Statement of Forward-Looking Information

In this quarterly report, references to "eMagin Corporation," "eMagin," "Virtual Vision," "the Company," "we," "us," and "our" refer to eMagin Corporation and its wholly owned subsidiary, Virtual Vision, Inc.

Except for the historical information contained herein, some of the statements in this Report contain forward-looking statements that involve risks and uncertainties. These statements are found in the sections entitled "Business," "Management's Discussion and Analysis of Financial Condition and Results of Operation," and "Risk Factors." They include statements concerning: our business strategy; expectations of market and customer response; liquidity and capital expenditures; future sources of revenues; expansion of our proposed product line; and trends in industry activity generally. In some cases, you can identify forward-looking statements by words such as "may," "will," "should," "expect," "plan," "could," "anticipate," "intend," "believe," "estimate," "predict," "potential," "goal," or "continue" or similar terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including, but not limited to, the risks outlined under "Risk Factors," that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. For example, assumptions that could cause actual results to vary materially from future results include, but are not limited to:
our ability to successfully develop and market our products to customers; our ability to generate customer demand for our products in our target markets; the development of our target markets and market opportunities; our ability to manufacture suitable products at competitive cost; market pricing for our products and for competing products; the extent of increasing competition; technological developments in our target markets and the development of alternate, competing technologies in them; and sales of shares by existing shareholders. Although we believe that the expectations reflected in the forward looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Unless we are required to do so under federal securities laws or other applicable laws, we do not intend to update or revise any forward-looking statements.

Overview

We design and manufacture miniature displays, which we refer to as OLED-on-silicon-microdisplays, and microdisplay modules for virtual imaging, primarily for incorporation into the products of other manufacturers. Microdisplays are typically smaller than many postage stamps, but when viewed through a magnifier they can contain all of the information appearing on a high-resolution personal computer screen. Our microdisplays use organic light emitting diodes, or OLEDs, which emit light themselves when a current is passed through the device. Our technology permits OLEDs to be coated onto silicon chips to produce high resolution OLED-on-silicon microdisplays.

We believe that our OLED-on-silicon microdisplays offer a number of advantages in near to the eye applications over other current microdisplay technologies, including lower power requirements, less weight, fast video speed without flicker, and wider viewing angles. In addition, many computer and video electronic system functions can be built directly into the OLED-on-silicon microdisplay, resulting in compact systems with lower expected overall system costs relative to alternate microdisplay technologies.

We have developed a strong intellectual property portfolio that includes patents, manufacturing know-how and unique proprietary technologies to create high performance OLED-on-silicon microdisplays and related optical systems. We believe our technology, intellectual property portfolio and position in the marketplace, gives us a leadership position in OLED and OLED-on-silicon microdisplay technology. We are one of only a few companies in the world to market and produce significant quantities of high resolution full-color small molecule OLED-on-silicon microdisplays.

At June 30, 2012, we had a total of 96 full-time and part-time employees as compared to 92 employees at December 31, 2011.

In the second quarter of 2012, we continued work on bringing up our new OLED deposition machine. We are currently manufacturing displays on the tool and continuing to work on full automation to optimize production capacity. During this period, we will continue to run production on the Satella (our other OLED deposition machine) as necessary to meet customer demand.

A detailed discussion of our business may be found in Part I, "Business," of our 2011 Annual Report on Form 10-K for the year ended December 31, 2011 as filed with the Securities and Exchange Commission on March 10, 2012.

CRITICAL ACCOUNTING POLICIES

Revenue and Cost Recognition

Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, selling price is fixed or determinable and collection is reasonably assured. Product revenue is generally recognized when products are shipped to customers. We defer revenue recognition on products sold directly to the consumer with a maximum thirty day right of return. Revenue is recognized upon the expiration of the right of return.

We also earn revenues from certain R&D activities (contract revenues) under both firm fixed-price contracts and cost-type contracts. Revenues relating to firm fixed-price contracts and cost-type contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis). Progress is generally based on a cost-to-cost approach however an alternative method may be used such as physical progress, labor hours or others depending on the type of contract. Physical progress is determined as a combination of input and output measures as deemed appropriate by the circumstances. Contract costs include all direct material and labor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party.

Other critical accounting policies, as described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, relate to product warranty, use of estimates, fair value of financial instruments, stock-based compensation and accounting for income taxes.

NEW ACCOUNTING PRONOUNCEMENTS

See Note 1 of the Condensed Consolidated Financial Statements in Item 1 for a description of recent account pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition.

RESULTS OF OPERATIONS

THREE AND SIX MONTHS ENDED JUNE 30, 2012 COMPARED TO THREE AND SIX MONTHS ENDED
JUNE 30, 2011

Revenues

Revenues for the three and six months ended June 30, 2012 were approximately $8.6 million and $14.7 million, respectively, as compared to approximately $7.4 million and $12.9 million, respectively, for the three and six months ended June 30, 2011, an increase of approximately $1.2 million or 15% and $1.8 million or 14%, respectively. The increase in revenue for the three and six month periods was primarily due to increased sales of our OLED micro-displays.

Product revenue is comprised of sales of displays, Z800 systems, and other hardware. For the three and six months ended June 30, 2012, product revenue increased approximately $1.2 million or 20% and $2.7 million or 26%, respectively, as compared to the three and six months ended June 30, 2011. The increase in product revenue for the three and six month periods was driven primarily by an increase in sales volume as the average sales price per display remained constant with the first six months of 2011. For the three and six months ended June 30, 2012, we shipped 21% and 26%, respectively, more displays as compared to the three and six months ended June 30, 2011.

Contract revenue is comprised of revenue from research and development or non-recurring engineering ("NRE") contracts. For the three and six months ended June 30, 2012, contract revenue decreased approximately $38 thousand or 3% and $862 thousand or 33%, respectively, as compared to the three and six months ended June 30, 2011. The decrease in contract revenue for the six month period was a result of fewer active contracts in the first quarter of 2012 as compared to 2011.

Cost of Goods Sold

Cost of goods sold is comprised of costs of product and contract revenues. Cost of product revenue includes materials, labor and manufacturing overhead related to our products. Cost of contract revenue includes direct and allocated indirect costs associated with performance of contracts. Cost of goods sold for the three and six months ended June 30, 2012 was approximately $4.1 million and $7.5 million, respectively, as compared to approximately $3.8 million and $7.0 million, respectively, for the three and six months ended June 30, 2011, an increase of approximately $0.3 million and $0.5 million, respectively. Cost of goods sold as a percentage of revenues was 47% and 51%, respectively, for the three and six months ended June 30, 2012 as compared to 51% and 54% for the three and six months ended June 30, 2011.

The following table outlines product, contract and total gross profit and related gross margins for the three and six months ended June 30, 2012 and 2011 (dollars in thousands):

                                       Three months ended           Six months ended
                                            June 30,                    June 30,
                                        2012          2011          2012         2011
                                           (unaudited)                 (unaudited)
     Product revenue gross profit    $    3,644      $ 2,905      $  6,172      $ 4,606
     Product revenue gross margin            51           49 %          48 %         45 %
     Contract revenue gross profit   $      869      $   721      $  1,022      $ 1,266
     Contract revenue gross margin           59           48 %          58 %         48 %
     Total gross profit              $    4,513      $ 3,626      $  7,194      $ 5,872
     Total gross margin                      53           49 %          49 %         46 %

The gross profit for the three and six months ended June 30, 2012 was approximately $4.5 million and $7.2 million, respectively, as compared to approximately $3.6 million and $5.9 million, respectively, for the three and six months ended June 3, 2011, an increase of $0.9 million and $1.3 million, respectively. Gross margin was 53% for the three months ended June 2012 up from 49% for the three months ended June 30, 2011. Gross margin was 49% for the six months ended June 30, 2012 up from 46% for the six months ended 2011.

The product gross profit for the three and six months ended June 30, 2012 was approximately $3.6 million and $6.2 million, respectively, as compared to approximately $2.9 million and $4.6 million, respectively, for the three and six months ended June 30, 2011, an increase of $0.7 million and $1.6 million, respectively. Product gross margin was 51% and 48%, respectively, for the three and six months ended June 30, 2012 up from 49% and 45% for the three and six months ended June 30, 2011. For the three and six month periods of 2012, our gross margin was favorably impacted as fixed production costs are spread over a higher revenue base. The cost per display produced in Q2 2012 was slightly less than displays produced in Q1 2011. A slight decrease of 2% in the average selling price offset a portion of the favorable impacts to gross margin.

The contract gross profit for the three and six months ended June 30, 2012 was approximately $0.9 million and $1.0 million, respectively, as compared to approximately $0.7 million and $1.3 million, respectively, for the three and six months ended June 30, 2011, an increase of $0.2 million and a decrease of $0.3 million, respectively. Contract gross margin was 59% and 58%, respectively, for the three and six months ended June 30, 2012 up from 48% for both the three and six months ended June 30, 2011. The contract gross margin is dependent upon the mix of costs, internal versus external third party costs. External third party costs lower gross margins and reduce the contract gross profit.

Operating Expenses

Research and Development. Research and development ("R&D") expenses are company-funded and include salaries and related benefits, development materials and other costs specifically allocated to the development of new microdisplay products, OLED materials and subsystems. R&D related costs associated with fulfilling contracts are categorized as contract cost of goods sold. R&D expenses for the three and six months ended June 30, 2012 were approximately $1.3 million and $2.4 million as compared to $0.8 million and $1.3 million for the three and six months ended June 30, 2011. The increase of approximately $0.5 million and $1.1 million, respectively, is related to an increase in personnel costs and related expenses to support R&D activities.

Selling, General and Administrative. Selling, general and administrative expenses consist principally of salaries and related benefits, professional services fees and marketing, general corporate, and administrative expenses. Selling, general and administrative expenses for the three and six months ended June 30, 2012 were approximately $2.3 million and $4.6 million, respectively, as compared to approximately $2.2 million and $4.4 million, respectively, for the three and six months ended June 30, 2011. The slight increase of approximately $0.1 million and $0.2 million, respectively, is related to an increase in personnel costs.

Other Income (Expense), net. Other income (expense), net consists primarily of interest income earned on investments, interest expense, and income (expense) applicable to the change in the fair value of the warrant liability. For the three and six months ended June 30, 2012, interest expense was approximately $5 thousand and $8 thousand, respectively, offset by the capitalization of interest of $5 thousand and $13 thousand, respectively, as compared to approximately $30 thousand and $59 thousand, respectively, for the three and six months ended June 30, 2011. We have no debt upon which we are incurring interest expense however we pay fees to keep our line of credit open. Other income, primarily interest income, for the three and six months ended June 30, 2012 was approximately $12 thousand and $18 thousand, respectively, as compared to approximately $13 thousand and $29 thousand, respectively, for the three and six months ended June 30, 2011.

Change in Fair Value of Warrant Liability. For the three and six months ended June 30, 2012, the change in fair value of the warrant liability was $0 as the Company had no warrants that are accounted for as a liability. For the three months ended June 30, 2011, the change in fair value of the warrant liability was income of $2.6 million and for the six months ended June 30, 2011, the change in fair value of the warrant liability was a charge of $0.5 million. The change in the fair value of the warrant liability was primarily due to the change in the common stock price of eMagin period over period. The change in fair value of the warrant liability had no impact on our cash balances, operations, or operating income.

Liquidity and Capital Resources

As of June 30, 2012, we had approximately $13.3 million of cash, cash equivalents, and investments as compared to $14.3 million at December 31, 2011. Of the $13.3 million in cash, approximately $9.3 million was invested in certificates of deposits ("CDs") and corporate bonds.

Cash flow provided by operating activities during the six months ended June 30, 2012 was approximately $0.4 million, attributable to our net income of approximately $0.1 million and net non-cash expenses of $1.5 million offset by the change in operating assets and liabilities of $1.2 million. Cash flow provided by operating activities during the six months ended June 30, 2011 was approximately $0.5 million, attributable to our net loss of approximately $0.4 million and change in operating assets and liabilities of $0.8 million offset by net non-cash expenses of $1.7 million.

Cash used in investing activities during the six months ended June 30, 2012 was approximately $3.6 million of which $2.6 million purchased investments in CDs and corporate bonds and approximately $1.0 million purchased equipment primarily for upgrading our production line. Cash used in investing activities during the six months ended June 30, 2011 was approximately $2.0 million of which $1.2 million purchased CDs and approximately $0.8 million purchased equipment primarily for upgrading our production line. Presently we have committed approximately $1.7 million for capital expenditures in 2012.

Cash used by financing activities during the six months ended June 30, 2012 was approximately $0.3 million, primarily representing the purchase of treasury stock as compared to the cash provided by financing activities during the six months ended June 30, 2011 which was approximately $0.6 million from the exercise of stock options and warrants.

Credit Facility

At June 30, 2012, we had a credit facility with Access Business Finance, LLC ("Access") that provides for up to a maximum amount of $3 million based on a borrowing base equivalent of 75% of eligible accounts receivable. The interest on the credit facility is equal to the Prime Rate plus 5% but may not be less than 8.25% with a minimum monthly interest payment of $1 thousand. The credit facility will automatically renew on September 1, 2012 for a one year term unless written notice is provided. We did not draw on our credit facility during the quarter ended June 30, 2012 or at any time since its inception in September 2010 and there is no outstanding balance.

The credit facility contains the customary representations and warranties as well as affirmative and negative covenants. We were in compliance with all debt covenants as of June 30, 2012.

We expect our business to experience revenue growth which may result in higher accounts receivable levels and may require increased production and/or higher inventory levels. We anticipate that our cash needs to fund these requirements as well as other operating or investing cash requirements over the next twelve months will be less than our current cash on hand, investments and the cash we anticipate generating from operations. We anticipate that we will not require additional funds over the next twelve months other than perhaps for discretionary capital spending. If unanticipated events arise during the next twelve months, we believe we can raise sufficient funds. However, if we are unable to obtain sufficient funds, we may have to reduce the size of our organization and/or be forced to reduce and/or curtail our production and operations, all of which could have a material adverse impact on our business prospects.

Off-Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, revenues, results of operations, liquidity or capital expenditures.