Description

DISCLAIMER

The following comments are only our opinions and should not be relied upon for making investment decisions.

INTRODUCTION

Ionatron claims to have developed a “directed energy weapon” that will transform modern warfare - “the gun of the 21st century.” Ionatron is really a stock promotion playing on the market’s speculative excitement over Taser and Homeland Security. While Ionatron is long on promises and short on details, we do know that this two-year-old company has no track record, no patents, no proven technology, no product, very limited resources, management with a history of stock manipulation, and a stock price that is up 1,200% this year to an absurd market capitalization of nearly $700MM.

DIRECTED ENERGY WEAPON R&D

Wireless energy transmission has been a fascination of scientists and engineers at least since the efforts of the prolific inventor Nikola Tesla 100 years ago. Tesla, probably best known for discovering the alternating current motor and radio frequency transmission, experimented extensively with the wireless conduction of electricity. His Tesla Coil is still widely used to generate lighting-like discharges. It is reported that in his Colorado lab, Tesla produced lightning bolts extending over 100 feet. In a 1934 New York Times article, Tesla even described a future “ray gun” that would dispense electrical shocks, sowing the imagination for many science-fiction scenes.

The Department of Defense (DOD) has funded directed energy weapon (DEW) research and development for decades. The field gained considerable attention and funding during President Reagan’s Star Wars initiative. Today, the primary efforts are focused on high-energy lasers (HEL), followed by high-power microwaves (HPM). There are several ongoing HEL programs, including the Mobile Tactical High Energy Laser (Northrop Grumman), the Airborne Laser (Boeing, Northrop, Lockheed), and the Advanced Tactical Laser (Boeing, Northrop, Lockheed). Some variants of the F-35 Joint Strike Fighter are also reportedly expected to be equipped with a 100kw laser weapon (Lockheed, Raytheon). To date, the land-based MTHEL has successfully destroyed 28 missiles in field tests. Despite the advances, field-ready weapons from these programs are not expected until the end of this decade. In HPM, the Active Denial System (Raytheon) appears reasonably close to deployment. The ADS is a non-lethal anti-personnel weapon reportedly using high-powered electromagnetic beams to cause burning pain without permanent injury. All of these major DEW programs plus numerous others have been under development for many years and have so far consumed total funding measured in the billions of dollars. Ionatron management has publicly labeled these programs as misdirected, expensive failures.

IONATRON BACKGROUND

Ionatron was formed in mid-2002 by Robert Howard and Thomas Dearmin, neither of whom have any previous experience in the directed energy field. The company claims that during its short history it has developed and demonstrated a revolutionary directed energy weapon that will very soon transform U.S. Military capabilities. According to management, certain unnamed senior military officials have told them that Ionatron has developed what will become the military’s “gun of the 21st century.”

Ionatron describes its new-age weapon as highly controlled man-made lighting:

“Ionatron Inc. is a publicly traded development stage company that has developed and tested a proprietary new Directed Energy Weapon technology, which, in a non-lethal mode, can direct electrical discharges through the atmosphere to disable vehicles, such as cars, trucks or boats, without banning [sic] the vehicles' occupants. These discharges can also shut down electronic and communications equipment. When fully developed, this technology will also have the capability of stunning personnel, in a manner similar to a common TASER(R) -- but in a wireless manner and over much longer distances.” (Form 10-Q, November 15, 2004)

The company asserts that its man-made lightning weapon is “rheostatic” and can adjust from non-lethal to lethal with a simple “flip of a switch.” Management describes its capability as ranging from disruptive (stunning a person or damaging electronic equipment) to destructive (destroying concrete). It can supposedly fire hundreds of times per second and at distances up to a couple kilometers. Ionatron states that its technology utilizes “mature laser targeting and tracking technology for our systems with slight modifications.” According to management, this miraculous weapon only requires a conventional 110 volt power source.

Ionatron has taken every opportunity to describe wide-ranging uses for this “gun of the 21st century,” including vehicle immobilization/destruction, aircraft self-protection, naval vessel protection, area denial/security, anti-personnel, and bio-chemical detection. The technology has conveniently been compared to a long-range wireless version of the TASER stun gun. Of course, the company expects to eventually expand the use of this technology from the military into civilian and commercial applications, and do at an unconventionally fast pace.

Ionatron refers to its weapon technology as “laser induced plasma channel”, or LIPC (pronounced lip-see). The concept is to use an extremely short wave laser to ionize a channel of air that in turn becomes a conductive path for sending an electrical charge. However, creating an ionized channel to control and direct electricity is not a new concept. It has been researched for decades. With funding from the government, Boeing attempted unsuccessfully to develop a LIPC-type missile defense system back in the 1980s. In addition to potential defense applications, a major field of LIPC study has been in lighting control. Scientists have actually used lasers to create ionized channels for capturing lightning bolts.

The science of LIPC has advanced significantly over the past two decades. However, in developing its revolutionary weapon, Ionatron claims that it is remarkably “the first company to understand filamentation,” a key aspect of the physics. A simple Google search on “laser filamentation plasma channel” produces hundreds of technical papers on this subject over the past five years. None of the research is attributed to Ionatron or its key principals. None of the principals of the company has received a patent in this field. Ionatron says that it developed all of its critical intellectual property before ever taking any government funding, and therefore owns all the rights to the technology. They claim to have filed certain patent applications, but the details of these applications might never be disclosed due to national security reasons.

HSVT AND XADS

Two small private companies, HSV Technologies (HSVT) and Xtreme Alternative Defense Systems (XADS), have been working for years on non-lethal weapons that appear to be very similar to Ionatron’s more recent efforts—perhaps a little too similar. We have been told by both of these companies that Ionatron originally indicated a desire to collaborate with HSVT. At the time, HSVT’s founder, Peter Schlesinger, was attempting to hire Dr. Stephen McCahon, who had been a directed energy researcher at Raytheon. Instead of continuing the collaboration, Ionatron hired McCahon and apparently may have brought along many of HSVT’s ideas. Actually, HSVT owns two patents that appear to cover much of what Ionatron advertises, U.S. Patent 5,952,600 (1999) – Engine Disabling Weapon, and U.S. Patent 5,675,103 (1997) – Non-lethal Tetanizing Weapon

Not only does Ionatron not have any patents on its technology, but it may have some patent infringement issues to deal with. Furthermore, the managements of HSVT and XADS appear to be very familiar with the current state of Ionatron’s efforts, and are quite skeptical of Ionatron's claims, to say the least.

Ionatron is not shy about applying the Taser label to its conceived weapon, but always pointing out that its product will be superior. However, Ionatron has no relationship with Taser, but HSVT and XADS have both been in discussions with Taser regarding potential opportunities to work together. Taser has 11 patents, including the very important “waveform” technology, and several more patent applications. It just hired a full-time patent attorney to defend its intellectual property. Taser also is quite skeptical of Ionatron’s claims.

GOVERNMENT FUNDING

Ionatron’s government funding appears to be due primarily to the efforts of the lobbying arm of Blank Rome, a prominent Philadelphia law firm, and its well-connected Chairman, David Girard-diCarlo. Girard-diCarlo and Blank Rome have strong ties to Tom Ridge and the Bush administration. Blank Rome has powerful lines into the Defense and Homeland Security Departments, and Girard-diCarlo has personally represented IOTN. Obviously some bureaucrats were impressed, at least by the company’s promises. Since inception, Ionatron has been awarded R&D contracts totaling over $12MM. The largest contract, $9MM awarded in April 2004, is for delivery of a mobile LIPC weapon prototype for field testing. Unbelievably, management has repeatedly indicated there is intense interest from multiple government agencies in securing multi-unit orders of its weapon in the near future. According to Ionatron, the government has acknowledged that the company has become the leader in directed energy weapons.

Despite what management would want you to believe, Ionatron’s other major contract, $3.4MM awarded in January 2004, does not even appear to be specifically aimed at weapon research. This joint Air Force-Navy contract is simply intended to establish the viability of LIPC to direct electrical energies.

Despite audacious claims regarding wide capabilities, management refuses to give specific details concerning its principle technologies, product performance, or operations. Their customary answer is, “We’re not in a position to tell you that for security reasons.” The company recently assured investors that the Navy’s Public Affairs Office will very soon be formally designating a spokesperson to discuss the promise of Ionatron’s program. We look forward to that opportunity.

IONATRON’S REVERSE MERGER

Ionatron became publicly traded in March 2004 through a reverse merger with defunct U.S. Home & Garden (USHG). The reverse merger increased fully-diluted shares outstanding from 24.5MM to 73MM, meaning that USHG shareholders received 34% of the equity in the new company while Ionatron holders received 66%. Since the announcement of the reverse merger, the stock price has risen from $0.75 to $9.50 giving Ionatron a fully-diluted market capitalization of nearly $700MM.

So what did the Ionatron owners get in return for giving up 34% of their company? They netted only the $9MM cash held by USHG, which provided Ionatron’s primary source of working capital. It is hard to reconcile why management would exchange one-third of the company for only $9MM given their claims to own the intellectual property and production know-how behind the most important weapon of the 21st century. Furthermore, CEO Thomas Dearmin stated on a conference call, “I get phone calls every day from people trying to give us money.” He also pointed out, “Mr. Howard, the Chairman, has always provided any cash that’s been required, so we have numerous options if we do in fact need cash to go forward.” Trading such a large portion of the company for such a small sum makes absolutely no sense if the management really believes in the technology and is drowning in funding offers. Amazingly, the stake they exchanged for $9MM is now valued in the market at $233MM.

Not having to raise funds through a public offering or lender other than the Chairman has conveniently avoided any more thorough due diligence.

RECENT DEVELOPMENTS AND GUIDANCE

Year-to-date, Ionatron has spent $513,000 on R&D. Its LIPC technology has only been demonstrated in limited applications in the lab. Ionatron is now working under a $9MM joint US Air Force contract for the development of a transportable demonstrator. Management originally predicted that it would deliver one or more transportable units in 2004. However, on the recent third quarter conference call, Dearmin indicated the delivery schedule has now been pushed back into early 2005 due to component supply issues and problems transitioning the technology from the laboratory to the real world. In July, the company announced that the 2005 DOD budget included a $12.6MM “funding line” for development of a transportable LIPC system for the Navy. So far, no contract has been awarded.

Ionatron acquired North Star Research in September. North Star designs power supply prototypes for commercial and military customers. Despite having been in business for 15 years, North Star has only about $3MM in revenue and is marginally profitable. Ionatron management claims that acquiring North Star provides “the required technical expertise to manufacture our high voltage transformers for our LIPC products in volume.” Yet the company says in its recent 10-Q that it is still outsourcing its electrical system requirements and having problems with a “bottleneck supply chain.”

Ionatron plans to relocate its operations from Tucson to an idle munitions plant at the Stennis Space Center in Mississippi. Management originally predicted the new operations would be up and running before the end of 2004. Now they are saying mid-2005, but that depends on how fast the Army completes renovations. Ionatron continues to predict that it will start low-rate initial production (LRIP) beginning in 2005 after the Stennis facility ramps up, with full-rate production (FRP) commencing shortly thereafter. Yet, the company doesn’t even have a viable product in hand today. Furthermore, the levels of testing required to initiate LRIP are enormous, even in the age of spiral development. The company hasn’t even discussed plans for testing human effects, multiple environmental conditions, electronics interference, etc. The development cycle on this type of weapon typically stretches 10 years or more. Management claims that its technology is so advanced and operations so sophisticated that Ionatron is not held to traditional development cycles.

Ionatron’s announcements about its move to Stennis are a transparent string of exaggerations. Management refers to Stennis as a “150,000 acre secure facility, co-located with . . . NASA and the Navy Seals [sic]”. They claim Ionatron will “initially utilize over 100,000 square feet, with the option to expand into 600,000 square feet.” The truth is the main operational area of Stennis has 13,500 acres and is surrounded by a 125,000-acre acoustical buffer zone, none of which is relevant since the Ionatron facility is not even located on the main Stennis facility. Furthermore, according to the lease filed with Iontaron’s September 30, 2004 10-Q, the company only plans to lease just over 50,000 square feet. That’s only about the size of a Best Buy store, which seems a bit small for R&D and manufacturing of a sophisticated weapon system and administrative space.

The company touts that it is on a hiring binge and “anticipates the need for up to 300 employees by the end of 2005, and more in the following years.” Ionatron may be falling woefully behind since in the third quarter it added three employees not including 20 people located at North Star. Furthermore, of the six job postings currently on the company’s web site, only one requires the ability to get security clearance. That seems odd given that virtually all employees are likely to be working on the company’s single product, which they insist is “top secret”. We also find it interesting application form posted on the web site does not even ask about security clearances,

Management has repeatedly stated that it has received indications of fully-funded orders for multiple units. Dearmin stated on the third quarter call, “we have been told that quite a few agencies require a great deal of these systems.” One of Dearmin’s most audacious claims came during a recent sell-side conference presentation when he said that Ionatron has a customer who would “like beginning in 2005 for us to deliver 3 to 4 units per month…And those are in the range of $14MM apiece.” They haven’t even produced a prototype or set up manufacturing operations, but they already have a customer hoping to pay $14MM per system and take delivery of three to four units per month beginning next year? That claim is simply ludicrous.

Management has been very liberal with its pricing projections. At times they have estimated they will be selling units in 2005 for around $9MM apiece, but have at times also given price estimates as high as $20MM per unit. It is hard to imagine how a vehicle-mounted system that uses “mature” laser technology and a compact power supply running off a 110 volt outlet could earn a cost-plus reimbursement of $14MM apiece. Earlier this year we wrote a report on United Industrial Corp., which sells an unmanned aerial vehicle system for $7MM that includes four planes, a launching system, and a ground control station.

FINANCIALS

Due primarily to the $9MM contract award, Ionatron reported revenue of $2.6MM in Q3’04. Based on its Q3’04 backlog of $8.5MM and the acquisition of North Star, we believe the company will report Q4’04 revenue of $4.5MM and a net loss of about $1MM. Assuming the company actually receives the $12.6MM contract it claims is coming, 2005 revenue could approximate $14MM. We believe there is virtually no chance that Ionatron will be delivering LRIP in 2005, 2006, or ever.

In the three quarters since the reverse merger, Ionatron’s cash balance has sequentially been $8.5MM, $6.6MM, and $5.1MM. We believe the company will continue to burn about $1.5MM per quarter, excluding an estimated $1MM needed for the move to Stennis. Total debt of $2.8MM is owed to the company’s Chairman, who so far this year has been paid $168,000 in interest. It seems likely Ionatron will need more funding soon.

MANAGEMENT

We have a very skeptical opinion of Ionatron’s management. This is due primarily to their history at prior companies, related party transactions, and flagrant promotional efforts to hype Ionatron’s stock.

Examples of management’s promotional approach include the use of flamboyant language (“the gun of the 21st century” and “we are considered the leaders within the government scientific community”), exaggerated market projections (claims that the market for LIPC will be $12B in 5-7 years, and eventually $100B for all directed energy weapons), and blatantly unrealistic production and revenue guidance. Possibly their most ludicrous assertion is that they founded Ionatron because they saw “certain niches after 9-11 that were lacking,” and “Rumsfeld and people in DOD wanted to transform the way [the DOD] does business.” Management suggests that they founded this company to provide a solution to some of the military’s most pressing post 9-11 challenges, which implies that the required technology was a secondary consideration.

Of course, management conceals even the most basic details under a cloak of national security, yet they have no problem issuing press releases, holding conference calls, and appearing at sell-side conferences to tell the world that they are likely the most important, top-secret program since the Manhattan Project. Ionatron issued a press release lauding its position as “one of seven Gold Sponsors at the Seventh Annual Directed Energy Symposium,” as if they were one of a few prestigious companies selected. The truth is anyone willing to pony up $5,000 became a Gold Sponsor. This was a four-day conference with dozens of scientific presentations on various directed energy subjects. Based on the sensitivity of the subject matter, presentations were either open to the general public, limited to military or government employees, or restricted to those with top security clearance. An Ionatron representative gave a talk on “Filament Guided Electrical Discharges” that was open to the general public. That certainly doesn’t fit with management’s claim that everything they do must be classified for national security reasons.

Management has repeatedly referred to their upcoming device as “Taser-like,” though superior in its capabilities. Their bush-league investor presentations (see 8-K filed 4/29/04) contain screen shots from such scientific sources as Star Trek and The Terminator, and are laced with crude drawings and picture manipulations of how the product eventually might look and work. Similar to many hastily organized promotions, their press releases and filings are littered with misspellings and grammatical errors.

Robert Howard, 81, is company Chairman. Howard was president and chairman of Centronics, and is the chairman of iCAD. He founded two controversial stock promotions, Howtek and Presstek. His promotional activities with these companies resulted in two “consent decree” agreements with the SEC and $2.7MM in fines for issuing false claims and questionable stock trading. Howard has $2.8MM in outstanding loans to Ionatron and collects $330,000 per year in lease payments.

Thomas Dearmin is Ionatron President/CEO/CFO. Dearmin worked at Lasertel, a Presstek subsidiary, and was co-founder of Opto Power Corp (a competitor of Lasertel and now a sub of Newport/Spectra-Physics), both of which are laser diode companies. Prior to this, he worked with laser technology at Ensign Bickford Aerospace.

Bernie Walik is VP of Manufacturing. He was brought in to ramp up the Stennis facility. Walik previously worked at Lasertel and Opto Power.

Two other managers, Stephen McCahon (VP, Engineering) and Joseph Hayden (VP, Business Development), came from Raytheon’s E-Systems group, where they worked with directed energy technologies.

MARKET VALUATION

Ionatron’s $697MM fully diluted market valuation is astounding. The company has no track record, a questionable history, no patents, management with a stock manipulation record, ludicrous claims of product capabilities, no prototype, a relatively small amount of government funding, and will soon run out of cash if the contract it keeps touting doesn’t come through.

Below is a list of well-established growing defense companies that have substantial revenue, earnings and backlog, but have a market value less than Ionatron.


COMPANY Mkt Cap T12 Rev Funded Backlog
Applied Signal $440MM $133MM $111MM
EDO Corp $675MM $503MM $501MM
Herley Ind $297MM $122MM $100MM
United Ind $515MM $374MM $323MM

Ionatron $697MM $5MM $8MM


RISKS

An obvious risk is the extreme volatility surrounding Ionatron’s hype. This stock could spike if they announce the pending $12.6MM is finally awarded, although we think it is firmly expected by the stock’s supporters. Of course, a $12.6MM contract would not change our estimation of value.

The shares can be difficult to borrow, but not impossible.

There is also the risk Ionatron can coax other agencies into research grants, but we think with no follow through on promises even gullible bureaucrats start to catch on.

There is always the risk that Ionatron could have a legitimate shot at developing this weapon, but we put that somewhere around a snowball in hell.

This is one of those schemes that can live on and on based on eternal hope that the Holy Grail is just around the corner (look at the lengthy, unprofitable history of REFR). But $700 million is simply too huge a market cap for that type of eternal-hope-and-hype concept stock with little caoital and no results. If Ionatron doesn’t deliver something of significance in the next year or so, a lot of the hot air they have pumped into the stock will quickly deflate. We expect it to be more than cut in half.

Catalyst

The most important catalyst here is simply the passage of the next twelve months with no milestones. Management has gone way out on a limb and made audacious promises regarding 2005-2006 expected performance. This charade can be carried on for awhile (possibly years), but holding anything close to this market cap will require delivering on at least some of their important promises. To say the least, we are skeptical that Ionatron will deliver a satisfactory prototype in 2005. We are very confident that Ionatron will not be producing multiple units any time soon.

Another catalyst would be the failure to get a contract from the $12.6MM 2005 budget “line item” that is supposedly being negotiated, but seems to keep getting further delayed. If Ionatron does not deliver a satisfactory demonstrator in early 2005,then we think this funding is in serious jeopardy, and our target price of cut in half will be conservative.