Quarterly Report

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on our management’s beliefs and assumptions and on information currently available to our management. Forward-looking statements include all statements other than statements of historical fact contained in this Quarterly Report on Form 10-Q, including, but not limited to, statements about:

In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail in Part II, Item IA. “Risk Factors.” Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date hereof. We hereby qualify all of our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

The following discussion should be read in conjunction with our financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q and with our financial statements and notes thereto for the fiscal year ended March 31, 2006, contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on June 29, 2006.

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Overview

Hoku Scientific is a materials science company focused on clean energy technologies. We were incorporated in Hawaii in March 2001, as Pacific Energy Group, Inc. In July 2001, we changed our name to Hoku Scientific, Inc. In December 2004, we were reincorporated in Delaware. In August 2005, we completed the move of our principal offices and all operations to a new approximately 14,000 square foot facility located in Kapolei, Hawaii.

We have historically focused our efforts on the design and development of fuel cell technologies, including our Hoku MEAs and Hoku Membranes. In May 2006, we announced our plans to form an integrated photovoltaic, or PV, module business, and our plans to manufacture polysilicon, a primary material used in the manufacture of PV modules, to complement our fuel cell business. We have reorganized our business into three unincorporated business units: Hoku Fuel Cells, Hoku Solar and Hoku Materials. We had net income during the six months ended September 30, 2006 and for the fiscal year ended March 31, 2006; however, we previously incurred net losses in each other fiscal year since our inception.

Hoku Fuel Cell We operate our fuel cell business under the name Hoku Fuel Cells, which continues to develop and manufacture membrane electrode assemblies, or Hoku MEA, and membranes for proton exchange membrane, or PEM fuel cells powered by hydrogen. Hoku MEAs are designed for the residential primary power, commercial back-up, and automotive hydrogen fuel cell markets. To date, our customers have not commercially deployed products incorporating Hoku MEAs or Hoku Membranes, and we have not sold any products commercially. Furthermore, we have begun to scale back our expenditures and investments in our fuel cell business, and intend to focus increasingly on our polysilicon and solar businesses.

Hoku Solar Our plan is to include PV cell manufacturing with a PV module assembly line to form an integrated PV module business. In August 2006, we announced our selection of the State of Idaho as the planned location for Hoku Solar, where we plan to build and equip a facility capable of producing 30 megawatts, or MW, of solar modules per year. The State of Idaho and the municipal governments have offered us a variety of incentives to attract Hoku Solar and Hoku Materials, including tax incentives, financial support for infrastructure improvements around the facilities, and grants to fund the training of new employees. In October 2006, we executed an agreement with Spire Corporation, a U.S. solar equipment manufacturer, for the purchase of photovoltaic module equipment and technical support for approximately $2.0 million. The equipment will enable us to manufacture up to 15 MW of photovoltaic modules each year and is scheduled to be delivered in the first half of calendar year 2007. We may install the equipment in our facility in Hawaii until the planned facility with a module production capacity of 30 MW per year in Idaho is completed.

In October 2006, we executed a contract to purchase solar cells manufactured in Taiwan from Swiss Wafers AG for approximately $2.8 million. Subsequent to the agreement, we and Swiss Wafers AG, mutually agreed to terminate the contract as Swiss Wafers AG was unable to secure the type of solar cells contemplated for purchase under the agreement.

In October 2006, we also entered into a contract to purchase solar cells manufactured in Taiwan from E-Ton Solar Tech Co., Ltd. for approximately $2.8 million. These cells are scheduled to be delivered later this calendar year. We plan to use the cells in our initial module product release, which we may manufacture using the equipment purchased from Spire Corporation, or by outsourcing to a third party original equipment manufacturer, which may result in revenue from solar module sales in the first half of calendar year 2007. During the three and six months ended September 30, 2006, Hoku Solar incurred $37,000 and $53,000, respectively, in expenses primarily related to payroll, travel, and professional fees.

Hoku Materials To ensure an adequate supply of polysilicon for Hoku Solar’s cells and modules, we intend to form Hoku Materials to manufacture this key material for consumption by Hoku Solar and for sale to the larger solar market. We are initially planning for production capacity of 1,500 metric tons of polysilicon per year. We anticipate the availability of polysilicon beginning in the second half of calendar year 2008.

In August 2006, we awarded a contract to CH2M HILL Lockwood Greene to provide engineering and related services for our planned polysilicon production plant. The contract’s initial value is approximately $255,000, however, we expect to require additional services from CH2M HILL Lockwood Greene to complete the design and construction of our planned polysilicon production plant.

In August 2006, we announced our selection of the State of Idaho as the planned location for Hoku Materials. During the three and six months ended September 30, 2006, Hoku Materials incurred $41,000 and $42,000, respectively, in expenses that mainly consist of travel expenses and professional fees. In addition, as of September 30, 2006, Hoku Materials had incurred $170,000 related to the construction of the Idaho plant and $50,000 related to an equipment deposit.

Financial Operations Review

Revenue

To date, we have derived substantially all of our revenue from Sanyo Electric Co., Ltd., or Sanyo, and Nissan Motor Co., Ltd., or Nissan, through contracts related to testing and engineering services. We have pursued engineering service contracts in order to strategically fund integration of our technology into our customers’ products. We anticipate our revenue for the remainder of fiscal 2007 to be principally comprised of service revenue from the U.S. Navy. Revenue under our service contracts is recognized based on the last deliverable as the contracts contain multiple elements. Revenue under our license contracts is recognized upon shipment of the associated licensed products.

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Sanyo Electric Co., Ltd. In March 2003, we entered into a contract with Sanyo to jointly develop a MEA assembly process using our Hoku Membranes for integration into Sanyo’s stationary fuel cell systems. The contract also granted Sanyo a license to our MEA assembly process to produce any non-Hoku MEA provided that Sanyo utilizes Hoku Membranes in its non-Hoku MEA. The term of the contract ends in September 2009, but will automatically renew for an additional five years unless we and Sanyo agree not to renew it. We have satisfied all of the performance milestones under the contract for which Sanyo has paid us a total of $2.5 million that was recognized as service and license revenue in fiscal 2005. In fiscal 2006, we recognized $2,000 under the license agreement granted to Sanyo pursuant to the contract for product deliveries. In addition, in September 2003, Sanyo purchased 333,333 shares of our Series B preferred stock at $3.00 per share which automatically converted to common stock upon the completion of our initial public offering in August 2005.

In December 2005, we entered into a material transfer and collaborative testing agreement, or the Testing Agreement, with Sanyo to allow Sanyo to conduct additional testing of newer versions of our Hoku Membrane and Hoku MEA products. We also agreed to collaborate with Sanyo on the testing of these products. In February 2006, pursuant to the Testing Agreement, Sanyo paid us a service and license fee of $260,000 for our collaboration work, which did not include the cost of our products to be ordered by Sanyo for testing that were invoiced separately. Revenue was recognized ratably over the duration of the contract as engineering services were rendered, and for product deliveries also ratably from the delivery date to the completion of the engineering services pursuant to the contract, which was July 31, 2006. During the three and six months ended September 30, 2006, we recognized $37,000 and $149,000, respectively, as revenue. We recognized $111,000 as revenue in fiscal 2006 pursuant to the Testing Agreement.

The Testing Agreement allowed Sanyo to evaluate newer versions of our membrane and MEA products that had been developed since completion of the collaboration portion of the previous contract, and provided us with additional funding for our collaboration with Sanyo on this testing. No rights or licenses to our products were granted to Sanyo as a result of this Testing Agreement, and this Testing Agreement did not alter or amend any of the rights and licenses agreed to in our previous agreement with Sanyo.

We expect that our Testing Agreement with Sanyo, which ended on July 31, 2006, will be our final engineering service contract with Sanyo; however, Sanyo may continue to purchase our products for testing. At this time, we do not believe we will receive any meaningful revenue from Sanyo in the foreseeable future. In addition, Sanyo may require additional testing of our Hoku Membrane and Hoku MEA products before purchasing commercial quantities of our products. We cannot predict when such sales will occur, if at all. As of September 30, 2006, there are no additional costs or obligations to Sanyo.

Nissan Motor Co., Ltd In March 2004, we entered into a testing and evaluation contract with Nissan under which we were paid $100,000. This contract was amended in May 2004 to provide for additional testing and ended in September 2004 upon completion of the testing.

In September 2004, we entered into two contracts with Nissan, an engineering contract to customize our Hoku MEAs for integration into Nissan’s automotive fuel cells and a membrane and MEA purchase contract. In connection with executing the engineering contract, Nissan paid us $400,000. The engineering contract ended in accordance with its terms in March 2005. Under the purchase contract, we also agreed to deliver our Hoku MEAs and Hoku Membranes to Nissan in exchange for $1.3 million. This contract was scheduled to expire in March 2005. However, we verbally modified the contract and delivered the remaining Hoku MEAs and Hoku Membranes on a purchase order basis with the last delivery made in December 2005. We recognized revenue of $1.4 million and $327,000 during fiscal 2006 and 2005, respectively, under these contracts.

In March 2005, we entered into a collaboration contract with Nissan to develop customized Hoku MEAs and a Hoku MEA assembly process for use in Nissan’s automotive fuel cells. Under the collaboration contract, Nissan was obligated to pay us $2.8 million upon execution of the contract which was recorded as deferred revenue as of March 31, 2005. We received payment from Nissan in May 2005. Revenue was recognized ratably over the duration of the contract as the engineering services were rendered and for product deliveries also ratably from the delivery date to the expected completion of the engineering services pursuant to the collaboration contract, which was December 31, 2005. Nissan was obligated to pay us an additional $240,000 upon verification from Nissan that all engineering services had been received. In January 2006, Nissan verified that all engineering services had been completed under the collaboration agreement and $240,000 was recognized as revenue. We received payment from Nissan in March 2006.

Under the collaboration contract, we granted Nissan a license to the final MEA product and the final MEA product assembly process, so that Nissan can manufacture the final MEA product developed under this contract using our processes and incorporating Hoku Membranes purchased from us. We retain all intellectual property related to the Hoku Membranes, Hoku MEAs and the final MEA product assembly process developed under this collaboration contract.

In January 2006, we entered into a Step 3 Collaboration contract, or Step 3 Contract, with Nissan to further develop customized Hoku MEAs and a Hoku MEA assembly process for use in Nissan’s automotive fuel cells. We provided work pursuant to the Step 3 Contract between January 1, 2006 and September 30, 2006. Under the Step 3 Contract, Nissan was obligated to pay us $2.7 million upon execution of the contract and an additional $240,000 on July 31, 2006 for the work we performed. Nissan paid us $2.7 million in March 2006. The payments above do not include the cost of our products ordered by Nissan for testing that were invoiced separately. Revenue was recognized ratably over the duration of the contract as engineering services were rendered and for product deliveries also ratably from the delivery date to the completion of the engineering services pursuant to the Step 3 Contract, which was September 30, 2006. During the three and six months ended September 30, 2006, we recognized $983,000 and $2.0 million, respectively, as revenue and have completed all work related to this contract. The Company recorded $983,000 as revenue in fiscal 2006 pursuant to the Step 3 Collaboration contract.

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Under the Step 3 Contract, we granted Nissan a non-exclusive license to the final MEA product and the final MEA product assembly process developed by Hoku to enable Nissan to manufacture MEA products using our processes and incorporating Hoku Membranes. We retained title to our Hoku Membranes, Hoku MEAs and the final MEA product assembly process developed under this agreement. We also agreed not to sell separately any of our products incorporated into our Hoku MEAs to any automotive company for any commercial purpose, other than testing and evaluation of these products, until September 30, 2006. There were no such restrictions on our ability to sell our Hoku MEAs to automotive companies other than the Hoku MEA we developed with Nissan. Nissan has no obligation under the Step 3 Contract to sell or promote our products.

We expect that our Step 3 Contract with Nissan, which ended on September 30, 2006, will be our final engineering service contract with Nissan; however, Nissan may continue to purchase our products for testing. At this time, we do not believe we will receive any meaningful revenue from Nissan in the foreseeable future. In addition, Nissan may require additional testing of our Hoku Membrane and Hoku MEA products before purchasing commercial quantities of our products. We cannot predict when such sales will occur, if at all. As of September 30, 2006, there are no additional costs or obligations to Nissan.

U.S. Navy - Naval Air Warfare Center Weapons Division In March 2005, we were awarded a contract with the U.S. Navy to develop and demonstrate a PEM fuel cell power plant prototype that incorporates our Hoku MEAs within IdaTech, LLC, or IdaTech, fuel cell stacks and integrated fuel cell systems. IdaTech owned by Investec Group Investments, Ltd., a UK-based specialist banking group serving international clients. Under the contract, the U.S. Navy agreed to pay us up to an aggregate of $2.1 million if and when we completed specified testing and performance milestones, as described below. As of March 31, 2006, we had completed all seven milestones including the construction and testing of a prototype.

The U.S. Navy agreed on September 30, 2005 that when we completed the seven milestones under the contract, the last three of which were completed in December 2005, it would proceed with both of its options. The first option is to manufacture 11 fuel cell power plants for which the U.S. Navy has agreed to pay us a total of $1.1 million in installments as each fuel cell power plant is completed. The second is to have us operate and maintain 10 of the 11 fuel cell power plants manufactured under the first option for a period of 12 months at a U.S. Navy facility, for which the U.S. Navy has agreed to pay us a total of $1.4 million in monthly installments beginning at the time each of the 10 fuel cell power plants are placed into service. The initial contract and the two options that the U.S. Navy have exercised will be accounted for as a single unit of accounting, with revenue recognition to occur in monthly installments at the time each of the 10 fuel cell power plants are placed into service over the period of the second option.

As of September 30, 2006, the U.S. Navy had officially accepted the 11 fuel cell power plants and commenced demonstration of 10 of these fuel cell power plants at Pearl Harbor. The aggregate amount of the contract is $4.5 million, of which $2.5 million has been classified as deferred revenue as of September 30, 2006. As of September 30, 2006, we had received $3.0 million in payments. We recognized $934,000 in revenue during the six months ended September 30, 2006. As of November 1, 2006, we received an additional $328,000 from the U.S. Navy. We expect that the contract will be completed by August 2007.

In connection with the U.S. Navy’s exercise of its options, on September 30, 2005, we notified IdaTech of our intent to extend our subcontract with them to build an additional 11 fuel cell power plants incorporating Hoku MEA, for which we paid IdaTech $463,000, and to provide services in connection with the operation and maintenance of 10 of these fuel cell power plants over a 12-month period, for which we have agreed to pay IdaTech $125,000 over the service period.

On March 2, 2006, we entered into an Amendment of Solicitation/Modification of Contract with the U.S. Navy pursuant to which the U.S. Navy extended the delivery date of its two options from March 2006 to September 2006 and March 2007 to September 2007 for options one and two, respectively. In addition, the total cost of the contract was decreased by $8,000. The change was primarily due to a delay in finalizing the demonstration site selection, preparation and logistics for the second option with the U.S. Navy.

We retain all intellectual property related to our Hoku Membranes and Hoku MEAs. We also retain the rights to any invention that is conceived while performing the work under this contract; however, the U.S. Government has a non-exclusive, non-transferable, irrevocable, paid-up license to use the invention throughout the world. This contract is ongoing, but the U.S. Navy may terminate the contract, in whole or in part, if it is determined that the termination is in the U.S. Government’s interest.

IdaTech, LLC In April 2005, we entered into a subcontract with IdaTech to specify the work that IdaTech will perform in connection with our prime contract with the U.S. Navy. We selected IdaTech based upon its focus on stationary applications, integrated fuel processor technology and experience in developing and demonstrating fuel cell technologies for the U.S. Department of Defense. Under the subcontract, IdaTech agreed to provide the necessary personnel, facilities, equipment, materials, data, supplies and services to integrate our Hoku MEAs within IdaTech’s fuel cell stacks and integrated fuel cell systems. We have agreed to pay IdaTech $380,000 in installments upon completion of certain phases outlined in this contract. The contract was extended when the U.S. Navy exercised the options described above. In accordance with the contract extension, we agreed to pay IdaTech $473,000 to purchase an additional 11 fuel cell power plants. We have also agreed to pay IdaTech $125,000, because the U.S. Navy exercised its option to have us operate and maintain 10 fuel cell power plants. On March 7, 2006, we entered into Amendment No. 1 to our agreement with IdaTech pursuant to which the statement of work in our subcontract with IdaTech was revised to allow us to complete the assembly of the IdaTech fuel cell stack, and the final integration of the stack into the IdaTech fuel cell system at our facility in Kapolei, Hawaii. In addition, the schedule of deliverables was amended to provide for the delay in commencement of the U.S. Navy demonstration described above, and the total cost of the subcontract was reduced by $10,000. As of September 30, 2006 we have paid $759,000 of the $968,000 due to Idatech pursuant to the agreement. In October 2006, we made an additional payment of $84,000 to Idatech. This contract will terminate if our contract with the U.S. Navy terminates, in which case we are required to pay IdaTech for costs incurred up to the date of termination.

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Additional Customers  We continue to have discussions with a total of twelve customers including Sanyo, Nissan and the U.S. Navy, which includes IdaTech, who are testing Hoku Membrane and/or Hoku MEA. We are actively continuing discussions with a thirteenth original equipment manufacturer, or OEM, that previously tested earlier versions of Hoku Membranes and Hoku MEAs regarding future testing of newer versions of these products, and other OEMs that may begin testing our products in the future. We have not disclosed the names of these customers; however, these customers are focused on building stacks and systems for automotive, stationary and micro fuel cell applications. They have purchased our Hoku Membrane and/or Hoku MEAs for testing and evaluation. To date, none of these customers has sold a commercial fuel cell system incorporating our Hoku Membrane or Hoku MEA. In addition, we believe that the total number of membranes and MEAs to be sold to OEMs in the next 6 to 12 months may be lower than we had previously anticipated. Although we continue to commit resources to our fuel cell products, in light of the uncertainty in the timing of significant sales, we have begun to scale back our expenditures and investments in our fuel cell business, and we intend to focus increasingly on our polysilicon and solar businesses. We continue to have product testing relationships with customers in the United States, Canada, Japan, Korea and Germany.

Cost of Revenue

Our cost of revenue consists primarily of employee compensation, including stock-based compensation, and supplies and materials. In fiscal 2006, we began allocating overhead to our cost of revenue. Such costs were immaterial in all prior fiscal years. We expect our cost of revenue to increase on an absolute basis as our product manufacturing activities and revenue increase.

Selling, General and Administrative Expenses

Our selling, general and administrative expenses consist primarily of employee compensation, including stock-based compensation for executive, sales and marketing, finance and administrative personnel. Other significant costs include insurance costs, professional fees for accounting, legal and consulting services and insurance costs. We expect our selling, general and administrative expenses to increase significantly due to increased staffing and the costs associated with operating as a publicly traded company. In addition, we expect our selling, general and administrative expenses to increase by a significant factor as a result of our planned entry into the PV module and polysilicon markets.

Research and Development Expenses

Research and development expenses consist primarily of employee compensation, including stock-based compensation, for research and development personnel. Other significant costs include facility costs, the cost of supplies and materials and depreciation. We expense research and development expenses as they are incurred. We expect our research and development expenses to increase significantly as we enhance our current products, research new products and hire additional employees. In addition, we expect to invest in the research and development of new solar products, which will result in a significant increase in our research and development expenses in the future.

Results of Operations

Three Months Ended September 30, 2006 and 2005

Revenue Revenue was $1.9 million for the three months ended September 30, 2006 compared to $1.3 million for the same period in 2005. The amount for the three months ended September 30, 2006 was principally comprised of revenue from contracts with Nissan and the U.S. Navy of $997,000 and $896,000, respectively, compared to $1.3 million from contracts with Nissan for the same period in the 2005.

Cost of Revenue Cost of revenue was $997,000 for the three months ended September 30, 2006 compared to $220,000 for the same period in 2005. The costs primarily related to Nissan and U.S. Navy contracts in the three months ended September 30, 2006 and primarily related to Nissan contracts in for the same period in 2005, consisting of manufacturing expenses, including employee compensation and supplies and materials. The increase was primarily a result of the recognition of costs related to the U.S. Navy contract.

Selling, General and Administrative Expenses Selling, general and administrative expenses were $703,000 for the three months ended September 30, 2006 compared to $476,000 for the same period in 2005. The increase of $227,000 was primarily due to increases in professional fees consisting principally of accounting, legal, and other service fees related to the annual report of $116,000, franchise taxes of $19,000, travel expenses of $17,000 and insurance of $9,000. In addition, employee and director compensation increased by $75,000 and $60,000, respectively. The increase in employee compensation includes payroll and stock-based compensation, primarily due to pay increases and bonuses to employees, and the director compensation were stock awards granted to the independent members of our Board of Directors. The increase was offset by $57,000 related to the redeployment of personnel (e.g. payroll related costs) and the application of other direct and indirect charges previously captured in selling, general and administrative expenses prior to the establishment of contracts, to existing customer contracts which have been recorded in costs of uncompleted contracts or cost of service and license revenue and by a reduction of marketing expenditures of $14,000.

Research and Development Expenses Research and development expenses were $254,000 for the three months ended September 30, 2006 compared to $444,000 for the same period in 2005. The decrease of $190,000 was primarily due to the redeployment of personnel (e.g. payroll related costs) and the application of other direct and indirect charges previously captured in selling, general and administrative expenses prior to the establishment of contracts, to existing customer contracts which have been recorded in costs of uncompleted contracts or cost of service and license revenue of $204,000. The decrease was offset by an increase of depreciation of $13,000.

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Interest and Other Income Interest and other income was $272,000 for the three months ended September 30, 2006, compared to $91,000 for the same period in 2005. The increase of $181,000 was primarily due to higher average cash equivalent and short-term investment balances and, to a lesser extent, higher interest rates earned on short-term investment balances.

Six Months Ended September 30, 2006 and 2005

Revenue Revenue was $3.1 million for the six months ended September 30, 2006 compared to $2.4 million for the same period in 2005. The amount for the six months ended September 30, 2006 was principally comprised of revenue from contracts with Nissan and the U.S. Navy of $2.0 million and $934,000, respectively, compared to $2.4 million from contracts with Nissan for the same period in the 2005.

Cost of Revenue Cost of revenue was $1.3 million for the six months ended September 30, 2006 compared to $364,000 for the same period in 2005. The costs primarily related to Nissan and U.S. Navy contracts in the six months ended September 30, 2006 and primarily related to Nissan contracts in for the same period in 2005, consisting of manufacturing expenses, including employee compensation and supplies and materials. The increase was primarily a result of the recognition of costs related to the U.S. Navy contract.

Selling, General and Administrative Expenses Selling, general and administrative expenses were $1.4 million for the six months ended September 30, 2006 compared to $989,000 for the same period in 2005. The increase of $439,000 was primarily due to increases in professional fees consisting principally of accounting, legal, and other service fees related to the annual report of $403,000, insurance costs of $79,000, travel expenses of $44,000 and franchise taxes of $29,000. In addition, employee and director compensation increased by $136,000 and $60,000, respectively. The increase in employee compensation includes payroll and stock-based compensation, primarily due to pay increases and bonuses to employees, and the director compensation were stock awards granted to the independent members of our Board of Directors. The increase was offset by $82,000 related to the redeployment of personnel (e.g. payroll related costs) and the application of other direct and indirect charges previously captured in selling, general and administrative expenses prior to the establishment of contracts, to existing customer contracts which have been recorded in costs of uncompleted contracts or cost of service and license revenue, and by a reduction in stock-based compensation of $225,000 related to officers’ common stock that was subject to our right to repurchase. As of September 30, 2006, no shares held by these officers remained subject to our right to repurchase.

Research and Development Expenses Research and development expenses were $528,000 for the six months ended September 30, 2006 compared to $689,000 for the same period in 2005. The decrease of $161,000 was primarily due to the redeployment of personnel (e.g. payroll related costs) and the application of other direct and indirect charges previously captured in selling, general and administrative expenses prior to the establishment of contracts, to existing customer contracts which have been recorded in costs of uncompleted contracts or cost of service and license revenue of $235,000, and by a reduction in stock-based compensation of $47,000 related to an officer’s common stock that was subject to our right to repurchase. As of September 30, 2006, no shares held by this officer remained subject to our right to repurchase. The decrease was offset by an increase in an increase in supplies, services and equipment costs of $74,000, depreciation expense of $26,000 and employee compensation of $21,000, which includes payroll and stock-based compensation, primarily due to pay increases and bonuses to employees.

Interest and Other Income Interest and other income was $543,000 for the six months ended September 30, 2006, compared to $128,000 for the same period in 2005. The increase of $415,000 was primarily due to higher average cash equivalent and short-term investment balances and, to a lesser extent, higher interest rates earned on short-term investment balances.

Income Taxes

Income taxes are accounted for under the asset and liability method of Statement of Financial Accounting Standards No. 109, or SFAS 109, Accounting for Income Taxes , which establishes financial accounting and reporting standards for the effect of income taxes. In accordance with SFAS 109, we recognize federal and state current tax liabilities based on our estimate of taxes payable to or refundable by each tax jurisdiction in the current fiscal year.

Deferred tax assets and liabilities are established for the temporary differences between the financial reporting bases and the tax bases of our assets and liabilities at the tax rates we expect to be in effect when these deferred tax assets or liabilities are anticipated to be recovered or settled. Our ultimate realization of deferred tax assets depends upon the generation of future taxable income during periods in which those temporary differences become deductible. Based on the best available objective evidence, it is more likely than not that our remaining net deferred tax assets will not be realized. Accordingly, we continue to provide a valuation allowance against our net deferred tax assets as of September 30, 2006.

During the three and six months ended September 30, 2006 and 2005, respectively, the Company qualified as a “Hawaii Qualified High Technology Business,” which provides potential tax credits to its investors as well as certain tax credits to the Company for qualified research and experimentation, or R&E costs. We recorded Hawaii R&E tax credits in the amounts of $42,000 and $51,000 for the three months ended September 30, 2006 and 2005, respectively, and $209,000 and $109,000 during the six months ended September 30, 2006 and 2005, respectively. As our business transitions from research and experimentation to commercial production, we will no longer qualify for additional tax credits through this program.

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Variability of Results

Our revenue, operating results and cash flows depend upon the size and timing of customer orders and payments and the dates of product deliveries and achievement of contractual milestones. We recognize contract revenue and related costs upon contract completion and customer acceptance and service and license revenue and related costs ratably over the term of the arrangement or the expected period of performance in compliance with the specific arrangement terms. These methods of revenue recognition often result in our receiving payment from a customer and deferring the recognition of the revenue and related costs of uncompleted contracts for some period of time until the milestones are achieved and accepted by the customer and/or the products are delivered. As a result, a new contract may not result in revenue in the quarter or year in which the contract is signed, and we may not be able to predict accurately when revenue and related costs from a contract will be recognized. Any failure or delay in our ability to meet contractual milestones and/or deliver our products to our customers may harm our operating results. Since our operating expenses are based on anticipated revenue and cash flows from contracts and because a high percentage of these expenses are relatively fixed, a delay in revenue and cash flows from one or more contracts could cause significant variations in operating results from quarter to quarter and cause unexpected results. Revenue from contracts that do not meet our revenue recognition policy requirements for which we have been paid or have a valid account receivable are recorded as deferred revenue. Our future operating results and cash flows will depend on many factors, including the following:

As a result of these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance.

Liquidity and Capital Resources

We had net income for the six months ended September 30, 2006 and fiscal 2006; however, we previously incurred net losses in each other fiscal year since our inception. As of September 30, 2006, we had an accumulated deficit of $4.5 million. Fluctuations in quarterly revenue are expected to continue in future periods due to uncertainty regarding the level and the timing of revenue from customer contracts and achievement of contract milestones. We expect that our Testing Agreement with Sanyo, which ended in July 2006, and Nissan, which ended in September 2006, will be our final engineering service contracts with the respective companies; however, Sanyo and Nissan may continue to purchase our products for testing. At this time, we do not believe we will receive any meaningful revenue from Sanyo or Nissan in the foreseeable future. In addition, Sanyo and Nissan may require additional testing of our Hoku Membrane and Hoku MEA products before purchasing commercial quantities of our products. We cannot predict when such sales will occur, if at all. As of September 30, 2006, there are no additional costs or obligations to Sanyo or Nissan.

In addition, we expect that we will need to increase our efforts in growing our customer base. We will also need to raise approximately $250 million to successfully complete our planned construction of PV modules and polysilicon manufacturing facilities. See “Solar and Polysilicon Facilities” below. The result is that we expect our costs to increase significantly, which may result in further losses on a quarterly or annual basis.

Through July 2005, we funded our operations principally from private placements of equity securities, raising aggregate gross proceeds of $7.8 million, and cash payments from our customers for testing and engineering services and delivery of products for test and evaluation. In August 2005, we issued 3,500,000 shares of common stock at $6.00 per share upon the closing of our initial public offering raising approximately $17.6 million, net of underwriting discounts and commissions and initial public offering costs. In September 2005, the underwriters exercised their over-allotment option to purchase an additional 183,200 shares of common stock at the public offering price of $6.00 per share raising $1.0 million, net of underwriting discounts and commissions and offering costs.

Net Cash Provided By (Used In) Operating Activities Net cash used in operating activities was $911,000 for the six months ended September 30, 2006, compared to net cash provided by operating activities of $5.5 million for the same period in 2005. The decrease of $6.4 million was primarily a result of the collection of accounts receivable in the six months ended September 30, 2005 and a reduction of accrued expenses related to the payment for our facility in Kapolei.

Net Cash Provided By (Used In) Investing Activities Net cash provided by investing activities was $1.6 million for the six months ended September 30, 2006, compared to net cash used in investing activities of $26.6 million for the same period in 2005. The increase of $28.2 million in net cash provided was primarily a result of a reduction in the amount of net purchases of short-term investments and acquisitions of property and equipment.

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Net Cash Provided By Financing Activities Net cash provided by financing activities was $2,000 for the six months ended September 30, 2006, compared to $18.6 million for the same period in 2005. The decrease of $18.6 million is primarily due to proceeds from initial public offering and over-allotment, net of underwriting discounts and commissions, which was off-set by initial public offering costs which were incurred in the prior year period.

Contractual Obligations

As of September 30, 2006, there has been no material change in our outstanding contractual obligations since March 31, 2006.

In October 2006, we terminated our operating lease related to testing equipment. We exercised a buy-out provision in the amount of $109,000 for one of the previously leased test equipment and returned the rest. The purchased equipment was recorded as an asset on our books and will be depreciated over two years, the expected remaining useful life.

As of October 15, 2006, our remaining contractual obligation is an operating lease for a printer with the aggregate total payment of $3,000.

In August 2006, we awarded a contract to CH2M HILL Lockwood Greene to provide engineering and related services for our planned polysilicon production plant. The contract’s initial value is approximately $255,000; however, we expect to require additional services from CH2M HILL Lockwood Greene to complete the design and construction of our planned polysilicon production plant. In October 2006, we executed an agreement with Spire Corporation, a U.S. solar equipment manufacturer, for the purchase of a photovoltaic module production line for approximately $2.0 million. The production line will enable us to manufacture up to 15 megawatts of photovoltaic modules each year and is scheduled to be delivered in the first half of calendar year 2007. We may install the equipment in our facility in Hawaii until the planned facility with a module production capacity of 30 MW per year in Idaho is completed.

In October 2006, we executed a contract to purchase solar cells manufactured in Taiwan from Swiss Wafers AG for approximately $2.8 million. Subsequent to the agreement, we and Swiss Wafers AG, mutually agreed to terminate the contract as Swiss Wafers AG was unable to secure the type of solar cells contemplated for purchase under the agreement.

In October 2006, we also executed a contract to purchase solar cells manufactured in Taiwan from E-Ton Solar Tech Co., Ltd. for approximately $2.8 million. These cells will be delivered later this calendar year and we expect to use the cells in our initial module product line in the first half of calendar year 2007.

Solar and Polysilicon Facilities

In May 2006, we announced our intention to form an integrated PV module business to complement our fuel cell business. This planned expansion includes developing manufacturing capabilities and the eventual planned manufacture of polysilicon, PV cells and PV modules. To date, our business has solely been focused on the stationary and automotive fuel cell markets and we have no experience in the PV module and polysilicon businesses. In order to be successful we will need to devote substantial management time, resources and funds to this planned expansion. In August 2006, we awarded a contract to CH2M HILL Lockwood Greene to provide engineering and related services for our planned polysilicon production plant. The contract’s initial value is approximately $255,000; however, we expect to require additional services from CH2M HILL Lockwood Greene to complete the design and construction of our planned polysilicon production plant. In October 2006, we executed an agreement with Spire Corporation, a U.S. solar equipment manufacturer, for the purchase of a photovoltaic module production line for approximately $2.0 million. The production line will enable us to manufacture up to 15 megawatts of photovoltaic modules each year and is scheduled to be delivered in the first half of calendar year 2007.

In October 2006, we executed a contract to purchase solar cells manufactured in Taiwan from Swiss Wafers AG for approximately $2.8 million. Subsequent to the agreement, we and Swiss Wafers AG, mutually agreed to terminate the contract as Swiss Wafers AG was unable to secure the type of solar cells contemplated for purchase under the agreement.

In October 2006, we also executed a contract to purchase solar cells manufactured in Taiwan from E-Ton Solar Tech Co., Ltd. for approximately $2.8 million. These cells will be delivered later this calendar year and we expect to use the cells in our initial module product line in the first half of calendar year 2007.

We are at an early planning stage of this expansion and at any point in time we may conclude that such expansion is not financially or technologically feasible and abandon our efforts to establish an integrated PV module business. Such abandonment after substantial investment of time and resources could harm our business. Even if successful, the diversion of management’s efforts, our resources and funds could harm our efforts to develop and commercialize our Hoku MEAs and Hoku Membranes.

Before we can even commence construction of our planned manufacturing facilities, we must successfully and timely accomplish the following:

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If we fail to successfully achieve any or all of the above objectives, we will be unable to commence construction of our planned manufacturing facilities and we may be forced to delay, alter or abandon our planned expansion. In addition, any delay in achieving these objectives may result in additional expense and increased diversion of management’s efforts from our fuel cell business, each of which would harm our business. Even if we achieve all of these objectives on a timely basis and complete the construction of our manufacturing facilities as currently planned, we may still be unsuccessful in developing, manufacturing and/or selling PV cells, PV modules and polysilicon for numerous reasons.

We are in discussions with leading solar ingot, wafer and cell companies for contracts to supply polysilicon from our planned Idaho plant. We still plan to finance a significant portion of our polysilicon plant construction costs through customer prepayments and debt. However, we have begun investing our own cash resources into this project, and expect that we will continue to do so in advance of signing these customer contracts and securing the debt.

Operating Capital and Capital Expenditure Requirements

As we develop our products, expand our research and development team and corporate infrastructure, prepare for the increased production of our products and evaluate new markets to grow our business, we expect that our research and development and selling, general and administrative expenses will continue to increase and, as a result, we will need to generate significant revenue to maintain profitability.

We do not expect to generate significant revenue until we successfully manufacture and sell our products in high volume. We believe that our cash, cash equivalent and short-term investment balances, will be sufficient to meet the anticipated capital expenditures and cash requirements for our fuel cell business through at least the next 12 months; however, we expect that we will need to raise approximately $250 million to support the construction of our planned PV cell and module, and polysilicon manufacturing facilities. If these sources are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities or obtain another credit facility. The sale of additional equity and convertible debt securities may result in additional dilution to our stockholders. If we raise additional funds through the issuance of convertible debt securities, these securities could have rights senior to those of our common stock and could contain covenants that would restrict our operations. We may require additional capital beyond our currently forecasted amounts. Any required additional capital may not be available on reasonable terms, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of, delay or eliminate some or all of our planned research, development and commercialization and manufacturing activities, which could harm our business.

Our forecasts of the period of time through which our financial resources will be adequate to support our operations are forward-looking statements and involve risks and uncertainties. Actual results could vary as a result of a number of factors, including the factors discussed in Part II, Item 1.A. “Risk Factors” and the section above entitled “Forward-Looking Statements.”

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations are based on our unaudited financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles for interim financial statements and the instructions to Form 10-Q and Regulation S-X. The preparation of these financial statements requires us to make estimates and assumptions relating to the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting periods. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

While our significant accounting policies are more fully described in note 1 to the unaudited financial statements included in this Quarterly Report on Form 10-Q and note 1 to the audited financial statements included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on June 29, 2006, we believe that the following accounting policies and estimates are critical to a full understanding and evaluation of our reported financial results.

Revenue Recognition We recognize revenue under Staff Accounting Bulletin No. 104, Revenue Recognition , or SAB 104, when there is evidence of an arrangement, delivery has occurred or services have been rendered, the arrangement fee is fixed or determinable and collectibility of the arrangement fee is reasonably assured.

We have entered into multiple-element arrangements that include testing and engineering services and license rights for our customers to perform their own testing and evaluation of our Hoku MEAs and Hoku Membranes. Historically, these arrangements have called for an upfront payment of a portion of the arrangement fee with remaining payments due over the service periods and/or as the Hoku MEAs and Hoku Membranes are delivered over the license period. We account for these arrangements as a single unit of accounting in accordance with Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables , because we have not established fair values for the undelivered elements. Therefore, the engineering and testing revenue has been combined with the Hoku MEA and Hoku Membrane revenue to form a single unit of accounting for purposes of revenue recognition. Revenue is recognized ratably over the term of the arrangement or the expected period of performance in compliance with the specific arrangement terms.

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We also provide testing and engineering services to customers pursuant to milestone-based contracts that are not multi-element arrangements. These contracts sometimes provide for periodic invoicing as we complete a milestone. Customer acceptance is usually required prior to invoicing. We recognize revenue for these arrangements under the completed contract method in accordance with Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts . Under the completed-contract method, we defer the contract fulfillment costs and any advance payments received from the customer and recognize the costs and revenue in our statement of operations once the contract is complete and the final customer acceptance, if required, has been obtained.

Stock-Based Compensation We account for stock-based employee compensation arrangements using the fair value method in accordance with the provisions of Statement of Financial Accounting Standards No. 123(R), or SFAS 123(R), Share-Based Payment . We account for stock options issued to non-employees in accordance with the provisions of Statement of Financial Accounting Standards No. 123, or SFAS 123, Accounting for Stock-Based Compensation , and Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments with Variable Terms That Are Issued for Consideration Other Than Employee Services Under FASB Statement No. 123 .

In accordance with SFAS 123(R), the fair value of stock options granted to our employees and non-employees is determined using the Black-Scholes option pricing model. The Black-Scholes option pricing model requires the input of several subjective assumptions including the expected life of the option and the expected volatility of the option at the time the option is granted. The fair value of our stock options, as determined by the Black-Scholes option pricing model is expensed over the requisite service period, which is generally five years.

Prior to our initial public offering, there was an absence of an active market for our common stock, and therefore our board of directors estimated the market value of our common stock on the date of grant of the stock option based on several factors, including progress and milestones achieved in our business and sales of our preferred stock. We did not obtain contemporaneous valuations from a valuation specialist during this period. Subsequent to our initial public offering, the market value is based on the active market for our common stock. In addition, we have assumed a volatility of 100% based on competitive benchmarks and management judgment and an expected life based on the average of the typical vesting period and the option’s contractual life which ranges from 6.5 to 7.5 years.

The assumptions used in calculating the fair value of our stock options represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, changes in these inputs and assumptions can materially affect the measure of the estimated fair value of our stock options. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. Furthermore, this accounting estimate is reasonably likely to change from period to period as further stock options are granted and adjustments are made for stock option forfeitures and cancellations. In accordance with SFAS 123(R), we do not record any deferred stock-based compensation on our balance sheet for our stock options.

We expect to incur an aggregate of $2.1 million of future stock-based compensation expense associated with unvested stock options outstanding as of September 30, 2006 through fiscal 2012 as set forth in the table below. We expect that some of the amounts noted below will be included as costs of delivering our products and services and as such, will be deferred and recognized as cost of revenue in conjunction with the recognition of revenue.

We expect our stock-based compensation expense from stock options to increase as we expand our operations and hire new employees. These expenses will increase our overall expenses and may increase our losses for the foreseeable future. As stock-based compensation is a non-cash expense, it will not have any effect upon our liquidity or capital resources.

Recent Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 requires retrospective application for voluntary changes in accounting principle unless it is impracticable to do so. In addition, indirect effects of a change in accounting principle should be recognized in the period of the accounting change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We adopted SFAS 154 as of fiscal 2006 and it has not had a material effect on our financial position or results of operations.

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 , or FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes . This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The effective date of this interpretation is the first fiscal year that begins after December 15, 2006. We do not believe the adoption of this interpretation will have a significant impact to our financial statements.

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In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements , or SAB 108, which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective as of the end of our 2007 fiscal year, allowing a one-time transitional cumulative effect adjustment to beginning retained earnings as of April 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. We do not believe the adoption of this interpretation will have a significant impact to our financial statements.

Off-Balance Sheet Arrangements

We have never engaged in off-balance sheet activities, including the use of structured finance, special purpose entities or variable interest entities.