UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

Commission file no. 1-33001

 

ENOVA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

19850 South Magellan Drive, Torrance, California 90502

(Address of principal executive offices, including zip code)

 

(310) 527-2800

(Registrant’s telephone number, including area code)

 

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

 

 

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

None

 

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

 

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

 

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

 

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

 

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

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

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

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2006 (the last business day of the registrant’s more recently completed second quarter) was $39,757,906

 

The number of shares of Common Stock outstanding as of March 27, 2007 was 14,816,000

 

 

ENOVA SYSTEMS, INC.

 

2006 FORM 10-K ANNUAL REPORT

 

TABLE OF CONTENTS

 

 

General

 

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

 

Enova believes it is a leader in the development and production of proprietary, commercial digital power management systems for transportation vehicles and stationary power generation systems. Power management systems control and monitor electric power in an automotive or commercial application such as an automobile or a stand-alone power generator. Drive systems are comprised of an electric motor, an electronics control unit and a gear unit which power an electric vehicle. Hybrid systems, which are similar to pure electric drive systems, contain an internal combustion engine in addition to the electric motor, eliminating 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. Stationary power systems utilize similar components to those which are in a mobile drive system in addition to other elements. These stationary systems are effective as power-assist or back-up systems, alternative power, for residential, commercial and industrial applications.

 

A fundamental element of Enova’s strategy is to develop and produce advanced proprietary software, firmware and hardware for applications in these alternative power markets. Our focus is digital power conversion, power management, and system integration, for two broad market applications — vehicle power generation and stationary power generation.

 

Specifically, we develop, design and produce drive systems and related components for electric, hybrid-electric, fuel cell and microturbine-powered vehicles. We also develop, design and produce power management and power conversion components for stationary distributed power generation systems. These stationary applications can employ hydrogen fuel cells, microturbines, or advanced batteries for power storage and generation. Additionally, we perform research and development to augment and support others’ and our own related product development efforts.

 

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

 

Enova’s primary market focus centers on both series and parallel heavy-duty drive systems for multiple vehicle and marine applications. A series hybrid system is one where only the electric motor connects to the drive shaft; a parallel hybrid system is one where both the internal combustion engine and the electric motor are connected to the drive shaft. We believe series-hybrid and parallel hybrid medium and heavy-duty drive system sales offer Enova the greatest return on investment in both the short and long term. 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 will attempt 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. Additionally, our management believes that this area will see significant growth over the next several years. As we penetrate more market areas, we are continually refining and optimizing both our market strategy and our product line to maintain our leading edge in power management and conversion systems for mobile applications.

 

Our website, www.enovasystems.com, contains up-to-date information on our company, our products, programs and current events. We are implementing an aggressive strategy to utilize our website and the internet as a prime focal point for current and prospective customers, investors and other affiliated parties seeking data on our business.

 

During 2005, our recapitalization initiatives were successful. We entered into an agreement with a placement agent relating to the sale of 5,300,000 new shares (after the 1 for 45 reverse stock split described in Item 5 below) of our common stock, in connection with our listing on AIM in the United Kingdom. We received approximately $18,000,000 of net proceeds from the offering.

 

During 2006, we experienced a decrease in production revenues. While we believe our development and market penetration initiatives are proving successful, we have not yet seen the maturation of these efforts into sustainable production revenues. In December, 2006, we announced a production contract with the Tanfield Group Plc., which we expect will lead to production of up to 200 units in 2007. We expect that this agreement will help to consolidate our position as a market leader in Europe.

 

In August, 2006, we entered into a contract with Verizon to design, integrate, and deliver 13 service vans. We believe that working with the 2nd largest fleet operator in North America will generate further exposure in the Domestic market, and bring additional focus on our unique fleet solutions. We believe that we have the operating resources to continue our market penetration efforts, but have not ruled out seeking additional capitalization.

 

As part of our continuing strategic relationship with International Truck and Engine Corp (IC Corp), we executed an agreement to produce the nations first 19 hybrid school busses. IC Corp is the nation’s largest school bus manufacturer, claiming over 60% of the Domestic Build. In addition to School Buses, IC Corp is teaming with Enova to supply hybrid buses to the Commercial Bus Market.

 

Enova believes that our business outlook is improving. Greater recognition and strong engineering have allowed us to make several key strides towards sustainable revenue. In conjunction with this expected outlook, we have recently made several key management changes early in 2007:

 

 

We continue to receive greater recognition from both governmental and private industry with regards to both commercial and military application of its hybrid drive systems and fuel cell power management technologies. Although we believe that current negotiations with several parties may result in development and production contracts during 2007 and beyond, there are no assurances that such additional agreements will be realized.

 

During 2006, we continued to advance our technologies and products for greater market penetration for 2007 and beyond. We continue to develop independently and in conjunction with the Hyundai-Enova Innovative Technology Center (ITC) progress on several fronts to produce commercially available heavy-duty, series and parallel hybrid drive systems.

 

During 2006, we continued to develop and produce electric and hybrid electric drive systems and components for First Auto Works of China, International Truck and Engine (IC Corp), Ford Motor Company (Ford), Hyundai Motor Car, US Military, Wright Bus of the United Kingdom, and Tomoe of Japan as well as several other domestic and international vehicle and bus manufacturers. We also were successful in introducing our technology to companies such as Concurrent Technology Corporation (CTC), PUES (Tokyo Research and Development), Verizon, Volvo/Mack, Tanfield/Smith Electric Vehicles and Navistar (International Truck and Engine, IC Corporation). The continued relationships, in addition to our newest customers helped Enova easily surpass, since our inception, the manufacturing of its 900th system. 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.

 

For the year ended December 31, 2006, the following customers each accounted for more than ten percent (10%) of our total revenues:

 

 

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:

 

 

Enova Systems is a trademark of Enova Systems, Inc . All other brand names or trademarks appearing in this annual report are the property of their respective holders.

 

HybridPower^tm Electric and Hybrid-Electric Drive Systems

 

Environmental Initiatives and Legislation

 

Because vehicles powered by internal combustion engines cause pollution, there has been significant public pressure in Europe and Asia, and enacted or pending legislation in the United States at the federal level and in certain states, to promote or mandate the use of vehicles with no tailpipe emissions (“zero emission vehicles”) or reduced tailpipe emissions (“low emission vehicles”). We believe legislation requiring or promoting zero or low emission vehicles is necessary to create a significant market for electric vehicles. The California Air Resources Board (CARB) is continually modifying its limits for low emission vehicles. Recently, CARB proposed additional amendments to the regulations. Furthermore, several car manufacturers have challenged these mandates in court and have obtained injunctions to delay these mandates. There can be no assurance that further legislation will be enacted 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 vehicles. Extensions, modifications or reductions of current federal and state legislation, mandates and potential tax incentives could adversely affect our business prospects if implemented.

 

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

 

Strategic Alliances, Partnering and Technology Developments

 

Our continuing strategy is to adapt ourselves to the ever-changing environment of alternative power markets for both stationary and mobile applications. Originally focusing on pure electric drive systems, we believe we are

now positioned as a global supplier of drive systems for electric, hybrid and fuel cell applications. We are now entering stationary power markets with its power management systems and intend to develop other systems to monitor and control the complex fuel cell and ancillary device systems being developed for distributed generation and mobile applications.

 

We continue to seek and establish alliances with major players in the automotive, stationary power and fuel cell fields. 2006 allowed Enova to further its penetration into the European and Asian markets, as well as allow them to begin relationships with significant North American companies. 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 will utilize our competitive advantages, including customer alliances, to gain greater market share. By aligning ourselves with key customers in our target market(s), we believe that the alliance will result in the latest technology being implemented and customer requirements being met, with a minimal level of additional time or expense.

 

Some recent highlights of our accomplishments are:

 

 

We also received recognition from both governmental and private industry with regards to U.S. military applications of its hybrid drive systems and fuel cell power management technologies. Through 2006 we completed development on several new power management and drive systems such as our High Voltage version of our 120kW and 240 kW drive system, Dual 8kW inverter, 380V DC/DC converter, Mobile Fuel Cell Generator, a multi-functional processor, as well as upgrades to our Battery Care Management system, Fuel Cell Management system and our High Voltage Power Converter. We continued to develop and produce electric and hybrid electric drive systems and components for Ford Motor Company (Ford), the City of Honolulu and several domestic and international vehicle and bus manufacturers in China, Italy, the United Kingdom, Malaysia and Japan. Our various electric and hybrid-electric drive systems, power management and power conversion systems are being used in applications including Class 8 trucks, monorail systems, transit buses and industrial vehicles. We have furthered our development and production of systems for both mobile and stationary fuel cell powered systems with major companies such as Ford, Chevron, Texaco, and UTC Fuel Cells, a division of United Technologies. We also are continuing on our current research and development programs with Mack/Volvo, EDO Corporation, the U.S. Air

Force and the U.S. Navy, as well as developing new programs with Hyundai Motor Company (HMC), the U.S. government and other private sector companies for hybrid and fuel cell systems.

 

Research and development programs included our advanced power management systems for fuel cells, our diesel generation engine/motor system for our heavy-duty drive systems, a dual 8kW inverter, and upgrades and improvements to our current power conversion and management components. Additionally, we continue to optimize our technologies to be more universally adaptable to the requirements of our current and prospective customers. By modifying our software and firmware, we believe we should be able to provide a more comprehensive, adaptive and effective solution to a larger base of customers and applications. We will continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers as we deem beneficial to our global growth strategy.

 

Products

 

Enova’s HybridPower hybrid electric drive system provides all the functionality one would find under the hood of an internal combustion engine powered vehicle. The HybridPower system consists of an enhanced electric motor and the electronic controls that regulate the flow of electricity to and from the batteries at various voltages and power to propel the vehicle. In addition to the motor and controller, the system includes a gear reduction/differential unit which ensures the desired propulsion and performance. The system is designed to be installed as a “drop in,” fully integrated turnkey fashion, or on a modular, “as-needed” basis. Regardless of power source (battery, fuel cell, diesel generator or turbine) the HybridPower electric motor is designed to meet the customer’s drive cycle requirements.

 

Our family of medium-duty drive systems includes:

 

 

Our family of heavy-duty electric drive systems includes:

 

 

Our drive systems, in conjunction with, internal combustion engines, microturbines, fuel cells, flywheels, and generators sets provide state of the art hybrid-electric propulsion systems.

 

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

 

There are two types of hybrid systems: series and parallel. A series hybrid system is one where only the electric motor connects to the drive shaft; a parallel hybrid system is one where both the internal combustion engine and the electric motor are connected to the drive shaft. In a series hybrid system, the ICE turns the generator, which charges

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

 

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

 

Hybrid Drive Configurations

 

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

 

Series Hybrid with Diesel Generator

 

 

 

The Series Hybrid is typically ideal for low floor vehicles with a driving cycle that has a high percentage of stop and go and/or hilly terrain. Refuse trucks, urban delivery trucks and intra-city buses are the primary target markets for these drive systems. Our clients for this application include WrightBus of the U.K., MTrans of Malaysia and Tomoedenki of Japan

 

Post Transmission Parallel Hybrid

 

 

 

The Post Transmission Parallel Hybrid is ideal for vehicles with a driving cycle with a high percentage of stop and go, as well as constant speed cruising. Target markets include refuse trucks, urban delivery trucks, School Buses and intra-city buses also. Our current and potential clients for this application include Navistar, Verizon, Mack Truck, Volvo and Waste Management.

 

Pre Transmission Parallel Hybrid

 

 

 

The Pre-Transmission Parallel Hybrid is ideal for vehicles with a driving cycle having a small percentage of constant speed cruising and a large percentage of stop and go cruising. Target markets include inter-city transit buses and trucks as well as military vehicles. Our current and potential clients for this application include Volvo Truck, Cummins, Caterpillar and First Auto Works of China as well as other drive system and vehicle manufacturers for these types of driving cycles.

 

Definitions:

 

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

 

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

 

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

 

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

 

Hybrid Drive Motors

 

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

 

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

 

Hybrid Motor Controllers

 

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

 

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

 

Hybrid Drive Systems

 

The Enova hybrid drive family currently includes a 120/60kW peak series hybrid system, a 240/60kW peak series hybrid system, a 90kW peak mild, pre-transmission parallel hybrid system, a 100kW peak post-transmission parallel hybrid systems and our 100kW peak pre-transmission parallel hybrid system to be introduced later this year.

 

The Enova HybridPower hybrid-electric drive systems are based on the component building blocks of the electric drive family, including the motor, controller and optional components. As an example, the 120/60 kW series hybrid system uses the 120kW electric drive components to propel the vehicle, and uses a 60kW diesel generator (genset)to generate power while the vehicle is in operation. This synergy of design reduces the development cost of our hybrid systems by taking advantage of existing designs. The diesel genset has been designed to take advantage of many different models of internal combustion engines for greater penetration into the burgeoning heavy-duty hybrid vehicle markets. Enova’s genset will accept any engine with an industry standard bell housing and flywheel. Enova’s control protocols are designed to easily interface with any standard engine controller with analog throttle inputs. Accessories for these drives include battery management, chargers and 12-volt power supplies, as for the electric drive family.

 

Our hybrid systems are designed to work with a variety of hybrid power generation technologies. In our 120/60kW hybrid system, an internal combustion engine connected to a motor and motor controller performs the power generation. Other power options include liquid fueled turbines, such as the Capstone system, fuel cells, such as the Hydrogenics or Ballard system, or many others. In all of these examples, Enova’s battery management system provides the power management to allow for proper power control.

 

Drive System Accessories

 

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

 

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

 

Battery Care Unit

 

Enova’s Battery Care Unit (BCU) monitors, manages, protects, and reports on the condition of the vehicles battery pack. It controls and manages battery performance, temperature, voltage and current to avoid harm to the batteries, to the entire system, and to the driver, operator and passengers. It also allows for monitoring for service to the battery and drive system. The BCU reports state-of-charge, amp hours and kilowatt-hours.

 

The BCU monitors the battery pack voltage and 28 additional individual voltages with a range of 0 to 18vDC. Optional expansion modules allow 28 additional inputs per module, with up to 16 modules permitted. The BCU has eight user-programmable outputs and four user-programmable inputs to allow full integration into the vehicle. These can be used to customize input and output parameters, and to provide for other custom monitoring and battery pack control. The device is approximately 7.1 inches by 4.3 inches by 1.6 inches.

 

The BCU directly interfaces with the HybridPower and other drive systems, and controls the Safety Disconnect Unit (SDU). It is capable of supporting any battery technology, and provides each type with optimized charging and protection algorithms. An internal real-time clock allows the BCU to wake up at user-specified times to initiate battery charging or pack monitoring. A precision shunt allows it to offer a wide dynamic range for monitoring charging and motoring current, without the errors commonly associated with other types of sensors.

 

The non-volatile RAM allows the BCU to update, store and report key battery pack parameters such as amp hours, kilowatt-hours and state of change. Using Enova’s proprietary Windows -based diagnostic software, the BCU control parameters can be programmed “live” in-vehicle. Additionally, battery performance can be monitored in real-time. Reports can be output to a laptop computer for precise results and “customer friendly” usage.

 

Hybrid Control Unit

 

Enova has reconfigured its Battery Care Unit to perform the critical role of hybrid controller. The Hybrid Control Unit (HCU) continuously monitors the condition of the battery pack through communications with the BCU, monitors the driver commands through communications with the motor controller, and the state of the hybrid generator. Based upon the data received, the HCU provides continuous updates to the hybrid generator with instructions on mode of operation and power level. This innovative control loop ensures that the entire system is optimized to provide quick response to driver commands while providing the best possible system efficiency.

 

Safety Disconnect Unit

 

The Safety Disconnect Unit (SDU) is under the control of the BCU, and allows vehicle systems to gracefully connect and disconnect from the battery pack, when necessary, to prevent damage or harm. It also protects the battery pack during charging, protects it from surges, and constantly verifies that the battery pack is isolated from the vehicle chassis. In the event a ground isolation fault is detected, the BCU commands the SDU to break the battery connection thus ensuring a safe environment for the vehicle and operator. The SDU is available in two configurations to match the requirements of the drive systems.

 

High Voltage Disconnect Unit

 

The High Voltage Disconnect Unit (HVDU) is a reduced feature version of the Safety Disconnect Unit. The pre-charge board has been eliminated in order to provide a lower cost method of safely switching high voltage systems on the vehicle that do not require the soft start feature.

 

Wiring Harness Connector Kits

 

We provide complete mating connector kits to help the vehicle OEM with their production process. By using the Enova supplied kit the vehicle manufacturer is ensuring that they will have all of the necessary connectors to complete the vehicle build.

 

Distributed Power Generation for Industrial/Commercial/Residential Applications

 

Enova’s distributed generation products are virtually identical in system configuration to that of a series hybrid vehicle, including a controller and battery management. For this market segment, we intend to provide DC-DC and DC-AC power conversion components to convert power supplied by batteries, fuel cells, generators and turbines to AC power that will be used by the end customer. Additionally, our BCU will provide power management functions to control the entire system. The main difference is that the 3-phase AC power typically supplied to the motor for propulsion power is, in this case, sent to the customer to supply power for their household or business.

 

20kW bi-directional Fuel Cell Power Conditioning System

 

Enova’s 20kW bi-directional Fuel Cell Power Conditioning System, originally designed to meet the demands of an automotive Fuel Cell propulsion system, is now being applied to the stationary market for distributed generation applications.

 

This unique unit, not much larger than a conventional briefcase, provides a transparent interface between the Fuel Cell or Turbine, the battery pack, accessory loads, and the output load. Fast response time allows the output load to be serviced without interruption while the Fuel Cell or Turbine ramps up.

 

This unit is designed to interface directly with the Master Controller of the Stationary Generation System over a CAN bus. Other communications protocols supported are SAE J-1850, RS-232, and RS-485. Shown below is the unit under test, including the RS-232 based diagnostic software package. This proprietary package allows all key parameters of the Power Conditioner to me monitored and control boundaries to be adjusted.

 

Fuel Cell Management Unit

 

Enova has reconfigured its Battery Management Unit to perform the functions required to monitor, manage, and report on the status of a Fuel Cell Stack. The FCU monitors the fuel cell voltage and 28 additional individual voltages with a range of 0 to 18vDC. Optional expansion modules allow 28 additional inputs per module, with up to 16 modules permitted. The FCU has eight (8) user-programmable outputs and four (4) user-programmable inputs to allow full integration into the distributed generation system. These can be used to customize input and output parameters, and to provide for other custom monitoring and battery pack control. The device is approximately 7.1 inches by 4.3 inches by 1.6 inches.

 

Research and Development Strategy

 

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

 

Our commitment to advancing technological superiority is evidenced by our internal efforts as well as our joint venture with HHI for future technologies.

 

Manufacturing Strategy

 

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

 

All tiers of manufacturing of electronic components begin with a complete engineering design package that includes a drawing tree, bill of material, electrical and mechanical drawings, and control software where appropriate. The control software and the design package are internally reviewed, validated, and released through our configuration management process.

 

For prototyping, electronic files for manufacturing circuit cards are generated and sent to pre-qualified circuit card manufactures. The vendors selected for this phase of manufacturing are specialists in low volume. They are able to provide quantities as small as a single square meter of circuit card. The completed circuit cards are inspected and populated by in our own prototype and low volume manufacturing facility. From circuit cards and other components sub assemblies are created and tested. Finally, a complete unit is assembled and tested.

 

For low volume manufacturing, where volumes are less than 10 to 20 units, the process is similar to that for prototyping. In this case however, the manufacturing of the entire circuit card is performed by an outside vendor. The circuit vendors selected for this phase are specialists in low volume circuit card manufacturing, automated component population, and testing. Upon receipt, the completed circuit cards are inspected and, together with other components, sub assemblies are created and tested. Finally, a complete unit is assembled and tested.

 

For higher volume manufacturing Enova has established strategic alliances with ISO certified manufacturers that can take on all aspects of the process from component sourcing, to circuit card assembly, to component assembly, to final unit assembly and test. These completed components and units are shipped to our facility to where complete drive systems that meet the customer’s unique requirements are packaged and shipped. In order to make this process as smooth as possible, Enova conducts a training session with the contract manufacturer here at our facility that covers the new product, the assembly and test instructions, as well as the design package.

 

As our market continues to grow and individual customers begin to order higher quantities of fixed drive system configurations, we intend to transition to a system where the final assembly is drop shipped directly to the

end customer. This critical concept has already been discussed with our strategic manufacturing partners and they are prepared to execute this change upon our request.

 

Our manufacturing strategy for mechanical components is somewhat more straightforward due to the nature of the final assemblies. ISO-900X certified contract manufacturers are in place that assemble and test motors to our specification. These motors are shipped to our facility where they are mated with the appropriate gear reduction unit. For low volume manufacturing where the annual volume is less than 50 — 75 units, the gear units are assembled and tested in our prototype and low volume manufacturing facility. Completed motor/gear assemblies are tested at our facility and shipped out to the end customer as part of a complete drive system.

 

For higher volume manufacturing we intend to transition the entire process of motor and gear assembly and test to a qualified contract manufacturer. Two strategic manufacturing partners have been identified and are prepared to ramp up at our request.

 

Competitive Conditions

 

Competition within the mobile and stationary hybrid power sector is still somewhat fragmented, although there are indications of some consolidation at this time. The market is still divided into very large players such as Allison, Siemens, BAE and Eaton; or smaller competitors such as ISE Research, Azure Dynamics/Solectria; PEI, Unique Mobility and others. The larger companies tend to still focus on single solutions but maintain the capital and wherewithal to aggressively market such. The smaller competitors offer a more diversified product line, but do not have the market presence to generate significant penetration at this juncture.

 

Our research and experience has indicated that our target market segments certainly focus on price, but would buy based on reliability, performance and quality support when presented the life-cycle business model for hybrid technologies for their application. Enova has good indications that many would pay a 10-20% premium for hybrids from a secure vendor providing warrantied performance, quality service and support.

 

The competition to develop and market electric, hybrid and fuel cell powered vehicles has increased during the last year and we expect this trend to continue. The competition consists of development stage companies as well as major U.S. and international companies. Our future prospects are highly dependent upon the successful development and introduction of new products that are responsive to market needs and can be manufactured and sold at a profit. There can be no assurance that we will be able to successfully develop or market any such products.

 

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

 

Various providers of electric vehicles have proposed products or offer products for sale in this emerging market. These products encompass a wide variety of technologies aimed at both consumer and commercial markets. The critical role of technology in this market is demonstrated through several product offerings. As the industry matures, key technologies and capabilities are expected to play critical competitive roles. Our goal is to position ourselves as a long term competitor in this industry by focusing on electric, hybrid and fuel cell powered drive systems and related sub systems, component integration, technology application and strategic alliances. The addition of new strategies to penetrate stationary power markets with current technologies will assist in creating a more diversified product mix. We believe that this strategy will enhance our position as a power management and conversion components supplier to both the mobile and stationary power markets.

 

In the near term and beyond, we believe that governments will require manufacturers of engines to lower their products’ emissions substantially. The emerging technology in Hybrid Electric drive-trains can bring down emissions, while at the same time saving on fuel costs.

 

We believe the Hybrid Vehicle market is poised for substantial growth and that Enova Systems products are ready to participate in this market. Enova is positioning itself capitalize on demands being placed on the market by offering solutions. Enova believes that our competitive advantages include:

 

 

 

Research and Development

 

Enova believes that timely development and introduction of new technology and products are essential to maintaining a competitive advantage. We are currently focusing our development efforts primarily in the following areas:

 

 

For the years ended December 31, 2006, 2005, and 2004, we spent $1,363,000, $804,000, and $925,000, respectively, on internal research and development activities. Enova is continually evaluating and updating the technology and equipment used in developing each of its products. The power management and conversion industry utilizes rapidly changing technology and we will endeavor to modernize our current products as well as continue to develop new leading edge technologies to maintain our competitive edge in the market.

 

Intellectual Property

 

Enova currently holds four U.S. patents and has one patent pending, relating to power management and control, with an additional patent relating to crash management safety, which was originally issued in 1997. We also have trademarks or service marks in the United States and have been filing for international patents as well. We continually review and append our protection of proprietary technology. We continue to place emphasis on the development and acquisition of patentable technology. A majority of our intellectual property is contained within our software which we believe is best protected under trade secret intellectual property law. Under such provisions, Enova does not have to publish its proprietary code in order to maintain protection.

 

We maintain an internal review and compensation process to encourage our employees to create new patentable technologies. The status of patents involves complex legal and factual questions, and the breadth of claims allowed is uncertain. Accordingly, there can be no assurance that patent applications filed by us will result in

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

 

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

 

Enova relies on unpatented trade secrets and know-how and proprietary technological innovation and expertise which are protected in part by confidentiality and invention assignment agreements with its employees, advisors and consultants and non-disclosure agreements with certain of its suppliers and distributors. These agreements may be breached, Enova may not have adequate remedies for any breach or Enova’s unpatented proprietary intellectual property may otherwise become known or independently discovered by competitors. Further, the laws of certain foreign countries may not protect Enova’s products or intellectual property rights to the same extent as do the laws of the United States.

 

Employees

 

As of December 31, 2006, we had 39 full time employees. Additionally, we employ 4 individuals as independent contractors, engaged on an hourly basis, one of whom is domiciled in South Korea. The departmental breakdown of these individuals includes 4 in administration, 1 in sales, 15 in engineering and research and development, and 15 in production.

 

Available Information

 

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

 

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

 

This annual report on Form 10-K, including the documents that we incorporate by reference, contains statements indicating expectations about future performance and other forward-looking statements that involve

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

 

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

 

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

 

We may not have net operating losses in the future against which to offset our future profits, if any

 

We have experienced recurring losses from operations and had an accumulated deficit of $107,422,000 at December 31, 2006. There is no assurance, however, that any net operating losses will be available to us in the future as an offset against future profits, if any, for income tax purposes.

 

We have experienced continued losses and may never become profitable

 

For the years ended December 31, 2006, 2005, 2004 and 2003, we had net losses of $4,836,000, $2,127,000, $3,382,000, and $3,186,000, respectively, on sales of $1,666,000, $6,084,000, $2,554,000, and $4,310,000, respectively. We may never become profitable, which may cause the market price of our common stock to drop.

 

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

 

The mobile and stationary power markets, including electric vehicle and hybrid electric vehicles, continue to be subject to rapid technological change. Most of the major domestic and foreign automobile manufacturers: (1) have already produced electric and hybrid vehicles, and/or (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. In addition, the stationary power market is still in its infancy. A number of established energy companies are developing new technologies. Cost-effective methods to reduce price per kilowatt have yet to be established and the stationary power market is not yet viable.

 

Our current products are designed for use with, and are dependent upon, existing technology. As technologies change, and subject to our limited available resources, we plan to upgrade or adapt our products in order to continue to provide products with the latest technology. We cannot assure you, however, that we will be able to avoid technological obsolescence, that the market for our products will not ultimately be dominated by technologies other than ours, or that we will be able to adapt to changes in or create “leading — edge” technology. In addition, further proprietary technological development by others could prohibit us from using our own technology.

 

Our industry is affected by political and legislative changes

 

In recent years there has been significant public pressure to enact legislation in the United States and abroad to reduce or eliminate automobile pollution. 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. Extensions, modifications or reductions of current federal and state legislation, mandates and potential tax incentives could also adversely affect our business prospects if implemented.

 

We are subject to increasing emission regulations in a changing legislative climate

 

Because vehicles powered by internal combustion engines cause pollution, there has been significant public pressure in Europe and Asia, and enacted or pending legislation in the United States at the federal level and in certain states, to promote or mandate the use of vehicles with no tailpipe emissions (“zero emission vehicles”) or reduced tailpipe emissions (“low emission vehicles”). Legislation requiring or promoting zero or low emission vehicles is necessary to create a significant market for electric vehicles. The California Air Resources Board (CARB) is continuing to modify its regulations regarding its mandatory limits for zero emission and low emission vehicles. Furthermore, several car manufacturers have challenged these mandates in court and have obtained injunctions to delay these mandates.

 

There are substantial risks involved in the development of unproven products

 

In order to remain competitive, we must adapt existing products as well as develop new products and technologies. In fiscal years 2006, 2005, 2004 and 2003, we spent collectively in excess of $3.5 million on research and development of new products and technology. Despite our best efforts a new product or technology may prove to be unworkable, not cost effective, or otherwise unmarketable. We cannot assure you that any new product or technology we may develop will be successful or that an adequate market for such product or technology will ever develop.

 

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, are larger, more established companies that have substantially greater financial, personnel, and other resources than we do. These companies may be actively engaged in the research and development of power management and conversion systems. 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 believe that developing and maintaining a competitive advantage will require continued investment in product development, manufacturing capability and sales and marketing. We cannot assure you however that we will have sufficient resources to make the necessary investments to do so. In addition, current and potential competitors may establish collaborative relationships among themselves or with third parties, including third parties with whom we have relationships. Accordingly, new competitors or alliances may emerge and rapidly acquire significant market share.

 

Potential intellectual property, shareholder or other litigation could adversely impact our business

 

Because of the nature of our business, we may face litigation relating to intellectual property matters, labor matters, product liability or shareholder disputes. Any litigation could be costly, divert management attention or result in increased costs of doing business. Although we intend to vigorously defend any future lawsuits, we cannot assure you that we would ultimately prevail in these efforts. An adverse judgment could negatively impact the price of our common stock and our ability to obtain future financing on favorable terms or at all.

 

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. Accidents involving our products could lead to personal injury or physical damage. 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. This could result in a decline in demand for our products, which would materially adversely affect our financial condition and results of operations.

 

We are an early growth stage company

 

Although we were originally founded in 1976, many aspects of our business are still in the early growth stage development, and our proposed operations are subject to all of the risks inherent in a start-up or growing business enterprise, including the likelihood of continued operating losses. Enova is relatively new in focusing its efforts on electric systems, hybrid systems and fuel cell management systems. The likelihood of our success must be considered in light of the problems, expenses, difficulties, complications, and delays frequently encountered in connection with the growth of an existing business, the development of new products and channels of distribution, and current and future development in several key technical fields, as well as the competitive and regulatory environment in which we operate.

 

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

 

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

 

There are minimal barriers to entry in our market

 

We presently license or own only certain proprietary technology and, therefore, have created little or no barrier to entry for competitors other than the time and significant expense required to assemble and develop similar production and design capabilities. Our competitors may enter into exclusive arrangements with our current or potential suppliers, thereby giving them a competitive edge which we may not be able to overcome, and which may exclude us from similar relationships.

 

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, 2006, the five highest outstanding accounts receivable balances totaled $494,000, representing 80% of our gross accounts receivable, with one customer accounting for $221,000, representing 36% 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.

 

We are exposed to risks relating to evaluations of our internal controls

 

In connection with the audit of our financial statements for the year ended December 31, 2006, PMB Helin Donovan, LLP, our independent registered public accounting firm, notified our management and audit committee of the existence of “significant deficiencies in internal controls,” which is an accounting term for internal controls deficiencies that, in the judgment of our independent registered public accounting firm, are significant and which could adversely affect our ability to record, process, summarize and report financial information.

 

PMB Helin Donovan concluded that these significant deficiencies constituted a “material weakness” in our internal controls. Auditing literature defines “material weakness” as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and the risk that such misstatements would not be detected within a timely period by employees in the normal course of performing their assigned functions. A “material weakness” is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

 

As of December 31, 2006, we did not maintain effective controls over the inventory pricing, tracking, and the reserve analysis process. This control deficiency resulted in an audit adjustment to our 2006 financial statements and could result in a misstatement to inventory and cost of sales that would result in a material misstatement to the annual and interim financial statements that would not be prevented or detected. Accordingly, our management has determined that this deficiency constituted a material weakness.

 

Under the current SEC rules and regulations as we understand them, for the fiscal year ending on or after December 15, 2007, our management will be required to assess the effectiveness of our internal controls in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act and the related SEC rules. Likewise, our independent registered public accounting firm will be required to make its own assessment for the fiscal year ending on or after December 15, 2008.

 

While we intend to address these material weaknesses and have begun efforts to remediate these material weaknesses, including, subsequent to the filing of this annual report on Form 10-K, the hiring of a Chief Financial Officer and a Controller to oversee the remedial process, there is no assurance that this will be accomplished. These efforts may necessitate significant time and attention of our management and additional resources. If we fail to satisfactorily strengthen the effectiveness of our internal controls, neither we nor our independent registered public accounting firm may be able to conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act.

 

Enova’s corporate offices are located in Torrance, California, in leased office space of approximately 20,000 square feet. This facility houses our various departments, including engineering, operations, executive, finance, planning, purchasing, investor relations and human resources. This lease terminates in February 2008. The monthly lease expense is approximately $14,000. Enova also has a leased office in Hawaii which is rented on a month-to-month basis at $1,500 per month, and a sales office in Michigan that it leases on a month-to-month basis at $500 per month.

 

We may from time to time become a party to various legal proceedings arising in the ordinary course of business. At December 31, 2006, we had no known material current, pending or threatened litigation.

 

We held our 2006 annual meeting on November 17, 2006. A quorum of 7,462,123 shares were present or represented by proxy, consisting of 7,421,587 shares of our common stock, 39,838 shares of series A convertible preferred stock, and 698 shares of series B convertible preferred stock. Common stock and Series A convertible preferred stock vote together as one class to elect six directors. In accordance with its terms, Series B convertible preferred stock has the right to elect two directors. For the remaining proposals, all classes of stock vote together as a single class. At the annual meeting, three matters were submitted to a vote of security holders:

 

1) To elect seven directors to serve until the 2007 annual meeting.

 

 

 

 

 

 

 

2) To vote on ratifying the selection of Windes & McClaughry Accountancy Corporation as our independent accountants. *Windes was succeeded by PMB Helin Donovan LLP as our independent accountants.

 

 

3) To vote on ratifying the 2006 Equity Compensation Plan.

 

 

The shares of our common stock trade on the American Stock Exchange under the trading symbol “ENA” and on the London Stock Exchange AIM Market under the symbol “ENVS.L” or “ENV.L”. The following table sets forth the high and low bid prices of the Common Stock as reflected on the AMEX and as reported on the NASD over-the-counter market bulletin board by the National Quote Bureau. Our common stock became listed on the AMEX on August 29, 2006. The over-the-counter market bulletin board quotations reflect inter-dealer prices,

without retail mark-up, markdown or commission, and may not necessarily represent actual transactions. Quotations have been restated to reflect the 1-45 reverse stock split, effective July 20, 2005.

 

 

On March 27, 2007, the last reported high bid price of the Common Stock was $4.05 and the last reported low bid price was $3.90. As of March 27, 2007, there were approximately 1,462 holders of record of our Common Stock. As of March 27, 2006, 106 shareholders, many of whom are also Common Stock shareholders, held our Series A Preferred Stock. As of March 27, 2007, approximately 33 shareholders held our Series B Preferred Stock. The number of holders of record excludes beneficial holders whose shares are held in the name of nominees or trustees.

 

Stock Issuances

 

On July 19, 2005, we entered into an agreement with a placement agent relating to the sale of up to 5,350,000 new shares of our common stock, after the reverse 1-45 stock split as described above. Pursuant to the agreement, we sold all such shares of common stock at a price of $3.78 per share to certain eligible investors located outside the United States pursuant to the requirements of Regulation S under the Securities Act of 1933, as amended. The gross proceeds from the sale are approximately $20,000,000, before fees to Investec Bank, which served as our nominated advisor and broker, and other costs associated with the listing and placement of approximately $2,000,000. We received approximately $18,000,000 of net proceeds from the offering. As a result of the offering, we listed our common stock for trading on the AIM Market of the London Stock Exchange on July 25, 2005.

 

Dividend Policy

 

To date, we have neither declared nor paid any cash dividends on shares of our Common Stock or Series A or B Preferred Stock. We presently intend to retain all future earnings for our business and do not anticipate paying cash dividends on our Common Stock or Series A or B Preferred Stock in the foreseeable future. We are required to pay dividends on our Series A and B Preferred Stock before dividends may be paid on any shares of Common Stock. At December 31, 2006, Enova had an accumulated deficit of approximately $107,422,000 and, until this deficit is eliminated, will be prohibited from paying dividends on any class of stock except out of net profits, unless it meets certain asset and other tests under Section 500 et. seq. of the California Corporations Code.

Performance Graph

 

The graph below compares the cumulative five year total shareholder return on our Common Stock with the cumulative total return on the Standard & Poor’s Small Capitalization 600 Index and an index of peer companies selected by us. A group of five other electric vehicle companies comprise the peer group index: Amerigon, Inc. (ARGN), Arotehch Corp. (ARTX), Azure Dynamics Corp. (AZD.TO), Energy Conversion Devices, Inc. (ENER), UQM Technology, Inc. (UQM), and Valence Technology, Inc. (VLNC).

 

The period shown commences on December 31, 2001, and ends on December 31, 2006, the end of our last fiscal year. The graph assumes an investment of $100 on December 31, 2001 and the reinvestment of any dividends. The comparisons in the graph below are based upon historical data and are not indicative of, nor intended to forecast, future performance of our Common Stock.

 

 

 

The performance graph and related information in this subsection is not “soliciting material,” is not deemed “filed” with the Securities and Exchange Commission and is not to be incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.

 

The following selected financial data tables set forth selected financial data for the years ended December 31, 2006, 2005, 2004, 2003, and 2002. The statement of operations data and balance sheet data for and as of the end of the years ended December 31, 2006, 2005, 2004, 2003, and 2002 are derived from the audited financial statements of Enova. The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Financial Statements, including the notes thereto, appearing elsewhere in this Form 10-K.

 

 

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with our 2006 Financial Statements and accompanying Notes. The matters addressed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, may contain certain forward-looking statements involving risks and uncertainties.

 

Overview

 

Enova Systems believes it is a leading supplier of efficient, environmentally-friendly digital power components and systems products in conjunction with our associated engineering services. Our core competencies are focused on the development and commercialization of power management and conversion systems for mobile and

stationary applications. Enova applies unique ’enabling technologies’ in the areas of alternative energy propulsion systems for light 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 Hyundai Motor Company and Ford Motor Company, trucks and buses for First Auto Works of China, Mack Truck, WrightBus of the U.K. and the U.S. Military, as well as digital power systems for EDO, Hydrogenics and UTC Fuel Cells, a division of United Technologies.

 

We continue to support IC Corp. in their efforts to maximize exposure in the Hybrid School Bus Market. We have been involved in large shows in Albany, NY and Reno, NV, Chicago, IL, Washington, DC as well as smaller venues throughout the Midwest. The exposure via shows and direct interface was aggressively pursued throughout the remainder of 2006, in an effort to promote IC Corp.’s production intent for Hybrid School Buses. IC Corp. claims to be the nation’s largest integrated school bus manufacturer with 60-65% of the school bus market share.

 

In July, IC Corp. announced it was ready to move to production on Hybrid School Buses. At the same time, IC Corp. announced that Enova would be their Hybrid drive system supplier. Also in July, Enova and IC Corp. were awarded a contract for nineteen Hybrid School Buses. These buses will be delivered to eleven states throughout the next three to six months. The award was based on a project coordinated by the Advanced Energy consortium and was the first major Hybrid School Bus award of its kind.

 

Ford Motor Company continues to evaluate our components in thirty Ford Focus Hydrogen Fuel Cell Vehicles being evaluated in three countries. According to Ford Motor Company communications, the vehicles have functioned satisfactorily, and they continue to evaluate markets for producing additional vehicles. In August, Enova announced that Ford Motor Company has ordered four (4) advanced design High Voltage Energy Converters (HVECs). This award confirms Ford’s continued interest in Enova’s technology and is expected to be delivered to Ford during the 2nd quarter 2007.

 

Throughout 2006 we hosted and visited numerous potential customers from the Pick Up and Delivery, Medium Duty and Heavy Duty markets. During the 4th quarter of 2006, we provided a large fleet operator a functional vehicle for evaluation. Every effort is made to continue to mature these relationships, as we hope that they will eventually lead to viable business relationships.

 

We also anticipate continuing our work with Tsinghua University of China, and their fuel cell bus development program. We believe that China intends to use hybrid-electric buses to shuttle athletes and guests at the 2008 Beijing Summer Olympics and the 2010 World’s Expo in Shanghai and China it is seeking up to one thousand full-size hybrid-electric buses to support these global events. MTrans of Malaysia has integrated two of our standard HybridPower 120kW drive system into a hybrid 10-meter bus with a Capstone microturbine as its power source. This drive system is currently on demonstration in Hong Kong, PRC. Also, Hyundai continues to evaluate our converters in their fuel cell hybrid electric vehicles and we currently expect to deliver an additional sixteen units in 2007.

 

Some recent highlights of Enova’s accomplishments are:

 

 

 

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

 

The latest state-of-the-art technologies, such as hybrid vehicles, fuel cell and micro turbine based systems, and stationary power generation, 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. We also develop, design and produce power management and power conversion components for stationary power generation — both on-site distributed power and on-site telecommunications back-up power applications. These stationary applications also employ fuel cells, microturbines and advanced batteries for power storage and generation. Additionally, Enova performs significant research and development to augment and support others’ and our internal related 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 9000X manufacturing and quality standards. We believe Enova’s redundancy of systems and rigorous quality standards result in high performance and reduced risk. For every component and piece of hardware, there are detailed performance specifications. Each piece is tested and evaluated against these specifications, which enhances and confirms the value of the systems to OEM customers. Our engineering services focus on system integration support for product sales and custom product design.

 

Critical Accounting Policies

 

Financial Reporting Release No. 60 requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 1 of the notes to the financial statements includes a summary of the significant accounting policies and methods used in the preparation of our financial statements. The following is a brief discussion of the more significant accounting policies and methods that we use.

 

Our discussion and analysis of our financial condition and result of operations are based on our financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Our preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The most significant estimates and assumptions relate to revenue recognition and potential allowances for doubtful accounts. Actual amounts may differ from such estimates under different assumptions or conditions. The following summarizes our critical accounting policies and significant estimates used in preparing our financial statements:

 

 

 

These accounting policies are applied consistently for all years 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.

 

Recent Accounting Pronouncements

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140.” This statement amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and resolves issues addressed in SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interest in Securitized Financial Assets”. We are required to apply SFAS 155 to all financial instruments acquired, issued or subject to a re-measurement event beginning January 1, 2007, although early adoption is permitted as of the beginning of an entity’s fiscal year. The provisions of SFAS 155 are not expected to have any impact on the financial statements at adoption.

 

In September 2006, the FASB issued SFAS 157 “Fair Value Measurement” which defines fair value, establishes a framework for measuring fair value and expanded disclosures about fair value measurement. Companies are required to adopt the new standard for fiscal periods beginning after November 15, 2007. We are evaluating the impact of this standard and currently does not expect it to have a significant impact on its financial position, results of operations or cash flows.

 

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which addresses how uncorrected errors in previous years should be considered when quantifying errors in current-year financial statements. SAB 108 requires companies to consider the effect of all carry over and reversing effects of prior-year misstatements when quantifying errors in current-year financial statements and the related financial statement disclosures. SAB 108 must be applied to annual financial statements for the first fiscal year ending after November 15, 2006. Our adoption of this standard will not have any impact on its financial position, results of operations or cash flows.

 

In June 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes. FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 (our fiscal year 2007) and the provisions of FIN 48 will be applied to all tax positions under Statement No. 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We do not expect the adoption of FIN 48 to have a material impact on its financial position, results of operations or cash flow.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115.” SFAS 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred, e.g., debt issue costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by us in the first quarter of fiscal 2009. Enova is currently is determining whether fair value accounting is appropriate for any of its eligible items and cannot estimate the impact, if any, which SFAS 159 will have on its consolidated results of operations and financial condition.

 

Results of Operations

 

Years Ended December 31, 2006 and 2005

 

Net sales of $1,666,000 for the twelve months ended December 31, 2006 decreased by $4,418,000 or 73% from $6,084,000 during the same period in 2005. The primary source of our revenue in 2005 was our contract with Tomoe Engineering. While we expect to do further business with Tomoe in the future, we did not have any recurring revenue from this relationship in 2006. Our revenues for 2006 primarily derived from our relationships with Hyundai Motor Company and the State of Hawaii, representing 39% and 16% respectively of overall revenues. These percentages are higher than in prior years because of our 2006 decline in overall revenues. In 2006, Enova focused on building new customer relationships in an effort to support our goals of transitioning into a production company. While we did continue several development projects throughout the year, the process by which management selected which development projects were accepted in 2006 largely depended on our assessment of which contracts had the greatest potential for a production contract. Consequently, we believe that the decline in revenue when comparing the years ended 2005 and 2006 is a result of our not actively seeking the types of non-recurring contracts that we had traditionally accepted in the past. This is evidenced by the fact that we have over $6,000,000 in production-type purchase orders on hand as of March 27, 2007.

 

Cost of sales consists of component and material costs, direct labor costs, integration costs and overhead related to manufacturing our products. Product development costs incurred in the performance of engineering development contracts for the U.S. Government and private companies are charged to cost of sales. Our customers continue to require additional integration and support services to customize, integrate and evaluate our products. We believe that a portion of these costs are initial, one-time costs for these customers and anticipate similar costs to be incurred with respect to new customers as we gain additional market share. Customers who have been using our products over one year do not incur this same type of initial costs. Cost of sales for the year ended December 31, 2006 decreased $3,101,000, or 52%, from $6,001,000 for the year ended December 31, 2005. This decrease is primarily attributable to the decrease in sales for the year combined with initial costs on first year customers, as described above.

 

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 expense increased in 2006 to $1,363,000 from $804,000 for the same period in 2005, an increase of $559,000 or 70%. During 2006, and as a consequence of our focus on production type revenues, we experienced a decrease in funded research and development. This increased our need to absorb these costs. In 2006, we continued to enhance our technologies to be more universally adaptable to the requirements of our current and prospective customers. By modifying our software and firmware, we believe we should be able to provide a more comprehensive, adaptive and effective solution to a larger base of customers and applications. We will

continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers as we deem beneficial to our global growth strategy.

 

Selling, general and administrative expenses consist primarily of personnel and related costs of sales and marketing employees, consulting fees and expenses for travel, trade shows and promotional activities and personnel and related costs for general corporate functions, including finance, accounting, strategic and business development, human resources and legal. Selling, general and administrative expenses increased by $1,308,000 at 2006 from the balance for the year ended December 31, 2005 of $2,870,000, representing a 46% increase in these costs. The predominant reason for the increase is Enova’s increased expenditures on sales and marketing initiatives. This includes such things as trade shows, travel, marketing materials, and market consultants. This, combined with an increased headcount and the associated increases in wages, health and workers compensation insurance, explain our increased selling, general and administrative expenses.

 

For the year ended December 31, 2006, interest and other income, increased by $537,000 to $550,000, up over 4000% from the 2005 balance. The increase is a result of our comparatively higher average cash balance throughout 2006, when compared to the average cash balance during 2005, and the increase in the associated interest revenue. The comparatively higher cash balance was the result of the equity offering that occurred in the third quarter of 2005.

 

In January and February of 2006, we settled $1,083,000 of principal and $472,000 of accrued interest under the secured note payable to the Credit Managers Association of California (CMAC). In consideration for the settlement, we paid the beneficiaries $163,000. We evaluated this transaction under the guidance set forth in SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and noted that the extinguishment of these liabilities was consistent with the guidance.

 

Years Ended December 31, 2005 and 2004

 

Net sales of $6,084,000 for the twelve months ended December 31, 2005 increased by $3,530,000 or 138% from $2,554,000 during the same period in 2004. The increase in sales was a result of Enova’s expanding research and development initiatives with Hyundai Motor Company (HMC) as well as the production associated with the Tomoe Machinery contract. In 2005, sales attributable to the Tomoe production contract were about $3,000,000. Additionally, sales related to the HMC development project were approximately $758,000.

 

Cost of sales consists of component and material costs, direct labor costs, integration costs and overhead related to manufacturing our products. 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 for this contract revenue. During 2005, our trend of establishing new customers and strengthening current alliances with customers, such as Tomoe and MTrans in the heavy-duty drive system market continued. Our new customers continue to require additional integration and support services to customize, integrate and evaluate our products. We believe these costs to be initial, one-time costs for these customers and anticipate similar costs to be incurred with respect to new customers as we gain additional market share. Customers who have been using our products over one year do not incur this same type of initial costs. Cost of sales for the year ended December 31, 2005 increased 3,762,000, or 168%, from $2,239,000 for the year ended December 31, 2004. This increase is primarily attributable to the increase in sales for the year and the scrapping of $376,000 of raw materials that were no longer usable.

 

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 expense decreased in 2005 to $804,000 from $925,000 for the same period in 2004, a decrease of $121,000 or 13%. During 2005, externally funded research and development from partners such as FAW, Mack/Volvo, Hyundai, and the U.S. Government offset the costs of development for new products in the areas of mobile and stationary power management and conversion thereby reducing the need for internal funding. We believe that this trend is continuing. Programs included our new parallel hybrid drive systems, our diesel generation engine/motor system for our heavy-duty drive systems, and upgrades and improvements to our current power conversion and management components. Additionally, we continued to enhance our technologies to be more universally adaptable to the requirements of our current and prospective customers. By modifying our software and firmware, we believe we should be able to provide a more comprehensive, adaptive and effective

solution to a larger base of customers and applications. We will continue to research and develop new technologies and products, both internally and in conjunction with our alliance partners and other manufacturers as we deem beneficial to our global growth strategy.

 

Selling, general and administrative expenses consist primarily of personnel and related costs of sales and marketing employees, consulting fees and expenses for travel, trade shows and promotional activities and personnel and related costs for general corporate functions, including finance, accounting, strategic and business development, human resources and legal. Selling, general and administrative expenses increased by $545,000 at 2005 from 2004 levels due to increased headcount and the associated increases in wages, health and workers compensation insurance, and taxes of approximately $279,000 and from a $266,000 increase in the allowance for doubtful accounts. For the year ended December 31, 2005, these expenses totaled $2,870,000 up from $2,325,000 for the similar period in 2004. This represents an 23% increase in these expenses. We are continually reviewing operations to control overhead costs and increase operational efficiencies.

 

For the year ended December 31, 2005, interest and financing fees shifted to a net other income of $13,000 from a net expense of $255,000. The change is a result of our comparatively higher cash balance at 2005 and the associated interest revenue as well as a $50,000 gain on a foreign currency transaction in the United Kingdom. The comparatively higher cash balance was the result of the equity offering that occurred in the third quarter of 2005.

 

In 2005, we charged off approximately $376,000 of our inventory relating to obsolete and slow moving raw materials. We believe that the relatively slight fluctuation in the inventory balances compared to the increased sales volume illustrates Enova’s continuing efforts to monitor and control inventory utilization.

 

In December 2005, we were informed by the Credit Managers Association of California that $1,011,000 of principal and $447,000 accrued interest under the secured note payable had been disclaimed and extinguished by the beneficiaries of such principal amount. The extinguishment result from the resolution of a substantially aged negotiation regarding consideration paid in settlement of the principal amount. We have recognized a gain on the extinguishment of the principal and associated accrued interest. We evaluated this transaction under the guidance set forth in SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and noted that the extinguishment of these liabilities were consistent with the guidance.

 

In October 2005, we agreed to a settlement on the unsecured 10% note payable. In exchange for immediate payment of the full principal balance of $120,000, the beneficiary of the note agreed to forgive the entire accrued interest balance of $111,000. We have recognized a gain on the extinguishment of the associated accrued interest. We evaluated this transaction under the guidance set forth in SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and noted that the extinguishment of these liabilities were consistent with the guidance.

 

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 propulsion and power management systems and components. Cash flows from operations have not been sufficient to meet our obligations. Therefore, 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, 2006 were financed by development contracts and product sales, as well as from working capital reserves.

 

During the year ended December 31, 2006, our operations required $5,144,000 more in cash than was generated, versus $2,997,000 in 2005 and $2,156,000 in 2004. Enova continues to increase marketing and development spending as well as administrative expenses necessary for expansion to meet expected customer demand. Accounts receivable decreased by $1,815,000 from $2,173,000, or approximately 84% from the balance at December 31, 2005 (net of write-offs). The decrease is due to lengthened delivery timelines for our customers, many of whom are characterized as “early adopters” of our unique technology. We are currently experiencing an

increase in sales activity for our drive systems, components and development services which commenced in the fourth quarter of 2006, which we anticipate will increase receivables in future quarters.

 

Inventory increased from $1,016,000 at the year ended December 31, 2005 to $1,704,000 at the year ended December 31, 2006, representing a 68% increase in the balance. In the fourth quarter of 2005, Enova completed and shipped our largest project of 2005 to Tomoe Manufacturing. This resulted in a depressed inventory balance at the end of 2005. Conversely, in the fourth quarter of 2006, Enova was increasing inventory purchasing in anticipation increased sales volume in the first quarter of 2007.

 

Prepaid expenses and other current assets increased by net $526,000 during 2006 from the December 31, 2005 balance of $182,000 or almost 289%. The increase is caused primarily by the interest receivable on a certificate of deposit and cash held in a short term, cash equivalent, investment account. Furthermore, prepaid expenses increased because of prepaid integration costs associated with the Verizon van project.

 

Net fixed assets increased by $51,000 or 9%, for the year ended December 31, 2006 from the prior year balance of $576,000 primarily due to the purchase of additional production tooling, machinery, and equipment associated with production.

 

Investments decreased by $3,000 during 2006, net of our pro-rata share of losses attributable to the investment, which reflects our forty percent (42%) interest in the Hyundai-Enova Innovative Technology Center (ITC) as noted elsewhere in this Form 10-K. For the year ended December 31, 2006, the ITC generated a net loss of approximately $7,000, resulting in a charge to Enova of $3,000 utilizing the equity method of accounting for our interest in the ITC. Based on contractual obligations of our Joint Venture Agreement with Hyundai Heavy Industries Co., we made an additional investment of $1,000,000 in 2004 which was funded by HHI through a stock purchase in September 2004 as noted in the Hyundai-Enova Innovative Technology Center description later in this Form 10-K.

 

Intangible Assets decreased by $116,000 during 2006 from $190,000 in 2005 as we continued to amortize the asset relating to the Ford Value Participation Agreement. Enova did not recognize any additional intellectual property assets, including patents and trademarks, during 2006.

 

Accounts payable decreased in 2006 by 73% from $1,396,000 at December 31, 2005 to $382,000 at December 31, 2006. At December 31, 2005, Enova had an outstanding trade payable to Hyundai Heavy Industries for approximately $1,250,000, associated with their assistance in the production of hybrid motors for the Tomoe Engineering contract. The year end 2006 accounts payable balance represents balances owed to vendors for fourth quarter inventory purchases made in expectation of increased sales volume in the first quarter of 2007.

 

Enova reported $399,000 of deferred revenue at December 31, 2006, compared to not having a deferred revenue balance at December 31, 2005. In the fourth quarter of 2005, Enova shipped our largest project of the year, and all revenue on this contract was appropriately recognized in 2005. During the fourth quarter of 2006, we have collected funds from several of our customers for charges related to in-house orders. However, based on our interpretation of the relevant revenue recognition guidance, Enova has concluded that these collections would appropriately be recognized as revenue in the first quarter of 2007.

 

Accrued interest decreased by $378,000 for the year ended December 31, 2006, a decrease of 34%. The decrease is associated with the net effect of interest accrued on the Note due the Credit Managers Association of California (CMAC) for $2.3 million (year end 2005 balance) per the terms of the Note, combined with the settlement and forgiveness of certain portions of the CMAC note in 2006. See additional explanation in the Results of Operations subsection above.

 

Other accrued expenses and payables increased by $362,000 during 2006, from $302,000 at December 31, 2005. The increase is a consequence of additional professional service fees incurred related to the re-filing of our third quarter Form 10-Q combined with additional accrued marketing and investor relations costs.

 

The future unavailability or inadequacy of financing to meet future needs could force us to delay, modify, suspend or cease some or all aspects of our planned operations.

 

Contractual Obligations

 

As of December 31, 2006, our contractual obligations for the next five years, and thereafter, were as follows (in thousands):

 

 

Hyundai-Enova Innovative Technology Center

 

In September 2003, Enova and Hyundai Heavy Industries, Co. Ltd. (HHI) funded the Hyundai-Enova Innovative Technology Center (HEITC) to be located at Enova’s Torrance headquarters. In connection with the Joint Venture Agreement entered into between the two parties in March 2003, HHI purchased $1,500,000 of common stock of Enova Systems, Inc. HHI purchased 23,076,923, shares representing a 6.2% ownership in Enova. Of this amount, Enova invested $1,000,000 in the HEITC for a forty percent (40%) ownership interest. HHI invested an additional $1,500,000 for a sixty percent (60%) ownership interest in the HEITC. In September 2004, HHI invested an additional $1,500,000 in Enova and $1,500,000 in the HEITC under the same terms as the initial investment. In this second tranche, HHI purchased 11,335,315 restricted shares of common stock in accordance with the Joint Venture Agreement. The joint venture company officially opened in November 2003 to pursue advanced research and development in hybrid automotive and stationary applications for fuel cell technologies. Share amounts do not include the effect of our July 2005 1-for-45 reverse stock split.

 

None.

 

All information required by this Item is included on pages F-1 to F-27 in Item 15 of Part IV of this annual report on form 10-K and is incorporated into this Item by reference. See Item 15.

 

On June 12, 2006, Singer Lewak Greenbaum & Goldstein LLP ceased being our registered public accounting firm and we engaged Windes & McClaughry Accountancy Corporation as our new independent registered public accounting firm for the fiscal year ending December 31, 2006. The decision regarding the end of the Singer Lewak engagement and the commencement of the engagement of Windes was made and approved by the audit committee of our board of directors after a review of our current needs in light of its listing on the AIM market.

 

The reports of Singer Lewak on the our financial statements for the fiscal years ended December 31, 2005 and December 31, 2004 contained no adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principle.

 

During the fiscal years ended December 31, 2005 and December 31, 2004, and through the date Singer Lewak ceased its services, there were no disagreements with Singer Lewak on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Singer Lewak would have caused it to make reference to the subject matter of the disagreement in its reports on our financial statements for such years. During the fiscal years ended December 31, 2005 and

December 31, 2004, and through the date of this Current Report on Form 8-K, there were no “reportable events” within the meaning of Item 304(a)(1)(v) of Regulation S-K.

 

On January 31, 2007, we dismissed Windes as our registered public accounting firm and engaged PMB Helin Donovan, LLP as our new independent registered public accounting firm. The decision regarding the end of the Windes engagement and the commencement of the PMB Helin Donovan’s engagement was made and approved by the audit committee of our board of directors after consideration of our current needs and position. Concurrent with the change in auditor, we also undertook managerial changes to our finance and operations departments, including a change in chief financial officer. In light of these organization changes and given the disagreement between us and Windes with respect to the filing of our Form 10-Q for the fiscal quarter ended September 30, 2006 filed November 13, 2006, the audit committee believed that engagement of a new auditor would lead to enhanced communications with respect to audit matters.

 

During the course of its engagement, Windes did not provide an audit report on our financial statements. Therefore, there is no applicable disclosure within the meaning of Item 304(a)(1)(ii).

 

During our two most recent fiscal years, and through the date of Windes’ dismissal, we and Windes had the following three “disagreements” within the meaning of Item 304(a)(1)(iv) of Regulation S-K on matters of accounting principles or practices, financial statement disclosure, or auditing or review scope or procedure, which if not resolved to the satisfaction of Windes would have caused it to make reference to the subject matter of the disagreement in its reports on our financial statements:

 

First, as reflected in the Current Reports on Form 8-K dated November 29 and December 5, 2006, Windes and we disagreed whether Windes authorized the Form 10-Q filing. After numerous discussions among Windes and us involving management and the audit committee, the disagreement was resolved by filing the requisite Item 4.02 Form 8-K and later filing the amended Form 10-Q for the fiscal period ended September 30, 2006 on December 29, 2006.

 

Second, Windes and we disagreed whether we followed the appropriate accounting policy and accounting literature to record revenue. This disagreement was resolved upon further analysis and by reversing the recorded revenue and related expenses in the amended Form 10-Q.

 

Third, Windes and we disagreed whether adequate documentation had been produced to support a material debt forgiveness transaction which, although negotiated in the 2005 fiscal year, was completed in the first quarter of the 2006 fiscal year and therefore included in our year-to-date operations. Consistent with the amended Form 10-Q’s Item 4 Controls and Procedures disclosure, we were unable to locate original documentation to support the accounting treatment for the transaction. This disagreement was resolved when we obtained replacement copies to reflect the original documentation and the accounting treatment.

 

Our audit committee discussed the subject matter of all three disagreements above with Windes and authorized Windes to respond fully to inquiries of PMB Helin Donovan concerning the subject matter of the disagreements.

 

During our two most recent fiscal years and through the date of Windes’ dismissal, the following were “reportable events” within the meaning of Item 304(a)(1)(v) of Regulation S-K:

 

(A) Consistent with the our Item 4 Controls and Procedures disclosure in the amended Form 10-Q, Windes advised that material weaknesses existed in our internal controls, and thereby our financial statement preparation and disclosure, regarding the (i) correct application of relevant accounting standards; (ii) ability to produce original documentation to support an accounting treatment; and (iii) internal and external communication by us in ensuring there was appropriate independent accountant review and authorization to file periodic reports such as the Form 10-Q for the fiscal period ended September 30, 2006.

 

(B) Given the three disagreements cited above, Windes expressed concern about its ability to rely on management representations. As a result, consistent with the Item 4 Controls and Procedures disclosure in our amended Form 10-Q, we agreed to dedicate additional time and resources to internal control matters and specifically agreed to (1) retain a consultant to review our accounting, documentation, and internal control

policies and (2) implement more stringent oversight policies to ensure proper auditor authorization is received prior to making SEC filings.

 

(C) Given the third disagreement cited above with respect to adequate documentation, Windes further advised us that it would need to expand significantly the scope of its audit within the meaning of Item 304(a)(1)(v)(C) to ensure that proper and sufficient documentation existed to support accounting conclusions reached in prior fiscal periods including the cited debt forgiveness transaction.

 

Disclosure Controls and Procedures

 

As of the end of the period covered by this 2006 Form 10-K, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were not effective.

 

First, as of December 31, 2006, we did not maintain effective controls over the inventory pricing, tracking, and the reserve analysis process. This control deficiency resulted in an audit adjustment to our 2006 financial statements and could result in a misstatement to cost of sales that would result in a material misstatement to the annual and interim financial statements that would not be prevented or detected. Our independent registered public accounting firm, PMB Helin Donovan, concluded that these significant deficiencies constituted a “material weakness” in our internal controls. Our management also determined that these deficiencies constitute a material weakness that impacted our disclosure controls and procedures.

 

Second, as previously disclosed in our amended Form 10-Q filed December 29, 2006 and in a Form 8-K filed November 29, 2006, our then independent auditor Windes & McClaughry Accountancy Corporation notified us that the initial Form 10-Q for the quarter ended September 30, 2006 as filed November 13, 2006 was filed without Windes’s express authorization. Although we believed we were authorized to file the Form 10-Q at the time, the notification by our independent auditor signified that our disclosure controls and procedures were not effective. We subsequently obtained authorization from Windes to refile the Form 10-Q as amended on December 29, 2006.

 

Third, in connection with filing the Form 10-Q described in the prior paragraph, we initially recorded revenue for invoiced purchase orders that upon further reflection had not been properly earned as revenue pursuant to relevant accounting literature. Accordingly, in the amended 10-Q for the quarter ended September 30, 3006, we reversed out the associated components of revenue and related costs resulting in a net increase in operating loss of $4,000.

 

Fourth, in two distinct instances, we encountered problems that did not materially impact our financial statements, yet contributed to our conclusion that our disclosure controls and procedures were not effective. We identified a clerical error in the preparation of the first quarter 2006 financial statements that resulted in a misclassification of certain line items within the total revenue and total cost of revenue. The total revenue, total cost of revenue, gross profit and net loss were not affected by the misclassification. Also, during the fourth quarter, in connection with the Form 10-Q filing issue discussed in the previous paragraph, we were unable to produce original documentation to support an accounting treatment that commenced in late 2005. Ultimately, we were able to obtain replacement documents that supported the original accounting treatment.

 

Changes in Internal Controls over Financial Reporting

 

In connection with resolving the previously disclosed September 30, 2006 Form 10-Q filing issue, each of the Chief Executive Officer, Chief Financial Officer, and the Chairman of the Audit Committee agreed to document that written auditor authorization has been delivered to Enova prior to filing any periodic report, current report, or registration statement that requires auditor consent or review.

 

To enhance its internal controls over financial reporting, we hired Jarett Fenton as a special consultant to assist in reviewing and documenting our accounting memoranda, assess our preparation for Section 404 compliance, and perform other documentation roles as requested. Mr. Fenton subsequently was hired as an employee and appointed to the position of Chief Financial Officer.

 

As part of our ongoing efforts to improve controls and in preparation for Section 404 testing of internal controls over financial reporting required by the Sarbanes-Oxley Act under current SEC rules starting with our fiscal year ended December 31, 2007, we substantially implemented a new accounting and reporting system in the fourth quarter of 2006. In particular, this accounting and reporting system will provide for greater monitoring controls over financial transactions and reduce errors through automation and application controls. Further, we changed responsibility sets to have a higher degree of segregation among critical duties. We segregated the payroll function from the accounting function. We added an independent treasury function and added clerical help to assist in the segregation of the payable and receivable function.

 

None

 

The following table sets forth certain information with respect to the current Directors and executive officers of Enova:

 

 

 

 

Anthony Rawlinson, Chairman of the Board of Directors.  Mr. Rawlinson was appointed Chairman of the Board of Directors in July 1999. He is Managing Director of The Global Value Investment Portfolio Management Pte. Ltd., a Singapore-based international fund management company, managing discretionary equity portfolios for institutions, pension funds and clients globally since 1996. Mr. Rawlinson is also Chairman of Cardsoft Inc., a privately-held company based in San Mateo California since 2001. Cardsoft develops and markets embedded Java software solutions that provide security and interoperability for applications running on disparate fixed and wireless payment devices. From June 2004 to June 2005 Mr. Rawlinson served as a director of Calvalley Petroleum, an oil and gas company. From February 2000 to October 2003 Mr. Rawlinson served as a director of Matrix Oil, an oil and gas exploration company.

 

Edwin O. Riddell, Chief Executive Officer, President, and Director.  Mr. Riddell was appointed President and Chief Executive Officer on August 20, 2004. Mr. Riddell has been a Director of Enova since 1995. Since 1999, Mr. Riddell has been President of CR Transportation Services, a consultant to the electric vehicle industry. From 1992 to 1999, Mr. Riddell was Product Line Manager of the Transportation Business Unit at the Electric Power

Research Institute, and from 1985 until 1992, he served with the Transportation Group, Inc. as Vice President, Engineering, working on electric public transportation systems. From 1979 to 1985, he was Vice President, General Manager and COO of Lift-U, Inc., the leading manufacturer of handicapped wheelchair lifts for the transit industry. Mr. Riddell has also worked with Ford, Chrysler, and General Motors in the area of auto design, and has worked as a member of senior management for a number of public transit vehicle manufacturers. Mr. Riddell has been a member of the American Public Transportation Association’s (APTA) Member Board of Governors for over 15 years, and has served on APTA’s Board of Directors. Mr. Riddell was also Managing Partner of the U.S. Advanced Battery Consortium.

 

Jarett Fenton, Chief Financial Officer.  From March 2003 through February 2007, Mr. Fenton served as the Chief Executive of the Clarity Group, a company he founded. The Clarity Group is a SEC reporting and corporate compliance consultancy. Mr. Fenton’s primary responsibility was practice development and he eventually grew the company to include such clients as Countrywide Financial and PC Mall Inc., as well as smaller SEC registrants. From September 1998 to March of 2003, Mr. Fenton served as a Senior Associate in the Middle Market practice of PricewaterhouseCoopers in the Orange County, CA office. At PricewaterhouseCoopers Mr. Fenton facilitated audit engagements, worked on SEC reporting issues, controls assessments, client reporting, financial guidance interpretation and staff development. Mr. Fenton has a BA in Business Economics with an emphasis in Accounting from the University of California at Santa Barbara and is a Certified Public Accountant in the State of California.

 

Bjorn Ahlstrom, Director.  Mr. Ahlstrom was elected to the Board of Directors in June 2004. Mr. Ahlstrom currently is a consultant in the heavy-duty vehicle industry. Mr. Ahlstrom retired as Chairman of Volvo Group North America, Inc. on April 1, 2004. Prior to that, Mr. Ahlstrom was President and Chief Executive Officer of Volvo North America Corporation from 1971 until 1994. During this term, Volvo North America Corporation owned and operated Volvo’s businesses in the United States and Canada. Under Mr. Ahlstrom’s leadership, VNAC grew from a $50 million car importer in the early 1970s to a $6 billion company with manufacturing and marketing operations for cars, trucks, marine engines, and financial services. In 1981, Mr. Ahlstrom received the Royal Order of the North Star from King Carl XVI Gustaf of Sweden. The United States Government awarded him the Medal of Peace and Commerce in 1983. He received the Ellis Island Medal of Honor in 1990. Mr. Ahlstrom has been awarded honorary Doctor of Law degree from St John’s University, NY, and Ramapo College of New Jersey.

 

Malcolm R. Currie, Ph.D, Director.  Dr. Currie had served as a Director of Enova from 1995 through 1997 and then 1999 to the present. From 1986 until 1992, Dr. Currie served as Chairman and Chief Executive Officer of Hughes Aircraft Co., and from 1985 until 1988, he was the Chief Executive Officer of Delco Electronics. His career in electronics and management has included research with many patents and papers in microwave and millimeter wave electronics, laser, space systems, and related fields. He has led major programs in radar, commercial satellites, communication systems, and defense electronics. He served as Undersecretary of Defense for Research and Engineering, the Defense Science Board, and currently serves on the Boards of Directors of LSI Logic, Inamed Corp., Innovative Micro Technology, Regal One, and Currie Technologies. He is past president of the American Institute of Aeronautics and Astronautics, and is a Member of the Board of Trustees of the University of Southern California.

 

Donald H. Dreyer, Director.  Mr. Dreyer was elected a Director of Enova in January 1997. Mr. Dreyer is President and CEO of Dreyer & Company, Inc., a consultancy in credit, accounts receivable and insolvency services, which he founded in 1990. Mr. Dreyer has served as Chairman of the Board of Credit Managers Association of California during the 1994 to 1995 term and remains a current member. Mr. Dreyer is also a member of the American Bankruptcy Institute and the National Advisory Committee of Dun & Bradstreet, Inc.

 

Sten Langenius, Director.  Mr. Langenius was made director in July 2006. Mr. Langenius currently serves as CEO and on the Board of Directors of Utsiktsvägen Consulting & Investment AB since 1998. He has been a member of the Boards of Gunnebo Industrier AB (Sweden) since 2005, NSS, Nordic Shelter Solutions Group OY (Finland) since 2002, Fästelement Intressenter AB and Fameco Group AB (Sweden) since 2005, chairman of the board of Nordea Region West Sweden, Large Companies Group (formerly known as Merita Nordbanken Region West (Sweden), name changed in 2005) since 1995. Mr. Langenius was formerly President and Chief Executive Officer of Volvo Truck Corporation. Prior to joining Volvo, he was President of IBM Svenska AB. Mr. Langenius brings an extensive and impressive background to Enova.

 

John R. Wallace, Director.  Mr. Wallace was elected as a Director of Enova in 2002. Since November of 2005, he has held the position of CEO, Xantrex Technology, Inc. in Burnaby, B.C., Canada. From 2002 to 2005, he worked independently as a consultant in the alternative energy sector. Mr. Wallace retired from the Ford Motor Company in 2002. Prior to his retirement, he was executive director of TH!NK Group. He has been active in Ford Motor Company’s alternative fuel vehicle programs since 1990, serving first as: Director, Technology Development Programs; then as Director, Electric Vehicle Programs; Director, Alternative Fuel Vehicles and finally Director, Environmental Vehicles. He is past Chairman of the Board of Directors of TH!NK Nordic; he is past chairman of the United States Advanced Battery Consortium; Co-Chairman of the Electric Vehicle Association of the Americas, and past Chairman of the California Fuel Cell Partnership. He served as Director of Ford’s Electronic Systems Research Laboratory, Research Staff, from 1988 through 1990. Prior to joining Ford Research Staff, he was president of Ford Microelectronics, Inc., in Colorado Springs. His other experience includes work as program manager with Intel Corporation. He also served as Director, Western Development Center, for Perkin-Elmer Corporation and as President of Precision Microdesign, Inc.

 

Michael Staran, Executive Vice President.  From 1998 to 2005 Mr. Staran was the President of Effective Solutions People LLC., providing specialized consulting to the OEM (original equipment manufacturer) supplier segment in the automotive industry. Mr. Staran consulted with Enova from November 2004 through February 2005 when he was hired by Enova as Director of Sales and Marketing. In September 2005, Mr. Staran was promoted to Vice President of Sales and Marketing. Mr. Staran’s affiliations and work history range from companies such as Ford, General Motors and DaimlerChrysler to suppliers such as Johnson Controls Inc. and Decoma International where he was vice president of sales and marketing for 13 years. Mike holds a Bachelor of Science degree in Mechanical Engineering with a minor in Mathematics from Lawrence Institute of Technology in Southfield, Michigan. Mr. Staran has developed three patented mechanical designs within the automotive components sector.

 

Relationships Among Directors or Executive Officers

 

There are no family relationships among any of the Directors or executive officers of Enova.

 

Board Composition

 

Our Articles of Incorporation provide that the holders of the Series B Preferred Stock are entitled, voting as a separate class, to elect two members of the Board. The holders of the Common Stock and Series A Preferred Stock, voting together as a single class, are entitled to elect the balance of the members of the Board. At our most recent annual meeting, only one director, Donald Dreyer, was nominated and elected by the holders of the Series B Preferred Stock and the remaining six directors were elected by the holders of the Common Stock and Series A Preferred Stock.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act requires our Directors, executive officers and persons who own more than 10% of our common stock to file reports of ownership and changes in ownership of our Common Stock to the SEC. Copies of these reports are also required to be delivered to Enova

 

We believe, based solely on our review of the copies of such reports received and written representations from applicable individuals, that the following individuals did not timely file the following reports during our last fiscal year: (i) Dr. Currie, a member of the Company’s Board of Directors, did not timely file a Form 4 on two separate transactions, (ii) Mr. Staran, our Executive Vice President, has not timely filed a Form 3, and has informed us that he intends to file the Form 3 promptly after we file this Form 10-K.

 

Code of Ethics

 

We have adopted a Code of Ethics, which constitutes a “code of ethics” as defined by the SEC, that applies to our Board of Directors as well as our Chief Executive Officer, Chief Financial Officer, principal accounting officer, controller, and our other employees. A copy of the Code of Ethics may be obtained free of charge by writing to Enova Systems, Inc., 19850 S. Magellan Drive, Torrance, California 90502, Attention: Chief Financial Officer or by accessing the “Investor Relations” section of our website www.enovasystems.com. To the extent required by the

rules of the SEC and the AMEX, we will disclose amendments and waivers relating to these documents in the same place on our website.

 

Audit Committee

 

The Board of Directors has established an Audit Committee. The current members of this committee are Messrs. Ahlstrom, Dreyer (Chair) and Wallace. The Board of Directors has determined that Mr. Wallace is an “audit committee financial expert” as defined by the SEC and the AMEX. Mr. Wallace’s designation by the Board as an “audit committee financial expert” is not intended to be a representation that he is an expert for any purpose as a result of such designation, nor is it intended to impose on him any duties, obligations or liability that are greater than the duties, obligations or liability imposed on him as a member of the Audit Committee and the Board in the absence of such designation. The Board of Directors has determined that the members of the Audit Committee, including the audit committee financial expert, are “independent” under the rules of the SEC and the AMEX. The Audit Committee, among other functions, has the sole authority to appoint and replace the independent auditors, is responsible for the compensation and oversight of the work of the independent auditors, reviews the results of the audit engagement with the independent auditors, and reviews and discusses with management and the independent auditors quarterly and annual financial statements and major changes in accounting and auditing principles.

 

Compensation Discussion and Analysis

 

The purpose of this Compensation Discussion and Analysis is to describe the material elements of compensation provided to the Company’s named executive officers for fiscal year 2006.

 

Executive Compensation Philosophy

 

Enova believes in rewarding executives based on their individual performance as well as aligning their interests with those of our stockholders, with the ultimate objective of improving stockholder value. To that end, we believe executive compensation packages should include both cash and stock-based compensation that reward performance. The goal of our executive compensation programs is to attract, retain and motivate key executives and to reward executives for value creation.

 

At the core of our compensation philosophy is our guiding belief that pay should be linked to performance, and several factors underscore that philosophy. First, a substantial portion of executive officer compensation is determined by each executive officer’s contribution to our profitability.

 

We believe that total compensation and accountability should increase with position and responsibility. Consistent with this philosophy, total compensation is higher for individuals with greater responsibility and greater ability to influence Enova’s targeted results and strategic initiatives. As position and responsibility increases, a greater portion of the named executive officer’s total compensation is performance-based pay.

 

In addition, our compensation methods focus management on achieving strong annual performance in a manner that supports and ensures our long-term success and profitability. We believe that stock options issued under the Enova’s stock option plans create long-term incentives that align the interests of management with the interests of long-term stockholders.

 

While overall compensation levels must be sufficiently competitive to attract talented leaders, we believe that compensation should be set at responsible levels. Our executive compensation programs are intended to be consistent with Enova’s cost control strategies.

 

The Compensation-Setting Process

 

The Compensation Committee administers the compensation program for the named executive officers and certain key employees, and makes all related decisions. The Compensation Committee also administers our employee stock option plan. The Compensation Committee ensures that the total compensation paid to the named executive officers is fair, reasonable and competitive. The Compensation Committee did not retain compensation

advisors during 2006, nor has it done so in the past. The fundamental responsibilities of the Compensation Committee are:

 

 

The Compensation Committee’s decisions involve a year-round process in determination of business and succession planning, evaluation of management performance, and consideration of our business environment. The individual judgments made by the Compensation Committee are subjective and are based largely on the Compensation Committee’s perception of each executive’s contribution to both our past performance and long-term growth potential.

 

Management plays a significant role in the compensation-setting process. The most significant aspects of management’s role are:

 

 

Our Chief Executive Officer also participates in Compensation Committee meetings at the Compensation Committee’s request to provide:

 

 

2006 Compensation

 

This section describes the compensation decisions that were made with respect to the named executive officers for fiscal 2006.

 

Executive Summary

 

In 2006, we continued to apply the compensation principles described above in determining the compensation of our named executive officers.

 

 

The primary components of total compensation for our named executive officers during fiscal year 2006 were as follows:

 

 

Base Salary

 

In determining base salaries, we consider the executive’s qualifications and experience, scope of responsibilities, the goals and objectives established for the executive, the executive’s past performance, internal pay equity, the tax deductibility of base salary and cash incentive payments, and the extent to which the company’s earnings were affected by the executive’s actions. While base salaries are not primarily performance-based, it is important for Enova to provide adequate fixed compensation to executives working in a highly volatile and competitive industry.

 

Base salary is largely determined based on the subjective judgment of the Compensation Committee without the use of a formula, taking into account the factors described above. In determining the base salary of the named executive officers, the Compensation Committee may periodically determine the applicable peer group and refer to surveys of compensation data for similar positions with similar companies.

 

Cash Incentive

 

Cash incentive bonus payments are discretionary, based primarily on each executive officers contribution to our profitability over the applicable performance measurement periods. The Compensation Committee believes that revenue and profitability are the most useful measures of management’s effectiveness in creating value for the stockholders of the Company.

 

For 2006, we established a performance cash incentive bonus formula for our Chief Executive Officer as follows:

 

 

Corinne Bertrand and Mike Staran, who later was elevated to the position of Executive Vice President, also were eligible for similar performance cash incentives of $10,000, $20,000 and $30.000 at the same revenue thresholds, respectively. We did not make any cash incentive bonus payments in 2006 because we did not meet the relevant revenue targets.

 

Equity Incentive

 

During 2005 and 2006, our executive officers were eligible to receive performance-based stock options granted under Enova’s 1996 Employee and Consultant Stock Option Plan and 2006 Equity Compensation Plan. The 1996 plan expired in 2006 for purposes of issuing new grants. Going forward, awards will be made under 2006 Equity Compensation Plan, which our shareholders adopted at the November 2006 annual meeting. We grant all stock options based on the fair market value as of the date of grant. The exercise price for stock option grants is determined by reference to the closing price per share on the AMEX at the close of business on the date of grant. The Company has not established a new performance based equity incentive plan.

 

Option awards under the compensation programs discussed above are made at regular or special Compensation Committee meetings. The effective date for such grants is the date of such meeting. We may also make grants of equity incentive awards at the discretion of the Compensation Committee or the board of directors in connection with the hiring of new executive officers and other employees.

 

In determining the number of options to be granted to executives and the frequency of option grants, we take into account the individual’s position, scope of responsibility, ability to affect profitability, the individual’s

performance and the value of stock options in relation to other elements of total compensation. Our profitability in its industry and over the applicable performance measurement periods is also taken into account when determining the number of options to be granted to executives.

 

Perquisites and Other Personal Benefits Compensation

 

We provide named executive officers with perquisites and other personal benefits that we and the Compensation Committee believes are reasonable and consistent with its overall compensation program to better enable us to attract and retain superior employees for key positions. The Compensation Committee periodically reviews the levels of perquisites and other personal benefits provided to named executive officers. The amounts shown in the Summary Compensation Table under the heading “Other Compensation” represent the value of living accommodations, the value of certain health and life insurance benefits, and the incremental cost of vehicle transportation. Executive officers did not receive any other perquisites or other personal benefits or property.

 

Summary Compensation Table

 

The table below summarizes the total compensation paid or earned by each of the named executive officers for the fiscal year ended December 31, 2006. Other than the three individuals named below, we had no other executive officers during 2006.

 

 

 

 

Grants of Plan-Based Awards

 

The following table sets forth certain information with respect to grants of plan-based awards for the fiscal year ended December 31, 2006 to the named executives.

 

 

 

 

Employment Contracts, Termination of Employment and Change in Control Arrangements

 

Effective January 3, 2005, as ratified by the Board of Directors on January 27, 2005, Enova entered into a letter agreement with its President and Chief Executive Officer, Edwin Riddell. The letter agreement subsequently was amended on May 1, 2005 and on December 13, 2005 effective on January 9, 2006. Pursuant to the [illegible] amended letter agreement, Mr. Riddell will receive a yearly salary of $225,000. In addition, Mr. Riddell will be eligible for performance awards mutually agreed upon by both parties. The actual performance goals for 2006 are reflected in Compensation Discussion and Analysis above. Under the original letter agreement, Mr. Riddell also received options to purchase 1,000,000 shares of Enova common stock at an original exercise price of $0.11 per share. The stock options vested over three years in equal monthly installments and will expire five years from the date of issuance. The agreement also provides for health benefits, a standard life insurance policy, living accommodations, and a company automobile. Mr. Riddell’s employment is at-will and may be terminated by either Mr. Riddell or Enova for any reason and at any time.

 

Mr. Riddell’s employment is at-will and may be terminated by Enova for any reason and at any time. In the event that Mr. Riddell’s employment is terminated by Enova without cause, as defined in the Agreement, Mr. Riddell is entitled to receive 12 month’s salary and health benefits as severance. If the Board should change Mr. Riddell’s duties or authority so that it may reasonably be found that Mr. Riddell is no longer performing as the Chief Executive Officer of Enova or if Enova is sold, merged, or closed, then, in either instance, Mr. Riddell shall have the right to terminate the Agreement and receive the same severance payment as if his employment had been terminated without cause. Mr. Riddell may otherwise terminate his employment at any time with 120 days written notice of his decision to terminate to Enova, but will not be entitled to any severance benefits. In the event of a single period of prolonged inability to work due to the result of a sickness or an injury, Mr. Riddell will be compensated at his full rate pay for at least 6 (six) months from the date of the sickness or injury. Assuming a severance triggering event occurred on December 31, 2006, Mr. Riddell would be entitled to 12 monthly payments of approximately $23,000.

 

During the term of his employment and during the 12-month period following termination of his employment, Mr. Riddell has agreed not to directly own, manage, operate, join, control, or participate in or be connected with, as an officer, employee, partner, stockholder or otherwise, any competitive company or related business, partnership, firm or corporation that is at the time engaged principally or significantly in a business that is, directly or indirectly, at the time in competition with the business of Enova.

 

During the term of his employment and during the 12-month period following termination of his employment, Mr. Riddell has agreed not to directly or indirectly through his own efforts, or otherwise, contract with, or in any way retain the services of, any employee or former employee of Enova, if such individual has provided professional or support services to Enova at any time since May 1, 2005 without the express written consent of Enova. In addition

Mr. Riddell has agreed not to interfere with the relationship of Enova and any of its employees and he will not attempt to divert from Enova any business in which Enova has been actively engaged during his employment.

 

Effective with her appointment as Chief Financial Officer on April 3, 2006, Corinne Bertrand and Enova entered into a letter agreement on March 13, 2006. Pursuant to the letter agreement, Ms. Bertrand was entitled to an annual salary of $170,000 and a signing bonus of $5,000. In addition, Ms. Bertrand was eligible for performance-based cash bonuses described above. Ms. Bertrand also received unvested options to purchase 23,000 shares of Enova common stock at an exercise price of $5.25 per share, subject to the achievement of certain performance-based revenue targets for the year ending December 31, 2006. The letter agreement also provided for certain health benefits, and a standard life insurance policy. Ms. Bertrand’s employment was at-will and was eligible to be terminated by either her or Enova for any reason and at any time. Ms. Bertrand resigned her position effective January 31, 2007.

 

In connection with his appointment as Chief Financial Officer effective February 5, 2007, Jarett Fenton entered into a letter agreement to receive an annual salary of $170,000. In addition, Enova agreed to issue Mr. Fenton 5,000 shares of common stock, participation in the executive bonus program, and health and life insurance benefits. In 2006, as principal of The Clarity Group, Mr. Fenton served as a consultant to Enova. During 2006, Enova paid The Clarity Group fees of $93,000 of which Mr. Fenton received approximately $79,050.

 

In connection with his appointment as Executive Vice President, effective November, 11, 2007, Mike Staran entered into a letter agreement, executed on March 27, 2007, to receive an annual salary of $190,000. In addition, Enova agreed to issue Mr. Staran 5,000 shares of common stock, participation in the executive bonus program, and health and life insurance benefits. Mr. Staran will also receiving living and transportation reimbursements.

 

Mr. Staran’s employment is at-will and may be terminated by Enova for any reason and at any time. In the event that Mr. Staran’s employment is terminated by Enova without cause, as defined in the Agreement, Mr. Staran is entitled to receive (i) three month’s salary and health benefits as severance and (ii) reimbursement for reasonable relocation expenses to return to Michigan. If the Board should change Mr. Staran’s duties or authority so that it may reasonably be found that Mr. Staran is no longer performing as the Executive Vice President of Enova or if Enova is sold, merged, or closed, then, in either instance, Mr. Staran shall have the right to terminate the Agreement and receive the same severance payment as if his employment had been terminated without cause. Mr. Staran may otherwise terminate his employment at any time with 120 days written notice of his decision to terminate to Enova, but will not be entitled to any severance benefits. In the event of a single period of prolonged inability to work due to the result of a sickness or an injury, Mr. Staran will be compensated at his full rate pay for at least 3 (three) months from the date of the sickness or injury. Assuming a severance triggering event occurred on December 31, 2006, Mr. Staran would be entitled to three monthly payments of approximately $16,500 and reasonable relocation reimbursement discussed above.

 

During the term of his employment and during the 12-month period following termination of his employment, Mr. Staran has agreed not to directly own, manage, operate, join, control, or participate in or be connected with, as an officer, employee, partner, stockholder or otherwise, any competitive company or related business, partnership, firm or corporation that is at the time engaged principally or significantly in a business that is, directly or indirectly, at the time in competition with the business of Enova.

 

During the term of his employment and during the 12-month period following termination of his employment, Mr. Staran has agreed not to directly or indirectly through his own efforts, or otherwise, contract with, or in any way retain the services of, any employee or former employee of Enova, if such individual has provided professional or support services to Enova at any time since March 27, 2007. In addition Mr. Staran has agreed not to interfere with the relationship of Enova and any of its employees and he will not attempt to divert from Enova any business in which Enova has been actively engaged during his employment.

 

Outstanding Equity Awards at Fiscal Year-End

 

 

In 2005, the Compensation Committee granted performance based stock options to executives under Enova’s 1996 Stock Option Plan. The options vested evenly in two annual tranches, based upon us reaching certain revenue milestones in 2005 and 2006. In 2005, these revenue milestones were met and the awards vested. In 2006, the revenue milestone was not met, and the options expired. We granted an additional set of second tranche options under the 1996 Plan to two new executives in 2006. These options also expired when the revenue milestone was not met.

 

Option Exercises and Stock Vested

 

Enova has not had any option exercises, that would be required to be disclosed as an exercise. Therefore, in accordance with SEC rules, we have omitted these tables.

 

Pension Benefits Nonqualified Deferred Compensation

 

Enova does not offer any post employment compensation that would be required to be disclosed as pension benefits or non-qualified deferred compensation. Therefore, in accordance with SEC rules, we have omitted these tables.

 

Compensation of Directors

 

Non-employee Directors receive quarterly compensation at a flat rate of $4,000 in cash and $6,000 in stock. Prior to Enova’s listing on AMEX on August 28, 2006, these stock awards were valued on the last trading day of the quarter at the average of the closing ask and bid prices on the over the counter bulletin board. After Enova’s listing on AMEX, the stock awards were valued on the last trading day of the quarter at the closing stock price on AMEX. The flat rate is not dependent on the amount or type of services performed by the Directors. All Directors are also reimbursed for out-of-pocket expenses incurred in connection with attending Board and committee meetings.

 

In addition to the compensation paid for their service on the Board, members of Enova’s Audit Committee receive an additional annual compensation of $5,000. In addition to the Audit Committee membership compensation, the Chairman of Enova’s audit committee receives an additional $5,000 annual compensation for his service as Chairman.

 

Our Chief Executive Officer, Mr. Riddell did not receive separate consideration for his service as a director.

The table below summarizes the compensation paid by Enova, to our Directors for the fiscal year ended December 31, 2006.

 

 

 

 

As of December 31, 2006, the following Directors held the following number of Enova Common Stock Mr. Rawlinson — 578,615 shares; Dr. Currie — 26,505 shares; Mr. Langenius — 3,145 shares; Mr. Ahlstrom — 13,837 shares; Mr. Wallace — 14,429 shares; and Mr. Dreyer — 25,144 shares.

 

Compensation Committee Interlocks and Insider Participation

 

The members of the Compensation Committee during fiscal year 2006 were Bjorn Ahlstrom and Malcom Currie. None of the members of the Compensation Committee was an Enova officer or employee in the past fiscal year. None of the Compensation Committee members has ever served as an Enova officer. No Enova executive officer served as a director or a member of the compensation committee of another entity, one of whose executive officers either served on our Board of Directors or on its Compensation Committee.

 

Report of the Compensation Committee

 

The Compensation Committee has submitted the following report for inclusion in this Annual Report on Form 10-K:

 

Our Committee has reviewed and discussed with management the Compensation Discussion and Analysis contained in this Annual Report on From 10-K. Based on our Committee’s review of and the discussions with management with respect to the Compensation Discussion and Analysis, our Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K for the fiscal year ended December 31, 2006 for filing with the SEC.

 

COMPENSATION COMMITTEE

 

Bjorn Ahlstrom

Malcom Currie

 

The preceding Report of the Compensation Committee shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Enova specifically incorporated it by reference.

 

The following table sets forth certain information known to us as of December 31, 2006 with respect to beneficial ownership of:

 

 

Beneficial ownership is determined in accordance with the rule of the SEC. Shares of common stock subject to options currently exercisable or exercisable within 60 days of December 31, 2006 are deemed outstanding for calculating the percentage of outstanding share of the person holding these options, but are not deemed outstanding for the percentage of any other person. Percentage of beneficial ownership is based upon 14,816,000 shares of common stock outstanding as of December 31, 2006. To our knowledge, except as set forth in the footnotes to this table and subject to applicable community property laws, each person named in the table has sole voting and investment power with respect to the shares set forth opposite such person’s name. Except as otherwise indicated, the address of each of the persons in this table is as follows: c/o Enova Systems, Inc., 19850 South Magellan Drive, Torrance, CA 90502.

 

 

 

 

 

 

Equity Compensation Plan Information

 

For the fiscal year ended December 31, 2006, we had two equity compensation plans: the 1996 Option Plan and the 2006 Equity Compensation Plan. Each plan was adopted with the approval of our shareholders. The 1996 Stock Option Plan has expired for purposes of issuing new grants. The 1996 Stock Option Plan, however, will continue to govern awards previously granted under that plan. The 2006 plan, adopted at our annual meeting in November 2006, has a total of 3,000,000 shares reserved for issuance. The following table provides information regarding our equity compensation plans as of December 31, 2006:

 

Equity Compensation Plan Information

 

 

The following is the only transaction, since January 1, 2006 or currently proposed, in which we were or are to be a participant and the amount involved exceeds $120,000 and in which any related person, as defined under SEC rules, will have a direct or indirect material interest:

 

During 2006, we purchased from Hyundai Heavy Industries, Co. (HHI) approximately $404,115 in components, materials and services for manufacture of our drive systems and power management systems. These purchases were made on terms and conditions equal to or better than our standard commercial terms with other vendors. At the year ended December 31, 2006, we had approximately $138,000 in outstanding payables to HHI.

 

Daniel Riddell, the son of our Chief Executive Officer, is a majority owner of a website consulting firm, which provides services (branding) to the Company. These services were utilized on terms and conditions equal to or better than our standard commercial terms with other vendors. The Company paid consulting fees and expenses to this firm in the amount of approximately $149,000 in 2006.

 

Currently, the Board of Directors reviews related party arrangements and has approval authority. The Board will consider the business case for the relationship and issue their approval. Given the relatively small size of our company and transparency of transactions within the company, we believe our management and audit committee is positioned to identify potentially related party transactions. While the policy is not currently in writing, the Board of Directors intends to formalize the policy soon after we file this Form 10-K.

 

Director Independence

 

Each of the following directors are “independent’ under applicable AMEX rules: Messrs. Messrs. Ahlstrom, Currie, Langenius Dreyer, Rawlinson, and Wallace. These persons represent a majority of the board of directors. All the members of the compensation, nominating or audit committees are independent. Messrs. Ahlstrom and Currie constitute the compensation committee. Messrs. Rawlinson and Currie constitute the nominating committee. Messrs. Ahlstrom, Dreyer, and Wallace constitute the audit committee.

 

PMB Helin Donovan was engaged in January 2007 to audit our financial statements for the fiscal year ended December 31, 2006. PMB Helin Donovan replaced Singer Lewak Greenbaum and Goldstein LLP as our auditors. Singer Lewak audited our financial statements for the fiscal year ended December 31, 2005, having previously been engaged to audit our financial statements for the years ended December 31, 2004 and 2003.

 

Additionally, Enova engaged Windes & McClaughry Accountancy Corporation to review Enova’s second and third quarter 2006 Form’s 10-Q.

 

Audit Fees

 

Having been engaged subsequent to the end of the year, PMB Helin Donovan has not billed us for professional services in 2006.

 

The aggregate fees billed during the last fiscal year by Windes for the review of Enova’s second and third quarter 2006 Form’s 10-Q were $69,000.

 

The aggregate fees billed for professional services rendered by Singer Lewak for the audit of Enova’s financial statements for the fiscal year ended December 31, 2005 and for its review of financial statements included in Enova’s Forms 10-Q during the last two fiscal years and other services that are normally provided by an accountant in connection with statutory and regulatory filings or engagements during such fiscal years were $143,000. In 2006, in conjunction with the review of Enova’s First Quarter 2006 Form 10-Q, Enova was billed $38,000 by Singer Lewak.

 

Audit-Related Fees

 

PMB Helin Donovan did not perform for Enova any assurance and related services that were reasonably related to the performance of the audit of our financial statements for the fiscal year ended December 31, 2006.

 

Tax Fees

 

In 2006, Enova paid Windes & McClaughry $5,000 for tax preparation services. In 2005, we paid Singer Lewak $5,000 for tax preparation services. We did not make any further payments to Windes and Singer Lewak, nor any payments to PMB Helin Donovan, in fiscal 2005 or fiscal 2006 with respect to tax compliance, tax advice, or tax planning services

 

All Other Fees

 

Neither PMB Helin Donovan LLP, nor Singer Lewak performed any other services for fees other than audit fees in fiscal 2006 or 2005.

 

Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors

 

The Audit Committee pre-approves all audit and permissible non-audit services provided by the independent auditors. These services may include audit services, audit-related services, tax services and other services. Pre-approval is provided for up to one year, and any pre-approval is detailed as to the particular service or category of services and is subject to a specific budget. The independent auditors and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent auditors in accordance with this pre-approval, and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.

 

(a) 1.  Financial Statements

 

The financial statements filed as a part of this report are identified in the Index to Financial Statements on page F-1.

 

(a) 2.  Financial Statement Schedule

 

No financial statement schedules are filed as a part of this report.

 

(a)3. Exhibits