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).

Overview of Results of Operations

We incurred significant operating losses for the year ended December 31, 2007 and for the first nine 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 nine 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 $1,362,000 during the first nine 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. We have completed our impairment review, which is done annually at the end of the second quarter. We have determined that the fair value of the respective reporting units exceeds their respective carrying values, and therefore, there will be no impairment charges relating to goodwill. Although the cumulative book value of our reporting units exceeds our market value as of the impairment review, management still believes that the goodwill is not impaired. Several factors confirm this judgment: the long term horizon of the valuation process versus a short term valuation using current market conditions; and the valuation by individual business segments versus the market share value based on the Company as a whole. Also, our stock is thinly traded and management feels that in the current market, our stock is undervalued, especially when compared to the estimated future cash flows of the underlying entities.

Financings

The non-cash charges that relate to our financings arise when we sell convertible debentures or notes and warrants. When we issue warrants in connection with convertible debentures or notes, we record the debt discount associated with the transaction that is amortized ratably over the term of the convertible debentures or notes; when the convertible debentures or notes are converted, the entire remaining unamortized financial expense is immediately recognized in the quarter in which the conversion occurs. As and to the extent that our remaining convertible debentures or notes are converted, we would incur similar non-cash charges going forward.

As a result of the application of the above accounting rule, we incurred non-cash debt discount amortization related to our financings in the amount of $17,179 during the first nine months of 2008.

During the third quarter of 2008 and pursuant to the terms of a Securities Purchase Agreement dated August 14, 2008, we issued and sold to a group of institutional investors 10% senior convertible notes in the aggregate principal amount of $5.0 million due August 15, 2011. These notes are convertible at any time prior to August 15, 2011 at a conversion price of $2.24 per share. As part of our analysis of the convertible debt and related warrants, we reviewed and followed the guidance of SFAS No. 150 and EITF Issues No. 00-19, 00-27 and 05-2.

As part of the securities purchase agreement, the Company issued to the purchasers of its 10% secured convertible notes due August 15, 2011, warrants to purchase an aggregate of 558,036 shares of common stock at any time prior to August 15, 2011 at a price of $2.24 per share. The warrants were classified as equity based on relative fair value.

The relative fair value of these warrants was determined using Black-Scholes pricing model, assuming a risk-free interest rate of 2.78%, a volatility factor 75%, dividend yields of 0% and a contractual life of 3.0 years.

In connection with these convertible notes, we calculated a deferred debt discount of $412,000 with respect to the warrants and the discount arising from fair value allocation of the warrants according to APB No. 14, which is being amortized from the date of issuance to the stated redemption date - August 15, 2011 - or to the actual conversion date, if earlier, as financial expenses.

Issuances of Restricted Shares and Options

During 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 nine months ended September 30, 2008 and 2007, compensation expense related to stock options and restricted shares of approximately $853,000 and $1.3 million, respectively, of which $52,000 and $145,000, respectively, was for stock options and $801,000 and $1.1 million, 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 nine months ended September 30, 2008 was $2.3 million on revenues of $45.1 million, compared to a net loss of $3.5 million on revenues of $40.0 million during the nine months ended September 30, 2007. As of September 30, 2008, our overall backlog totaled $41.7 million.

In our Training and Simulation Division, revenues increased from $17.8 million in the first nine months of 2007 to $23.1 million in the first nine months of 2008. As of September 30, 2008, our backlog for our Training and Simulation Division totaled $15.3 million.

In our Battery and Power Systems Division, revenues increased from $8.1 million in the first nine months of 2007 to $9.7 million in the first nine months of 2008. As of September 30, 2008, our backlog for our Battery and Power Systems Division totaled $13.7 million.

In our Armor Division, revenues decreased from $14.1 million during the first nine months of 2007 to $12.3 million during the first nine months of 2008. As of September 30, 2008, our backlog for our Armor Division totaled $12.7 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 September 30, 2008 compared to the three months ended September 30, 2007.

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

††† FAAC, IES 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 September 30, 2008 totaled $19.2 million, compared to $15.5 million in the comparable period in 2007, an increase of $3.7 million, or 24.4%. In the third quarter of 2008, revenues were $8.4 million for the Training and Simulation Division (compared to $8.4 million in the third quarter of 2007, unchanged, due to level sales of military vehicle simulators and use of force simulators); $4.4 million for the Battery and Power Systems Division (compared to $3.0 million in the third quarter of 2007, an increase of $1.4 million, or 44.6%, due primarily to increased sales of our battery products at Epsilor and EFB); and $6.5 million for the Armor Division (compared to $4.0 million in the third quarter of 2007, an increase of $2.5 million, or 62.2%, due primarily to increased revenues from AoA for personal protection devices along with increased revenues (albeit with lower margins) from MDT and MDT Armor in respect of the completion of orders for the "David" Armored Vehicle).

Cost of revenues. Cost of revenues totaled $13.5 million during the third quarter of 2008, compared to $11.1 million in the third quarter of 2007, an increase of $2.4 million, or 21.7%, due primarily to increased sales in our Battery and Power Systems and Armor divisions.

Direct expenses for our three divisions during the third quarter of 2008 were $6.8 million for the Training and Simulation Division (compared to $6.7 million in the third quarter of 2007, an increase of $96,000, or 1.4%, due primarily to slight increases in material costs); $4.1 million for the Battery and Power Systems Division (compared to $3.0 million in the third quarter of 2007, an increase of $1.1 million, or 36.8%, due primarily to increased revenues); and $5.7 million for the Armor Division (compared to $4.5 million in the third quarter of 2007, an increase of $1.2 million, or 25.6%, due primarily to increased production of the "David" Armored Vehicle).

Amortization of intangible assets. Amortization of intangible assets totaled $377,000 in the third quarter of 2008, compared to $308,000 in the third quarter of 2007, an increase of

$69,000, or 22.5%, 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.

Research and development expenses. Research and development expenses for the third quarter of 2008 were $399,000, compared to $492,000 during the third quarter of 2007, a decrease of $93,000, or 18.9%. This decrease was primarily attributable to a minor reduction in research and development activity in each of the three divisions.

Selling and marketing expenses. Selling and marketing expenses for the third quarter of 2008 were $1.0 million, compared to $906,000 in the third quarter of 2007, an increase of $98,000, or 10.8%. This increase was primarily attributable to the overall increase in revenues and their associated sales and marketing expenses.

General and administrative expenses. General and administrative expenses for the third quarter of 2008 were $3.2 million, compared to $3.3 million in the third quarter of 2007, a decrease of $110,000, or 3.3%. This decrease was primarily attributable to a reduction in corporate stock compensation expenses compared to the previous year.

Financial expenses, net. Financial expenses totaled approximately $289,000 in the third quarter of 2008, compared to $80,000 in the third quarter of 2007, an increase of $208,000, or 259.0%. The difference was due primarily to interest on convertible debt and increased interest expense as a result of higher line of credit balances outstanding in 2008 compared to the previous year.

Income taxes. We and certain of our subsidiaries incurred net operating losses during the three months ended September 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 $375,000 in tax expense in the third quarter of 2008, compared to $123,000 in tax expense in the third quarter of 2007, an increase of $252,000, or 204.1%, mainly concerning state and local taxes.

Net loss. Due to the factors cited above, we recognized a net loss of $44,000 in 2008, compared to a net loss of $783,000 in 2007, an improvement of $739,000, or 94.3%.

Nine months ended September 30, 2008 compared to the nine months ended September 30, 2007.

Revenues. During the nine months ended September 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 nine months ended September 30, 2008 totaled $45.1 million, compared to $40.0 million in the comparable period in 2007, an increase of $5.1 million, or 12.7%. In the first nine months of 2008, revenues were $23.1 million for the Training and Simulation Division (compared to $17.8 million in the first nine months of 2007, an increase of $5.3 million, or 29.5%, due primarily to increased sales of military vehicle simulators and use of force simulators); $9.7 million for the Battery and Power Systems Division (compared to $8.1 million in the first nine months of 2007, an increase of $1.6 million, or 19.5%, due primarily to increased sales of our battery products at Epsilor and EFB); and $12.3 million for the Armor Division (compared to $14.1 million in the first nine months of 2007, a decrease of $1.8 million, or 12.7%, 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. Cost of revenues totaled $33.3 million during the first nine months of 2008, compared to $27.8 million in the first nine months of 2007, an increase of $5.5 million, or 19.8%, due primarily to increased sales in our Training and Simulation and our Battery and Power Systems divisions and to some extent by erosion of the margin in our Armor Division.

Direct expenses for our three divisions during the first nine months of 2008 were $19.0 million for the Training and Simulation Division (compared to $14.3 million in the first nine months of 2007, an increase of $4.7 million, or 33.1%, due primarily to increased sales of FAAC); $9.9 million for the Battery and Power Systems Division (compared to $7.7 million in the first nine months of 2007, an increase of $2.2 million, or 28.8%, due primarily to increased revenues and increased prices for materials); and $13.1 million for the Armor Division (compared to $13.0 million in the first nine months of 2007, an increase of $124,000, or 1.0%, due primarily to increased production of the "David" Armored Vehicle).

Amortization of intangible assets. Amortization of intangible assets totaled $1.4 million in the first nine months of 2008, compared to $1.5 million in the first nine months of 2007, a decrease of $120,000, or 8.1%, 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, offset by fully amortized intangibles.

Research and development expenses. Research and development expenses for the first nine months of 2008 were $1.2 million, compared to $1.4 million during the first nine months of 2007, a decrease of $182,000, or 12.9%. This decrease was primarily attributable to a minor reduction in research and development activity in each of the three divisions.

Selling and marketing expenses. Selling and marketing expenses for the first nine months of 2008 were $3.3 million, compared to $3.0 million in the first nine months of 2007, an increase of $291,000, or 9.7%. This increase was primarily attributable to the overall increase in revenues and their associated sales and marketing expenses.

General and administrative expenses. General and administrative expenses for the first nine months of 2008 were $10.0 million, compared to $9.2 million in the first nine months of 2007, an increase of $804,000, or $8.7%. This increase was primarily attributable to increases in expenses in our Simulation division due to the additional expenses related to our new entity, Realtime Technologies, Inc.

Financial expenses, net. Financial expenses totaled approximately $342,000 in the first nine months of 2008, compared to $707,000 in the first nine months of 2007, a decrease of $366,000, or 51.7%. The difference was due primarily to decreased interest expense as a result of lower line of credit balances outstanding in 2008 compared to the previous year.

Income taxes. We and certain of our subsidiaries incurred net operating losses during the nine months ended September 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 $387,000 in tax expense in the first nine months of 2008, compared to $298,000 in tax expense in the first nine months of 2007, an increase of $88,000, or 29.7%, mainly concerning state and local taxes.

Net loss. Due to the factors cited above, net loss decreased from $4.0 million in 2007 to $3.0 million in 2008, a decrease of $1.0 million, or 25.3%.

Liquidity and Capital Resources

As of September 30, 2008, we had $1.6 million in cash, $163,000 in restricted collateral securities and restricted held-to-maturity securities due within one year, and $54,000 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 nine months ended September 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 nine months ended September 30, 2008 by $983,000 over the investment as at December 31, 2007. Our net fixed assets amounted to $5.2 million at quarter end.

Net cash used in operating activities from continuing operations for the nine months ended September 30, 2008 and 2007 was $3.3 million and $885,000, respectively, an increase of $2.4 million. This increase in cash used was primarily the result of the payment of the judgment in the AoA arbitration, part of which we had previously carried as an escrow receivable, and an increase in inventories in all divisions.

Net cash used in investing activities for the nine months ended September 30, 2008 and 2007 was $1.9 million and $1.1 million, an increase of $791,000. This increase was primarily the result of the payment of the judgment in the AoA arbitration, our issuance of a convertible loan to DEI, the RTI acquisition and the purchase of the minority interest in MDT.

Net cash provided by financing activities for the nine months ended September 30, 2008 and 2007 was $3.2 million and $1.3 million, respectively, an increase of $1.9 million, primarily due to the new senior notes offset by the reduction in short-term bank debt.

As of September 30, 2008, we have approximately $2.8 million in bank debt and $5.0 million in long term senior subordinated notes outstanding, compared to $4.6 million in bank debt 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.