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TABLE OF CONTENTS	Page
FORWARD-LOOKING STATEMENTS	ii
ABOUT THIS PROSPECTUS	ii
BACKGROUND	iii
SUMMARY	1
RISK FACTORS	7
USE OF PROCEEDS	19
PRICE RANGE OF COMMON STOCK	19
DIVIDEND POLICY	20
RATIO OF EARNINGS TO COMBINED FIXED CHARGES  AND PREFERRED SHARE DIVIDEND REQUIREMENTS	20
SELECTED FINANCIAL DATA	21
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	23
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	38
BUSINESS	38
MANAGEMENT	63
EXECUTIVE COMPENSATION	69
CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS	73
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT	74
EQUITY COMPENSATION PLAN AND WARRANT INFORMATION (1)	77
LIMITATION ON LIABILITY AND INDEMNIFICATION MATTERS	77
DESCRIPTION OF CAPITAL STOCK	78
SELLING SHAREHOLDERS	85
PLAN OF DISTRIBUTION	89
LEGAL MATTERS	91
EXPERTS	91
WHERE YOU CAN FIND MORE INFORMATION	92
INDEX TO FINANCIAL STATEMENTS	93

	i

·	the development and commercialization schedule for our fuel cell technology and products;

·	future funding under government research and development contracts;

·	the expected cost competitiveness of our fuel cell technology and products;

·	our intellectual property;

·	the timing and availability of our products;

·	the electric power supply industry and the distributed generation market;

·	our business strategy; and

·	general economic conditions in the electric power supply industry and our target markets.

·	We are selling ‘ultra-clean’ high-temperature fuel cell power plants for stationary base load power, which provide high fuel efficiency and high-value waste heat for cogeneration applications.

·	We have strong global distribution partners, including original equipment manufactures (OEMs) and energy service companies (ESCOs), with expertise in selling and marketing energy products and services to commercial and industrial customers worldwide.

·	We obtained commercial product certifications for safety, interconnection, installation and performance.

·	We are operating a fleet of DFC power plants at customer sites throughout the world, with a backlog that we expect will double the fleet in service in the next 12-18 months.

·	We have established production facilities, with equipment in place to produce 50 MW of DFC products annually.

·	We achieved our 2004 value-engineering cost reduction target of 25 percent and are confident we can continue to reduce costs.

·	We have expanded our sales and service capabilities to support our DFC products.

·	We have a strong balance sheet, with over $240 million in cash, cash equivalents and investments (U.S. Treasury Securities) as of November 18, 2004 to support our growth.

	3

The Offering
Securities offered:
5% Series B Cumulative Convertible
Perpetual Preferred Stock	43,550 shares.
Common stock	3,706,372 shares.
Securities outstanding after this offering:
5% Series B Cumulative Convertible
Perpetual Preferred Stock	62,325 shares.(1)
Common stock	51,869,796 shares.(2)
Use of proceeds	The proceeds from the sale of the shares of our Series B preferred stock and common stock being offered by the selling shareholders pursuant to this prospectus, net of any broker’s fee or commissions, will belong to the selling shareholders. We will not receive any of the proceeds from the sale of these shares. See section entitled “Use of Proceeds”.
Risk factors	See section entitled “Risk Factors” and other information in this prospectus for a discussion of factors you should carefully consider before deciding to invest in shares of our Series B preferred stock and common stock.
Dividend policy	We have never paid a cash dividend on our common stock and do not anticipate paying any cash dividends on common stock in the foreseeable future.
Nasdaq National Market symbol	FCEL.

 

		Year Ended October 31,
		2004			2003			2002			2001			2000
Revenues:
Research and development contracts		$	18,750		$	17,709		$	33,575		$	20,882		$	17,986
Product sales and revenue			12,636			16,081			7,656			5,297			2,729
Total revenues			31,386			33,790			41,231			26,179			20,715
Costs and expenses:
Cost of research and development contracts			27,290			35,827			45,664			19,033			12,508
Cost of product sales and revenues			39,961			50,391			32,129			16,214			4,968
Administrative and selling expenses			14,901			12,631			10,451			9,100			8,055
Research and development expenses			26,677			8,509			6,806			3,108			1,917
Purchased in-process research and development			12,200			—			—			—			—
Total costs and expenses			121,029			107,358			95,050			47,455			27,448
Loss from operations			(89,643	)		(73,568	)		(53,819	)		(21,276	)		(6,733	)
License fee income, net			19			270			270			270			266
Interest expense			(137	)		(128	)		(160	)		(116	)		(141	)
Interest and other income, net			2,472			6,012			4,876			5,684			2,138
Minority interest			—			—			—			—			11
Provision for taxes			—			—			7			—			—
Net loss from continuing operations			(87,289	)		(67,414	)		(48,840	)		(15,438	)		(4,459	)
Discontinued operations, net of tax			846			—			—			—			—
Net loss		$	(86,443	)	$	(67,414	)	$	(48,840	)	$	(15,438	)	$	(4,459	)
Basic and diluted loss per share
Continuing operations		$	(1.82	)	$	(1.71	)	$	(1.25	)	$	(0.45	)	$	(0.16	)
Discontinued operations		$	0.01		$	—		$	—		$	—		$	—
Net loss		$	(1.81	)	$	(1.71	)	$	(1.25	)	$	(0.45	)	$	(0.16	)
Basic and diluted weighted average shares outstanding			47,875			39,342			39,135			34,359			28,298

		As of October 31,
		2004			2003			2002			2001			2000
Cash, cash equivalents and short term investments (U.S. treasury securities)		$	152,395		$	134,750		$	205,996		$	274,760		$	74,754
Working capital			156,798			143,998			218,423			276,173			71,576
Total current assets			178,866			160,792			234,739			289,225			79,405
Long-term investments (U.S. treasury securities)			—			18,690			14,542			15,773			—
Total assets			236,510			223,363			289,803			334,020			91,028
Total current liabilities			22,070			16,794			16,316			13,052			7,588
Total non-current liabilities			1,476			1,484			1,785			1,252			—
Total shareholders’ equity			212,964			205,085			271,702			319,716			83,251
Book value per share(1)		$	4.42		$	5.20		$	6.93		$	8.20		$	2.65
____________

•

the cost competitiveness of our fuel cell products;

•

the future costs of natural gas and other fuels used by our fuel cell products;

•

consumer reluctance to try a new product;

•

consumer perceptions of the safety of our fuel cell products;

•

the pace of utility deregulation nationwide, which could affect the market for distributed generation;

•

local permitting and environmental requirements; and,

•

the emergence of newer, more competitive technologies and products.

•

any of the U.S., Canadian or other foreign patents owned by us or other patents that third parties license to us will not be invalidated, circumvented, challenged, rendered unenforceable or licensed to others; or,

•

any of our pending or future patent applications will be issued with the breadth of claim coverage sought by us, if issued at all.

•

failure to meet our product development and commercialization milestones;

•

variations in our quarterly operating results from the expectations of securities analysts or investors;

•

downward revisions in securities analysts’ estimates or changes in general market conditions;

•

announcements of technological innovations or new products or services by us or our competitors;

•

announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;

•

additions or departures of key personnel;

•

investor perception of our industry or our prospects;

•

insider selling or buying;

•

demand for our common stock; and,

•

general technological or economic trends.

		Common Stock Price
		High			Low
Year Ended October 31, 2002
First Quarter		$	21.85		$	13.55
Second Quarter		$	18.46		$	15.15
Third Quarter		$	16.73		$	6.62
Fourth Quarter		$	8.01		$	4.58
Year Ended October 31, 2003
First Quarter		$	9.05		$	5.39
Second Quarter		$	6.22		$	5.03
Third Quarter		$	9.90		$	6.28
Fourth Quarter		$	15.37		$	6.81
Year Ended October 31, 2004
First Quarter		$	17.25		$	11.44
Second Quarter		$	19.44		$	11.86
Third Quarter		$	17.23		$	8.36
Fourth Quarter		$	13.14		$	7.42

 

SELECTED FINANCIAL DATA

 

The selected consolidated financial data presented below as of the end of each of the years in the five-year period ended October 31, 2004 have been derived from our audited consolidated financial statements together with the notes thereto included elsewhere in this prospectus. The data set forth below is qualified by reference to, and should be read in conjunction with, such financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.             

(Amounts presented in thousands, except for per share amounts)

Consolidated Statement of Operations Data:

		Year Ended October 31,
		2004			2003			2002			2001			2000
Revenues:
Research and development contracts		$	18,750		$	17,709		$	33,575		$	20,882		$	17,986
Product sales and revenue			12,636			16,081			7,656			5,297			2,729
Total revenues			31,386			33,790			41,231			26,179			20,715
Costs and expenses:
Cost of research and development contracts			27,290			35,827			45,664			19,033			12,508
Cost of product sales and revenues			39,961			50,391			32,129			16,214			4,968
Administrative and selling expenses			14,901			12,631			10,451			9,100			8,055
Research and development expenses			26,677			8,509			6,806			3,108			1,917
Purchased in-process research and development			12,200			—			—			—			—
Total costs and expenses			121,029			107,358			95,050			47,455			27,448
Loss from operations			(89,643	)		(73,568	)		(53,819	)		(21,276	)		(6,733	)
License fee income, net			19			270			270			270			266
Interest expense			(137	)		(128	)		(160	)		(116	)		(141	)
Interest and other income, net			2,472			6,012			4,876			5,684			2,138
Minority interest			—			—			—			—			11
Provision for taxes			—			—			7			—			—
Net loss from continuing operations			(87,289	)		(67,414	)		(48,840	)		(15,438	)		(4,459	)
Discontinued operations, net of tax			846			—			—			—			—
Net loss		$	(86,443	)	$	(67,414	)	$	(48,840	)	$	(15,438	)	$	(4,459	)
Basic and diluted loss per share
Continuing operations		$	(1.82	)	$	(1.71	)	$	(1.25	)	$	(0.45	)	$	(0.16	)
Discontinued operations		$	0.01		$	—		$	—		$	—		$	—
Net loss		$	(1.81	)	$	(1.71	)	$	(1.25	)	$	(0.45	)	$	(0.16	)
Basic and diluted weighted average shares outstanding			47,875			39,342			39,135			34,359			28,298

	21

Consolidated Balance Sheet Data:

		As of October 31,
		2004			2003			2002			2001			2000
Cash, cash equivalents and short term investments (U.S. treasury securities)		$	152,395		$	134,750		$	205,996		$	274,760		$	74,754
Working capital			156,798			143,998			218,423			276,173			71,576
Total current assets			178,866			160,792			234,739			289,225			79,405
Long-term investments (U.S. treasury securities)			—			18,690			14,542			15,773			—
Total assets			236,510			223,363			289,803			334,020			91,028
Total current liabilities			22,070			16,794			16,316			13,052			7,588
Total non-current liabilities			1,476			1,484			1,785			1,252			—
Total shareholders’ equity			212,964			205,085			271,702			319,716			83,251
Book value per share(1)		$	4.42		$	5.20		$	6.93		$	8.20		$	2.65
____________

(1)    Calculated as total shareholder’s equity divided by common shares issued and outstanding as of the balance sheet date.

 

	22

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided as a supplement to the accompanying financial statements and footnotes to help provide an understanding of our financial condition, changes in our financial condition and results of operations. The MD&A is organized as follows:

 

Overview and recent developments. This section provides a general description of our business. We also briefly summarize any significant events occurring subsequent to the close of the reporting period.

 

Critical accounting policies and estimates. This section discusses those accounting policies and estimates that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application.

 

Results of operations. This section provides an analysis of our results of operations for the years ended October 31, 2004, 2003 and 2002. In addition, a description is provided of transactions and events that impact the comparability of the results being analyzed.

 

Liquidity and capital resources. This section provides an analysis of our cash position and cash flows.

 

Recent accounting pronouncements. This section summarizes recent accounting pronouncements and their impact on the company.

 

Factors that may affect future results.    In this section, we detail risk factors that affect our quarterly and annual results, but which are difficult to predict.

OVERVIEW AND RECENT DEVELOPMENTS

 

Overview

FuelCell Energy is a world leader in the development and manufacture of fuel cell power plants for clean, efficient and reliable electric power generation.  We have been developing fuel cell technology since our founding in 1969. We are currently commercializing our core carbonate fuel cell products (Direct FuelCell^® or DFC^® Power Plants), stationary applications for commercial and industrial customers, and continuing to develop our next generation of carbonate fuel cell products. In addition, we are beginning the development of another high temperature fuel cell system, planar solid oxide fuel cell (SOFC) technology, as a prime contractor in the U.S. Department of Energy’s (DOE) Solid State Energy Conversion Alliance (SECA) Program and through our 42 percent ownership interest in Versa Power Systems (Versa).

Direct FuelCell Power Plants

Increasing demand for reliable power worldwide, supplemented by air pollution concerns caused by older, combustion power generation, and unreliable electrical grid delivery systems present significant market opportunities for our core distributed generation products. Our proprietary carbonate DFC power plants electrochemically produce electricity directly from readily available hydrocarbon fuels, such as natural gas and wastewater treatment gas.  We believe our products offer significant advantages compared to other power generation technologies, including:

 

	23

 

 

·	High fuel efficiency;

·	Ultra-clean emissions;

·	Improved reliability;

·	Quiet operation;

·	Flexible siting and permitting requirements;

·	Scalability;

·	Ability to provide electricity and heat for cogeneration applications, such as district heating, process steam, hot water and absorption chilling for air conditioning;

·	Potentially lower operating, maintenance and generation costs than alternative distributed power generation technologies; and

·	Because our DFC power plants produce hydrogen from readily available fuels such as natural gas and wastewater treatment gas, they can be used to cost-effectively cogenerate hydrogen as well as electricity and heat.

Our current products, the DFC300A, DFC1500 and DFC3000, are rated in capacity at 250 kW, 1 MW and 2 MW, respectively, and are scalable for distributed applications up to 10 MW or larger.  Our products are designed to meet the base load power requirements of a wide range of commercial and industrial customers including wastewater treatment plants (municipal, such as sewage treatment facilities, and industrial, such as breweries and food processors), data centers, manufacturing facilities, office buildings, hospitals, universities, prisons, mail processing facilities and hotels, as well as in grid support applications for utility customers.  We are currently operating 29 power plants that incorporate our DFC technology at customer sites throughout the U.S., Europe and Japan. Installations at customer sites, including those that have completed their operations, have generated more than 55 million kWh of electricity through January 10, 2005.

 

On November 3, 2003, we completed our acquisition of Global located in Calgary, Canada. At the time of the acquisition, Global had been developing SOFC power plants since 1997 with the goal of commercializing its technology for residential, commercial and light industrial applications ranging in size from 3 to 10 kW. Through its thermoelectric generator (TEG) product line, Global also sold thermoelectric generators for use as a source of electrical power in remote areas. In connection with the acquisition, we issued, in the aggregate, approximately 8.2 million shares of our common stock and exchangeable shares, the latter of which were issued by FuelCell Energy, Ltd., our wholly-owned Canadian subsidiary (formerly FCE Canada Inc.). We also assumed Global's Series 2 Preferred Shares. Total consideration for the acquisition was approximately $94.8 million.

 

On May 28, 2004, we sold Global's TEG business for proceeds of approximately $16 million. The sale of the TEG business was affected through a sale of all of the outstanding common shares of Global. Prior to the sale, Global transferred substantially all of its assets and liabilities not relating to its TEG business (including substantially all of Global's assets and liabilities relating to its SOFC business and substantially all of its cash) to FuelCell Energy, Ltd. In addition, prior to the sale, the Global Series 2 Preferred Shares were cancelled and replaced with substantially equivalent Class A cumulative redeemable exchangeable preferred shares (which we refer to as the Series 1 preferred shares) issued by FuelCell Energy, Ltd.

 

On October 31, 2004, we redeemed all of the approximately two million issued and outstanding exchangeable shares issued by FuelCell Energy, Ltd. The exchangeable shares were redeemed in exchange for shares of our common stock on a one-for-one basis. The redemption had no impact on the total number of shares of our common stock deemed outstanding.

 

	24

Recent Developments

Preferred Share Offering

On November 11, 2004 we entered into a purchase agreement with Citigroup Global Markets Inc., RBC Capital Markets Corporation, Adams Harkness, Inc., and Lazard Freres & Co., LLC (collectively referred to as the “Initial Purchasers”) for the private placement under Rule 144A of up to 135,000 shares of our 5% Series B Cumulative Convertible Perpetual Preferred Stock (Liquidation Preference $1,000). On November 17, 2004, we closed on the sale of 100,000 shares of Series B preferred stock to the Initial Purchasers. Net proceeds to us were approximately $93.5 million.

 

Under the terms of the purchase agreement, the Initial Purchasers have an option through January 25, 2005 to purchase an additional 35,000 shares of Series B preferred stock and are entitled to indemnification from us in certain circumstances. On November 15, 2004, 5,875 of such shares have been sold and the Initial Purchasers now have the option through January 25, 2005 to purchase the remaining 29,125 shares of Series B preferred stock.

Sale of Canadian Solid Oxide Fuel Cell Operation to Versa Power Systems, Inc.

On November 1, 2004, pursuant to an asset purchase agreement, dated October 19, 2004, by and among us, our wholly-owned Canadian subsidiary, FuelCell Energy, Ltd., Versa Power Systems, Inc. (Versa), a Delaware corporation, and Versa Power Systems, Ltd., a Canadian corporation and wholly-owned subsidiary of Versa Power Systems, Inc., FuelCell Energy, Ltd. transferred substantially all of its solid oxide fuel cell (SOFC) assets and operations (including manufacturing and test equipment, intellectual property and personnel) to Versa Power Systems, Ltd. In exchange, we received 5,714 shares of Versa Power Systems, Inc. common stock, increasing our ownership position in Versa to 7,714 shares, or 42 percent. No cash was exchanged in the transaction.

 

Assets sold to Versa totaled approximately $12.4 million and were classified as held for sale on the balance sheet as of October 31, 2004. Upon closing of the sale on November 1, 2004, our total investment in Versa was approximately $14.4 million and will be classified as “Equity investments”. We will account for this investment under the equity method in future periods.

 

Pursuant to the terms of the transaction, we expect to incur cash costs in the range of approximately $1.0 million to $1.5 million related to severance and facility consolidations in Calgary, Canada. Approximately $0.1 million of this amount is related to severance payments to employees paid during the quarter ended October 31, 2004. The remaining payments are expected to be made during fiscal year 2005. In addition, we have committed to paying future severance costs for time and service accrued up to November 1, 2004 by employees that are moving to Versa in the event that they are terminated by Versa Power Systems, Ltd. (or its parent). Our liability for such severance costs is limited to the period commencing on November 1, 2004 through the earlier of (1) award of Phase 2 of the SECA program to FuelCell, (2) one year after completion of Phase 1 of the SECA program, or (3) February 26, 2008. Subsequent to this period, Versa Power Systems, Ltd. (or its parent) will be responsible for the severance liability for such employees. We estimate this liability at approximately $0.8 million.

	25

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Revenue Recognition

We contract with our customers to perform research and development or manufacture and install fuel cell components and power plants under long-term contracts. We recognize revenue on a method similar to the percentage-of-completion method.

 

Revenues on fuel cell research and development contracts are recognized proportionally as costs are incurred and compared to the estimated total research and development costs for each contract. In many cases, we are reimbursed only a portion of the costs incurred or to be incurred on the contract. Revenues from government funded research, development and demonstration programs are generally multi-year, cost reimbursement and/or cost shared type contracts or cooperative agreements. We are reimbursed for reasonable and allocable costs up to the reimbursement limits set by the contract or cooperative agreement.

 

While government research and development contracts may extend for many years, funding is often provided incrementally on a year-by-year basis if contract terms are met and Congress has authorized the funds. As of October 31, 2004, research and development sales backlog totaled $16.4 million, of which 79 percent is funded. Should funding be temporarily delayed or if business initiatives change, we may choose to devote resources to other activities, including internally funded research and development.

 

Fuel cell product sales and revenues include revenues from product sales and service contracts. Revenues from fuel cell product sales are recognized proportionally as costs are incurred and assigned to a customer contract by comparing the estimated total manufacture and installation costs for each contract to the total contract value. Revenues from service contracts are recognized ratably over the contract term while costs are expensed as incurred. As our fuel cell products are in their initial stages of development and market acceptance, actual costs incurred could differ materially from those previously estimated. Once we have established that our fuel cell products have achieved commercial market acceptance and future costs can be reasonably estimated, then estimated costs to complete an individual contract, in excess of revenue, will be accrued immediately upon identification.

Warrant Value Recognition

Warrants have been issued as sales incentives to certain of our business partners. These warrants vest as orders from our business partners exceed stipulated levels. Should warrants vest, or when management estimates that it is probable that warrants will vest, we will record a proportional amount of the fair value of the warrants against related revenue as a sales discount. During the three months ended April 30, 2004, a tranche of 200,000 warrants issued to one of our business partners vested with the receipt of a 4 MW order. The fair value of these warrants was determined to be $0.5 million. This has been recorded as other current assets on the consolidated balance sheet with the offsetting entry to additional paid in capital. In accordance with our warrant value recognition policy, as we recognize the associated revenue for orders placed in accordance with these sales agreements, a proportional amount of the fair value of the warrants will be recorded against the revenue as a sales discount. To date, approximately $0.1 million of sales discounts have been recognized.

 

	26

Inventories

During the procurement and manufacturing process of a fuel cell power plant, costs for material, labor and overhead are accumulated in raw materials and work-in-process (WIP) inventory until they are transferred to a customer contract.

Our inventories are stated at the lower of cost or market price. As we sell products at or below cost, we provide for a lower of cost or market (LCM) adjustment to the cost basis of inventory. This adjustment is estimated by comparing the current sales prices of our power plants to estimated costs of completed power plants. In certain circumstances, for long-lead time items, we will make advance payments to vendors for future inventory deliveries, which are recorded as a component of other current assets on the consolidated balance sheet. We also provide for a LCM adjustment to the advance payments to vendors.

 

As of October 31, 2004 and October 31, 2003, the LCM adjustment to cost basis of inventory and advance payments to vendors was approximately $13.5 million and $11.0 million respectively, which equates to a reduction of approximately 45 and 41 percent respectively of the inventory value. The increase in the adjustment to cost basis and percentage over our fiscal year ended October 31, 2003 is due to changes in the mix of inventory. As of October 31, 2004, our balance of plant inventory and advances to vendors had increased over the prior year-end due to our current production schedule. As inventory levels increase or decrease, appropriate adjustments to cost basis are made.

Internal Research and Development Expenses

We conduct internally funded research and development activities to improve current or anticipated product performance and reduce product life-cycle costs. These costs are classified as research and development expenses on our statements of operations.

 

	27

 

RESULTS OF OPERATIONS

Management evaluates the results of operations and cash flows using a variety of key performance indicators. Indicators that management uses include revenues compared to prior periods and internal forecasts, costs of our products and results of our “cost-out” initiatives, and operating cash use. These are discussed throughout the ‘Results of Operations’ and ‘Liquidity and Capital Resources’ sections contained under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Comparison of the Years Ended October 31, 2004 and October 31, 2003

Revenues and costs of revenues

 

The following tables summarize our revenue and cost mix for the years ended October 31, 2004 and 2003 respectively (dollar amounts in thousands):

		Year Ended October 31, 2004						Year Ended October 31, 2003						Percentage Increase /
Revenues:			Revenues			Percent of Revenues			Product Revenues			Percent of Revenues		(Decrease) in Revenues
Research and development contracts		$	18,750			60	%	$	17,709			52	%		6	%
Product sales and revenues			12,636			40	%		16,081			48	%		(21	%)
Total		$	31,386			100	%	$	33,790			100	%		(7	%)

 

 

		Year Ended October 31, 2004						Year Ended October 31, 2003						Percentage Increase /
Cost of revenues:			Costs of Revenues			Percent of Costs of Revenues			Costs of Revenues			Percent of Costs of Revenues		(Decrease) in Costs of Revenues
Research and development contracts		$	27,290			41	%	$	35,827			42	%		(24	%)
Product sales and revenues			39,961			59	%		50,391			58	%		(21	%)
Total		$	67,251			100	%	$	86,218			100	%		(22	%)

 

Total revenues for the year ended October 31, 2004 decreased by $2.4 million, or 7 percent, to $31.4 million from $33.8 million during the same period last year. The components of our revenues and cost of revenues are further described as follows:

 

Research and development contracts

Revenue from research and development contracts will vary from year to year depending on government funding levels, new contracts and work on existing contracts. Revenue from research and development contracts increased 6 percent during the year ended October 31, 2004 to $18.8 million from $17.7 million in same period of the prior year. Revenues have increased on the Vision 21 and Solid State Energy Conversion Alliance (SECA) contracts with the U.S. Department of Energy (DOE). These increases were offset by lower revenue from the Clean Coal contract as the installation phase for this two megawatt DFC3000 power plant was completed.

 

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The cost of research and development contract revenue declined by $8.5 million for the year ended October 31, 2004 (fiscal 2004) compared to the prior year due to the mix of cost shared contracts and reduced costs for the Clean Coal, Product Design Improvement (PDI), and King County contracts as major tasks were completed on those contracts. The ratio of costs to contract revenues was 1.5 to 1, which decreased from 2.0 to 1 when compared to the same period of the prior year. The primary driver of the improved cost ratio was increased funding for the PDI program during fiscal 2004. Significant cost share contracts in fiscal 2004 included Clean Coal, PDI, Vision 21, King County, Navy Phase II and SECA. We concluded work on the PDI contract during the quarter ended October 31, 2004 and do not expect significant future revenues or costs related to this contract.

For strategic reasons, we currently plan to continue to participate in government cost share contracts that advance the development of fuel cells. As a result, we expect that costs on these contracts will be higher than revenues received.

 

Fuel cell product sales and revenues and product costs

Fuel cell product sales were $12.6 million for the year ended October 31, 2004 compared to $16.1 million in the same period of a year ago. The lower product sales and revenues were due to production scheduling for customer requirements and production on power plants for power purchase agreements where product revenues are not recognized until power is sold to the customer over an extended term. Power plant production was at approximately the same level as the prior year (6 MW). As of October 31, 2004, product sales backlog totaled approximately $26.3 million, compared to $14.4 million as of October 31, 2003. This backlog does not include 1.5 MW of orders for power purchase agreements for Santa Barbara and Sierra Nevada Brewing Co.

Product costs decreased with lower revenue to $40.0 million from $50.4 million. The ratio of costs to revenue increased slightly from 3.1 to 3.2 to 1 over the prior year due to costs totaling approximately $2.0 million associated with the power purchase agreements noted above. This increase was partially offset by lower overall product costs recognized on power plants built in 2004 when compared to the prior year due to progress on our cost out program.

Our products do not ship on an even production schedule. The shipment date to customers depends on a number of factors that are outside of our control, including siting requirements, construction and permits. We do not have the sales or order history to quantify trends as of yet.

Administrative and selling expenses

Excluding costs from our Canadian SOFC operations, administrative and selling expenses increased by $1.1 million or 9 percent, to $13.7 million during the year ended October 31, 2004 compared to $12.6 million in the prior year. Approximately $0.8 million of this increase was due to increased sales and marketing expenses and $0.2 million was due to higher investor relations costs related to our increased shareholder base. In addition, we incurred $1.2 million of administrative and selling expenses in our Canadian SOFC operations as a result of our acquisition during the year ended October 31, 2004. We do not expect to incur any significant administrative and selling expenses related to the Canadian SOFC operation in our fiscal year ending October 31, 2005 (fiscal 2005), as it was sold effective November 1, 2004.

Research and development expenses

Excluding costs from our Canadian SOFC operations, research and development expenses increased to $17.6 million during year ended October 31, 2004 compared to $8.5 million recorded in 2003. The increase is due to continued focus on our “cost-out” program (implemented in fiscal 2003), product documentation and engineering support for products in the field. During fiscal 2004, we expanded our cost out program by hiring additional engineering employees. Our cost-out program is expected to: reduce material costs, simplify design, improve manufacturing yields, reduce product assembly labor, and reduce production cycle time of our DFC products. In addition, we incurred $9.0 million of research and development expenses in our Canadian SOFC operations as a result of our acquisition during the year ended October 31, 2004. We do not expect to incur any significant research and development expenses related to the Canadian SOFC operation in fiscal 2005, as it was sold effective November 1, 2004.

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Purchased in-process research and development

The $12.2 million in-process research and development (IPR&D) charge relates to SOFC technology acquired in the Global transaction. In 1997, Global began developing SOFC technology, which is still in development. The $12.2 million allocated to IPR&D was determined using two established valuation techniques. An average of the cost valuation and market valuation approaches were used to determine the IPR&D amount. The amounts estimated in this valuation were calculated using a risk-adjusted discount rate of 30 percent. As the acquired technology has not yet reached technological feasibility and no alternative future uses existed, it was expensed upon acquisition in accordance with Statement of Financial Accounting Standards (SFAS) No. 2, “Accounting for Research and Development Costs.”

The IPR&D acquired was related to one project, the development of a solid oxide fuel cell. Prior to the transaction date, Global spent approximately five years developing this technology. In 2003, we received notice of an award to participate in the DOE’s ten-year SECA program to develop low cost solid oxide fuel cells for residential, commercial, and light industrial applications. We currently estimate that it will take approximately five to ten years to complete the development. The SECA program is a cost-share program totaling approximately $139 million. This technology was subsequently sold to our partner in the SECA program, Versa, along with fixed assets in exchange for stock, which increased our ownership in Versa to approximately 42 percent.

Loss from operations

The loss from operations for the year ended October 31, 2004 totaled $89.6 million compared to the $73.6 million recorded in 2003. The loss from operations for the year ended October 31, 2004 totaled $67.2 million compared to the $73.6 million recorded in 2003 or a reduction of approximately 9 percent excluding the Canadian SOFC operation. The reduction in operating loss was due to lower cost of research and development and product revenues partially offset by increased administrative, selling and internal research and development costs.

We expect to incur operating losses in future reporting periods as we continue to participate in government cost share programs, sell products at prices lower than our current production costs, and invest in our “cost out” initiatives. As a result of selling our Canadian SOFC operations, we expect to reduce our annual cash use by approximately $10.0 million. The Global and SOFC operations were part of Global, which was acquired by us in November 2003, thus there are no comparable periods of the prior year.

Interest and other income, net

Interest and other income, net, declined by $3.5 million when comparing the fiscal year ended October 31, 2004 to the prior year. During the year ended October 31, 2003, we realized Connecticut state research and development incentives totaling $3.4 million. We did not realize tax incentives during the year ended October 31, 2004 although we have applied for approximately $1.5 million of such credits. During the year ended October 31, 2004, we realized foreign currency gains totaling approximately $0.5 million, which offset a decline (compared to the prior year) of interest income totaling approximately $0.9 million. The reduction in interest income is due to reduced average interest rates on the invested cash.

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Provision for income taxes

We believe, that due to our efforts to commercialize our DFC technology, we will continue to incur losses. Based on projections for future taxable income over the period in which the deferred tax assets are realizable, management believes that significant uncertainty exists surrounding the recoverability of the deferred tax assets. Therefore, no tax benefit has been recognized related to current year losses and other deferred tax assets.

Discontinued operations, net of tax

Discontinued operations reflects the net income of $0.8 million of the TEG business segment that was sold on May 28, 2004. Refer also to Note 2 - Discontinued Operations of our consolidated financial statements. The Global TEG business segment was acquired by us in November 2003, thus there are no results from discontinued operations in the comparable period of the prior year.

Comparison of the Years Ended October 31, 2003 and October 31, 2002

Revenues and cost of revenues

 

The following tables summarize our revenue and cost mix for the years ended October 31, 2003 and 2002, respectively (dollar amounts in thousands):

Revenues:		Year Ended October 31, 2003						Year Ended October 31, 2002						Percentage Increase /
		Revenues			Percent of Revenues			Revenues			Percent of Revenues			(Decrease) in Revenues
Research and development contracts		$	17,709			52	%	$	33,575			81	%		(47	%)
Product sales and revenues			16,081			48	%		7,656			19	%		110	%
Total		$	33,790			100	%	$	41,231			100	%		(18	%)

 

Cost of revenues:		Year Ended October 31, 2003						Year Ended October 31, 2002						Percentage Increase /
		Costs of Revenues			Percent of Costs of Revenues			Cost of Revenues			Percent of Costs of Revenues				(Decrease) in Cost
Research and development contracts		$	35,827			42	%	$	45,664			59	%		(22	%)
Product sales and revenues			50,391			58	%		32,129			41	%		57	%
Total		$	86,218			100	%	$	77,793			100	%		11	%

Total revenues for the year ended October 31, 2003 decreased by $7.4 million or 18 percent, to $33.8 million from $41.2 million during the prior year. This decrease in total revenues was comprised of a 47 percent decrease in government research and development contracts partially offset by a 110 percent increase in product sales revenue.

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Research and development contracts

Fiscal 2002 research and development contract revenue included a large portion of our one-megawatt and two megawatt power plants for King County, Washington and Clean Coal, respectively. Combined revenue on these contracts was lower in 2003. Also, in 2003, under budgetary constraints, funding from the U.S. government for certain of our other contracts was delayed. 

Cost of research and development contracts decreased to $35.8 million during the year ended October 31, 2003, compared to $45.7 million during fiscal 2002. The decrease was partially due to completion of tasks on the King County, Washington project and delayed funding on certain government contracts. While our funding was reduced due to timing and budgetary constraints, we continue to participate in cost-share contracts and invest in developing fuel cell technology. Our significant cost share contracts during fiscal 2003 included Clean Coal, Department of Energy, King County, and Navy Phase II. The ratio of costs to contract revenues increased in 2003 as the mix of cost-share contracts increased during the year.

 

Product sales and revenues

The fiscal 2003 increase in product sales revenue was related to increased manufacturing and delivery of our DFC300A power plants for both our distribution partners and direct customers. As a percent of total revenues, product revenues comprised 48 percent compared to 19 percent in the prior year as we continue to focus our business initiatives on the manufacture and delivery of our fuel cell products.

 

Cost of product sales and revenues increased to $50.3 million during the year ended October 31, 2003 compared to $32.1 million during the prior year. This increase was due to additional product sales recorded during the year. The ratio of costs to contract revenues decreased in 2003 as we have reduced overall product costs through our “cost-out” initiatives and incurred less “first time” costs including qualifying multiple vendors for materials and components.

Administrative and selling expenses

Administrative and selling expenses increased by 21 percent, to $12.6 million during the year ended October 31, 2003 compared to $10.5 million in the prior year. This increase was primarily comprised of higher business insurance costs, sales and marketing salaries and franchise taxes.

Research and development expenses

Research and development expenses increased 25 percent, to $8.5 million during the year ended October 31, 2003 compared to the $6.8 million recorded in fiscal 2002. This increase is primarily due to increased investment in development costs associated with the design, engineering, fabrication and installation of our products.

Loss from operations

The net result of our revenues and costs was a loss from operations during the year ended October 31, 2003 totaling $73.6 million. This operating loss is approximately 37 percent higher than the $53.8 million loss recorded in fiscal 2002. We continue to invest in the standardization of our DFC power plants. For strategic reasons, we also continue to participate in government cost share contracts to advance the development of fuel cells. These factors contributed to our operating loss. Other factors impacting the operating loss included reduced funding on certain government contracts, development of our distribution network, and increases in operating costs including depreciation on new production equipment, business insurance premiums, information systems and infrastructure.

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Interest and other income, net

Interest and other income, net, increased by 23 percent, to $6.0 million during the year ended October 31, 2003 compared to the $4.9 million recorded in fiscal 2002. We have participated in a program available from the State of Connecticut that allows certain taxpayers to exchange the amount of research and development credits generated during a taxable year for cash to be received over a three-year period. The increase to interest and other income, net was due, in part, to tax credits generated in fiscal years 2001 and 2002 totaling $3.4 million being recorded in fiscal 2003. There were no tax credits recorded during fiscal 2002. Interest income for the year declined by $2.3 million or 47 percent as a result of reduced interest rates and lower cash and investment balances compared to the prior year.

Taxes

We believe that due to our efforts to commercialize our DFC technology, we have and will continue to incur losses. Based on projections for future taxable income over the period in which the deferred tax assets are realizable, management believes that significant uncertainty exists surrounding the recoverability of the deferred tax assets. Therefore, no tax benefit has been recognized related to current year losses and other deferred tax assets.

LIQUIDITY AND CAPITAL RESOURCES

We had approximately $152.4 million of cash, cash equivalents and investments as of October 31, 2004 compared to $153.4 million as of October 31, 2003. Net cash and investments used during the year was $1.0 million, consisting of approximately $70 million used in operations offset by $69 million of cash and investments received in the Global Thermoelectric, Inc. (Global) transactions. Cash used during the year included approximately $10.9 million related to our Canadian operations. As our Canadian operations were sold in fiscal 2004, we expect reduced cash use in Canada in future periods.

Subsequent to our fiscal year end, we received net proceeds of approximately $93.5 million from our preferred stock sale, which closed on November 17, 2004.

Sources and Uses of Cash and Investments

We continue to invest in new product development and bringing our products to market and, as such, we are not currently generating positive cash flow from our operations.  Our operations are funded primarily through sales of equity securities and cash generated from operations. Cash from operations includes revenue from government research and development contracts, product sales, license fees and interest income. Our future cash requirements depend on numerous factors including future involvement in research and development contracts, implementing our cost reduction efforts on our fuel cell products and increasing annual order volume.

Future involvement in research and development contracts

Our research and development contracts are generally multi-year, cost reimbursement type contracts.  The majority of these are U.S. Government contracts that are dependent upon the government’s continued allocation of funds and may be terminated in whole or in part at the convenience of the government. We will continue to seek research and development contracts. To obtain these contracts, we must continue to prove the benefits of our technologies and be successful in our competitive bidding.

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Implementing our cost reduction efforts on our fuel cell products

We believe that reducing product cost is essential for us to penetrate the market for our fuel cell products and is critical to achieving profitability.  We believe this will reduce and/or eliminate the need for incentive funding programs that are currently available to allow our product pricing to compete with grid-delivered power and other distributed generation technologies. In 2003, we began a “cost-out” program that focuses on three key areas:

·	increased performance output;

·	increased stack life; and

·	design simplification and materials replacement and/or elimination to reduce product cost.

Increasing annual order volume

We believe that increased production volumes will spread fixed costs over more units of production, resulting in a lower per unit cost. Our manufacturing, testing and conditioning facilities have equipment in place to accommodate 50 MW of annual production. Our multi-disciplined cost reduction program is expected to significantly reduce our product costs over time.  We currently believe that we can achieve operating break-even at annual production volumes of approximately 100 MW. Our fiscal 2004 production volume is estimated at approximately 6 MW.

We anticipate that our existing capital resources, together with anticipated revenues, will be adequate to satisfy our planned financial requirements and agreements through at least the next twelve months.

Cash Inflows and Outflows

During year ended October 31, 2004, total cash and cash equivalents and investments decreased by $1.0 million, compared with a decrease of $67.1 million during the year ended October 31, 2003.  In fiscal 2004, we had a net cash use of approximately $70.0 million offset by cash and investments acquired in the Global acquisition and subsequent disposition (net of fees) totaling $69.0 million.

The key components of our cash inflows and outflows from continuing operations were as follows:

Operating Activities: During the year ended October 31, 2004, we used $64.6 million in cash in our operating activities, which consists of a net loss for the period of approximately $86.4 million, offset by non-cash adjustments totaling $20.6 million, cash generated from working capital of approximately $2.0 million and income from discontinued operations of approximately $.8 million.  This compares to an operating cash usage of $58.8 million during the year ended October 31, 2003. 

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Accounts Receivable

Accounts receivable as of October 31, 2004 increased by approximately $2.7 million from October 31, 2003 due to approximately $3.2 million more in product receivables offset by a decline of government accounts receivable totaling $0.5 million. The increase in product receivables is due to greater milestone billings to customers consistent with the expanded product backlog. We bill our fuel cell contracts based upon certain milestones that generally commence with contract signing and extend to commissioning of a completed power plant. We generally bill our government contracts on a monthly basis as costs are incurred. As revenues increase or decrease, billings and accounts receivable will increase or decrease as well.

Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses combined have increased by approximately $2.7 million since October 31, 2003 due to the timing of inventory payments related to our current production schedule. In addition we had accrued approximately $0.8 million in severance costs as of October 31, 2004 related to our sale of the SOFC business to Versa.

 

Investing Activities:  We acquired Global on November 3, 2003 by issuing, in total, approximately 8.2 million common and exchangeable shares.  In connection with the acquisition, we acquired $55.8 million of cash and investments.  The cash acquired from Global was offset by approximately $2.8 million of transaction and professional fees. In May 2004, we completed our sale of the Global entity and its TEG product line for net proceeds of approximately $16.0 million.

Capital expenditures for the year ended October 31, 2004 were approximately $7.9 million compared to $6.6 million in the prior period. Reductions in systems and infrastructure spending during fiscal 2004 have been offset by capital expenditures totaling approximately $4.7 million related to power plants being built for power purchase agreements. In addition, there were capital expenditures totaling approximately $1.0 million relating to one DFC300A that we have provided to the Department of Defense (DoD) Fuel Cell Test and Evaluation Center (FCTec).

Financing Activities:  During the year ended October 31, 2004, we generated $2.7 million from financing activities through the exercise of stock options, partially offset by repayments of debt and preferred dividends.  This compares with $0.5 million generated in the year ended October 31, 2003.

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Commitments and Significant Contractual Obligations

 

A summary of our significant future commitments and contractual obligations as of October 31, 2004 and the related payments by fiscal year is summarized as follows (in thousands):