Enova Systems, Inc. Enova Announces Annual Results for FY2012 (6149C)

TIDMENV TIDMENVS

RNS Number : 6149C

Enova Systems, Inc.

17 April 2013

   For Immediate release                                      16th of April 2013 

Enova Systems, Inc., (OTCQB: ENVS and AIM: ENV and ENVS), a developer and manufacturer of electric, hybrid and fuel cell digital power management systems, announces results for the fiscal year ended December 31, 2012.

 
Inquires: 
Enova Systems 
John Micek, Chief Executive Officer and Chief Financial Officer    [phone] 
 
Daniel Stewart & Company Plc 
Jamie Barklem                                                      [phone] 
 

HIGHLIGHTS

 
                                                For and as of the 
                                                    Year Ended 
                                                   December 31, 
                                             2012               2011 
 Revenues                                $ 1,103,000        $ 6,622,000 
 Cost of revenues                             2,407,000          6,364,000 
 Gross income                              (1,304,000)             258,000 
 Operating expenses 
   Research and development                     805,000         2,039,000 
   Selling, general & administrative        3,915,000          5,075,000 
   Total operating expenses                 4,720,000          7,114,000 
 Operating loss                           (6,024,000)        (6,856,000) 
 Other income and (expense) 
   Loss on litigation                      (2,014,000)            (41,000) 
   Interest and other income 
    (expense)                                (197,000)            (87,000) 
   Total other income and 
    (expense)                              (2,211,000)          (128,000) 
 Net loss                                (8,235,000)        (6,984,000) 
 
 

For the Years Ended December 31, 2012 compared December 31, 2011

Results of Operations

Net Revenues. Net revenues were $1,103,000 for the year ended December 31, 2012, representing a decrease of $5,519,000 or 83% from net revenues of $6,622,000 during the same period in 2011. Revenues in the current year were negatively affected by uncertainty over battery performance and non-recoverable engineering costs associated with battery development and subsequent to our restructuring in June 2012, our reduced capacity to pursue new business. As a result, OEM and other customers have delayed major all-electric vehicle marketing initiatives, resulting in decreased demand for our systems. The decrease in revenue for the twelve months ended December 31, 2012 compared to the same period in 2011 was mainly due to a decrease in deliveries to our core customer base in the United States. Revenues in 2012 were mainly attributed to shipments to First Auto Works in China and the Optare Group in the U.K in the first half of the year. We will have fluctuations in revenue from quarter to quarter. Although we have seen indications from our customers to support future revenue, there can be no assurance there will be continuing demand for our products and services.

Cost of Revenues. Cost of revenues were $2,407,000 for the year ended December 31, 2012, compared to $6,364,000 for the year ended December 31, 2011, representing a decrease of $3,957,000, or 62%. Cost of revenues decreased in 2012 compared to the same period in the prior year primarily due to the decrease in revenue. We recorded a charge of approximately $1,436,000 during 2012 increasing our inventory obsolescence reserve after management updated its estimate of the realizable value of inventory. 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. 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, 2012 was negative 118.4% compared to a positive 3.9% in the prior year, a decrease of 122.3 percentage points. The decrease in gross margin is primarily attributable to lower production volumes and charges to increase the inventory reserve in 2012 associated with certain obsolete parts.

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, 2012 were $805,000 compared to $2,039,000 for the same period in 2011, a decrease of $1,234,000 or approximately 61%. R&D costs were lower in 2012 as we reduced engineering staff in June 2012 due to the Company's lack of financial resources. As a result, the Company's development of its next generation Omni-series motor control unit and 10kW charger was put on hold from the second half of 2012.

Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of sales and marketing costs, including consulting fees and expenses for travel, 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 decreased by $1,160,000, or 23%, during the year ended December 31, 2012 to $3,915,000 from $5,075,000 in the prior year, is attributable the Company's implementation of staff reductions, the termination of employment with the Company by approximately 80% of the Company's workforce and other cost savings measures. We continually monitor S, G & A in light of our business outlook and are taking proactive steps to control these costs.

Loss on Litigation. For the year ended December 31, 2012, loss on litigation was $2,014,000, an increase of $1,973,000 from an expense of $41,000 in 2011. The primary reason for the increase is due to our recording a charge of approximately $2 million in 2012 for a judgment entered in the litigation with Arens Controls, as detailed in Item 3 - Legal Proceedings of this Form 10-K.

Interest and Other Income (Expense). For the year ended December 31, 2012, interest and other expense was $197,000, an increase of $110,000 or 126%, from an expense of $87,000 in 2011. The primary reason for the increase is due to our recording a charge of approximately $2 million in 2012 for a judgment entered in the litigation with Arens Controls, as detailed in Item 3 - Legal Proceedings of this Form 10-K.

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, 2012 were financed by product sales, working capital reserves and equity offerings in December 2011 and May 2012 that resulted in net proceeds of $1,245,000 and $132,000, respectively. As of December 31, 2012, the Company had $57,000 of cash and cash equivalents.

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 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. During the fourth quarter of 2012, the irrevocable letter of credit was fully drawn down by Sunshine Distribution L.P. in order to pay rent on our corporate headquarters, and the certificate of deposit was fully utilized to fund draws on the secured facility. Therefore, the facility was fully drawn and expired on December 31, 2012.

Net cash used in operating activities was $3,388,000 for the year ended December 31, 2012, a decrease of $2,914,000 compared to $6,302,000 for the year ended December 31, 2011. Operating cash used decreased in 2012 compared to the prior year period primarily due to decreases in our sales volume in 2012 and the use of our existing cash resources to fund our current operations. Non-cash items include expense for stock-based compensation, depreciation and amortization, inventory reserve and other losses. These non-cash items increased by $2,632,000 for the year ended December 31, 2012 as compared to the same period in the prior year primarily due to accrual of the Arens litigation judgment and an increase in the inventory reserve and reserve for doubtful accounts. The increase in net loss was primarily due to an accrual of $2,017,000 for the Arens litigation judgment and inventory reserve and allowance for doubtful accounts charges of $1,436,000 and $296,000, respectively. As of December 31, 2012, the Company had $57,000 of cash and cash

equivalents compared to $3,096,000 as of December 31, 2011.

Net cash from investing activities was $237,000 for the year ended December 31, 2012, compared to net cash used of $275,000 for the year ended December 31, 2011. In 2012, a certificate of deposit investment of $200,000 was redeemed in order to fund drawdowns from an irrevocable letter of credit by Sunshine Distribution L.P. to pay rent on our corporate headquarters during the fourth quarter of 2012. In 2012 and 2011, investing expenditures for capital expenditures were expended mainly for the acquisition and integration of test vehicles and for test equipment utilized in R&D and production.

Net cash provided from financing activities totaled $112,000 for the year ended December 31, 2012, a decrease of $1,130,000 compared to $1,242,000 for the year ended December 31, 2011. Financing activities in 2012 and 2011 were primarily attributable to private offerings of common stock. In 2012, we received proceeds of $132,000 from the issuance of Common Stock during second quarter of 2012 from the Lincoln Park facility, as explained in Note 11 - Stockholders' Equity to the financial statements included in Item 1 of this Form 10-K.. In 2011, we sold 11,250,000 shares of common stock at $0.15 per share to certain accredited investors, resulting in gross proceeds of $1,687,500 and net proceeds of $1,245,000 after costs related to the equity raise.

The Certificate of Deposit decreased to $0 as of December 31, 2012 from $200,000 as of December 31, 2011. As explained above, the CD was used to secure the revolving credit facility in the amount of $200,000 with Union Bank which was fully drawn during the fourth quarter of 2012 to fund draw downs form the irrevocable letter of credit that were used to pay rent for our facility to Sunshine Distribution L.P.

Accounts receivable decreased by $551,000, or 73%, to $208,000 as of December 31, 2012 from $759,000 as of December 31, 2011. The decrease in the receivable balance was primarily due to collections of receivables and an increase in the Reserve for Doubtful Accounts. As of December 31, 2012 and December 31, 2011, the Company maintained a reserve for doubtful accounts receivable of $313,000 and $18,000, respectively.

Inventory decreased by $1,833,000, or 45%, from $4,036,000 as of December 31, 2011 to $2,203,000 as of December 31, 2012. The decrease resulted from net inventory activity including receipts totaling $545,000, consumption of $942,000 and an inventory reserve charge of $1,436,000.

Prepaid expenses and other current assets were $242,000 as of December 31, 2012 and 2011, respectively.

Long term accounts receivable decreased by $41,000, or 52%, to $38,000 as of December 31, 2012 compared to $79,000 at December 31, 2011. The decrease is primarily due to reclassification of amounts that will be due within one year to current accounts receivable. 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 $621,000 or approximately 67%, net of accumulated depreciation, to $307,000 as of December 31, 2012 from a balance of $928,000 as of December 31, 2011. The decrease is primarily due to depreciation expense of $466,000, an asset impairment charge of $90,000, proceeds from assets sales of $53,000 and a loss on asset sales of $28,000, which was partially offset by additions to fixed assets totaling $16,000 in 2012.

Accounts payable increased by $204,000, or approximately 58%, to $558,000 at December 31, 2012 from $354,000 at December 31, 2011. The increase was primarily due to unpaid legal and administrative costs and inventory purchases during 2012.

Deferred revenue decreased by $202,000, or approximately 63%, to $118,000 as of December 31, 2012 from $320,000 as of December 31, 2011. The balance at December 31, 2012 is anticipated to be realized into revenue in the first half of 2013, and is associated with prepayments on purchases orders from certain customers.

Accrued payroll and related expenses decreased by $168,000, or 63%, to $98,000 as of December 31, 2012 from $266,000 at December 31, 2011. The decrease was primarily due to the reduction in our workforce by over 80% in June 2012 which resulted in a pay out of accrued vacation of approximately $143,000 in the second quarter.

Accrued judgment As previously disclosed in Item 3. Legal Proceedings, on December 12, 2012, a judgment was entered in favor of Arens Controls Company, L.L.C. by the United States District Court Northern District of Illinois in the amount of $2,014,169 in the case of Arens Controls Company, L.L.C. v. Enova Systems, Inc.

Other accrued liabilities decreased by $262,000, or 51%, to $255,000 at December 31, 2012 compared to a balance of $517,000 at December 31, 2011. The decrease was primarily due to a decrease in the accrued warranty balance as costs for warranty claims were greater than warranty accruals during 2012 and a decrease in accruals for professional services in 2012.

Accrued interest increased by $81,000, or 7%, to $1,318,000 at December 31, 2012 from $1,237,000 at December 31, 2011. The majority of the increase is associated with the interest accrued on the $1.2 million note due the Credit Managers Association of California.

Going concern

To date, the Company has incurred recurring net losses and negative cash flows from operations. At December 31, 2012, the Company had an accumulated deficit of approximately $159.3 million, working capital of approximately negative $0.4 million and shareholders' equity deficit of approximately $2.6 million. Until the Company can generate significant cash from its operations, the Company expects to continue to fund its operations with existing cash resources, proceeds from one or more private placement agreements, as well as potentially through debt financing or the sale of equity securities. However, the Company may not be successful in obtaining additional funding. In addition, the Company cannot be sure that its existing cash and investment resources will be adequate or that additional financing will be available when needed or that, if available, financing will be obtained on terms favorable to the Company or its shareholders.

Our operations will require us to make necessary investments in human and production resources, regulatory compliance, as well as sales and marketing efforts. We do not currently have adequate internal liquidity to meet these objectives in the long term. On June 21, 2102, we reported in a Form 8-K filing that, as part of cost cutting measures in response to our decrease in revenue amid continued delays in industry adoption of EV technology resulting from ongoing battery cost and reliability concerns, in excess of 80% of our workforce left our Company, including the resignation of members of our senior management. We continue to evaluate strategic partnering opportunities and other external sources of liquidity, including the public and private financial markets and strategic partners. Having insufficient funds may require the Company to delay or eliminate some or all of its product develop, relinquish some or even all rights to product candidates at an earlier stage of development or negotiate less favorable terms than it would otherwise choose. Failure to obtain adequate financing also may adversely affect the Company's ability to continue in business. If the Company raises additional funds by issuing equity securities, substantial dilution to existing stockholders would likely result. If the Company raises additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations, as well as covenants and specific financial ratios that may restrict its ability to operate its business.

As of December 31, 2012, the Company had approximately $57,000 in cash and cash equivalents and we do not anticipate that our existing cash and anticipated receivables collections will be sufficient to meet projected operating requirements through the end of 2013 to continue operations and market trading.

We have also accessed the capital markets to obtain additional operating funds. In December 2011, we raised approximately $1,245,000, net of financing costs of $442,500 through an equity issuance to certain accredited investors, which was disclosed in our Form 10-K filed on March 29, 2012. Additionally, we entered into two Purchase Agreements (the facility) with Lincoln Park Capital Fund in April to issue up $10,000,000 in shares of our common stock and received proceeds of $132,000, net of financing costs of $152,000, from the initial purchase of shares of Common Stock from Lincoln Park in the second quarter. Access to funding under the facility is dependent upon our shares being listed on a national exchange, and as our shares were delisted from the NYSE Amex exchange on October 31, 2012, the Company can no longer raise funds from the facility.

Judgment entered in Arens Controls Litigation

On December 12, 2012, a judgment was entered by the United States District Court Northern District of Illinois in favor of Arens Controls Company, L.L.C. in the amount of $2,014,169 regarding claims for two counts. In 2008, Arens Controls Company, L.L.C. ("Arens") filed claims against Enova with the United States District Court Northern District of Illinois. A Partial Settlement Agreement, as amended on January 14, 2011, resolved certain claims made by Arens. However, the claims were preserved under two remaining counts concerning i) anticipatory breach of contract by Enova for certain purchase orders that resulted in lost profit to Arens and ii) reimbursement for engineering and capital equipment costs incurred by Arens exclusively for the fulfillment of certain purchase orders received from Enova.

The Company filed a notice of appeal in January 11, 2013. The Company believes the court committed errors leading to the verdict and judgment, and the Company is evaluating its options on appeal. However, there can be no assurance that the appeal will be successful or a negotiated settlement can be attained or that Arens will assert its claim in the state of California, and thereby cause the Company to go into bankruptcy.

Off-Balance Sheet Arrangements

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

ITEM 1. BUSINESS

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.

THE FOLLOWING BUSINESS DISCUSSION SET FORTH BELOW AND ELSEWHERE IN THIS 10-K IS QUALIFIED IN ITS ENTIRETY BY THE FOLLOWING: ENOVA REMAINS INSOLVENT AND OWES IN EXCESS OF $4.5 MILLION IN THE AGGREGATE TO ITS TWO PRINCIPAL CREDITORS, THE CREDIT MANAGERS ASSOCIATION AND ARENS CONTROLS COMPANY, L.L.C. ('ARENS"). WITHOUT IMMEDIATE ADDITIONAL FINANCING OR COLLECTION OF RECEIVABLES, THE COMPANY WILL NEED TO CEASE OPERATIONS. THE COMPANY CURRENTLY HAS NO VISIBILITY AS TO EITHER ADDITIONAL FINANCING OR THE COLLECTION OF RECEIVABLES. SPECIFICALLY, WITHOUT A MUTUALLY ACCEPTABLE SETTLEMENT OF THE ARENS JUDGMENT ARISING OUT OF ARENS CONTROLS COMPANY, L.L.C. v. ENOVA SYSTEMS, INC., CASE NO. 13 1102 (7TH CIRCUIT) IN THE AMOUNT OF $2.0 MILLION, THE COMPANY DOES NOT CURRENTLY BELIEVE IT HAS ANY ALTERNATIVE OTHER THAN TO CEASE OPERATIONS. THE COMPANY CURRENTLY EMPLOYS ONLY TWO PERSONNEL, JOHN MICEK, THE COMPANY'S CEO, CFO AND SECRETARY, AND ONE ADDITIONAL INDIVIDUAL IN THE FINANCE DEPARTMENT.

Enova believes it has been 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, 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 has been to develop and produce advanced proprietary software and hardware for applications in these alternative power markets. Our focus has been on powertrain systems including digital power conversion, power management and system integration, focusing chiefly on vehicle power generation.

Specifically, we have developed, designed 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 has been centered 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. Provided we generate necessary resources, we will continue to work refining both our market strategy and our product line to maintain our 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.

During 2012, we continued to produce electric and hybrid electric drive systems and components for First Auto Works of China ("FAW"), Smith Electric Vehicles ("Smith"), Optare Bus ("Optare") and the US Military as well as other domestic and international vehicle and bus manufacturers. 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.

In 2012, the Company delivered a total of 58 full systems units of Enova drive systems to its customers.

For the year ended December 31, 2012, the following customers each accounted for more than ten percent (10%) of our total revenues:

 
 
Customer                             Percent 
-----------------------------------  -------- 
First Auto Works Group Corporation        63% 
Optare Group Ltd.                         20% 
 

Please refer to the Management's Discussion and Analysis of Financial Condition and Results of Operations and our financial statements for further analysis of our results.

Climate Change Initiatives and Environmental Legislation

Because vehicles powered by internal combustion engines cause pollution (greenhouse gasses), there has been significant public pressure in throughout the world to reduce these emissions. Thus, the US (federal and state levels) and countries in Europe and Asia have enacted legislation 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").

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 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 have the potential to be 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 2012, Enova continued marketing efforts to world 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.

 
--  First Auto Works ("FAW") - Enova continues to supply FAW drive systems for their hybrid buses. 
     Since the 2008 Olympics in Beijing, Enova Systems and First Auto Works have deployed over 
     500 vehicles, all utilizing Enova's pre-transmission hybrid drive system components. First 
     Auto Works is one of China's largest vehicle producers, manufacturing in excess of 1,000,000 
     vehicles annually. The Enova drive system is integrated and branded under the name of Jiefang 
     CA6120URH hybrid. The Jiefang 40 ft. long hybrid city bus can carry up to 103 passengers and 
     travel at a speeds of over 50 miles per hour. With the Enova hybrid system components, the 
     Jiefang bus meets Euro III emission standards, consumes only 7.84 miles per gallon and achieves 
     a reduction of 20 percent in harmful emissions. 
 
 
--  Smith Electric Vehicles N.A. Inc. ("Smith") - Enova continues to supply Smith with electric 
     drive systems. Smith has deployed several hundred vehicles utilizing Enova's electric drive 
     system. Smith develops, produces and sells zero-emission commercial electric vehicles that 
     are designed to be an alternative to traditional diesel trucks, providing higher efficiency 
     and lower total cost of ownership. Smith has manufacturing facilities in Kansas City, Missouri, 
     and outside of Newcastle, UK. Smith's vehicle designs leverage more than 80 years of market 
     knowledge from selling and servicing electric vehicles in the United Kingdom. Smith produces 
     the Newton and the Edison. 
 
 
--  Optare plc ("Optare") - Enova received a second contract in 2012 as a production drive system 
     supplier for their all electric buses. Optare designs, manufactures and sells single deck 
     and double deck buses and mini coaches. Its buses operate in the UK, Continental Europe, and 
     North America. 
 

Through the first half of 2012, we continued the development of our next generation Omni-series 200kVA-capable power inverter for hybrid-electric and all-electric vehicles power management and drive system component. The inverter has undergone a series of rigorous tests, based on specifications from FCCC, Navistar, Ford and Enova's own internal requirements. We are also progressed in the design of a next generation on-board 10kW charger, which is designed to be compatible with a wide range of vehicle drive systems and motors, and can be configured for HEV, PHEV and EV applications. 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.

Research and development programs included our advanced power management systems for fuel cells and upgrades and improvements to our current power conversion and management components. We also continued evaluation of new technologies for electric motors, gear drive units and peripheral mechanical components to improve product performance and manufacturing efficiency. Provided we can obtain additional resources, we intend to continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read this Management's Discussion and Analysis of Financial Condition and Results of Operations in conjunction with our 2012 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 has been 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 Freightliner Customer Chassis Corporation, Navistar Corporation, First Auto Works, 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.

Some notable highlights of Enova's accomplishments in 2012, as noted earlier are:

 
--  First Auto Works ("FAW") - Enova continues to supply FAW drive systems for their hybrid buses. 
     Since the 2008 Olympics in Beijing, Enova Systems and First Auto Works have deployed nearly 
     500 vehicles, all utilizing Enova's pre-transmission hybrid drive system components. First 
     Auto Works is one of China's largest vehicle producers, manufacturing in excess of 1,000,000 
     vehicles annually. The Enova drive system is integrated and branded under the name of Jiefang 
     CA6120URH hybrid. The Jiefang 40 ft. long hybrid city bus can carry up to 103 passengers and 
     travel at a speeds of over 50 miles per hour. With the Enova hybrid system components, the 
     Jiefang bus meets Euro III emission standards, consumes only 7.84 miles per gallon and achieves 
     a reduction of 20 percent in harmful emissions. 
 
 
--  Smith Electric Vehicles N.A. Inc. ("Smith") - Enova continues to supply Smith with electric 
     drive systems. Smith has deployed several hundred vehicles utilizing Enova's electric drive 
     system. Smith develops, produces and sells zero-emission commercial electric vehicles that 
     are designed to be an alternative to traditional diesel trucks, providing higher efficiency 
     and lower total cost of ownership. Smith has manufacturing facilities in Kansas City, Missouri, 
     and outside of Newcastle, UK. Smith's vehicle designs leverage more than 80 years of market 
     knowledge from selling and servicing electric vehicles in the United Kingdom. Smith produces 
     the Newton and the Edison. 
 
 
--  Optare plc. ("Optare") awarded Enova a contract as the production 
     drive system supplier for their all electric buses. Enova has 
     shipped systems to Optare that are currently being integrated 
     into buses. Optare designs, manufactures and sells single deck 
     and double deck buses and mini coaches. Its buses operate in 
     the UK, Continental Europe, and North America. 
 
 
--  The Company delivered a total of 58 full systems to its customers, including 50 pre-transmission 
     hybrid drive systems to FAW for their Jiefang 112 passenger hybrid bus during the year. 
 

Enova's product focus has been on digital power management and power conversion systems. Its software and hardware manage and control the power that drives a vehicle, converting 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 and 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 has performed 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.

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 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, stock-based compensation, 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 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 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 - 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.

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 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.

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.

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 full 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.

2. Summary of Significant Accounting Policies

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.

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 exists; 
 
 
--  Delivery has occurred or services have been rendered; 
 
 
--  The fee for the arrangement is fixed or determinable; and 
 
 
--  Collectibility is reasonably assured. 
 

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 is 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 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. Certificates of deposits that have a penalty for early withdrawal are excluded from cash and cash equivalents.

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 are charged against the allowance after all collection efforts have been exhausted and the potential for recovery is considered remote. As of December 31, 2012 and 2011, the Company maintained a reserve of $313,000 and $18,000 for doubtful accounts receivable. There was bad debt expense recorded of $296,000 in 2012 and $71,000 in 2011, 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.

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, 2012 and 2011, 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 options exercise behaviors.

The cash flows from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are 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, 2012 and 2011.

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.

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 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 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. During 2012 and 2011, the Company did not recognize any 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, warrants and preferred stock

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:

 
                                                                                      Fiscal Years Ended December 31, 
                                                                                         2012             2011 
Options to purchase common 
 stock............................................................................. 
 ............................                                                            810,000       2,259,000 
Warrants to purchase common 
 stock............................................................................. 
 ..........................                                                          11,250,000       11,250.000 
Series A and B preferred shares 
 conversion........................................................................ 
 ...................                                                                        83,000            83,000 
                                                        Potential equivalent shares 
 excluded.......................................................................... 
                                                      .............................       12,143,000        13,592,000 
 

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.

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

Effective January 1, 2012, the Company adopted revised guidance related to the presentation of comprehensive income that increases comparability between U.S. GAAP and International Financial Reporting Standards. This guidance eliminates the current option to report other comprehensive income (OCI) and its components in the statement of changes in stockholders' equity. The Company adopted this guidance during the first quarter of 2012, which had no impact on the Company's financial position, operations, or cash flows. The Company currently does not have any components of other comprehensive income or loss.

In May 2011, the Financial Accounting Standards Board ("FASB") issued new guidance to achieve common fair value measurement and disclosure requirements between GAAP and International Financial Reporting Standards. This new guidance amends current fair value measurement and disclosure guidance to include increased disclosures regarding valuation inputs and investment categorization. The adoption of this new accounting guidance in 2012 did not have a material impact on the Company's financial position, operations or cash flows.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies did not or are not expected to have a material impact on the Company's financial positions, results of operations and cash flows.

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

Given the nature of our business, we are subject from time to time to 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. Other than the Arens matter outlined below, we are not aware of any other pending legal matters. 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.

The Company reported in a 8-K filed January 20, 2011 that we entered into a Partial Settlement Agreement, as amended on January 14, 2011, 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"). 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 preserved it claims under two of the counts in the Legal Action.

The two remaining counts concerned i) anticipatory breach of contract by Enova for certain purchase orders that resulted in lost profit to Arens and ii) reimbursement for engineering and capital equipment costs incurred by Arens exclusively for the fulfillment of certain purchase orders received from Enova. On December 12, 2012, a judgment was entered under the two remaining counts by the United States District Court Northern District of Illinois in favor of Arens Controls Company, L.L.C. in the amount of $2,014,169. The Company filed an appeal of the judgment in the 7th Circuit Court of Appeals on January 15, 2013. The Company believes the court committed errors leading to the verdict and judgment. However, there can be no assurance that the appeal will be successful, a negotiated settlement can be attained, or that Arens will enforce its claim in the state of California and thereby cause the Company to go into bankruptcy.

ITEM 1A. Risk Factors

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.

We may be forced into bankruptcy if we cannot reach a settlement with our two major creditors

Enova owes in excess of $4.5 million in aggregate to its two principal creditors, Arens Controls Company, L.L.C. ("Arens") and the Credit Managers Association. Without immediate additional financing or collection of receivables, the company will need to cease operations. The Company currently has no visibility as to either additional financing or the collection of receivables. Specifically, without a mutually acceptable settlement of the Arens Judgment arising out of Arens Controls Company, L.L.C. v. Enova Systems, Inc., Case No. 13-1102 (7th Circuit) in the amount of $2,014,169, the company does not currently believe it has any alternative other than to cease operations.

Our common stock has been delisted from the NYSE MKT

On October 24, 2012, the Company received notification from the NYSE MKT (the "Exchange") stating that, because the Company was not in compliance with certain of the Exchange's continued listing standards, the Exchange intended to strike the common stock of the Company from the Exchange by filing a delisting application with the Securities and Exchange Commission (the "SEC"). The Company previously disclosed in Current Reports on Form 8-K filed with the SEC on April 20, 2012, May 29, 2012, July 6, 2012, and October 24, 2012 the provisions of the Exchange's continued listing standards with which the Company was not in compliance. The Company did not request an appeal of the Exchange's delisting determination.

Effective October 31, 2012, the Company's common shares were delisted from the Exchange and, on the same date, trading of the Company's shares commenced on the OTCQB Marketplace under the trading symbol "ENVS". The OTCQB is a market tier operated by the OTC Market Group Inc. for over-the-counter traded companies. The delisting and transition to the OTCQB does not change the Company's obligations to file periodic and other reports with the SEC under applicable federal securities laws.

As a result of the delisting of our common stock from the NYSE MKT, we believe that the price and liquidity of our common stock, and our ability to raise funds from the sale of equity in the future, will be materially affected.

Raising additional funds by issuing securities, engaging in debt financings or through licensing arrangements may cause substantial dilution to existing stockholders, restrict our operations or require us to relinquish proprietary rights.

To the extent that we raise additional capital by issuing equity securities as we did in 2011, April 2012 and May 2012, our existing stockholders' ownership may be substantially diluted. Any debt financing we enter into may involve covenants that restrict our operations or our ability to enter into other funding arrangements. These restrictive covenants may include limitations on additional borrowing and specific restrictions on the use of our assets, as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments. In addition, if we raise additional funds through licensing arrangements, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

One group of our shareholders holds a large percentage of our outstanding common stock, and, should they choose to do so, may have significant influence over the outcome of corporate actions requiring stockholder approval.

Approximately 22% of our outstanding common stock is held by a group of 17 shareholders (the "Low-Beer Managed Accounts") who invested in our December 2011 placement of 11,250,000 shares of common stock together with warrants to purchase up to 11,250,000 shares of common stock. The warrants are exercisable for a period of five years and exercisable at a price of $0.22 per share. The warrants further provide that if, for a twenty consecutive trading day period, the average of the closing price quoted on the OTCQB market is greater than or equal to $0.44 per share, with at least an average of 10,000 shares traded per day, then, on the 10th calendar day following written notice from the Company, any outstanding warrants will be deemed automatically exercised pursuant to the cashless/net exercise provisions under the warrants. Accordingly, the Low-Beer Managed Accounts, should they choose to do so, may be able to significantly influence the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction, and such group of investors could delay or prevent a change of control of our company, even if such a change of control would benefit our other stockholders. The interests of the Low-Beer Managed Accounts may differ from the interests of our other stockholders.

Funding from our equity lines of credit may be limited or be insufficient to fund our operations or to implement our strategy.

Under our purchase agreements with Lincoln Park, we may direct Lincoln Park to purchase up to $3,400,000 of shares of common stock over a 36 month period, and, upon effectiveness of a registration statement for resale of the shares and subject to other conditions, we also may direct Lincoln Park to purchase up to $6,600,000 of our shares of common stock over a 36 month period. The amounts available for purchase is limited under each purchase agreement. The extent to which we rely on Lincoln Park as a source of funding will depend on a number of factors including, the amount, if any, of additional working capital needed, the prevailing market price of our common stock and the extent to which we are able to secure working capital from other sources. If we are unable to sell enough of our products to finance our working capital requirements and if sufficient funding from Lincoln Park were to prove unavailable or prohibitively dilutive, we would need to secure another source of funding. Even if we sell all $10,000,000 under the aggregate purchase agreements to Lincoln Park, there can be no assurance this would be sufficient to support our operations or implement our growth plans in all cases.

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 $8,235,000 for the year ended December 31, 2012 and our accumulated deficit was $159,347,000 as of December 31, 2012. 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.

We are dependent on access to capital markets in order to fund continued operations of the Company.

We do not currently have adequate internal liquidity to fund the Company's operations on an ongoing basis. We will need to continue to look for partnering opportunities and other external sources of liquidity, including the public and private financial markets and strategic partners. We may not be able to obtain financing arrangements in amounts or on terms acceptable to us in the future. In the event we are unable to obtain additional financing when needed, and without substantial reductions in development programs and strategic initiatives, we do not expect that our cash and cash equivalents and short-term investments will be sufficient to fund our operating and capital needs for the twelve months following December 31, 2012.

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. In the fiscal year ended December 31, 2012, our two largest customers comprised 83% 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:

 
--  perceptions about alternative fuel vehicles safety (in particular 
     with respect to lithium-ion battery packs), design, performance 
     and cost, especially if adverse events or accidents occur that 
     are linked to the quality or safety of alternative fuel vehicles; 
 
 
--  volatility in the cost of oil and gasoline; 
 
 
--  consumer's perceptions of the dependency of the United States 
     on oil from unstable or hostile countries; 
 
 
--  improvements in fuel of the internal combustion engine; 
 
 
--  the environmental consciousness of consumers; 
 
 
--  government regulation 
 
 
--  macroeconomics 
 

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, 2012, the two highest outstanding accounts receivable balances totaled approximately $560,000 which represents 100% 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 ability to continue in business is dependent on the performance of key management and technical personnel, the loss of whom could severely affect our business. Additionally, in order to successfully implement any future growth, we will be dependent on our ability to generate resources necessary to hire qualified personnel. There can be no assurance that we will be able to retain or hire 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 ability to attract, retain, and motivate highly skilled personnel in an increasingly competitive market.

We are highly dependent on a few vendors for key system components made to our engineering specifications and disruption of vendor supply could adversely impact our results of operations.

Our product specifications often involve upfront investment in tooling and machinery, which result in our commitment to a limited number of high quality vendors that can meet our manufacturing standards. Any disruption to our supply of key components from the suppliers would have an adverse impact on our business and results of operations.

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.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

Our corporate offices are located at a manufacturing and warehouse facility at 2945 Columbia Street, Torrance, California which we are sub-leasing on a month-to-month basis. The lease on our former corporate offices ended on January 31, 2013.

ITEM 1. FINANCIAL STATEMENTS

ENOVA SYSTEMS, INC.

BALANCE SHEETS

 
                                                        December          December 
                                                           31,               31, 
                                                          2012              2011 
 
 ASSETS 
 Current assets: 
  Cash and cash equivalents                           $ 57,000          $ 3,096,000 
  Certificate of deposit, 
   restricted                                                     -           200,000 
  Accounts receivable, net                                  208,000           759,000 
  Inventories and 
   supplies, net                                         2,203,000         4,036,000 
  Prepaid expenses and other current assets                 242,000            242,000 
   Total current 
    assets                                               2,710,000         8,333,000 
  Long term accounts 
   receivable                                                 38,000            79,000 
  Property and equipment, 
   net                                                   307,000           928,000 
   Total assets                                       $ 3,055,000        $ 9,340,000 
 
 LIABILITIES AND STOCKHOLDERS' EQUITY 
 Current liabilities: 
  Accounts payable                                   $ 558,000         $ 354,000 
  Deferred revenues                                        118,000           320,000 
  Accrued payroll and related expenses                       98,000          266,000 
  Accrued loss for 
   litigation settlement                                2,014,000                   - 
  Other accrued liabilities                                255,000         517,000 
  Current portion 
   of notes payable                                          66,000            62,000 
   Total current 
    liabilities                                         3,109,000         1,519,000 
  Accrued interest 
   payable                                              1,318,000         1,237,000 
  Notes payable, net of current portion                 1,262,000         1,286,000 
   Total liabilities                                    5,689,000       4,042,000 
 Stockholders' 
  equity: 
 
  Series A convertible preferred stock 
   - no par value, 30,000,000 shares authorized; 
   2,642,000 shares issued and outstanding; 
   liquidating preference at $0.60 per 
   share as of December 31, 2012 and December 
   31, 2011, respectively                            528,000           528,000 
 
  Series B convertible preferred stock 
   - no par value, 5,000,000 shares authorized; 
   546,000 shares issued and outstanding; 
   liquidating preference at $2 per share 
   as of December 31, 2012 and December 
   31, 2011                                          1,094,000         1,094,000 
 
  Common Stock - no par value, 750,000,000 
   shares authorized; 44,520,000 and 42,765,000 
   shares issued and outstanding as of 
   December 31, 2012 and December 31, 2011, 
   respectively                                      145,512,000       145,380,000 
  Additional paid-in 
   capital                                              9,579,000         9,408,000 
  Accumulated 
   deficit                                             (159,347,000)     (151,112,000) 
   Total stockholders' 
    equity                                              (2,634,000)      5,298,000 
   Total liabilities and stockholders' 
    equity                                            $ 3,055,000       $ 9,340,000 
 

See accompanying notes to these financial statements.

ENOVA SYSTEMS, INC.

STATEMENTS OF OPERATIONS

 
                                                                      Twelve Months 
                                                                       Ended 
                                                                            December 31, 
                                                                       2012                         2011 
 Revenues                                                     $ 1,103,000                    $ 6,622,000 
 Cost of revenues                                                 2,407,000                      6,364,000 
 Gross income                                                   (1,304,000)                         258,000 
 Operating expenses 
   Research and development                                         805,000                     2,039,000 
   Selling, general & administrative                             3,915,000                      5,075,000 
   Total operating expenses                                     4,720,000                      7,114,000 
 Operating loss                                                (6,024,000)                    (6,856,000) 
 Other income and (expense) 
   Loss on litigation                                           (2,014,000)                       (41,000) 
   Interest and other income 
    (expense)                                                     (197,000)                       (87,000) 
   Total other income and 
    (expense)                                                  (2,211,000)                       (128,000) 
 Net loss                                                     $ (8,235,000)                  $ (6,984,000) 
 
 Basic and diluted loss 
  per share                                                    $ (0.19)                      $ (0.22) 
 Weighted average number 
  of common shares outstanding                                 43,952,000                31,537,000 
 
 
 

See accompanying notes to these financial statements

ENOVA SYSTEMS, INC.

STATEMENTS OF CASH FLOWS

 
 
                                                    For the Year Ended 
                                                                    December 31, 
       Cash flows from operating 
         activities:                       2012           2011 
                                      -------------  ------------- 
      Net loss                         $(8,235,000)   $(6,984,000) 
           Adjustments to reconcile 
            net loss to net cash 
            used in operating 
            activities: 
      Reserve for doubtful 
       accounts                             296,000         71,000 
      Inventory reserve                   1,436,000        845,000 
      Depreciation and 
       amortization                         466,000        495,000 
      Loss on asset disposal                 28,000         49,000 
      Loss on asset impairment               90,000              - 
      Loss on litigation 
       settlement                       2,014,000     41,000 
      Stock option expense                  171,000        368,000 
      (Increase) decrease 
       in: 
      Accounts receivable                   255,000      2,020,000 
      Inventory and supplies                397,000      (426,000) 
      Prepaid expenses 
       and other current 
       assets                                     -        240,000 
      Long term accounts 
       receivable                            41,000         21,000 
      Increase (decrease) 
       in: 
      Accounts payable                      204,000    (1,493,000) 
      Deferred revenues                (202,000)           289,000 
      Accrued payroll and 
       related expense                    (168,000)      (656,000) 
      Other accrued liabilities           (262,000)    (1,263,000) 
      Accrued interest 
       payable                         81,000            81,000 
                                                     ------------- 
      Net cash used in 
       operating activities            (3,388,000)     (6,302,000) 
                                      -------------  ------------- 
 
 
 
         Cash flows from investing 
         activities: 
      Sale of certificate 
       of deposit, restricted               200,000        - 
      Proceeds from the 
       sale of fixed assets                  53,000   - 
      Purchases of property 
       and equipment                       (16,000)      (275,000) 
                                      -------------  ------------- 
      Net cash provide 
       by (used in) investing 
       activities                           237,000      (275,000) 
                                      -------------  ------------- 
 
      Cash flows from financing 
       activities: 
      Payment on notes 
       payable                             (20,000)       (26,000) 
      Net proceeds from 
       the exercise of stock 
       options                                    -         23,000 
      Net proceeds from 
       the issuance of common 
       stock                                132,000      1,245,000 
                                      -------------  ------------- 
      Net cash provided 
       by financing activities              112,000      1,242,000 
                                      -------------  ------------- 
 
      Net decrease in cash 
       and cash equivalents             (3,039,000)    (5,335,000) 
      Cash and cash equivalents, 
       beginning of period                3,096,000      8,431,000 
                                      -------------  ------------- 
      Cash and cash equivalents, 
       end of period                   $ 57,000       $ 3,096,000 
                                      =============  ============= 
 
      Supplemental disclosure 
       of cash flow information: 
      Interest paid                    5,000          $ 6,000 
                                      =============  ============= 
      Assets acquired through 
       financing arrangements          $ -            $ 25,000 
                                      =============  ============= 
      Conversion of preferred 
       stock series A to 
       common stock                    $ -            $ 2,000 
                                      =============  ============= 
 

ENOVA SYSTEMS, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

 
                                                                   Convertible Preferred                                                                               Additional                            Total 
                                                                    Stock 
                                                                            Series A                           Series B                  Common Stock                    Paid-in     Accumulated       Stockholders' 
                                                                 Shares               Amount       Shares         Amount        Shares                Amount             Capital          Deficit           Equity 
Balance, December 31, 
 2010....................................................              2,652,000  $ 530,000     546,000       $1,094,000   31,479,000            $144,110,000         $9,040,000    $(144,128,000)     $ 10,646,000 
  Issuance of common stock 
   upon exercise of stock 
   options............................................... 
   ........................................                                                                                       36,000                     23,000                                             23,000 
Issuance of common stock 
 for cash.........................................                                                                         11,250,000                  1,245,000                                          1,245,000 
Issuance of common stock 
 upon conversion of preferred 
 stock................................................... 
 ............................................                           (10,000)     (2,000)                                                  -                2,000                                                  - 
Stock option 
 expense................................................. 
 ................                                                                                                                                                          368,000                            368,000 
Net 
 loss.................................................... 
 ......................................                                                                                                                                                   (6,984,000)    (6,984,000) 
Balance, December 31, 
 2011....................................................              2,642,000  $ 528,000     546,000       $1,094,000   42,765,000            $145,380,000         $9,408,000    $(151,112,000)     $ 5,298,000 
Issuance of common stock 
 for cash                                                                                                                   1,755,000            $ 132,000                                             $ 132,000 
Stock option 
 expense................................................. 
 ................                                                                                                                                                          171,000                            171,000 
Net 
 loss.................................................... 
 ......................................                                                                                                                                                   (8,235,000)    (8,235,000) 
Balance, December 31, 
 2012....................................................              2,642,000  $ 528,000     546,000       $1,094,000   44,520,000            $145,512,000         $9,579,000    $(159,347,000)      $(2,634,000) 
 

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

ENOVA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

Twelve months ended December 31, 2012 and 2011

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 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 th-rough a combination of private and public equity offerings, and debt financing. During 2012, the Company's growth and working capital needs have been funded primarily through a combination of product sales, existing cash reserves and equity financing. As of December 31, 2012, the Company had approximately $57,000 of cash and cash equivalents. At December 31, 2012, the Company had net working capital of negative $399,000 compared to $6.8 million at December 31, 2011, representing a decrease of approximately $7.2 million.

Management manages costs in line with estimated total revenue. However, there can be no assurance that anticipated revenue will be realized or that the Company will successfully implement its plans. Management implemented measures to conserve cash, including the reduction of over 80% of employee headcount in the second quarter of 2012, and stringent controls over inventory purchases and administrative expenses. The Company will continue to conserve available cash by closely scrutinizing expenditures and extensively utilizing current inventory for sales during 2013. The Company will need to raise additional capital to accomplish continue in business over the next year. The Company can make no assurance with respect to either the availability or terms of such financing and capital when it may be required.

Going Concern

The Company has experienced and continues to experience operating losses and negative cash flows from operations, as well as an ongoing requirement for substantial additional capital investment. At December 31, 2012, the Company had an accumulated deficit of approximately $159.3 million, working capital of approximately negative $399,000 and shareholders' equity deficit of approximately $2.6 million. Over the past years, the Company has been funded through a combination of debt financing and private equity offerings. As of December 31, 2012, the Company had approximately $57,000 in cash and cash equivalents.

The Company expects that it will need to raise additional capital to pursue recovery of its business over the long term and is currently pursuing a variety of funding options. There can be no assurance as to the availability or terms upon which such financing and capital might be available. If the Company is not successful in its efforts to raise additional funds, the Company may be required to cease its business operations.

In December 2011, we raised approximately $1,245,000, net of financing costs of $442,500, through an equity issuance to certain accredited investors. And in the second quarter of 2012, through the Lincoln Park facility, we were able to raise $132,000, net of financing costs of $152,000. See Note 11 - Stockholders' Equity for further analysis of the equity issuance in 2012. The Company continues to pursue other options to raise additional capital fund continuing operations; however, there can be no assurance that we can successfully raise additional funds through the capital markets.

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The accompanying financial statements do not include any adjustments relating to the recoverability of assets and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

Judgment entered in Arens Controls Litigation

On December 12, 2012, a judgment was entered by the United States District Court Northern District of Illinois in favor of Arens Controls Company, L.L.C. in the amount of $2,014,169 regarding claims for two counts concerning i) anticipatory breach of contract by Enova for certain purchase orders that resulted in lost profit to Arens and ii) reimbursement for engineering and capital equipment costs incurred by Arens exclusively for the fulfillment of certain purchase orders received from Enova.

The Company filed an appeal of the judgment in the 7th Circuit Court of Appeals on January 15, 2013. The Company believes the court committed errors leading to the verdict and judgment. However, there can be no assurance that the appeal will be successful, a negotiated settlement can be attained, or that Arens will enforce its claim in the state of California and thereby cause the Company to go into bankruptcy.

3. Inventory

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:

 
                                                                                         2012                2011 
Raw 
 materials...................................................................... 
 ................................................................                 $ 3,988,000         $ 4,431,000 
Work-in-process................................................................ 
 .................................................................                             2,000           144,000 
Finished 
 goods.......................................................................... 
 .........................................................                                 587,000             644,000 
Reserve for 
 obsolescence................................................................... 
 ..............................................                                        (2,374,000)         (1,183,000) 
                                                                                  $ 2,203,000         $ 4,036,000 
 

Inventory reserve charged to operations amounted to $1,436,000 and $845,000 during 2012 and 2011, respectively. Inventory valuation adjustments and other inventory write-offs in 2012 and 2011 amounted to $245,000 and $291,000, respectively.

4. Property and Equipment

Property and equipment consisted of the following at December 31:

 
                                                                                   2012                 2011 
Computers and 
 software....................................................................... 
 .........................................................                        $ 580,000          $ 618,000 
Machinery and 
 equipment...................................................................... 
 .......................................................                              535,000          892,000 
Furniture and office 
 equipment...................................................................... 
 ...............................................                                      87,000             98,000 
Demonstration vehicles and 
 buses.......................................................................... 
 ....................................                                                675,000            774,000 
Leasehold 
 improvements................................................................... 
 ............................................................                       1,327,000                1,348,000 
Construction in 
 progress....................................................................... 
 ........................................................                                       -       39,000 
                                                                                          3,204,000          3,769,000 
Less accumulated depreciation and 
 amortization................................................................... 
 ....................                                                              (2,897,000)        (2,841,000) 
 Total......................................................................... 
  .............................................................................. 
  ..........                                                                      $ 307,000          $ 928,000 
 

Fixed assets totaling $482,000 and $187,000 were retired or disposed of in the years ended December 31, 2012 and 2011, respectively. Depreciation and amortization expense was $466,000 and $495,000 for the years ended December 31, 2012 and 2011, respectively, which included amortization expense of leasehold improvements of $262,000 for the years ended December 31, 2012 and 2011, respectively.

5. Litigation judgment

On December 12, 2012, a judgment was entered by the United States District Court Northern District of Illinois in favor of Arens Controls Company, L.L.C. in the amount of $2,014,169 regarding claims for two counts. In 2008, Arens Controls Company, L.L.C. ("Arens") filed claims against Enova with the United States District Court Northern District of Illinois. A Partial Settlement Agreement, as amended on January 14, 2011, resolved certain claims made by Arens. However, the claims were preserved under two remaining counts concerning i) anticipatory breach of contract by Enova for certain purchase orders that resulted in lost profit to Arens and ii) reimbursement for engineering and capital equipment costs incurred by Arens exclusively for the fulfillment of certain purchase orders received from Enova.

The Company filed an appeal of the judgment in the 7th Circuit Court of Appeals on January 15, 2013. The Company believes the court committed errors leading to the verdict and judgment. However, there can be no assurance that the appeal will be successful, a negotiated settlement can be attained, or that Arens will enforce its claim in the state of California and thereby cause the Company to go into bankruptcy.

6. Other Accrued Liabilities

Other accrued liabilities consisted of the following at December 31:

 
                                                                             2012          2011 
Accrued inventory 
 received............................................................. 
 ...................................................................    $ 14,000    $ 2,000           ,000 
Accrued professional 
 services............................................................. 
 ...............................................................            45,000           150,000           525,000 
Accrued 
 warranty............................................................. 
 ..................................................................... 
 ................                                                        117,000             227,000           510,000 
Other................................................................ 
 ..................................................................... 
 ...................................                                       79,000            138,000           125,000 
 Total............................................................... 
  .................................................................... 
  .....................................                                 $ 255,000   $ 517,000         ,739,000 
 

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

 
                                                                                            2012             2011 
Balance at beginning of 
 year............................................................................... 
 ............................                                                         $ 227,000        $ 510,000 
Accruals for warranties issued during 
 the period........................................................................          141,000          470,000 
Warranty 
 claims............................................................................. 
 ....................................................                                       (251,000)        (753,000) 
Balance at end of 
 year............................................................................... 
 ........................................                                             $ 117,000        $ 227,000 
 

7. Notes Payable, Long-Term Debt and Other Financing

Notes payable consisted of the following at:

 
                                                                                                                     December          December 
                                                                                                                      31, 2012          31, 2011 
Secured note payable to Credit Managers Association 
 of California, bearing interest at prime plus 3% 
 (6.25% as of December 31, 2012), and is adjusted 
 annually in April through maturity. Principal and 
 unpaid interest due in April 2016. A sinking fund 
 escrow may be funded with 10% of future equity financing, 
 as defined in the Agreement...............................                                                        $ 1,238,000         $ 1,238,000 
Secured note payable to a Coca Cola Enterprises in 
 the original amount of $40,000, bearing interest 
 at 10% per annum. Principal and unpaid interest due 
 on demand................................                                                                                    40,000              40,000 
Secured note payable to a financial institution in 
 the original amount of $38,000, bearing interest 
 at 8.25% per annum, payable in 60 equal monthly installments 
 of principal and interest through February 19, 
 2014...................................................................................................                      11,000              18,000 
Secured note payable to a financial institution in 
 the original amount of $19,000, bearing interest 
 at 10.50% per annum, payable in 60 equal monthly 
 installments of principal and interest through August 
 25, 2014.....................................................................................................                  8,000             12,000 
Secured note payable to a financial institution in 
 the original amount of $26,000, bearing interest 
 at 7.91% per annum, payable in 60 equal monthly installments 
 of principal and interest through April 9, 
 2015............................................................................................................             14,000              18,000 
Secured note payable to a financial institution in 
 the original amount of $25,000, bearing interest 
 at 7.24% per annum, payable in 60 equal monthly installments 
 of principal and interest through March 10, 
 2016.......................................................................................................                  17,000              22,000 
                                                                                                                         1,328,000           1,348,000 
Less current portion of notes 
 payable...............................................................................................                      (66,000)            (62,000) 
 Notes payable, net of current 
  portion...............................................................................................           $ 1,262,000         $ 1,286,000 
 
 

As of December 31, 2012 and 2011, the balance of long term interest payable amounted to $1,318,000 and $1,237,000, respectively, of which the Credit Managers Association of California note amounted to $1,286,000 and $1,209,000, respectively. Interest expense on notes payable amounted to approximately $88,000 during each of the years ended December 31, 2012 and 2011, respectively.

Future minimum principal payments of notes payable at December 31, 2012 consisted of the following:

 
Year Ending                                                                                                                                                                                                  Principal 
 December 31                                                                                                                                                                                                  Amounts 
2013...................................................................................................................................................................................................              66,000 
2014...................................................................................................................................................................................................              16,000 
2015...................................................................................................................................................................................................                8,000 
2016...................................................................................................................................................................................................         1,238,000 
Thereafter.........................................................................................................................................................................................                      - 
 Total.................................................................................................................................................................................................   $ 1,328,000 
 
   8.   Revolving Credit Agreement 

On June 30, 2010, the Company entered into a secured 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 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.

During the fourth quarter of 2012, the irrevocable letter of credit was fully drawn down by Sunshine Distribution L.P. in order to pay rent on our corporate headquarters, and the certificate of deposit was fully utilized to fund draws on the secured facility. Therefore, the facility was fully drawn and expired on December 31, 2012.

9. Deferred Revenues

The Company had deferred $118,000 and $320,000 in revenue related to production and development contracts at December 31, 2012 and 2011, respectively. The Company anticipates that the December 31, 2012 deferred revenue balance will be recognized in the first half of 2013.

10. Commitments and Contingencies

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 expired January 31, 2013. Our corporate offices are currently located at a manufacturing and warehouse facility at 2945 Columbia Street, Torrance, California which we are sub-leasing on a month-to-month basis.

The total base monthly rent is approximately $39,000. Under the Lease, Enova pays 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 had an office in Hawaii rented on a month-to-month basis at $3,400 per month, which was closed in November 2011. Rent expense was approximately $537,000 and $611,000 for the years ended December 31, 2012, and 2011, respectively.

Future minimum lease payments under non-cancelable operating lease obligations at December 31, 2012 were as follows:

 
Year Ending                                                                                                                                                                                                   Operating 
 December 31                                                                                                                                                                                                   Leases 
2013.......................................................................................................................................................................................................   $ 44,000 
 Total.....................................................................................................................................................................................................   $ 44,000 
 

11. Stockholders' Equity

Common Stock

On April 23, 2012, the Company entered into a $6,600,000 purchase agreement with Lincoln Park Capital Fund pursuant to which the Company has the right to sell to Lincoln Park up to $6,600,000 in shares of the Company's common stock, and on April 24, 2012, the Company entered into another purchase agreement with Lincoln Park Capital Fund pursuant to which the Company has the right to sell to Lincoln Park up to $3,400,000 in additional shares of the Company's common stock, subject to certain limitations. We issued a total of 1,754,974 shares of common stock in the second quarter of 2012, of which 1,450,000 shares were issued for cash proceeds of $132,000, net of financing costs of $152,000, as consideration for its commitment to purchase common stock under the $3,400,000 Purchase Agreement and commissions on each drawdown, the Company issued to Lincoln Park a total of 304,974 shares of common stock. The purchase agreement stipulates that our shares be listed on a national exchange in order to access the facility. As the company's shares were delisted from the NYSE Amex Exchange on October 31, 2012, the Company is no longer able to sell shares to Lincoln Park under the facility.

During the twelve months ended December 31, 2012 and 2011, the Company did not issue any shares of common stock to directors or employees as compensation. During the twelve months ended December 31, 2011, 10,000 shares of the Company's Series A Preferred Stock were converted into 222 shares of its common stock. There were no conversions of the Company's Series A Preferred Stock for the comparable period in 2012.

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.

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.

12. Stock Options

Stock Option Program Description

For the year ended December 31, 2012 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 270,000 and 1,405,000 were granted in 2012 and 2011, respectively.

Stock-based compensation expense related to stock options was $171,000 and $368,000 for the years ended December 31, 2012 and 2011, respectively. As of December 31, 2012, the total compensation cost related to non-vested awards not yet recognized is $21,000. The remaining period over which the future compensation cost is expected to be recognized is 29 months.

Stock-based compensation expense recognized in the Statement of Operations for the years ended December 31, 2012 and 2011 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.

The following is a summary of changes to outstanding stock options during the fiscal year ended December 31, 2012 and 2011:

 
                                                                                                                   Weighted 
                                                                                                         Weighted  Average 
                                                                                             Number      Average   Remaining     Aggregate 
                                                                                             of          Exercise  Contractual   Intrinsic 
                                                                                             Share       Price     Life          Value(1) 
                                                                                             Options 
Outstanding at December 31, 
 2010.................................................................................      1,393,000   $ 2.06          6.92    $ 267,000 
 Granted................................................................................ 
  ..............................................                                            1,405,000   $ 0.30          6.13    $ - 
 Exercised.............................................................................. 
  ..............................................                                              (36,000)  $ 0.63             -    $ - 
 Forfeited or 
  Cancelled.............................................................................. 
  .......................                                                                   (233,000)   $ 2.36          -       $ - 
Outstanding at December 31, 
 2011.................................................................................      2,529,000   $ 1.07          6.09    $ - 
 Granted................................................................................ 
  ..............................................                                               270,000  $ 0.08          3.96    $ - 
 Exercised............................................................................... 
 .............................................                                                      -   $ -                -    $ - 
 Forfeited or 
  Cancelled.............................................................................. 
  .......................                                                                  (1.989,000)  $ 1.11          -       $ - 
Outstanding at December 31, 
 2012.................................................................................         810,000  $ 0.64          4.06    $ - 
                                                                                                                                ========== 
Exercisable at December 31, 
 2012....................................................................................      574,000  $ 0.86          4.36    $ - 
                                                                                                                                ========== 
Vested and expected to 
 vest(2)................................................................................. 
 ......                                                                                        810,000  $ 0.64          4.06    $ - 
                                                                                                                                ========== 
 

____________

 
 (1)   Aggregate intrinsic value represents the value of the closing price per share of our common 
        stock on the last trading day of the fiscal period in excess of the exercise price multiplied 
        by the number of options outstanding or exercisable, except for the "Exercised" line, which 
        uses the closing price on the date exercised. 
 (2)   Number of shares includes options vested and those expected to vest net of estimated forfeitures. 
 

During 2011, the Company issued 36,000 shares of common stock for $23,000 in cash related to 36,000 options exercised. During 2012 and 2011, the Company granted 270,000 and 1,405,000 options for fair value of $13,500 and $329,000, respectively. During 2012 and 2011, 1,989,000 and 233,000 options were forfeited.

At December 31, 2012, there were 2,111,000 shares available for grant under the 2006 plan. The exercise prices of the options outstanding at December 31, 2012 ranged from $0.07 to $4.35. The weighted-average grant date fair value of the options granted during the years ended December 31, 2012 and 2011 was $0.05 and $0.23, respectively.

Unvested share activity for the year ended December 31, 2012 is summarized below:

 
                                                                                                              Unvested    Weighted-Average 
                                                                                                               Number      Grant Date Fair 
                                                                                                               of          Value 
                                                                                                               Options 
Unvested balance at December 31, 
 2011.......................................................................................................   1,403,000         $ 0.26 
 Granted................................................................................................... 
  ...........................................................                                                    270,000         $ 0.05 
 Vested.................................................................................................... 
  ............................................................                                                 (917,000)         $ 0.19 
 Forfeited................................................................................................. 
  ...........................................................                                                  (519,000)         $ 0.29 
Unvested balance at December 31, 
 2012.......................................................................................................     236,000         $ 0.04 
 

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, 2012 and 2011:

 
                                                                                                     Years Ended 
                                                                                                      December 31, 
                                                                                                  2012        2011 
Total intrinsic value of stock options 
 exercised..........................................                                          $ -         $ 25,000 
Cash received from stock option exercises..................................................   $ -         $ 23,000 
Gross income tax benefit from the exercise 
 of stock options....................                                                         $ -         $ - 
 

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, 2012 and 2011 were estimated on the date of grant using the following range of assumptions:

 
                                                                                                Years Ended 
                                                                                                 December 31, 
                                                                                          2012 2011 
Expected life (in 
years)................................................................................ 
...................................................                                         1.5- 6.5      2.5- 6.5 
Average risk-free interest 
 rate................................................................................. 
 .....................................                                                         1.66%         1.63% 
Expected 
 volatility...........................................................................     108% -        107% - 
 ...............................................................                            135%          132% 
Expected dividend 
 yield................................................................................ 
 ................................................                                              0%            0% 
Forfeiture 
 rate................................................................................. 
 .................................................................                             3%            3% 
 
 

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.

13. Warrants

In December 2011, the Company completed a private equity placement of 11,250,000 shares of common stock for $1,245,000 together with warrants to purchase up to 11,250,000 shares of common stock to a group of 17 shareholders (the "Low-Beer Managed Accounts"). The warrants are exercisable for a period of five years and exercisable at a price of $0.22 per share. The warrants further provide that if, for a twenty consecutive trading day period, the average of the closing price quoted on the OTCQB market is greater than or equal to $0.44 per share, with at least an average of 10,000 shares traded per day, then, on the 10th calendar day following written notice from the Company, any outstanding warrants will be deemed automatically exercised pursuant to the cashless/net exercise provisions under the warrants.

The following is a summary of changes to outstanding warrants during the fiscal year ended December 31, 2012 and 2011:

 
 
                                                                   Weighted 
                                       Number      Weighted         Average 
                                         of        Average         Remaining 
                                       Share       Exercise       Contractual 
                                      Options       Price            Life 
                                   -----------  ------------  --------------- 
Outstanding at December 31, 2010             -  $          -                - 
Granted                             11,250,000  $       0.22             5.00 
Exercised                                    -  $          -                - 
Forfeited or Cancelled                       -  $          -                - 
                                    ----------      --------  --------------- 
Outstanding at December 31, 2011    11,250,000  $       0.22             5.00 
                                    ==========      ========  =============== 
Granted                                      -  $          -                - 
Exercised                                    -  $          -                - 
Forfeited or Cancelled                       -  $          -                - 
                                    ----------      --------  --------------- 
Outstanding at December 31, 2012    11,250,000  $       0.22             4.00 
                                    ==========      ========  =============== 
Exercisable at December 31, 2012             -  $          -               -. 
                                    ==========      ========  =============== 
 

14. Income Taxes

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:

 
                                                                                   2012                   2011 
Deferred tax assets 
 Net operating loss 
  carry-forwards........................................................ 
  ...........................................                             $ 25,079,000           $ 25,701,000 
 Stock based 
  compensation.......................................................... 
  .....................................................                                845,000                772,000 
  Other, 
   net.................................................................. 
   ..................................................................... 
   .....                                                                              (406,000)              (743,000) 
                                                                                  27,518,000             25,730,000 
Less valuation 
 allowance.............................................................. 
 .....................................................                           (27,518,000)           (25,730,000) 
  Net deferred tax 
   assets............................................................... 
   .....................................................                  $ -                    $ - 
 

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 $1,788,000 in 2012 compared to a decrease of $2,346,000 in 2011. As of December 31, 2012, the Company had net operating loss carry forwards for federal and state income tax purposes of approximately $66,515,000 and $50,493,000, respectively. These operating loss carry forwards will expire in 2013 through 2032.

The provision for income taxes differs from the amount computed by applying the U.S. federal statutory tax rate (34% in 2012 and 2011) to income taxes as follows:

 
                                                                               December              December 31, 
                                                                               31, 
                                                                                2012                  2011 
Tax benefit computed at 
 34%...................................................................... 
 ............................                                                $ (2,800,000)         $ (2,375,000) 
Change in valuation 
 allowance................................................................ 
 ...............................                                                      1,788,000           (2,346,000) 
State tax (net of Federal 
 benefit)................................................................. 
 ............................                                                          (480,000)             (406,000) 
Change in carryovers and tax 
 attributes............................................................... 
 .................                                                           1,492,000             5,127,000 
Net tax 
 benefit.................................................................. 
 ..........................................................                  $ -                   $ - 
 

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, 2012 and 2011.

15. Employee Benefit Plan

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 to make discretionary contributions. For the years ended December 31, 2012 and 2011, the Company did not make any contributions to the plan. On February 28, 2013, the Company commenced closure of the 401(k) plan, which we anticipate will be completed during the second quarter of 2013.

16. Geographic Area Data

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:

 
                                                                                        2012               2011 
 United 
  States............................................................................ 
  ...........................................................................         $ 142,000     $ 4,474,000 
 China............................................................................. 
  .................................................................................. 
  ......                                                                                 716,000          1,075,000 
 United 
  Kingdom........................................................................... 
  .......................................................................                 243,000         1,070,000 
 Japan............................................................................. 
  .................................................................................. 
  ......                                                                                     2,000               3,000 
 Total............................................................................. 
  .................................................................................. 
  .......                                                                             $ 1,103,000   $ 6,622,000 
 
 

17. Concentration

During the years ended December 31, 2012 and 2011, the Company's sales were concentrated with a few large customers. Sales to two customers comprised 63% and 20% of total revenues and two customers accounted for 61% and 39% of gross accounts receivable, respectively. During the year ended December 31, 2011, sales to four customers comprised 52%, 16%, 16% and 10% of total revenues and two customers accounted for 62% and 37% of gross accounts receivable, respectively. The Company performs ongoing credit evaluations of certain customers' financial condition and generally requires no collateral from its customers. The Company's inventory purchases are concentrated with certain key vendors that produce components according to our engineering specifications. During the year ended December 31, 2012, 39% of purchases were concentrated with one vendor and during the year ended December 31, 2011, 16% of purchases were concentrated with one vendor.

18. Subsequent Events

The Company has evaluated subsequent events and has determined that there were no subsequent events to recognize or disclose in these financial statements.

 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING 
          AND FINANCIAL DISCLOSURES 
 

None.

 
ITEM 9A.  CONTROLS AND PROCEDURES 
 

Evaluation of Disclosure Controls and Procedures

As required by SEC Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of December 31, 2012. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that as of December 31, 2012, our disclosure controls and procedures were not effective to ensure the information required to be disclosed by an issuer in the reports it files or submits under the Securities Exchange Act of 1934, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms relating to us, and was accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.

Management's Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act. We maintain internal control over financial reporting designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation of management, including the Company's Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. This evaluation included an assessment of the design of the Company's internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting.

In June 2012, all but two of the Company's employees resigned, and such staff reduction resulted in our inability to complete documentation of proper accounting procedures and management review. Not all fully implemented fundamental elements of an effective control were present as of December 31, 2012, including formalized monitoring procedures. Based on this evaluation, management has concluded that the aforementioned factors constituted a material weakness in the Company's internal control over financial reporting as of December 31, 2012.

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. We were not required to have, nor have we engaged our independent registered public accounting firm, to perform an audit of internal control over financial reporting pursuant to the rules of the Securities and Exchange Commission that permits us to provide only management's report in this annual report.

Changes in Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

This information is provided by RNS

The company news service from the London Stock Exchange

END

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