Summary of NCOAT, INC. - Yahoo! Finance

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

This management's discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes included elsewhere in this report on Form10-Q.

This management's discussion and analysis, as well as other sections of this report on Form10-Q, may contain "forward-looking statements" that involve risks and uncertainties, including statements regarding our plans, future events, objectives, expectations, forecasts, or assumptions. Any statement that is not a statement of historical fact is a forward-looking statement, and in some cases, words such as "believe," "estimate," " project," "expect," "intend," "may," "anticipate," "plans," "seeks," and similar expressions identify forward-looking statements. These statements involve risks and uncertainties that could cause actual outcomes and results to differ materially from the anticipated outcomes or results, and undue reliance should not be placed on these statements. These risks and uncertainties include, but are not limited to uncertainties discussed in filings made with the Securities and Exchange Commission. The Company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

The following Management's discussion and Analysis of financial Condition and Results of Operations ("MD&A") is intended to help the reader understand nCoat, Inc., our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes thereto contained in Item 1 of this report. This overview summarizes MD&A, which includes the following sections:

· Overview - a general description of our business and the markets in which we operate; our objective; our areas of focus; and challenges and risks of our business.

· Significant Accounting Policies - a discussion of accounting policies that require critical judgments and estimates.

· Results of Operations - an analysis of our Company's consolidated results of operations for the three years presented in our consolidated financial statements. Except to the extent that differences among our operating segments are material to an understanding of our business as a whole, we present the discussion in the MD&A on a consolidated basis.

· Liquidity and Capital Resources - an analysis of cash flows; off-balance sheet arrangements and aggregate contractual obligations; the impact of foregoing exchange; an overview of financial position; and the impact of inflation and changing prices.

We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our financial statements. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of the Company as a whole. This discussion should be read in conjunction with our financial statements as of September 30, 2008, and the year then ended and the notes accompanying those financial statements.

Overview

Our principal business strategy includes the following components:

Acquisitions. We completed the acquisition, transition and integration of HPC and MCCI which have given us a base of operations and market presence. As capital, the economy and opportunities allow, we will identify additional specific target companies for acquisition. The high performance coating industry includes a number of "sub-niche" sectors, such as corrosion and thermal management coatings solar and alternative energy equipment manufacturing, thermal and corrosion management coatings for orbital and non-orbital aircraft and aircraft engine manufacturing, self-healing coatings for continuous corrosion management, hard-face coatings for the gas and oil and aerospace industries, piston manufacturing and protection, lubritic dry film coatings, anti-porosity/anti-oxidation coatings, conformal coatings used to control corrosion and fugitive dust on printed circuit boards and microchips, gas and oil tools, valves and pipelines, marine applications for engine parts and anti-fouling technologies to name just a few. The fragmentation of the industry provides us with a large number of small to medium size companies that we will prudently investigate to determine both synergies and diversification with respect to our first two acquisitions.

Internal Organic Growth. We have already introduced into the existing "book of business" of our two subsidiaries additional products, both as cross sales opportunities from the sister company's product lines as well as the introduction of nano-formulated coatings. Operationally we have created common core formulations that represent the best-of-breed from all sources acquired or owned. Our emphasis on the after-market retail customer continues to be one of the two major segments of our business. In additional to the aftermarket sector, we continue to develop customers in the OEM market segment. A strong source for internal organic growth in the next three years is the continued emphasis by the manufacturers of diesel, gasoline and hybrid fueled engines to meet demanding environmental requirements imposed on their respective industries as we seek to improve emissions, fuel economy and safety. nCoat also continues to innovate new nano-products that meet the needs of our customers. nCoat is completing the development of a new anti-oxidation nano-coating to eliminate discoloration of chrome on vehicle exhaust systems. This product appears to be a unique innovation that to the knowledge of the Company is not offered by any other competitive company. nCoat expects these kinds of new products to create cross selling opportunities with existing customers and opportunities to expand the market base for product offerings to existing and new market segments. nCoat expects these product opportunities to add to the internal growth of customer base and revenues.

Licensed Application and Joint Venture Development. We continue to work to develop technology licensing and/or joint venture business agreements to establish on-site coatings application as part of the assembly-line process within the manufacturing and/or assembly process of a large customer. nCoat current has two OEM customers employing a licensing model and continues to have discussions with other prospects. The savings on handling, shipping, inventory, logistics management and other similar expenses that comes from having the on-site process is the principle benefit for our larger customers.

Licensing Intellectual Property. We continue to enter into protective "field of use" licensing with manufacturers that are tier-one suppliers of large OEM companies or who deploy a licensed application or joint venture model as described above. However, unlike the licensed application and/or joint venture model where application expertise and management control are inherent elements of the model, our "field of use" license agreements supply proprietary coatings to third parties already applying coating at their plants. The license agreements will be limited to targeted applications and industries where nCoat is not likely to engage in application services in the future and are structured as joint ventures to avoid creating competition in our own current market space.

Strengthen nTech's research and development efforts. On January 15, 2008, nCoat announced that North Carolina Agricultural and Technical State University (NC A&T) in Greensboro, North Carolina, and nCoat Inc. had established a technical collaboration agreement for characterization and development of nanotechnology based materials and industrial coatings. The Memorandum of Understanding ("MOU") was signed December 20th, 2007 with the Division of Research and Economic Development at the university's campus in Greensboro, North Carolina. Under the MOU, nCoat collaborates with NC A&T's Center for Advanced Materials and Smart Structures (CAMSS) in areas of advanced composites, carbon nanotubes, nano enhanced slurry coatings and metallic degradation from extreme thermal and chemical environments. CAMSS has a track record in nano-science based advanced materials as applied to thin film research, nano-composites, tribological and environmental coatings.

CAMSS is an extensively equipped and staffed materials research facility located on the campus of NC A&T in Greensboro a few miles from nCoat's location in Whitsett. CAMSS is a NC A&T-wide umbrella center receiving support from the National Science Foundation (Center for Research Excellence in Science and Technology), Department of Energy, Department of Defense (Center for Nanoscience and Nanomaterials), Air Force, and many industries. The center has extensive nano characterization equipment including recent multiple innovations in atomic and electron scanning microscopy and optical technologies. NC A&T has been recognized as one of the leading nano materials research and development centers in the United States.

The agreement outlines joint efforts between nCoat and NC A&T to identify, characterize, develop and commercialize new nano technology enhancements for functional coatings and materials with applications in aerospace, medical, energy, automotive, industrial, textile, advance composites, diesel engine applications and other industries.

Among other activities, the MOU is intended to establish a framework for conceptualization and implementation of R&D projects with subsequent commercialization. The agreement outlines governance of jointly and separately developed intellectual property and potential patent alliances for inventions. The agreement is also designed to establish joint revenues through technology licensing for commercial applications.

Some of the initial collaborative commercialization activities will be in the nano-structured surface engineered systems to improve thermal barrier, corrosion, tribological properties, biocompatibility and creating surface technologies that create a cleaner environment. The MOU also allows nCoat to collaborate with CAMSS on testing, prototyping and development of materials specific to enhancing nCoat industry needs.

This agreement and others under discussion with outside research and development groups, including technology transfer offices of universities, private laboratories and other small start-up technology companies are designed to continue to strengthen and exploit our research and development capacities while reducing R&D costs. All of nTech's research activities are focused on projects that can show commercialization within three to six months, rather than long term R&D projects. Many research projects are driven by direct requests from customers seeking immediate solutions to immediate critical problems.

Acquisitions

Management believes that there is a strategic acquisition opportunities resulting from the market dynamics of the high performance coatings markets. Acquisitions of HPC and Jet-Hot have further validated our strategic research. We expect to prudently search for, complete due diligence on and acquire other coatings companies in the future as allowed by available capital, cooperative economic conditions, internal financial conditions favorable to acquiring, and the ability of management to negotiate structures and valuation agreements favorable shareholder value. Key considerations for acquisitions include (i) have a customer base that includes enterprise level customers in a mature market, (ii) enjoy strong and stable market presence in our targeted primary markets, (iii) are profitable, (iv) have a brand presence similar to HPC, and Jet-Hot, and (v) have an existing product mix whose performance and functionality can be significantly improved by the integration of nanotechnology know-how.

Acquisition of Jet-Hot

With respect to the acquisition of Jet-Hot, we have realized key synergies which include:

1. Jet-Hot had a plant in Arizona as did HPC. The plants were about 10 miles apart. These were consolidated into a single location.
2. Jet-Hot plants are built for high through-put and packaging of individual aftermarket production. HPC plants are built for high volume of OEM parts production. Key strengths of each company have be used to create best-of-breed know-how at all operating plants.
3. Two corporate headquarters existed. The Jet-Hot accounting, human resources, legal, purchasing, sales and marketing, R&D and company management were consolidated into our North Carolina headquarter.
4. HPC and JET-HOT sales and marketing groups were consolidated for maximum production and efficiency, including advertising budgets.
5. Jet-Hot R&D and technical services were consolidated to nTech, for efficiency and intellectual property synergies.
6. HPC and JET-HOT sales prospects include many of the same names, including several where the two companies are the only two competitors for the account. This list was sorted into HPC and MCCI responsibilities, creating a non-competing sales effort.
7. We have acquired sufficient market and operational experience to realize that a single coating entity has a competitive disadvantage in attempting to create high volume productions of both aftermarket parts and OEM parts. The addition of MCCI allows us to create focused operations for each of our major market sectors.
8. Competition between MCCI and HPC for stand-alone coatings sales (no applications services) has been eliminated and we are offering "best of breed" coating from each company to customers.
9. JET-HOT has more thermal barrier customers than HPC. HPC has more corrosion resistance and lubritic coatings customers than JET-HOT. Cross selling now occurs in each company's customer base to attempt to raise same-customer revenue. In addition, JET-HOT did not sell internal engine coatings. Their product line was for coatings on external parts only. HPC internal engine coatings are now offered to all of JET-HOT's approximate 9000 annual individual aftermarket customers.

Company contact information

Our headquarters' address is 7237 Pace Drive, P.O. Box 38, Whitsett, NC 27377, and our phone number is (336) 447-2000.

Results of Operations

Performance in First three Months of 2009 Compared to First Three Months of 2008

Performance Overview

The comparative revenue for the three months ending March 31, 2008, to March 31, 2009, shows a decrease of $485,941 or 16.7%. Much of this reduction is attributable to aftermarket sales. Aftermarket sales began to experience declines in August, 2008 as consumer confidence plummeted and uncertain and negative economic conditions began to impact consumer spending. Quarter over quarter aftermarket sales experienced 60% reduction in the fourth quarter of 2008 as economic conditions and consumer uncertainty worsened. In the first quarter of 2009, aftermarket sales were down quarter over quarter, but recovered a significant portion of the reduction in the previous quarter. Additionally, OEM sales have been negatively impacted by reductions in demand with diesel engine manufacturers. The weakness in this sector is may continue into the fall. One media source has cited engine build rates as being down 60% over prior year, which was already well below '07 levels. Revenues for the quarter benifited from $500,000 credit resulting from cancellation of liability associated with Jeffry Homes case which was settled in January of this year.
Beginning in 2007, our diesel engine manufacturing customers were required to introduce new engine platforms to meet new Environmental Protection Agency (EPA) requirements to lower harmful particulates in engine emissions in order to comply with Federal clean air standards. nCoat sells and applies corrosion resistant coatings created from that the use of new technology that aides diesel emissions systems to meet these new standards. The standards affected those engine platforms commencing in 2007 and the complete 2007 year was a period of "wait and see" as the new engineering was road-proven prior to the acceptance by the market. The downturn of active new unit purchases was further affected by the dramatic increase in fuel prices, followed on by the recession.
Additionally, the national economic downturn and severe limitations on corporate credit resources beginning in the fall of 2008 continued the limitations of unit sales. Until economic activity shows signs of rebounding, and liquidity returns to the financial markets, transportation companies will tend to defer capital expenditures regarding rolling stock. Once markets begin to thaw a combination of aging fleets, increasing EPA requirements, and potential government incentives will ultimately produce a surge of production to relieve this demand. Our earliest expectation would be that this may be in the fourth quarter of 2009, but potentially this weakness will continue into 2010.

Cost of Sales

Cost of sales was $1,141,793 for the first three months of 2009, a reduction of 39% from the same period last year. The company continues to realize efficiencies stemming from closing Mississippi and Utah plant locations. Additionally we continue to improve processes and reduce variable cost and waste through our lean manufacturing program and Six-Sigma management training.

General and Administrative Expenses

General and administrative expenses for the three months ended March 31, 2009, decreased by approximately $538,000 or 33%. Management has instituted a number of steps designed to reduce these expenses including:

1) Closing Mississippi and Utah plant locations, relocating their capacity to other existing facilities.

2) Increasing the effectiveness of communications and reducing unnecessary travel.

3) Realigning upper management positions to more closely track the size and present revenues of the Company.

Sales and Marketing Expense

Sales and marketing expense for the three months ended March 31, 2009, decreased by approximately $128,000 or 45% compared to the same period in 2008. Management has restructured the marketing and sales group, revamped commission structure and reduced print advertising expense. However, management believes some expense reductions have impacted aftermarket sales and that that further reductions to advertising and direct marketing and sales efforts will adversely impact both aftermarket and OEM sales efforts and thereby revenues and the overall financial condition of the Company. Management believes that some increase in marketing and sales expenditures will be necessary to sustain sales and customer services.

Interest Expense

Management's greatest concern remains that all of the significant positive changes that have been made to reach operating profitability have been overshadowed by the great impact seen in our financial reports of the interest expense which has been attributed to the contractual redemption premium computations. We are in technical default under the terms of the Series A and Series B Promissory Notes and hence are subject to the premium computed on a redemption right granted to the holders of the Notes. As of the date of this report, and as an event subsequent to the end of the accounting period ending September 30, 2008, management has received demand from only one note holder for the redemption of its Series A note. The note was originally issued May 31, 2007 with the face amount of $1,500,000. The note holder has previously converted a portion of its note ($25,000) as reflected in the financial statements set forth herein. The demand is for the remaining balance of the note of $1,475,000 plus interest of $232,183 multiplied by a 115% premium factor for a total demand of $1,963,209. As of the date hereof, the demand has not been paid. No other demand has been made by the remaining note holders for redemption of the Series A and B Notes. We have had no indication from the other Note holders of demand, or other negative impacts and are working to complete further negotiations with them in order to resturcture the triggering events which have lead to the accounting entries.

Earnings per Share

As a result of the share exchange transaction discussed in the overview section above, exercise of warrants and conversion of debt, the number of outstanding shares increased to 102,108,606 as of December 31, 2008. For the three month period ended March 31, 2009 there was a loss per share of 4.76.

Financial Statements, One-Time Charges and Capital Expenditures

Cost reduction activities have been underway since funding failed in 2007. We have included reductions in personnel, consolidation of facilities and emphasis on lean manufacturing practices. Our resulting operational savings have been encouraging.

1. Facilities - Since the first quarter of last year, facilities have been shut down in Mississippi and Utah. The capacity was shifted to other existing facilities, reducing our overhead and improving our labor productivity.

Our plans call for a second OEM production line in 2009 at a cost of approximately $250,000 for its installation. Most of this cost will be for installation of existing equipment which has been relocated due to the shutdown of the Mississippi and Utah plant locations.

2. Personnel - The Company has reduced the workforce from over 200 employees in July, 2007 to approximately 116 employees. This decrease comes from operating plants more efficiently and reducing the number of plant locations. Additionally the first quarter of last year included some management positions which presumed full funding of our investments and subsequent growth. The current management staff level is in line with existing business levels. We have focused on completion of Standard Operating Procedure documentation, preparation of information systems, accounting, human resource, production, communications, mixing and blending, strategic finance and other systems to accommodate rapid growth from internal and acquisition growth.

3. Research and Development - Our expenditures for research and development were $79,709 for the three months ended March 31, 2009. These numbers were not broken out specifically in the first quarter of last year, however our total expenditures for the 2008 year as shown on our annual report totaled $376,165.

4. Financing - Expenses in the first three months of 2008 show Redemption premium interest expense of $486,181,192. This is the current calculation for the penalty associated with the default on the A and B notes discussed at length elsewhere in this report.

Liquidity and Capital Resources

nCoat is a company with limited operating history and experience upon which to base an evaluation of its performance. In September of 2005, we acquired High Performance Coatings, Inc. ("HPC"), an operational coatings company, which was responsible for the majority of our consolidated revenues. In 2006, we formed an intellectual property and development entity, nTech, Inc. ("nTech"), and in June 2007, we acquired all of the common stock of Metallic Ceramic Coatings, Inc. ("MCCI"), a primary competitor of HPC with 26 years of coatings experience and historical revenues similar to HPC.

On April 13, 2007, we converted $2,000,000 of convertible debentures and $67,752 of accrued interest into 4,135,503 shares of our common stock at $0.50 per share. The remaining $500,000 of convertible debentures, along with accrued interest of $18,107, was converted to 1,036,215 shares of common stock at $0.50 per share on August 24, 2007.

From May 25, 2007, through July 9, 2007, we issued $9,000,000 of Series A 6% convertible promissory notes (the "Series A Notes") and warrants to purchase 22,500,000 shares of common stock, exercisable at $1.00 per share through May 31, 2012. The Series A Notes are convertible into common stock at $0.40 per share through May 31, 2010 when the Series A Notes are due. On May 31, 2007, the Company issued $3,250,000 of Series B 6% convertible promissory notes (the "Series B Notes") and warrants to purchase 8,125,000 shares of common stock at $0.80 per share through May 31, 2010. The Series B Notes are convertible into common stock at $0.40 per share through May 31, 2010 when the Series B Notes are due. The Series A and B private placement offerings included the conversion of $800,000 of advances from investors of which $700,000 had been received prior to March 31, 2007. The Company received $10,618,916 of proceeds from the issuance of the Series A and Series B convertible notes, net of the $700,000 of advances previously recognized and net of cash offering costs of $931,064.

In the final stages of the offering, after we had closed on the purchase of MCCI, a subscribed investor did not fund its portion of offering. Our intended use of proceeds included retirement of debt and related accrued interest of $3,677,286, $5,000,000 for the acquisition of MCCI, payment of significant pre-offering liabilities and establishing a working capital reserve. The retirement of pre-offering liabilities and the working capital portion of the offering did not get raised prior to our contractual obligation to close the offering. This deficiency of the expected $6,500,000 in funding, combined with the seasonal lull in aftermarket and OEM revenues, caused us to experience a significant liquidity crisis. A number of our vendors turned our account over to collection agencies and at December 31, 2008, we had accounts payable in excess of $2.0 million over 120 days past due.

At December 31, 2008 we are in technical breech of the Securities Purchase Agreement and the related Series A and B Convertible Notes and Registration Agreement (collectively the "Note Agreement"). This technical breech is due to our failure to pay partial liquidating damages and failure to pay interest nCoat is attempting to negotiate a restructure of these debenture notes to provide a work out arrangement favorable to both current debenture holders and shareholders. To accomplish this restructure, nCoat must raise in the next twelve (12) months, additional capital to satisfy negotiated demands of the current debenture holders and to pay aged accounts payables current owed by nCoat to its vendors. Capital raised to this end may (1) be accomplished in a debt instrument which will incur debt to the Company, and/or (2) be raised in an equity offering which may create significant dilution to current shareholders, or (3) not be completed at all. nCoat is seeking in the restructured a negotiated settlement of all outstanding penalties, interest, carrying charges and principal accrued under the current debenture notes. Any changes to the agreement or to accounting treatment described herein will be reflected in subsequent periods.

Although no demand has been made, the Note Agreement provides that in the event of a breech, within the first 12 months following closing, the holders are entitled to demand immediate redemption of all, or any portion of, the face value of the Series A Notes and Series B Notes, along with a redemption . . .