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Could Financial Scandal Decouple Zoltek Growth?

Carbon Composite A producer of parts for wind turbines faces investigation into accounting irregularities that could have serious consequences for its business.

Zoltek Companies recently disclosed that its audit committee is reviewing two unauthorized fund transfers amounting to $250,000 from a company subsidiary. The supplier of carbon fiber reinforced composites used in wind turbines now faces a potential delisting from the Nasdaq, as it is late filing its first-quarter earnings report with the SEC due to the ongoing internal review of the accounting errors, according to a regulatory filing on May 22, 2008.

Zoltek Companies LogoThe Securities and Exchange Commission is initiating its own fact-finding investigation into the matter, too.

A delisting and/or SEC enforcement action could prove disastrous to Zoltek -- just when the company is on the verge of profitability.

The company is experiencing explosive growth due to sharply increased demand for commercial carbon fibers, principally from producers of large composite blades used in wind turbines, including Denmark-based Vestas Wind Systems and DeWind of Germany. Sales increased 63 percent to $150.9 million in the fiscal year ended last Sept. 30.

To support growth, Zoltek expanded its manufacturing capacity from two carbonization lines in early 2005 to a current 18 lines. Operating results, however, continue to be hampered by capacity expansion programs and higher raw material costs, including energy and acrylic fiber precursors (which alone comprises about 50% of aggregate cost of producing carbon fibers.) Nonetheless, unit volume growth increases and improved efficiencies at its carbon fiber manufacturing facility in Abilene, Texas, offset increased cost of goods, and Zoltek reported a narrower net loss of $2.0 million in fiscal 2007, compared with a net loss of $65.8 million in fiscal year 2006.

To fund growth, management has historically tapped the credit and equity markets. For example, in 2007 the company raised $155.5 million from the issuance of common stock.

Accordingly, if Zoltek loses its pending appeal before the Nasdaq (date of hearing to be determined), the company's ability to raise capital for its expansion program would be limited. Its common stock as currency would be about as attractive as Continental dollars issued during the Revolutionary War, as most institutional investors cannot invest in bulletin-board companies.

The antagonist in this story is likely Kevin Schott, 41, who resigned as the company's chief financial officer effective May 1. Although Zoltek did not give a reason for Schott's departure, a filing with the SEC disclosed -- coincidentally enough -- that Schott would pay the company $250,000 in connection with his resignation.

This story reads like a mystery novel, too. Grant Thornton, Zoltek's outside auditor, warned the company in December 2007 that it had "identified material weaknesses in Zoltek's internal control over financial reporting.... Additionally, these deficiencies resulted in more than a remote likelihood that a material misstatement of the annual or interim financial statements would not be prevented or detected."

Flipping through to the last chapter, who do you think played a lead role in conducting a follow-up assessment of the effectiveness of the company's internal control over financial reporting? Kevin Schott.

The strongest carbon fibers are ten times stronger than steel and eight times hardier than aluminum. Little good that bit of trivia will be to Zoltek when the SEC is done looking through the fabric of its financial accounting systems.

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