300	)
Changes in operating assets and liabilities:
(Increase) decrease in assets:
Accounts receivable			(397,472	)		130,860
Inventories			(764,389	)		(315,039	)
Prepaid expenses			(149,089	)		27,076
Other assets			(16,855	)		265,088
Increase in liabilities:
Accounts payable			71,007			314,416
Accrued expenses and customer deposits			738,670			274,652
Total adjustments			(182,563	)		959,038
Net cash (used in) provided by operating activities			(152,771	)		1,164,581
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds on sale of equipment			2,000			18,670
Purchases of property and equipment			(93,836	)		(212,016	)
Net cash used in investing activities			(91,836	)		(193,346	)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from exercise of common stock options			10,250			9,625
Proceeds from exercise of common stock warrants			68,021			26,909
Payments related to registration of common stock			(16,906	)		(32,255	)
Payments related to Preferred Series B dividend			(24,566	)		-
Proceeds from note payable			400,000			-
Principal payments on capital lease obligations			(467,869	)		(106,977	)
Net cash used in financing activities			(31,070	)		(102,698	)

The accompanying notes are an integral part of these financial statements.

 

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SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF CASH FLOWS (CONTINUED)

NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

(UNAUDITED)

		2008			2007
NET (DECREASE) INCREASE IN CASH		$	(275,677	)	$	868,537
CASH - Beginning of period			1,182,086			648,494
CASH - End of period		$	906,409		$	1,517,031
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the years for:
Interest, net		$	79,487		$	56,433
Income taxes		$	-		$	-
SUPPLEMENTAL DISCLOSURES OF NONCASH FINANCING ACTIVITIES
Property and equipment purchased by capital lease		$	262,900		$	1,067,315
Machinery & equipment accrued asset retirement obligation increase		$	2,484		$	2,484
SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING ACTIVITIES
Stock based compensation expense		$	45,873		$	42,938

The accompanying notes are an integral part of these financial statements.

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1.

Business Organization and Purpose

SCI Engineered Materials, Inc. (“SCI” or the “Company”), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987. The Company manufactures ceramic and metal sputtering targets for a variety of industrial applications including: Photonics, Semiconductor, Thin Film Battery, and, to a lesser extent High Temperature Superconductive (HTS) materials. Photonics (which includes solar) currently represents the Company’s largest market for its targets. Thin Film Battery is a developing market where manufacturers of batteries use the Company’s targets to produce very small power supplies with small quantities of stored energy. Semiconductor is a developing market.

Note 2.

Summary of Significant Accounting Policies

The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation of the results of operations for the periods presented have been included. The financial statements should be read in conjunction with the audited financial statements and the notes thereto for the year ended December 31, 2007. Interim results are not necessarily indicative of results for the full year.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Equipment purchased with grant funding

In 2004, the Company received funds of $517,935 from the Ohio Department of Development’s Third Frontier Action Fund (TFAF) for the purchase of equipment related to the grant’s purpose. The Company has elected to record the funds disbursed as a contra asset; therefore, the assets are not reflected in the Company’s financial statements. As assets were purchased, the liability initially created when the cash was received was reduced with no revenue recognized or fixed asset recorded on the balance sheet. As of September 30, 2008, the Company had disbursed the entire amount received. The grant and contract both provide that as long as the Company performs in compliance with the grant, the Company retains the rights to the equipment. Management states that the Company will be in compliance with the requirements and, therefore, will retain the equipment at the end of the grant in 2009.

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

 

Note 2.

Summary of Significant Accounting Policies (continued)

Stock Based Compensation

 

In December 2004, the FASB issued SFAS No. 123 (Revised), “Shared Based Payment” (SFAS No. 123R). SFAS No. 123R replaced SFAS No. 123, and superseded APB Opinion No. 25. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R and related interpretations using the modified-prospective transition method. Under this method, compensation cost recognized in 2008 and 2007 includes compensation cost for all stock-based awards granted on or subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. Non cash stock based compensation costs were $45,873 and $42,938 for the nine months ended September 30, 2008 and 2007, respectively. The four non-employee board members each received compensation of 1,819 shares of the Company’s common stock and $5,000 in cash each year.

Reclassification

Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation.

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Note 3.

Common Stock and Stock Options

The cumulative status of options granted and outstanding at September 30, 2008, and December 31, 2007, as well as options which became exercisable in connection with the Stock Option Plans is summarized as follows:

Employee Stock Options

					Weighted
					Average
		Stock Options			Exercise Price
Outstanding at December 31, 2006			343,750		$	2.09
Granted			-			-
Exercised			-			-
Forfeited			(500	)		3.25
Outstanding at December 31, 2007			343,250		$	2.08
Granted			21,000			3.10
Exercised			-			-
Forfeited			(1,500	)		3.10
Outstanding at September 30, 2008			362,750		$	2.14
Shares exercisable at December 31, 2007			313,650		$	1.97
Shares exercisable at September 30, 2008			321,050		$	2.00

 

Non-Employee Director Stock Options

					Weighted
					Average
		Stock Options			Exercise Price
Outstanding at December 31, 2006			247,000		$	2.48
Granted			-			-
Exercised			(6,000	)		1.60
Expired			-			-
Forfeited			-			-
Outstanding at December 31, 2007			241,000		$	2.51
Granted			-			-
Exercised			(7,500	)		1.37
Expired			-			-
Forfeited			-			-
Outstanding at September 30, 2008			233,500		$	2.54
Shares exercisable at December 31, 2007			241,000		$	2.51
Shares exercisable at September 30, 2008			233,500		$	2.54

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

 

Note 3.

Common Stock and Stock Options (continued)

Exercise prices for options range from $1.00 to $4.00 at September 30, 2008. The weighted average option price for all options outstanding is $2.30 with a weighted average remaining contractual life of 4.8 years.

 

Note 4.

Preferred Stock

On March 5, 2008 the Board of Directors approved the payment of one year of accrued dividends on convertible preferred stock, Series B, to shareholders of record as of December 31, 2007. This payment of $24,566 was disbursed on June 30, 2008.

Note 5.

Inventory

Inventory is comprised of the following:

 

		September 30,			December 31,
		2008			2007
		(unaudited)
Raw materials		$	298,964		$	392,937
Work-in-progress			1,014,006			205,528
Finished goods			290,577			240,693
Inventory reserve			(90,089	)		(82,159	)
		$	1,513,458		$	756,999

 

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Note 6.

Earnings Per Share

Basic income per share is calculated as income available to common stockholders divided by the weighted average of common shares outstanding. Diluted earnings per share is calculated as diluted income available to common stockholders divided by the diluted weighted average number of common shares. Diluted weighted average number of common shares has been calculated using the treasury stock method for Common Stock equivalents, which includes Common Stock issuable pursuant to stock options and Common Stock warrants. The following is provided to reconcile the earnings per share calculations:

 

		Three months ended Sept. 30, 2008			Three months ended Sept. 30, 2007			Nine  months ended Sept. 30, 2008			Nine months ended Sept. 30, 2007
Income applicable to common shares		$	198,635		$	30,011		$	11,390		$	186,706
Weighted average common shares outstanding – basic			3,560,196			3,468,756			3,520,490			3,457,005
Effect of dilutions – stock options/warrants			526,710			747,564			601,949			767,894
Weighted average common shares outstanding – diluted			4,086,906			4,216,320			4,122,439			4,224,899

 

Note 7.

Capital Requirements

The Company’s accumulated deficit since inception was $7,496,634 (unaudited) at September 30, 2008. Historically, the losses have been financed primarily from additional investments and loans by major shareholders and private offerings of common stock and warrants to purchase common stock. The Company cannot assure that it will be able to raise additional capital in the future to fund its operations.

As of September 30, 2008, cash on-hand was $906,409. Management believes, based on forecasted sales and expenses, that funding will be adequate to sustain operations at least through September 30, 2009.

Numerous factors may make it necessary for the Company to seek additional capital. In order to support the initiatives included in its business plan, the Company may need to raise additional funds through public or private financing, collaborative relationships or other arrangements. Its ability to raise additional financing depends on many factors beyond its control, including the state of capital markets, the market price of its common stock and the development or prospects for development of competitive products by others. Because the common stock is not listed on a major stock exchange, many investors may not be willing or allowed to purchase it or may demand steep discounts. The additional financing may not be available or may be available only on terms that would result in further dilution to the current owners of the common stock.

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SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Note 8.

Note Payable

During the third quarter of 2006, the Company met with the Development Financing Advisory Council (DFAC) of the Ohio Department of Development (ODOD) and applied for a loan from the Innovation Ohio Loan Fund. The Company was subsequently approved for a 166 Direct Loan from the ODOD in the amount of $400,000. These funds were received in July of 2008. The proceeds were used to reduce the balance on current outstanding capital lease obligations. The term of the loan is 84 months at an interest rate of 3%. There is also a one-quarter percent annual servicing fee to be charged monthly on the outstanding principal balance. During each of the first 12 months the Company will make only monthly servicing fee and interest payments. During months 13 through 84, the Company will make monthly servicing fee, interest and principal payments. The loan principal balance will be fully amortized over the last 72 months.

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Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Financial Statements and Notes contained herein and with those in our Form 10-KSB for the year ended December 31, 2007.

 

Except for the historical information contained herein, the matters discussed in this Quarterly Report on Form 10-Q include certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Those statements include, but may not be limited to, all statements regarding our intent, belief, and expectations, such as statements concerning our future profitability and operating and growth strategy. Words such as “believe,” “anticipate,” “expect,” “will,” “may,” “should,” “intend,” “plan,” “estimate,” “predict,” “potential,” “continue,” “likely” and similar expressions are intended to identify forward-looking statements. Investors are cautioned that all forward-looking statements contained in this Quarterly Report on Form 10-Q and in other statements we make involve risks and uncertainties including, without limitation, the factors set forth under the caption “Risk Factors” included in our Annual Report on Form 10-KSB for the year ended December 31, 2007, and other factors detailed from time to time in our other filings with the Securities and Exchange Commission. One or more of these factors have affected, and in the future could affect our business and financial condition and could cause actual results to differ materially from plans and projections. Although we believe the assumptions underlying the forward-looking statements contained herein are reasonable, there can be no assurance that any of the forward-looking statements included in this Quarterly Report on Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

 

Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statements are made or reflect the occurrence of unanticipated events, unless necessary to prevent such statements from becoming misleading. New factors emerge from time to time and it is not possible for us to predict all factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

Overview

 

SCI Engineered Materials, Inc. (“SCI” or the “Company”), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987. We manufacture ceramic and metal sputtering targets for a variety of industrial applications including: Photonics, Semiconductor, Thin Film Battery and, to a lesser extent HTS materials. Photonics (which includes solar) currently represents the largest market for our targets. Thin Film Battery is a developing market where manufacturers of batteries use our targets to produce very small power supplies with small quantities of stored energy. Semiconductor is a developing market. We hired additional marketing staff during late 2006 to develop opportunities in this market, and we added to our sales staff in late 2007 for the purpose of focusing on opportunities for our products in the Solar industry. We also added staff to our Technology group during the second half of 2007 for the development of innovative products. During the third quarter of 2008 we entered into an exclusive agreement with a manufacturer’s representative headquartered in Ede, The Netherlands. This firm will market and sell our sputtering targets for Thin Film Solar applications in 26 European countries plus Russia and Turkey.

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Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Executive Summary

For the nine months ended September 30, 2008, we had revenues of $7,240,088. This was a decrease of $1,207,601, or 14.3%, compared to the nine months ended September 30, 2007. The decrease in revenues was attributed to a reduction in the cost of a high value raw material. We anticipate that the cost of this high value raw material will continue to be lower for the remainder of 2008 compared to 2007. Revenues for the third quarter of 2008 were a record $4,008,635, which was the first time we have had quarterly revenues in excess of $4 million. The increase in revenues was mostly attributable to one of our largest customers who increased orders on certain targets that shipped during the third quarter and also by increased revenues for other products. We do not expect the orders for this customer to remain at this level in the fourth quarter of 2008. The order backlog at September 30, 2008 was $2.7 million, which was essentially the same as June 30, 2008.

Reflecting positive benefits from product mix, gross profit increased 12.0% to $1,636,438 for the first nine months of 2008 from $1,461,381 for the same period in 2007. Gross margin increased to 22.6% of total revenues for the first nine months of 2008 from 17.3% for the same period in 2007. For the third quarter of 2008 gross profit was $769,566 compared to $489,633 for the third quarter of 2007, an increase of $279,933, or 57.2%. Gross margin increased to 19.2% for the third quarter of 2008 from 18.9% for the third quarter of 2007.

For the nine months ended September 30, 2008, we had net income applicable to common shares of $11,390 compared to $186,706 for the same period in 2007. This decrease can be largely attributed to additional operating expenses of approximately $294,000 along with an increase in depreciation expense. For the three months ended September 30, 2008, we had net income applicable to common shares of $198,635 compared to $30,011 for the same period in 2007. We continued to invest in R&D, marketing, and sales to take advantage of current and future market opportunities. During the past 24 months we have been actively marketing to additional customers in select markets. This has resulted in trial and qualification orders that were shipped to customers in the semiconductor and solar industries during the first nine months of 2008 that totaled approximately 14% of our revenues. We have received additional trial orders that should ship during the fourth quarter of 2008.

We received notification during the third quarter of 2008 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $125,000. This award provides support for Phase II of an SBIR award entitled “Flux Pinning Additions to Increase Jc Performance in BSCCO-2212 Round Wire for Very High Field Magnets.” The final amount of the award is still in negotiations and is expected to total approximately $750,000. The work on the contract began during the third quarter of 2008 and is expected to continue through August 2010.

We received notification during the second quarter of 2008 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $99,961. This award provides support for Phase I of an SBIR award entitled “Homogenous BSCCO-2212 Round Wires for Very High Field Magnet Applications.” The work on the contract began during the third quarter of 2008.

We received notification during the second quarter of 2007 from the Department of Energy of a Notice of Financial Assistance Award in the amount of $97,900. This award provides support for Phase I of a Small Business Innovative Research (SBIR) award entitled “Flux Pinning Additions to Increase Jc Performance in BSCCO-2212 Round Wire for Very High Field Magnets.” The work on the contract was completed during the first quarter of 2008.

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Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

RESULTS OF OPERATIONS

Nine months ended September 30, 2008 (unaudited) compared to nine months ended September 30, 2007 (unaudited):

Revenues    

Revenues for the nine months ended September 30, 2008 were $7,240,088 compared to $8,447,689, for the same period last year, a decrease of $1,207,601 or 14.3%. The revenue decline can be attributed to the ongoing purchase of raw materials whose prices have historically experienced periods of significant fluctuation. Cost changes for this high value raw material are fully reflected in the final selling price that insulates us from market risk associated with the raw material. We anticipate the cost of this high value raw material will continue to be lower for the remainder of 2008. This will result in lower total revenues. Revenues exclusive of this high value raw material increased approximately $500,000, or 19.0% over the first nine months of 2007.

Gross Profit

Gross profit for the nine months ended September 30, 2008 was $1,636,438 compared to $1,461,381 for the nine months ended September 30, 2007. Gross margin as a percentage of revenue was 22.6% for the nine months ended September 30, 2008 versus 17.3% for the nine months ended September 30, 2007. The increase in gross margin was primarily due to less cost related to the high value raw material that has low margins and product mix.

Marketing and Sales Expense

Marketing and Sales expense for the nine months ended September 30, 2008 increased 33.1% to $441,556 from $331,703 for the same period in 2007. The increase was due to the addition of staff and increased travel. We added a sales engineer late in 2007 to focus marketing efforts on applications in the rapidly expanding Thin Film Solar market.    

General and Administrative Expense

General and administrative expense for the nine months ended September 30, 2008 increased to $751,562 from $669,423 for the nine months ended September 30, 2007, or 12.3%. The increase was due to an increase in staff and professional fees.

Research and Development Expense

Research and development expense for the first nine months of 2008 was $355,785 compared to $253,980 for the same period in 2007, an increase of 40.1%. The increase was due to additional staff and expenses associated within the continued development efforts in the Photonic, Solar, Thin Film Battery and Semiconductor markets as well as research related to the SBIRs.

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Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Interest Income and Expense

Interest income was $19,744 and $48,721 for the nine months ended September 30, 2008 and 2007, respectively.

Interest expense was $79,487 and $56,433 for the nine months ended September 30, 2008 and 2007, respectively. The increase was due to additional capital lease obligations incurred for the purchase of production equipment for increased production capacity.

 

INCOME APPLICABLE TO COMMON SHARES

Income applicable to common shares was $11,390, or $0.00 per basic common share and $186,706, or $0.05 per basic common share for the nine months ended September 30, 2008 and 2007, respectively. Basic net income per common share before dividends on preferred stock was $0.01 and $0.06 for the nine months ended September 30, 2008 and 2007, respectively. The income applicable to common shares includes net income from operations and the accretion of Series B preferred stock dividends. Dividends on the Series B preferred stock accrue at 10% annually on the outstanding shares. Dividends accrued during the nine months ended September 30, 2008 and 2007, was $18,402 and $18,837, respectively.

 

Basic net income for the nine