Summary of ADA-ES INC - Yahoo! Finance

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

This Report contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties. Words or phrases such as "anticipate," "assume," "believe," "hope," "expect," "intend," "plan," the negative expressions of such words, or similar expressions are used in this Report to identify forward-looking statements, and such forward-looking statements include, but are not limited to, statements or expectations regarding:

(a) existing and expected future national and state environmental laws and regulations and their impact on our target markets;

(b) rapid development of the mercury emission control market;

(d) amounts and timing of future financial measures including revenues, expenses, gross margins, cash flows and financing needs;

(e) the timing of completion of projects and future demonstrations;

(f) the expected costs and timing for the development of and commencement of operations at our activated carbon ("AC") Facility and offsite processing facility, including statements regarding project costs, equity and debt financing, participation of our strategic partner, availability of raw materials and facilities and securing long term customer contracts for delivery of AC;

(g) our ability to meet a significant portion of the expected shortage in AC supply;

(h) the appropriation of funds by Congress for DOE projects;

(i) pending legal proceedings

(j) availability of skilled personnel; and

(k) the immateriality of any future adjustments to previously recognized revenue as a result of DOE audits.

The forward-looking statements included in this Report involve significant risks and uncertainties. Actual events or results could differ materially from those discussed in the forward-looking statements as a result of various factors including, but not limited to: changing economic conditions and market demand for our products and services, changes in technology, availability of and demand for alternative energy sources, failure to satisfy performance guarantees, availability of adequate supplies of treatable carbon at reasonable prices to meet AC demand, the availability of federal funding to support our research and development work, changes in the costs and timing of construction of the planned AC Facility, failure to satisfy funding or other conditions in the equity financing agreements providing financing for the AC Facility, inability to sign or close acceptable definitive agreements for debt financing, coal supply or off-take agreements with respect to the AC Facility in a timely manner, our ability to secure necessary permits and other regulatory approvals, to negotiate and enter into ancillary agreements needed to allow us to finance, design and build the new AC plant and to obtain necessary raw materials to supply the plant, anticipated or unexpected changes in laws or regulations, competition, litigation, cost increases, results of demonstrations of ADA's and other's licensed technologies, operational difficulties, availability of skilled personnel and other risks related to the development, construction and placing into operation of the AC Facility, as well as other factors relating to our business, as described in our filings with the U.S. Securities and Exchange Commission ("SEC"), with particular emphasis on the risk factor disclosures contained in those filings. You are cautioned not to place undue reliance on the forward-looking statements made in this Report, and to consult filings we have made and will make with the SEC for additional discussion concerning risks and uncertainties that may apply to our business and the ownership of our securities. The forward-looking statements contained in this Report are presented as of the date hereof, and we disclaim any duty to update such statements unless required by law to do so.

Overview

We develop and implement proprietary environmental technology and provide specialty chemicals to the coal-burning electric utility industry. Revenues are generated through (1) the supply of powdered activated carbon injection ("ACI") systems, mercury measurement instrumentation and related services for the emerging mercury emission control ("MEC") market, including projects that are co-funded by government (Department of Energy - "DOE") and industry and (2) the sale of specialty chemicals and services for flue gas conditioning ("FGC") and other applications. We have also begun research and development efforts in CO2 capture and control from coal-fired boilers, and we recently signed and commenced work on our first significant contract for this work which is scheduled to continue over at least the next two years. In addition, through a joint venture with Energy Capital Partners I, LP and its affiliated funds ("ECP") we are developing a new AC Facility for the manufacture of AC for mercury control applications and are developing interim sources of AC to supply to utility customers until such time as the AC Facility is operational. We are also developing and marketing our refined coal technology through our Clean Coal joint venture with NexGen Refined Coal, LLC, an affiliate of NexGen Resources Corporation.

Mercury has been identified as a toxic substance and, pursuant to a court order, the EPA issued regulations for its control in March 2005. A dozen States and several environmental groups had previously sued the EPA alleging that the process that resulted in the relatively lenient Clean Air Mercury Rule ("CAMR") violated the Clean Air Act and that CAMR was therefore invalid. In February 2008, the United States Court of Appeals for the District of Columbia Circuit ruled in favor of the plaintiffs in that case, holding that the EPA violated the Clean Air Act in the process it used to enact CAMR, and that CAMR was therefore invalid. The Court's ruling remands the matter to the EPA for further proceedings; and the EPA filed an appeal of the ruling with the Court. In May 2008, the District of Columbia Circuit Court rejected the EPA's petition for an en banc rehearing on CAMR. The EPA says that it is evaluating its course of action. In the interim, the lack of clear regulations has generated some short-term uncertainty among utilities as to what they will be required to do to reduce mercury emissions and is impacting their ability to include mercury control costs in their rate bases. However, we believe that the likely result will be that either EPA will adopt stricter mercury emission control rules or Congress will enact new legislation requiring stricter mercury emission control within the next year or two.

We expect the mercury control market to grow significantly with a new Federal rule, and the likelihood of such a rule increased on July 11, 2008 when the U.S. Court of Appeals unanimously rejected EPA's Clean Air Interstate Rule ("CAIR"). Announced in 2005, the CAIR regulation required 28 mostly Eastern states to reduce SO2 and NOx emissions from power plants. The vacatur of CAIR creates difficulties for all parties involved: the environmentalists are concerned about public health issues related to continued higher levels of emissions of pollutants, the States are concerned because they have federal mandates to come into compliance with particulate and ozone requirements and their implementation plans were based upon control equipment being added because of CAIR; and finally the power generators are faced with trying to recover costs for capital equipment that now has no regulatory driver. Because of these issues, the vacaturs of both CAMR and CAIR have created a strong motivation for Congress to fix the problem through multi-pollutant legislation for SO2, NOx, and mercury. While federal regulation remains uncertain, the market remains strong in 14 states that have passed their own mercury control regulations, for new power plants and several Canadian provinces. We believe that the long-term growth of the MEC market for the electric utility industry will most likely depend on how industry chooses to respond to federal and state regulations. We anticipate this will create an even larger market for our mercury control products beyond 2010. As many as 1,100 existing coal-fired boilers may be affected by such regulations, if and when they are fully implemented. DOE's latest report issued in 2008 includes 110 existing and planned plant projects totaling 64 GW of capacity. Permitting of new coal-fired plants generally requires them to meet more stringent requirements that likely include MEC. For the near-term, our revenues from this market will be dependent on (i) equipment sales of ACI systems, (ii) mercury testing services, and (iii) AC sales to new and existing plants affected by the implementation of enacted regulations. State regulations and increasing numbers of consent decrees, which were unaffected by the invalidation of CAMR are the largest market driver for this part of our business. Although we expect this market to show steady growth over the next several years, we believe the most significant revenue growth will occur when final federal regulations or legislation impacts a significant portion of previously uncontrolled, existing boilers.

Thus far in 2008, we have signed contracts or orders to proceed for 6 ACI systems to be delivered in 2008 through 2009, bringing our total number of ACI systems installed or currently in process to 35. During the three and nine months ended September 30, 2008 we recognized approximately $3.1 million and $7.8 million, respectively in revenue related to ACI systems sales. Unrecognized remaining revenue from ACI system contracts totaled approximately $7.5 million as of September 30, 2008 which is expected to be recognized from 2008 through 2010. We expect to realize approximately $2.1 million of that amount in the remaining three months of 2008. ACI systems are usually delivered from 12 to 16 months after the award, but may be in excess of two years for installations at new power plants. We expect the supply of ACI systems to be our dominant revenue source for 2008 and expect to bid on between 30 and 40 ACI systems through 2009 based upon current regulations. Given the uncertainties surrounding the recent court rulings concerning CAMR we are projecting that our revenues from sales of ACI systems will show little growth, if any over 2007.

The market for our FGC chemicals and services has been declining over the last couple of years, and is expected to continue to decline in the near-term or at least until the recent uncertainty caused by the CAMR ruling has been eliminated. Prior to the CAMR ruling we were responding to inquiries about our product meeting the needs of the changing regulations in combination with mercury emissions. Although margins on these products are declining, they are typically higher than what we recognize for our present MEC sales and represent an important, but decreasing, contribution to our overall revenue and profit potential.

The DOE committed to provide us $2.0 million in funds for the purpose of executing our project, entitled "Evaluation of Solid Sorbents as a Retrofit Technology for CO2 Capture from Coal-Fired Power Plants" which commenced on October 1, 2008. In addition, several coal-fired power plants have provided letters of commitment to contribute approximately $1.2 million in additional funding for the project. We are designing this technology to provide a means of reducing emissions of greenhouse gases from coal-fired boilers based around the use of solid sorbents. Most competing technologies use liquid solvents such as ammonia or amines to accomplish this task.

To date, we have made significant progress in the development of our AC Facility to produce AC for the use in capturing mercury from coal-fired power plants. Previously, we had announced that in order to stay ahead of an expected billion dollar market, we had undertaken preliminary activities for the new AC Facility including plant design, engineering and initial permitting for the initial site development in Louisiana and for additional sites in North Dakota and third-party market analysis.

The following major milestones have been accomplished in 2008:

� The Louisiana Department of Environmental Quality approved our permit to construct and operate a facility for the first two production lines capable of producing up to 350 million pounds per year of AC in Red River Parish in Northwest Louisiana. In addition, we purchased the land of the building site.

� We entered into long-term customer off-take contracts with Luminant and another major utility to supply treated AC. The confirmed minimum volumes will result in total revenues for the initial terms of the contracts in excess of $160 million. The two five-year contracts require us to begin delivering AC upon written notice from the utilities. Early supply of AC will be provided by our interim supply program, described below, until mid-2010, when we expect the new AC Facility to commence operations. Both contracts provide for option periods in which the utilities could increase AC quantities, which could result in significant additional revenues.

� We entered into a contract with BE&K Construction Company, an engineering, procurement and construction ("EPC") company to perform work needed to build the first production line. Site work began in August 2008.

� We entered into contracts with two critical suppliers to initiate the construction of the AC Facility. First, we entered into contracts for the purchase of four multiple-hearth furnaces, which are key components of the AC production process. Second, our EPC contractor entered into an agreement for the purchase of a boiler to generate steam for manufacturing AC. We believe that these contracts keep us on the critical path to maintain the schedule for the AC Facility to start producing AC mid-2010.

� We formed a joint venture with ECP for the AC Supply Business. Pursuant to the LLC Agreement for the AC Joint Venture, ECP will provide, subject to certain conditions, the equity capital required to construct the first production line of the new AC Facility.

The AC Joint Venture is continuing the process of specifying and sourcing key capital equipment, negotiating agreements to support facility operations, including feedstock supply, and negotiating long-term customer off-take contracts to satisfy the securitization requirements for project financing. "All-in" capital costs for the AC Facility are anticipated to be approximately $350 million.

In order to supply early and interim quantities of AC to the utility mercury control market, we acquired from Winfield Industries the assets of an AC processing facility and entered into a take or pay Carbons Supply Agreement with Winfield to purchase AC beginning in 2008, with annual quantities expected to increase to over 20 million pounds during 2009 with additional amounts available for 2010. The AC processing facility and Carbon Supply Agreement were assigned to Crowfoot Supply in October 2008 under the JDA. Initial capital expenditures were approximately $412,000 plus the purchase of existing AC inventory and a processing facility lease, which are capitalized on our balance sheet under Development Projects. From this facility, we produced our first batch of treated AC and performed a full scale power plant test that achieved greater than 90% mercury removal. A number of additional tests are under way and others scheduled to allow clients to evaluate this product. Given the expected costs of the foreign carbons to be used for processing plus the transportation expenses in shipping AC from overseas, our AC Supply Business is expected to operate at significantly lower margins than the anticipated margins for the planned AC Facility. The AC Joint Venture is also developing a larger offsite processing facility that is expected to operate prior to and then in conjunction with the planned AC Facility. The AC Joint Venture is currently procuring additional AC processing equipment to enable us to expand capacity to over 30 million pounds of AC per year.

The AC Joint Venture is planning to secure 60% of the financing, or what we expect will be approximately $210 million, through debt financing. We are working to support the senior project debt with off-take contracts for the AC that we expect to supply through both interim sources and the new production from the plant. We hope to put in place long-term take or pay off-take contracts for AC that will have a total contract value of approximately $250 million, $160 million of which are in place. In addition to the debt financing, the AC Joint Venture is planning to fund 40% of the expected project requirements through equity. Our financing plan is based on the contribution by ECP of at least 50% of this amount at the project level including a matching contribution of our internal project expenditures to date under the LLC Agreement. We expect to fund future capital contributions to the AC Joint Venture with funds from additional equity financing at the ADA-ES corporate level under the SPA for the Private Placement working capital and, if deemed appropriate, funds from additional sales up to 1 million shares of our common stock.

We will be soliciting approval of our shareholders for the Private Placement and the issuance of up to 1 million additional shares of common stock pursuant to a definitive Proxy Statement to be filed with the SEC, which will contain additional information regarding the AC Joint Venture and the transactions between ECP and ADA-ES. We filed a preliminary Proxy Statement with the SEC on October 22, 2008.

Results of Operations - 3 rd Quarter and YTD 2008 versus 3rd Quarter and YTD 2007

Revenues totaled $5.0 million and $12.9 million for the three and nine months ended September 30, 2008, respectively versus $5.6 million and $14.4 million for the three and nine months ended September 30, 2007, respectively, representing decreases of (10%) and (11%) for the quarter and year to date, respectively. We expect overall revenues for 2008 will show little growth, if any, over 2007. Revenues in our MEC segment for 2008 decreased for the third quarter and nine months by ($287,000) and ($868,000), respectively (6% for both periods), and FGC and other activities decreased by ($281,000) and ($696,000), respectively (61% and 65%) as compared to the same periods in 2007.

Revenues from the MEC segment for the nine months ended September 30, 2008 were comprised of ACI systems (62%), government and industry-supported contracts (27%), and consulting services (11%), compared to 51%, 41% and 8%, respectively, in 2007. We had contracts in progress at quarter-end for supply of ACI systems with remaining revenue of approximately $7.5 million, which is expected to be recognized from 2008 through 2010. We expect to realize approximately $2.1 million of that amount in the remaining three months of 2008. As mentioned above, CAMR issues have resulted in utilities delaying deliveries and installations up to 3 to 6 months and continuing to delay previously planned ACI systems from being awarded although activity in the third quarter has improved. Our ACI systems revenues were $3.1 million and $7.8 million for the three and nine months ended September 30, 2008, representing an increase of 25% and 15%, compared to those same periods in 2007. However, despite the uncertainty being caused by the CAMR remand, we anticipate our ACI systems revenue will continue to grow in 2008 primarily as a result of an increasing number of retrofit ACI systems in response to mercury emission control legislation enacted by states as evidenced by the significant increase in bid and proposal activity for ACI systems we saw in the third quarter.

Our DOE and industry mercury demonstration contract revenues totaled $1.0 million and $3.4 million for the three and nine months ended September 30, 2008, representing a decrease of 55% and 39% compared to 2007. Based on the scope of work to be performed as of September 30, 2008, the expected remaining unearned revenue for DOE related contracts was $4.4 million, of which $684,000 is expected to be recognized in the remaining three months of 2008 (including cash contributions by other industry partners). We expect the DOE funding for mercury related projects to continue to decline or be eliminated, however we expect increased funding for CO2 capture technology from government and industry supported contracts will begin to replace that source of revenue for us beginning in late 2008. As reported earlier future commitments on two of our DOE mercury contracts, amounting to $600,000 have not been made as of September 30, 2008 and it is unclear whether the funds will be allocated and paid on the contracts. Those funds remain at risk pending DOE final decision and are not included in the amounts above. In addition, in 2008 we conducted independent industry sponsored demonstrations related to mercury and CO2 control that generated approximately $211,000 and $594,000 in revenues, for the three and nine months ended September 30, 2008, respectively.

Our contracts with the government are subject to audit by the federal government, which could result in adjustment(s) to previously recognized revenue. We believe, however, that we have complied with all requirements of the contracts and future adjustments, if any, will not be material. In addition, the federal government must appropriate funds on an annual basis to support DOE contracts, and funding is always subject to unknown and uncontrollable contingencies.

Revenues from consulting services included in the MEC segment totaled $798,000 and $1.3 million for the three and nine months ended September 30, 2008, representing an increase of 48% and 30% compared to 2007. This increase was primarily related to two new mercury control test programs that commenced in the second quarter of 2008.

FGC and other revenues for the three and nine months ended September 30, 2008 decreased by $281,000 and $696,000 or 61% and 65%, respectively, due to fewer shipments of chemical to continuing customers and one customer not extending an equipment lease. We expect FGC and other revenues in 2008 to be likewise lower than in 2007. Demonstrations planned for 2008 have been delayed or cancelled due to the recent CAMR ruling and we are uncertain if these demonstrations will be conducted. Sales related to our ADA-249M product, which are recorded in the FGC and other segment also declined and were $58,000 and $97,000 for the nine months ended September 30, 2008 and 2007, respectively.

Cost of revenues decreased by $357,000 and $1.2 million or 10% and 13% for the three and nine months ended September 30, 2008, respectively from the same periods in 2007 primarily due to changes in our business mix, a decline in the amount of direct work being performed on DOE contracts, and a decline in chemical sales, offset by improved efficiency in our ACI system production. Gross margins were 33% and 34% for the three and nine months ended September 30, 2008 respectively, as compared to 33% for both the periods in 2007. For the near term, we expect the sales of ACI systems to continue to represent an increasing source of revenues, for

which the anticipated gross margins are lower than both of our specialty chemical sales and our DOE demonstration work that involves industry cost sharing. As a result, we expect the gross margin for fiscal year 2008 to approximately equal the 31% margin realized in fiscal year 2007.

Cost of revenues for the MEC segment decreased by $254,000 and $846,000 or 7% and 9% for the three and nine months ended September 30, 2008, respectively, from the same periods in 2007, primarily from reduced amount of direct DOE work being performed and a decrease in outsourcing portions of our ACI systems, offset by an increase in commercial consulting that generally has higher margins than the ACI systems sales. Enhanced design and engineering in our ACI system group has allowed us to adopt procedures to complete systems "in-house" at lower costs. Gross margins for the MEC segment were 33% and 35% for the three and nine months ended September 30, 2008 respectively, as compared to 32% and 33% for 2007. We are continuing our efforts to decrease costs and improve efficiencies to maintain acceptable margins from our ACI system sales. Competition in the ACI systems sales has required, and we expect may continue to require us to lower our margins to maintain our desired market share. In the short term, we anticipate our commercial mercury consulting services will increase and positively enhance our margins. Looking further ahead, we expect CO2 government and industry supported demonstration work and sales of AC to also positively affect margins.

Cost of revenues for the FGC and other segment decreased by $103,000 and $364,000 or 49% and 57% for the three and nine months ended September 30, 2008, respectively, from the same periods in 2007. Gross margins for this segment were 40% and 25% for the three and nine months ended September 30, 2008 respectively, as compared to 54% and 40% for 2007. The decrease in gross margins from 2008 to 2007 is a result of increased costs related to the current joint venture activities of Clean Coal, a greater portion of FGC sales of a product we license from ARKAY Technologies, which carries a lower margin than historical FGC sales, and overall lower chemical sales. FGC and other revenues comprised 3% of total revenues for the nine months ended September 30, 2008, compared to 7% for the nine months ended September 30, 2007. The changes in the FGC segment profits for the nine months ended September 30, 2008 from the nine months ended September 30, 2007 are a result of the same factors mentioned above.

For the MEC segment we expect the sale of ACI systems to continue to represent an increasing source of revenues, for which the anticipated gross margins are lower than our contract R&D work. As a result and based on our expected revenue mix, we expect the gross margin for fiscal year 2008 to decline from the levels achieved for the nine months ended September 30, 2008 to approximately equal gross margins realized in 2007.

General and administrative expenses increased by $216,000 and $517,000 or 15% and 13% to approximately $1.6 million and $4.6 million for the three and nine months ended September 30, 2008, respectively, from the same periods in 2007. The dollar increase in the three months ended September 30, 2008 resulted primarily from increased legal fees ($143,000) and from wage related taxes and benefits ($69,000). The dollar increase in the nine months ended September 30, 2008 resulted primarily from increased wage related taxes and benefits ($211,000) and increased legal costs ($203,000), increased administrative and overhead wage costs ($121,000), increased facilities and office costs ($106,000) which were offset by a decrease in Sarbanes-Oxley compliance costs and miscellaneous consulting costs of $113,000 because of our change in status to a smaller reporting company. We have been hiring personnel in response to the growth we have realized in the past and expect to achieve in 2008. Adequate resources of skilled labor have been and are expected to be available to meet anticipated needs.

The increasing legal costs are principally related to transactions in the AC Supply Business and a lawsuit filed against us by Norit Americas, Inc. ("Norit"). We expect continued increases in legal fees because of the actions filed against us by Norit and Calgon Carbon Corporation ("Calgon"), respectively. See Part II, Item 1 below. Responding to Norit's or similar claims, whether or not they are ultimately found to have merit, will be time consuming and costly, adversely impact our ability to obtain funding for our planned AC Facility, cause development delays, require us to enter into royalty or license agreements, or require us to cease using technology that is . . .