FUEL TECH, INC. — Interim / Quarterly Report 2005

Aug 5, 2005

---------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 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: 000-21724 -------------------- FUEL-TECH N.V. (Exact name of registrant as specified in its charter) Netherlands Antilles N.A. -------------------- ----------------- (State of Incorporation) (I.R.S. Employer Identification No.) Fuel-Tech N.V. Fuel Tech, Inc. (Registrant) (U.S. Operating Subsidiary) Castorweg 22-24 695 East Main Street A-1 Curacao, Netherlands Antilles Stamford, CT 06901 (599) 9-461-3754 (203) 425-9830 (Address and telephone number of principal executive offices) 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 and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 under the Securities Exchange Act of 1934). Yes X No --- --- As of July 20, 2005, there were outstanding 20,050,240 shares of Common Stock, par value $0.01 per share, of the registrant. ================================================================================ FUEL-TECH N.V. Form 10-Q for the six-month period ended June 30, 2005 INDEX

PART I. FINANCIAL INFORMATION Item 1. Financial Statements FUEL-TECH N.V. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands of U.S. dollars, except share data)

See notes to condensed consolidated financial statements. 1 FUEL-TECH N.V. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands of U.S. dollars, except share data)

See notes to condensed consolidated financial statements. 2 FUEL-TECH N.V. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands of U.S. dollars)

See notes to condensed consolidated financial statements. 3 FUEL-TECH N.V. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS June 30, 2005 (Unaudited) NOTE A: BASIS OF PRESENTATION The accompanying unaudited, condensed, consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results of operations for the periods covered have been included. Operating results for the six-month period ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in Fuel-Tech N.V.'s Annual Report on Form 10-K for the year ended December 31, 2004. Fuel-Tech N.V., through its subsidiaries ("Fuel Tech"), is a technology company active in the business of air pollution control and fuel treatment chemicals. Fuel Tech, incorporated in 1987 under the laws of the Netherlands Antilles, is registered at Castorweg 22--24 in Curacao under No. 1334/N.V. 4 NOTE B: EARNINGS PER SHARE DATA Basic earnings per share excludes the dilutive effects of stock options and warrants and of the nil coupon non-redeemable convertible unsecured loan notes. Diluted earnings per share includes the dilutive effect of stock options and warrants and of the nil coupon non-redeemable convertible unsecured loan notes. Such amounts have been excluded for the three and six-month periods ended June 30, 2004, as they are antidilutive to the net loss for these periods. The following table sets forth the weighted-average shares (in thousands) used in calculating the earnings per share for the three and six-month periods ended June 30, 2005 and 2004:

NOTE C: TOTAL COMPREHENSIVE INCOME (LOSS) Total comprehensive income (loss) for Fuel Tech is comprised of net income (loss) and the impact of foreign currency translation as follows:

NOTE D: DERIVATIVE FINANCIAL INSTRUMENTS Foreign Currency Risk Management: Fuel Tech's earnings and cash flow are subject to fluctuations due to changes in foreign currency exchange rates. Fuel Tech does not enter into foreign currency forward contracts or into foreign currency option contracts to manage this risk due to the immaterial nature of the transactions involved. 5 NOTE E: STOCK-BASED COMPENSATION Fuel Tech accounts for stock option grants in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Under Fuel Tech's current plan, options may be granted at not less than the fair market value on the date of grant, and therefore, no compensation expense is recognized for the stock options granted. If compensation expense for Fuel Tech's plans had been determined based on the fair value at the grant dates for awards under its plans, consistent with the method described in SFAS No. 123, "Accounting for Stock-Based Compensation," Fuel Tech's net income and income per share would have been adjusted as follows for the three and six-month periods ended June 30, 2005 and 2004:

The application of the "As adjusted" disclosures presented above are not representative of the effects SFAS No. 123 may have on such operating results in future years due to the timing of stock option grants and considering that options vest over a period of immediately to four years. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," (SFAS No. 123R). SFAS No. 123R eliminates the intrinsic value method under APB No. 25, and requires Fuel Tech to use a fair-value based method of accounting for share-based payments. Under APB No. 25, no compensation cost related to stock options is recognized in the Consolidated Statements of Operations. SFAS No. 123R requires that compensation cost for employee services received in exchange for an award of equity instruments be recognized in the Consolidated Statements of Operations based on the grant-date fair value of that award. That cost recognized at the grant-date will be amortized in the Consolidated Statements of Operations over the period during which an employee is required to provide service in exchange for that award (requisite service period). The provisions of SFAS No. 123R are effective as of the first interim period that begins after June 15, 2005. On April 14, 2005, the Securities and Exchange Commission announced that it would permit companies to delay implementation of SFAS No. 123(R) to the beginning of their next fiscal year. The Company currently plans to implement the revised standard on January 1, 2006. The Company is still evaluating the impact and has the option to use the modified prospective or modified retrospective methods upon adoption of SFAS No. 123R. 6 NOTE F: DEBT Fuel Tech, Inc. (FTI) has a $15.0 million revolving credit facility expiring July 31, 2006, which is collateralized by all personal property owned by FTI. FTI can use this facility for cash advances and standby letters of credit. Cash advances under this facility bear interest based on the following: - The Bank Prime Rate reduced by a range of zero to 50 basis points, or - The Bank Interbank Offering Rate increased by a range of 200 to 250 basis points Fuel Tech can choose which rate to apply to borrowings. At June 30, 2005, there were no borrowings outstanding on the facility. NOTE G: DISCONTINUATION OF ACUITIV(TM) BUSINESS Effective March 1, 2005, Fuel Tech announced that it would discontinue commercialization activities associated with its ACUITIV visualization software business. The software will continue to be maintained and utilized internally on a prospective basis because it is an essential tool in the design, marketing and sale of Fuel Tech's Nitrogen Oxide (NOx) reduction and FUEL CHEM(R) product applications. As part of the cessation of activities, Fuel Tech terminated three individuals, and a charge of $31,000 for severance obligations was recorded in the "Selling, general and administrative" expense line item in the condensed consolidated statement of operations for the six-month period ended June 30, 2005. In addition, effective December 31, 2004, patent assets related to the ACUITIV visualization software business were deemed impaired. The impact of the impairment loss for Fuel Tech was $88,000 and was recorded in the "Other expense" line item in the consolidated statements of operations for the year ended December 31, 2004. NOTE H: BUSINESS SEGMENT AND GEOGRAPHIC DISCLOSURES Fuel Tech is organized into three reportable segments, two that provide advanced engineering solutions for the optimization of combustion systems in utility and industrial applications, and one that markets and sells visualization software. The two segments that comprise the advanced engineering solutions product offerings are as follows: - The NOx reduction technology segment, which includes the NOxOUT(R), NOxOUT CASCADE(R), NOxOUT ULTRA(R) and NOxOUT SCR(R) processes for the reduction of NOx emissions in flue gas from boilers, incinerators, furnaces and other stationary combustion sources, and - The fuel treatment chemical segment, which uses chemical processes for the control of slagging, fouling, and corrosion and for plume abatement in furnaces and boilers through the addition of chemicals into the fuel or by Targeted In-Furnace Injection (TIFI). As described in Note G above, the segment that markets and sells visualization software was discontinued in the quarter ending March 31, 2005. The visualization software segment does not meet the materiality test for disclosure and is aggregated in "Other" below. In addition, "Other" also includes those profit and loss items not allocated by Fuel Tech to each reportable segment. Lastly, there are no intersegment sales that require elimination. Fuel Tech evaluates performance and allocates resources based on reviewing gross margin by reportable segment. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Fuel Tech does not review assets by reportable segment, but rather, in aggregate for Fuel Tech as a whole. 7 Information about reporting segment net sales and gross margin are provided below in thousands of U.S. dollars:

8 Information concerning Fuel Tech's operations by geographic area is provided below in thousands of U.S. dollars. Revenues are attributed to countries based on the location of the customer. Assets are those directly associated with operations of the geographic area.

NOTE I: INCOME TAXES For the three months ended June 30, 2005, Fuel Tech recorded a tax benefit of $1,588,000. The tax benefit included a $2,200,000 reduction in the deferred tax asset valuation allowance which represented the anticipated utilization of net operating loss carryforwards in subsequent periods. Partially offsetting this amount was $570,000 in deferred tax expense and $42,000 in current state income tax expense. Based on a review of both historical and projected taxable income at the end of June 30, 2005, Fuel Tech concluded that it was more likely than not that some portion of the net operating losses would be utilized in subsequent periods and that a reduction in the deferred tax valuation allowance was required. On a year-to-date basis Fuel Tech recorded a tax benefit of $1,105,000. The tax benefit was comprised of the $2,200,000 reduction in the deferred tax asset valuation allowance, partially offset by $1,044,000 in deferred tax expense and $51,000 in current state income tax expense. At December 31, 2004, Fuel Tech recorded a $1,500,000 reduction in the deferred tax asset valuation allowance, which represented the anticipated utilization of net operating loss carryforwards in subsequent periods. Based on a review of both historical and projected taxable income, Fuel Tech had concluded that it was more likely than not that some portion of the net operating losses would be utilized in subsequent periods and that a reduction in the deferred tax valuation allowance was required. No provision for federal or state income taxes was recorded during the three or six-month periods ended June 30, 2004 due to the existence of net operating loss carryforwards. 9 FUEL-TECH N.V. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Net sales for the three months ended June 30, 2005 and 2004 were $11,780,000 and $7,352,000, respectively, while net sales for the six months ended June 30, 2005 and 2004 were $23,831,000 and $13,504,000, respectively. The year to date increase is due to a $10,166,000 increase in revenues derived from the nitrogen oxide (NOx) reduction business. This business segment, which began to show increased strength in the second half of 2004, continues to experience a robust period of order activity. Utilities and industrial facilities that are impacted by the Environmental Protection Agency's (EPA) State Implementation Plan (SIP) Call regulation are continuing to prove that Fuel Tech's technology is a viable tool in their ongoing regulatory compliance planning. Fuel Tech continues to work towards developing alliance agreements with critical customers looking to finalize their compliance plans. The fuel treatment chemical business segment generated revenues of $7,506,000 for the six months ended June 30, 2005 versus $7,344,000 in the comparable period of 2004. Revenue gains were limited by the following circumstances in the first six months of the year: - Demonstration programs- there were four demonstration programs during the first six months of the year that did not yield commercial revenues. One was a no-cost demonstration at a critical coal-fired utility, while the other three demonstrations were structured on a cost-share basis, one on a coal-fired unit and two on oil-fired units. Under cost-share arrangements, during the demonstration period, Fuel Tech will invoice the customer at a specified percentage of the commercial price. At the end of the demonstration, if Fuel Tech meets the criteria for success that were established for the program, Fuel Tech will invoice the customer for the remaining percentage of the commercial price. These latter three demonstrations are expected to reach their evaluation date in the third quarter. - Coal supply chain issues- during the first six months of the year one critical Western-coal fired utility unit was significantly and unexpectedly derated for an extended period due to transportation related shortages of Western coal deliveries to the plant. Rail disruptions in the Powder River Basin have impacted several utilities, while maintenance and repair work on key rail lines is expected to hamper coal shipments in several parts of the country for the remainder of the year. - Oil pricing - the high price of oil has resulted in reduced oil-fired electricity generation in the United States. Fuel Tech's oil-fired business was negatively impacted by this market dynamic. Fuel Tech's TIFI technology alleviates the slagging and fouling issues associated with burning coals that are high in low-melting-point ash constituents, such as sodium. More than half of the coal burned today to generate electricity is Western coal and it is Western coal that has higher levels of low-melting-point ash constituents. Due to its lower cost and lower pollutant content relative to Eastern coals, Western coals are being burned in larger quantities and in an increasing number of facilities. Consequently, the penetration of the Western coal-fired utility market remains the top priority for this business segment. Cost of sales as a percentage of net sales for the three-month period ended June 30, 2005 decreased to 51% from 57% in the second quarter of the prior year. On a year-to-date basis the cost of sales percentage is 52% and 55%, respectively, for 2005 and 2004. The improvement in the cost of sales percentage on a year-to-date basis is primarily attributable to the nitrogen oxide business, where the percentage decreased to 51% in 2005 from 56% in 2004. The decrease is attributable to the mix of project business. Selling, general and administrative expenses for the three months ended June 30, 2005 and 2004 were $3,753,000 and $3,151,000, respectively, while these expenses for the six months ended June 30, 2005 and 2004 were $7,809,000 and $6,328,000, respectively. The increase is primarily attributable to human resource-related expenses as staffing levels were increased in several areas in anticipation of overall business growth. Revenue-related expenses attributable to the NOx reduction business also contributed to the increase, as did increases in audit and legal fees to a lesser degree. 10 Research and development expenses for the three months ended June 30, 2005 and 2004 were $326,000 and $270,000, respectively, while these expenses for the six months ended June 30, 2005 and 2004 were $660,000 and $573,000, respectively. Fuel Tech continues to pursue commercial applications for its technologies outside of its traditional markets, from both an industrial and geographical perspective. In the first quarter of 2005, Fuel Tech funded a successful demonstration of its TIFI technology in Mexico with a research facility owned by the Mexican government. The decline in other income and expense for the six months ended June 30, 2005 versus the prior year is due principally to the impact of foreign currency translation. For the three months ended June 30, 2005, Fuel Tech recorded a tax benefit of $1,588,000. The tax benefit included a $2,200,000 reduction in the deferred tax asset valuation allowance which represented the anticipated utilization of net operating loss carryforwards in subsequent periods. Partially offsetting this amount was $570,000 in deferred tax expense and $42,000 in current state income tax expense. Based on a review of both historical and projected taxable income at the end of June 30, 2005, Fuel Tech concluded that it was more likely than not that some portion of the net operating losses would be utilized in subsequent periods and that a reduction in the deferred tax valuation allowance was required. On a year-to-date basis Fuel Tech recorded a tax benefit of $1,105,000. The tax benefit was comprised of the $2,200,000 reduction in the deferred tax asset valuation allowance, partially offset by $1,044,000 in deferred tax expense and $51,000 in current state income tax expense. At December 31, 2004, Fuel Tech recorded a $1,500,000 reduction in the deferred tax asset valuation allowance, which represented the anticipated utilization of net operating loss carryforwards in subsequent periods. Based on a review of both historical and projected taxable income, Fuel Tech had concluded that it was more likely than not that some portion of the net operating losses would be utilized in subsequent periods and that a reduction in the deferred tax valuation allowance was required. No provision for federal or state income taxes was recorded during the three or six-month periods ended June 30, 2004 due to the existence of net operating loss carryforwards. LIQUIDITY AND SOURCES OF CAPITAL On June 30, 2005, Fuel Tech had cash and cash equivalents of $5,129,000 and working capital of $14,292,000 versus $6,531,000 and $11,292,000 at the end of 2004, respectively. Operating activities used $622,000 of cash in the first six months of 2005, primarily due to an increase in accounts receivable from the improvement in overall business activity. Investing activities used cash of $1,058,000 during the first six months of 2005, largely for equipment purchases related to the fuel treatment chemical business. During the first half of 2005, Fuel Tech generated cash from the exercise of stock options in the amount of $396,000. 11 FORWARD-LOOKING STATEMENTS Statements in this Form 10-Q that are not historical facts, so-called "forward-looking statements," are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that all forward-looking statements involve risks and uncertainties, including those detailed in Fuel Tech's filings with the Securities and Exchange Commission. See "Risk Factors of the Business" in Item 1, "Business," and also Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Fuel Tech's Form 10-K for the year ended December 31, 2004. Item 3. Quantitative and Qualitative Disclosures about Market Risk Foreign Currency Risk Management: Fuel Tech's earnings and cash flow are subject to fluctuations due to changes in foreign currency exchange rates. Fuel Tech does not enter into foreign currency forward contracts or into foreign currency option contracts to manage this risk due to the immaterial nature of the transactions involved. Item 4. Controls and Procedures Fuel Tech maintains disclosure controls and procedures and internal controls designed to ensure that information required to be disclosed in Fuel Tech's filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Fuel Tech's management, with the participation of its principal executive and financial officers, has evaluated the effectiveness of Fuel Tech's disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Fuel Tech's principal executive and financial officers have concluded, based on such evaluation, that such disclosure controls and procedures were effective for the purpose for which they were designed as of the end of such period. In performing the evaluation of internal controls as of December 31, 2004, one instance was found where the procedures and controls were insufficient to ensure that infrequent or unusual business transactions, such as lease agreements, are analyzed, recorded, and monitored in the context of authoritative accounting guidance such that these transactions are recognized in accordance with generally accepted accounting principles. Rent expense during 2004 was understated due to the accounting treatment for a "free rent" period that was provided in its lease agreement for its corporate headquarters. Fuel Tech had recorded rent expense in accordance with the required rental payment schedule in the lease, rather than amortizing the total minimum lease payments over the full term of the lease. The adjustment for additional rent expense of $123,000 was recorded subsequent to the press release issued on Thursday, March 3, 2005. Fuel Tech has only one other building lease agreement. To remediate the material weakness that was recognized in Fuel Tech's internal control over financial reporting, Fuel Tech implemented additional review procedures over the factors affecting infrequent or unusual business transactions, including lease agreements. These additional procedures include inquiries of all management personnel that can legally bind Fuel Tech to infrequent or unusual business transactions. If the inquiries reveal that Fuel Tech has entered into infrequent or unusual business transactions, such transactions are documented, analyzed, recorded, and monitored in the context of authoritative accounting guidance. Other than the addition of this procedure, there was no change in Fuel Tech's internal control over financial reporting that was identified in connection with such evaluation that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, Fuel Tech's internal control over financial reporting. 12 PART II. OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders At the annual meeting on June 2, 2005, with a total vote of 16,523,872 shares, or 83% of the outstanding shares present by proxy, all of the nominated directors have been elected, the report of management for the year 2004 was approved, and the appointment of Ernst & Young LLP as auditors was ratified. The details are: 1. To approve the election of the directors: For Withheld --- -------- Douglas G Bailey 16,132,671 391,201 Ralph E. Bailey 16,211,025 312,847 Miguel Espinosa 16,218,145 305,727 Charles Grinnell 16,257,252 266,620 Thomas L. Jones 16,257,722 266,150 Samer Khanachet 16,218,815 305,057 John D. Morrow 16,220,145 303,727 Thomas S. Shaw 16,219,675 304,197 2. Approve Report of Management for 2004 For: 16,488,209 Against: 3,500 Abstained: 32,163 3. Ratify Appointment of Ernst & Young LLP for 2005 For: 16,188,236 Against: 326,616 Abstained: 8,930 Item 5. Other Information None Item 6. Exhibits a. Exhibits Exhibit 31.1 and 31.2 are filed herewith Exhibit 32 is furnished herewith b. Reports on Form 8-K None 13 FUEL-TECH N.V. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: August 5, 2005 By: /s/ Ralph E. Bailey ------------------- Ralph E. Bailey Chairman, Managing Director and Chief Executive Officer Date: August 5, 2005 By: /s/ Vincent J. Arnone --------------------- Vincent J. Arnone Chief Financial Officer, Vice President and Treasurer 14