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PART I   FINANCIAL INFORMATION
Item 1	Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2009 (unaudited) and December 31, 2008	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2009 and 2008 (unaudited)	4
	Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months ended September 30, 2009 (unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2009 and 2008 (unaudited)	6
	Notes to Condensed Consolidated Financial Statements (unaudited)	7-13
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3	Quantitative and Qualitative Disclosures About Market Risk	18
Item 4T	Controls and Procedures	18
PART II OTHER INFORMATION
Item 1	Legal Proceedings	20
Item 1A	Risk Factors	20
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	20
Item 3	Defaults Upon Senior Securities	20
Item 4	Submission of Matters to a Vote of Security Holders	20
Item 5	Other Information	20
Item 6	Exhibits	20
SIGNATURES		22
CERTIFICATIONS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

Note 1:  Description of the Business and Summary of Significant Accounting Policies

The Business

eMagin Corporation (the “Company”) designs, develops, manufactures, and markets OLED (organic light emitting diode) on silicon microdisplays, virtual imaging products which utilize OLED microdisplays. The Company’s products are sold mainly in North America, Asia, and Europe.

Basis of Presentation

In the opinion of management, the accompanying unaudited condensed consolidated financial statements of eMagin Corporation and its subsidiary reflect all adjustments, including normal recurring accruals, necessary for a fair presentation.  Certain information and footnote disclosure normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to instructions, rules and regulations prescribed by the Securities and Exchange Commission (“SEC”).  The Company believes that the disclosures provided herein are adequate to make the information presented not misleading when these unaudited condensed consolidated financial statements are read in conjunction with the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.  The results of operations for the period ended September 30, 2009 are not necessarily indicative of the results to be expected for the full year.

 

Reclassifications

Certain operating expense amounts have been reclassified from Selling, General, and Administrative to Research and Development in order to conform with prior year’s presentation.

Use of Estimates

In accordance with accounting principles generally accepted in the United States of America, management utilizes certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other assumptions that are believed 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. Actual results could differ from those estimates.

Revenue and Cost Recognition

Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, selling price is fixed or determinable and collection is reasonably assured.  The Company records a reserve for estimated sales returns, which is reflected as a reduction of revenue at the time of revenue recognition.  The Company defers revenue recognition on products sold directly to the consumer with a maximum thirty day right of return.  Revenue is recognized upon the expiration of the right of return.

The Company also earns revenues from certain R&D activities under both firm fixed-price contracts and cost-type contracts, including some cost-plus-fee contracts.  Revenues relating to firm fixed-price contracts are generally recognized on the percentage-of-completion method of accounting as costs are incurred (cost-to-cost basis).  Revenues on cost-plus-fee contracts include costs incurred plus a portion of estimated fees or profits based on the relationship of costs incurred to total estimated costs. Contract costs include all direct material and labor costs and an allocation of allowable indirect costs as defined by each contract, as periodically adjusted to reflect revised agreed upon rates. These rates are subject to audit by the other party. 

 

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Research and Development Costs

Research and development costs are expensed as incurred.

Note 2:  Recently Issued Accounting Pronouncement

In June 2009, the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“Codification” or “ASC”) became the single source of authoritative nongovernmental U.S. generally accepted accounting principles (“GAAP”) except for additional authoritative rules and interpretive releases issued by the SEC. The Codification did not create any new GAAP standards but incorporated existing accounting and reporting standards into a new topical structure with a new referencing system to identify authoritative accounting standards, replacing the prior references to Statement of Financial Accounting Standards (“SFAS”), Emerging Issues Task Force (“EITF”), FASB Staff Position (“FSP”), etc.  Authoritative standards included in the Codification are designated by their ASC topical reference, and new standards will be designated as Accounting Standards Updates (“ASU”), with a year and assigned sequence number.  Beginning with the interim report for this third quarter, the Company adopted the Codification and it had no effect on its financial position, results of operations, or cash flows.

Note 3:  Receivables

 

The majority of the Company’s commercial accounts receivable are due from Original Equipment Manufacturers ("OEM’s”). Credit is extended based on evaluation of a customer’s financial condition and, generally, collateral is not required. Accounts receivable are payable in U.S. dollars, are due within 30-90 days and are stated at amounts due from customers, net of an allowance for doubtful accounts. Any account outstanding longer than the contractual payment terms is considered past due.

The Company determines the allowance for doubtful accounts by considering a number of factors, including the length of time the trade accounts receivable are past due, historical experience, the customer's current ability to pay its obligations, and the condition of the general economy and the industry as a whole.   The Company will record a specific reserve for individual accounts when the Company becomes aware of a customer's inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer's operating results or financial position.  If circumstances related to customers change, the Company would further adjust estimates of the recoverability of receivables.

Receivables consisted of the following (in thousands):

		September 30, 2009 (unaudited)				December 31, 2008
Accounts receivable		$	4,545			$	4,500
Less allowance for doubtful accounts			(434	)			(857	)
Net receivables		$	4,111			$	3,643

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Note 4:  Net Income (Loss) per Common Share

The net income (loss) per common share ("basic EPS") is computed by dividing net income (loss) by the weighted average number of common shares outstanding and excluding any potential dilution.  Net income (loss) per common share assuming dilution ("diluted EPS") is computed by reflecting potential dilution from the exercise of stock options, warrants, convertible preferred stock and redeemable stock.

 

The following table presents a reconciliation of the numerator and denominator of the basic and diluted EPS calculations (in thousands, except share and per share data):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2009				2008				2009				2008
Numerator:
Net income (loss)		$	1,190			$	361			$	2,923			$	(2,435	)
Adjustment for interest expense on convertible notes, net of taxes			—				121				—				—
		$	1,190			$	482			$	2,923			$	(2,435	)
Denominator:
Weighted average shares outstanding for basic earnings per share			16,513,101				14,617,235				16,133,646				13,854,860
Effective of dilutive shares:
Dilution from stock options and warrants			2,427,166				365,216				685,840				—
Redeemable stock			—				117,277				—				—
Convertible notes			—				8,330,688				—				—
Convertible preferred stock			7,652,000				—				7,652,000				—
Dilutive potential common shares			10,079,166				8,813,181				8,337,840				—
Weighted average shares outstanding for diluted earnings per share			26,592,267				23,430,416				24,471,486				13,854,860

For the three and nine months ended September 30, 2009, there were stock options and warrants outstanding to acquire 3,498,592 and 10,226,638 shares, respectively, of the Company common stock which were excluded from the calculation of its diluted earnings per share as their effect would be anti-dilutive.   The convertible preferred stock is included in the calculation of diluted earnings per share as all shares are assumed converted.

For the three and nine months ended September 30, 2008, there were stock options, warrants and convertible notes outstanding to acquire 10,901,343 and  20,376,584 shares, respectively, of the Company’s common stock which were excluded from the computation of diluted loss per share because their effect would be anti-dilutive. For the three and nine months ended September 30, 2008, the Company also excluded 360,000 and 522,500 redeemable shares, respectively as their effect would be anti-dilutive.  The convertible notes are included in the calculation of diluted earnings per share as all shares are assumed converted.

Note 5:  Inventory

Inventory is stated at the lower of cost or market. Cost is determined using the first-in first-out method.  The Company reviews the value of its inventory and reduces the inventory value to its net realizable value based upon current market prices and contracts for future sales. The components of inventories are as follows (in thousands):

		September 30,  2009  (unaudited)				December 31, 2008
Raw materials		$	824			$	1,109
Work in process			324				280
Finished goods			917				985
Total inventory		$	2,065			$	2,374

 

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Note 6:  Prepaid Expenses and Other Current Assets:

Prepaid expenses and other current assets consist of the following (in thousands):

		September 30,  2009  (unaudited)				December 31, 2008
Vendor prepayments		$	418			$	180
Other prepaid expenses *			467				383
Other assets			—				233
Total prepaid expenses and other current assets		$	885			$	796

*No individual amounts greater than 5% of current assets.

Note 7:  Debt

Debt, all of which is current, is as follows (in thousands):

		September 30,
		2009 (unaudited)				December 31, 2008
Line of credit		$	—			$	1,631
Other debt			—				60
Total debt		$	—			$	1,691

The Company’s line of credit with Moriah Capital, L.P. (“Moriah”) matured on August 7, 2009 and the Company repaid a total of approximately $232 thousand in principal due on the line of credit.  The Company did not renew its loan agreement with Moriah.  

The Company entered into an agreement effective as of September 1, 2009 (the “Agreement”), with Access Business Finance, LLC (“Access”) pursuant to which it may borrow an amount not to exceed $3,000,000.  The Agreement provides that from time to time the Company may request advances in an amount equal to the lesser of (i) Borrowing Base less the Availability Reserves and (ii) the Maximum Amount as defined in the Agreement.  The interest on the line of credit is equal to the Prime Rate plus 4.00% but may not be less than 7.25%.  The term of the Agreement is for one year and will automatically renew for successive one year terms unless, at least 60 days’ prior to the end of the current term, the Company gives Access prior written notice of its intent not to renew or if Access, at least ten days prior to the end of the current term, gives the Company written notice of its intent not to renew. The Company’s obligations under the Agreement are secured by its assets.   As of September 30, 2009, the Company had not borrowed on its line of credit.  The Company paid $25,000 in annual loan fees to Access which were charged to prepaid expense and will be amortized over the life of the Agreement.  As of September 30, 2009, $2,000 had been amortized to interest expense.

In the three and nine months ended September 30, 2009, approximately $61 thousand and $362 thousand, respectively, of deferred debt issuance costs were amortized to interest expense.  For the three and nine months ended September 30, 2009, interest expense includes interest paid or accrued of approximately $15 thousand and $55 thousand, respectively, on outstanding debt.

Note 8:  Stock-based Compensation

The Company uses the fair value method of accounting for share-based compensation arrangements. The fair value of stock options is estimated at the date of grant using the Black-Scholes option valuation model.   Stock-based compensation expense is reduced for estimated forfeitures and is amortized over the vesting period using the straight-line method.

The following table summarizes the allocation of non-cash stock-based compensation to the expense categories for the three and nine month periods ended September 30, 2009 and 2008 (in thousands):

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2009				2008				2009				2008
Cost of revenue		$	25			$	31			$	111			$	106
Research and development			39				58				165				192
Selling, general and administrative			317				149				650				547
Total stock compensation expense		$	381			$	238			$	926			$	845

 

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At September 30, 2009, total unrecognized non-cash compensation cost related to stock options was approximately $415 thousand, net of forfeitures.  Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures and is expected to be recognized over a weighted average period of approximately 1.2 years.

Options granted to non-employees are measured at the grant date using a fair value options pricing model and remeasured to the current fair market value at each reporting period as the underlying options vest and services are rendered.  For the nine months ended September 30, 2009, there were 60,000 options granted to consultants.  The following assumptions were used in the Black-Scholes option pricing model to determine the fair value of stock options granted:  dividend yield – 0%; risk free interest rates – 1.44% to 1.64%; expected volatility – 71.4% to 84.1%; and expected term – 3 years.

There were 411,600 and 1,278,841 options granted to employees and directors during the three and nine months ended September 30, 2009 and 171,000 and 919,253 options granted to employees and directors during the three and nine months ended September 30, 2008. The following key assumptions were used in the Black-Scholes option pricing model to determine the fair value of stock options granted:

		For the Nine Months Ended September 30,
		2009				2008
Dividend yield			0	%			0	%
Risk free interest rates		2.02 to 2.51		%		2.46 to 3.37		%
Expected  volatility		80.3 to 86.4		%		88.4 to 92.3		%
Expected term (in years)		4.0 to 5.5					5

The Company has not declared or paid any dividends and do not currently expect to do so in the near future.  The risk-free interest rate used in the Black-Scholes option pricing model is based on the implied yield currently available on U.S. Treasury securities with an equivalent term.   Expected volatility is based on the weighted average historical volatility of the Company’s common stock for the most recent five year period.  The expected term of options represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience and vesting schedules of similar awards.

The 2008 Incentive Stock Plan (“the 2008 Plan”) adopted and approved by the Board of Directors on November 5, 2008 provides for  shares of common stock and options to purchase shares of common stock to employees, officers, directors and consultants.  The 2008 Plan has an aggregate of 2,000,000 shares. As of September 30, 2009, 1,278,841 options were granted from this plan with a fair value of approximately $814 thousand and 498,533 shares were issued with a fair value of approximately $304 thousand. At September 30, 2009, there were 222,626 shares available for grant.

A summary of the Company’s stock option activity for the nine months ended September 30, 2009 is presented in the following tables:

		Number of Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Life (In Years)				Aggregate Intrinsic Value
Outstanding at January 1, 2009			1,615,673			$	1.63
Options granted			1,278,841				1.03
Options exercised			—
Options forfeited			(71,598	)			2.60
Options cancelled			—
Outstanding at September 30, 2009			2,822,916			$	1.33				6.37			$	1,549,944
Vested or expected to vest at September 30, 2009 (1)			2,740,781			$	1.29				6.37			$	1,068,090
Exercisable at September 30, 2009			2,001,564			$	1.39				6.71			$	1,068,090

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The Company’s stock option activity for the nine months ended September 30, 2009 (continued):

				Options Outstanding												Options Exercisable
				Number Outstanding				Weighted Average Remaining Contractual Life (In Years)				Weighted Average Exercise Price				Number Exercisable				Weighted Average Exercisable Price
$	0.34 - $0.98				1,226,793				6.56			$	0.83				895,127			$	0.81
$	1.00 - $1.44				1,200,177				7.40				1.20				773,390				1.24
$	2.60 - $2.70				358,746				2.75				2.62				298,847				2.61
$	3.50 - $22.50				37,200				2.03				9.75				34,200				9.54
					2,822,916				6.37			$	1.33				2,001,564			$	1.39

(1)  The expected to vest options are the result of applying the pre-vesting forfeiture rate assumptions to total unvested options.

The aggregate intrinsic value in the table above represents the difference between the exercise price of the underlying options and the quoted price of the Company’s common stock.  There were 2,417,970 options in-the-money at September 30, 2009.   The Company’s closing stock price was $1.65 as of September 30, 2009. The Company issues new shares of common stock upon exercise of stock options.

Note 9:  Shareholders’ Equity

Preferred Stock

The Company has designated 10,000 shares of the Company’s preferred stock as Preferred Stock – Series B at a stated value of $1,000 per share.  The Preferred Stock – Series B is convertible into common stock at a conversion price of $0.75 per share.  The Preferred Stock – Series B does not pay interest.  The holders of the Preferred Stock – Series B are not entitled to receive dividends unless the Company’s Board of Directors declare a dividend for holders of the Company’s common stock and then the dividend shall be equal to the amount that such holder would have been entitled to receive if the holder converted its Preferred Stock – Series B into shares of the Company’s common stock. Each share of Preferred Stock – Series B has voting rights equal to (i) the number of shares of Common Stock issuable upon conversion of such shares of Preferred Stock – Series B at such time (determined without regard to the shares of Common Stock so issuable upon such conversion in respect of accrued and unpaid dividends on such share of Preferred Stock) when the Preferred Stock – Series B votes together with the Company’s Common Stock or any other class or series of stock of the Company and (ii) one vote per share of Preferred Stock when such vote is not covered by the immediately preceding clause.  In the event of a liquidation, dissolution, or winding up of the Company, the Preferred Stock – Series B is entitled to receive liquidation preference before the Common Stock.  The Company may at its option redeem the Preferred Stock – Series B by providing the required notice to the holders of the Preferred Stock – Series B and paying an amount equal to $1,000 multiplied by the number of shares for all of such holder’s shares of outstanding Preferred Stock – Series B to be redeemed.  As of September 30, 2009, there were 5,739 shares of Preferred Stock – Series B issued and outstanding.

Common Stock

For the three and nine months ended September 30, 2009 and 2008, there were no stock options exercised.  For the three and nine months ended September 30, 2009, there were 2.9 million warrants exercised on a cashless basis resulting in 727 thousand shares of common stock issued. No warrants were exercised for the three and nine months ended September 30, 2008.

For the three and nine months ended September 30, 2009, the Company issued 42,857 and 498,533 shares of common stock, respectively, for payment of approximately $45 thousand and $304 thousand, respectively, for services rendered and to be rendered in the future.  For the three and nine months ended September 30, 2008, the Company issued 629,400 and 811,400 shares of common stock, respectively, for payment of approximately $441 thousand and $643 thousand, respectively, for services rendered and to be rendered in the future.  The Company recorded the fair value of the services rendered and to be rendered in the future in prepaid expenses and selling, general and administrative expenses in the accompanying unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2009 and 2008.

At December 31, 2008, the 522,500 shares underlying the 2007 and 2008 put options (“put options”) granted to Moriah were presented on the balance sheet as redeemable common stock in the amount of $429,000 which represented the amount for which the shares may be redeemed at the option of Moriah.   On August 7, 2009, the put options expired when Moriah elected not to exercise its put options.  At September 30, 2009, the 522,500 shares were classified as permanent equity on the balance sheet.

 

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Note 10:  Income Taxes

The Company accounts for income taxes under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns.  The effect on deferred tax assets and liabilities of changes in tax rates will be recognized as income or expense in the period that the change occurs.  A valuation allowance for deferred tax assets is recorded when it is more likely than not that some or all of the benefit from the deferred tax asset will not be realized.  Changes in circumstances, assumptions and clarification of uncertain tax regimes may require changes to any valuation allowances associated with the Company’s deferred tax assets.

The tax years 2005-2008 remain open to examination by the major taxing jurisdictions to which the Company is subject. In the event that the Company is assessed interest or penalties at some point in the future, it will be classified in the financial statements as general and administrative expense.

 

Note 11:  Commitments and Contingencies

Royalty Payments

The Company, in accordance with a royalty agreement with Eastman Kodak, must pay to Eastman Kodak a certain percentage of net sales with respect to certain products, which percentages are defined in the agreement. The percentages are on a sliding scale depending on the amount of sales generated. Any minimum royalties paid will be credited against the amounts due based on the percentage of sales. The royalty agreement terminates upon the expiration of the issued patent which is the last to expire.

Effective May 30, 2007, Kodak and eMagin entered into an intellectual property agreement where eMagin has assigned Kodak the rights, title, and interest to a Company owned patent currently not being used by the Company and in consideration, Kodak waived the royalties due under the existing licensing agreements for the first six months of 2007, and reduced the royalty payments by 50% for the second half of 2007 and for the entire calendar year of 2008. In addition, the minimum royalty payment was delayed until December 1st for the years 2007 and 2008.  The Company recorded approximately $142 thousand and $396 thousand for the three and nine months ended September 30, 2008, respectively, as income from the license of intangible assets and included this amount as other income in the condensed consolidated statements of operations. Royalty expense (including amounts imputed – see above) was approximately $284 thousand and $792 thousand, respectively, for the three and nine months ended September 30, 2008.

Effective January 1, 2009, the royalty payments are to be calculated at 100%.  The minimum annual royalty payment of $125 thousand was paid in January 2009.

In late 2008, the Company began evaluating the status of its manufacturing process and the use of the IP associated with its license agreement.  After this analysis and after making a few changes to its manufacturing process, the Company determined it was no longer using the IP covered under the license agreement.  As such, future royalty payments will be limited to the minimum royalty payment amount of $125,000 plus any residual royalties on sales of product produced prior to the manufacturing process change if such amount exceeds the minimum royalty payment. The associated royalty liability has been reduced to royalties on inventory produced prior to the manufacturing process changes.  The Company is in discussions with the licensor regarding its position on the license agreement and the final outcome of these discussions is yet to be determined. As of September 30, 2009, the Company’s believes that the total royalty owed is $250 thousand which is based on applying the royalty formula to only the sold displays produced prior to the manufacturing process changes.  Until a final outcome is reached, the Company will continue to recognize the reduced royalty liability as stated above.  For the nine months ended September 30, 2009, the Company estimated that the royalty would be approximately $1.0 million if the Company applied the royalty formula to all sold displays produced without consideration of the change in the manufacturing process.   For the nine months ended September 30, 2009, the Company recorded $250 thousand as royalty expense in its consolidated statements of operations and the associated liability on its consolidated balance sheet as the Company believes that is the amount due under the agreement.

Contractual Obligations

The Company leases office facilities and office, lab and factory equipment under operating leases.  Certain leases provide for payments of monthly operating expenses. The Company currently has lease commitments for space in Hopewell Junction, New York and Bellevue, Washington.  In May 2009, the Company renewed its lease with IBM until May 31, 2014 with the option of extending the lease for five years.  The Company’s prior lease in Bellevue, Washington expired August 31, 2009.  The Company signed a lease agreement for 5,100 square feet of office space effective September 1, 2009 through August 31, 2014 which will reduce the Company’s monthly rent by approximately $26 thousand. Rent expense was approximately $336 thousand and $1.1 million, respectively, for the three and nine months ended September 30, 2009 and $332 thousand and $996 thousand, respectively, for the three and nine months ended September 30, 2008.

Note 12:  Subsequent Events

In preparing the Company’s financial statements, the Company evaluated events and transactions for potential recognition or disclosure through November 12, 2009, the date on which this Quarterly Report on Form 10-Q was filed with the SEC.

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