Quarterly Report

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:

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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, 2007, contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on June 29, 2007.

Overview

Hoku Scientific, Inc. 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.

We have historically focused our efforts on the design and development of fuel cell technologies, including our Hoku membrane electrode assemblies, or MEAs, and Hoku Membranes. In May 2006, we announced our plans to form a photovoltaic, or PV, module and system installation business, and our plans to produce polysilicon, a primary material used in the manufacture of PV modules, to complement our fuel cell business. In fiscal 2007, we reorganized our business into three business units: Hoku Materials, Hoku Solar and Hoku Fuel Cells. In February and March 2007, we incorporated Hoku Materials, Inc. and Hoku Solar, Inc., respectively, as wholly-owned subsidiaries to operate our polysilicon and solar businesses, respectively.

Hoku Materials

In February 2007, in order to ensure an adequate supply of polysilicon for Hoku Solar’s modules, we incorporated Hoku Materials to produce this key material for consumption by Hoku Solar and for sale to the larger solar market. We commenced construction of our planned polysilicon production facility in May 2007 and anticipate the availability of polysilicon beginning in the first half of calendar year 2009. We intend to finance the construction of this facility through a combination of prepayments from customers and debt and/or equity financing.

In January 2007, we signed a contract with Sanyo Electric Company, Ltd., or Sanyo, to provide Sanyo with $370 million of polysilicon sales over a seven year period and Sanyo advanced to us $2 million and deposited an additional $109 million into an escrow account at Bank of Hawaii to be released to us upon achievement of certain polysilicon production and quality milestones. In October 2007, we amended the agreement with Sanyo by extending the date to complete the financing for the construction of our polysilicon production plant from October 17, 2007 to December 31, 2007.

In May 2007, the City of Pocatello approved an ordinance that would provide us with tax incentives related to the infrastructure necessary for the completion of our planned polysilicon plant. We would receive up to $25.9 million in real property tax reimbursements for infrastructure improvements and up to $17 million in real property tax reimbursements based on employment numbers.

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In June 2007, we entered into an agreement with Wuxi Suntech Power Co., Ltd., or Suntech, to provide Suntech with up to $678 million of polysilicon sales over a ten year period, and Suntech advanced to us $2 million and will make additional prepayments for products in the amount of $45 million in installments upon achievement of certain polysilicon production and quality milestones. In August 2007, the parties amended the agreement to eliminate the requirement that Suntech’s $45 million letter of credit be issued by Bank of China and to clarify the limitations on our ability to sell additional polysilicon products to third party customers in connection with any planned expansion of our production capacity. In August, as security for Suntech’s prepayment obligation, Suntech delivered a $45 million letter of credit issued to us by the Chicago branch of ABN AMRO Bank NV. The contract also includes a provision that allows for either party to cancel years 8 through 10 of delivery for any reason. Such cancellation notice must be delivered to the other party prior to the end of the fourth year of delivery under the agreement.

In June 2007, we entered into an agreement with Global Expertise Wafer Division Ltd., or GEWD, a wholly-owned subsidiary of Solar-Fabrik AG, to provide GEWD with up to $185 million of polysilicon sales over a seven year period, and GEWD advanced to us $2 million and will make additional prepayments for products in the amount of $51 million in installments upon achievement of certain polysilicon production and quality milestones. As security for GEWD’s $51 million prepayment obligation, GEWD obtained a $25 million letter of credit in our favor from Dresdner Bank AG. GEWD was required to obtain an additional $26 million bank letter of credit to us on or before September 30, 2007. As GEWD did not obtain the additional $26 million letter of credit, we reduced the predetermined volume of polysilicon and increased the predetermined price under the agreement. The result is we will now provide GEWD with up to $117 million of polysilicon sales over a seven year period, and GEWD’s prepayment obligation has been reduced to $27 million, including the $2 million already paid to us in cash and the $25 million that is supported by the Dresdner Bank standby letter of credit.

In August 2007, we entered into an agreement with Stone & Webster, Inc., or S&W, a subsidiary of The Shaw Group Inc., for engineering, procurement, and construction management services, or the EPCM Agreement, for the construction of a polysilicon production plant with an annual capacity of 2,000 metric tons. We will pay S&W on a time and materials basis plus a fee for its services and incentives if certain schedule and cost targets are met. The target cost for the services to be provided under the EPCM Agreement is $41.5 million, plus up to $5.0 million of additional incentives that may be payable. In October 2007, we issued a change order under the EPCM Agreement to increase the rated polysilicon production capacity of our planned facility to up to 2,500 metric tons per year. The change order did not change S&W’s target costs or their incentives under the EPCM Agreement.

In August 2007, we entered into an agreement with JH Kelly LLC., or JH Kelly, for construction services for the construction of a polysilicon production plant with an annual capacity of 2,000 metric tons, or the Construction Agreement. We will pay JH Kelly on a time and materials basis plus a fee for its services and incentives if certain schedule, cost and safety targets are met. The target cost for the services to be provided under the Construction Agreement is $120.0 million, including up to $5.0 million of incentives that may be payable. In October 2007, we issued a change order under the Construction Agreement to increase the rated polysilicon production capacity of our planned facility to up to 2,500 metric tons per year. The change order increased JH Kelly’s target cost by $1.0 million; however there is no change to the additional incentives of the contract.

In October 2007, we entered into an agreement with Dynamic Engineering Inc., or Dynamic, for design and engineering services, and a related technology license, for the process to produce and purify trichlorosilane, or TCS. Under the agreement, Dynamic is obligated to design and engineer a TCS production facility that is capable of producing a sufficient quantity of TCS for us to produce up to 2,500 metric tons of polysilicon per year at our planned polysilicon production facility. The Dynamic process is to be integrated by S&W into the overall polysilicon production facility, and will be constructed by JH Kelly. Dynamic’s engineering services will be provided and invoiced on a time and materials basis, and the license fee will be calculated upon the successful completion of the TCS production facility, and demonstration of certain TCS purity and production efficiency capabilities. The maximum aggregate amount that we may pay Dynamic for the engineering services and the technology license is $12.5 million, which includes an incentive for Dynamic to complete the engineering services under budget. Dynamic is guaranteeing the quantity and purity of the TCS to be produced at the completed facility, and has agreed to indemnify us for any third party claims of intellectual property infringement.

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In October 2007, we entered into an amended and restated contract with GEC Graeber Engineering Consultants GmbH, or GEC, and MSA Apparatus Construction for Chemical Equipment Ltd., or MSA, to include an option for us to purchase additional hydrogen reduction reactors and hydrogenation reactors for the production of polysilicon, or the Reactor Contract, for a total purchase price of up to approximately 6.7 million Euros ($9.6 million as of September 30, 2007). The option will enable us to produce up to an additional 500 metric tons of polysilicon per year, which, if exercised, would bring our total polysilicon production capacity to 2,500 metric tons per year, and the total amounts payable to GEC and MSA up to 27 million Euros ($38.5 million as of September 30, 2007). As of September 30, 2007, we have paid GEC and MSA 3.1 million Euros. In addition, we, GEC and MSA agreed to eliminate the requirement from our prior contract that we establish an irrevocable Letter of Credit for 65% of the total contract amount, providing instead for us to make monthly progress payments.

Due to our recent developments, we plan to build and equip a polysilicon production facility capable of producing between 2,000 and 2,500 metric tons of polysilicon per year. We continue to estimate a range for our annual production capacity of polysilicon, rather than a fixed number, because we have not exercised our option to purchase additional polysilicon reactors from GEC and MSA, which would bring our total polysilicon production capacity to 2,500 metric tons per year. We estimate the total cost to construct and equip the polysilicon facility with an annual capacity of 2,500 metric tons will be approximately $300 million. We intend to use the $185 million in advance payment commitments from our polysilicon customer agreements to contribute to the financing of the construction, subject to our successful achievement of various polysilicon production and quality milestones. However, there are no assurances that we will be able to obtain the financing for the remaining construction costs on satisfactory terms, or at all.

During the three and six months ended September 30, 2007, Hoku Materials incurred expenses of $539,000 and $1.1 million, respectively, which mainly consist of payroll, travel expenses, and professional fees. In addition, as of September 30, 2007, Hoku Materials had incurred $3.3 million related to services for the construction of the Idaho plant and $4.3 million related to equipment deposits for the Idaho plant.

Hoku Solar

In March 2007, we incorporated Hoku Solar to assemble and install photovoltaic, or PV, systems. To date, we have signed installation contracts which include Hardware Hawaii and Paradise Beverages, and in July 2007, we entered into an agreement with Bank of Hawaii to install a PV system on Bank of Hawaii’s historic Kohala (Kapa’au) branch, located on the Big Island of Hawaii. We expect to complete some of these installations in the second half of fiscal 2008. We and Bank of Hawaii also signed a non-binding letter of intent for us to explore additional turnkey PV system installations for Bank of Hawaii’s other neighbor island facilities on the islands of Hawaii, Maui and Kauai.

As of October 2007, we are still in negotiations with Hawaiian Electric Company for the installation of a 167 kilowatt PV system and the sale of the power generated by that system over a 20-year period to Hawaiian Electric Company. We plan to continue to market, sell and install turnkey PV systems and will use modules purchased from third party suppliers. In addition, we continue to explore the sale of our land and facility in Kapolei, Hawaii and the relocation to a smaller leased warehouse and office space on the island of Oahu, Hawaii.

In June 2007, we announced our strategy to focus on the sale of turnkey PV system installations, and related services, and our plan to exit the solar module manufacturing business. In connection with this strategy, we resold our 15 megawatt-per-year solar module production line in July 2007, before it was delivered, for $1.8 million, and in September 2007, we resold our inventory of solar cells for $2.1 million and recognized a loss on the sale of $285,000. The module production line and the solar cells had been originally purchased for $1.9 million, and $2.8 million, respectively. In March 2007, we recognized a write-down of $379,000 related to solar cell inventory and in June 2007 we wrote-down the solar module production line to $1.8 million.

During the three and six months ended September 30, 2007, Hoku Solar incurred expenses of $691,000 and $1.2 million, respectively, which mainly consist of payroll expenses, including stock-based compensation, professional fees, the impairment related to the solar module equipment and depreciation. In addition, as of September 30, 2007, Hoku Solar had incurred $214,000 related to cost of uncompleted contracts.

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Hoku Fuel Cells

We operate our fuel cell business under the name Hoku Fuel Cells, which has designed, developed and manufactured MEAs for proton exchange membrane, or PEM, fuel cells. 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. In August 2007, we completed our contract with the U.S. Navy, and have one testing agreement with another customer; however, there are no current testing activities under this agreement. We do not currently plan on actively pursuing any new contracts or committing resources to further develop our fuel cell products and intend to selectively pursue patent applications in order to protect our technology, inventions and improvements related to our fuel cell products.

During the three and six months ended September 30, 2007, Hoku Fuel Cells incurred expenses of $79,000 and $180,000, respectively, which mainly consist of stock-based compensation and professional fees.

Financial Operations Review

Revenue

To date, we have derived substantially all of our revenue with the U.S. Navy, Nissan Motor Co., Ltd., or Nissan, and Sanyo Electric Co., Ltd., or Sanyo, through contracts related to testing and engineering services related to Hoku Fuel Cells. We anticipate our revenue in fiscal 2008 from Hoku Fuel Cells to be principally comprised of service and license revenue from the U.S. Navy. Revenue under our service contracts are 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.

As of September 30, 2007, we had not generated any revenue from Hoku Solar. In October 2007, we began generating revenue from Hoku Solar through the sale of PV system installations. In July 2007, we entered into an agreement with Bank of Hawaii to install a PV system on Bank of Hawaii’s historic Kohala (Kapa’au) branch, located on the Big Island of Hawaii, which we anticipate to complete during the quarter ended December 31, 2007. We and Bank of Hawaii also signed a non-binding letter of intent for Hoku Solar to explore additional turnkey PV system installations for the Bank’s other facilities on the islands of Hawaii, Maui and Kauai. As of October 31, 2007, we are still in negotiations with Hawaiian Electric Company for the installation of a 167 kilowatt PV system and the sale of the power generated by that system over a 20-year period to Hawaiian Electric Company, and we continue to actively pursue other PV system installation contracts. There is no guarantee that we will obtain these contracts.

We also anticipate generating revenue from Hoku Materials through the sale of polysilicon beginning in the first half of calendar year 2009.

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.

Pursuant to the contract, we manufactured 11 fuel cell power plants for delivery to the U.S. Navy. The U.S. Navy officially accepted the 11 fuel cell power plants and demonstrated 10 of these fuel cell power plants at Pearl Harbor, Hawaii. The aggregate amount of the contract was $4.5 million and as of September 30, 2007, we have received $4.4 million in payments. We received an additional $108,000 in payments from the U.S. Navy in October 2007. We recognized $239,000 and $1.3 million in revenue during the three and six months ended September 30, 2007, respectively, and $896,000 and $934,000 in revenue during the three and six months ended September 30, 2006. We completed all work related to this contract in August 2007.

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.

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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 paid 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 paid IdaTech $473,000 to purchase an additional 11 fuel cell power plants. We also paid 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, 2007, we have paid $947,000 of the $968,000 due to Idatech pursuant to the agreement.

Nissan Motor Co., Ltd. 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.

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 December 31, 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, 2007, there are no additional costs or obligations to Nissan.

Sanyo Electric Co., Ltd. In December 2005, we entered into a material transfer and collaborative testing agreement, or 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.

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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, 2007, there are no additional costs or obligations to Sanyo.

Additional Customers. We have significantly scaled-back our expenditures and investments in Hoku Fuel Cells, and we intend to focus increasingly on Hoku Solar and Hoku Materials. We are not currently seeking new fuel cell customers to test our products.

Cost of Revenue

Our cost of revenue consists primarily of employee compensation, including stock-based compensation, and supplies and materials. We expect our cost of revenue to increase on an absolute basis as our polysilicon production and our PV system installation activities 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 by a significant factor as a result of our entry into the polysilicon and PV module 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. Although our research and development expenses have decreased significantly since we reduced our investment in our fuel cell business, 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.

Consolidated Results of Operations

The following analysis of the unaudited consolidated financial condition and results of operations of Hoku Scientific, Inc. and its subsidiaries should be read in conjunction with the consolidated financial statements and the related notes thereto in this Quarterly Report on Form 10-Q.

Results of Operations

Three Months Ended September 30, 2007 and 2006

Revenue. Revenue was $239,000 for the three months ended September 30, 2007 compared to $1.9 million for the same period in 2006. Revenue for the three months ended September 30, 2007 was comprised of service and license revenue from contracts with the U.S. Navy compared to service and license revenue primarily from contracts with Nissan and the U.S. Navy of $983,000 and $896,000, respectively, for the same period in the 2006.

Cost of Service and License Revenue. Cost of service and license revenue was $195,000 for the three months ended September 30, 2007 compared to $997,000 for the same period in 2006. The cost of service and license revenue for the three months ended September 30, 2007 related to contracts with the U.S. Navy compared to cost of service and license revenue primarily related to the Nissan and the U.S Navy contracts for the same period in 2006. Cost of service license revenue primarily consists of manufacturing expenses, including employee compensation and supplies and materials.

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Selling, General and Administrative Expenses. Selling, general and administrative expenses were $1.3 million for the three months ended September 30, 2007 compared to $703,000 for the same period in 2006. The increase of $567,000 was primarily due to the loss on the resale of solar cells of $285,000, redeployment of personnel, supplies and other costs, which were previously captured in customer contracts as costs of uncompleted contracts or cost of service and license of $109,000, and an increase in travel expenses of $31,000. In addition, employee compensation, including stock-based compensation, increased by $150,000 due to the hiring of additional employees and employees formerly in research and development transferring to the selling, general and administrative department. The increase was offset by a decrease in D&O insurance expense of $7,000, due to better premiums for the same coverage limits.

Research and Development Expenses . Research and development expenses were $39,000 for the three months ended September 30, 2007 compared to $254,000 for the same period in 2006. The decrease of $215,000 was primarily due to the reduction of employees in our fuel cell business resulting in reductions in payroll and stock-based compensation expense of $77,000, office supplies and other facility costs of $53,000, medical benefits of $16,000, and by reductions in costs related to materials and services used for research and development of $31,000. The decrease was also due to a reduction in depreciation of $32,000 primarily due to the write-down of fuel cell equipment and the reclassification of fuel cell equipment from held-for-use to held-for-sale.

Interest and Other Income . Interest and other income was $261,000 for the three months ended September 30, 2007, compared to $272,000 for the same period in 2006. The decrease of $11,000 was primarily due to lower average balances of cash equivalent and short-term investments.

Six Months Ended September 30, 2007 and 2006

Revenue. Revenue was $1.3 million for the six months ended September 30, 2007 compared to $3.1 million for the same period in 2006. Revenue for the six months ended September 30, 2007 was comprised of service and license revenue from contracts with the U.S. Navy compared to service and license revenue primarily from contracts with Nissan and the U.S. Navy of $2.0 million and $934,000, respectively, for the same period in the 2006.

Cost of Service and License Revenue. Cost of service and license revenue was $953,000 for the six months ended September 30, 2007 compared to $1.3 million for the same period in 2006. The cost of service and license revenue for the six months ended September 30, 2007 related to contracts with the U.S. Navy compared to cost of service and license revenue primarily related to the Nissan and the U.S Navy contracts for the same period in 2006. Cost of service license revenue primarily consists of manufacturing expenses, including employee compensation and supplies and materials.

Selling, General and Administrative Expenses. Selling, general and administrative expenses were $2.4 million for the six months ended September 30, 2007 compared to $1.4 million for the same period in 2006. The increase of $1.0 million was primarily due to employee compensation, including stock-based compensation, increasing by $372,000 due to the hiring of additional employees and employees formerly in research and development transferring to the selling, general and administrative department. The increase was also due to redeployment of personnel, supplies and other costs, which were previously captured in customer contracts as costs of uncompleted contracts or cost of service and license of $292,000. Furthermore the increase was attributable to the loss on the resale of solar cells of $285,000, the write-down of equipment of $79,000 and an increase in travel expenses of $54,000. The increase was offset by a decrease in professional fees consisting principally of legal, accounting, consulting and other service fees of $49,000, insurance expense of $16,000 and office supplies of $10,000.

Research and Development Expenses . Research and development expenses were $82,000 for the six months ended September 30, 2007 compared to $528,000 for the same period in 2006. The decrease of $446,000 was primarily due to a reduction in payroll expenses of $161,000 primarily due to the reduction of employees in our fuel cell business and by reductions in costs related to materials and services used for research and development of $110,000. The decrease was also due to a reduction in facility costs of $83,000, depreciation of $63,000, primarily due to the write-down of fuel cell equipment and reclassification of fuel cell equipment from held-for-use to held-for-sale and insurance expense of $34,000.

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Interest and Other Income . Interest and other income was $480,000 for the six months ended September 30, 2007, compared to $543,000 for the same period in 2006. The decrease of $63,000 was primarily due to lower average balances of cash equivalent and short-term investments.

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, 2007.

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. We adopted FIN 48 on April 1, 2007. The adoption of this interpretation did not have a material impact on our consolidated financial statements.

Variability of Results

We were the prime contractor in a U.S. Navy fuel cell demonstration project which was completed in August 2007. Although we began the installation of PV systems in October 2007, in the near term, we have limited sources of revenue. To date, we have entered into several installation contracts which include Bank of Hawaii, Hardware Hawaii, and Paradise Beverages. In May 2007, Hawaiian Electric Company selected us to enter into negotiations for the installation of a 167 kW PV system and our sale to Hawaiian Electric Company of the power generated by that system over a 20-year period. As of October 31, 2007, we are still in negotiations with Hawaiian Electric Company and there is no guarantee that we will obtain this contract.

Our future operating results and cash flows will depend on many factors that impact Hoku Materials, Hoku Solar and Hoku Fuel Cells including the following:

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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 indicators of future performance.

Liquidity and Capital Resources

We had net income for fiscal 2006, however, we incurred cumulative net losses since our inception through September 30, 2007. As of September 30, 2007, we had an accumulated deficit of $9.6 million. During the six months ended September 30, 2007, Hoku Materials and Hoku Solar did not generate any revenue and our revenue from Hoku Fuel Cells was limited to our contract with the U.S. Navy which was completed in August 2007. We expect that our Step 3 Contract with Nissan, which ended in September 2006, our Testing Agreement with Sanyo, which ended in July 2006, and our contracts with the U.S. Navy, which ended in August 2007, will be our final engineering service contracts with these companies. At this time, we do not believe we will receive any meaningful revenue from Nissan, Sanyo or the U.S. Navy in the foreseeable future. In addition, Nissan, Sanyo or the U.S. Navy 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, 2007, there are no additional costs or obligations to Nissan, Sanyo or the U.S. Navy.

Although we began the installation of PV systems in October 2007, in the near term, we have limited sources of revenue. To date, we have entered into several installation contracts which include Bank of Hawaii, Hardware Hawaii, and Paradise Beverages. In May 2007, Hawaiian Electric Company selected us to enter into negotiations for the installation of a 167 kW PV system and our sale to Hawaiian Electric Company of the power generated by that system over a 20-year period. As of October 31, 2007, we are still in negotiations with Hawaiian Electric Company and there is no guarantee that we will obtain this contract.

We will also need approximately $300 million to successfully complete our planned construction of our polysilicon manufacturing facilities. See “Solar and Polysilicon Facilities” below. The result is that we expect our costs to increase significantly, which will result in further losses on a quarterly and 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.

In March 2007, we entered into a credit facility of up to $13 million with Bank of Hawaii and as of September 30, 2007 had $5.8 million available under the credit facility. In October 2007, we borrowed an additional $3.0 million against the credit facility. We plan to use these funds to finance, in part, certain expenses related to our polysilicon production facility in Idaho. In August 2007, we amended the maturity date of the credit facility to March 31, 2008 from September 23, 2007.

Net Cash Provided By (Used In) Operating Activities Net cash provided by operating activities was $1.4 million for the six months ended September 30, 2007 compared to net cash used of $911,000 for the same period in 2006. The increase of $2.3 million was primarily a result of the receipt of deposits related to polysilicon supply agreements and sale of the solar module equipment and solar cell inventory. The increase was offset by the payments made for equipment deposits for the polysilicon facility and net loss for the six months ended September 30, 2007.

Net Cash Provided By (Used In) Investing Activities Net cash used in investing activities was $1.6 million for the six months ended September 30, 2007 compared to net cash provided by investing activities of $1.6 million for the same period in 2006. The decrease of $3.2 million is primarily due to the use of investments as restricted cash for our note payable.

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Net Cash Provided By Financing Activities Net cash provided by financing activities was $7.3 million for the six months ended September 30, 2007 compared to net cash provided by financing activities of $2,000 for the same period in 2006. The increase of $7.3 million is primarily due to proceeds from our note payable.

VECO USA, Inc. In March 2007, we awarded a contract to VECO USA, Inc. for the initial design phase engineering, procurement and construction management services of our polysilicon production plant on a time and materials basis. We paid $458,000 to VECO USA, Inc. and the contract expired prior to September 30, 2007.

Sanyo Electric Co., Ltd. In January 2007, we entered into a supply agreement with Sanyo for the sale and delivery of polysilicon to Sanyo over a seven-year period beginning in January 2009. Under the contract, up to $370 million may be payable to us during the seven-year period, subject to the achievement of certain polysilicon production and quality milestones. The contract provides for the delivery of predetermined volumes of polysilicon to Sanyo each year at set prices from January 2009 through December 2015.

Graeber Engineering Consultants GmbH and MSA Apparatus Construction for Chemical Equipment Ltd. In January 2007, we entered into a contract with Graeber Engineering Consultants GmbH, or GEC, and MSA Apparatus Construction for Chemical Equipment Ltd., or MSA, for the purchase and sale of hydrogen reduction reactors and hydrogenation reactors for the production of polysilicon, and related engineering and installation services. Under the contract, we will pay up to a total of 20.9 million Euros ($29.8 million as of September 30, 2007) for the reactors. The reactors are designed and engineered to produce approximately 2,000 metric tons of polysilicon per year. The term of the contract extends until the end of the first month after the expiration date of the warranty period, but may be terminated earlier under certain circumstances. In May 2007, we paid GEC and MSA 3.1 million Euros ($4.2 million on the date of payment) for the initial deposit of 15% for hydrogen reduction reactors capable of producing 2,000 metric tons of polysilicon per year. In October 2007, we, GEC and MSA amended and restated the contract to eliminate the requirement that an irrevocable letter of credit equal to 65% of the purchase price for the reactors to be delivered, and to include an option for us to order additional reactors capable of producing an additional 500 metrics of polysilicon per year for a total purchase price of approximately 6.7 million Euros ($9.6 million as of September 30, 2007).

Idaho Power Company . In June 2007, we entered into an Agreement for Engineering of Hoku Electric Substation and Associated Facilities, or the Engineering Agreement, with Idaho Power Company to begin the engineering and procurement process for the electric substation to provide power for the planned polysilicon production plant in Pocatello, Idaho. We paid Idaho Power Company two payments of $458,500 in June and September 2007.

Wuxi Suntech Power Co. Ltd. In June 2007, we entered into a supply agreement with Suntech for the sale and delivery of polysilicon to Suntech over a ten-year period beginning in July 2009, or the Suntech Supply Agreement. Under the Suntech Supply Agreement, up to approximately $678 million may be payable to us during the ten-year period, subject to certain polysilicon production and quality milestones. The Suntech Supply Agreement provides

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for the delivery of predetermined volumes of polysilicon by us and purchase of these volumes by Suntech each month and each year at set prices from or before July 1, 2009, for a continuous period of ten years. The term of the Suntech Supply Agreement is ten years from the date of the first shipment in 2009, which is approximately July 1, 2019. Each party, however, may elect to shorten the term of the Suntech Supply Agreement to seven years by providing written notice to the other party at any time prior to the end of the fourth year after the first shipment. If the term of the Suntech Supply Agreement is shortened to seven years, then the aggregate amount that may be payable to us for product shipments during the seven year period shall be reduced to $378 million.

Global Expertise Wafer Division Ltd . In June 2007, we entered into a supply agreement with GEWD, a wholly-owned subsidiary of Solar-Fabrik AG, for the sale and delivery of polysilicon to GEWD over a seven-year period beginning in December 2009, or the GEWD Supply Agreement. Pursuant to the GEWD Supply Agreement, GEWD obtained a $25 million standby letter of credit from Dresdner Bank, and was required to obtain an additional $26 million letter of credit by September 30, 2007. As this second letter of credit was not obtained, we have reduced the predetermined volume of polysilicon and increased the predetermined price under the agreement, while also reducing GEWD’s prepayment obligation to $27 million. Based on this reduction in volume and increase in price, the GEWD Supply Agreement provides for the delivery of predetermined volumes of polysilicon by us and purchase of these volumes by GEWD each month and each year at set prices from or before December 31, 2009, for a continuous period of seven years in the aggregate amount of $117 million.

Stone & Webster, Inc. In August 2007, we entered into an agreement with S&W, a subsidiary of The Shaw Group Inc., for engineering, procurement, and construction management services, or the EPCM Agreement, for the construction of a polysilicon production plant with an annual capacity of 2,000 metric tons. S&W will be paid on a time and materials basis plus a fee for its services and incentives if certain schedule and cost targets are met. The target cost for the services to be provided under the EPCM Agreement is $41.5 million, plus up to $5.0 million of additional incentives that may be payable. In October 2007, we issued a change order under the EPCM Agreement to increase the rated polysilicon production capacity of our planned facility to up to 2,500 metric tons per year. The change order did not change S&W’s target costs or their incentives under the EPCM Agreement. In August and October 2007, we made payments to S&W of $197,000 and $803,000, respectively.

JH Kelly LLC . In August 2007, we entered into an agreement with JH Kelly for construction services for the construction of a polysilicon production plant with an annual capacity of 2,000 metric tons, or the Construction Agreement. We will pay JH Kelly on a time and materials basis plus a fee for its services and incentives if certain schedule, cost and safety targets are met. The target cost for the services to be provided under the Construction Agreement is $120.0 million, including up to $5.0 million of incentives that may be payable. In October 2007, we issued a change order under the Construction Agreement to increase the rated polysilicon production capacity of our planned facility to up to 2,500 metric tons per year. The change order increased JH Kelly’s target cost by $1.0 million; however, there is no change to the additional incentives of the contract. In August and October 2007, we made payments to JH Kelly of $74,000 and $204,000, respectively.

Dynamic Engineering Inc. In October 2007, we entered into an agreement with Dynamic for design and engineering services, and a related technology license for the process to produce and purify TCS. Dynamic’s engineering services will be provided and invoiced on a time and materials basis, and the license fee will be calculated upon the successful completion of the TCS production facility, and demonstration of certain TCS purity and production efficiency capabilities. The maximum aggregate amount that we may pay Dynamic for the engineering services and the technology license is $12.5 million, which includes an incentive for Dynamic to complete the engineering services under budget. In October 2007, we made payments to Dynamic of $375,000.

Note Payable

Bank of Hawaii. In March 2007, we entered into a credit facility of up to $13.0 million with Bank of Hawaii. Loans under the credit facility will bear interest, dependent upon our election at the time of the advance, at either: (1) a floating rate per annum equal to the sum of the primary index rate established from time to time by the Bank of Hawaii minus 1.25%, or (2) a rate per annum equal to the sum of LIBOR for such LIBOR interest period plus 0.50%. Loans under the credit facility are secured by a first priority security interest in Hoku Materials’ cash, cash equivalents, short-term investments and marketable securities contained in an account at Piper Jaffray, a third-party

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investment bank. As of September 30, 2007, the aggregate amount in the Hoku Materials’ account with Piper Jaffray was $9.4 million consisting of cash equivalent securities and the remaining amount available to draw was $5.8 million. We consider the entire Hoku Materials balance as restricted cash pursuant to the terms of the credit facility. In addition, Hoku Materials must maintain a loan-to-value ratio between 70% to 95% dependent upon the collateral type in such account. Hoku Scientific and Hoku Materials are also subject to certain financial and operational covenants, including maintaining an effective tangible net worth of not less than $20.0 million. Effective tangible net worth is defined as GAAP net worth, less intangible assets. As of September 30, 2007, we and Hoku Materials were in compliance with the covenants of the credit facility. In August 2007, we amended the maturity date of the credit facility to March 31, 2008 from September 23, 2007.

We plan to use these funds to finance, in part, certain expenses related to constructing our polysilicon production facility in Pocatello, Idaho. In October 2007, we borrowed an additional $3.0 million and increased our restricted cash accordingly to be in compliance with the terms of the credit facility.

Polysilicon Production Plant and Financing Requirements

In May 2006, we announced our intention to form integrated PV module and polysilicon production businesses to complement our fuel cell business. This planned expansion includes developing manufacturing and production capabilities and the eventual production of polysilicon and manufacture of PV modules. In June 2007, we announced our strategy to focus on the sale of turnkey PV system installations, and related services, and our plan to not enter the solar module manufacturing business. Furthermore, due to the change in our business strategy to not manufacture solar modules along with our downsizing of our fuel cell business, we are exploring the sale of our land and facility in Kapolei, Hawaii and the relocation to a smaller leased warehouse and office space on Oahu, Hawaii. To date, our business has solely been focused on the stationary and automotive fuel cell markets and we have no experience in the polysilicon and PV system installation businesses.

We intend to produce polysilicon at our planned polysilicon production plant in Pocatello, Idaho. We commenced construction in May 2007 and anticipate the availability of polysilicon beginning in the first half of calendar year 2009. We estimate the capacity of our polysilicon production plant to be between 2,000 and 2,500 metric tons per year, but we have not determined the final capacity at this time. However, we expect the estimated cost to construct a production plant with an annual capacity of 2,500 metric tons of polysilicon will be approximately $300 million. We plan to finance the construction of our planned polysilicon production plant through a combination of pre-payments from customers, debt and/or equity financing.

Pursuant to our polysilicon supply agreements with Sanyo and Suntech, we must obtain financing of at least $100 million by December 31, 2007 and March 31, 2008, respectively, for the construction of our planned polysilicon production plant. If these deadlines are not met, Sanyo and Suntech may terminate their respective agreements with us. Pursuant to our polysilicon supply agreement with GEWD, we must obtain financing by March 31, 2008, for the construction of our planned polysilicon production plant, or GEWD may also terminate their agreement with us.

We have engaged Calyon Securities Inc., or Calyon, as our financial advisor in our efforts to obtain debt and/or equity financing; however our agreement expired on October 31, 2007 and has not been renewed at this time. We are currently seeking a specific type of debt financing that is generally referred to as project financing. Project financing is different from traditional forms of financing because lenders principally look to the assets and revenue of the project to secure and service the debt. In this case, a potential lender will look at the polysilicon plant as an asset and source of revenue. In contrast to typical borrowed debt, in project financing the lenders are not expected to have any recourse to the non-project assets, such as Hoku Solar and Hoku Fuel Cells. We have begun investing significant amounts of our own cash resources into this project, and expect that we will continue to do so in advance of securing any debt financing.

We believe that prior to obtaining debt financing we will have to satisfy potential lenders that we have adequately addressed the principal risks associated with the project including risks that: (1) the construction of the polysilicon plant is not completed on time, on budget, or at all; (2) the polysilicon plant does not operate at its full capacity; or (3) the polysilicon plant fails to generate sufficient revenue to service the debt. In order to address these risks we are taking the below actions.

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In March 2007, we awarded a contract to VECO USA, Inc. for initial design phase engineering, procurement and construction management services related to our polysilicon plant. VECO has completed this initial design phase, and in August 2007, we entered into an agreement with S&W to provide the additional engineering, procurement, and construction management services for a polysilicon production plant with an annual capacity of up to 2,500 metric tons. S&W will be paid on a time and materials basis plus a fee for its services and incentives if certain schedule and cost targets are met. The target cost for the services to be provided under the EPCM Agreement is $41.5 million, plus up to $5.0 million of additional incentives that may be payable.

We also entered into an agreement with JH Kelly for construction services for the construction of a polysilicon production plant with an annual capacity of up to 2,500 metric tons. We will pay JH Kelly on a time and materials basis plus a fee for its services and incentives if certain schedule, cost and safety targets are met. The target cost for the services to be provided by JH Kelly is $121.0 million, including up to $5.0 million of incentives that may be payable.

We expect that the remaining costs will primarily be for equipment and other services necessary for the completion of the polysilicon production plant and will result in an aggregate project cost for a polysilicon facility with an annual capacity of 2,500 metric tons to be approximately $300 million.

Each of Sanyo, Suntech and GEWD must agree to assign any purchase payments for polysilicon made to Hoku Materials to the benefit of the lenders that may provide us with debt financing. Sanyo, Suntech and GEWD must also agree to subordinate each of their pari passu security interests in Hoku Materials to the senior security interest of such lenders. While we expect that Sanyo, Suntech and GEWD will each agree to such assignments and to execute a subordinated intercreditor agreement, they are not contractually obligated to do so at this time. In addition, each of S&W, JH Kelly, Dynamic, Idaho Power Company, Bank of Hawaii, as escrow agent, GEC and MSA and other potential vendors must also agree to assign their respective construction and/or service contracts to the lenders that may provide us with debt financing.

We have received the air permit and storm water prevention permit that are necessary to begin construction of our polysilicon plant, and we will need to apply for additional permits with federal, state and local authorities, including building permits to continue the construction our polysilicon plant, and permits to operate the plant when construction is complete. The government regulatory process is lengthy and unpredictable. We expect to obtain the necessary permits when and as required to continue construction and to operate our polysilicon plant, but we may experience delays which could cause additional expense.

We currently have limited access to our polysilicon plant site across an at-grade railroad crossing pursuant to a private crossing agreement with Union Pacific Railroad that will expire on December 31, 2012. We believe that this is sufficient to continue construction, and to date we have only experienced minor and temporary physical limitations in our ability to access the site due to the operation of the rail line by Union Pacific Railroad. We plan to install a signalized rail crossing as an interim solution, and to ultimately build an overpass across the railroad; however, prior to completion of the overpass, our lenders may require that we obtain traditional road access to the site through other legally enforceable rights of access, such as an easement, from adjoining property owners who are under no obligation to provide us with such legally enforceable rights of access. We have commenced discussions with the property owners.

We also have received a report of an independent engineering firm which supports our construction plans, our operating plans and our pro forma financial models which support the feasibility of our operating plans and business model. Although we believe we have made significant progress, at any point in time we may conclude that our plans are not financially or technologically feasible and abandon our efforts to establish a polysilicon business. Such abandonment after substantial investment of time and resources could harm our business. Lenders, suppliers, contractors, customers and regulatory agencies may have additional consents, permits and requirements which we have not anticipated that could delay or prevent us from obtaining debt financing or completing construction as currently planned. If we fail to successfully achieve any or all of the above objectives necessary to obtain financing, we will be unable to complete construction of our planned polysilicon production plant 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. Even if we achieve all of these objectives on a timely basis, obtain the needed financing and complete the construction of our production plant as currently planned, we may still be unsuccessful in developing, producing and/or selling polysilicon for numerous reasons.

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Operating Capital and Capital Expenditure Requirements

As we invest resources towards a polysilicon production and PV systems installation service business, develop our products, expand our corporate infrastructure, prepare for the increased production of our products and evaluate new markets to grow our business, we expect that our 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 commence the production of polysilicon and begin meeting the obligations under our supply contracts. 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 Hoku Fuel Cells and Hoku Solar through at least the next 12 months; however, we expect that we will need to raise up to $300 million to support the construction of our planned polysilicon facility and operations of Hoku Materials. The sale of additional equity securities or securities that are convertible into equity, may result in additional dilution to our current stockholders. If we raise additional funds through the issuance of equity 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 consolidated 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 consolidated 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 consolidated 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, 2007, 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 currently recognize revenue through service and license agreements and plan to expand the type of revenue recognized through the sale of polysilicon and PV system installations and the sale of electricity. In general, we recognize revenue when persuasive evidence of an arrangement exists, delivery of the service or product has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured.

Polysilicon and PV Systems Installations Revenue Recognition. Revenue from polysilicon and PV system installations will be recognized in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition , 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. Revenue from the sale of electricity will be recorded when collection is reasonably assured.

Hoku Fuel Cell Revenue Recognition. For arrangements that do not fall within the scope of higher-level authoritative literature, we recognize revenue under Staff Accounting Bulletin No. 104, Revenue Recognition , 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.

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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.

We also provided testing and engineering services to customers pursuant to milestone-based contracts that were not multi-element arrangements. These contracts sometimes provided for periodic invoicing as we completed a milestone. Customer acceptance was usually required prior to invoicing. We recognized 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 deferred the contract fulfillment costs and any advance payments received from the customer and recognized the costs and revenue in our statement of operations once the contract was completed and the final customer acceptance, if required, had 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 public 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 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.

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Accounting for the Impairment or Disposal of Long Lived Assets. In accordance with Statement of Financial Accounting Standards No. 144, or SFAS No. 144, Accounting for the Impairment or Disposal for Long-Lived Assets, we evaluate the carrying value of our long-lived assets whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Such events or circumstances include, but are not limited to, a prolonged industry downturn, a significant decline in our market value, or significant reductions in projected future cash flows.

As a result of the downsizing of our fuel cell business, and the change in business strategy to not manufacture solar modules, we are exploring the potential sale of our land and facility in Kapolei, and the relocation to a smaller leased warehouse and office space on Oahu. As we have not exited any business and are only exploring the possibility of the sale of the land and facility, there are no costs to be recorded in accordance with SFAS No. 144.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 157, or SFAS 157, Fair Value Measurements . This new standard establishes a framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS 157 also expands financial statement disclosure requirements about a company’s use of fair value measurements, including the effect of such measures on earnings. This standard is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. While we are currently evaluating the provisions of SFAS 157, we do not expect the adoption of this statement to have a material impact on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of SFAS No. 115, or SFAS 159. This new standard permits companies to choose to measure many financial instruments and certain other items at fair value that are currently not required to be measured at fair value. This standard is effective for fiscal years beginning after November 15, 2007. While we are currently evaluating the provisions of SFAS 159, we do not expect the adoption of this statement to have a material impact on our consolidated 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.