This Management's Discussion and Analysis of Financial Condition and Results of Operations includes many forward-looking statements. For cautions about relying on such forward looking statements, please refer to the section entitled "Forward Looking Statements" at the beginning of this Report immediately prior to Item 1.
General
We are a leading company in high temperature superconductor ("HTS") materials and related technologies. HTS materials have the unique ability to conduct various signals or energy (e.g., electrical current or radio frequency ("RF") signals) with little or no resistance when cooled to "critical" temperatures. Electric currents that flow through conventional conductors encounter resistance that requires power to overcome and generates heat. HTS materials can substantially improve the performance characteristics of electrical systems, reducing power loss, lowering heat generation and decreasing electrical noise. Circuits designed to remove interference inherent in some RF signals can also be made from HTS materials. Commercial use of HTS materials requires a number of cutting edge technologies, including development of HTS materials, specialized manufacturing expertise to create uniform thin layers of these materials, expert designs of circuits optimized for HTS materials, and technologies to maintain an extremely low temperature environment for HTS applications (although the critical temperatures for HTS are "high" compared with traditional superconductors, they are still extremely cold by other standards). Our Proprietary Technology
We are focused on research and development to maintain our technological edge. As of December 31, 2008, we had 29 employees in our research and development division; eight of our employees have Ph.D.s, and 13 others hold advanced degrees in physics, materials science, electrical engineering and other fields. Our development efforts over the last 21 years have yielded an extensive patent portfolio as well as critical trade secrets, unpatented technology and proprietary knowledge. We enter into confidentiality and non-disclosure agreements with our employees, suppliers and consultants to protect our proprietary information. As of December 31, 2008, we held 57 U.S. patents in the following categories:
• 7 patents for technologies directed toward producing thin-film materials and structures, which expire between 2010 and 2025. We have developed a proprietary state-of-the-art manufacturing process for producing HTS thin-films of the highest quality.

• 29 patents for cryogenic and non-microwave circuit designs, which expire between 2010 and 2026. The expertise of our highly qualified team has allowed us to design and fabricate extremely small, high-performance circuits including RF signal filters.

• 17 patents covering cryogenics, packaging and systems, which expire between 2013 and 2025. Our proprietary and patented cryogenic packaging innovation provides us with a significant competitive advantage in maintaining our HTS materials at their critical temperatures.

• 4 patents covering other superconducting technologies, which expire between 2013 and 2015.

As of December 31, 2008, we also had 15 issued foreign patents, 25 U.S. patent applications pending and 44 foreign applications patents pending.
We are currently focusing our efforts on applications in areas such as:
• Wireless Networks. Our current commercial products help maximize the performance of wireless telecommunications networks by improving the quality of uplink signals from mobile wireless devices. Our products increase capacity utilization, lower dropped and blocked calls, extend coverage, and enable higher wireless data throughput - all while reducing capital and operating costs.

• Reconfigurable Handset Filters. The trend in the wireless handset industry is to continually reduce size and cost, while adding more features and making the unit more adaptable to different air interfaces and frequencies throughout the world. This drives the need for more complex and reconfigurable transceivers. We believe our strong intellectual property and expertise in frequency agile and thin film filters position us well to meet this demand.

• Superconducting Power Transmission Lines. We have entered into a collaborative effort and signed a Material Transfer Agreement with the Department of Energy's Los Alamos National Laboratory ("LANL") to apply our

HTS expertise to LANL's research initiative to develop HTS coated conductors for power transmission lines. If successfully developed, HTS superconducting cables could replace copper power transmission lines, resulting in higher capacity with less resistive cable losses.

• Government Products. As the worldwide leader in developing tunable HTS filter systems for military applications, we continue to be a crucial partner in the U.S. government's future success. Our high-performance HTS filter systems have been proven to increase the detection range, reduce interference, and in some cases, detect signals that were previously undetectable with conventional technology. Currently, we actively participate in the development of technologies for application in military communications, signals intelligence, and electronic warfare.

Our development efforts can take a significant number of years to commercialize, and we must overcome significant technical barriers and deal with other significant risks, some of which are set out in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report. Our Business Model
To be successful, we must use our expertise and our technology to generate revenues in various ways, including government contracts, commercial operations, joint ventures and licenses:
Government Contracts
We generate significant revenues from government contracts. We typically own the intellectual property developed under these contracts, and grant the Federal government a royalty-free, non-exclusive and nontransferable license to use it. As a result, our government contracts can not only generate a profit for us, but we can also make additional money through exploiting of the resulting technology in our commercial operations as well as government products, or through licenses or joint ventures. Contracts with the U.S. government contain provisions, and are subject to laws and regulations, that give the government rights and remedies not typically found in commercial contracts, including rights that allow the government to:
• terminate existing contracts for convenience, which affords the U.S. government the right to terminate the contract in whole or in part anytime it wants for any reason or no reason, as well as for default;

• reduce or modify contracts or subcontracts, if its requirements or budgetary constraints change;

• cancel or reduce multi-year contracts and related orders, if funds for contract performance for any subsequent year become unavailable;

• adjust reimbursable contract costs and fees on the basis of audits completed by its agencies through exercise of its oversight rights; and

• control or prohibit the export of products.

Compensation in the event of a termination, if any, is limited to compensation for work completed at the time of termination. In the event of termination for convenience, we may receive a certain allowance for profit on the work performed.
Commercial Applications
We have chosen to manufacture and sell certain commercial products on our own. To date, our commercial efforts have been focused on the design, manufacture, and sale of high performance infrastructure products for wireless voice and data applications. We have three current product lines, all of which relate to wireless base stations:
• SuperLink, a highly compact and reliable receiver front-end HTS wireless filter system to eliminate out-of-band interference for wireless base stations, combining filters with a proprietary cryogenic cooler and a cooled low-noise amplifier.

• AmpLink, a ground-mounted unit for wireless base stations that includes a high-performance amplifier and up to six dual duplexers.

• SuperPlex, a high-performance multiplexer that provides extremely low insertion loss and excellent cross-band isolation designed to eliminate the need for additional base station antennas and reduce infrastructure costs.

We sell most of our current commercial products to a small number of wireless carriers in the United States, including ALLTEL, AT&T, Sprint Nextel, T-Mobile and Verizon Wireless. Verizon Wireless and AT&T each accounted for more than 10% of our commercial revenues in 2008 and 2007. We are seeking to expand our customer base by selling directly to other wireless network operators and manufacturers of base station equipment, including internationally. Demand for wireless communications equipment fluctuates dramatically and unpredictably. The wireless communications infrastructure equipment market is extremely competitive and is characterized by rapid technological change, new product development, product obsolescence, evolving industry standards and price erosion over the life of a product. We face constant pressures to reduce prices. Consequently, we expect the average selling prices of our products will continue decreasing over time. We expect these trends to continue and may cause significant fluctuations in our quarterly and annual revenues. Our commercial operations are subject to a number of significant risks, some of which are set out in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report.
Joint Ventures
From time to time we may pursue joint ventures with other entities to commercialize our technology. In particular, we have agreed to license certain technology for our SuperLink®interference elimination solution for the China market to a joint venture where we own 45 percent of the equity. In the first quarter of 2008, we received orders from the joint venture for our new TD-SCDMA solution to perform lab trial and field trial activities in China. The lab trial was successfully completed in the second quarter of 2008, and the field trial was successfully completed during the fourth quarter of 2008. The commencement of manufacturing and the transfer of our processes to the joint venture will be driven by product demand from the China market. The joint venture's activities remain subject to successful product marketing efforts in addition to a number of other conditions, including certain critical approvals from the Chinese and United States governments. In particular, we have been in discussions with the United States government concerning the national security implications of our joint venture and investment from BAOLI. There continues to be no assurance that these conditions will be met, or that all required approvals (if obtained) will be obtained on a timely basis. Even if these conditions are met and the approvals received, the results from our joint venture will be subject to a number of significant risks associated with international operations and new ventures, some of which are set forth in our public filings, including in particular the "Risk Factors" included in Item 1A of this Report.
Licenses
From time to time we grant licenses for our technology to other companies. Specifically, we have granted licenses to, among others, (1) Bruker for Nuclear Magnetic Resonance application, (2) General Dynamics for government applications and (3) Star Cryoelectronics for Superconducting Quantum Interference Device applications.

Recent Developments
Operating Lease
In February 2009, we amended our office and production facilities lease. The base rent and the minimum annual escalation clause were reduced, and the term of the lease was extended five years to November 2016.
Contract Funding
In March 2009, the second phase of our U.S. Air Force contract was funded for an additional twelve months and provides for progress billing of up to $4.1 million.
Backlog
Our commercial backlog consists of accepted product purchase orders with scheduled delivery dates during the next twelve months. We had commercial backlog of $272,000 at December 31, 2008, as compared to $352,000 at December 31, 2007.
Results of Operations
2008 Compared to 2007
Net revenues decreased by $6.6 million, or 37%, to $11.3 million in 2008 from $17.9 million in 2007. Net revenues consist primarily of commercial product revenues and government contract revenues. We also generate some additional revenues from sublicensing our technology.
Net commercial product revenues decreased by $6.0 million, or 47%, to $6.8 million in 2008 from $12.8 million in 2007. The decrease is primarily the result of lower sales volume for our products. Average sales prices for our products were essentially unchanged in 2008. Our two largest customers accounted for 92% of our net commercial revenues in 2008, as compared to 75% in 2007. These customers generally purchase products through non-binding commitments with minimal lead-times. Consequently, our commercial product revenues can fluctuate dramatically from quarter to quarter based on changes in our customers' capital spending patterns.
Government contract revenues decreased to $4.5 million in 2008 from $5.1 million in 2007, a decrease of $590,000, or 12%. This decrease is primarily attributable to the completion of the first phase of a major contract and a funding gap before the second phase of that contract was funded.
Cost of commercial product revenues includes all direct costs, manufacturing overhead and provision for excess and obsolete inventories. The cost of commercial product revenues totaled $8.9 million for 2008 as compared to $12.9 million for 2007, a decrease of $4.0 million, or 31%. The lower costs resulted principally from lower production as a result of lower sales. Our expense provision for obsolete inventories totaled $17,000 in 2008 as compared to $160,000 in 2007.
Our cost of sales includes both variable and fixed cost components. The variable component consists primarily of materials, assembly and test labor, overhead, which includes equipment and facility depreciation, transportation costs and warranty costs. The fixed component includes test equipment and facility depreciation, purchasing and procurement expenses and quality assurance costs. Given the fixed nature of such costs, the absorption of our production overhead costs into inventory decreases and the amount of production overhead variances expensed to cost of sales increases as production volumes decline since we have fewer units to absorb our overhead costs against. Conversely, the absorption of our production overhead costs into inventory increases and the amount of production overhead variances expensed to cost of sales decreases as production volumes increase since we have more units to absorb our overhead costs against. As a result, our gross profit margins generally decrease as revenue and production volumes decline due to lower sales volume and higher amounts of production overhead variances expensed to cost of sales; and our gross profit margins generally increase as our revenue and production volumes increase due to higher sales volume and lower amounts of production overhead variances expensed to cost of sales. Our inventory is valued at the lower of its actual cost or the current estimated market value of the

inventory. We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory and/or vendor cancellation charges related to purchase commitments. If the results of the review determine that a write-down is necessary, we recognizes a loss in the period in which the loss is identified, whether or not the inventory is retained.
The following is an analysis of our commercial product gross profit margins for 2007 and 2008:

                                                    Years Ended December 31,
      Dollars in Thousands                       2007                      2008
      Net commercial product sales       $ 12,787       100.0 %    $  6,768       100.0 %
      Cost of commercial product sales     12,944       101.2 %       8,911       131.7 %

Gross profit $ (157 ) (1.2 %) $ (2,143 ) (31.7 %)

We had a negative gross margin of $2.1 million in 2008 from the sale of our commercial products as compared to a negative gross margin of $157,000 in 2007. The negative gross margin in 2008 is primarily because the reduced level of commercial sales was insufficient to cover our fixed manufacturing overhead costs. Our gross margins were also adversely impacted by a $17,000 charge for excess and obsolete inventory in 2008 and a similar charge of $160,000 in 2007. Gross margins were favorably impacted by $195,000 in 2007 by the sale of previously written-off inventory. There was no similar benefit in 2008. We regularly review inventory quantities on hand and provide an allowance for excess and obsolete inventory based on numerous factors, including sales backlog, historical inventory usage, forecasted product demand and production requirements for the next twelve months.
Contract research and development expenses totaled $3.6 million in 2008 as compared to $2.9 million in 2007, an increase of $743,000 or 26%. As a percentage of government revenue, contract research and development expenses increased from 57% in 2007 to 81% in 2008 because of different cost recognition criteria on one of our 2008 cost-plus contracts.
Other research and development expenses relate to development of new wireless commercial products and other products related to our expertise. We also incur design expenses associated with reducing the cost and improving the manufacturability of our existing products. These expenses totaled $3.4 million in 2008 compared to $3.2 million in 2007, an increase of $222,000, or 7%. The increase is due to increased efforts associated with new commercial products development.
Selling, general and administrative expenses totaled $8.2 million in 2008 as compared to $8.1 million in 2007, an increase of $28,000, or less than 1%. Expenses were lower in 2007 primarily from reversal of a $610,000 reserve in the first quarter of 2007. In 2008 we had lower insurance premiums and lower selling expenses that were slightly offset by higher legal expenses associated with our China joint venture.
In the fourth quarter of 2008 we reduced our work force and incurred a $141,000 severance charge. There was no similar charge in 2007.
Interest income increased to $284,000 in 2008, as compared to $156,000 in 2007, primarily because of higher cash balances in 2008.
Interest expense in 2008 amounted to $32,000, as compared to $39,000 in 2007, as a result of lower borrowing levels.
Our loss totaled $12.7 million in 2008, as compared to $9.1 million in 2007. The net loss available to common stockholders totaled $0.77 per common share in 2008, as compared to $0.73 per common share in 2007. 2007 Compared to 2006
Net revenues decreased by $3.2 million, or 15%, from $21.1 million in 2006 to $17.9 million in 2007.

Net commercial product revenues decreased by $4.9 million, or 28%, to $12.8 million in 2007 from $17.7 million in 2006. The decrease is primarily the result of lower sales volume for some or our products. Average sales prices for our products decreased only slightly in 2007. Our two largest customers accounted for 75% of our net commercial revenues in 2007, as compared to 76% in 2006. These customers generally purchase products through non-binding commitments with minimal lead-times. Consequently, our commercial product revenues can fluctuate dramatically from quarter to quarter based on changes in our customers' capital spending patterns.
Government contract revenues increased to $5.1 million in 2007 from $3.4 million in 2006, an increase of $1.7 million, or 52%. This increase is primarily attributable to the addition of new or amended contracts in 2007.
The cost of commercial product revenues totaled $12.9 million for 2007 as compared to $15.9 million for 2006, a decrease of $3.0 million, or 19%. The lower costs resulted principally from lower production as a result of lower sales. In addition, with lower production, we had fewer units to absorb our fixed overhead costs. Our provision for obsolete inventories decreased to $160,000 in 2007 as compared to $360,000 in 2006.
The following is an analysis of our commercial product gross profit margins for 2006 and 2007:

                                                   Years Ended December 31,
      Dollars in Thousands                       2006                     2007
      Net commercial product sales       $ 17,697       100.0 %   $ 12,787       100.0 %
      Cost of commercial product sales     15,922          90 %     12,944       101.2 %

Gross profit $ 1,775 10 % $ (157 ) (1.2 %)

We had a negative gross margin of $157,000 in 2007 from the sale of our commercial products as compared to a positive gross margin of $1.8 million in 2006. We experienced negative gross profits in 2007 primarily because the reduced level of commercial sales was insufficient to cover our fixed manufacturing overhead costs. Our gross margins were also adversely impacted by a $160,000 charge for excess and obsolete inventory. Gross margins were favorably impacted by $195,000 in 2007 and $700,000 in 2006 by the sale of previously written-off inventory. We regularly review inventory quantities on hand and provide an allowance for excess and obsolete inventory based on numerous factors, including sales backlog, historical inventory usage, forecasted product demand and production requirements for the next twelve months.
Contract research and development expenses totaled $2.9 million in 2007 as compared to $2.4 million in 2006, an increase of $499,000 or 21%. The increase was primarily the result of higher expenses associated with performing a greater number of government contracts. As a percentage of Government contract revenues, contract research and development expenses was 72% in 2006 and 57% in 2007.
Other research and development expenses relate to development of new wireless commercial products. We also incur design expenses associated with reducing the cost and improving the manufacturability of our existing products. These expenses totaled $3.2 million in 2007 as compared to $3.5 million in 2006, a decrease of $316,000, or 9%. The decrease is due to lower expenses associated with commercial products development and the result of our cost reduction efforts.
Selling, general and administrative expenses totaled $8.1 million in 2007 as compared to $9.1 million in 2006, a decrease of $1.0 million, or 11%. The lower expenses resulted primarily from $610,000 received from a settlement agreement with a former director and lower insurance premiums.
In connection with the acquisition of Conductus in December 2002 we recognized $20.1 million of goodwill. At July 1, 2006, we concluded that our declining stock price constituted an event under FAS 142 and required us to test for goodwill impairment. Our analysis led us to reasonably estimate at that time that our fair market value was less than our net assets excluding goodwill. Accordingly, we recorded a full write-down of the goodwill ($20.1 million) in the second quarter of 2006. We also recorded an impairment charge of $38,000 related to a note receivable from a Board member in 2006.
Interest income decreased to $156,000 in 2007, as compared to $391,000 in 2006, primarily because of lower cash balances in 2007.

Interest expense in 2007 amounted to $39,000, as compared to $45,000 in 2006, as a result of lower borrowing levels.
Our loss totaled $9.1 million in 2007 as compared to $29.6 million in 2006. The net loss available to common stockholders totaled $0.73 per common share in 2007, as compared to $2.37 per common share in 2006. Liquidity and Capital Resources
Cash Flow Analysis
As of December 31, 2008, we had working capital of $12.3 million, including $7.6 million in cash and cash equivalents, as compared to working capital of $3.3 million at December 31, 2007, which included $3.9 million in cash and cash equivalents. We currently invest our excess cash in short-term, investment-grade, money-market instruments with maturities of three months or less. Our investments have no exposure to the auction rate securities market. We believe that all of our cash investments would be readily available to us should the need arise.
Cash and cash equivalents increased by $3.7 million from $3.9 million at December 31, 2007 to $7.6 million at December 31, 2008. Cash was used principally in operations and to a lesser extent for our joint venture and the purchase of property and equipment. These uses were offset by gross cash proceeds of $16.5 million provided by the sales of common and preferred stock.
Cash used in operations totaled $12.1 million in 2008. We used $10.4 million to fund the cash portion of our net loss. We also used cash to fund a $3.8 million increase in inventory, accounts payable payments, patents and licenses payments and prepaid and other current asset payments. These uses were offset by cash generated from lower accounts receivable and other assets totaling $2.1 million.
Net cash used in investing activities totaled $700,000 in 2008. We invested $521,000 in our joint venture and we purchased $179,000 in fixed assets.
Net cash provided by financing activities totaled $16.5 million in 2008. The cash was provided by $10.9 million, net of $89,000 in expenses, from the final payments under the $15.0 million August 2007 BAOLI investment and $5.6 million, net of $442,000 in expenses, from the sale of 2,000,000 shares of common stock at $3.00 per share in May 2008. Net cash provided by financing activities totaled $4.0 million in 2007.
Financing Activities
We have historically financed our operations through a combination of cash on hand, equipment lease financings, available borrowings under bank lines of credit and both private and public equity offerings. We have effective registration statements on file with the Securities and Exchange Commission covering the public resale by investors of common stock issued in our private placements, as well as common stock acquired upon exercise of warrants.
As described above, we completed two financing activities in 2008 totaling $16.5 million: the balance of the $15.0 million BAOLI investment and a $5.6 million offering of common stock in May 2008.
In 2007, we did not complete a financing transaction. However, in 2007, we received $4.0 million from BAOLI as an installment toward completion of a $15.0 million financing completed in February 2008.
We have an existing line of credit from a bank. The line of credit expires in July 2009. The loan agreement is structured as a sale of our accounts receivable and provides for the sale of up to $5.0 million of eligible accounts receivable, with advances to us totaling 80% of the receivables sold. Advances bear interest at the prime rate (3.25% at December 31, 2008) plus 2.50% subject to a minimum monthly charge. Advances are collateralized by a lien on all of our assets. . . .