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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K/A
 
 
 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2004.
 
OR
 
 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO ______.

Commission File Number:   0-23336  
 
 
AROTECH CORPORATION

(Exact name of registrant as specified in its charter)
Delaware
 
95-4302784
(State or other jurisdiction of incorporation or organization)
 
 
(I.R.S. Employer Identification No.)
 
354 Industry Drive, Auburn, Alabama
 
36830
(Address of principal executive offices)
 
 
(Zip Code)
 
 
(334) 502-9001
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
 
Name of each exchange on which registered
None
 
 
Not applicable
 
 
Securities registered pursuant to Section 12(g) of the Act: 
 
Common Stock, $0.01 par value
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: 
 
Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
 
 o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
 
 Yes x No o
The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant as of June 30, 2004 was approximately $128,605,410 (based on the last sale price of such stock on such date as reported by The Nasdaq National Market and assuming, for the purpose of this calculation only, that all of the registrant’s directors and executive officers are affiliates).
 
   
(Applicable only to corporate registrants) Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:
 
 
80,103,668 as of 3/10/05
 
Documents incorporated by reference:  
 
None


 


 
Potential persons who are to respond to the collection of information contained in this form are not required to respond unless the form displays a currently valid OMB control number.




PRELIMINARY NOTE
 
This amended annual report contains historical information and forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to our business, financial condition and results of operations. The words “estimate,”“project,”“intend,”“expect” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated in such forward-looking statements. Further, we operate in an industry sector where securities values may be volatile and may be influenced by economic and other factors beyond our control. In the context of the forward-looking information provided in this annual report and in other reports, please refer to the discussions of risk factors detailed in, as well as the other information contained in, our other filings with the Securities and Exchange Commission.
 
Electric Fuel® is a registered trademark and Arotech™ is a trademark of Arotech Corporation, formerly known as Electric Fuel Corporation. All company and product names mentioned may be trademarks or registered trademarks of their respective holders. Unless otherwise indicated, “we,”“us,”“our” and similar terms refer to Arotech and its subsidiaries.

 

 
PART II
 
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI-TION AND RESULTS OF OPERATION
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve inherent risks and uncertainties. When used in this discussion, the words “believes,”“anticipated,”“expects,”“estimates” and similar expressions are intended to identify such forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those set forth elsewhere in this report. Please see “Risk Factors,” below, and in our other filings with the Securities and Exchange Commission.
 
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements contained in Item 8 of this report, and the notes thereto. We have rounded amounts reported here to the nearest thousand, unless such amounts are more than 1.0 million, in which event we have rounded such amounts to the nearest hundred thousand.
 
General
 
We are a defense and security products and services company, engaged in three business areas: interactive simulation for military, law enforcement and commercial markets; batteries and charging systems for the military; and high-level armoring for military, paramilitary and commercial vehicles. Until September 17, 2003, we were known as Electric Fuel Corporation. We operate in three business units:
 
Ø  
we develop, manufacture and market advanced hi-tech multimedia and interactive digital solutions for use-of-force and driving training of military, law enforcement, security and other personnel, as well as offering security consulting and other services (our Simulation, Security and Consulting Division);
 
Ø  
we manufacture aviation armor and we utilize sophisticated lightweight materials and advanced engineering processes to armor vehicles (our Armoring Division); and
 
Ø  
we manufacture and sell Zinc-Air and lithium batteries for defense and security products and other military applications and we pioneer advancements in Zinc-Air battery technology for electric vehicles (our Battery and Power Systems Division).
 
During 2004, we acquired three new businesses: FAAC Corporation, located in Ann Arbor, Michigan, which provides simulators, systems engineering and software products to the United States military, government and private industry (which we have placed in our Simulation and Security Division); Epsilor Electronic Industries, Ltd., located in Dimona, Israel, which develops and sells rechargeable and primary lithium batteries and smart chargers to the military and to private industry in the Middle East, Europe and Asia (which we have placed in our Battery and Power Systems Division); and Armour of America, Incorporated, located in Los Angeles, California, which manufacturers aviation armor both for helicopters and for fixed wing aircraft, marine armor, personnel armor, armoring kits for military vehicles, fragmentation blankets and a unique ballistic/flotation vest (ArmourFloat) that is U.S. Coast Guard-certified, which we have placed in our Armor Division. Prior to the acquisition of FAAC and Epsilor, we were organized into two divisions: Defense and Security Products (consisting of IES, MDT and MDT Armor), and Electric Fuel Batteries (consisting of EFL and EFB). Our financial results for 2003 do not include the activities of FAAC, Epsilor or AoA and therefore are not directly comparable to our financial results for 2004.
  

 
Restatement of Previously-Issued Financial Statements
 
During our management’s review of our interim financial statements for the period ended September 30, 2004, we, after discussion with and based on a new and revised review of accounting treatment by our independent auditors, conducted a comprehen-sive review of the re-pricing of warrants and grant of new warrants to certain of our investors and others during the years 2004 and 2003. As a result of that review, we, upon recommendation of our management and with the approval of the Audit Committee of our Board of Directors after discussion with our independent auditors, reconsidered the accounting related to these transactions and reclassified certain expenses as a deemed dividend, a non-cash item, instead of as general and administrative expenses due to the recognition of these transactions as capital transactions that should not be expensed. These restatements did not affect our balance sheet, shareholders’ equity or cash flow statements. In addition and as a result of the remeasurement described above, we have reviewed assumptions used in the calculation of fair value of all warrants granted during the year 2003. As a result of this comprehensive review, we have decreased general and administrative expenses in the amount of $150,000, related to errors found in the valuation of warrants granted in the litigation settlement described in Note 14.f.6. of the Notes to Consolidated Financial Statements for the year ended December 31, 2004.
 
In addition, during our management’s review of our interim financial statements for the period ended September 30, 2004, we also reviewed our calculation of amortization of debt discount attributable to the beneficial conversion feature associated with our convertible debentures. As a result of this review, we found errors which increased our financial expenses in the amount of $568,000 for the year ended December 31, 2003. The errors were related to the amortization of debt discount attributable to the warrants and the related convertible debentures, whereby we understated the amount of amortization for the year ended December 31, 2003 attributable to certain of the convertible debentures.
 
Similar errors were also noted in our interim financial statements in the three-month period ended June 30, 2003, the nine-month period ended September 30, 2003, and the three- and six-month periods ended March 31 and June 30, 2004.
 
The impacts of these restatements with respect to the year ended December 31, 2003 are summarized below:
 
- 2 -

 
Statement of Operations Data:
 
   
For the Year ended December 31, 2003
 
   
Previously
Reported
 
Adjustment
 
As Restated
 
General and administrative expenses 
 
$
6,196,779
 
$
(338,903
)
$
5,857,876
 
Operating loss 
   
5,408,932
   
(338,903
)
 
5,070,029
 
Financial expenses, net 
   
3,470,459
   
568,250
   
4,038,709
 
                     
Loss from continuing operations 
   
9,118,684
   
229,347
   
9,348,031
 
Net loss 
   
9,008,274
   
229,347
   
9,237,621
 
Deemed dividend to certain stockholders of common stock  
   
-
   
350,000
   
350,000
 
Net loss attributable to common stockholders 
 
$
9,008,274
 
$
579,347
 
$
9,587,621
 
                     
Basic and diluted net loss per share from continuing operations 
 
$
0.23
 
$
0.01
 
$
0.24
 
Basic and diluted net loss per share 
 
$
0.23
 
$
0.02
 
$
0.25
 

Balance Sheet Data:
 
   
As of December 31, 2003
 
   
Previously Reported
 
Adjustment
 
As Restated
 
Other accounts payable and accrued expenses 
 
$
4,180,411
 
$
(150,000
)
$
4,030,411
 
Total current liabilities 
   
6,859,752
   
(150,000
)
 
6,709,752
 
Convertible debenture 
   
881,944
   
568,250
   
1,450,194
 
Total long term liabilities 
   
4,066,579
   
568,250
   
4,634,829
 
                     
Additional paid in capital 
   
135,891,316
   
(188,903
)
 
135,702,413
 
Accumulated deficit 
   
(109,681,893
)
 
(229,347
)
 
(109,911,240
)
Total shareholders’ equity 
   
22,044,127
   
(418,250
)
 
21,625,877
 

Cash Flow Data:
 
   
For the Year ended December 31, 2003
 
   
Previously
Reported
 
Adjustment
 
As Restated
 
Net loss 
 
$
9,008,274
 
$
229,347
 
$
9,237,621
 
Stock based compensation related to repricing of warrants granted to investors and the grant of new warrants 
   
388,403
   
(188,903
)
 
199,500
 
Increase in other accounts payable and accrued expenses 
   
1,827,668
   
(150,000
)
 
1,677,668
 
                     
Amortization of compensation related to beneficial conversion feature and warrants issued to holders of convertible debentures 
   
3,359,987
   
568,250
   
3,928,237
 
 
 
- 3 -


 
Critical Accounting Policies
 
The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowance for bad debts, inventory, contingencies and warranty reserves, impairment of intangible assets and goodwill. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Under different assumptions or conditions, actual results may differ from these estimates.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Revenue Recognition
 
Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differences in the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management’s estimates change on the basis of development of the business or market conditions. Management judgments and estimates have been applied consistently and have been reliable historically.
 
A portion of our revenue is derived from license agreements that entail the customization of FAAC’s simulators to the customer’s specific requirements. Revenues from initial license fees for such arrangements are recognized in accordance with Statement of Position 81-1 “Accounting for Performance of Construction - Type and Certain Production - Type Contracts” based on the percentage of completion method over the period from signing of the license through to customer acceptance, as such simulators require significant modification or customization that takes time to complete. The percentage of completion is measured by monitoring progress using records of actual time incurred to date in the project compared with the total estimated project requirement, which corresponds to the costs related to earned revenues. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management.
 
We believe that the use of the percentage of completion method is appropriate as we have the ability to make reasonably dependable estimates of the extent of progress towards completion, contract revenues and contract costs. In addition, contracts executed include provisions that clearly specify the enforceable rights regarding services to be provided and received by the parties to the contracts, the consideration to be exchanged and the manner and terms of settlement. In all cases we expect to perform our contractual obligations and our licensees are expected to satisfy their obligations under the contract. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent with the application of the percentage of completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and specification and testing requirement changes.
   
- 4 -

 
We account for our other revenues from IES simulators in accordance with the provisions of SOP 97-2, “Software Revenue Recognition,” issued by the American Institute of Certified Public Accountants and as amended by SOP 98-4 and SOP 98-9 and related interpretations. We exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period.
 
We assess whether collection is probable at the time of the transaction based on a number of factors, including the customer’s past transaction history and credit worthiness. If we determine that the collection of the fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon the receipt of cash.
 
Allowance for Doubtful Accounts
 
We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding receivables. In determining the provision, we analyze our historical collection experience and current economic trends. We reassess these allowances each accounting period. Historically, our actual losses and credits have been consistent with these provisions. If actual payment experience with our customers is different than our estimates, adjustments to these allowances may be necessary resulting in additional charges to our statement of operations.
 
Accounting for Income Taxes
 
Significant judgment is required in determining our worldwide income tax expense provision. In the ordinary course of a global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities, the process of identifying items of revenue and expense that qualify for preferential tax treatment and segregation of foreign and domestic income and expense to avoid double taxation. Although we believe that our estimates are reasonable, the final tax outcome of these matters may be different than that which is reflected in our historical income tax provisions and accruals. Such differences could have a material effect on our income tax provision and net income (loss) in the period in which such determination is made.
 
We have provided a valuation allowance on the majority of our net deferred tax assets, which includes federal and foreign net operating loss carryforwards, because of the uncertainty regarding their realization. Our accounting for deferred taxes under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“Statement 109”), involves the evaluation of a number of factors concerning the realizability of our deferred tax assets. In concluding that a valuation allowance was required, we primarily considered such factors as our history of operating losses and expected future losses in certain jurisdictions and the nature of our deferred tax assets. The Company and its subsidiaries provide valuation allowances in respect of deferred tax assets resulting principally from the carryforward of tax losses. Management currently believes that it is more likely than not that the deferred tax regarding the carryforward of losses and certain accrued expenses will not be realized in the foreseeable future. The company does not provide for US Federal Income taxes on the undistributed earnings of its foreign subsidiaries because such earnings are re-invested and, in the opinion of management, will continue to be re-invested indefinitely.
 
 
- 5 -

 
In addition, we operate within multiple taxing jurisdictions and may be subject to audits in these jurisdictions. These audits can involve complex issues that may require an extended period of time for resolution. In management’s opinion, adequate provisions for income taxes have been made.
 
Inventories
 
Our policy for valuation of inventory and commitments to purchase inventory, including the determination of obsolete or excess inventory, requires us to perform a detailed assessment of inventory at each balance sheet date, which includes a review of, among other factors, an estimate of future demand for products within specific time horizons, valuation of existing inventory, as well as product lifecycle and product development plans. The estimates of future demand that we use in the valuation of inventory are the basis for our revenue forecast, which is also used for our short-term manufacturing plans. Inventory reserves are also provided to cover risks arising from slow-moving items. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions. We may be required to record additional inventory write-down if actual market conditions are less favorable than those projected by our management. For fiscal 2004, no significant changes were made to the underlying assumptions related to estimates of inventory valuation or the methodology applied.
 
Goodwill
 
Under Financial Accounting Standards Board Statement No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests based on estimated fair value in accordance with SFAS 142.
 
In June 2004, we completed our annual impairment test and assessed the carrying value of goodwill as required by SFAS 142. The goodwill impairment test compared the carrying value of the Company’s reporting units with the fair value at that date. Because the market capitalization exceeded the carrying value significantly, no impairment arose.
 
We determine fair value using discounted cash flow analysis. This type of analysis requires us to make assumptions and estimates regarding industry economic factors and the profitability of future business strategies. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economic conditions, as well as future expectations. In assessing the recoverability of our goodwill, we may be required to make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. This process is subjective and requires judgment at many points throughout the analysis. If our estimates or their related assumptions change in subsequent periods or if actual cash flows are below our estimates, we may be required to record impairment charges for these assets not previously recorded.
 
Other Intangible Assets
 
Other intangible assets are amortized to the Statement of Operations over the period during which benefits are expected to accrue, currently estimated at two to ten years.
 
- 6 -

 
We recorded a $320,000 impairment charge in 2004 in respect of certain technology acquired from Bristlecone in 2003.
 
The determination of the value of such intangible assets requires us to make assumptions regarding future business conditions and operating results in order to estimate future cash flows and other factors to determine the fair value of the respective assets. If these estimates or the related assumptions change in the future, we could be required to record additional impairment charges.
 
Contingencies
 
We are from time to time involved in legal proceedings and other claims. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. We have not made any material changes in the accounting methodology used to establish our self-insured liabilities during the past three fiscal years.
 
A determination of the amount of reserves required, if any, for any contingencies are made after careful analysis of each individual issue. The required reserves may change due to future developments in each matter or changes in approach, such as a change in the settlement strategy in dealing with any contingencies, which may result in higher net loss.
 
If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material.
 
Warranty Reserves
 
Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically twelve months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factors that may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality products and the fact that our products are complex and may contain undetected defects, errors or failures in either the hardware or the software.
 
Functional Currency
 
We consider the United States dollar to be the currency of the primary economic environment in which we and our Israeli subsidiary EFL operate and, therefore, both we and EFL have adopted and are using the United States dollar as our functional currency. Transactions and balances originally denominated in U.S. dollars are presented at the original amounts. Gains and losses arising from non-dollar transactions and balances are included in net income.
 
The majority of financial transactions of our Israeli subsidiaries MDT and Epsilor is in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS. Management believes that the NIS is the functional currency of MDT and Epsilor. Accordingly, the financial statements of MDT and Epsilor have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of accumulated other comprehensive loss in shareholders’ equity.
 
 
- 7 -

 
Recent Developments
 
CECOM IDIQ Order
 
In March 2005 we received a new Firm Fixed Price, Indefinite Delivery, Indefinite Quantity (IDIQ) order from the U.S. Army’s Communications Electronic Command (CECOM) to supply up to $24 million in zinc-air batteries and adaptors to the Department of Defense over the next three years. Under the new contract, EFB will be enabled to deliver the BA-8180/U zinc-air battery and the three existing interface adapters. In addition, a new battery, the BA-8140/U, and four new adapters are included in this contract and have been ordered for First Article Testing (FAT).
 
Executive Summary
 
The following executive summary includes discussion of our new subsidiaries, FAAC Incorporated, Epsilor Electronic Industries, Ltd. and Armour of America Incorporated, that we purchased in 2004.
 
Divisions and Subsidiaries
 
We operate primarily as a holding company, through our various subsidiaries, which we have organized into three divisions. Our divisions and subsidiaries (all 100% owned, unless otherwise noted) are as follows:
 
Ø  
Our Simulation and Security Division, consisting of:
 
·  
FAAC Incorporated, located in Ann Arbor, Michigan, which provides simulators, systems engineering and software products to the United States military, government and private industry (“FAAC”); and
 
·  
IES Interactive Training, Inc., located in Littleton, Colorado, which provides specialized “use of force” training for police, security personnel and the military (“IES”).
 
Ø  
Our Armor Division, consisting of:
 
·  
Armour of America, located in Los Angeles, California, which manufacturers ballistic and fragmentation armor kits for rotary and fixed wing aircraft, marine armor, personnel armor, military vehicles and architectural applications, including both the LEGUARD Tactical Leg Armor and the Armourfloat Ballistic Floatation Device, which is a unique vest that is certified by the U.S. Coast Guard (“AoA”); 
 
·  
MDT Protective Industries, Ltd., located in Lod, Israel, which specializes in using state-of-the-art lightweight ceramic materials, special ballistic glass and advanced engineering processes to fully armor vans and SUVs, and is a leading supplier to the Israeli military, Israeli special forces and special services (“MDT”) (75.5% owned); and
 
- 8 -

·  
MDT Armor Corporation, located in Auburn, Alabama, which conducts MDT’s United States activities (“MDT Armor”) (88% owned).
 
Ø  
Our Battery and Power Systems Division, consisting of:
 
·  
Epsilor Electronic Industries, Ltd., located in Dimona, Israel (in Israel’s Negev desert area), which develops and sells rechargeable and primary lithium batteries and smart chargers to the military and to private industry in the Middle East, Europe and Asia (“Epsilor”);
 
·  
Electric Fuel Battery Corporation, located in Auburn, Alabama, which manufactures and sells Zinc-Air fuel sells, batteries and chargers for the military, focusing on applications that demand high energy and light weight (“EFB”); and
 
·  
Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh, Israel, which produces water-activated lifejacket lights for commercial aviation and marine applications, and which conducts our Electric Vehicle effort, focusing on obtaining and implementing demonstration projects in the U.S. and Europe, and on building broad industry partnerships that can lead to eventual commercialization of our Zinc-Air energy system for electric vehicles (“EFL”).
 
Overview of Results of Operations
 
We incurred significant operating losses for the years ended December 31, 2004, 2003 and 2002. While we expect to continue to derive revenues from the sale of products that we manufacture and the services that we provide, there can be no assurance that we will be able to achieve or maintain profitability on a consistent basis.
 
During 2003 and 2004, we substantially increased our revenues and reduced our net loss, from $18.5 million in 2002 to $9.2 million in 2003 to $9.0 million in 2004. This was achieved through a combination of cost-cutting measures and increased revenues, particularly from the sale of Zinc-Air batteries to the military and from sales of products manufactured by the subsidiaries we acquired in 2002 and 2004.
 
We succeeded during 2004 in moving Arotech to a positive cash flow situation, for the first time in our history. We are focused on continuing this success in 2005 and beyond, and ultimately on achieving profitability. In this connection, we note that most of our business lines historically have had weaker first halves than second halves, and weaker first quarters than second quarters. We expect this to be the case for 2005 as well.
 
A portion of our operating loss during 2004 and 2003 arose as a result of non-cash charges. These charges were primarily related to our acquisitions, financings and issuances of restricted shares and options to employees. Because we anticipate continuing certain of these activities during 2005, we expect to continue to incur such non-cash charges in the future.
 
- 9 -

 
Acquisitions
 
In acquisition of subsidiaries, part of the purchase price is allocated to intangible assets and goodwill, Amortization of intangible assets related to acquisition of subsidiaries is recorded based on the estimated expected life of the assets. Accordingly, for a period of time following an acquisition, we incur a non-cash charge related to amortization of intangible assets in the amount of a fraction (based on the useful life of the intangible assets) of the amount recorded as intangible assets. Such amortization charges will continue during 2005. We are required to review intangible assets for impairment whenever events or changes in circumstances indicate that carrying amount of the assets may not be recoverable. If we determine, through the impairment review process, that intangible asset has been impaired, we must record the impairment charge in our statement of operations.
 
In the case of goodwill, the assets recorded as goodwill are not amortized; instead, we are required to perform an annual impairment review. If we determine, through the impairment review process, that goodwill has been impaired, we must record the impairment charge in our statement of operations.
 
As a result of the application of the above accounting rule, we incurred non-cash charges for amortization of intangible assets and impairment in the amount of $2.8 million during 2004. See “Critical Accounting Policies - Other Intangible Assets,” above.
 
Financings
 
The non-cash charges that relate to our financings occurred in connection with our issuance of convertible debentures with warrants, and in connection with our repricing of certain warrants and grants of new warrants. When we issue convertible debentures, we record a discount for a beneficial conversion feature that is amortized ratably over the life of the debenture. When a debenture is converted, however, the entire remaining unamortized beneficial conversion feature expense is immediately recognized in the quarter in which the debenture is converted. Similarly, when we issue warrants in connection with convertible debentures, we record debt discount for financial expenses that is amortized ratably over the term of the convertible debentures; when the convertible debentures are converted, the entire remaining unamortized debt discount is immediately recognized in the quarter in which the convertible debentures are converted. As and to the extent that our remaining convertible debentures are converted, we would incur similar non-cash charges going forward.
 
As a result of the application of the above accounting rule, we incurred non-cash charges related to amortization of debt discount attributable to beneficial conversion feature in the amount of $4.1 million during 2004.
 
Additionally, in an effort to improve our cash situation and our shareholders’ equity, and in order to reduce the number of our outstanding warrants, during 2003 and 2004 we induced holders of certain of our warrants to exercise their warrants by lowering the exercise price of the warrants to approximately market value in exchange for immediate exercise of such warrants, and by issuing to such investors a lower number of new warrants at a higher exercise price. Under such circumstances, we record a deemed dividend in an amount determined based upon the fair value of the new warrants. As and to the extent that we engage in similar warrant repricings and issuances in the future, we would incur similar non-cash charges.
 
As a result of the application of the above accounting rule, we recorded a deemed dividend related to warrants repricing and grant of new warrants in the amount of $3.3 million during 2004.
 
 
- 10 -

Restricted Share and Option Issuances
 
During 2004, we issued restricted shares to certain of our employees. These shares were issued as stock bonuses, and are restricted for a period of two years from the date of issuance. Relevant accounting rules provide that the aggregate amount of the difference between the purchase price of the restricted shares (in this case, generally zero) and the market price of the shares on the date of grant is taken as a general and administrative expense, amortized over the life of the period of the restriction.
 
Additionally, during 2003 and 2004 we issued options to employees that were subject to shareholder approval of a new stock option plan. While the options were issued at the market price of our stock on the respective dates of issuance, they were not considered by applicable accounting rules to have been finally issued until the date shareholder approval for the new stock option plan was obtained. In the interim, the market price of our stock had risen, and thus the options were deemed to have been issued at a below-market price. We were therefore required to take as a general and administrative expense the aggregate difference
As a result of the application of the above accounting rules, we incurred non-cash charges related to stock-based compensation in the amount of $884,000 during 2004.
 
Overview of Financial Condition and Operating Performance
 
We shut down our money-losing consumer battery operations and began acquiring new businesses in the defense and security field in 2002. Thereafter, we concentrated on eliminating our operating deficit and moving Arotech to cash-flow positive operations, a goal we achieved for the first time in our history in the second half of 2004. In order to do this, we focused on acquiring businesses with strong revenues and profitable operations.
 
In our Simulation and Security Division, revenues grew from approximately $8.0 million in 2003 to $21.5 million in 2004 (on a pro forma basis, assuming we had owned all components of our Simulation and Security Division since January 1, 2003, revenues would have grown from approximately $17.9 million in 2003 to $21.5 million in 2004). We attribute this to a number of substantial orders, such as orders from the U.S. Army and the Chicago Transit Authority. As of December 31, 2004, our backlog for our Simulation and Security Division totaled $12.7 million.
 
Our Armor Division had record revenues during 2004, with revenues growing from approximately $3.4 million in 2003 to $18.0 million in 2004 (on a pro forma basis, assuming we had owned all components of our Armor Division since January 1, 2003, revenues would have grown from approximately $10.9 million in 2003 to $29.2 million in 2004). Much of this growth was attributable to armoring orders connected with the war in Iraq. As of December 31, 2004, our backlog for our Armor Division totaled $4.0 million.
 
- 11 -

 
In our Battery and Power Systems Division, revenues grew from approximately $5.9 million in 2003 to $10.5 million in 2004 (on a pro forma basis, assuming we had owned all components of our Battery and Power Systems Division since January 1, 2003, revenues would have fallen from approximately $10.8 million in 2003 to $10.5 million in 2004). As of December 31, 2004, our backlog for our Battery and Power Systems Division totaled $8.3 million.
 
Results of Operations
 
Preliminary Note
 
Summary
 
Results of operations for the year ended December 31, 2004 include the results of FAAC, Epsilor and AoA for the periods following our acquisition of each such company during 2004. However, the results of these subsidiaries were not included in our operating results for the year ended December 31, 2003. Accordingly, the following year-to-year comparisons should not necessarily be relied upon as indications of future performance.
 
Following is a table summarizing our results of operations for the years ended December 31, 2004 and 2003, after which we present a narrative discussion and analysis:
 
 
   
Year Ended December 31,
 
   
2004
 
2003*
 
Revenues:
         
Simulation and Security Division
 
$
21,464,406
 
$
8,022,026
 
Armor Division
   
17,988,687
   
3,435,716
 
Battery and Power Systems Division
   
10,500,753
   
5,868,899
 
   
$
49,953,846
 
$
17,326,641
 
Cost of revenues:
             
Simulation and Security Division
 
$
11,739,690
 
$
3,944,701
 
Armor Division
   
15,449,084
   
2,621,550
 
Battery and Power Systems Division
   
6,822,320
   
4,521,589
 
   
$
34,011,094
 
$
11,087,840
 
Research and development expenses:
             
Simulation and Security Division
 
$
395,636
 
$
132,615
 
Armor Division
   
17,065
   
84,186
 
Battery and Power Systems Division
   
1,318,678
   
836,607
 
   
$
1,731,379
 
$
1,053,408
 
Sales and marketing expenses:
             
Simulation and Security Division
 
$
3,185,001
 
$
2,237,386
 
Armor Division
   
565,981
   
180,631
 
Battery and Power Systems Division
   
1,171,235
   
926,872
 
All Other
   
-
   
187,747
 
   
$
4,922,217
 
$
3,532,636
 
General and administrative expenses:
             
Simulation and Security Division
 
$
2,852,969
 
$
1,001,404
 
Armor Division
   
1,323,982
   
518,053
 
Battery and Power Systems Division
   
965,058
   
188,655
 
All Other
   
5,514,857
   
4,149,764
 
   
$
10,656,866
 
$
5,857,876
 
 
 
- 12 -

 
   
Year Ended December 31,
 
   
2004
 
2003*
 
Financial expense (income):
             
Simulation and Security Division
 
$
27,842
 
$
(119,750
)
Armor Division
   
13,503
   
(19,918
)
Battery and Power Systems Division
   
54,511
   
7,936
 
All Other
   
4,133,109
   
4,170,441
 
   
$
4,228,965
 
$
4,038,709
 
Tax expenses:
             
Simulation and Security Division
 
$
77,811
 
$
30,130
 
Armor Division
   
134,949
   
363,173
 
Battery and Power Systems Division
   
320,878
   
-
 
All Other
   
52,471
   
2,890
 
   
$
586,109
 
$
396,193
 
Amortization of intangible assets and impairment losses:
             
Simulation and Security Division
 
$
1,643,682
 
$
720,410
 
Armor Division
   
661,914
   
144,500
 
Battery and Power Systems Division
   
509,239
   
-
 
   
$
2,814,835
 
$
864,910
 
Minority interest in loss (profit) of subsidiaries:
             
Simulation and Security Division
 
$
-
 
$
-
 
Armor Division
   
(44,694
)
 
156,900
 
Battery and Power Systems Division
   
-
   
-
 
   
$
(44,694
)
$
156,900
 
Loss from continuing operations:
             
Simulation and Security Division
 
$
1,541,775
 
$
75,130
 
Armor Division
   
(222,485
)
 
(299,559
)
Battery and Power Systems Division
   
(661,166
)
 
(612,760
)
All Other
   
(9,700,437
)
 
(8,510,842
)
   
$
(9,042,313
)
$
(9,348,031
)
Income from discontinued operations:
             
Simulation and Security Division
 
$
-
 
$
-
 
Armor Division
   
-
   
-
 
Battery and Power Systems Division
   
-
   
110,410
 
 
   $
-
 
$
110,410
 
Net loss:
             
Simulation and Security Division
 
$
1,541,775
 
$
75,130
 
Armor Division
   
(222,485
)
 
(299,559
)
Battery and Power Systems Division
   
(661,166
)
 
(502,350
)
All Other
   
(9,700,437
)
 
(8,510,842
)
   
$
(9,042,313
)
$
(9,237,621
)
 
 
- 13 -

 
 
   
Year Ended December 31,
 
   
2004
 
2003*
 
Revenues:
         
Simulation and Security Division
 
$
21,464,406
 
$
8,022,026
 
Armor Division
   
17,988,687
   
3,435,716
 
Battery and Power Systems Division
   
10,500,753
   
5,868,899
 
   
$
49,953,846
 
$
17,326,641
 
Cost of revenues:
             
Simulation and Security Division
 
$
11,739,690
 
$
3,944,701
 
Armor Division
   
15,449,084
   
2,621,550
 
Battery and Power Systems Division
   
6,822,320
   
4,521,589
 
   
$
34,011,094
 
$
11,087,840
 
Research and development expenses:
             
Simulation and Security Division
 
$
395,636
 
$
132,615
 
Armor Division
   
17,065
   
84,186
 
Battery and Power Systems Division
   
1,318,678
   
836,607
 
   
$
1,731,379
 
$
1,053,408
 
Sales and marketing expenses:
             
Simulation and Security Division
 
$
3,185,001
 
$
2,237,386
 
Armor Division
   
565,981
   
180,631
 
Battery and Power Systems Division
   
1,171,235
   
926,872
 
All Other
   
-
   
187,747
 
   
$
4,922,217
 
$
3,532,636
 
General and administrative expenses:
             
Simulation and Security Division
 
$
2,852,969
 
$
1,001,404
 
Armor Division
   
1,323,982
   
518,053
 
Battery and Power Systems Division
   
965,058
   
188,655
 
All Other
   
5,514,857
   
4,149,764
 
   
$
10,656,866
 
$
5,857,876
 
 
 
 
* Restated (see Note 1.b. of Notes to Consolidated Financial Statements).
 
Fiscal Year 2004 compared to Fiscal Year 2003
 
Revenues. During 2004, we recognized revenues as follows:
 
Ø  
From the sale of interactive training systems and from the provision of warranty services in connection with such systems (FAAC and IES);
 
Ø  
From payments under armor contracts and for service and repair of armored vehicles (AoA and MDT);
 
Ø  
From the sale of batteries, chargers and adapters to the military, and under certain development contracts with the U.S. Army (EFB and Epsilor);
 
Ø  
From the sale of lifejacket lights (EFL); and
 
 
- 14 -

 
Ø  
From subcontracting fees received in connection with Phase III of the United States Department of Transportation (DOT) electric bus program, which began in October 2003 and was completed in March 2004. Phase IV of the DOT program, which began in October 2004, did not result in any revenues during 2004 (EFL).
 
Revenues from continuing operations for the year ended December 31, 2004 totaled $50.0 million, compared to $17.3 million for 2003, an increase of $32.6 million, or 188%. This increase was primarily attributable to the following factors:
 
Ø  
Increased revenues from vehicle armoring; and
 
Ø  
Revenues generated by FAAC, Epsilor and AoA in 2004 that were not present in 2003.
 
These increases were offset to some extent by decreased revenues from sales of interactive use-of-force training systems and decreased revenues from sales of our Zinc-Air military batteries.
 
In 2004, revenues were $21.5 million for the Simulation and Security Division (compared to $8.0 million in 2003, an increase of $13.4 million, or 168%, due primarily to the added revenues from sales of driver training systems since we acquired FAAC (approximately $16.5 million), offset to some extent by decreased revenues from use-of-force training systems); $18.0 million for the Armor Division (compared to $3.4 million in 2003, an increase of $14.6 million, or 424%, due primarily to increased revenues from vehicle armoring and to the added revenues from aircraft armoring since we acquired AoA); and $10.5 million for the Battery and Power Systems Division (compared to $5.9 million in 2003, an increase of $4.6 million, or 79%, due primarily to the added revenues from sales of lithium batteries and chargers since we acquired Epsilor (approximately $5.3 million), offset to some extent by decreased revenues from our Zinc-Air military batteries).
 
Cost of revenues and gross profit. Cost of revenues totaled $34.0 million during 2004, compared to $11.1 million in 2003, an increase of $22.9 million, or 207%, due to increased cost of goods sold, particularly in the Armor Division (partly as a result of our beginning to sell pre-armored vehicles in 2004, which requires us to purchase vehicles for pre-armoring) and in the Simulation and Security Division, as well as the inclusion of the cost of goods of FAAC, Epsilor and AoA in our results for 2004 but not 2003.
 
Direct expenses for our three divisions during 2004 were $17.9 million for the Simulation and Security Division (compared to $7.3 million in 2003, an increase of $10.6 million, or 145%, due primarily to the addition of expenses associated with sales of driver training systems through FAAC (approximately $12.0 million), offset to some extent by decreased expenses associated with the sales of use-of-force training systems); $16.4 million for the Armor Division (compared to $3.6 million in 2003, an increase of $12.9 million, or 359%, due primarily to increased expenses associated with sales of vehicle armoring (a $12.1 million increase in 2004, including the expenses of purchasing vehicles for pre-armoring in 2004, which was not present in 2003), and to the addition beginning in August 2004 of expenses associated with sales of aircraft armoring through our new subsidiary AoA); and $10.0 million for the Battery and Power Systems Division (compared to $5.9 million in 2003, an increase of $4.0 million, or 68%, due primarily to the addition of expenses associated with sales of lithium batteries and chargers through our new Epsilor subsidiary ($4.2 million), offset to some extent by decreased expenses associated with the sales of Zinc-Air military batteries).
 
- 15 -

 
Gross profit was $15.9 million during 2004, compared to $6.2 million during 2003, an increase of $9.7 million, or 155%. This increase was the direct result of all factors presented above, most notably the inclusion of FAAC, Epsilor and AoA in our results for 2004 ($10.2 million), as well as the increased revenues from vehicle armoring ($1.6 million), offset to some extent by a decrease of $2.0 million in gross profit from IES.
 
Research and development expenses. Research and development expenses for 2004 were $1.7 million, compared to $1.1 million in 2003, an increase of $678,000, or 64%. This increase was primarily the result of the inclusion of the research and development expenses of FAAC, Epsilor and AoA in our results in 2004 ($533,000) and increased research and development expenses of EFL and EFB.
 
Sales and marketing expenses. Sales and marketing expenses for 2004 were $4.9 million, compared to $3.5 million in 2003, an increase of $1.4 million, or 39%. This increase was primarily attributable to the inclusion of the sales and marketing expenses of FAAC, Epsilor and AoA in our results for 2004 ($2.0 million), offset to some extent by a decrease of $600,000 in expenses related to our military batteries and a decrease in sales and marketing expenses related to interactive use-of-force training.
 
General and administrative expenses. General and administrative expenses for 2004 were $10.7 million, compared to $5.9 million in 2003, an increase of $4.8 million, or 82%. This increase was primarily attributable to the following factors:
 
Ø  
The inclusion of the general and administrative expenses of FAAC, Epsilor and AoA in our results for 2004 ($2.4 million);
 
Ø  
Expenses in 2004 in connection with grant of options and shares to employees that were not present in 2003 ($830,000);
 
Ø  
Costs associated with our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 that were not present in 2003 ($150,000); and
 
Ø  
Increases in other general and administrative expenses, such as employee salaries and bonuses, travel expenses, audit fees, director fees, legal fees, and expenses related to due diligence performed in connection to certain potential acquisitions, that were not present in 2003.
 
We are not anticipating a reduction in our general and administrative expenses in the coming year, and we expect that our travel expenses, audit fees, legal fees, and due diligence expenses will continue or increase to the extent that we continue to pursue acquisitions in the future.
 
These increases were offset to some extent by:
 
- 16 -

 
Ø  
Expenses in 2003 in connection with a litigation settlement agreement that were not present in 2004 ($700,000); and
 
Ø  
Amortization of legal and consulting expenses in 2003 in connection with our convertible debentures that were lower (by $260,000) than in 2004.
 
Financial expenses, net. Financial expense, net of interest income and exchange differentials, totaled approximately $4.2 million in 2004 compared to $4.0 million in 2003, an increase of $190,000, or 5%. This difference was due primarily to amortization of debt discount related to the issuance of convertible debentures and their conversion, as well as interest expenses related to those debentures.
 
Income taxes. We and certain of our subsidiaries incurred net operating losses during 2004 and, accordingly, we were not required to make any provision for income taxes. With respect to some of our subsidiaries that operated at a net profit during 2004, we were able to offset federal taxes against our net operating loss carry forwards. We recorded a total of $586,000 in tax expenses in 2004, with respect to certain of our subsidiaries that operated at a net profit during 2004 and we are not able to offset their taxes against our net operating loss carry forwards and with respect to state taxes. In 2003, tax expenses were recorded with respect to MDT’s taxable income. Out of the $586,000 tax expense that we recorded in 2004, $84,000 was related to prior years and $(37,000) represented income from deferred taxes, net.
 
Amortization of intangible assets. Amortization of intangible assets totaled $2.8 million in 2004, compared to $865,000 in 2003, an increase of $1.9 million, or 225%, resulting from the inclusion of the amortization of the intangible assets of FAAC, Epsilor and AoA in our results in 2004 and impairment in the amount of $320,000 of technology previously purchased by IES from Bristlecone Technologies.
 
Net loss before deemed dividend of common stock to certain stockholders. Due to the factors cited above, we reported a net loss of $9.0 million in 2004, compared to a net loss of $9.2 million in 2003, a decrease of $195,000, or 2%.
 
Net loss after deemed dividend of common stock to certain stockholders was $12.4 million due to a deemed dividend of $3.3 million (see Notes 14.f.4. and 14.f.5. to the financial statements) compared to $9.6 million in 2003, an increase of 2.8 million, or 29%.
 
Fiscal Year 2003 compared to Fiscal Year 2002
 
Revenues. During 2003, we (through our subsidiaries) recognized revenues as follows:
 
Ø  
IES recognized revenues from the sale of interactive use-of-force training systems and from the provision of warranty services in connection with such systems;
 
Ø  
MDT recognized revenues from payments under vehicle armoring contracts and for service and repair of armored vehicles;
 
Ø  
EFB recognized revenues from the sale of batteries and adapters to the military, and under certain development contracts with the U.S. Army;
 
Ø  
Arocon recognized revenues under consulting agreements; and
 
 
- 17 -

 
Ø  
EFL recognized revenues from the sale of lifejacket lights and from subcontracting fees received in connection with Phase III of the United States Department of Transportation (DOT) electric bus program, which began in October 2002 and was completed in March 2004. Phase IV of the DOT program, which began in October 2003, did not result in any revenues during 2003.
 
Revenues from continuing operations for the year ended December 31, 2003 totaled $17.3 million, compared to $6.4 million for 2002, an increase of $10.9 million, or 170%. This increase was primarily the result of increased sales attributable to IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 but only part of 2002.
 
In 2003, revenues were $8.0 million for the Simulation and Security Division (compared to $2.0 million in 2002, an increase of $6.0 million, or 305%, due primarily to the inclusion of IES in our results for the full year of 2003 but only part of 2002), $5.9 million for the Battery and Power Systems Division (compared to $1.7 million in the comparable period in 2002, an increase of $4.2 million, or 249%, due primarily to increased sales to the U.S. Army on the part of EFB), and $3.4 million for the Armor Division (compared to $2.7 million in 2002, an increase of $691,000, or 25%, due primarily to the inclusion of MDT in our results for the full year of 2003 but only part of 2002).
 
Cost of revenues and gross profit. Cost of revenues totaled $11.1 million during 2003, compared to $4.4 million in 2002, an increase of $6.7 million, or 151%, due to increased cost of goods sold, particularly by IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 but only part of 2002.
 
Direct expenses for our three divisions during 2003 were $7.3 million for the Simulation and Security Division (compared to $2.0 million in 2002, an increase of $5.3 million, or 259%, due primarily to increased sales attributable to the inclusion of IES in our results for the full year of 2003 but only part of 2002), $5.9 million for the Battery and Power Systems Division (compared to $3.1 million in the comparable period in 2002, an increase of $2.9 million, or 94%, due primarily to increased sales on the part of EFB to the U.S. Army), and $3.6 million for the Armor Division (compared to $2.3 million in 2002, an increase of $1.3 million, or 55%, due primarily to the inclusion of MDT in our results for the full year of 2003 but only part of 2002).
 
Gross profit was $6.2 million during 2003, compared to $2.0 million during 2002, an increase of $4.3 million, or 214%. This increase was the direct result of all factors presented above, most notably the increased sales of IES and EFB, as well as the inclusion of IES and MDT in our results for the full year of 2003 but only part of 2002. In 2003, IES contributed $4.1 million to our gross profit, EFB contributed $1.6 million, and MDT contributed $833,000.
 
Research and development expenses. Research and development expenses for 2003 were $1.1 million, compared to $686,000 in 2002, an increase of $367,000, or 54%. This increase was primarily because certain research and development personnel who had worked on the discontinued consumer battery operations during 2002 (the expenses of which are not reflected in the 2002 number above) were reassigned to military battery research and development in 2003.
 
- 18 -

 
Sales and marketing expenses. Sales and marketing expenses for 2003 were $3.5 million, compared to $1.3 million in 2002, an increase of $2.2 million, or 170%. This increase was primarily attributable to the following factors:
 
Ø  
The inclusion of the sales and marketing expenses of IES and MDT in our results for the full year of 2003 but only part of 2002;
 
Ø  
An increase in IES’s sales activity during 2003, which resulted in both increased sales and increased sales and marketing expenses during 2003; and
 
Ø  
We incurred expenses for consultants in the amount of $810,000 in connection with our CECOM battery program with the U.S. Army and $345,000 in connection with our security consulting business.
 
General and administrative expenses. General and administrative expenses for 2003 were $5.9 million, compared to $4.0 million in 2002, an increase of $1.8 million, or 46%. This increase was primarily attributable to the following factors:
 
Ø  
The inclusion of the general and administrative expenses of IES and MDT in our results for the full year of 2003 but only part of 2002;
 
Ø  
Expenses in 2003 in connection with a litigation settlement agreement, in the amount of $714,000, that were not present in 2002;
 
Ø  
Expenses in 2003 in connection with warrant grants, in the amount of $199,500, that were not present in 2002;
 
Ø  
Legal and consulting expenses in 2003 in connection with our convertible debentures, in the amount of $484,000, that were not present in 2002; and
 
Ø  
Expenses in 2003 in connection with the start-up of our security consulting business in the United States and with the beginning of operations of MDT Armor, in the amount of $250,000, that were not present in 2002.
 
Financial income (expense). Financial expense totaled approximately $4.0 million in 2003 compared to financial income of $100,000 in 2002, an increase of $4.1 million. This increase was due primarily to amortization of compensation related to the issuance of convertible debentures issued in December 2002 and during 2003 in the amount of $3.9 million, and interest expenses related to those debentures in the amount of $376,000.
 
Tax expenses. We and our Israeli subsidiary EFL incurred net operating losses during 2003 and 2002 and, accordingly, we were not required to make any provision for income taxes. MDT and IES had taxable income, and accordingly we were required to make provision for income taxes in the amount of $396,000 in 2003. We were able to offset IES’s federal taxes against our loss carryforwards. In 2002 we did not accrue any tax expenses due to our belief that we would be able to utilize our loss carryforwards against MDT’s taxable income, estimation was revised in 2003. Of the amount accrued in 2003, approximately $352,000 was accrued on account of income in 2002.
 
- 19 -

 
Amortization of intangible assets and in-process research and development. Amortization of intangible assets totaled $865,000 in 2003, compared to $649,000 in 2002, an increase of $215,000, or 33%, resulting from amortization of these assets subsequent to our acquisition of IES and MDT in 2002. Of this $215,000 increase, $169,000 was attributable to IES and $46,000 was attributable to MDT.
 
Loss from continuing operations. Due to the factors cited above, we reported a net loss from continuing operations of $9.3 million in 2003, compared to a net loss of $4.9 million in 2002, an increase of $4.4 million, or 90%.
 
Profit (loss) from discontinued operations. In the third quarter of 2002, we decided to discontinue operations relating to the retail sales of our consumer battery products. Accordingly, all revenues and expenses related to this segment have been presented in our consolidated statements of operations for the years ended December 31, 2003 and 2002 in an item entitled “Loss from discontinued opera-tions.”
 
Income from discontinued operations in 2003 was $110,000, compared to a loss of $13.6 million in 2002, a decrease of $13.7 million. This decrease was the result of the elimination of the losses from these discontinued operations beginning with the fourth quarter of 2002. The income from discontinued operations was primarily from cancellation of past accruals made unnecessary by the closing of the discontinued operations.
 
Net loss before deemed dividend. Due to the factors cited above, we reported a net loss before deemed dividend of $9.2 million in 2003, compared to a net loss of $18.5 million in 2002, a decrease of $9.3 million, or 50%.
 
Net loss after deemed dividend of common stock to certain stockholders. Due to the factors cited above, we reported a net loss after deemed dividend of $9.6 million in 2003, compared to a net loss of $18.5 million in 2002, a decrease of $8.9 million, or 48%.
 
Liquidity and Capital Resources
 
As of December 31, 2004, we had $6.7 million in cash, $7.0 million in restricted collateral securities and restricted held-to-maturity securities due within one year, $4.0 million in long-term restricted deposits, and $136,000 in available-for-sale marketable securities, as compared to at December 31, 2003, when we had $13.7 million in cash and $706,000 in restricted cash deposits due within one year. The decrease in cash was primarily the result of the costs of the acquisitions of FAAC, Epsilor and AoA, and working capital needed in our other segments.
 
We used available funds in 2004 primarily for acquisitions, sales and marketing, continued research and development expenditures, and other working capital needs. We increased our investment in fixed assets by $1.7 million during the year ended December 31, 2004, primarily in the Battery and Power Systems Division and in the Simulation and Security Division. Our net fixed assets amounted to $4.6 million as at year end.
 
Net cash used in operating activities for 2004 and 2003 was $852,000 and $3.3 million, respectively, a decrease of $2.5 million, or 75%. This decrease was primarily the result of an increase in our adjusted net income in 2004 (net income in statement of operations less non-cash charges such as depreciation, amortization, non-cash financial expenses and non-cash expenses related to options and warrants).
 
- 20 -

 
Net cash used in investing activities for 2004 and 2003 was $50.5 million and $1.8 million, respectively, an increase of $48.7 million. This increase was primarily the result of our investment in the acquisition of FAAC, Epsilor and AoA in 2004.
 
Net cash provided by financing activities for 2004 and 2003 was $44.4 million and $17.4 million, respectively, an increase of $27.0 million, or 156%. This increase was primarily the result of higher amounts of funds raised through sales of our securities in 2004 compared to 2003.
 
During 2004, certain of our employees exercised options under our registered employee stock option plan. The proceeds to us from the exercised options were approximately $1.1 million.
 
We have approximately $5.5 million in long-term debt outstanding (not including accrued severance pay), of which $4.5 million was related to convertible debt (unamortized financial expenses related to the beneficial conversion feature of these convertible debentures amounted to approximately $2.8 million at year end), and approximately $13.7 million in short-term debt (not including trade payables and other accounts payable), of which $13.4 million relates to the earn-out provision in connection with our acquisition of FAAC.
 
Our debt agreements contain customary affirmative and negative operations covenants that limit the discretion of our management with respect to certain business matters and place restrictions on us, including obligations on our part to preserve and maintain our assets and restrictions on our ability to incur or guarantee debt, to merge with or sell our assets to another company, and to make significant capital expenditures without the consent of the debenture holders, as well as granting to our investors a right of first refusal on any future financings, except for underwritten public offerings in excess of $30 million. We do not believe that this right of first refusal will materially limit our ability to undertake future financings.
 
Based on our internal forecasts, we believe that our present cash position and anticipated cash flows from operations should be sufficient to satisfy our current estimated cash requirements through at least the twelve months. This belief is based on certain assumptions that our management believes to be reasonable, some of which are subject to the risk factors detailed below. Over the long term, we will need to become profitable, at least on a cash-flow basis, and maintain that profitability in order to avoid future capital requirements. Additionally, we would need to raise additional capital in order to fund any future acquisitions.
 
Effective Corporate Tax Rate
 
We and certain of our subsidiaries incurred net operating losses during the years ended December 31, 2002, 2003 and 2004, and accordingly no provision for income taxes was required. With respect to some of our U.S. subsidiaries that operated at a net profit during 2004, we were able to offset federal taxes against our net operating loss carryforward, which amounted to $23 million as of December 31, 2004. These subsidiaries are, however, subject to state taxes that cannot be offset against our net operating loss carryforward. With respect to certain of our Israeli subsidiaries that operated at a net profit during 2004, we were unable to offset their taxes against our net operating loss carryforward, and we are therefore exposed to Israeli taxes, at a rate of up to 35% (less, in the case of companies that have “approved enterprise” status as discussed in Note 15 to the Notes to Financial Statements).
 
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As of December 31, 2004, we had a U.S. net operating loss carryforward of approximately $23.0 million that is available to offset future taxable income under certain circumstances, expiring primarily from 2009 through 2024, and foreign net operating and capital loss carryforwards of approximately $87.0 million, which are available indefinitely to offset future taxable income under certain circumstances.
 
Contractual Obligations
 
The following table lists our contractual obligations and commitments as of December 31, 2004, not including trade payables and other accounts payable:
 


   
Payment Due by Period
 
Contractual Obligations  
Total
 
Less Than 1 Year
 
1-3 Years
 
3-5 Years
 
More than 5 Years
 
Long-term debt*
 
$
5,558,391
 
$
-
 
$
5,558,391
 
$
-
 
$
-
 
Short-term debt**
 
$
13,766,677
 
$
13,766,677
 
$
-
 
$
-
 
$
-
 
Operating lease obligations
 
$
1,427,965
 
$
762,636
 
$
641,017
 
$
24,312
 
$
-
 
Severance obligations***
 
$
1,642,801
 
$
223,333
 
$
1,240,871
 
$
-
 
$
178,597
 
 


* Includes convertible debentures in the gross amount of $4,537,500. Unamortized financial expenses related to the beneficial conversion feature of these convertible debentures amounted to $2,782,697 at year end.
** Includes sums owed in respect of an earn-out provision related to our acquisition of FAAC, in the amount of $13.4 million.
*** Includes obligations related to special severance pay arrangements in addition to the severance amounts due to certain employees pursuant to Israeli severance pay law.
 
 
 
RISK FACTORS
 
The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this Report and presented elsewhere by management from time to time.
 
Business-Related Risks
 
We have had a history of losses and may incur future losses.
 
We were incorporated in 1990 and began our operations in 1991. We have funded our operations principally from funds raised in each of the initial public offering of our common stock in February 1994; through subsequent public and private offerings of our common stock and equity and debt securities convertible or exercisable into shares of our common stock; research contracts and supply contracts; funds received under research and development grants from the Government of Israel; and sales of products that we and our subsidiaries manufacture. We have incurred significant net losses since our inception. Additionally, as of December 31, 2004, we had an accumulated deficit of approximately $119.0 million. There can be no assurance that we will ever be able to achieve or maintain profitability consistently or that our business will continue to exist.
 
- 22 -

 
Our existing indebtedness may adversely affect our ability to obtain additional funds and may increase our vulnerability to economic or business downturns.
 
Our bank and certificated indebtedness aggregated approximately $5.5 million as of December 31, 2004. Accordingly, we are subject to the risks associated with indebtedness, including:
 
·  
we must dedicate a portion of our cash flows from operations to pay debt service costs and, as a result, we have less funds available for operations, future acquisitions of consumer receivable portfolios, and other purposes;
 
·  
it may be more difficult and expensive to obtain additional funds through financings, if available at all;
 
·  
we are more vulnerable to economic downturns and fluctuations in interest rates, less able to withstand competitive pressures and less flexible in reacting to changes in our industry and general economic conditions; and
 
·  
if we default under any of our existing debt instruments or if our creditors demand payment of a portion or all of our indebtedness, we may not have sufficient funds to make such payments.
 
The occurrence of any of these events could materially adversely affect our results of operations and financial condition and adversely affect our stock price.
 
The agreements governing the terms of our debentures contain numerous affirmative and negative covenants that limit the discretion of our management with respect to certain business matters and place restrictions on us, including obligations on our part to preserve and maintain our assets and restrictions on our ability to incur or guarantee debt, to merge with or sell our assets to another company, and to make significant capital expenditures without the consent of the debenture holders. Our ability to comply with these and other provisions of such agreements may be affected by changes in economic or business conditions or other events beyond our control.
 
Failure to comply with the terms of our debentures could result in a default that could have material adverse consequences for us.
 
A failure to comply with the obligations contained in our debenture agreements could result in an event of default under such agreements which could result in an acceleration of the debentures and the acceleration of debt under other instruments evidencing indebtedness that may contain cross-acceleration or cross-default provisions. If the indebtedness under the debentures or other indebtedness were to be accelerated, there can be no assurance that our assets would be sufficient to repay in full such indebtedness.
 
We have pledged a substantial portion of our assets to secure our borrowings.
 
Our debentures are secured by a substantial portion of our assets. If we default under the indebtedness secured by our assets, those assets would be available to the secured creditors to satisfy our obligations to the secured creditors, which could materially adversely affect our results of operations and financial condition and adversely affect our stock price.
 
- 23 -

 
We need significant amounts of capital to operate and grow our business.
 
We require substantial funds to market our products and develop and market new products. To the extent that we are unable to fully fund our operations through profitable sales of our products and services, we may continue to seek additional funding, including through the issuance of equity or debt securities. However, there can be no assurance that we will obtain any such additional financing in a timely manner, on acceptable terms, or at all. If additional funds are raised by issuing equity securities, stockholders may incur further dilution. If additional funding is not secured, we will have to modify, reduce, defer or eliminate parts of our anticipated future commitments and/or programs.
 
We may not be successful in operating new businesses.
 
Prior to the acquisitions of IES and MDT in 2002 and the acquisitions of FAAC and Epsilor in January 2004 and AoA in August 2004, our primary business was the marketing and sale of products based on primary and refuelable Zinc-Air fuel cell technology and advancements in battery technology for defense and security products and other military applications, electric vehicles and consumer electronics. As a result of our acquisitions, a substantial component of our business is the marketing and sale of hi-tech multimedia and interactive training solutions and sophisticated lightweight materials and advanced engineering processes used to armor vehicles. These are relatively new businesses for us and our management group has limited experience operating these types of businesses. Although we have retained our acquired companies’ management personnel, we cannot assure that such personnel will continue to work for us or that we will be successful in managing these new businesses. If we are unable to successfully operate these new businesses, our business, financial condition and results of operations could be materially impaired.
 
Our acquisition strategy involves various risks.
 
Part of our strategy is to grow through the acquisition of companies that will complement our existing operations or provide us with an entry into markets we do not currently serve. Growth through acquisitions involves substantial risks, including the risk of improper valuation of the acquired business and the risk of inadequate integration. There can be no assurance that suitable acquisition candidates will be available, that we will be able to acquire or manage profitably such additional companies or that future acquisitions will produce returns that justify our investments therein. In addition, we may compete for acquisition and expansion opportunities with companies that have significantly greater resources than we do. Furthermore, acquisitions could disrupt our ongoing business, distract the attention of our senior officers, make it difficult to maintain our operational standards, controls and procedures and subject us to contingent and latent risks that are different, in nature and magnitude, than the risks we currently face.
 
We may finance future acquisitions with cash from operations or additional debt or equity financings. There can be no assurance that we will be able to generate internal cash or obtain financing from external sources or that, if available, such financing will be on terms acceptable to us. The issuance of additional common stock to finance acquisitions may result in substantial dilution to our stockholders. Any debt financing may significantly increase our leverage and may involve restrictive covenants which limit our operations.
 
We may not successfully integrate our acquisitions.
 
In light of our acquisitions of IES, MDT, FAAC, Epsilor and AoA, our success will depend in part on our ability to manage the combined operations of these companies and to integrate the operations and personnel of these companies along with our other subsidiaries and divisions into a single organizational structure. There can be no assurance that we will be able to effectively integrate the operations of our subsidiaries and divisions and our acquired businesses into a single organizational structure. Integration of these operations could also place additional pressures on our management as well as on our key technical resources. The failure to successfully manage this integration could have an adverse material effect on us.
 
If we are successful in acquiring additional businesses, we may experience a period of rapid growth that could place significant additional demands on, and require us to expand, our management, resources and management information systems. Our failure to manage any such rapid growth effectively could have a material adverse effect on our financial condition, results of operations and cash flows.
 
If we are unable to manage our growth, our operating results will be impaired.
 
As a result of our acquisitions, we are currently experiencing a period of significant growth and development activity which could place a significant strain on our personnel and resources. Our activity has resulted in increased levels of responsibility for both existing and new management personnel. Many of our management personnel have had limited or no experience in managing growing companies. We have sought to manage our current and anticipated growth through the recruitment of additional management and technical personnel and the implementation of internal systems and controls. However, our failure to manage growth effectively could adversely affect our results of operations.
 
A significant portion of our business is dependent on government contracts and reduction or reallocation of defense or law enforcement spending could reduce our revenues.
 
Many of the customers of IES, FAAC and AoA to date have been in the public sector of the U.S., including the federal, state and local governments, and in the public sectors of a number of other countries, and most of MDT’s customers have been in the public sector in Israel, in particular the Ministry of Defense. Additionally, all of EFB’s sales to date of battery products for the military and defense sectors have been in the public sector in the United States. A significant decrease in the overall level or allocation of defense or law enforcement spending in the U.S. or other countries could reduce our revenues and have a material adverse effect on our future results of operations and financial condition. MDT has already experienced a slowdown in orders from the Ministry of Defense due to budget constraints and a requirement of U.S. aid to Israel that a substantial proportion of such aid be spent in the U.S., where MDT has only recently opened a factory.
 
Sales to public sector customers are subject to a multiplicity of detailed regulatory requirements and public policies as well as to changes in training and purchasing priorities. Contracts with public sector customers may be conditioned upon the continuing availability of public funds, which in turn depends upon lengthy and complex budgetary procedures, and may be subject to certain pricing constraints. Moreover, U.S. government contracts and those of many international government customers may generally be terminated for a variety of factors when it is in the best interests of the government and contractors may be suspended or debarred for misconduct at the discretion of the government. There can be no assurance that these factors or others unique to government contracts or the loss or suspension of necessary regulatory licenses will not reduce our revenues and have a material adverse effect on our future results of operations and financial condition.
 
- 24 -

 
Our U.S. government contracts may be terminated at any time and may contain other unfavorable provisions.
 
The U.S. government typically can terminate or modify any of its contracts with us either for its convenience or if we default by failing to perform under the terms of the applicable contract. A termination arising out of our default could expose us to liability and have a material adverse effect on our ability to re-compete for future contracts and orders. Our U.S. government contracts contain provisions that allow the U.S. government to unilaterally suspend us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations, reduce the value of existing contracts, issue modifications to a contract and control and potentially prohibit the export of our products, services and associated materials.
 
A negative audit by the U.S. government could adversely affect our business, and we might not be reimbursed by the government for costs that we have expended on our contracts.
 
Government agencies routinely audit government contracts. These agencies review a contractor's performance on its contract, pricing practices, cost structure and compliance with applicable laws, regulations and standards. If we are audited, we will not be reimbursed for any costs found to be improperly allocated to a specific contract, while we would be required to refund any improper costs for which we had already been reimbursed. Therefore, an audit could result in a substantial adjustment to our revenues. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or debarment from doing business with United States government agencies. We could suffer serious reputational harm if allegations of impropriety were made against us. A governmental determination of impropriety or illegality, or an allegation of impropriety, could have a material adverse effect on our business, financial condition or results of operations.
 
We may be liable for penalties under a variety of procurement rules and regulations, and changes in government regulations could adversely impact our revenues, operating expenses and profitability.
 
Our defense and commercial businesses must comply with and are affected by various government regulations that impact our operating costs, profit margins and our internal organization and operation of our businesses. Among the most significant regulations are the following:
 
·  
the U.S. Federal Acquisition Regulations, which regulate the formation, administration and performance of government contracts;
 
·  
the U.S. Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations; and
 
 
- 25 -

 
·  
the U.S. Cost Accounting Standards, which impose accounting requirements that govern our right to reimbursement under certain cost-based government contracts.
 
These regulations affect how we and our customers do business and, in some instances, impose added costs on our businesses. Any changes in applicable laws could adversely affect the financial performance of the business affected by the changed regulations. With respect to U.S. government contracts, any failure to comply with applicable laws could result in contract termination, price or fee reductions or suspension or debarment from contracting with the U.S. government.
 
Our operating margins may decline under our fixed-price contracts if we fail to estimate accurately the time and resources necessary to satisfy our obligations.
 
Some of our contracts are fixed-price contracts under which we bear the risk of any cost overruns. Our profits are adversely affected if our costs under these contracts exceed the assumptions that we used in bidding for the contract. Often, we are required to fix the price for a contract before we finalize the project specifications, which increases the risk that we will mis-price these contracts. The complexity of many of our engagements makes accurately estimating our time and resources more difficult.
 
If we are unable to retain our contracts with the U.S. government and subcontracts under U.S. government prime contracts in the competitive rebidding process, our revenues may suffer.
 
Upon expiration of a U.S. government contract or subcontract under a U.S. government prime contract, if the government customer requires further services of the type provided in the contract, there is frequently a competitive rebidding process. We cannot guarantee that we, or if we are a subcontractor that the prime contractor, will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract. Further, all U.S. government contracts are subject to protest by competitors. The termination of several of our significant contracts or nonrenewal of several of our significant contracts, could result in significant revenue shortfalls.
 
The loss of, or a significant reduction in, U.S. military business would have a material adverse effect on us.
 
U.S. military contracts account for a significant portion of our business. The U.S. military funds these contracts in annual increments. These contracts require subsequent authorization and appropriation that may not occur or that may be greater than or less than the total amount of the contract. Changes in the U.S. military’s budget, spending allocations and the timing of such spending could adversely affect our ability to receive future contracts. None of our contracts with the U.S. military has a minimum purchase commitment, and the U.S. military generally has the right to cancel its contracts unilaterally without prior notice. We manufacture for the U.S. aircraft and land vehicle armor systems, protective equipment for military personnel and other technologies used to protect soldiers in a variety of life-threatening or catastrophic situations, and batteries for communications devices. The loss of, or a significant reduction in, U.S. military business for our aircraft and land vehicle armor systems, other protective equipment, or batteries could have a material adverse effect on our business, financial condition, results of operations and liquidity.
 
- 26 -

 
A reduction of U.S. force levels in Iraq may affect our results of operations.
 
Since the invasion of Iraq by the U.S. and other forces in March 2003, we have received steadily increasing orders from the U.S. military for armoring of vehicles and military batteries. These orders are the result, in substantial part, from the particular combat situations encountered by the U.S. military in Iraq. We cannot be certain, therefore, to what degree the U.S. military would continue placing orders for our products if the U.S. military were to reduce its force levels or withdraw completely from Iraq. A significant reduction in orders from the U.S. military could have a material adverse effect on our business, financial condition, results of operations and liquidity.
 
There are limited sources for some of our raw materials, which may significantly curtail our manufacturing operations.
 
The raw materials that we use in manufacturing our armor products include Kevlar®, a patented product of E.I. du Pont de Nemours Co., Inc. We purchase Kevlar in the form of woven cloth from various independent weaving companies. In the event Du Pont and/or these independent weaving companies were to cease, for any reason, to produce or sell Kevlar to us, we might be unable to replace it with a material of like weight and strength, or at all. Thus, if our supply of Kevlar were materially reduced or cut off or if there were a material increase in the price of Kevlar, our manufacturing operations could be adversely affected and our costs increased, and our business, financial condition and results of operations could be materially adversely affected.
 
Some of the components of our products pose potential safety risks which could create potential liability exposure for us.
 
Some of the components of our products contain elements that are known to pose potential safety risks. In addition to these risks, there can be no assurance that accidents in our facilities will not occur. Any accident, whether occasioned by the use of all or any part of our products or technology or by our manufacturing operations, could adversely affect commercial acceptance of our products and could result in significant production delays or claims for damages resulting from injuries. Any of these occurrences would materially adversely affect our operations and financial condition. In the event that our products, including the products manufactured by MDT and AoA, fail to perform as specified, users of these products may assert claims for substantial amounts. These claims could have a materially adverse effect on our financial condition and results of operations. There is no assurance that the amount of the general product liability insurance that we maintain will be sufficient to cover potential claims or that the present amount of insurance can be maintained at the present level of cost, or at all.
 
Our fields of business are highly competitive.
 
The competition to develop defense and security products and electric vehicle battery systems, and to obtain funding for the development of these products, is, and is expected to remain, intense.
 
Our defense and security products compete with other manufacturers of specialized training systems, including Firearms Training Systems, Inc., a producer of interactive simulation systems designed to provide training in the handling and use of small and supporting arms. In addition, we compete with manufacturers and developers of armor for cars and vans, including O’Gara-Hess & Eisenhardt, a division of Armor Holdings, Inc.
 
- 27 -

 
Our battery technology competes with other battery technologies, as well as other Zinc-Air technologies. The competition in this area of our business consists of development stage companies, major international companies and consortia of such companies, including battery manufacturers, automobile manufacturers, energy production and transportation companies, consumer goods companies and defense contractors.
 
Various battery technologies are being considered for use in electric vehicles and defense and safety products by other manufacturers and developers, including the following: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc, nickel-metal hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine, lithium-ion, lithium-polymer, lithium-iron sulfide, primary lithium, rechargeable alkaline and Zinc-Air.
 
Many of our competitors have financial, technical, marketing, sales, manufacturing, distribution and other resources significantly greater than ours. If we are unable to compete successfully in each of our operating areas, especially in the defense and security products area of our business, our business and results of operations could be materially adversely affected.
 
Our business is dependent on proprietary rights that may be difficult to protect and could affect our ability to compete effectively.
 
Our ability to compete effectively will depend on our ability to maintain the proprietary nature of our technology and manufacturing processes through a combination of patent and trade secret protection, non-disclosure agreements and licensing arrangements.
 
Litigation, or participation in administrative proceedings, may be necessary to protect our proprietary rights. This type of litigation can be costly and time consuming and could divert company resources and management attention to defend our rights, and this could harm us even if we were to be successful in the litigation. In the absence of patent protection, and despite our reliance upon our proprietary confidential information, our competitors may be able to use innovations similar to those used by us to design and manufacture products directly competitive with our products. In addition, no assurance can be given that others will not obtain patents that we will need to license or design around. To the extent any of our products are covered by third-party patents, we could need to acquire a license under such patents to develop and market our products.
 
Despite our efforts to safeguard and maintain our proprietary rights, we may not be successful in doing so. In addition, competition is intense, and there can be no assurance that our competitors will not independently develop or patent technologies that are substantially equivalent or superior to our technology. In the event of patent litigation, we cannot assure you that a court would determine that we were the first creator of inventions covered by our issued patents or pending patent applications or that we were the first to file patent applications for those inventions. If existing or future third-party patents containing broad claims were upheld by the courts or if we were found to infringe third-party patents, we may not be able to obtain the required licenses from the holders of such patents on acceptable terms, if at all. Failure to obtain these licenses could cause delays in the introduction of our products or necessitate costly attempts to design around such patents, or could foreclose the development, manufacture or sale of our products. We could also incur substantial costs in defending ourselves in patent infringement suits brought by others and in prosecuting patent infringement suits against infringers.
 
- 28 -

 
We also rely on trade secrets and proprietary know-how that we seek to protect, in part, through non-disclosure and confidentiality agreements with our customers, employees, consultants, and entities with which we maintain strategic relationships. We cannot assure you that these agreements will not be breached, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors.
 
We are dependent on key personnel and our business would suffer if we fail to retain them.
 
We are highly dependent on the presidents of our IES, FAAC and AoA subsidiaries and the general managers of our MDT and Epsilor subsidiaries, and the loss of the services of one or more of these persons could adversely affect us. We are especially dependent on the services of our Chairman, President and Chief Executive Officer, Robert S. Ehrlich. The loss of Mr. Ehrlich could have a material adverse effect on us. We are party to an employment agreement with Mr. Ehrlich, which agreement expires at the end of 2005, and we may not be able to renew such contract on terms acceptable to us, or at all. We do not have key-man life insurance on Mr. Ehrlich.
 
There are risks involved with the international nature of our business.
 
A significant portion of our sales are made to customers located outside the U.S., primarily in Europe and Asia. In 2004, 2003 and 2002, without taking account of revenues derived from discontinued operations, 19%, 42% and 56%, respectively, of our revenues, were derived from sales to customers located outside the U.S. We expect that our international customers will continue to account for a substantial portion of our revenues in the near future. Sales to international customers may be subject to political and economic risks, including political instability, currency controls, exchange rate fluctuations, foreign taxes, longer payment cycles and changes in import/export regulations and tariff rates. In addition, various forms of protectionist trade legislation have been and in the future may be proposed in the U.S. and certain other countries. Any resulting changes in current tariff structures or other trade and monetary policies could adversely affect our sales to international customers.
 
Investors should not purchase our common stock with the expectation of receiving cash dividends.
 
We currently intend to retain any future earnings for funding growth and, as a result, do not expect to pay any cash dividends in the foreseeable future.
 
Market-Related Risks
 
The price of our common stock is volatile.
 
The market price of our common stock has been volatile in the past and may change rapidly in the future. The following factors, among others, may cause significant volatility in our stock price:
 
·  
Announcements by us, our competitors or our customers;
 
 
- 29 -

 
·  
The introduction of new or enhanced products and services by us or our competitors;
 
·  
Changes in the perceived ability to commercialize our technology compared to that of our competitors;
 
·  
Rumors relating to our competitors or us;
 
·  
Actual or anticipated fluctuations in our operating results;
 
·  
The issuance of our securities, including warrants, in connection with financings and acquisitions; and
 
·  
General market or economic conditions.
 
If our shares were to be delisted, our stock price might decline further and we might be unable to raise additional capital.
 
One of the continued listing standards for our stock on the Nasdaq National Market is the maintenance of a $1.00 bid price. Our stock price has traded below $1.00 in the past. If our bid price were to go and remain below $1.00 for 30 consecutive business days, Nasdaq could notify us of our failure to meet the continued listing standards, after which we would have 180 calendar days to correct such failure or be delisted from the Nasdaq National Market.
 
Although we would have the opportunity to appeal any potential delisting, there can be no assurances that this appeal would be resolved favorably. As a result, there can be no assurance that our common stock will remain listed on the Nasdaq National Market. If our common stock were to be delisted from the Nasdaq National Market, we might apply to be listed on the Nasdaq SmallCap market; however, there can be no assurance that we would be approved for listing on the Nasdaq SmallCap market, which has the same $1.00 minimum bid and other similar requirements as the Nasdaq National Market. If we were to move to the Nasdaq SmallCap market, current Nasdaq regulations would give us the opportunity to obtain an additional 180-day grace period and an additional 90-day grace period after that if we meet certain net income, stockholders’ equity or market capitalization criteria. While our stock would continue to trade on the over-the-counter bulletin board following any delisting from the Nasdaq, any such delisting of our common stock could have an adverse effect on the market price of, and the efficiency of the trading market for, our common stock. Also, if in the future we were to determine that we need to seek additional equity capital, it could have an adverse effect on our ability to raise capital in the public equity markets.
 
In addition, if we fail to maintain Nasdaq listing for our securities, and no other exclusion from the definition of a “penny stock” under the Securities Exchange Act of 1934, as amended, is available, then any broker engaging in a transaction in our securities would be required to provide any customer with a risk disclosure document, disclosure of market quotations, if any, disclosure of the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market values of our securities held in the customer’s account. The bid and offer quotation and compensation information must be provided prior to effecting the transaction and must be contained on the customer’s confirmation. If brokers become subject to the “penny stock” rules when engaging in transactions in our securities, they would become less willing to engage in transactions, thereby making it more difficult for our stockholders to dispose of their shares.
 
- 30 -

 
We expect our auditors to report a material weakness in our internal controls. If we fail to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act, we may not be able to accurately report our financial results.
 
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with this Annual Report on Form 10-K for the fiscal year ending December 31, 2004, we are required to furnish a report by our management on our internal control over financial reporting.
 
Pursuant to Securities and Exchange Commission Release No. 34-50754, which, subject to certain conditions, provides up to 45 additional days beyond the due date of this Form 10-K for the filing of management’s annual report on internal control over financial reporting required by Item 308(a) of Regulation S-K, and the related attestation report of the independent registered public accounting firm, as required by Item 308(b) of Regulation S-K, management’s report on internal control over financial reporting and the associated report on the audit of management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, are not filed herein and are expected to be filed no later than May 2, 2005.
 
The internal control report must contain (i) a statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting, (ii) a statement identifying the framework used by management to conduct the required evaluation of the effectiveness of our internal control over financial reporting, (iii) management’s assessment of the effectiveness of our internal control over financial reporting as of the end of our most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective, and (iv) a statement that our independent registered public accounting firm has issued an attestation report on management’s assessment of internal control over financial reporting.
 
We expect that our auditors will inform us, although they have not yet done so, that they identified significant deficiencies that constitute a material weakness under standards established by the American Institute of Certified Public Accountants (AICPA). A material weakness is a condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions. We expect that our auditors will report to us that at December 31, 2004, we had a significant deficiency in our financial statement closing process and related processes because the size our accounting and finance department and the press of work related to our recent acquisitions caused us to be unable independently to comply with the selection and application of generally accepted accounting principles related to highly complex financial transactions applicable to equity issuances and business combinations.
 
As a public company, we will have significant requirements for enhanced financial reporting and internal controls. The process of designing and implementing effective internal controls is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments and to expend significant resources to maintain a system of internal controls that is adequate to satisfy our reporting obligations as a public company. We cannot assure you that the measures we have taken or will take to remediate any material weaknesses or that we will implement and maintain adequate controls over our financial processes and reporting in the future as we continue our rapid growth.
 
- 31 -

 
If we are unable to establish appropriate internal financial reporting controls and procedures, it could cause us to fail to meet our reporting obligations, result in material mis-statements in our financial statements, harm our operating results, cause investors to lose confidence in our reported financial information and have a negative effect on the market price for shares of our common stock.
 
A substantial number of our shares are available for sale in the public market and sales of those shares could adversely affect our stock price.
 
Sales of a substantial number of shares of common stock into the public market, or the perception that those sales could occur, could adversely affect our stock price or could impair our ability to obtain capital through an offering of equity securities. As of February 28, 2005, we had 80,103,668 shares of common stock issued and outstanding. Of these shares, most are freely transferable without restriction under the Securities Act of 1933, and a substantial portion of the remaining shares may be sold subject to the volume restrictions, manner-of-sale provisions and other conditions of Rule 144 under the Securities Act of 1933.
 
Exercise of our warrants, options and convertible debt could adversely affect our stock price and will be dilutive.
 
As of February 28, 2005, there were outstanding warrants to purchase a total of 16,961,463 shares of our common stock at a weighted average exercise price of $1.55 per share, options to purchase a total of 9,102,761 shares of our common stock at a weighted average exercise price of $1.28 per share, of which 7,002,390 were vested, at a weighted average exercise price of $1.28 per share, and outstanding debentures convertible into a total of 3,156,298 shares of our common stock at a weighted average conversion price of $1.44 per share. Holders of our options, warrants and convertible debt will probably exercise or convert them only at a time when the price of our common stock is higher than their respective exercise or conversion prices. Accordingly, we may be required to issue shares of our common stock at a price substantially lower than the market price of our stock. This could adversely affect our stock price. In addition, if and when these shares are issued, the percentage of our common stock that existing stockholders own will be diluted.
 
Our certificate of incorporation and bylaws and Delaware law contain provisions that could discourage a takeover.
 
Provisions of our amended and restated certificate of incorporation may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock. These provisions:
 
·  
divide our board of directors into three classes serving staggered three-year terms;
 
 
- 32 -

 
·  
only permit removal of directors by stockholders “for cause,” and require the affirmative vote of at least 85% of the outstanding common stock to so remove; and
 
·  
allow us to issue preferred stock without any vote or further action by the stockholders.
 
The classification system of electing directors and the removal provision may tend to discourage a third-party from making a tender offer or otherwise attempting to obtain control of us and may maintain the incumbency of our board of directors, as the classification of the board of directors increases the difficulty of replacing a majority of the directors. These provisions may have the effect of deferring hostile takeovers, delaying changes in our control or management, or may make it more difficult for stockholders to take certain corporate actions. The amendment of any of these provisions would require approval by holders of at least 85% of the outstanding common stock.
 
Israel-Related Risks
 
A significant portion of our operations takes place in Israel, and we could be adversely affected by the economic, political and military conditions in that region.
 
The offices and facilities of three of our subsidiaries, EFL, MDT and Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively, all of which are within Israel’s pre-1967 borders). Most of our senior management is located at EFL’s facilities. Although we expect that most of our sales will be made to customers outside Israel, we are nonetheless directly affected by economic, political and military conditions in that country. Accordingly, any major hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could have a material adverse effect on our operations. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors and a state of hostility, varying in degree and intensity, has led to security and economic problems for Israel.
 
Historically, Arab states have boycotted any direct trade with Israel and to varying degrees have imposed a secondary boycott on any company carrying on trade with or doing business in Israel. Although in October 1994, the states comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai, Bahrain and Oman) announced that they would no longer adhere to the secondary boycott against Israel, and Israel has entered into certain agreements with Egypt, Jordan, the Palestine Liberation Organization and the Palestinian Authority, Israel has not entered into any peace arrangement with Syria or Lebanon. Moreover, since September 2000, there has been a significant deterioration in Israel’s relationship with the Palestinian Authority, and a significant increase in terror and violence. Efforts to resolve the problem have failed to result in an agreeable solution. Continued hostilities between the Palestinian community and Israel and any failure to settle the conflict may have a material adverse effect on our business and us. Moreover, the current political and security situation in the region has already had an adverse effect on the economy of Israel, which in turn may have an adverse effect on us.
 
- 33 -

 
 
Service of process and enforcement of civil liabilities on us and our officers may be difficult to obtain.
 
We are organized under the laws of the State of Delaware and will be subject to service of process in the United States. However, approximately 22% of our assets are located outside the United States. In addition, two of our directors and most of our executive officers are residents of Israel and a portion of the assets of such directors and executive officers are located outside the United States.
 
There is doubt as to the enforceability of civil liabilities under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, in original actions instituted in Israel. As a result, it may not be possible for investors to enforce or effect service of process upon these directors and executive officers or to judgments of U.S. courts predicated upon the civil liability provisions of U.S. laws against our assets, as well as the assets of these directors and executive officers. In addition, awards of punitive damages in actions brought in the U.S. or elsewhere may be unenforceable in Israel.
 
Exchange rate fluctuations between the U.S. dollar and the Israeli NIS may negatively affect our earnings.
 
Although a substantial majority of our revenues and a substantial portion of our expenses are denominated in U.S. dollars, a portion of our costs, including personnel and facilities-related expenses, is incurred in New Israeli Shekels (NIS). Inflation in Israel will have the effect of increasing the dollar cost of our operations in Israel, unless it is offset on a timely basis by a devaluation of the NIS relative to the dollar. In 2004, the inflation adjusted NIS appreciated against the dollar, which raised the dollar cost of our Israeli operations.
 
Some of our agreements are governed by Israeli law.
 
Israeli law governs some of our agreements, such as our lease agreements on our subsidiaries’ premises in Israel, and the agreements pursuant to which we purchased IES, MDT and Epsilor. While Israeli law differs in certain respects from American law, we do not believe that these differences materially adversely affect our rights or remedies under these agreements.
 
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Index to Financial Statements
 
Page
Consolidated Financial Statements
 
Reports of Independent Registered Public Accounting Firms 
F-2
Consolidated Balance Sheets 
F-4
Consolidated Statements of Operations
F-6
Statements of Changes in Shareholders’ Equity
F-7
Consolidated Statements of Cash Flows
F-10
Notes to Consolidated Financial Statements
F-14
Supplementary Financial Data
 
Quarterly Financial Data (unaudited) for the two years ended December 31, 2004
F-61
Financial Statement Schedule
 
Schedule II - Valuation and Qualifying Accounts 
F-62
 
- 34 -

 
ITEM 9A.
CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
 
As of December 31, 2004, our management, including the principal executive officer and principal financial officer, evaluated our disclosure controls and procedures related to the recording, processing, summarization, and reporting of information in our periodic reports that we file with the SEC. These disclosure controls and procedures are intended to ensure that material information relating to us, including our subsidiaries, is made known to our management, including these officers, by other of our employees, and that this information is recorded, processed, summarized, evaluated, and reported, as applicable, within the time periods specified in the SEC’s rules and forms. Due to the inherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Any system of controls and procedures, no matter how well designed and operated, can at best provide only reasonable assurance that the objective of the system are met and management necessarily is required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Our controls and procedures are intended to provide only reasonable, not absolute, assurance that the above objectives have been met.
 
Based on their evaluation as of December 31, 2004, and solely because of the material weaknesses described below, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were not effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
 
In light of the material weakness described below, our management performed additional analyses and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP). Accordingly, management believes that the consolidated financial statements included in this report fairly present in all material respects our financial position, results of operations and cash flows for the periods presented.
 
Management’s Report on Internal Control Over Financial Reporting
 
Our management, including our principal executive and financial officers, is responsible for establishing and maintaining adequate internal control over our financial reporting. Our management has evaluated the effectiveness of our internal controls, pursuant to the requirements of Sarbanes-Oxley Section 404, as of the end of the period covered by this Annual Report on Form 10-K for December 31, 2004. In making our assessment of internal control over financial reporting, management used the criteria set forth by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission in Internal Control - Integrated Framework. In accordance with the rules of the SEC, we did not assess the internal control over financial reporting of Armour of America, Incorporated, which we acquired in August 2004, financial statements of which reflect total assets of 4% of our consolidated assets as of December 31, 2004, and total revenues of 5% of our consolidated revenues for the year then ended. In our Annual Report on Form 10-K for the year ending December 31, 2005, we will be required to provide an assessment of our compliance that takes into account an assessment of Armour of America, Incorporated and all of our other currently existing subsidiaries as of December 31, 2005.
 
- 35 -

 
For the reasons described below, we have concluded that there were material weaknesses in our internal controls at December 31, 2004. We note in this connection that our Independent Registered Public Accounting Firm audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), our consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2004, and their report dated March 24, 2005 expressed an unqualified opinion with respect thereto.
 
On November 22, 2004, the Audit Committee of our Board of Directors, on the recommendation of our management and after discussion with our Independent Registered Public Accounting Firm, made an internal determination and concluded that our Annual Report on Form 10-K for the year ended December 31, 2003, including the financial statements that our Independent Registered Public Accounting Firm had previously audited that are contained therein, contained certain errors related to the re-pricing of warrants and grant of additional warrants to certain of our investors and others and the amortization of debt discount arising from the allocation of the debt discount between the convertible debentures and their detachable warrants. The net effect of these errors, which generally related to the timing and characterization of certain non-cash expenses, was (i) to increase our net loss attributable to common stockholders for 2003 by approximately $579,000 and to decrease our net loss for the first half of 2004 by approximately $608,000, and (ii) to decrease our net loss attributable to common stockholders for the nine and three months ended September 30, 2004 by approximately $1,583,778 and $976,129, respectively. The Audit Committee of our Board of Directors therefore concluded to restate certain previously issued financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2003. The decision to restate these financial statements was made by our Audit Committee, upon the recommendation of our management and with the concurrence of our Independent Registered Public Accounting Firm.
 
As a result of the restatement referred to in the preceding paragraph, we have identified material weaknesses for inadequate controls related to the financial statement close process, convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions. A material weakness is a control deficiency (within the meaning of the Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard No. 2), or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The material weaknesses arise from insufficient staff with technical accounting expertise to independently apply our accounting policies, as they relate to non-routine and highly complex transactions, in accordance with U.S. generally accepted accounting principles. Management has identified that due to the reasons described above, we did not consistently follow established internal control over financial reporting procedures related to the analysis, documentation and review of selection of the appropriate accounting treatment for non-routine and highly complex transactions. Because of these material weaknesses, we have concluded that we did not maintain effective internal control over financial reporting as of December 31, 2004, based on the criteria in Internal Control-Integrated Framework.
 
- 36 -

 
The foregoing management assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004, has been audited by Kost, Forer, Gabbay and Kassierer, a member of Ernst & Young Global, the registered public accounting firm that audited the financial statements included in our annual report, as stated in their report which is included below.
 
Management’s Response to the Material Weaknesses
 
In response to the material weaknesses described above, we have undertaken to take the following initiatives with respect to our internal controls and procedures that we believe are reasonably likely to improve and materially affect our internal control over financial reporting. We anticipate that remediation will be continuing throughout fiscal 2005, during which we expect to continue pursuing appropriate corrective actions, including the following:
 
Ø  
Preparing appropriate written documentation of our financial control procedures;
 
Ø  
Adding additional qualified staff to our finance department;
 
Ø  
Scheduling training for accounting staff to heighten awareness of generally accepted accounting principles applicable to complex transactions;
 
Ø  
Strengthening our internal review procedures in conjunction with our ongoing work to enhance our internal controls so as to enable us to identify and adjust items proactively;
 
Ø  
Engaging an outside accounting firm to support our Sarbanes-Oxley Section 404 compliance activities and to provide technical expertise in the selection and application of generally accepted accounting principles related to complex transactions to identify areas that require control or process improvements and to consult with us on the appropriate accounting treatment applicable to complex transactions; and
 
Ø  
Implementing the recommendations of our outside accounting consultants.
 
Our management and Audit Committee will monitor closely the implementation of our remediation plan. The effectiveness of the steps we intend to implement is subject to continued management review, as well as Audit Committee oversight, and we may make additional changes to our internal control over financial reporting.
 
We cannot assure you that we will not in the future identify further material weaknesses in our internal control over financial reporting. We currently are unable to determine when the above-mentioned material weaknesses will be fully remediated. However, because remediation will not be completed until we have added finance staff and strengthened pertinent controls, we presently anticipate that we will report in our Quarterly Report on Form 10-Q for the second quarter of fiscal 2005 that material weaknesses continue to exist.
 
- 37 -

 
Changes in Internal Controls Over Financial Reporting
 
Except as noted above, there have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter to which this Annual Report on Form 10-K relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
- 38 -

 
PART IV
 
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
 
(a)
The following documents are filed as part of this amended report:
 
(1)
Financial Statements - See Index to Financial Statements on page above.
 
(2)
Financial Statements Schedules - Schedule II - Valuation and Qualifying Accounts. All schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is presented in the financial statements or related notes thereto.
 
(3)
Exhibits - The following Exhibits are either filed herewith or have previously been filed with the Securities and Exchange Commission and are referred to and incorporated herein by reference to such filings:
 


Exhibit No.
Description
*23.1
Consent of Kost, Forer, Gabbay & Kassierer, a member of Ernst & Young Global
*23.2
Consent of Stark Winter Schenkein & Co., LLP
*31.1
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
*31.2
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
*32.1
Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*32.2
Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 

* Filed herewith
 
 
- 39 -

 

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized, on August   15  , 2005.
 
     
  AROTECH CORPORATION
 
 
 
 
 
 
  By:   /s/ Robert S. Ehrlich
 
Name: Robert S. Ehrlich
  Title:
Chairman, President and Chief Executive Officer 
 
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this amended report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
 
Signature
 
Title
 
Date
 
/s/ Robert S. Ehrlich
Robert S. Ehrlich
 
Chairman, President, Chief Executive Officer and Director
(Principal Executive Officer)
 
August   15  , 2005
 
/s/ Avihai Shen 
Avihai Shen
 
Vice President - Finance
(Principal Financial Officer)
 
August   15  , 2005
 
/s/ Danny Waldner 
Danny Waldner
 
Controller
(Principal Accounting Officer)
 
August   15  , 2005
 
/s/ Steven Esses 
Steven Esses
 
Executive Vice President, Chief Operating Officer and Director
 
August  15  , 2005
 
/s/ Jay M. Eastman 
Dr. Jay M. Eastman
 
Director
 
August   15  , 2005
 
/s/ Lawrence M. Miller 
Lawrence M. Miller
 
Director
 
August   15  , 2005
 

Jack E. Rosenfeld
 
Director
 
August      , 2005
 
/s/ Seymour Jones 
Seymour Jones
 
Director
 
August   15  , 2005

 

Edward J. Borey
 
Director
 
August       , 2005


 
- 40 -

 
AROTECH CORPORATION AND ITS SUBSIDIARIES
 
CONSOLIDATED FINANCIAL STATEMENTS
 
AS OF DECEMBER 31, 2004
 
IN U.S. DOLLARS
 
INDEX
 
 
Page
   
Reports of Independent Registered Public Accounting Firms
 
2 - 3
 
Consolidated Balance Sheets
 
4 - 5
 
Consolidated Statements of Operations
 
6
 
Statements of Changes in Stockholders’ Equity
 
7 - 9
 
Consolidated Statements of Cash Flows
 
10 - 13
 
Notes to Consolidated Financial Statements
 
14 - 60
 



 


 



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Stockholders of
 
AROTECH CORPORATION
 
We have audited the accompanying consolidated balance sheets of Arotech Corporation (the “Company”) and its subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in Item 15(a)(2) of the Company’s 10-K. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We did not audit the financial statements of “Armor of America,” a wholly-owned subsidiary of the Company, financial statements of which reflect total assets of 4% of the consolidated assets of the Company as of December 31, 2004, and total revenues of 5% of the consolidated revenues of the Company for the year then ended. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the data included for this subsidiary, is based solely on the report of the other auditors.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion based on our audits and the other auditors the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and its subsidiaries as of December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Additionally, in our opinion the related financial statement schedule, when considered in relation to the basic financial statements and schedule taken as a whole, present fairly in all material respects the information set forth therein.
 
As discussed in Note 1.b., the Consolidated Financial Statements at December 31, 2003 and for the year then ended have been restated for the matters set forth therein.
 
Tel Aviv, Israel
KOST, FORER, GABBAY & KASIERER
March 24, 2005
A Member of Ernst & Young Global
   
 
 
F-2



 



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Stockholders of
 
AROTECH CORPORATION
 
We have audited management’s assessment, included in the accompanying “Report of Management on Internal Control Over Financial Reporting,” that Arotech Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of material weaknesses in internal controls related to the financial statement close process, the convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Arotech Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
F-3

 
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment. Management identified material weaknesses for inadequate controls related to the financial statement close process, convertible debentures and share capital processes as it applies to non-routine and highly complex financial transactions. The material weaknesses arise from insufficient staff with technical accounting expertise to independently apply the Company’s accounting policies, as they relate to non-routine and highly complex transactions, in accordance with U.S. generally accepted accounting principles (“GAAP”). Management has identified that due to the reasons described above, the Company did not consistently follow established internal control over financial reporting procedures related to the analysis, documentation and review of selection of the appropriate accounting treatment for non-routine and highly complex transactions. These material weaknesses resulted in a restatement of the 2003 consolidated financial statements and quarterly unaudited consolidated financial statements for each of the quarters through September 30, 2004 and related to the errors in the appropriate accounting treatment to be applied to (i) re-pricing of warrants and grant of additional warrants to certain investors and others, and (ii) amortization of debt discount arising from the allocation of the debt discount between the convertible debentures and their detachable warrants. The net effect of these errors, which generally related to the timing and characterization of certain non-cash expenses, was (i) to increase net loss attributable to common stockholders for 2003 by approximately $579,000 and to decrease net loss for the first half of 2004 by approximately $608,000, and (ii) to decrease net loss attributable to common stockholders for the nine and three months ended September 30, 2004 by approximately $1,583,778 and $976,129, respectively. The above material weaknesses resulted in the material misstatement of amount of convertible debentures, finance expenses related to convertible debentures and stockholders’ equity.
 
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the December 31, 2004 consolidated financial statements, and this report does not affect our report dated March 24, 2005 on those consolidated financial statements.
 
As indicated in the accompanying “Report of Management on Internal Control Over Financial Reporting,” management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Armour of America Inc., a wholly-owned subsidiary whose total assets and total revenues represent 4% and 5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2004, which was acquired by the Company in a purchase business combination during 2004. Our audit of internal control over financial reporting of Arotech Corporation also did not include an evaluation of the internal control over financial reporting of Armour of America Inc.
 
In our opinion, management’s assessment that Arotech Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Arotech Corporation has not maintained effective internal control over financial reporting as of December 31, 2004, based on the COSO control criteria.
 
Tel-Aviv, Israel
KOST, FORER, GABBAY & KASIERER
April 21, 2005
A Member of Ernst & Young Global
  
 
F-4


Stark Winter Schenkein
 
  
Report of Independent Registered Public Accounting Firm
 
To the Shareholder
Armour of America, Inc.
Gardena, California
 
We have audited the accompanying balance sheets of Armour of America, Inc. as of December 31, 2004, and the related statements of income, stockholder’s equity and cash flows for the period August 11, 2004 to December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Armour of America, Inc. as of December 31, 2004, and the results of its operations, stockholder’s equity and cash flows for the period August 11, 2004 to December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
 
/s/ Stark Winter Schenkein & Co., LLP
 
Denver, Colorado
January 31, 2005
 
Stark Winter Schenkein & Co., LLP  Certified Public Accountants  Financial Consultants

7535 East Hampden Avenue  Suite 109  Denver, Colorado 80231
Phone: 303.694.6700  Fax: 303.694.6761  Toll Free: 888.766.3985  www.swscpas.com


 
F-5

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

In U.S. dollars
 
   
December 31,
 
   
2004
 
2003*
 
           
ASSETS
         
           
CURRENT ASSETS:
         
Cash and cash equivalents
 
$
6,734,512
 
$
13,685,125
 
Restricted collateral deposits and restricted held-to-maturity securities
   
6,962,110
   
706,180
 
Available for sale marketable securities
   
135,568
   
-
 
Trade receivables (net of allowance for doubtful accounts in the amounts of $55,394 and $61,282 as of December 31, 2004 and 2003, respectively)
   
8,266,880
   
4,706,423
 
               
Unbilled receivables
   
2,881,468
   
-
 
Other accounts receivable and prepaid expenses
   
1,339,393
   
1,187,371
 
Inventories
   
7,277,301
   
1,914,748
 
Assets of discontinued operations
   
-
   
66,068
 
               
Total current assets
   
33,597,232
   
22,265,915
 
               
SEVERANCE PAY FUND
   
1,980,047
   
1,023,342
 
               
RESTRICTED DEPOSITS
   
4,000,000
   
-
 
               
PROPERTY AND EQUIPMENT, NET
   
4,600,691
   
2,292,741
 
               
OTHER INTANGIBLE ASSETS, NET
   
14,368,701
   
2,375,195
 
               
GOODWILL
   
39,745,516
   
5,064,555
 
               
   
$
98,292,187
 
$
33,021,748
 
 
 
 
The accompanying notes are an integral part of the consolidated financial statements.
F-6

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

In U.S. dollars


   
December 31,
 
   
2004
 
2003*
 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY
         
           
CURRENT LIABILITIES:
         
Trade payables
 
$
6,177,546
 
$
1,967,448
 
Other accounts payable and accrued expenses
   
5,818,188
   
4,030,411 **
 
Current portion of promissory notes due to purchase of subsidiaries
   
13,585,325
   
150,000
 
Short term bank credit and current portion of long term loans
   
181,352
   
40,849
 
Deferred revenues
   
618,229
   
140,936 **
 
Liabilities of discontinued operations
   
-
   
380,108
 
               
Total current liabilities
   
26,380,640
   
6,709,752
 
               
LONG TERM LIABILITIES
             
Accrued severance pay
   
3,422,951
   
2,814,492
 
Convertible debenture
   
1,754,803
   
1,450,194
 
Deferred revenues
   
163,781
   
220,143
 
Long term loan
   
20,891
   
-
 
Long-term portion of promissory note due to purchase of subsidiaries
   
980,296
   
150,000
 
               
Total long-term liabilities
   
6,342,722
   
4,634,829
 
               
COMMITMENTS AND CONTINGENT LIABILITIES (Note 12)
             
               
MINORITY INTEREST
   
95,842
   
51,290
 
               
STOCKHOLDERS’ EQUITY:
             
Share capital -
             
Common stock - $0.01 par value each;
             
Authorized: 250,000,000 shares and 100,000,000 shares as of December 31, 2004 and 2003, respectively; Issued: 80,576,902 shares and 47,972,407 shares as of December 31, 2004 and 2003, respectively; Outstanding - 80,021,569 shares and 47,417,074 shares as of December 31, 2004 and 2003, respectively
   
805,769
   
479,726
 
Preferred shares - $0.01 par value each;
             
Authorized: 1,000,000 shares as of December 31, 2004 and 2003; No shares issued and outstanding as of December 31, 2004 and 2003
   
-
   
-
 
Additional paid-in capital
   
189,266,704
   
135,702,413
 
Accumulated deficit
   
(118,953,553
)
 
(109,911,240
)
Deferred stock compensation
 
 
(1,258,295
)
 
(8,464
)
Treasury stock, at cost (common stock - 555,333 shares as of December 31, 2004 and 2003)
   
(3,537,106
)
 
(3,537,106
)
Notes receivable from stockholders
   
(1,222,871
)
 
(1,203,881
)
Accumulated other comprehensive income
   
372,335
   
104,429
 
               
Total stockholders’ equity
   
65,472,983
   
21,625,877
 
               
   
$
98,292,187
 
$
33,021,748
 

* Restated (see Note 1.b.).
** Reclassified.
 
 
The accompanying notes are an integral part of the consolidated financial statements.
F-7

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

In U.S. dollars

   
Year ended December 31,
 
   
2004
 
2003*
 
2002
 
               
Revenues
 
$
49,953,846
 
$
17,326,641
 
$
6,406,739
 
                     
Cost of revenues
   
34,011,094
   
11,087,840
   
4,421,748
 
                     
Gross profit
   
15,942,752
   
6,238,801
   
1,984,991
 
                     
Operating expenses:
                   
Research and development, net
   
1,731,379
   
1,053,408
   
685,919
 
Selling and marketing expenses
   
4,922,217
   
3,532,636
   
1,309,669
 
General and administrative expenses
   
10,656,866
   
5,857,876
   
4,023,103
 
Amortization of intangible assets and impairment losses
   
2,814,835
   
864,910
   
623,543
 
In-process research and development write-off
   
-
   
-
   
26,000
 
                     
Total operating costs and expenses
   
20,125,297
   
11,308,830
   
6,668,234
 
                     
Operating loss
   
(4,182,545
)
 
(5,070,029
)
 
(4,683,243
)
Financial income (expenses), net
   
(4,228,965
)
 
(4,038,709
)
 
100,451
 
                     
Loss before minorities interests in loss (earnings) of a subsidiaries and tax expenses
   
(8,411,510
)
 
(9,108,738
)
 
(4,582,792
)
Income taxes
   
(586,109
)
 
(396,193
)
 
-
 
Minorities interests in loss (earnings) of a subsidiaries
   
(44,694
)
 
156,900
   
(355,360
)
Loss from continuing operations
   
(9,042,313
)
 
(9,348,031
)
 
(4,938,152
)
                     
Income (loss) from discontinued operations (including loss on disposal of $4,446,684 during 2002)
   
-
   
110,410
   
(13,566,206
)
Net loss
 
$
(9,042,313
)
$
(9,237,621
)
$
(18,504,358
)
                     
Deemed dividend to certain stockholders
 
$
(3,328,952
)
$
(350,000
)
$
-
 
                     
Net loss attributable to common stockholders
 
$
(12,371,265
)
$
(9,587,621
)
$
(18,504,358
)
                     
Basic and diluted net loss per share from continuing operations
 
$
(0.13
)
$
(0.24
)
$
(0.15
)
Basic and diluted net loss per share from discontinued operations
 
$
0.00
 
$
0.00
 
$
(0.42
)
Basic and diluted net loss per share
 
$
(0.18
)
$
(0.25
)
$
(0.57
)
                     
Weighted average number of shares used in computing basic and diluted net loss per share
   
69,933,057
   
38,890,174
   
32,381,502
 

* Restated (see Note 1.b.).


 
The accompanying notes are an integral part of the consolidated financial statements.
F-8

AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

In U.S. dollars
 

   
Common stock
                                 
   
Shares
 
Amount
 
Additional
paid-in
capital
 
Accumulated
deficit
 
Deferred
stock
compensation
 
Treasury
stock
 
Notes
receivable
from
stockholders
 
Accumulated other
comprehensive loss
 
Total
comprehensive
loss
 
Total
stockholders’
equity
 
Balance as of January 1, 2002
   
29,059,469
 
$
290,596
 
$
105,686,909
 
$
(82,169,261
)
$
(18,000
)
$
(3,537,106
)
$
(845,081
)
$
-
       
$
19,408,057
 
Adjustment of notes from stockholders
                                       
(178,579
)
           
(178,579
)
Repayment of notes from employees
                                       
43,308
               
43,308
 
Issuance of shares to investors
   
2,041,176
   
20,412
   
3,209,588
                                       
3,230,000
 
Issuance of shares to service providers
   
368,468
   
3,685
   
539,068
                                       
542,753
 
Issuance of shares to lender in respect of prepaid interest expenses
   
387,301
   
3,873
   
232,377
                                       
236,250
 
Exercise of options by employees
   
191,542
   
1,915
   
184,435
                     
(36,500
)
             
149,850
 
Amortization of deferred stock com-pensation
                           
6,000
                           
6,000
 
Stock compensation re-lated to options issued to employees
   
13,000
   
130
   
12,870
                                       
13,000
 
Issuance of shares in respect of acquisition
   
3,640,638
   
36,406
   
4,056,600
                                       
4,093,006
 
Accrued interest on notes re-ceivable
               
160,737
                     
(160,737
)
             
-
 
Other comprehensive loss Foreign currency translation adjustment
                                             
(1,786
)
$
(1,786
)
 
(1,786
)
Net loss
                     
(18,504,358
)
                         
(18,504,358
)
 
(18,504,358
)
Total comprehensive loss
                                                 
$
(18,506,144
)
     
                                                               
Balance as of December 31, 2002
   
35,701,594
 
$
357,017
 
$
114,082,584
 
$
(100,673,619
)
$
(12,000
)
$
(3,537,106
)
$
(1,177,589
)
$
(1,786
)
        
$
9,037,501
 
 

The accompanying notes are an integral part of the consolidated financial statements.
F-9

AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 

   
Common stock
                                 
   
Shares
 
Amount
 
Additional
paid-in
capital
 
Accumulated
deficit
 
Deferred
stock
compensation
 
Treasury
stock
 
Notes
receivable
from
stockholders
 
Accumulated other
comprehensive loss
 
Total
comprehensive
loss
 
Total
stockholders’
equity
 
Balance as of January 1, 2003*
   
35,701,594
 
$
357,017
 
$
114,082,584
 
$
(100,673,619
)
$
(12,000
)
$
(3,537,106
)
$
(1,177,589
)
$
(1,786
)
     
$
9,037,501
 
Compensation related to warrants issued to the holders of convertible debentures
               
5,157,500
                                       
5,157,500
 
Compensation related to beneficial conversion feature of convertible debentures
               
5,695,543
                                       
5,695,543
 
Issuance of shares on conversion of convertible debentures
   
6,969,605
   
69,696
   
6,064,981
                     
(9,677
)
             
6,125,000
 
Issuance of shares on exercise of warrants
   
3,682,997
   
36,831
   
3,259,422
                                       
3,296,253
 
Issuance of shares to consultants
   
223,600
   
2,236
   
159,711
                                       
161,947
 
Compensation related to grant and reprcing of warrants and options issued to consultants
               
229,259
                                       
229,259
 
Compensation related to non-recourse loan granted to shareholder
               
38,500
                                       
38,500
 
Deferred stock compensation
               
4,750
         
(4,750
)
                         
-
 
Amortization of deferred stock compensation
                           
8,286
                           
8,286
 
Exercise of options by employees
   
689,640
   
6,896
   
426,668
                                       
433,564
 
Exercise of options by consultants
   
15,000
   
150
   
7,200