Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Overview

During the first quarter of fiscal 2009, we generated $68.1 million in net revenues, which is over 29.0% greater than our net revenues of $52.8 million in the first quarter of fiscal year 2008. The substantial increase in net revenues over the net revenues generated in the same period of last year was primarily due to the significant increase in revenues from the sale of our aluminum case cells and cylindrical cells. Our strong cylindrical cell sales largely resulted from increased sales to the laptop computer market. We also continued to make progress in expanding our manufacturing capability to afford us first-tier OEM capabilities, and in working to satisfy the qualification processes of targeted first-tier OEMs. Our achievements during the first quarter of fiscal year 2009 include the following:

� Net revenue remained strong in the midst of the global financial crisis and recession; gross margin remained at a similar level to our previous fiscal quarter's gross margin;

� Revenue from cylindrical cells, used primarily in notebook computers, continued to be strong, accounting for 27% of total revenue; prismatic cells revenue continued to grow, reflecting our further penetration into the China OEM cellular phone market;

� We implemented cost-cutting measures, and in combination with other initiatives that we took during the most recent fiscal quarter, we expect a reduction of quarterly general and administrative operating expenses of at least $1.5 million for the current and coming quarters of fiscal year 2009 as compared to such expenses for the first quarter of this fiscal year;

� Our "Electric Vehicles Lithium-phosphate Power Battery Industrialization Project" was accepted into the PRC's National High Technology Research and Development Program, or "863 Program", by the PRC's Ministry of Science and Technology.

As reflected by our overall strong net revenues for the first quarter of fiscal year 2009, we mitigated the potentially negative effects of the global financial crisis and recession. However, during this time, the financial crisis and recession adversely affected many of the markets that our customers serve which consequently exposes us to potentially inferior operating results . For example, our polymer cell customers, which are based mainly in the United States, suffered serious adverse effects from the financial crisis and recession. As a result, our polymer battery sales for the last fiscal quarter suffered.

In the near-term, we anticipate operating challenges due to the global financial crisis and recession, including lower market demand, which may in turn compel us to lower selling prices. These challenges may impede the trend of increasing our revenues. In response to these challenges, in the first quarter of fiscal 2009, we initiated a number of actions to cut costs and expenses. These included reductions in total headcount, work hours for hourly workers, and compensation packages for salaried employees, including senior executives. Employees were also required to take unpaid leaves and will be required to take longer holiday leaves for the Chinese New Year. Beyond the last fiscal quarter, we suspended our prismatic cell production for January 2009 to reduce unneeded inventory and to lower our energy costs. All of these measures are expected to reduce quarterly general and administrative operating expenses by at least $1.5 million for the current and coming quarters of fiscal year 2009 as compared to such expenses for the first quarter of this fiscal year. In addition, our sales of prismatic cells for the cellular phone market remained strong during the last fiscal quarter, and we seek to increase the market share of our prismatic cells for OEM cellular phones in China. We also plan to increase our investment in sales and marketing with regard to our polymer cells and cylindrical cells, as these markets have been significantly negatively impacted by the global financial crisis and recession. In addition, we are pursuing opportunities to raise our selling prices by penetrating high-end markets, and to further reduce the purchase costs of raw materials.

From a long-term perspective, we believe that our investment in building our first tier OEM capabilities and increasing our production capacity will ultimately improve our profitability and competitiveness as increased volume absorbs the higher fixed overhead costs of the investment in applicable equipment and infrastructure once we have completed the qualification processes of applicable first tier OEM companies.

To help us finance and expand our operations, we have access to $145.7 million in short-term credit facilities and $64.5 million in long-term credit facilities. As of December 31, 2008, the principal outstanding amounts under our credit facilities included short-term bank loans of $112.1 million, long-term bank loans of $13.2 million maturing within one year and long-term bank loans of $46.9 million maturing in over one year, and bills payable of $22.9 million, leaving $10.7 million of short-term funds and $4.4 million of long-term funds available for additional cash needs. In addition, on July 10, 2008, our $60.0 million shelf registration statement was declared effective by the SEC, pursuant to which we have issued $16.0 million in securities, giving us the potential to raise up to an additional aggregate $44.0 million in gross proceeds from future equity financings.

Our Business

We are one of the largest manufacturers of lithium-ion battery cells in the world, as measured by production output. We produce battery cells that are the principal component of rechargeable batteries commonly used to power the following applications:

� cellular phones-customer segments include OEM customers and replacement battery manufacturers;

� notebook computers;

� portable consumer electronics, such as digital cameras, portable media players, portable gaming devices and personal digital assistants, or PDAs; and

� other applications, such as cordless power tools, mining lamps, light electric vehicles, and hybrid electric vehicles.

We conduct all of our operations in China, in close proximity to China's electronics manufacturing base and its rapidly growing market, and have distribution offices in Taiwan, India, Germany, and the United States where our sales representatives market and sell our products and also provide after-sale service. Historically, we have primarily manufactured prismatic lithium-ion cells for the cellular phone replacement battery market and the OEM market. Our products are packed into batteries by third-party battery pack manufacturers in accordance with the specifications of manufacturers of portable electronic applications. At the request of our customers that order prismatic battery packs, we also engage pack battery manufacturers to assemble our prismatic cells into batteries for a fee and then sell battery packs to these customers both for the replacement and OEM markets.

Financial Statement Presentation

Net revenues. Our net revenues represent the invoiced value of our products sold, net of value added taxes ("VAT"), sales returns, trade discounts and allowances. We are subject to VAT, which is levied on most of our products at the rate of 17% on the invoiced value of our products. Provision for sales returns are recorded as a reduction of revenue in the same period that revenue is recognized. The provision for sales returns represents our best estimate of the amount of goods that will be returned from our customers based on historical sales returns data.

Cost of Revenues. Cost of revenues consists primarily of material costs, employee remuneration for staff engaged in production activity, share-based compensation, depreciation and related expenses that are directly attributable to the production of products. Cost of revenues also includes write-downs of inventory to lower of cost or market. Cost of revenues from the sales of battery packs includes the fees we pay to pack manufacturers for assembling our prismatic cells into battery packs.

Research and Development Expenses. Research and development expenses primarily comprise of remuneration for R&D staff, share-based compensation, depreciation and maintenance expenses relating to R&D equipment, and R&D material costs.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of remuneration for staff involved in selling and marketing efforts, including staff engaged in the packaging of goods for shipment, advertising cost, depreciation, share-based compensation and travel and entertainment expenses. We do not pay slotting fees to retail companies for displaying our products, engage in cooperative advertising programs, participate in buy-down programs or similar arrangements. No material estimates are required by management to determine our actual marketing or advertising costs for any period.

General and Administrative Expenses. General and administrative expenses consist primarily of employee remuneration, share-based compensation, professional fees, insurance, benefits, general office expenses, depreciation, liquidated damages, and bad debt expenses.

Government Grant Income / Other Income. Government grant income for the three months ended December 31, 2008 mainly consisted of receipt of grant funds to subsidize the interest expenses incurred by the Company in prior years for research and development activities, to reward Shenzhen BAK for its contributions to the Shenzhen area's economy, and to subsidize the payment for land use rights of BAK Industrial Park. Government grant income for the three months ended December 31, 2007 mainly consisted of government grant funds to subsidize the interest expenses incurred by the Company in prior years for research and development activities and to refund the valued-added tax by Shenzhen BAK in prior years in light of Shenzhen BAK's qualification as a new and high-technology enterprise. No present or future obligation arises from the receipt of such amount.

Finance Costs, Net. Finance costs consist primarily of interest income, interest on bank loans, net of capitalized interest, and bank charges.

Income Taxes. Under PRC income tax laws and regulations, before January 1, 2008, a foreign-invested enterprise ("FIE") was generally subject to an enterprise income tax rate of 33.0%, which included a 30% state income tax and a 3.0% local income tax. However, from at least calendar year 2002 through calendar year 2007, an enterprise recognized as a "Manufacturing Enterprise Located in Special Economic Zone" under PRC tax laws was entitled to a preferential income tax rate of 15%. Moreover, a foreign-invested manufacturing enterprise, starting from its first profitable calendar year after offset of accumulated tax losses, was entitled to a two-year exemption from enterprise income tax followed by a three-year 50% reduction in its enterprise income tax rate. An enterprise qualified for such treatment may receive a further tax rate reduction related to the size of qualified capital contributions received. In addition, from at least calendar year 2002 through calendar year 2007, an enterprise qualified as an "advanced technology enterprise" under PRC tax law was also entitled to a 50% reduction of income taxes.

Shenzhen BAK and BAK Electronics are both registered and operate in Shenzhen, the PRC, and are each recognized as "Manufacturing Enterprise Located in Special Economic Zone." As a result, they have been entitled to a preferential income tax rate of 15%. In accordance with the relevant income tax laws, the profits of Shenzhen BAK and BAK Electronics were fully exempted from income tax for two years from the first profitable calendar year of operations after offset of accumulated tax losses, followed by a 50% exemption for the immediate next three calendar years (the "Tax Holiday").

The Tax Holiday of Shenzhen BAK commenced in 2002, the first calendar year in which Shenzhen BAK had assessable profit, and ended on December 31, 2006. In addition, due to our qualified capital contributions to Shenzhen BAK in both 2005 and 2006 and Shenzhen BAK's qualification as an advanced technology enterprise in 2007 and 2008, Shenzhen BAK was granted a preferential income tax rate of 3.309%, 3.82%, 7.5%, and 11.8% for calendar years 2005, 2006, 2007, and 2008, respectively. In accordance with the transition period of the new corporate income tax law (the "New CIT Law") described below, Shenzhen BAK's income tax rate for calendar years 2009, 2010 and 2011 is expected to be 20%, 22%, and 24%, respectively, before the application of any applicable tax preferences. Starting in calendar year 2012, it is expected to be subject to an income tax rate of 25%.

BAK Electronics, established in August 2005, has been eligible for the same preferential tax treatment previously applicable to Shenzhen BAK and was in the Tax Holiday and fully exempt from any enterprise income tax for calendar years 2006 and 2007 followed by a three-year 50% reduction in its enterprise income tax rate. In addition, pursuant to the transition period of the New CIT Law described below, and before considering the above-mentioned 50% reduction, BAK Electronics' income tax rate for calendar year 2008 was 18%, and for calendar years 2009, 2010, and 2011 are expected to be 20%, 22%, and 24%, respectively. Therefore, BAK Electronics' income tax rate after consideration of its Tax Holiday was 9% for calendar year 2008, and is expected to be 10%, 11%, and 24% for calendar years 2009, 2010, and 2011, respectively. Starting in calendar year 2012, it is expected to be subject to an income tax rate of 25%.

Shenzhen BAK and BAK Electronics received in aggregate a tax benefit of $50,000 pursuant to their Tax Holiday for the three months ended December 31, 2008, or $0.0008 per basic share.

BAK Tianjin is currently exempted from any enterprise income tax due to cumulative tax losses.

On March 16, 2007, the National People's Congress of the PRC adopted the New CIT Law. The New CIT Law unifies the application scope, tax rate, tax deduction and preferential policy for both domestic enterprises and FIEs. The New CIT Law became effective on January 1, 2008. According to the New CIT Law, the applicable income tax rate for Shenzhen BAK, BAK Electronics and BAK Tianjin will be 25% after their preferential tax holidays and the transition period of the New CIT Law have ended, before the application of any applicable tax preferences. This transition period started in 2008 and will end in 2011. Pursuant to the transition period, tax rates for subject entities were 18% for calendar year 2008, and are expected to be 20%, 22%, and 24% for calendar years 2009, 2010, and 2011, respectively, before the application of applicable tax holidays or other tax preferences.

China BAK Battery, Inc. is subject to U.S. tax at the statutory rate of 35%. We have not made provisions for any U.S. tax because we have determined that we have no U.S. taxable income.

Our Canadian subsidiary, BAK Canada, is subject to Canada's profits tax at the rate of 38%. However, because it does not have any assessable income derived from or arising in Canada, it has not paid any Canadian profits tax.

Our German subsidiary, BAK Europe, is subject to Germany's profits tax at the rate of 25%. However, because it does not have any assessable income derived from or arising in Germany, it has not paid any German profits tax.

Our Indian subsidiary, BAK India, is subject to India's profits tax at the rate of 30%. However, because it does not have any assessable income derived from or arising in India, it has not paid any Indian profits tax.

Our Hong Kong subsidiary, BAK International, is subject to Hong Kong's profits tax at the rate of 16.5%. However, because it does not have any assessable income derived from or arising in Hong Kong, it has not paid any Hong Kong profits tax.

Our effective tax benefit rate was 12.9% and 9.2% for the three months ended December 31, 2007 and 2008 respectively.

Net Revenues. Net revenues increased to $68.1 million for the three months ended December 31, 2008 as compared to $52.8 million for the same period of the prior year, an increase of $15.3 million or 29.0%. Our net revenues were greater for the fiscal quarter ended December 31, 2008 than for the same period of the prior year in part because of increased shipments as we ramped up our production capacity to meet increased customer orders for our products. The following sets forth the breakdown of our net revenues by battery cell type for the periods indicated.

� Net revenues from the sales of steel-case cells decreased to $3.1 million in the three months ended December 31, 2008 from $9.8 million in the same period of 2007, a decrease of $6.7 million or 68.3%, due to our strategic reduction of steel-case cell production in order to increase our aluminum-case cell production capacity, to facilitate our transition from the secondary market to the OEM market, and to capitalize on the greater benefits of aluminum-case cells. During the three months ended December 31, 2008, the price and profit margin of steel-case cells were lower than those of aluminum-case cells, and market demand for aluminum-case cells was stronger than that for steel-case cells. We started to phase out the production of steel-case cells during the fiscal quarter ended December 31, 2008, so we expect revenue from steel-case cells to be minimal in coming quarters.

� Net revenues from the sales of aluminum-case cells increased to $37.3 million in the three months ended December 31, 2008 from $30.1 million in the same period of 2007, an increase of $7.2 million or 24.0%, due to an increase in sales volume of 5.0% driven by increased sales to the OEM market in the PRC and an increase in our average selling price by 18.1%.

� Net revenues from sales of battery packs increased to $5.4 million in the three months ended December 31, 2008 from $5.0 million in the same period of 2007, an increase of $408,000 or 8.1%. This increase was due to an increase in our average selling price of 13.8% driven by increased sales to the OEM market in the PRC, which offset a decrease in sales volume of 4.9%.

� Net revenues from the sales of cylindrical cells increased to $18.4 million in the three months ended December 31, 2008 from $2.6 million in the same period of 2007, an increase of $15.8 million or 615.7%, due to an increase of 471.8% in sales volume and an increase of 25.2% in average selling price, driven by increased sales to the laptop computer market.

� We also sold $3.9 million of lithium polymer cells in the three months ended December 31, 2008, compared to $5.4 million of lithium polymer cells in the same period of 2007, a decrease of $1.5 million or 27.4%, due to a decrease of 34.6% in sales volume offset by an increase of 10.7% in our average selling price as a result of a decline in market demand relating to the global financial crisis and recession.

Cost of Revenues. Cost of revenues increased to $57.5 million for the three months ended December 31, 2008, as compared to $45.7 million for the same period of 2007, an increase of $11.8 million or 25.9%. The increase in cost of revenues was mainly due to an increase of sales volume.

As a result, gross profit for the three months ended December 31, 2008 was $10.6 million or 15.6% of net revenues as compared to gross profit of $7.1 million or 13.5% of net revenues for the same period of 2007. The increase in gross profit as a percentage of net revenues was primarily due to the significant increase in sales of cylindrical cells as a result of increased sales to the laptop computer market, and an increase in our average selling price, which together generated a higher gross margin.

Research and Development Expenses. Research and development expenses increased to $1.4 million for the three months ended December 31, 2008, as compared to $1.3 million for the same period of 2007, an increase of $99,000 or 7.5%. Salaries related to R&D staff increased to $568,000 from $377,000 for the same period of the prior year, an increase of $191,000, primarily due to our hiring of additional R&D professionals. Equity-based compensation included in R&D expenses was $207,000 for the three months ended December 31, 2008, as compared to $306,000 for the same period of the prior year, a decrease of $99,000 or 32.4%, mainly due to stock options granted to the employees in our R&D department on June 25, 2007, January 28, 2008 and May 29, 2008.

Sales and Marketing Expenses. Sales and marketing expenses increased to $1.6 million for the three-month period ended December 31, 2008 as compared to $1.3 million for the same period of 2007,an increase of $252,000 or 18.7%, primarily due to a $124,000 increase in salaries and a $44,000 increase in packing expenses due to increased sales. As a percentage of net revenues, sales and marketing expenses decreased to 2.3% for the three months ended December 31, 2008, from 2.6% for the same period of 2007.

General and Administrative Expenses. General and administrative expenses increased to $6.8 million or 10.0% of net revenues for the three months ended December 31, 2008, as compared to $4.2 million or 8.0% of net revenues for the same period of 2007, an increase of $2.5 million or 59.5%. Share-based compensation included in general and administrative expenses increased by $199,000 due to new stock options granted to the employees in our general administration department on June 25, 2007, January 28, 2008 and May 29, 2008. We also recognized an exchange loss of $704,000 for the three months ended December 31, 2008. Salaries and benefit expenses increased by $530,000 in the aggregate due to an increase in average salaries paid. Bad debt expenses increased by $1.1 million primarily due to delayed collection of accounts receivable relating to the timing of the Chinese New Year holiday.

During the fiscal quarter ended December 31, 2008, we incurred liability for liquidated damages to a shareholder whose shares were required to be included in an effective resale registration statement on Form S-3 by a certain date pursuant to a registration rights agreement that we entered into with this shareholder and certain other investors in relation to a private placement that we closed in November 2007. The SEC did not declare this registration statement effective by the necessary date, and we therefore became liable for liquidated damages to this shareholder and the other investors in this offering, as disclosed in our previous reports. As of December 31, 2008, we believe that we were not liable for any liquidated damages relating to the November 2007 registration rights agreement. The above-referenced shareholder waived any claim to liquidated damages during the fiscal quarter ended December 31, 2008. The other investors who had been party to the November 2007 registration rights agreement, or affiliates under their control, had received shares of our common stock in a subsequent offering at prices that had been discounted by the full amounts that were owed to them. Please see Part II, Item 1. "Legal Proceedings - Liquidated Damages Pursuant to November 2007 Registration Rights Agreement" for a further description of these liquidated damages. We therefore did not recognize in general and administrative expenses any amount for liquidated damages for the three months ended December 31, 2008; we likewise did not recognize any such charges for the same period of the previous year.

Operating Income. As a result of the above, operating income totaled $816,000 for the three months ended December 31, 2008 as compared to operating income of $201,000 for the same period of the prior year, an increase of $615,000 or 306.0%. As a percentage of net revenues, operating income was 1.2% for the three months ended December 31, 2008, as compared to 0.4% for the same period of the prior year.

Finance Costs, Net. Finance costs, net increased to $2.8 million for the three-month period ended December 31, 2008, as compared to $2.2 million for the same period of the prior year, an increase of $616,000 or 27.7%. We have $112.1 million in short-term bank loans maturing in less than one year, $13.2 million in long-term bank loans maturing within one year, and $46.9 million in long-term bank loans maturing in more than one year, outstanding as of December 31, 2008, as compared to $99.9 million in short-term bank loans, $6.8 million in long-term bank loans maturing within one year, and $34.2 million in long-term bank loans maturing in more than one year, respectively, outstanding as of December 31, 2007. The increase in net finance costs is mainly attributable to the increase in outstanding principal of both our short-term and long-term bank loans.

Government Grant Income. Government grant income was $102,000 for the three months ended December 31, 2008 as compared to $901,000 for the same period of 2007, a decrease of $799,000 or 88.7%. Government grant income for the three months ended December 31, 2008 mainly consisted of receipt of grant funds of $32,000 to subsidize the interest expenses incurred by the Company in prior years for research and development activities, $12,000 to reward Shenzhen BAK for its contributions to the Shenzhen economy, and $58,000 to subsidize the payment for land use rights of BAK Industrial Park. Government grant income for the three months ended December 31, 2007 mainly represented receipt of grant .