Summary of AROTECH CORP - Yahoo! Finance

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements involve inherent risks and uncertainties. When used in this discussion, the words "believes," "anticipated," "expects," "estimates" and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forth elsewhere in this report. Please see "Risk Factors," below, and in our other filings with the Securities and Exchange Commission.

Arotech™ is a trademark and Electric Fuel® is a registered trademark of Arotech Corporation. All company and product names mentioned may be trademarks or registered trademarks of their respective holders. Unless the context requires otherwise, all references to us refer collectively to Arotech Corporation and its subsidiaries.

We make available through our internet website free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to such reports and other filings made by us with the SEC, as soon as practicable after we electronically file such reports and filings with the SEC. Our website address is www.arotech.com. The information contained in this website is not incorporated by reference in this report.

The following discussion and analysis should be read in conjunction with the interim financial statements and notes thereto appearing elsewhere in this Quarterly Report. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than 1.0 million, in which event we have rounded such amounts to the nearest hundred thousand.

Executive Summary

Divisions and Subsidiaries

We are a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercial markets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. We operate in three business units:

† we develop, manufacture and market advanced high-tech multimedia and interactive digital solutions for use-of-force and driving training of military, law enforcement, security and other personnel (our Training and Simulation Division);

† we provide aviation armor kits and we utilize sophisticated lightweight materials and advanced engineering processes to armor vehicles (our Armoring Division); and

† we develop, manufacture and market primary Zinc-Air batteries, rechargeable batteries and battery chargers for defense and security products and other military applications (our Battery and Power Systems Division).

Recent Developments

AoA Arbitration

In connection with our acquisition of AoA, we had a contingent earnout obligation in an amount equal to the revenues AoA realized from certain specific programs that were identified by us and the seller of AoA ("Seller") as appropriate targets for revenue increases. As of December 31, 2006, we had reduced the $3.0 million escrow held by the Seller by $1,520,000 for a putative claim against such escrow in respect of such earnout obligation.

On March 20, 2007, we filed a Demand for Arbitration with the American Arbitration Association against the Seller. In our demand, we sought the return of $3.0 million, plus interest, held in escrow by the Seller in connection with his sale of AoA to us in 2004. The Seller asserted counterclaims against us in the arbitration, alleging (i) that he is entitled to keep the $3.0 million, (ii) that he is entitled to an additional $3.0 million in post-sale earnout, and
(iii) that he is entitled to $70,000 in compensation (plus interest and statutory penalties) wrongfully withheld by us when we constructively terminated his employment.

In February 2008, the arbitration panel issued a decision denying the Seller's counterclaims (i) and (ii) above, granting the Seller's counterclaim for $70,000 in compensation, awarding us the entire $3.0 million escrow (less the $70,000 in compensation (with simple interest but without statutory penalties)), awarding us $135,000 in attorneys' fees, and interest of approximately $325,000. This award was paid to us in April 2008, and the time for the Seller to move to vacate or modify this award has now expired. In the first quarter of 2008, we adjusted the escrow receivable to reflect the updated amount of the escrow due to the arbitration panel's decision and final resolution of the remaining legal questions.

Overview of Results of Operations

We incurred significant operating losses for the year ended December 31, 2007 and for the first six months of 2008. While we expect to continue to derive revenues from the sale of products that our subsidiaries manufacture and the services that they provide, there can be no assurance that we will be able to achieve or maintain profitability on a consistent basis.

A portion of our operating loss during 2007 and the first six months of 2008 arose as a result of non-cash charges. These charges were primarily related to our acquisitions, financings and issuances of restricted shares and options to employees. To the extent that we continue these activities during the remainder of 2008, we would expect to continue to incur such non-cash charges in the future.

Acquisitions

In acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill. Amortization of intangible assets related to acquisition of subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related to amortization of intangible assets in the amount of a fraction (based on the useful life of the intangible assets) of the amount recorded as intangible assets. Such amortization charges continued during 2008. We are required to review intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of the assets may not be recoverable. If we determine, through the impairment review process, that intangible asset has been impaired, we must record the impairment charge in our statement of operations. We incurred non-cash charges for amortization of intangible assets in the amount of $985,000 during the first six months of 2008.

In the case of goodwill, the assets recorded as goodwill are not amortized; instead, we are required to perform an annual impairment review. If we determine, through the impairment review process, that goodwill has been impaired, we must record the impairment charge in our statement of operations. The Company is currently performing its impairment review, which is done annually using the June 30 results. We expect to complete our review during the third quarter and as noted, will record impairment charges, if any, as determined in this review.

Financings and Issuances of Restricted Shares and Options

During 2006 and 2007, we issued options and restricted shares to certain employees along with restricted shares to our directors in 2007 and 2008. These options and shares were issued as bonuses, and generally vest over a period of two or three years from the date of issuance. Relevant accounting rules provide that the aggregate amount of the difference between the purchase price of the restricted shares (in this case, generally zero) and the market price of the shares on the date of grant is taken as a general and administrative expense, amortized over the life of the period of the restriction.

As a result of the application of the above accounting rules, we incurred, for the six months ended June 30, 2008 and 2007, compensation expense related to stock options and restricted shares of approximately $631,000 and $1.0 million, respectively, of which $34,000 and $104,000, respectively, was for stock options and $597,000 and $928,000, respectively, was for restricted shares.

Overview of Operating Performance and Backlog

Overall, our net loss before minority interest earnings, earnings from affiliated company and tax expenses for the six months ended June 30, 2008 was $2.8 million on revenues of $25.9 million, compared to a net loss of $2.8 million on revenues of $24.6 million during the six months ended June 30, 2007. As of June 30, 2008, our overall backlog totaled $51.6 million.

In our Training and Simulation Division, revenues increased from approximately $9.4 million in the first six months of 2007 to $14.7 million in the first six months of 2008. As of June 30, 2008, our backlog for our Training and Simulation Division totaled $20.5 million.

In our Battery and Power Systems Division, revenues increased from approximately $5.1 million in the first six months of 2007 to approximately $5.3 million in the first six months of 2008. As of June 30, 2008, our backlog for our Battery and Power Systems Division totaled $12.7 million.

In our Armor Division, revenues decreased from $10.1 million during the first six months of 2007 to $5.8 million during the first six months of 2008. As of June 30, 2008, our backlog for our Armor Division totaled $18.4 million.

Functional Currency

We consider the United States dollar to be the currency of the primary economic environment in which we and our Israeli subsidiary EFL operate and, therefore, both we and EFL have adopted and are using the United States dollar as our functional currency. Transactions and balances originally denominated in U.S. dollars are presented at the original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.

The majority of financial transactions of our Israeli subsidiaries MDT and Epsilor are in New Israel Shekels ("NIS") and a substantial portion of MDT's and Epsilor's costs is incurred in NIS. Management believes that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss in shareholders' equity.

Results of Operations

Three months ended June 30, 2008 compared to the three months ended June 30, 2007.

Revenues. During the three months ended June 30, 2008, we (through our subsidiaries) recognized revenues as follows:

† FAAC and RTI recognized revenues from the sale of multimedia interactive simulators, interactive use-of-force training systems, and from the provision of maintenance services in connection with such systems.

† MDT, MDT Armor and AoA recognized revenues from payments under vehicle armoring contracts, for service and repair of armored vehicles, and on the sale of armoring products.

† EFB and Epsilor recognized revenues from the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army.

† EFL recognized revenues from the sale of water-activated battery (WAB) lifejacket lights.

Revenues for the three months ended June 30, 2008 totaled $12.6 million, compared to $13.0 million in the comparable period in 2007, a decrease of $422,000, or 3.2%. In the second

quarter of 2008, revenues were $7.2 million for the Training and Simulation Division (compared to $5.2 million in the second quarter of 2007, an increase of $2.0 million, or 38.7%, due primarily to increased sales of military vehicle simulators and use of force simulators); $2.2 million for the Battery and Power Systems Division (compared to $2.5 million in the second quarter of 2007, a decrease of $335,000, or 13.2%, due primarily to decreased sales of our battery products at Epsilor and EFB); and $3.2 million for the Armor Division (compared to $5.3 million in the second quarter of 2007, a decrease of $2.1 million, or 39.5%, due primarily to decreased revenues from MDT and MDT Armor, mostly in respect of the completion of orders for the "David" Armored Vehicle).

Cost of revenues, exclusive of amortization of intangibles. Cost of revenues totaled $9.8 million during the second quarter of 2008, compared to $9.3 million in the second quarter of 2007, an increase of $486,000, or 5.2%, due primarily to increased sales in our Training and Simulation and our Battery and Power Systems divisions offset by erosion of the margin in our Battery Division and Armor Division.

Research and development. Research and development expenses for the second quarter of 2008 were $226,000, compared to $424,000 during the second quarter of 2007, a decrease of $198,000, or 46.8%. This decrease was primarily attributable to a general reduction of research and development in the Simulation and Battery Divisions, offset by an increase in research and development expenses in the Armor Division.

Selling and marketing expenses. Selling and marketing expenses for the second quarter of 2008 were $1.1 million, compared to $1.1 million in the second quarter of 2007, an increase of $82,000, or 7.7%. This increase was primarily attributable to additional expenses in our Battery and Armor Divisions, offset by slightly reduced expenses in our Simulation Division.

General and administrative expenses. General and administrative expenses for the second quarter of 2008 were $3.3 million, compared to $2.6 million in the second quarter of 2007, an increase of $668,000, or 25.5%. This increase was primarily attributable to additional expenses in our Simulation and Battery Divisions along with additional corporate expenses, offset by reduced expenses in our Armor Division.

Amortization of intangible assets. Amortization of intangible assets totaled $492,000 in the second quarter of 2008, compared to $396,000 in the second quarter of 2007, an increase of $96,000, or 24.3%, due primarily to an increase in amortization of capitalized technology in our Training and Simulation Division along with an increase in identified intangibles due to the acquisition of RTI.

Financial income (expenses), net. Financial income (expenses) totaled approximately $137,000 in the second quarter of 2008, compared to an expense of $(503,000) in the second quarter of 2007, an improvement of $640,000, or 127.3%. The difference was due primarily to reductions in debenture expenses, debenture interest, line of credit interest and currency fluctuations in payments made in 2008

Income tax credits (expenses). We and certain subsidiaries incurred net operating losses during the three months ended June 30, 2008 and accordingly, no provision for income taxes was

recorded in this quarter. With respect to some of our subsidiaries that operated at a net profit during 2008, we were able to offset federal taxes against our accumulated loss carry forward. We recorded a total of $(108,000) in tax expense in the second quarter of 2008, compared to $69,000 in tax expense in the second quarter of 2007, a decrease of $177,000, or 256.7%, mainly concerning state and local taxes.

Net loss. Due to the factors cited above, net loss increased from $1.5 million in the second quarter of 2007 to $1.9 million in the second quarter of 2008, an increase of $463,000, or 31.2%.

Six months ended June 30, 2008 compared to the six months ended June 30, 2007.

Revenues. During the six months ended June 30, 2008, we (through our subsidiaries) recognized revenues as follows:

† MDT, MDT Armor and AoA recognized revenues from payments under vehicle armoring contracts, for service and repair of armored vehicles, and on the sale of armoring products.

† EFB and Epsilor recognized revenues from the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army.

† EFL recognized revenues from the sale of water-activated battery (WAB) lifejacket lights.

Revenues for the six months ended June 30, 2008 totaled $25.9 million, compared to $24.6 million in the comparable period in 2007, an increase of $1.3 million, or 5.3%. In the first six months of 2008, revenues were $14.7 million for the Training and Simulation Division (compared to $9.4 million in the first six months of 2007, an increase of $5.3 million, or 56.7%, due primarily to increased sales of military vehicle simulators and use of force simulators); $5.3 million for the Battery and Power Systems Division (compared to $5.1 million in the first six months of 2007, an increase of $233,000, or 4.6%, due primarily to increased sales of our battery products at Epsilor and EFB); and $5.8 million for the Armor Division (compared to $10.1 million in the first six months of 2007, a decrease of $4.3 million, or 42.2%, due primarily to decreased revenues from MDT and MDT Armor, mostly in respect of the completion of orders for the "David" Armored Vehicle due to the model changeover and unforeseen material shortages from our primary steel supplier).

Cost of revenues, exclusive of amortization of intangibles. Cost of revenues totaled $19.8 million during the first six months of 2008, compared to $16.7 million in the first six months of 2007, an increase of $3.1 million, or 18.5%, due primarily to increased sales in our Training and Simulation and our Battery and Power Systems Divisions along with erosion in margin in our Armor Division.

Research and development. Research and development expenses for the first six months of 2008 were $833,000, compared to $922,000 during the first six months of 2007, a decrease of $89,000, or 9.7%. This decrease was primarily attributable to a general reduction of research and development in the Battery Division, offset by a small increase in research and development expenses in the Simulation and Armor Divisions.

Selling and marketing expenses. Selling and marketing expenses for the first six months of 2008 were $2.3 million, compared to $2.1 million in the first six months of 2007, an increase of $193,000, or 9.2%. This increase was primarily attributable to additional expenses in our Battery and Armor Divisions, offset by slightly reduced expenses in our Simulation Division.

General and administrative expenses. General and administrative expenses for the first six months of 2008 were $6.8 million, compared to $6.3 million in the first six months of 2007, an increase of $476,000, or 7.5%. This increase was primarily attributable to additional expenses in our Simulation and Battery Divisions, offset by reduced expenses in our Armor Division and in corporate.

Amortization of intangible assets. Amortization of intangible assets totaled $985,000 in the first six months of 2008, compared to $736,000 in the first six months of 2007, an increase of $249,000, or 33.8%, due primarily to an increase in amortization of capitalized technology in our Training and Simulation Division along with an increase in identified intangibles due to the acquisition of RTI.

Escrow adjustment - credit. The escrow adjustment - credit of $1.4 million represents the first quarter adjustment to operating expenses resulting from the completion of the escrow arbitration. This was a contingent earnout obligation that was identified by us when AoA was purchased.

Financial income (expenses), net. Financial income (expenses) totaled approximately $(53,000) in the first six months of 2008, compared to $(627,000) in the first six months of 2007, an improvement of $574,000, or 91.6%. The difference was due primarily to reductions in debenture expenses, debenture interest, line of credit interest and currency fluctuations in payments made in 2008

Income taxes. We and certain of our subsidiaries incurred net operating losses during the six months ended June 30, 2008 and accordingly, no provision for income taxes was recorded in this quarter. With respect to some of our subsidiaries that operated at a net profit during 2008, we were able to offset federal taxes against our accumulated loss carry forward. We recorded a total of $12,000 in tax expense in the first six months of 2008, compared to $175,000 in tax expense in the first six months of 2007, a decrease of $163,000, or 93.2%, mainly concerning state and local taxes.

Net loss. Due to the factors cited above, net loss decreased from $3.2 million in the first six months of 2007 to $2.9 million in the first six months of 2008, a decrease of $265,000, or 8.3%.

Liquidity and Capital Resources

As of June 30, 2008, we had $1.7 million in cash, $179,000 in restricted collateral securities and restricted held-to-maturity securities due within one year, and $55,000 in available-for-sale marketable securities, as compared to December 31, 2007, when we had $3.4 million in cash, $320,000 in restricted collateral securities, $1.5 million in an escrow receivable and $47,000 in available-for-sale marketable securities.

We used available funds in the six months ended June 30, 2008 primarily for sales and marketing, continued research and development expenditures, and other working capital needs. We increased our investment in fixed assets during the six months ended June 30, 2008 by $665,000 over the investment as at December 31, 2007. Our net fixed assets amounted to $5.2 million at quarter end.

Net cash provided by (used in) operating activities from continuing operations for the six months ended June 30, 2008 and 2007 was $(487,000) and $(453,000), respectively, a decrease of $(34,000). This decrease in cash used was primarily the result of changes in working capital.

Net cash provided by (used in) investing activities for the six months ended June 30, 2008 and 2007 was $1.0 million and $(383,000) an increase of $1.3 million. This increase was primarily the result of the escrow settlement, offset by the RTI acquisition and the purchase of minority interest in MDT.

Net cash used in financing activities for the six months ended June 30, 2008 and 2007 was $(2.3) million and $(110,000), respectively, an increase of $2.2 million, primarily due to the reduction in short term bank debt.

As of June 30, 2008, we had approximately $2.3 million in bank debt outstanding compared to $4.6 million as of December 31, 2007.

Subject to all of the reservations regarding "forward-looking statements" set forth above, we believe that our present cash position, anticipated cash flows from operations and lines of credit should be sufficient to satisfy our current estimated cash requirements through the remainder of the year. In this connection, we note that from time to time our working capital needs are partially dependent on our subsidiaries' lines of credit. In the event that we are unable to continue to make use of our subsidiaries' lines of credit for working capital on economically feasible terms, our business, operating results and financial condition could be adversely affected.

Over the long term, we need to sustain profitability, at least on a cash-flow basis, to avoid future capital requirements. Additionally, we would need to raise additional capital in order to fund any future acquisitions.