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CDTI > SEC Filings for CDTI > Form 10-Q on 13-Nov-2012All Recent SEC Filings

Show all filings for CLEAN DIESEL TECHNOLOGIES INC | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for CLEAN DIESEL TECHNOLOGIES INC


13-Nov-2012

Quarterly Report


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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This Quarterly Report on Form 10-Q should also be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. This discussion contains forward-looking statements, the accuracy of which involves risks and uncertainties, see "Cautionary Note Concerning Forward-Looking Statements" at the beginning of this Quarterly Report on Form 10-Q. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, as a result of many important factors, including those set forth in Part I - Item 1A "Risk Factors" of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

All percentage amounts and ratios included in this Management's Discussion and Analysis of Financial Condition and Results of Operations were calculated using the underlying data in thousands.

Overview

We are a leading global manufacturer and distributor of heavy diesel and light duty vehicle emissions control systems and products to major automakers and retrofitters. Our emissions control systems and products are designed to deliver high value to our customers while benefiting the global environment through air quality improvement, sustainability and energy efficiency. Our business is driven by increasingly stringent global emission standards for internal combustion engines, which are major sources of a variety of harmful pollutants.

We organize our operations in two business divisions: the Heavy Duty Diesel Systems division and the Catalyst division.

Heavy Duty Diesel Systems:Through our Heavy Duty Diesel Systems division we design and manufacture verified exhaust emissions control solutions. Our Heavy Duty Diesel Systems division offers a full range of products for the verified retrofit and original equipment manufacturer, or OEM, markets through its distribution/dealer network and direct sales. These ECS and Clean Diesel Technologies-branded products, such as Purifilter®, Purifier™, ARIS® and exhaust gas recirculation with selective catalytic reduction are used to reduce exhaust emissions created by on-road, off-road and stationary diesel and alternative fuel engines including propane and natural gas. Revenues from our Heavy Duty Diesel Systems division accounted for approximately 67% and 75% of the total consolidated revenues for the nine months ended September 30, 2012 and 2011, respectively.

Catalyst: Through our Catalyst division, we produce catalyst formulations to reduce emissions from gasoline, diesel and natural gas combustion engines that are offered for multiple markets and a wide range of applications. A family of unique high-performance catalysts has been developed - with base-metals or low platinum group metal and zero- platinum group metal content - to provide increased catalytic function and value for technology-driven automotive industry customers. Our technical and manufacturing competence in the light duty vehicle market is aimed at meeting auto makers' most stringent requirements, and we have supplied over ten million parts to light duty vehicle customers since 1996. Our Catalyst division also provides catalyst formulations for our Heavy Duty Diesel Systems division. Revenues from our Catalyst division accounted for approximately 33% and 25% of the total consolidated revenues for the nine months ended September 30, 2012 and 2011, respectively.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in the financial statements. Critical accounting policies are those accounting policies that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. While we base our estimates and judgments on our experience and on various other factors that we believe to be reasonable under the circumstances, actual results may differ from these estimates under different assumptions or conditions.

We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, allowance for doubtful accounts, inventory valuation, accounting for income taxes, business combinations, goodwill, impairment of long-lived assets other than goodwill, stock-based compensation and warrant derivative liability have the greatest potential impact on our condensed consolidated financial statements. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our year ended December 31, 2011 for a more complete discussion of our critical accounting policies and estimates.


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Recent Accounting Pronouncements

In December 2011, the FASB issued ASU 2011-11, "Disclosures about Offsetting Assets and Liabilities," which requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. ASU No. 2011-11 is effective for annual and interim periods beginning on or after January 1, 2013. Retrospective application is required. The guidance concerns disclosure only and will not have an impact on our financial position or results of operations.

For additional discussion regarding other recent accounting pronouncements, see Note 2 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Factors Affecting Future Results

Factors Affecting our Heavy Duty Diesel Systems Division

The nature of our business and, in particular, our Heavy Duty Diesel Systems division, is heavily influenced by government funding of emissions control projects and increased diesel emission control regulations and mandates. Compliance with these regulatory initiatives drives demand for our products and the timing of implementation of emission reduction projects.

Emission reduction programs are often one-off, or have staggered compliance dates, which mean they do not generally result in a regular source of recurring revenues for our company. For example, London, U.K. had mandated that certain heavy duty diesel vehicles entering the London Low Emissions Zone (or LEZ) were required to meet certain emission standards by January 2012. We believe that approximately 20,000 such vehicles were required to have a retrofit emission control device installed on the vehicle by year end 2011. In December 2011, the regulator extended the deadline for compliance into the first quarter of 2012. We believe that the bulk of the vehicles were retrofitted in the fourth quarter of 2011, with sales of our products of approximately $6 million in the fourth quarter and $8 million in the full year 2011. However, due to the extension, we recorded additional sales of $4.3 million and $1.0 million in the first and second quarters of 2012, respectively. This program is now virtually complete and as such, we do not expect sales in London in the balance of 2012 and beyond. In addition, the California Air Resources Board ("CARB") has mandated that all Class 7 and Class 8 heavy diesel trucks meet certain emission targets by 2016, with interim targets established for 2011, 2012 and 2013, such that 90% of current operating diesel trucks will be required to meet these targets by 2014. We estimate that this rule will require well over 100,000 heavy duty diesel trucks to be replaced or retrofitted. According to industry estimates, approximately 66,000 vehicles have elected or will elect to retrofit between 2011 and 2015. We believe that the rate of adoption of electing to retrofit by truck owners as well as the overall level of retrofit activity and our ability to gain sales are dependent upon several factors, including the level of enforcement of the mandate by CARB, the level of new truck acquisitions by truck owners and also our success in attaining the required verifications and approvals for products currently under review by CARB. We have experienced a slower than anticipated ramp up in adoption by truck owners and a delay in verification for a product currently under review by CARB. This has resulted in weaker than expected sales in the third quarter and order activity in the fourth quarter to date. Though we continue to pursue this retrofit opportunity aggressively, the rate of adoption, industry projections pertaining to the overall market opportunity and the success and timing of product verifications are uncertain and are expected to have a negative effect on sales in the remainder of this year and could result in fluctuations in revenue and working capital requirements from quarter-to-quarter next year.

Factors Affecting our Catalyst Division

Because the customers of our Catalyst division are OEM auto makers, our business is also affected by macroeconomic factors that impact the automotive industry generally, which can result in increased or decreased purchases of vehicles, and consequently demand for our products. Sales to our largest OEM auto customer have been positively impacted during the first nine months of 2012 due to increased vehicle shipments, expansion of our catalysts onto new vehicle platforms, increased purchasing by the customer to build initial stock of parts for a new model and an increase in pass through sales of rare earth materials due to increased prices of these materials. At present, we expect sales in the fourth quarter to this customer to be consistent with the third quarter.

In addition, our sales and gross margins are also impacted by the pass through sales of rare earth materials and the extent to which the price increases are shared with our customer. Through June 2012, the customer was reimbursing us the full amount actually spent by us on these materials. In the third quarter and beyond, it is the intent of both our customer and us to establish a formula for this reimbursement which is based on formulae established by this customer with other vendors. Until such a formula is agreed to, our customer is reimbursing rare earth cost increases only partially. We expect that a formula will be agreed to before the end of the year. However, even if such a formula is in place, we may experience margin reduction if the formula does not accurately reflect actual costs.

Supply of Catalyst Division Products to Heavy Duty Diesel Systems Division

Our strategy is to progressively utilize the products of our Catalyst division in the products of our Heavy Duty Diesel Systems division. We anticipate that our intercompany sales of catalysts will increase compared to historical levels, as our planned new products are approved by the regulatory agencies and begin to generate sales. While this will not impact our reported sales, we believe that the manufacturing gross margin associated with these sales will improve our total gross margin.


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Results of Operations

We conducted an intercompany transfer pricing study in the end of 2011 which resulted in us adjusting the prices our group companies charge each other for the sale of products and services. The Catalyst division adjusted certain prices it charges for products sold to the Heavy Duty Diesel Systems division to be consistent with market prices. The impact for the full year was recorded in the fourth quarter of 2011 which resulted in a $1.3 million increase in revenues for the Catalyst division and the offsetting intercompany eliminations. The change also resulted in a $1.3 million decrease in loss from continuing operations for the Catalyst division with an offsetting decrease in Heavy Duty Diesel Systems income from continuing operations for the year ended December 31, 2011. Of this amount, $1.0 million related to previous interim periods in 2011 with the impact on the individual quarters of $0.1 million, $0.4 million and $0.5 million for the quarters ended March 31, June 30, and September 30, 2011, respectively. The Catalyst revenues and related eliminations and the Heavy Duty Diesel Systems and Catalyst income (loss) from operations for the three and nine months ended September 30, 2011 have been recast to reflect the impact of this change in measurement. The change in intercompany pricing did not result in any change in consolidated revenues or in the consolidated loss from operations.

Comparison of Three Months Ended September 30, 2012 to Three Months Ended September 30, 2011

Revenues

The table below and the tables in the discussion that follow are based upon the way we analyze our business. See Note 12 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for additional information about our divisions.

                                          Three Months Ended September 30,
                                    % of                        % of
                      2012      Total Revenue     2011      Total Revenue    $ Change    % Change
                                                (Dollars in millions)
Heavy Duty Diesel
Systems               $  8.7            60.3%    $  11.1            74.0%     $ (2.4)     (21.6)%
Catalyst                 6.7            46.2%        6.4            43.0%         0.3        3.3%
Intercompany
revenue                (1.0)           (6.5)%      (2.5)          (17.0%)         1.5     (63.2)%
Total revenue         $ 14.4           100.0%    $  15.0           100.0%     $ (0.6)      (3.8)%

Total revenue for the three months ended September 30, 2012 decreased by $0.6 million, or 3.8% to $14.4 million from $15.0 million for the three months ended September 30, 2011.

Our Heavy Duty Diesel Systems division includes on-road diesel retrofit business most often driven by increasingly stringent emission regulations as well as product applications sold on an OEM and aftermarket basis with applications for the reduction of exhaust emissions of off-road and stationary engines and licensing revenue. Revenues for our Heavy Duty Diesel Systems division for the three months ended September 30, 2012 decreased $2.4 million, or 21.6%, to $8.7 million from $11.1 million for the three months ended September 30, 2011. The decrease was due to decreased retrofit sales of $1.6 million and decreased non-retrofit sales of $0.8 million. Retrofit sales declined $1.1 million in the London LEZ and $0.5 million in North America. Significant programs in North America included California and New Jersey. California sales of $1.7 million continued to be weak compared to expectations and were down $2.2 million year over year as we benefited from a CARB early compliance incentive program which was implemented in the second and third quarters of 2011. This decline was partially offset by growth driven by sales in the New Jersey Department of Environmental Protection Mandatory Diesel Retrofit Program and in other retrofit programs in North America. Non-retrofit sales decreased due to declines in sales of standard exhaust parts in North America, European material handling sales and North American sales to OEMs and integrators.


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Total revenues for our Catalyst division for the three months ended September 30, 2012 increased $0.3 million, or 3.3%, to $6.7 million from $6.4 million for the three months ended September 30, 2011. Excluding intercompany revenue, sales for this division increased 46.7% to $5.7 million for the three months ended September 30, 2012 as compared to $3.9 million for the three months ended September 30, 2011. The increase was in part due to the recognition of $1.0 million in revenue upon completion of performance under a contract to provide equipment, engineering and support services to assist our investment partner in the Asia Pacific, TKK, in establishing operations in China to manufacture automotive and exhaust emission products for the China market. The remaining increase was due to an increase of $1.0 million in sales to our Japanese OEM customer due to higher vehicle shipments, expansion of our catalysts onto new vehicle platforms, increased purchasing by the customer to build an initial stock of parts for a new model and rare earth material price increases that were passed on to the customer. This was partially offset by reductions of $0.2 million in sales to other OEM customers for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. We eliminate intercompany sales by the Catalyst division to our Heavy Duty Diesel Systems division in consolidation.

Cost of revenues

Cost of revenues decreased by $0.2 million, or 1.7% to $10.5 million for the three months ended September 30, 2012, compared to $10.7 million for the three months ended September 30, 2011. The primary reason for the decrease in costs was lower product sales volume.

Gross profit

The following table shows our gross profit and gross margin (gross profit as a percentage of revenues) by division for the periods indicated.

                                          Three Months Ended September 30,
                                      % of                  % of
                           2012    Revenue (1)   2011    Revenue (1)   $ Change   % Change
                                                (Dollars in millions)
 Heavy Duty Diesel Systems $ 2.2         25.7%   $ 3.2         28.5%    $ (1.0)    (29.3)%
 Catalyst                    1.6         23.7%     1.2         18.4%        0.4      24.7%
 Intercompany eliminations   0.1             ?   (0.1)             ?        0.2        NM
 Total gross profit        $ 3.9         26.9%   $ 4.3         28.5%    $ (0.4)     (9.3)%

(1) Division calculation based on division revenue. Total based on total revenue.

Gross profit for the three months ended September 30, 2012 decreased by $0.4 million, or 9.3%, to $3.9 million from $4.3 million for the three months ended September 30, 2011. Gross margin was 26.9% during the three months ended September 30, 2012 compared to 28.5% during the three months ended September 30, 2011.

The decrease in gross margin for our Heavy Duty Diesel Systems division from 28.5% for the three months ended September 30, 2011 to 25.7% for the three months ended September 30, 2012 is a result of reduced leverage of fixed manufacturing costs resulting from lower sales volume, $0.3 million of warranty expense and increased inventory obsolescence of $0.2 million.

The increase in gross margin for our Catalyst division from 18.4% for the three months ended September 30, 2011 to 23.7% for the three months ended September 30, 2012 is due to the impact of favorable margins under the TKK contract which was completed during the three months ended September 30, 2012. The TKK contract was a non-standard contract for the Company and is not expected to occur on a regular basis. Excluding this impact, gross margins for our Catalyst division decreased to 14.9% for the three months ended September 30, 2012 from 18.4% for the three months ended September 30, 2011. This decrease in gross margin is a result of the escalation of prices of rare earth materials that we use in our catalysts. One of our OEM customers provides price adjustments to isolate us from the impact of rare earth cost increases. Through June 2012, that customer was reimbursing us the full amount actually spent by us on these materials. In the third quarter and beyond, it is the intent of both us and our customer to establish a formula for this reimbursement which is based on formulae established by this customer with other vendors. Until such a formula is agreed to, our customer is only partially reimbursing rare earth cost increases. We expect that a formula will be agreed to before the end of the year. With the significant increases in rare earth prices, this cost reimbursement is dilutive to margin on a percent of sales. With two of our other OEM customers, we were not reimbursed for the increased costs of the rare earth material but are pursuing both for retroactive reimbursement for the as well as for future business.


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Operating expenses

The following table shows our operating expenses and operating expenses as a percentage of revenues for the periods indicated.

                                         Three Months Ended September 30,
                                  % of
                                  Total                    % of
                       2012      Revenue     2011      Total Revenue    $ Change    % Change
                                               (Dollars in millions)
Selling, general and
administrative          $ 3.4      23.4%      $ 3.9            26.0%     $ (0.5)     (13.2)%
Research and
development               1.6      11.4%        1.6            10.8%           ?        1.4%
Total operating
expenses                $ 5.0      34.8%      $ 5.5            36.8%     $ (0.5)      (8.9)%

For the three months ended September 30, 2012, operating expenses decreased by $0.5 million to $5.0 million from $5.5 million for the three months ended September 30, 2011.

Selling, general and administrative expenses

For the three months ended September 30, 2012, selling, general and administrative expenses decreased by $0.5 million, or 13.2%, to $3.4 million from $3.9 million for the three months ended September 30, 2011. This decrease is a result of a reduction in costs related to the former Corporate office in Connecticut of $0.2 million, our London operation of $0.1 million and a reduction in stock compensation and bonus $0.2 million. Selling, general and administrative expenses as a percentage of revenues decreased to 23.4% in the three months ended September 30, 2012 compared to 26.0% in the three months ended September 30, 2011.

Research and development expenses

Research and development expenses were $1.6 million in each of the three months ended September 30, 2012 and 2011. As a percentage of revenues, research and development expenses were 11.4% in the three months ended September 30, 2012, compared to 10.8% in the three months ended September 30, 2011.

Other expense

The following table shows the components of other expense and other (expense) income as a percentage of revenues for the periods indicated.

                                              Three Months Ended September 30,
                                                   % of                           % of
                                    2012       Total Revenue       2011       Total Revenue
                                                    (Dollars in millions)
Interest expense                    $ (0.4)           (3.1)%       $ (0.3)           (2.2)%
Loss on change in fair value of
common stock warrant liability        (0.1)           (0.4)%             ?              ?
Foreign currency exchange (loss)
gain                                  (0.4)           (3.1)%           0.2            1.6
Total other expense                 $ (0.9)           (6.6)%       $ (0.1)           (0.6)%

We incurred interest expense of $0.4 million in the three months ended September 30, 2012 compared to $0.3 million in the three months ended September 30, 2011. The three months ended September 30, 2012 includes $0.1 million in financing costs related to the amendment of our FGI credit facility (see -Description of Indebtedness below and Note 7 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. For the three months ended September 30, 2012, there was a loss of $0.1 million related to the change in fair value of liability classified common stock warrants. The three months ended September 30, 2012 included a $0.4 million exchange loss related primarily to changes in value of the Canadian dollar in relation to the U.S. dollar as compared to a gain of $0.2 million in the three months ended September 30, 2011.


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Net loss

For the foregoing reasons, we had a net loss of $1.8 million for the three months ended September 30, 2012 compared to a net loss of $2.0 million for the three months ended September 30, 2011. Excluding net income of $0.2 million in the three months ended September 30, 2012 from discontinued operations and net loss of $0.1 million in the three months ended September 30, 2011, we had a net loss from continuing operations of $2.0 million for the three months ended September 30, 2012 compared to a net loss from continuing operations of $1.9 million for the three months ended September 30, 2011.We continue to have legal and other expenses as well as gains on litigation settlements related to the 2009 divestiture of the assets of Applied Utility Systems. We record these activities as discontinued operations. For additional information relating to Applied Utility Systems, see Note 17 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011.

Comparison of Nine Months Ended September 30, 2012 to Nine Months Ended
September 30, 2011

Revenues



                                           Nine Months Ended September 30,
                                    % of                        % of
                      2012      Total Revenue     2011      Total Revenue    $ Change    % Change
                                                (Dollars in millions)
Heavy Duty Diesel
Systems               $ 32.3            67.1%    $  30.1            74.7%       $ 2.2        7.2%
Catalyst                19.2            39.9%       15.0            37.3%         4.2       27.9%
Intercompany
revenue                (3.4)           (7.0)%      (4.8)          (12.0%)         1.4       30.4%
Total revenue         $ 48.1           100.0%    $  40.3           100.0%       $ 7.8       19.4%

Total revenue for the nine months ended September 30, 2012 increased by $7.8 million, or 19.4%, to $48.1 million from $40.3 million for the nine months ended September 30, 2011.

Revenues for our Heavy Duty Diesel Systems division for the nine months ended September 30, 2012 increased $2.2 million, or 7.2%, to $32.3 million from $30.1 million for the nine months ended September 30, 2011. The increase was due to increased retrofit sales of $2.5 million partially offset by decreased non-retrofit sales of $0.3 million. Retrofit sales increased $4.0 million in the London LEZ and decreased $1.5 million in North America. Significant programs in North America included California, New Jersey and Texas. California sales of $6.2 million continued to be weak compared to expectations and were down $1.5 million year over year as we benefited from a CARB early compliance incentive program which was implemented in the second and third quarters of 2011. Sales increased $3.0 million under the New Jersey Department of Environmental Protection Mandatory Diesel Retrofit Program, increased $1.0 million for the retrofit of school buses in the State of Texas and decreased $4.0 million . . .

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