Overview

SCI Engineered Materials, Inc. ("SCI" or the "Company"), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987. We manufacture ceramic and metal sputtering targets for a variety of industrial applications including: Photonics, Thin Film Solar, Semiconductor, Thin Film Battery and, to a lesser extent HTS materials. Photonics currently represents the largest market for our targets. Thin Film Solar is an industry that is exhibiting rapid growth and we expect this market to grow quickly. Thin Film Battery is a developing market where manufacturers of batteries use our targets to produce very small power supplies with small quantities of stored energy. Semiconductor is a developing market for us. We added to our sales staff in late 2007 for the purpose of focusing on opportunities for our products in the Solar industry. We also added staff to our Technology group during the second half of 2007 for the development of innovative products. During the fourth quarter of 2008 we added an exclusive manufacturer's representative for Europe.

Executive Summary

For the year ended December 31, 2008, we had revenues of $9,619,895. This was a decrease of $1,212,787, or 11.2%, compared to 2007. The decrease in revenues was attributed to a reduction in the cost of a high value raw material. We anticipate that the cost of this raw material will continue to be lower in 2009. The order backlog at December 31, 2008 was $2.9 million, which compared to $1.0 million at December 31, 2007.

Despite the decrease in revenues we experienced positive benefits from product mix and improved production efficiency. Gross profit increased 7.5% to $2,211,477 for 2008 from $2,057,823 for 2007. Gross margin also increased to 23.0% of total revenues for 2008 from 19.0% in 2007.

For the year ended December 31, 2008, we recorded net income applicable to common shares of $100,177 compared to $307,682 for 2007. This decrease can be largely attributed to additional operating expenses of approximately $297,000 along with an increase in depreciation expense of approximately $82,000. We continued to invest in R&D, marketing and sales, and additional production equipment to take advantage of current and future market opportunities. During the past 24 months we have been actively marketing to additional customers in select markets. This has resulted in trial and qualification orders that were shipped to customers in the semiconductor and solar industries during 2008 that totaled approximately 10% of our revenues. We have received additional trial orders that should ship during the first quarter of 2009.

Orders received in 2008 were $11,675,439, compared to $10,362,995, in 2007, an increase of 13%.

Results of Operations

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 2 to the Financial Statements in the Annual Report on Form 10-K for the year ended December 31, 2008 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer's credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross margin could be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will provide benefit to us. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.

Year 2008 As Compared to Year 2007

Revenues

Revenues were $9,619,895 in 2008, a decrease of $1,212,787, or 11.2%, from 2007. The revenue decline can be attributed to the ongoing purchase of raw materials whose prices have historically experienced periods of significant fluctuation. Cost changes for this high value raw material are fully reflected in the final selling price which insulates us from market risk associated with the raw material. We anticipate the cost of this high value raw material will continue to be lower during 2009. Revenues exclusive of this high value raw material increased approximately $750,000, or 21.5% over 2007.

Gross Profit

Reflecting positive benefits from product mix and improved production efficiency, gross profit increased 7.5% in 2008. Gross profit in 2008 was $2,211,477 or 23.0% of total revenue as compared to $2,057,823 or 19.0% in 2007

Marketing and Sales Expense

Marketing and sales expense increased 28.3% to $587,202 in 2008 from $457,689 in 2007. This increase was due to the addition of sales and marketing staff and increased travel. We added a sales engineer late in 2007 to focus efforts on applications in the rapidly expanding Thin Film Solar market. We continue to increase our visibility in the global arena by attending various trade shows targeted at the Photonics, Semiconductor and Solar markets. During the fourth quarter of 2008 we added an exclusive manufacturer's representative for Europe.

General and Administrative Expense

General and administrative expense in 2008 was $966,979 compared to $884,771 in 2007, an increase of 9.3%. This increase was due to an increase in staff and professional fees.

Research and Development Expense

Research and development expense for 2008 was $454,424 compared to $368,971 in 2007, an increase of 23.2%. The increase was due to additional staff and expense associated within the continued development efforts in the Photonic, Solar, Thin Film Battery and Semiconductor markets, as well as research related to the SBIRs.

Interest Income and Expense

Interest income was $24,271 and $64,600 for 2008 and 2007, respectively. While our cash position increased slightly in 2008, the decrease in interest rates reduced the amount of interest earned.

Interest expense was $102,763 or 1.1% of revenues in 2008, compared to $79,788, or 0.7% of revenues in 2007. The increase was due to additional capital lease obligations incurred for the purchase of production equipment for increased production capacity.

Income Applicable To Common Shares

Income applicable to common shares was $100,177 and $307,682 for 2008 and 2007, respectively. Net income per common share based on the income applicable to common shares for 2008 and 2007 was $0.03 and $0.09, respectively. The income applicable to common shares includes the net income from operations and the accretion of Series B preferred stock dividends. The net income per common share before dividends on preferred stock was $0.04 and $0.10 for 2008 and 2007, respectively.

Dividends on the Series B preferred stock accrue at 10% annually on the outstanding shares. Dividends accrued on the Series B preferred stock was $24,373 during 2008 and $24,979 in 2007.

Basic earnings for 2008 were $0.03 per common share based on 3,530,486 average shares outstanding compared to $0.09 per common share based on 3,461,374 weighted average shares outstanding for 2007.

Diluted earnings per common share for 2008 were $0.02 based on 4,035,065 average shares outstanding compared to $0.07 per share based on 4,217,936 weighted average shares outstanding for 2007.

The following schedule represents our outstanding common shares during the period of 2009 through 2019 assuming all outstanding stock options and stock warrants are exercised during the year of expiration. If each shareholder exercises his or her options or warrants, it could increase our common shares by 1,693,307 to 5,255,566 by December 31, 2019. Exercise prices for options and warrants range from $1.00 to $6.00 at January 31, 2009. Assuming all such options and warrants are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:

                               Options and       Potential
                               Warrants due      Shares
                               to expire         Outstanding
                        2009         160,418        3,722,677
                        2010         443,389        4,166,066
                        2011          62,500        4,228,566
                        2012         170,000        4,398,566
                        2013          30,500        4,429,066
                        2014         180,000        4,609,066
                        2015         140,000        4,749,066
                        2016          37,000        4,786,066
                        2017               -        4,786,066
                        2018          19,500        4,805,566
                        2019         450,000        5,255,566

Liquidity and Working Capital

At December 31, 2008, working capital was $1,786,360 compared to $1,520,218 at December 31, 2007, an increase of $266,142. Net cash provided by operating activities was approximately $457,000 for the twelve months ended December 31, 2008. Net cash provided by operating activities was approximately $995,000 for the twelve months ended December 31, 2007. Significant non-cash items including depreciation, accretion and amortization, stock based compensation expense, inventory reserve on excess and obsolete inventory, and allowance for doubtful accounts were approximately $418,000 and $355,000, for the twelve months ended December 31, 2008 and 2007, respectively. Accounts receivable, inventory, prepaid expenses and other assets increased approximately $806,000 for the twelve months ended December 31, 2008. This increase was due to higher accounts receivable and inventory. Inventory reserves are established for obsolete inventory, excess inventory quantities based on our estimate of net realizable value and for lower-of-cost or market. We believe the inventory reserve, after its assessment of obsolete inventory, at December 31, 2008, of $49,043 will be adequate for excess inventory and a lower of cost-or-market analysis. Accounts receivable, inventory, prepaid expenses and other assets decreased approximately $930,000 for the twelve months ended December 31, 2007. Accounts payable, accrued expenses and customer deposits increased approximately $722,000 during 2008. The increase was due primarily to customer deposits received. Accounts payable, accrued expenses and customer deposits decreased approximately $619,000 during 2007.

Cash of approximately $140,000 and $288,000 was used for investing activities for the twelve months ended December 31, 2008 and 2007, respectively. The amounts invested were used to purchase machinery and equipment for increased production capacity, new product lines and leasehold improvements for the facility. Proceeds on sale of equipment totaled $2,000 and $19,220 during 2008 and 2007, respectively.

Cash of approximately $100,000 was used for financing activities during the twelve months ended December 31, 2008. Cash payments to third parties for capital lease obligations approximated $537,000. Proceeds received from the exercise of common stock warrants were approximately $68,000. Proceeds received from the exercise of common stock options were $10,250. Cash payments for services provided for the registration of common stock were approximately $17,000. A cash payment related to Series B preferred stock dividend was approximately $25,000. Proceeds received from The Ohio Department of Development were $400,000. We incurred new capital lease obligations of approximately $339,000 for new production equipment during 2008. We obtained additional lease commitments of approximately $468,000 for production equipment that should be placed in service during the first quarter of 2009.

Cash of approximately $173,000 was used for financing activities during the twelve months ended December 31, 2007. Principal payments to third parties for capital lease obligations approximated $178,000, and cash payments for services provided for the registration of common stock were approximately $32,000. Proceeds received from the exercise of common stock options were $9,625. Proceeds received from the exercise of common stock warrants were approximately $27,000. We incurred new capital lease obligations of approximately $1,067,000 for new production equipment during 2007.

While certain of our major shareholders have advanced funds in the form of subordinated debt, accounts payable and guaranteeing bank debt in the past, there is no commitment by these individuals to continue funding us or guaranteeing bank debt in the future. We will continue to seek new financing or equity financing arrangements. However, we cannot be certain that it will be successful in efforts to raise additional new funds.

Inflation

We believe that there has not been a significant impact from inflation on our operations during the past three fiscal years.

Future Operating Results

We plan to place some of our larger purchase commitments for raw materials on an annualized basis because they can be purchased in larger quantities at reduced prices. In general, we attempt to limit inventory price increases by making an annual commitment, and drawing the material either as required, or on a monthly or quarterly basis. Such annual commitments may reach $500,000 in 2009 and greater in 2010 depending on sales volume increases. The terms of payment for such commitments are worked out with the vendor on a case-by-case basis, but in all cases are cancelable at our discretion without penalty.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

This document contains forward-looking statements that reflect the views of management with respect to future events and financial performance. These forward-looking statements are subject to certain uncertainties and other factors that could cause actual results to differ materially from such statements. See "Risk Factors" above. These uncertainties and other factors include, but are not limited to, the words "anticipates," "believes," "estimates," "expects," "plans," "projects," "targets" and similar expressions which identify forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date the statements were made. We undertake no obligation to publicly update or revise any forward-looking statements.