UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K

 

 

 

Commission file no. 1-33001

 

ENOVA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

1560 West 190th Street, Torrance, California 90501

(Address of principal executive offices, including zip code)

 

Registrant’s telephone number, including area code:

(310) 527-2800

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act:  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act:  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)  Yes o     No þ

 

As of June 30, 2010, the approximate aggregate market value of common stock held by non-affiliates of the Registrant was $10,224,000 (based upon the closing price for shares of the Registrant’s common stock as reported by The NYSE Amex). As of February 28, 2011, there were 31,485,953 shares of common stock, no par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

None.

 

 

ENOVA SYSTEMS, INC.

 

2010 FORM 10-K ANNUAL REPORT

 

TABLE OF CONTENTS

 

 

 

General

 

In July 2000, we changed our name to Enova Systems, Inc. (“Enova” or “the Company”). Our company, previously known as U.S. Electricar, Inc., a California corporation, was incorporated on July 30, 1976.

 

Enova believes it is a leader in the development, design and production of proprietary, power train systems and related components for electric and hybrid electric buses and medium and heavy duty commercial vehicles. Electric drive systems are comprised of an electric motor, an electronics control unit and a gear unit which power a vehicle. Hybrid electric systems, which are similar to pure electric drive systems, contain an internal combustion engine in addition to the electric motor, and may eliminate external recharging of the battery system. A hydrogen fuel cell based system is similar to a hybrid system, except that instead of an internal combustion engine, a fuel cell is utilized as the power source. A fuel cell is a system which combines hydrogen and oxygen in a chemical process to produce electricity.

 

A fundamental element of Enova’s strategy is to develop and produce advanced proprietary software and hardware for applications in these alternative power markets. Our focus is powertrain systems including digital power conversion, power management and system integration, focusing chiefly on vehicle power generation.

 

Specifically, we develop, design and produce drive systems and related components for electric, hybrid electric and fuel cell powered vehicles in both the new and retrofit markets. We also perform internal research and development (“R&D”) and funded third party R&D to augment our product development and support our customers.

 

Our product development strategy is to design and introduce to market successively advanced products, each based on our core technical competencies. In each of our product/market segments, we provide products and services to leverage our core competencies in digital power management, power conversion and system integration. We believe that the underlying technical requirements shared among the market segments will allow us to more quickly transition from one emerging market to the next, with the goal of capturing early market share.

 

Enova’s primary market focus centers on aligning ourselves with key customers and integrating with original equipment manufacturers (“OEMs”) in our target markets we believe that alliances will result in the latest technology being implemented and customer requirements being met, with an optimized level of additional time and expense. As we penetrate new market areas, we are continually refining both our market strategy and our product line to maintain our leading edge in power management and conversion systems for vehicle applications.

 

Our website, www.enovasystems.com, contains up-to-date information on our company, our products, programs and current events. Our website is a prime focal point for current and prospective customers, investors and other affiliated parties seeking additional information on our business.

 

We continue to develop existing relationships and enter into new development programs with both governmental and private industry with regards to both commercial and military application of our electric and hybrid electric drive systems and fuel cell power management technologies. Although we believe that current negotiations with several parties may result in development and production contracts during 2011 and beyond, there are no assurances that such additional agreements will be realized.

 

During 2010, we continued to produce electric and hybrid electric drive systems and components for First Auto Works of China (“FAW”), Navistar Corporation (“Navistar”), Tanfield Engineering Plc (“Tanfield”), Smith Electric Vehicles (“Smith”), Freightliner Custom Chassis Corporation (“Freightliner”) and the US Military as well as several other domestic and international vehicle and bus manufacturers. We also were successful in characterizing our electric drive system components with Freightliner’s chassis in late 2010. Our various electric and hybrid-electric drive systems, power management and power conversion systems are being used in applications including several light, medium and heavy duty trucks, train locomotives, transit buses and industrial vehicles.

Enova believes that its business outlook will continue to improve in line with the recovery of the world economy and in light of messages from the governments in the United States, China and the United Kingdom regarding their intentions to mandate the reduction of green house gas emissions in the future as well as intentions to provide government incentives that may induce consumption of our products and services.

 

The Company delivered a total of 369 full systems and 48 additional motor controller units of Enova drive systems to its customers. Enova delivered 149 all-electric drive systems to Smith in 2010. Smith’s Newton product offering carries a GVWR of 26,000 lbs. Enova also delivered 120 pre-transmission hybrid drive systems to FAW for their Jiefang 103 passenger hybrid bus and 25 charge depleting bus systems to Navistar during the year.

 

For the year ended December 31, 2010, the following customers each accounted for more than ten percent (10%) of our total revenues:

 

 

Please refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 below and our financial statements in Item 8 below for further analysis of our results.

 

Climate Change Initiatives and Environmental Legislation

 

Due to vehicles powered by internal combustion engines cause pollution (green house gasses), there has been significant public pressure in Europe and Asia to reduce these emissions. Thus, countries in Europe and Asia and the US (federal and state levels) have enacted or pending legislation in Europe, to promote the use of zero or low emission vehicles. We believe legislation requiring or promoting zero or low emission vehicles is necessary to create a significant market for both hybrid electric (“HEV”) and electric vehicles (“EV”).

 

The California Air Resources Board (“CARB”) is continually modifying its limits for low emission vehicles. Governor Arnold Schwarzenegger’s Executive Order S-01-07, the Low Carbon Fuel Standard (“LCFS”) calls for a reduction of at least 10 percent in the carbon intensity of California’s transportation fuels by 2020. Also, the U.S. Environmental Protection Agency (“EPA”) found that six greenhouse gases (carbon dioxide (“CO₂”), methane (“CH4”), nitrous oxide (“N2O”), hydrofluorocarbons (“HFCs”), perfluorocarbons (“PFCs”), and sulfur hexafluoride (“SF6”)) taken in combination endanger both the public health and public welfare of current and future generations. The EPA also found that the combined emissions of these greenhouse gases from motor vehicles and internal combustion engines contribute to the greenhouse gas air pollution that endangers public health and welfare under the Clean Air Act, Section 202(a). The Company believes these types of government findings are beneficial to a more prompt transition into alternative fuel vehicle commercialization and may act as a catalyst for demand of our products. However, there are no assurances revenues from these government regulations will be realized.

 

The current U.S. administration has proposed implementing a wide array of government initiatives and laws which are designed to be “environmentally-friendly”. Proposals such as an increase in fuel economy standards (i.e. CAFE), placing one million plug-in electric vehicles on the road by 2015, financing in the form of tax credits and loan guarantees to domestic auto and parts manufacturers (i.e. ATVM Loan Program and Heavy Duty Hybrid Tax Credit) and investing in an electrical infrastructure are all considered by management to be conducive to an environment where our products and services may thrive. In order to advance these types of initiatives by using the U.S. government as a model, President Barack Obama signed Executive Order No. 13514 titled “Federal Leadership in Environment, Energy, and Economic Performance.” This Executive Order directs Federal agencies to set 2020 greenhouse gas emissions reduction targets, increase energy efficiency, reduce fleet petroleum consumption by 30% by 2020, conserve water, reduce waste, support sustainable communities, and leverage Federal purchasing power to promote environmentally responsible products and technologies. The Company believes these types of initiatives may assist in a more prompt transition into alternative fuel vehicle commercialization. Although the Company believes these planned initiatives will be pursued by the current U.S. administration, there are no assurances any revenues will be realized from such proposals or initiatives.

In the United Kingdom, the Environmental Transformation Fund (“ETF”) was formed by the UK government in April 2008 as an initiative to move forward the commercialization of low carbon energy and energy efficiency technologies in the UK and developing countries. In particular, it focuses on the demonstration and deployment phases of bringing low carbon technologies to the market. The UK element of the ETF will total 400 million pounds sterling (approximately US$653 million) from 2009 through 2011. Although the Company expects our customers to benefit from the ETF, there are no assurances revenues will be realized from such benefits.

 

In China, the Ministry of Environmental Protection reported that the Ministry of Industry and Information Technology, the National Development and Reform Commission and the Ministry of Science and Technology implemented policies in early 2010 on alternative-fuel vehicles and goals for a reduction in greenhouse gases as announced at the First China Green Energy Automotive Development Summit of 2008. In addition, the Ministry of Environmental Protection reported “new energy vehicles” are currently in low numbers as their costs to produce are high and incentives will be necessary to induce consumption. Although the Company expects our customer to benefit from these policies, there are no assurances revenues will be realized from such policies.

 

As our products reduce emissions and dependence on foreign energy, they are subject to federal, state, local and foreign laws and regulations, governing, among other things, emissions as well as laws relating to occupational health and safety. Regulatory agencies may impose special requirements for implementation and operation of our products or may significantly impact or even eliminate some of our target markets. We may incur material costs or liabilities in complying with government regulations. In addition, potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future.

 

Strategic Alliances, Partnering and Technology Developments

 

Our continuing strategy is to adapt ourselves to the ever-changing environment of alternative fuel markets for mobile applications. Originally focusing on pure electric drive systems, we are currently positioned as a global supplier of drive systems for electric, hybrid and fuel cell applications.

 

We continue to seek and establish alliances with major players in the automotive and fuel cell fields. In 2010, Enova furthered its penetration into the U.S. and Asian markets. We believe the medium and heavy-duty hybrid market’s best chances of significant growth lie in identifying and pooling the largest possible numbers of early adopters in high-volume applications. We seek to utilize our competitive advantages, including customer alliances, to gain greater market share. By aligning ourselves with key customers in our target market(s), we believe that the alliance will result in the latest technology being implemented and customer requirements being met, with a minimal level of additional time or expense.

 

Some highlights of our accomplishments in 2010:

 

 

 

Throughout 2010, we finalized the development of our next generation power management and drive system component: the Omni controller. We continue to work on the development of a next generation on-board 10kW charger. Our various electric and hybrid-electric drive systems, power management and power conversion systems continue to be used in applications including Class 3-6 trucks, transit buses and heavy industrial vehicles. We also are continuing our current research and development programs and formulating new programs with the U.S. government and other private sector companies for electric and hybrid systems.

 

Some technological developments in 2010:

 

Omni Inverter.  Enova Systems recently introduced its next-generation of power electronics with the new Omni-series 200kVA-capable power inverter for hybrid-electric and all-electric vehicles. Power-source agnostic, the new Omni-series controller also offers increased flexibility and ease-of-integration. With plug-and-play connectivity, it is compatible with a wide range of vehicle drive systems and motors, and can be configured for HEV, PHEV and EV applications. Features include:

 

 

Omni On-Board Charger.  Enova started formulating the plan to develop and validate its next-generation of power electronics with the new Omni-series 10kVA power on-board charger for hybrid-electric and all-electric vehicles. The new Omni-series charger also offers increased flexibility and ease-of-integration. With plug-and-play connectivity, it is compatible with a wide range of vehicle drive systems and motors, and can be configured for HEV, PHEV and EV applications. Features will include:

 

 

 

Omni DC/DC Converter.  Enova is also entertaining complementing our aforementioned components strategies with the idea of creating a DC/DC converter unit either within the housing of the Omni charger or as a standalone unit. This plan is at a very preliminary stage but the primary features are expected to include:

 

 

Battery Suppliers

 

LG Chem Power Inc. (“LGCPI”).  Enova entered into a production intent supply partnership with LGCPI, the North American subsidiary of LG Chem Ltd., for power oriented battery packs on Enova’s charge sustaining post transmission hybrid systems. LG Chem Ltd. client list includes major domestic and international OEMs. Combined with Enova’s new Omni inverter, we believe these LGCPI battery packs will provide Enova’s customers with an advanced and robust medium duty truck and bus hybrid systems while presenting strong value and performance to the end user.

 

Enova also continues to mature its long standing relationship with Valence for their battery packs, as well as evaluating technologies offered by A123, Tesla, Samsung Bosch and Dow Kokam.

 

Research and development programs included our advanced power management systems for fuel cells, our diesel generation engine/motor system for our heavy-duty drive systems and upgrades and improvements to our current power conversion and management components. Additionally, we continue to optimize our technologies to be more universally adaptable to the requirements of our current and prospective customers. By modifying our software, we believe we should be able to provide a more comprehensive, adaptive and effective solution to a larger base of customers and applications. We intend to continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers as we deem beneficial to our global growth strategy.

 

Electric and Hybrid-Electric Drive Products

 

Enova’s hybrid and electric drive systems provide all the functionality one would find under the hood of an internal combustion engine powered vehicle. The hybrid and electric power system consists of an enhanced electric motor and the electronic controls that regulate the flow of electricity to and from the batteries at various voltages and power to propel the vehicle. In addition to the motor and controller, the system includes a gear reduction/differential unit which ensures the desired propulsion and performance. The system is designed to be installed as a “drop in,” fully integrated turnkey fashion, or on a modular, “as-needed” basis. Regardless of power source (battery, fuel cell, diesel generator or turbine) the hybrid and electric power system is designed to meet the customer’s drive cycle requirements. Enova’s all electric drive systems use largely the same designs as the hybrid systems, excepting that there is no internal combustion engine in the vehicle.

 

Hybrid vehicles are those that utilize an electric motor and batteries in conjunction with an internal combustion engine (“ICE”), whether piston or turbine. With a hybrid system, a small piston or turbine engine — fueled by gasoline or diesel, CNG, methane, etc., in a tank — supplements the electric motor and battery. These systems are self-charging, in that the operating ICE recharges the battery.

 

There are two types of hybrid systems: series and parallel. A series hybrid system is one where only the electric motor connects to the drive shaft; a parallel hybrid system is one where both the internal combustion engine and the

electric motor connect to the drive shaft. In a series hybrid system, the ICE turns the generator, which charges the battery, which — through a control unit — powers the electric motor that turns the wheels. In a parallel hybrid system, both the electric motor and the ICE can operate simultaneously to drive the wheels (see diagrams below). In both hybrid systems and in pure electric systems, regenerative braking occurs which assists in the charging of the batteries.

 

The parallel hybrid system is ideally suited for conditions where most of the driving is done at constant speed cruising, with a smaller amount of the driving involving random acceleration, such as “up hill” or with “stop and go” conditions. For acceleration, the controller causes the electric motor to assist the ICE, both running simultaneously. When speed is steady or the ground is flat, only the ICE runs. Additionally, when the batteries are low, the controller causes the ICE and motor to charge the batteries. As a result, the series hybrid system is best suited for starts and stops, and is ideal for applications such as urban transit buses and urban garbage trucks. The design of the series hybrid system is based on a driving cycle with a high percentage of random acceleration conditions.

 

Hybrid and Electric Drive Configurations

 

Enova has identified four primary configurations based upon how well they meet market needs economic requirements. We have developed all of the relevant technology required to produce these drive systems and we are currently introducing the Hybrid Power product line worldwide. All of our innovative hybrid drive systems are compatible with a wide range of fuel sources and engine configurations.

 

Series Hybrid with Diesel Generator

 

 

The Series Hybrid is typically ideal for low floor vehicles with a driving cycle that has a high percentage of stop and go and/or hilly terrain. Refuse trucks, urban delivery trucks and intra-city buses are the primary target markets for these drive systems.

 

Post Transmission Parallel Hybrid

 

 

The Post Transmission Parallel Hybrid is ideal for vehicles with a driving cycle with a high percentage of stop and go, as well as constant speed cruising. Target markets include refuse trucks, urban delivery trucks, school buses and intra-city buses.

Pre Transmission Parallel Hybrid

 

 

The Pre-Transmission Parallel Hybrid is ideal for vehicles with a driving cycle having a small percentage of constant speed cruising and a large percentage of stop and go. Target markets include inter-city transit buses and trucks as well as military vehicles.

 

All Electric Vehicle Drive System

 

 

The Electric Drive Systems works well with vehicles with a disciplined driving route that has a high percentage of stop and go conditions. Refuse trucks, urban delivery trucks and intra-city vehicles are the primary markets for these drive systems.

 

Definitions:

 

BCU — Battery Care Unit; HCU — Hybrid Control Unit; SDU — Safety Disconnect Unit; VCU — Vehicle Control Unit

 

CEU — Control Electronics Unit (Houses MCU, DC-DC, and Charger); MCU — Motor Control Unit;

 

EDM — Electric Drive Motor; EDU — Electric Drive Unit (Includes EDM & GDU); GDU — Gear Drive Unit

 

GCU — Generator Control Unit; EGM — Electric Generator Motor; ICE — Internal Combustion Engine

 

Electric Drive Motors

 

The electric drive unit is essentially an electric motor with additional features and functionality. The motor is liquid-cooled, environmentally sealed, designed to handle automotive shock and vibration, and includes parking pawl, which stops the vehicle when the driver parks the car. It also permits regenerative braking to provide power recovery, in which the mechanical energy of momentum is converted into electrical energy as the motor slows during braking or deceleration. The optional gear reduction unit takes the electric motor’s high rpm and gears it down to the lower rpm required by the vehicle’s conventional drive shaft. As the revolutions per minute (“rpm”) go down, the torque of the electric motor increases.

 

The hybrid electric drive systems exclusively utilize induction AC motors for their high performance, power density, robustness and low cost. The AC drive system is scalable and can be customized for different applications. Due to the large operating range that these propulsion systems offer, all parameters can be optimized; the user will not have to choose between acceleration, torque or vehicle speed.

Motor Controllers

 

The controller houses all the components necessary to control the powering of a vehicle, in one easy-to-install package. Our main component is an inverter, which converts DC electricity to AC electricity. We also offers optional controllers for the air conditioning, power steering and heat pumps, 12VDC/24VDC DC-to-DC converter for vehicle auxiliary loads such as cell phones, radio, lights, and a 6.6kW AC-to-DC on-board conductive charger which allows for direct 110 VAC or 220 VAC battery charging. These are located in the same housing as the controller, thus extra interconnects are not required. This approach simplifies the vehicle wiring harness and increases system reliability.

 

Using our proprietary Windows based software package, vehicle interfaces and control parameters can be programmed in-vehicle. Real-time vehicle performance parameters can be monitored and collected.

 

Drive System Accessories

 

Enova’s drive system accessories range from battery management systems to hybrid controllers, to rapid charging systems. These critical components are designed to complement the drive system family by providing the elements necessary to create a complete technical solution for alternative energy drive systems.

 

Enova’s drive system accessories are not only integral, but also are the perfect complement to our drive systems and are designed to provide our customers with a complete solution to their drive system needs.

 

Manufacturing Strategy

 

We have developed a multi-tiered manufacturing strategy that allows us to meet the market’s demand for high quality production goods while optimizing cost of goods sold across the spectrum of low to high volumes. At the core of this strategy is a strong reliance on pre-selected highly qualified outside manufacturing houses that specialize in various aspects of the manufacturing process. This closely managed outsourcing strategy helps Enova control product costs while also minimizing fixed costs within the organization.

 

Competitive Conditions

 

The competition to develop and market electric, hybrid and fuel cell powered vehicles continued to accelerate during the last year and we expect this trend to continue as governments in our target markets adopt initiatives that reduce greenhouse gas emissions. In the event governments in our target markets completely rescinded their support for the reduction of greenhouse gas emissions and sustainability initiatives, our business model would be adversely and significantly affected. Moreover, competition within the mobile hybrid sector is still somewhat fragmented, although there are indications of some consolidation at this time. The competition consists of development stage companies as well as major U.S. and international companies. The larger companies tend to focus on single solutions and maintain the capital and wherewithal to aggressively market such. The smaller competitors offer a more diversified product line, but do not have the market presence to generate significant penetration at this juncture.

 

Our research and experience has indicated that our target market segments certainly focus on price, but would buy based on reliability, performance and quality support when presented the life-cycle business model for EV-HEV technologies for their application. Our future prospects are highly dependent upon the successful development and introduction of new products that are responsive to market needs and can be manufactured and sold at a profit. There can be no assurance that we will be able to successfully develop or market any such products.

 

The development of hybrid-electric and alternative fuel vehicles, such as compressed natural gas, fuel cells and hybrid cars poses a competitive threat to our markets for low emission vehicles or LEVs but not in markets where government mandates call for zero emission vehicles or ZEVs. Enova is involved in the development of hybrid vehicles and fuel cell systems in order to meet future government requirements and applications.

 

Various providers of electric vehicles have proposed products or offer products for sale in this emerging market. These products encompass a wide variety of technologies aimed at both consumer and commercial markets. As the industry matures, key technologies and capabilities are expected to play critical competitive roles. Our goal

is to position ourselves as a long term competitor in this industry by focusing on all-electric, hybrid and fuel cell powered drive systems and related sub systems, component integration, technology application and strategic alliances.

 

We believe the Hybrid Vehicle market is poised for growth over the medium and long term and that Enova’s products are ready to participate in this market. Enova is positioned to capitalize on demands being placed on the market by offering solutions. Enova believes that our competitive advantages include:

 

 

By building a business based on long-standing relationships with satisfied clients such as Navistar, Smith Electric Vehicles, First Auto Works and Freightliner Custom Chassis Corporation , we believe we are building defenses against competition by securing customers with global reach and OEM status. Teaming with recognized global manufacturers allows Enova to avoid devoting resources to manufacturing infrastructure and allows us access to production capacity at relatively low costs.

 

Research and Development

 

Enova maintains a strategy of continual enhancement of its current product line and development of more efficient and reliable products for the ever-changing alternative energy sectors. Management believes R&D must be continued in order to be remain competitive, minimize production costs and meet our customers’ specifications. Because microprocessors and other components continue to advance in speed, miniaturization and reduction of cost, we must re-examine our designs to take advantage of such developments. We seek to provide internal funding where technology development is critical to our future.

 

For the years ended December 31, 2010, and 2009, we spent $1,838,000, and $1,228,000, respectively, on internal research and development activities. Enova is continually evaluating and updating the technology and equipment used in developing each of its products. The power management and conversion industry utilizes rapidly changing technology and we will endeavor to modernize our current products as well as continue to develop new leading edge technologies to maintain our competitive edge in the market.

 

Intellectual Property

 

Enova currently holds three U.S. patents relating to power management and control that will expire in 2015. We also have trademarks or service marks in the United States. We continually review and append our protection of proprietary technology. We continue to place emphasis on the development and acquisition of patentable technology. A majority of our intellectual property is contained within our software which we believe is best protected under trade secret intellectual property law. Under such provisions, Enova does not have to publish its proprietary code in order to maintain protection. Enova currently advanced initiatives to produce next-generation electric drive system components like the Omni Inverter and Omni 10kW On-Board Charger. In light of these advancements and initiatives, Enova made an immaterial adjustment to bring the three U.S patents to a zero book value balance.

 

The introduction of the Omni Inverter and Omni 10kW On-Board Charger may involve patenting new technology. This process involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, there can be no assurance that patent applications filed by us will result in patents being

issued. Moreover, there can be no assurance that third parties will not assert claims against us with respect to existing and future products. Although we intend to vigorously protect our rights, there can be no assurance that these measures will be successful. In the event of litigation to determine the validity of any third party claims, such litigation could result in significant expense to Enova. Additionally, the laws of certain countries in which our products are or may be developed, manufactured or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States.

 

Enova’s pending or future patent applications may not be approved and the claims covered by such applications may be reduced. If allowed, patents may not be of sufficient scope or strength, others may independently develop similar technologies or products, duplicate any of Enova’s products or design around its patents, and the patents may not provide Enova with competitive advantages. Further, patents held by third parties may prevent the commercialization of products incorporating Enova’s technologies or third parties may challenge or seek to narrow, invalidate or circumvent any of Enova’s pending or future patents. Enova also believes that foreign patents, if obtained, and the protection afforded by such foreign patents and foreign intellectual property laws, may be more limited than that provided under United States patents and intellectual property laws. Litigation, which could result in substantial costs and diversion of effort by Enova, may also be necessary to enforce any patents issued or licensed to Enova or to determine the scope and validity of third-party proprietary rights. Any such litigation, regardless of outcome, could be expensive and time-consuming, and adverse determinations in any such litigation could seriously harm Enova’s business.

 

Enova relies on unpatented trade secrets and know-how and proprietary technological innovation and expertise which are protected in part by confidentiality and invention assignment agreements with its employees, advisors and consultants and non-disclosure agreements with certain of its suppliers and distributors. If these agreements are breached, Enova may not have adequate remedies for any breach and Enova’s unpatented proprietary intellectual property may otherwise become known or independently discovered by competitors.

 

Employees

 

As of December 31, 2010, we had a total of 59 employees comprising of 17 temporary and 42 full time employee positions. In addition, we employ three individuals as independent contractors engaged on a monthly basis.

 

Available and Additional Information

 

Included in Item 8 of this 10K are audited financial statements which include revenues, a measure of profit or loss and total assets.

 

We file electronically with the SEC our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We make available free of charge on or through our website copies of these reports as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov. You may also read and copy any of our materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information regarding the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. Our website address is www.enovasystems.com. Information found on, or that can be accessed through, our website is not incorporated by reference into this annual report.

 

The statements in this Section describe the major risks to our business and should be considered carefully. In addition, these statements constitute our cautionary statements under the Private Securities Litigation Reform Act of 1995 and apply to all sections of this Form 10-K.

 

This annual report on Form 10-K, including the documents that we incorporate by reference, contains statements indicating expectations about future performance and other forward-looking statements that involve risks and uncertainties. We usually use words such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “future,” “intend,” “potential,” or “continue” or the negative of these terms or similar expressions to identify forward-looking statements. These statements appear throughout the Form 10-K and are statements regarding our current intent, belief, or expectation, primarily with respect to our operations and related industry developments. Examples of these statements include, but are not limited to, statements regarding the following: our expansion plans, our future operating expenses, our future losses, our future expenditures for research and development and the sufficiency of our cash resources. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this annual report. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in this “Risk Factors” section and elsewhere in this annual report.

 

We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could differ materially from past results and those anticipated, estimated or projected. You should bear this in mind as you consider forward-looking statements.

 

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our 10-Q and 8-K reports to the SEC. Also note that we provide the following cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our businesses. These are factors that, individually or in the aggregate, we think could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by the Private Securities Litigation Reform Act of 1995. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

 

Our history of operating losses and our expectation of continuing losses may hurt our ability to reach profitability or continue operations.

 

We have experienced significant operating losses since our inception. Our net loss was $7,420,000 for the fiscal year ended December 31, 2010 and our accumulated deficit was $144,128,000 as of December 31, 2010. It is likely that we will continue to incur substantial net operating losses for the foreseeable future, which may adversely affect our ability to continue operations. To achieve profitable operations, we must successfully develop and market our products at higher margins. We may not be able to generate sufficient product revenue to become profitable. Even if we do achieve profitability, we may not be able to sustain or increase our profitability on a quarterly or yearly basis.

 

Because we depend upon sales to a limited number of customers, our revenues will be reduced if we lose a major customer

 

Our revenue is dependent on significant orders from a limited number of customers. We typically enter into supply agreements with major customers establishing product and price standards for future periods. Subsequent events may change the needs of the customer, requiring us to make corresponding adjustments. In the fiscal year ended December 31, 2010, Smith accounted for 45% of our total revenues and our three largest customers, inclusive of Smith, comprised 85% of revenues. We believe that revenues from major customers will continue to represent a significant portion of our revenues. This customer concentration increases the risk of quarterly fluctuations in our revenues and operating results. The loss or reduction of business from one or a combination of our significant customers could adversely affect our revenues, financial condition and results of operations. Moreover, our success

will depend in part upon our ability to obtain orders from new customers, as well as the financial condition and success of our customers and general economic conditions.

 

Our future growth depends on consumers’ willingness to accept hybrid and electric vehicles

 

Our growth is highly dependent upon the acceptance by consumers of, and we are subject to an elevated risk of any reduced demand for, alternative fuel vehicles in general and electric vehicles in particular. If the market for electric vehicles does not develop as we expect or develops more slowly than we expect, our business, prospects, financial condition and operating results will be materially and adversely affected. The market for alternative fuel vehicles is relatively new, rapidly evolving, characterized by rapidly evolving and changing technologies, price competition, additional competitors and changing consumer demands or behaviors. Factors that may influence the acceptance of alternative fuel vehicles, include:

 

 

We extend credit to our customers, which exposes us to credit risk

 

Most of our outstanding accounts receivable are from a limited number of large customers. At December 31, 2010, the three highest outstanding accounts receivable balances totaled approximately $2,482,000 which represents 83% of our gross accounts receivable. If we fail to monitor and manage effectively the resulting credit risk and a material portion of our accounts receivable is not paid in a timely manner or becomes uncollectible, our business would be significantly harmed, and we could incur a significant loss associated with any outstanding accounts receivable.

 

Our business is affected by current economic and financial market conditions in the markets we serve

 

Current global economic and financial markets conditions, including severe disruptions in the credit markets and the significant and potentially prolonged global economic recession, may materially and adversely affect our results of operations and financial condition. We are particularly impacted by any global automotive slowdown and its effects on OEM inventory levels, production schedules, support for our products and decreased ability to accurately forecast future product demand.

 

The nature of our industry is dependent on technological advancement and is highly competitive

 

The mobile power market, including electric vehicle and hybrid electric vehicles, continue to be subject to rapid technological changes. Most of the major domestic and foreign automobile manufacturers: (1) have already produced electric and hybrid vehicles, (2) have developed improved electric storage, propulsion and control systems, and/or (3) are now entering or have entered into production, while continuing to improve technology or incorporate newer technology. Various companies are also developing improved electric storage, propulsion and control systems.

 

Our industry is affected by political and legislative changes

 

In recent years there has been significant legislation enacted in the United States and abroad to reduce or eliminate automobile pollution, promote or mandate the use of vehicles with no tailpipe emissions (“zero emission

vehicles”) or reduced tailpipe emissions (“low emission vehicles”). Although states such as California have enacted such legislation, we cannot assure you that there will not be further legislation enacted changing current requirements or that current legislation or state mandates will not be repealed or amended, or that a different form of zero emission or low emission vehicle will not be invented, developed and produced, and achieve greater market acceptance than electric or hybrid electric vehicles.

 

We may be unable to effectively compete with other companies who have significantly greater resources than we have

 

Many of our competitors, in the automotive, electronic, and other industries, have substantially greater financial, personnel, and other resources than we do. Because of their greater resources, some of our competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the promotion and sales of their products than we can.

 

We may be exposed to product liability or tort claims if our products fail, which could adversely impact our results of operations

 

A malfunction or the inadequate design of our products could result in product liability or other tort claims. Any liability for damages resulting from malfunctions could be substantial and could materially adversely affect our business and results of operations. In addition, a well-publicized actual or perceived problem could adversely affect the market’s perception of our products.

 

We are highly dependent on a few key personnel and will need to retain and attract such personnel in a labor competitive market

 

Our success is largely dependent on the performance of our key management and technical personnel, the loss of one or more of whom could adversely affect our business. Additionally, in order to successfully implement our anticipated growth, we will be dependent on our ability to hire additional qualified personnel. There can be no assurance that we will be able to retain or hire other necessary personnel. We do not maintain key man life insurance on any of our key personnel. We believe that our future success will depend in part upon our continued ability to attract, retain, and motivate additional highly skilled personnel in an increasingly competitive market.

 

There are minimal barriers to entry in our market

 

We presently license or own only certain proprietary technology, and therefore have created little or no barrier to entry for competitors other than the time and significant expense required to assemble and develop similar production and design capabilities.

 

Our competitors may enter into exclusive arrangements with our current or potential suppliers, thereby giving them a competitive edge which we may not be able to overcome, and which may exclude us from similar relationships.

 

 

Not applicable.

 

 

Our corporate offices are located at an office and manufacturing facility at 1560 West 190th Street, Torrance, California. We lease this 43,000 square foot office and manufacturing facility. Enova also rents an office in Hawaii on a month-to-month basis.

 

 

We are subject to a number of lawsuits, investigations and disputes (some of which involve substantial amounts claimed) arising out of the conduct of our business, including matters relating to commercial transactions. We recognize a liability for any contingency that is probable of occurrence and reasonably estimable. We continually

assess the likelihood of adverse outcomes in these matters, as well as potential ranges of probable losses (taking into consideration any insurance recoveries), based on a careful analysis of each matter with the assistance of outside legal counsel and, if applicable, other experts.

 

Most contingencies are resolved over long periods of time, potential liabilities are subject to change due to new developments, changes in settlement strategy or the impact of evidentiary requirements, which could cause us to pay damage awards or settlements (or become subject to equitable remedies) that could have a material adverse effect on our results of operations or operating cash flows in the periods recognized or paid.

 

As previously reported in an 8-K filed January 20, 2011 with date of earliest event reported being January 14, 2011, on January 6, 2011, we entered into a Partial Settlement Agreement, dated January 5, 2011 (the “Settlement Agreement”), with Arens Controls Company, L.L. C. (“Arens”) to resolve certain claims made by Arens in connection with its action captioned Arens Controls Company, L.L.C. v. Enova Systems, Inc., filed in 2008 with the Northern District of Illinois of the U.S. District Court (the “Legal Action”). The Settlement Agreement was amended by Amendment No. 1 to Partial Settlement Agreement (the “Amendment”) dated January 14, 2011.

 

In the Legal Action, Arens asserted eight counts against Enova, including certain claims regarding inventory asserted by Arens to be valued at $1,671,000 (the “Inventory Claim”), a claim for payment under certain invoices, and claims for certain other monetary obligations of Enova to Arens.

 

Under the terms of the Settlement Agreement, we paid $327,000 directly to Arens and Arens dismissed with prejudice all but two of the counts under the Legal Action. Additionally, under the Settlement Agreement (as amended), on January 14, 2011, we acquired the inventory that was the subject of the Inventory Claim (the “Inventory”) for payment of $1,498,000, net of an agreed upon reduction of $173,000 for the acquisition price of such Inventory. In return, Arens was deemed to have released us from any further liability on the Inventory Claim. However, per the terms of the Settlement Agreement (as amended), Arens is not deemed to have released us from (but instead is deemed to have preserved its claims under) two of the counts in the Legal Action. We intend to vigorously defend such remaining claims.

 

 

 

Shares of our common stock now trade on the NYSE Amex under the same and previous trading symbol “ENA” and on the London Stock Exchange AIM Market under the symbol “ENVS.L” or “ENV.L”. Our common stock became listed on the NYSE Amex on August 29, 2006. The following table sets forth the high and low sales closing prices of our Common Stock as reflected on the NYSE Amex.

 

As of December 31, 2010, there were approximately 1,500 holders of record of our Common Stock. As of December 31, 2010, 100 shareholders, many of whom are also Common Stock shareholders, held our Series A Preferred Stock. As of December 31 2010, approximately 32 shareholders held our Series B Preferred Stock. The number of holders of record excludes beneficial holders whose shares are held in the name of nominees or trustees.

 

Dividend Policy

 

To date, we have neither declared nor paid any cash dividends on shares of our Common Stock or Series A or B Preferred Stock. We presently intend to retain all future earnings for our business and do not anticipate paying cash dividends on our Common Stock or Series A or B Preferred Stock in the foreseeable future. We are required to pay dividends on our Series A and B Preferred Stock before dividends may be paid on any shares of Common Stock. At December 31, 2010, Enova had an accumulated deficit of approximately $144,128,000 and, until this deficit is eliminated, will be prohibited from paying dividends on any class of stock except out of net profits, unless it meets certain asset and other tests under Section 500 et. seq. of the California Corporations Code.

 

 

The following selected financial data tables set forth selected financial data for the years ended December 31, 2010, 2009 and 2008. The statement of operations data and balance sheet data for and as of the years ended December 31, 2010, 2009, and 2008 are derived from the audited financial statements of Enova. The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Financial Statements, including the notes thereto, appearing elsewhere in this Form 10-K.

 

 

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with our 2010 Financial Statements and accompanying Notes. The matters addressed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain certain forward-looking statements involving risks and uncertainties.

 

Overview

 

Enova Systems believes it is a leading innovator of proprietary hybrid and electric drive systems propelling the alternative energy industry. Our core competencies are focused on the development and commercialization of power management and conversion systems for mobile applications. Enova applies unique ‘enabling technologies’ in the areas of alternative energy propulsion systems for medium and heavy-duty vehicles as well as power conditioning and management systems for distributed generation systems. Our products can be found in a variety of OEM vehicles including those from Navistar Corporation, First Auto Works, Freightliner Customer Chassis Corporation, Hyundai Motor Company and Ford Motor Company, trucks and buses for Smith Electric Vehicles, Wright Bus, Optare Plc and the U.S. Military, as well as digital power systems for EDO and other major manufacturers.

 

We continue to support Navistar in their efforts to maximize exposure in the hybrid school bus market. We have been involved in large shows in St. Louis, MO, Washington, DC and the Principality of Monaco as well as smaller venues throughout the Midwest. The exposure via shows and direct interface were aggressively pursued throughout 2010 in an effort to promote our drive systems production intent for medium and heavy duty applications.

 

Some notable highlights of Enova’s accomplishments in 2010 are:

 

 

 

Enova’s product focus is digital power management and power conversion systems. Its software, and hardware manage and control the power that drives a vehicle. They convert the power into the appropriate forms required by the vehicle or device and manage the flow of this energy to optimize efficiency and provide protection for both the system and its users. Our products and systems are the enabling technologies for power systems.

 

The latest state-of-the-art technologies in hybrid and electric vehicles, fuel cell systems, all require some type of power management and conversion mechanism. Enova Systems supplies these essential components. Enova drive systems are ‘fuel-neutral,’ meaning that they have the ability to utilize any type of fuel, including diesel, liquid natural gas or bio-diesel fuels. Enova also performs significant research and development to augment and support others’ and our internal product development efforts.

 

Our products are “production-engineered.” This means they are designed so they can be commercially produced (i.e., all formats and files are designed with manufacturability in mind, from the start). For the automotive market, Enova designs its products to ISO 9001 manufacturing and quality standards. We believe Enova’s redundancy of systems and rigorous quality standards result in high performance and reduced risk. For every component and piece of hardware, there are detailed performance specifications. Each piece is tested and evaluated against these specifications, which enhances and confirms the value of the systems to OEM customers. Our engineering services focus on system integration support for product sales and custom product design.

 

In light of our efforts to grow market share in our target markets and penetrate emerging ones, the Company continues to acknowledge the principal barrier to commercialization of our drive systems is cost. The cost of engineering proprietary software and hardware for our drive systems is high because economies of production in specialized hybrid drive system component parts, batteries, and vehicle integration have not been achieved. Therefore, the cost of our products and engineering services are currently higher than our gasoline and diesel competitor counterparts. We also believe maturation into commercialization of our drive systems will result in decreases to our long run average costs of materials and services as volume increases over time.

Critical Accounting Policies

 

The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, intangible assets, income taxes, warranty obligations, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances, including current and anticipated worldwide economic conditions, both in general and specifically in relation to the hybrid and electric vehicle markets, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of this Form 10-K. We believe the following critical accounting policies necessitated that significant judgments and estimates be used in the preparation of its consolidated financial statements. We have reviewed these policies with our Audit Committee.

 

Revenue Recognition — We generally recognizes revenue at the time of shipment when title and risk of loss have passed to the customer, persuasive evidence of an arrangement exists, performance of our obligation is complete, our price to the buyer is fixed or determinable, and we are reasonably assured of collection. If a loss is anticipated on any contract, a provision for the entire loss is made immediately. Determination of these criteria, in some cases, requires management’s judgment. Should changes in conditions cause management to determine that these criteria are not met for certain future transactions, revenue for any reporting period could be adversely affected.

 

The Company also recognizes engineering and construction contract revenues using the percentage-of-completion method, based primarily on contract costs incurred to date compared with total estimated contract costs. Customer-furnished materials, labor, and equipment, and in certain cases subcontractor materials, labor, and equipment, are included in revenues and cost of revenues when management believes that the company is responsible for the ultimate acceptability of the project. Contracts are segmented between types of services, such as engineering and construction, and accordingly, gross margin related to each activity is recognized as those separate services are rendered.

 

Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Claims against customers are recognized as revenue upon settlement. Revenues recognized in excess of amounts billed are classified as current assets under contract work-in-progress. Amounts billed to clients in excess of revenues recognized to date are classified as current liabilities on contracts.

 

Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to engineering and development contract costs and revenue.

 

Warranty — We warrant our products against defects in materials and workmanship arising during normal use. We service warranty claims directly through our customer service department. Our warranty periods generally range up to eighteen months. We estimate and recognize product warranty costs, which are included in cost of sales, as we sell the related products. Warranty costs are forecasted based on the best available information, primarily historical claims experience and the expected costs. We have not made any material changes in our warranty reserve methodology during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in assumptions we use to calculate the warranty reserve. However, actual claim costs may differ from the amounts estimated. If a significant product defect were to be discovered, our financial statements may be materially impacted.

 

Allowance for doubtful accounts — The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable; however, changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. Past due balances over 90 days and other higher risk amounts are reviewed individually for collectibility. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payment, additional allowances may be required. In addition, the Company maintains a general reserve for all invoices by applying a

percentage based on the age category. Account balances are charged against the allowance after all collection efforts have been exhausted and the potential for recovery is considered remote.

 

Inventory — Inventories include material, labor, and manufacturing overhead are priced at the lower of cost or market utilizing the first-in, first-out (FIFO) cost flow assumption. We maintain a perpetual inventory system and continuously record the quantity on-hand and standard cost for each product, including purchased components, subassemblies and finished goods. We maintain the integrity of perpetual inventory records through periodic physical counts of quantities on hand (i.e., cycle counts). Finished goods are reported as inventories until the point of transfer to the customer. Generally, title transfer is documented in the terms of sale.

 

Inventory reserve — We maintain an allowance against inventory for the potential future obsolescence or excess inventory. A substantial decrease in expected demand for our products, or decreases in our selling prices could lead to excess or overvalued inventories and could require us to substantially increase our allowance for excess inventory. If future customer demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of revenues in the period the revision is made.

 

Property and Equipment — Property and equipment are stated at cost and depreciated over the estimated useful lives of the related assets, which range from three to seven years using the straight-line method for financial statement purposes. The Company uses other depreciation methods (generally, accelerated depreciation methods) for tax purposes where appropriate. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the improvements.

 

Repairs and maintenance are expensed as incurred. Expenditures that increase the value or productive capacity of assets are capitalized. When property and equipment are retired, sold, or otherwise disposed of, the asset’s cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in operations.

 

Impairment of Long-Lived Assets — The Company assesses the impairment of its long-lived assets periodically in accordance with the provisions of FASB ASC 360-10-35-15, “Impairment or Disposal of Long-Lived Assets”. The Company reviews the carrying value of property and equipment for impairment whenever events and circumstances indicate that the carrying value of an asset may not be recoverable from the estimated future cash flows expected to result from its use and eventual disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to an amount by which the carrying value exceeds the fair value of assets. The factors considered by management in performing this assessment include current operating results, trends, and prospects, as well as the effects of obsolescence, demand, competition, and other economic factors. Long-lived assets that management commits to sell or abandon are reported at the lower of carrying amount or fair value less cost to sell.

 

Intangible Assets — Intangible assets consist of patents. Intangible assets with an indefinite life are not amortized. Intangible assets with a definite life are amortized on a straight-line basis over their estimated useful lives ranging up to 20 years. Intangible assets with a definite life are tested for impairment whenever events or circumstances indicate that their carrying amounts may not be recoverable.

 

Stock-Based Compensation — The Company calculates stock-based compensation expense in accordance with FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC 718”). This pronouncement requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options, to be based on estimated fair values.

 

The Company’s determination of estimated fair value of share-based awards utilizes the Black-Scholes option-pricing model. The Black-Scholes model is affected by the Company’s stock price as well as assumptions regarding certain highly complex and subjective variables. These variables include, but are not limited to; the Company’s expected stock price volatility over the term of the awards as well as actual and projected employee stock option exercise behaviors.

 

Deferred Income Taxes — We evaluate the need for a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. We determined that we

may not be able to realize all or part of its net deferred tax asset in the future, thus a valuation allowance was recorded against our deferred tax assets.

 

These accounting policies were applied consistently for all periods presented. Our operating results would be affected if other alternatives were used. Information about the impact on our operating results is included in the footnotes to our financial statements.

 

Research and Development — Research, development, and engineering costs are expensed in the period incurred. Costs of significantly altering existing technology are expensed as incurred.

 

Recent Accounting Pronouncements

 

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition — Milestone Method (Topic 605): Milestone Method of Revenue Recognition, or ASU 2010-17. ASU 2010-17 allows the milestone method as an acceptable revenue recognition methodology when an arrangement includes substantive milestones. ASU 2010-17 provides a definition of substantive milestone, and should be applied regardless of whether the arrangement includes single or multiple deliverables or units of accounting. ASU 2010-17 is limited to transactions involving milestones relating to research and development deliverables. ASU 2010-17 also includes enhanced disclosure requirements about each arrangement, individual milestones and related contingent consideration, information about substantive milestones, and factors considered in the determination. ASU 2010-17 is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010, with early adoption permitted. The adoption of this standard did not have any impact on our consolidated financial statements.

 

In January 2010, the FASB issued ASU 2010-06 providing authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 classifications as well as provisions requiring a reconciliation of the activity in Level 3 recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on our business, financial position, results of operations or liquidity

 

In October 2009, the FASB issued ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB EITF, or ASU 2009-14. ASU 2009-14 changes the accounting model for revenue arrangements that include tangible products and software elements. The amendments of this update provide additional guidance on how to determine which software, if any, relating to the tangible product also would be excluded from the scope of the software revenue recognition guidance. The amendments in this update also provide guidance on how a vendor should allocate arrangement consideration to deliverables in an arrangement that includes tangible products and software as well as arrangements that have deliverables both included and excluded from the scope of software revenue recognition guidance. This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The adoption is not expected to have an effect on the Company’s financial position, results of operations, or cash flows.

 

In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 650): Multiple-Deliverable Revenue Arrangements — a consensus of the FASB EITF, or ASU 2009-13. ASU 2009-13 will separate multiple-deliverable revenue arrangements. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The amendments of this update will replace the term “fair value” in the revenue allocation guidance with “selling price” to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. The amendments of this update will eliminate the residual method of allocation and require that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. The amendments in this update will require that a vendor determine its best estimated selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company does not believe that the adoption of the pronouncement will have a material impact on the Company’s consolidated financial statements.

Results of Operations

 

Years Ended December 31, 2010 and 2009

 

Net Revenues.  Net revenues were $8,572,000 for the year ended December 31, 2010, representing an increase of $2,950,000 or 52% from net revenues of $5,622,000 during the same period in 2009. Revenues in the current year benefited from U.S. government grant programs, resulting in increased sales for fulfillment of orders from Smith Electric Vehicles and Navistar Inc. Smith Electric Vehicles, Navistar and FAW comprised 45%, 26% and 14% of our 2010 revenues, respectively. In the prior year, FAW, Navistar and HCATT comprised 56%, 15% and 13% of our 2009 revenues, respectively. The Company continued its strategy to concentrate support to core customers in 2010 in our migration to a first tier production company, recording sales with several OEMs, including Navistar, Freightliner and Smith Electric Vehicles in the United States and FAW in China. Although we have seen indications for future production growth, there can be no assurance there will be continuing demand for our products and services.

 

Cost of Revenues.  Cost of revenues were $7,159,000 for the year ended December 31, 2010, compared to $5,016,000 for the year ended December 31, 2009, representing an increase of $2,143,000, or 43%. Cost of revenues increased in 2010 compared to the same period in the prior year primarily due to the increase in revenue. The improvement in cost of revenues is primarily attributable to our strategy to concentrate on higher volume production orders and our continuing focus on manufacturing and inventory processes that resulted in tighter control over production costs. Cost of revenues consists of component and material costs, direct labor costs, integration costs and overhead related to manufacturing our products as well as warranty accruals and inventory valuation reserve amounts. Product development costs incurred in the performance of engineering development contracts for the U.S. Government and private companies are charged to cost of sales. Our customers continue to require additional integration and support services to customize, integrate and evaluate our products. We believe that a portion of these costs are initial, one-time costs for these customers and anticipate similar costs to be incurred with respect to new customers as we pursue a greater market share. Typically we do not incur these same types of costs for customers who have been using our products for over one year.

 

Gross Margin.  The gross margin for the year ended December 31, 2010 was 16.5% compared to 10.8% in the prior year; an increase of 53%. The improvement in gross margin is primarily attributable to our focus on key customer production contracts, maturity of our supply chain, and efficiencies gained through focus on manufacturing and inventory processes that resulted in tighter controls over production costs. As we continue to make deliveries on production contracts in 2011, we expect to achieve continued benefit from these initiatives, although we may continue to experience variability in our gross margin.

 

Research and Development Expenses.  Research and development expenses consist primarily of personnel, facilities, equipment and supplies for our research and development activities. Non-funded development costs are reported as research and development expense. Research and development expenses during the year ended December 31, 2010 were $1,838,000 compared to $1,228,000 for the same period in 2009, an increase of $610,000 or 50%. R&D costs were higher in 2010 as we devoted increased engineering personnel resources to the development of our next generation motor control unit and charger, continued testing of our EV vehicles, and testing and integration of new battery technologies and electric motors. In 2009, R&D efforts were focused on development of our new “Ze” all electric vehicle, the initial development of our next generation motor control unit, testing of new battery technologies as well as engine off capability for our post transmission parallel hybrid drive system. We also continued to allocate necessary resources to the development and testing of upgraded proprietary control software, enhanced DC-DC converters and other power management software. We intend to continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers as we deem beneficial to our global growth strategy.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses consist primarily of sales and marketing costs, including consulting fees and expenses for travel, trade shows and promotional activities and personnel and related costs for the quality and field service functions and general corporate functions, including finance, strategic and business development, human resources, IT, accounting reserves and legal costs. Selling, general and administrative expenses increased by $335,000, or 5%, during the year ended December 31, 2010 to $6,558,000 from $6,223,000 in the prior year, mainly due to executive bonuses and share-based compensation charges.

Interest and Other Income (Expense).  For the year ended December 31, 2010, interest and other income (expense) was an expense of $437,000, representing an increase of $241,000 or 123%, from an expense of $196,000 in 2009. The increase in 2010 was primarily due to a charge of approximately $328,000 for partial settlement of litigation with Arens, as detailed in Note 18 to these financial statements.

 

Equity in losses of non-consolidated joint venture.  A net loss of $4,000 was recorded in the year ended December 31, 2009, reflecting a loss of $10,000 in our pro-rata share of losses attributable to our forty percent investment interest in the Hyundai-Enova Innovative Technology Center (ITC) and a gain of $6,000 that was recorded upon the dissolution of the joint venture in April 2009. There was no activity attributed to this account in the year ended December 31, 2010.

 

Liquidity and Capital Resources

 

We have experienced losses primarily attributable to research, development, marketing and other costs associated with our strategic plan as an international developer and supplier of electric drive and power management systems and components. Historically cash flows from operations have not been sufficient to meet our obligations and we have had to raise funds through several financing transactions. At least until we reach breakeven volume in sales and develop and/or acquire the capability to manufacture and sell our products profitably, we will need to continue to rely on cash from external financing sources. Our operations during the year ended December 31, 2010 were financed by product sales and working capital reserves. As of December 31, 2010, the Company had $8,631,000 of cash and cash equivalents and short term investments.

 

On June 30, 2010, the Company entered into a secured a revolving credit facility with a financial institution for $200,000 which was secured by a $200,000 certificate of deposit. The facility is for a period of 3 years and 6 months from July 1, 2010 to December 31, 2013. The interest rate on a drawdown from the facility is the certificate of deposit rate plus 1.25% with interest payable monthly and the principal due at maturity. The financial institution also renewed the $200,000 irrevocable letter of credit for the full amount of the credit facility in favor of Sunshine Distribution LP, with respect to the lease of the Company’s corporate headquarters at 1560 West 190th Street, Torrance, California.

 

Net cash used in operating activities was $4,319,000 for the year ended December 31, 2010, compared to $1,609,000 for the year ended December 31, 2009. Cash used in operating activities was primarily affected by the cost of revenue, R&D, personnel and general operating costs, which were partially mitigated by our utilization of existing inventory balances to fulfill customer orders in 2010. Non-cash items included expenses for stock-based compensation, depreciation and amortization, inventory reserve, impairment loss, and issuance of common stock for services. In 2009, in conjunction with the reduction of our credit facility, as explained above, we redeemed a certificate of deposit for $2,000,000 which included a $200,000 irrevocable letter of credit for the full amount of a credit facility in favor of Sunshine Distribution LP, with respect to the lease of the Company’s corporate headquarters. This certificate of deposit for $2,000,000 is shown on the statement of cash flows as $1,800,000 for the year ended December 31, 2009.

 

Net cash used in investing activities was $317,000 for the year ended December 31, 2010, compared to net cash provided by investing activities of $2,000 for the year ended December 31, 2009. In 2010, capital expenditures were expended mainly for the acquisition and integration of test vehicles and for production test equipment. In 2009, we received proceeds of $137,000 from the dissolution of the Enova-ITC joint venture and had capital expenditures of $135,000.

 

Net cash used in financing activities totaled $11,000 for the year ended December 31, 2010 and was attributable to proceeds from stock options and payments made to notes payable agreements compared to net cash provided by financing activities of $9,361,000 for the year ended December 31, 2009 from an offering of common stock. We sold 9,024,960 shares of common stock at $1.00 per share to certain accredited investors, resulting in gross proceeds of $9,024,960. In addition, we sold 1,323,200 shares of common stock at 62.5 pence per share (approximately US$1.00 per share) to certain eligible offshore investors resulting in gross proceeds of approximately $1,323,000. Costs related to our December 2009 equity raise were approximately $928,000.

 

The company maintained the same certificate of deposit with Union Bank with a balance of $200,000 in 2010 and 2009, which is used to secure a credit facility.

Accounts receivable increased by $1,408,000, or 98%, from $1,442,000 as of December 31, 2009 to $2,850,000 as of December 31, 2010 due to increased shipments to Smith Electric Vehicles, Navistar and FAW in the fourth quarter of 2010.

 

Inventory decreased by $1,150,000, or 21%, from $5,605,000 as of December 31, 2009 to $4,455,000 as of December 31, 2010 due to our utilization of existing inventory balances to fulfill increases in customer orders during the second half of 2010. The decrease resulted from the utilization of existing inventory balances to fulfill increases in customer orders during 2010 and net inventory activity which included receipts of approximately $4,412,000 and normal consumption of approximately $5,562,000, net of inventory write-offs and reserves.

 

Prepaid expenses and other current assets increased by $219,000, or 83%, to $482,000 as of December 31, 2010 from a balance of $263,000 as of December 31, 2009. The increase was primarily attributable to deposits made to vendors for certain purchase orders.

 

Long term accounts receivable increased to $100,000 at December 31, 2010 compared to $0 at December 31, 2009. The Company agreed to defer collection of accounts receivable as requested by a customer for the term of the Company’s warranty period. The Company has remedied all past and current warranty claims and anticipates full collection of the receivable.

 

Property and equipment decreased by $191,000 or 14%, net of accumulated depreciation, to $1,172,000 as of December 31, 2010 from a balance of $1,363,000 as of December 31, 2009. The decrease was due to recording of depreciation expense during the year. For the year ended December 31, 2010, the Company recognized depreciation expense of $534,000 and recorded additions to fixed assets totaling $343,000.

 

Intangible assets decreased by $60,000 as Patents were written off completely during 2010 from $60,000 at December 31, 2009 to zero at December 31, 2010. Enova did not recognize any additional intellectual property assets, including patents and trademarks, during 2010. The Company recognized an impairment loss of $55,000 during 2010 as the Company determined that these patents have no future economic value.

 

Accounts payable increased by $1,432,000, or 345%, from $415,000 at December 31, 2009 to $1,847,000 at December 31, 2010. The accounts payable balance increased due to purchases of inventory made to support fourth quarter sales and in-line with our short-term sales forecast for 2011.

 

Enova reported $31,000 of deferred revenue at December 31, 2010 consisting of customer deposits for purchase orders, compared to a deferred revenue balance at December 31, 2009 of $357,000. The Company anticipates recognition of the December 31, 2010 balance into revenue in the first quarter of 2011.

 

Accrued payroll and related expenses increased by $645,000, or 233%, from $277,000 at December 31, 2009 to $922,000 at December 31, 2010. The change is primarily due to the accrual of 2010 employee and executive incentive bonuses which are expected to be paid in 2011.

 

Other accrued liabilities increased by $452,000, or 35%, to $1,739,000 at December 31, 2010 from $1,287,000 at December 31, 2009. The increase is primarily attributable to an accrual for the partial settlement of the Arens litigation and an accrual for severance to paid in 2011.

 

Accrued interest increased by $82,000, or 8%, from $1,074,000 at December 31, 2009 to $1,156,000 at December 31, 2010. The majority of the increase is associated with the interest accrued on the $1.2 million note due the Credit Managers Association of California (CMAC).

 

Off-Balance Sheet Arrangements

 

Other than contractual obligations incurred in the normal course of business, we don’t have any off-balance sheet financing arrangements or liabilities.

 

 

Not applicable.

 

ENOVA SYSTEMS, INC.

 

CONTENTS

December 31, 2010 and 2009

 

 

To the Board of Directors and Stockholders

of Enova Systems, Inc.:

 

We have audited the accompanying balance sheets of Enova Systems, Inc. as of December 31, 2010 and 2009, and the related statements of operations, stockholders’ equity and cash flows for the years then ended. Enova Systems, Inc.’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statement are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statement, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Enova Systems, Inc. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

 

PMB Helin Donovan, LLP

San Francisco, California

March 30, 2011

ENOVA SYSTEMS, INC.

 

BALANCE SHEETS

 

 

The accompanying notes are an integral part of these financial statements.

ENOVA SYSTEMS, INC.

 

STATEMENTS OF OPERATIONS

 

 

The accompanying notes are an integral part of these financial statements.

 

ENOVA SYSTEMS, INC.

 

STATEMENTS OF STOCKHOLDERS’ EQUITY

 

 

The accompanying notes are an integral part of these financial statements.

 

30

 

ENOVA SYSTEMS, INC.

 

STATEMENTS OF CASH FLOWS

 

 

The accompanying notes are an integral part of these financial statements.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS

 

 

General

 

Enova Systems, Inc., (the “Company”), is a California corporation that develops, designs and produces drive systems and related components for electric, hybrid electric, and fuel cell systems for mobile applications. The Company retains development and manufacturing rights to many of the technologies created, whether such research and development is internally or externally funded. The Company sells drive systems and related components in the United States, Asia and Europe.

 

Liquidity

 

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has sustained recurring losses and negative cash flows from operations. Management believes that the Company’s losses in recent years have primarily resulted from a combination of insufficient product and service revenue to support the Company’s skilled and diverse technical staff believed to be necessary to support exploitation of the Company’s technologies. Historically, the Company’s growth and working capital needs have been funded through a combination of private equity, debt and lease financing. During 2010, the Company’s growth has been funded primarily through a combination of product sales and existing cash reserves. As of December 31, 2010, the Company had approximately $8.4 million of cash and cash equivalents. At December 31, 2010, the Company had net working capital of approximately $11.6 million as compared to $18.0 million at December 31, 2009, representing a decrease of $6.4 million.

 

Management is focused on managing costs in line with estimated total revenue, including contingencies for cost reductions if projected revenue is not fully realized. However, there can be no assurance that anticipated revenue will be realized or that the Company will successfully implement its plans. Management has implemented measures to conserve cash, including a reduced employee headcount from the peak in 2008, stringent inventory management. The Company will continue to conserve available cash by closely scrutinizing expenditures and extensively utilizing current inventory for sales during 2011. The Company believes that it currently has sufficient cash and financial resources to meet its operating requirements over the next twelve months. The Company has experienced increasing operating margins in 2010 however, it had negative cash flow from operations, and if this trend continues, the Company may have an ongoing requirement for additional capital investment. The Company may need to raise additional capital to accomplish all of its business objectives over the next several years. In addition, the Company may in the future selectively pursue possible acquisitions of businesses, technologies, content, or products complementary to those of the Company in order to expand its presence in the marketplace and achieve operating efficiencies. The Company can make no assurance with respect to either the availability or terms of such financing and capital when it may be required.

 

 

Basis of Presentation

 

These financial statements have been prepared in accordance with accounting principles generally accepted in the United States.

 

Reclassifications

 

Certain amounts in the prior year have been reclassified to conform to the current year presentation. This change in classification does not affect previously reported cash flows from operating or financing activities in the Company’s previously reported Statements of Cash Flows, or the Company’s previously reported Statements of Operations for any period.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Revenue Recognition

 

The Company manufactures proprietary products and other products based on design specifications provided by its customers.

 

The Company recognizes revenue only when all of the following criteria have been met:

 

 

Persuasive Evidence of an Arrangement — The Company documents all terms of an arrangement in a written contract signed by the customer prior to recognizing revenue. Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.

 

Delivery Has Occurred or Services Have Been Rendered — The Company performs all services or delivers all products prior to recognizing revenue. Professional consulting and engineering services are considered to be performed when the services are complete. Equipment is considered delivered upon delivery to a customer’s designated location. In certain instances, the customer elects to take title upon shipment.

 

The Fee for the Arrangement is Fixed or Determinable — Prior to recognizing revenue, a customer’s fee is either fixed or determinable under the terms of the written contract. Fees professional consulting services, engineering services and equipment sales are fixed under the terms of the written contract. The customer’s fee is negotiated at the outset of the arrangement and is not subject to refund or adjustment during the initial term of the arrangement.

 

Collectibility is Reasonably Assured — The Company determines that collectibility is reasonably assured prior to recognizing revenue. Collectibility is assessed on a customer-by-customer basis based on criteria outlined by management. New customers are subject to a credit review process, which evaluates the customer’s financial position and ultimately its ability to pay. The Company does not enter into arrangements unless collectibility is reasonably assured at the outset. Existing customers are subject to ongoing credit evaluations based on payment history and other factors. If it is determined during the arrangement that collectibility is not reasonably assured, revenue is recognized on a cash basis. Amounts received upfront for engineering or development fees under multiple-element arrangements are deferred and recognized over the period of committed services or performance, if such arrangements require the Company to provide on-going services or performance. All amounts received under collaborative research agreements or research and development contracts are nonrefundable, regardless of the success of the underlying research.

 

Since some customer orders contain multiple items such as equipment and services which are delivered at varying times, the Company determines whether the delivered items can be considered separate units of accounting. Delivered items are considered separate units of accounting if delivered items have value to the customer on a standalone basis, there is objective and reliable evidence of the fair value of undelivered items, and if delivery of undelivered items is probable and substantially in the Company’s control. The recognition of revenue from milestone payments are over the remaining minimum period of performance obligation. As required, the Company evaluates its sales contract to ascertain whether multiple element agreements are present.

 

The Company recognizes engineering and construction contract revenues using the percentage-of-completion method, based primarily on contract costs incurred to date compared with total estimated contract costs. Customer-furnished materials, labor, and equipment, and in certain cases subcontractor materials, labor, and equipment, are included in revenues and cost of revenues when management believes that the company is responsible for the ultimate acceptability of the project. Contracts are segmented between types of services, such as engineering and

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

construction, and accordingly, gross margin related to each activity is recognized as those separate services are rendered. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Claims against customers are recognized as revenue upon settlement. Revenues recognized in excess of amounts billed are classified as current assets under contract work-in-progress. Amounts billed to clients in excess of revenues recognized to date are classified as current liabilities under advance billings on contracts. Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to engineering and development contract costs and revenue.

 

Deferred Revenues

 

The Company recognizes revenues as earned. Amounts billed in advance of the period in which service is rendered are recorded as a liability under Deferred revenues. The Company has entered into several production and development contracts with customers. The Company has evaluated these contracts, ascertained the specific revenue generating activities of each contract, and established the units of accounting for each activity. Revenue on these units of accounting is not recognized until a) there is persuasive evidence of the existence of a contract, b) the service has been rendered and delivery has occurred, c) there is a fixed and determinable price, and d) collectability is reasonable assured.

 

Warranty Costs

 

The Company provides product warranties for specific product lines and accrues for estimated future warranty costs in the period in which revenue is recognized. Our products are generally warranted to be free of defects in materials and workmanship for a period of 12 to 24 months from the date of installation, subject to standard limitations for equipment that has been altered by other than Enova Systems personnel and equipment which has been subject to negligent use. Warranty provisions are based on past experience of product returns, number of units repaired and our historical warranty incidence over the past twenty-four month period. The warranty liability is evaluated on an ongoing basis for adequacy and may be adjusted as additional information regarding expected warranty costs becomes known.

 

Shipping and Handling Costs

 

The Company includes shipping and handling costs associated with inbound and outbound freight in costs of goods sold.

 

Cash and Cash Equivalents

 

Short-term, highly liquid investments with an original maturity of three months or less are considered cash equivalents.

 

Certificate of deposit, restricted

 

The certificate of deposit matures on June 14, 2011 and is used to secure a revolving credit facility.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable; however, changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. Past due balances over 90 days and other higher risk amounts are reviewed individually for collectability. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payment, additional allowances may be required. In addition, the Company maintains a general reserve for all invoices by applying a percentage based on the age category. Account balances

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

are charged against the allowance after all collection efforts have been exhausted and the potential for recovery is considered remote. As of December 31, 2010 and 2009, the Company maintained a reserve of $29,000 and $31,000 for doubtful accounts receivable. There was no bad debt expense recorded in 2010 and 2009, respectively.

 

Inventory

 

Inventories and supplies are comprised of materials used in the design and development of electric, hybrid electric, and fuel cell drive systems, and other power and ongoing management and control components for production and ongoing development contracts, finished goods and work-in-progress, and is stated at the lower of cost or market utilizing the first-in, first-out (FIFO) cost flow assumption. The Company maintains a perpetual inventory system and continuously record the quantity on-hand and standard cost for each product, including purchased components, subassemblies and finished goods. The Company maintains the integrity of perpetual inventory records through periodic physical counts of quantities on hand. Finished goods are reported as inventories until the point of transfer to the customer. Generally, title transfer is documented in the terms of sale.

 

Inventory reserve

 

The Company maintains an allowance against inventory for the potential future obsolescence or excess inventory. A substantial decrease in expected demand for our products, or decreases in our selling prices could lead to excess or overvalued inventories and could require us to substantially increase our allowance for excess inventory. If future customer demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of revenues in the period the revision is made.

 

Property and Equipment

 

Property and equipment are stated at cost and depreciated over the estimated useful lives of the related assets, which range from three to seven years using the straight-line method for financial statement purposes. The Company uses other depreciation methods (generally, accelerated depreciation methods) for tax purposes where appropriate. Amortization of leasehold improvements is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful lives of the improvements.

 

Repairs and maintenance are expensed as incurred. Expenditures that increase the value or productive capacity of assets are capitalized. When property and equipment are retired, sold, or otherwise disposed of, the asset’s cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in operations.

 

Impairment of Long-Lived Assets

 

The Company reviews the carrying value of property and equipment for impairment whenever events and circumstances indicate that the carrying value of an asset may not be recoverable from the estimated future cash flows expected to result from its use and eventual disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized equal to an amount by which the carrying value exceeds the fair value of assets. The factors considered by management in performing this assessment include current operating results, trends, and prospects, as well as the effects of obsolescence, demand, competition, and other economic factors. Long-lived assets that management commits to sell or abandon are reported at the lower of carrying amount or fair value less cost to sell.

 

Patents

 

Patents are measured based on their fair values. Patents are being amortized on a straight-line basis over a period of 20 years and are stated net of accumulated amortization.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Impairment of Intangible Assets

 

The Company evaluates the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable. Such circumstances could include, but are not limited to: (1) a significant decrease in the market value of an asset, (2) a significant adverse change in the extent or manner in which an asset is used, or (3) an accumulation of costs significantly in excess of the amount originally expected for the asset. The Company measures the carrying amount of the asset against the estimated undiscounted future cash flows associated with it. Should the sum of the expected future net cash flows be less than the carrying value of the asset being evaluated, an impairment loss would be recognized. The impairment loss would be calculated as the amount by which the carrying value of the asset exceeds its fair value. The fair value is measured based on quoted market prices, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including the discounted value of estimated future cash flows. The evaluation of asset impairment requires the Company to make assumptions about future cash flows over the life of the asset being evaluated. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts. For the year ended December 31, 2010, the Company recognized an impairment loss $55,000 on the book value of intangible assets (see Note 7).

 

Fair Value of Financial Instruments

 

The carrying amount of financial instruments, including cash and cash equivalents, certificates of deposit, accounts receivable, accounts payable and other accrued liabilities, approximate fair value due to the short maturity of these instruments. The recorded values of notes payable and long-term debt approximate their fair values, as interest approximates market rates.

 

The Company defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. At December 31, 2010 the Company had no financial assets or liabilities periodically re-measured at fair value.

 

Stock-Based Compensation

 

The Company measures and recognizes compensation expense for all share-based payment awards made to employees and directors, including employee stock options based on the estimated fair values at the date of grant. The compensation expense is recognized over the requisite service period.

 

The Company’s determination of estimated fair value of share-based awards utilizes the Black-Scholes option-pricing model. The Black-Scholes model is affected by the Company’s stock price as well as assumptions regarding certain highly complex and subjective variables. These variables include, but are not limited to; the Company’s expected stock price volatility over the term of the awards as well as actual and projected employee stock option exercise behaviors.

 

The cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. Due to the Company’s loss position, there were no such tax benefits for the years ended December 31, 2010 and 2009.

 

The Company determines the fair value of the restricted stock awards utilizing the quoted market prices of the Company’s shares on the date they were granted.

 

Research and Development

 

Research development, and engineering costs are expensed in the period incurred. Costs of significantly altering existing technology are expensed as incurred.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Income Taxes

 

The Company accounts for income taxes under an asset and liability approach. This process involves calculating the temporary and permanent differences between the carrying amounts of the assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The temporary differences can result in deferred tax assets and liabilities, which would be recorded on the Company’s consolidated balance sheets. The Company must assess the likelihood that its deferred tax assets will be recovered from future taxable income and, to the extent the Company believes that recovery is not likely, the Company must establish a valuation allowance. Changes in the Company’s valuation allowance in a period are recorded through the income tax provision on the consolidated statements of operations.

 

Uncertainty in income taxes are recognized in the Company’s financial statements based on the recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. The impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The Company has recognized no liability for unrecognized income tax benefits.

 

Loss Per Share

 

Basic loss per share is computed by dividing loss available to common stockholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Common equivalent shares are excluded from the computation if their effect is anti-dilutive. The Company’s common share equivalents consist of stock options.

 

The potential shares, which are excluded from the determination of basic and diluted net loss per share as their effect is anti-dilutive, are as follows:

 

 

Commitments and Contingencies

 

Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company but which will only be resolved when one or more future events occur or fail to occur. The Company’s management and its legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company’s legal counsel evaluates the perceived merits of any legal proceedings or unasserted claims as well as the perceived merits of the amount of relief sought or expected to be sought therein. If the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Loss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the nature of the guarantee would be disclosed.

 

Estimates

 

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

Concentration of Credit Risk

 

Financial instruments which potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents and accounts receivable. The Company places its cash and cash equivalents with high credit, quality financial institutions. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. With respect to accounts receivable, the Company routinely assesses the financial strength of its customers and, as a consequence, believes that the receivable credit risk exposure is limited.

 

Recent Accounting Pronouncements

 

In April 2010, the FASB issued ASU No. 2010-17, Revenue Recognition — Milestone Method (Topic 605): Milestone Method of Revenue Recognition, or ASU 2010-17. ASU 2010-17 allows the milestone method as an acceptable revenue recognition methodology when an arrangement includes substantive milestones. ASU 2010-17 provides a definition of substantive milestone, and should be applied regardless of whether the arrangement includes single or multiple deliverables or units of accounting. ASU 2010-17 is limited to transactions involving milestones relating to research and development deliverables. ASU 2010-17 also includes enhanced disclosure requirements about each arrangement, individual milestones and related contingent consideration, information about substantive milestones, and factors considered in the determination. ASU 2010-17 is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010, with early adoption permitted. The adoption of this standard did not have any impact on our consolidated financial statements.

 

In January 2010, the FASB issued ASU 2010-06 providing authoritative guidance related to fair value measurements and disclosures. The provisions of the guidance require new disclosures related to transfers in and out of Levels 1 and 2 classifications. The provisions also require a reconciliation of the activity in Level recurring fair value measurements. Existing disclosures also were expanded to include Level 2 fair value measurement valuation techniques and inputs. The guidance is effective for all interim and annual reporting periods beginning after December 15, 2009, except for the disclosures for Level 3 activity which is effective for fiscal years beginning after December 15, 2010. The adoption of the guidance did not, and is not expected to, have a material impact on our business, financial position, results of operations or liquidity

 

In October 2009, the FASB issued ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements — a consensus of the FASB EITF, or ASU 2009-14. ASU 2009-14 changes the accounting model for revenue arrangements that include tangible products and software elements. The amendments of this update provide additional guidance on how to determine which software, if any, relating to the tangible product also would be excluded from the scope of the software revenue recognition guidance. The amendments in this update also provide guidance on how a vendor should allocate arrangement consideration to deliverables in an arrangement that includes tangible products and software as well as arrangements that have deliverables both included and excluded from the scope of software revenue recognition guidance. This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

June 15, 2010. The adoption is not expected to have an effect on the Company’s financial position, results of operations, or cash flows.

 

In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 650): Multiple-Deliverable Revenue Arrangements — a consensus of the FASB EITF, or ASU 2009-13. ASU 2009-13 will separate multiple-deliverable revenue arrangements. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The amendments of this update will replace the term “fair value” in the revenue allocation guidance with “selling price” to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. The amendments of this update will eliminate the residual method of allocation and require that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. The amendments in this update will require that a vendor determine its best estimated selling price in a manner consistent with that used to determine the price to sell the deliverable on a standalone basis. This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company does not believe that the adoption of the pronouncement will have a material impact on the Company’s consolidated financial statements.

 

Other recent accounting pronouncements issued by the FASB, the American Institute of Certified Public Accountants (“AICPA”), and the SEC did not or are not believed by management to have a material impact on the Company’s present condensed consolidated financial statements.

 

 

Inventories, consisting of materials, labor, and manufacturing overhead, are stated at the lower of cost (first-in, first-out) or market and consist of the following at December 31:

 

 

Inventory reserve charged to operations amounted to $232,000 and $714,000 during 2010 and 2009, respectively. Inventory valuation adjustments and other inventory write-offs in 2010 and 2009 amounted to $582,000 and $638,000, respectively.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

 

Property and equipment consisted of the following at December 31:

 

 

Fixed assets totaling $0 and $748,000 were retired or disposed of in the years ended December 31, 2010 and 2009, respectively. Depreciation and amortization expense was $534,000 and $600,000 for the years ended December 31, 2010 and 2009, respectively, which included amortization expense of leasehold improvements of $268,000 and $269,000 for the years ended December 31, 2010 and 2009, respectively.

 

 

Other accrued liabilities consisted of the following at December 31:

 

 

Accrued warranty consisted of the following activities for the years ended December 31:

 

 

 

On April 6, 2009, Enova Systems Inc. and Hyundai Heavy Industries of Korea (“HHI”) agreed to dissolve their 60/40 joint venture, Hyundai-Enova Innovative Technology Center, Inc. (“ITC”), by mutual agreement based on their evaluation of the joint venture and its business relationship to each of Enova and HHI.

 

The Dissolution Agreement required Enova and ITC to enter into a Stock Purchase Agreement, dated as of April 6, 2009. Pursuant to the Stock Purchase Agreement, ITC re-purchased the 2,000,000 shares of common stock of ITC owned by Enova, which represented 40% of the issued shares of ITC, for a purchase price of $1,334,000 with

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

HHI becoming the sole shareholder of ITC immediately subsequent to this transaction. Enova received from ITC a cash payment of $137,000 and, as was agreed under the Dissolution Agreement, the amount of $1,197,000 was paid to HHI to settle open purchase orders that Enova had placed with HHI for electrical component inventory which became part of salable systems; and to settle other payables and receivables between Enova, HHI and ITC. During 2009, Enova received approximately $1,179,000 in inventory from HHI as full settlement for ITC.

 

The summary of the ITC dissolution is as follows:

 

 

HHI continues to be a key strategic supplier of components for Enova, including electric drive motors and control electronic units that are manufactured using Enova specifications.

 

 

Intangible assets consisted of legal fees directly associated with patent licensing. The Company has been granted three patents and in 2010, made an immaterial adjustment to value them at a zero balance. These patents were capitalized and were being amortized on a straight-line basis over a period of 20 years.

 

Intangible assets consisted of the following as of December 31:

 

 

Amortization expense charged to operations was $5,000 for each of the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, the Company performed an impairment analysis to its intangible assets and determined that the technologies covered by the Company’s patents did not have any future economic value. The Company recorded an impairment loss of $55,000 during 2010.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

 

Notes payable at December 31, consisted of the following:

 

 

As of December 31, 2010 and 2009, the balance of long term interest payable with respect to the Credit Managers Association of California note amounted to $1,132,000 and $1,054,000, respectively. Interest expense on notes payable amounted to approximately $88,000 and $91,000 during the years ended December 31, 2010 and 2009, respectively.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Future minimum principal payments of notes payable at December 31, 2010 consisted of the following:

 

 

 

On June 30, 2010, the Company entered into a secured a revolving credit facility with a financial institution for $200,000 which was secured by a $200,000 certificate of deposit. The facility is for a period of 3 years and 6 months from July 1, 2010 to December 31, 2013.

 

The interest rate on a drawdown from the facility is the certificate of deposit rate plus 1.25% with interest payable monthly and the principal due at maturity. The financial institution also renewed the $200,000 irrevocable letter of credit for the full amount of the credit facility in favor of Sunshine Distribution LP, with respect to the lease of the Company’s corporate headquarters at 1560 West 190th Street, Torrance, California.

 

 

The Company had deferred $31,000 and $357,000 in revenue related to production and development contracts at December 31, 2010 and 2009, respectively. The Company anticipates that the December 31, 2010 deferred revenue balance will be recognized in the first quarter of 2011.

 

 

Leases

 

In October 2007, The Company entered into a lease agreement with Sunshine Distribution LP (“Landlord”), with respect to the lease of an approximately 43,000 square foot facility located at 1560 West 190th Street, Torrance, California (the “Lease”). The lease term commenced on November 1, 2007, and expires January 1, 2013. The total base monthly rent is approximately $37,000, and will be increased effective May 1, 2011 based on the increase in the consumer price index. Under the Lease, Enova will pay the Landlord certain commercially reasonable and customary common area maintenance costs of approximately $5,000 per month, increasing ratably as these costs are increased to the Landlord. The Lease is secured by an irrevocable standby letter of credit in the amount of $200,000 and naming the Landlord as the beneficiary. Enova also has an office in Hawaii which is rented on a month-to-month basis at $3,400 per month. Rent expense was $556,000 and $561,000 for the years ended December 31, 2010, and 2009, respectively.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Future minimum lease payments under non-cancelable operating lease obligations at December 31, 2010 were as follows:

 

 

 

Common Stock

 

On October 29, 2009, Enova entered into a Purchase Agreement (“Purchase Agreement”) with certain accredited investors (as such term is defined under Regulation D promulgated by the Securities and Exchange Commission (“SEC”)) pursuant to which the Investors agreed to purchase 9,024,960 shares of Common Stock (“Investor Shares”) and the Company received $9,024,960 in gross proceeds from the offering.

 

On October 29, 2009, the Company entered into a Placing Agreement (the “Placing Agreement”) to which Investec Bank (UK) Limited (“Investec”) acted as Enova’s agent to place 1,323,200 shares of the Common Stock (the “Placing Shares”) at 62.5 Pence (the “Placing Price”), or approximately the equivalent of $1.00 (U.S. Dollars) per share as of such date based on the exchange rate on October 29, 2009 as reported by Fidessa.

 

On December 15, 2009, Enova Systems, Inc. completed the sale of the above 10,348,160 shares of the Company’s common stock, no par value (“Common Stock”), at $1.00 (U.S.) per share for gross proceeds of approximately $10,348,160 (based on current exchange rates as described above) pursuant in part to a Purchase Agreement and in part to a Placing Agreement as more particularly described above. The transactions contemplated by the Purchase Agreement and the Placing Agreement were approved by shareholders at the company’s annual meeting held on December 8, 2009. Costs related to the December 2009 equity raise were approximately $928,000.

 

During the year ended December 31, 2009, the Company issued 158,000 shares of common stock, respectively, to directors as compensation. The common stock issued to directors in 2009 was valued at $165,000, based upon the trading value of the common stock on the date of issuance. No common stock was issued to directors during 2010.

 

During the years ended December 31, 2010 and 2009, the Company issued 25,000 and 58,000 shares of common stock, respectively, to employees as compensation. The common stock issued to employees in 2010 and 2009 was valued at $95,000 and $172,000, respectively, based upon the trading value of the common stock on the date of issuance.

 

Series A Preferred Stock

 

Series A preferred stock is currently unregistered. Each share is convertible into 1/45 of a share of common stock at the election of the holder or automatically upon the occurrence of certain events including: sale of stock in an underwritten public offering; registration of the underlying conversion stock; or the merger, consolidation, or sale of more than 50% of the Company. Holders of Series A preferred stock have the same voting rights as common stockholders. The stock has a liquidation preference of $0.60 per share plus any accrued and unpaid dividends in the event of voluntary or involuntary liquidation of the Company. Dividends are non-cumulative and payable at the annual rate of $0.036 per share if, when, and as declared by, the Board of Directors. No dividends have been declared on the Series A preferred stock.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

Series B Preferred Stock

 

Series B preferred stock is currently unregistered. Each share is convertible into 2/45 of a share of common stock at the election of the holder or automatically upon the occurrence of certain events including: sale of stock in an underwritten public offering, if the offering results in net proceeds of $10,000,000, and the per share price of common stock is at least $2.00; and the merger, consolidation, or sale of common stock or sale of substantially all of the Company’s assets in which gross proceeds received are at least $10,000,000. The Series B preferred stock has certain liquidation and dividend rights prior and in preference to the rights of the common stock and Series A preferred stock. The stock has a liquidation preference of $2.00 per share together with an amount equal to, generally, $0.14 per share compounded annually at 7% per year from the filing date, less any dividends paid. Dividends on the Series B preferred stock are non-cumulative and payable at the annual rate of $0.14 per share if, when, and as declared by, the Board of Directors. No dividends have been declared on the Series B preferred stock.

 

 

Stock Option Program Description

 

For the year ended December 31, 2010 the Company had two equity compensation plans, the 1996 Stock Option Plan (the “1996 Plan”) and the 2006 equity compensation plan (the “2006 Plan”). The 1996 Plan has expired for the purposes of issuing new grants. However, the 1996 Plan will continue to govern awards previously granted under that plan. The 2006 Plan has been approved by the Company’s Shareholders. Equity compensation grants are designed to reward employees and executives for their long term contributions to the Company and to provide incentives for them to remain with the Company. The number and frequency of equity compensation grants are based on competitive practices, operating results of the company, and government regulations.

 

The maximum number of shares issuable over the term of the 1996 Plan was limited to 65 million shares (without giving effect to subsequent stock splits). Options granted under the 1996 Plan typically have an exercise price of 100% of the fair market value of the underlying stock on the grant date and expire no later than ten years from the grant date. The 2006 Plan has a total of 3,000,000 shares reserved for issuance, of which 104,000 and 903,000 were granted in 2010 and 2009, respectively.

 

Stock-based compensation expense related to stock options was $704,000 and $387,000 for the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, the total compensation cost related to non-vested awards not yet recognized is $453,000. The remaining period over which the future compensation cost is expected to be recognized is 15 months.

 

Stock-based compensation expense recognized in the Statement of Operations for the years ended December 31, 2010 and 2009 has been based on awards ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. If the actual number of forfeitures differs from that estimated by management, additional adjustments to compensation expense may be required in future periods.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

The following is a summary of changes to outstanding stock options during the fiscal year ended December 31, 2010 and 2009:

 

 

 

 

At December 31, 2010, there were 1,607,000 shares available for grant under the 2006 plan. The exercise prices of the options outstanding at December 31, 2010 ranged from $0.21 to $4.95. The weighted-average grant date fair value of the options granted during the years ended December 31, 2010 and 2009 was $1.22 and $0.69, respectively.

 

Unvested share activity for the year ended December 31, 2010 is summarized below:

 

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

The company settles employee stock option exercises with newly issued common shares. The table below presents information related to stock option activity for the fiscal years ended December 31, 2010 and 2009:

 

 

Valuation and Expense Information

 

The fair value of stock-based awards to officers and employees is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is calculated by using the SAB 107 “simplified method” of estimating the expected term which is derived by taking the average of the time to vesting and the full term of the option. The risk-free rate selected to value any particular grant is based on the bond equivalent yields that corresponds to the pricing term of the grant effective as of the date of the grant. The expected volatility is based on the historical volatility of the Company’s stock price. These factors could change in the future, affecting the determination of stock-based compensation expense in future periods.

 

The fair values of all stock options granted during the fiscal years ended December 31, 2010 and 2009 were estimated on the date of grant using the following range of assumptions:

 

 

The estimated fair value of grants of stock options to nonemployees of the Company is charged to expense, if applicable, in the financial statements. These options vest in the same manner as the employee options granted under each of the option plans as described above.

 

Restricted Stock

 

During the year ended December 31, 2010 and 2009, the Company issued 25,000 and 216,000 restricted shares of the Company’s common stock to its employees and directors, respectively. The Company recorded compensation expense of $95,000 and $337,000 in 2010 and 2009, respectively. There are no unvested restricted stock awards granted to employees or directors as of December 31, 2010.

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

 

Significant components of the Company’s deferred tax assets and liabilities for federal and state income taxes as of December 31, consisted of the following:

 

 

The Tax Reform Act of 1986 limits the use of net operating loss carryforwards in certain situations where changed occur in the stock ownership of a company. In the event the Company has had a change in ownership, utilization of the carryforwards could be restricted.

 

Deferred taxes arise from temporary differences in the recognition of certain expenses for tax and financial reporting purposes. The deferred tax assets have been offset by a valuation allowance since management does not believe the recoverability of these in future years is more likely than not to occur. The valuation allowance increased by $2,809,000 and decreased by $9,247,000 during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, the Company had net operating loss carry forwards for federal and state income tax purposes of approximately $71,121,000 and $45,305,000, respectively. These operating loss carry forwards will expire in 2011 through 2030.

 

The provision for income taxes differs from the amount computed by applying the U.S. federal statutory tax rate (34% in 2010 and 2009) to income taxes as follows:

 

 

The Company files federal income tax returns in the U.S. and in various state jurisdictions. The Company has not been audited by the Internal Revenue Service or any state for income taxes. The Company reviews its recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. The Company reviews all material tax positions for all years open to statute to determine whether it is more likely than not that the positions taken would be sustained based on the technical merits of those positions. The Company did not recognize any adjustments for uncertain tax positions as of and during the years ended December 31, 2010 and 2009.

 

 

The Company has a 401(k) profit sharing plan covering substantially all employees. Eligible employees may elect to contribute a percentage of their annual compensation, as defined, to the plan. The Company may also elect

ENOVA SYSTEMS, INC.

 

NOTES TO FINANCIAL STATEMENTS — (Continued)

 

to make discretionary contributions. For the years ended December 31, 2010 and 2009, the Company did not make any contributions to the plan.

 

 

The Company operates as a single reportable segment and attributes revenues to countries based upon the location of the entity originating the sale. Revenues by geographic area are as follows: