UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From                      To                     

ENOVA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

CALIFORNIA		95-3056150
(State or other jurisdiction of		(IRS employer identification number)
incorporation or organization)

19850 South Magellan Drive Torrance, CA 90502

(310) 527-2800

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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

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 Exchange Act). Yes o No þ

As of August 4, 2006, there were 14,801,000 shares of Common Stock, no par value, 2,674,000 shares of Series A Preferred Stock, no par value, and 1,185,000 shares of Series B Preferred Stock, no par value, outstanding.

 

 

INDEX

ENOVA SYSTEMS, INC.

				Page No.
PART I.		FINANCIAL INFORMATION
Item 1.		Financial Statements
		Balance Sheets:
		June 30, 2006 (unaudited) and December 31, 2005			3
		Statements of Operations (unaudited):
		Three and six months ended June 30, 2006 and 2005			4
		Statements of Cash Flows (unaudited):
		Six months ended June 30, 2006 and 2005			5
		Notes to Financial Statements (unaudited):
		Three and six months ended June 30, 2006 and 2005			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			11
Item 3.		Quantitative and Qualitative Disclosures about Market Risk			20
Item 4.		Controls and Procedures			21
PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings			22
Item 1.A		Risk Factors			22
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			27
Item 3.		Defaults upon Senior Securities			28
Item 4.		Submission of Matters to a Vote of Security Holders			28
Item 5.		Other Information			28
Item 6.		Exhibits			28
SIGNATURE					29
CERTIFICATIONS
EXHIBIT 10.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

Enova Systems is a trademark of Enova Systems, Inc. All other brand names or trademarks appearing in this quarterly report on Form 10-Q are the property of their respective holders.

ENOVA SYSTEMS, INC.

BALANCE SHEETS

ASSETS
		As of				As of
		June 30, 2006				December 31, 2005
		(unaudited)
Current assets
Cash and cash equivalents		$	3,105,000			$	16,187,000
Short term investment			10,000,000				—
Accounts receivable, net			1,062,000				2,173,000
Inventories and supplies, net			862,000				1,016,000
Prepaid expenses and other current assets			386,000				182,000
Total current assets			15,415,000				19,558,000
Property and equipment, net			614,000				576,000
Equity method investment			1,607,000				1,649,000
Other assets			134,000				190,000
Total assets		$	17,770,000			$	21,973,000
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities
Accounts payable		$	185,000			$	1,396,000
Accrued payroll and related expense			202,000				195,000
Other accrued expenses			275,000				302,000
Current portion of notes payable			40,000				42,000
Total current liabilities			702,000				1,935,000
Accrued interest payable			666,000				1,113,000
Notes payable, net of current portion			1,238,000				2,321,000
Total liabilities		$	2,606,000			$	5,369,000
Commitments and contingencies
Stockholders’ equity (deficit)
Series A convertible preferred stock — no par value 30,000,000 shares authorized 2,674,000 and 2,674,000 shares issued and outstanding Liquidating preference at $0.60 per share, aggregating $1,604,000		$	1,679,000			$	1,679,000
Series B convertible preferred stock — no par value 5,000,000 shares authorized 1,217,000 and 1,217,000 shares issued and outstanding Liquidating preference at $2 per share, aggregating $2,434,000			2,434,000				2,434,000
Common Stock, no par value 750,000,000 shares authorized, 14,797,000 and 14,783,000 shares issued and outstanding			109,382,000				109,323,000
Common stock subscribed			30,000				30,000
Stock notes receivable			(1,176,000	)			(1,176,000	)
Additional paid-in capital			6,928,000				6,900,000
Accumulated deficit			(104,113,000	)			(102,586,000	)
Total stockholders’ equity			15,164,000				16,604,000
Total liabilities and stockholders’ equity		$	17,770,000			$	21,973,000

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

ENOVA SYSTEMS, INC.

STATEMENTS OF OPERATIONS (Unaudited)

For the Three and Six Months Ended June 30,

		Six Months								Three Months
		2006				2005				2006				2005
Net revenues
Research and development contracts		$	419,000			$	705,000			$	161,000			$	505,000
Production			341,000				1,309,000				291,000				817,000
Total net revenues			760,000				2,014,000				452,000				1,322,000
Cost of revenues
Research and development contracts			556,000				419,000				253,000				300,000
Production			818,000				1,175,000				661,000				724,000
Total cost of revenues			1,374,000				1,594,000				914,000				1,024,000
Gross profit (loss)			(614,000	)			420,000				(462,000	)			298,000
Operating expenses
Research and development			632,000				395,000				308,000				178,000
Selling, general and administrative			1,959,000				1,158,000				1,035,000				550,000
Loss from operations			(3,205,000	)			(1,133,000	)			(1,805,000	)			(430,000	)
Other income and (expense)
Interest and other income/expense, net			329,000				(141,000	)			151,000				(72,000	)
Equity in losses of equity method investee			(42,000	)			(66,000	)			(16,000	)			(26,000	)
Debt extinguishment			920,000				—				—				—
Interest extinguishment			472,000				—				—				—
Total other income (expense)			1,679,000				(207,000	)			135,000				(98,000	)
Net loss		$	(1,526,000	)		$	(1,340,000	)		$	(1,670,000	)		$	(528,000	)
Basic earnings (loss) per share		$	(0.10	)		$	(0.14	)		$	(0.11	)		$	(0.06	)
Diluted earnings (loss) per share		$	(0.10	)		$	(0.14	)		$	(0.11	)		$	(0.06	)
Weighted-average number of shares outstanding			14,797,000				9,263,000				14,797,000				9,263,000

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

ENOVA SYSTEMS, INC.

STATEMENTS OF CASH FLOWS (Unaudited)

For the Six Months Ended June 30,

		2006				2005
Cash flows from operating activities
Net loss		$	(1,526,000	)		$	(1,340,000	)
Adjustments to reconcile net loss to net cash used in operating activities
Debt extinguishment			(920,000	)			—
Interest extinguishment			(472,000	)			—
Depreciation and amortization			169,000				146,000
Equity in losses of equity method investee			42,000				66,000
Issuance of common stock for services			60,000				63,000
Equity compensation expense			28,000				—
(Increase) decrease in:
Accounts receivable			1,111,000				(204,000	)
Inventory and supplies			154,000				147,000
Prepaid expenses and other current asset			(204,000	)			(141,000	)
Increase (decrease) in:
Accounts payable			(1,211,000	)			252,000
Accrued expenses			(20,000	)			11,000
Deferred revenues			—				(308,000	)
Accrued interest payable			25,000				150,000
Net cash used in operating activities			(2,764,000	)			(1,158,000	)
Cash flows from investing activities
Purchase of short term investment		$	(10,000,000	)		$	—
Purchases of property and equipment			(153,000	)			(51,000	)
Net cash used in investing activities			(10,153,000	)			(51,000	)
Cash flows from financing activities
Net payments on line of credit		$	—			$	(229,000	)
Payment on notes payable and capital lease obligations			—				(13,000	)
Payment to extinguish debt			(165,000	)			500,000
Net cash provided by (used in) financing activities			(165,000	)			258,000
Net decrease in cash and cash equivalents			(13,082,000	)			(951,000	)
Cash and cash equivalents, beginning of period			16,187,000				1,575,000
Cash and cash equivalents, end of period		$	3,105,000			$	624,000
Supplemental disclosure of cash flow information
Interest paid		$	—			$	4,000
Income taxes paid		$	—			$	—
Supplemental schedule of non-cash investing and financing activities
Conversion of preferred stock to common stock		$	—			$	13,000

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

ENOVA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 — Basis of Presentation

The accompanying unaudited financial statements have been prepared from the records of our company without audit and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial position at June 30, 2006 and the interim results of operations for the three and six months ended June 30, 2006 and cash flows for the six months ended June 30, 2006 have been included. The balance sheet at December 31, 2005, presented herein, has been prepared from the audited financial statements of our company for the year then ended.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. The June 30, 2006 and December 31, 2005 inventories are reported at the lower of cost or market value. Inventories have been valued on the basis that they would be used, converted and sold in the normal course of business. The amounts estimated for the above, in addition to other estimates not specifically addressed, could differ from actual results; and the difference could have a significant impact on the financial statements.

Accounting policies followed by us are described in Note 1 to the audited financial statements for the fiscal year ended December 31, 2005. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted for purposes of the interim financial statements. The financial statements should be read in conjunction with the audited financial statements, including the notes thereto, for the year ended December 31, 2005, which are included in our Form 10-K Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 as filed with the Securities and Exchange Commission.

Basic earnings (loss) per common share is computed using the weighted average number of common shares outstanding. Diluted earnings per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of employee stock options and preferred stock conversions.

The results of operations for the three and six months ended June 30, 2006 presented herein are not necessarily indicative of the results to be expected for the full year.

Short Term Investments

Short term investments consist of highly liquid instruments with original maturities greater than three months and current maturities less than twelve months from the balance sheet date.

Stock Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including stock options related to the Company’s Employee Stock Option Plan (the “Employee Option Plan”) based on their fair values. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), which the Company previously followed in accounting for stock-based awards. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) to provide guidance on SFAS 123(R). The Company has applied SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method as of and for the three and six months ended June 30, 2006. In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in the Company’s Statement of Operations during the three and six months ended June 30, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of, December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123.

The Company uses the Black-Scholes option-pricing model for estimating the fair value of options granted. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates, trended into future years. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s options. For purposes of pro forma disclosures, the estimated fair values of the options are amortized over the options’ vesting periods.

Stock Option Program Description

As of June 30, 2006, the Company had one stock option plan: the 1996 Stock Option Plan (the “1996 Plan”).

Stock option grants are designed to reward employees and executives for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of stock option grants are based on competitive practices, operating results of the Company, and government regulations.

The maximum number of shares issuable over the term of the 1996 Plan is limited to 65 million shares. Options granted under the 1996 Plan typically have an exercise price of 100% of the fair market value of the underlying stock on the grant date and expire no later than ten years from the grant date.

Options issued to executives will vest based on the Company achieving certain revenue milestones for the years ended December 31, 2005 and 2006. If such milestones are not met, the options with respect to those milestones will terminate. Options issued to employees will vest in equal installments over 36 months. All of the granted options will remain in effect for a period of 10 years or until 90 days after the employment of the optionee terminates.

Diluted shares outstanding include the dilutive effect of in-the-money options. As of June 30, 2006, and on December 31, 2005, the Company did not have any in-the-money options, and therefore, there was no dilutive effect relating to stock options outstanding on the 1996 plan.

Current quarter ended June 30, 2006

In conjunction with the adoption of SFAS 123(R), the Company elected to attribute the value of share-based compensation to expense using the straight-line method, which was previously used for its pro forma information required under SFAS 123. Share-based compensation expense related to stock options was $14,000 and $28,000 for the three and six months ended June 30, 2006, respectively, and was recorded in the financial statements as a component of selling, general and administrative expense.

Share-based compensation expense reduced the Company’s results of operations for the three months ended June 30, 2006 as follows:

Income from continuing operations before income taxes		$	14,000
Income from continuing operations after income taxes		$	14,000
Cash flows from operations		$	14,000
Cash flows from financing activities		$	—
Basic and Diluted EPS		$	—

During the quarter ended June, 2006, the Company did not grant any stock options.

As of June 30, 2006, the total compensation cost related to non-vested awards not yet recognized is $124,000. The weighted average period over which the future compensation cost is expected to be recognized is 27 months. The aggregate intrinsic value of total awards outstanding is zero.

General Option Information

A summary of option activity follows:

		1996 Plan
						Weighted
						Average
						Exercise
		Shares				Price
Outstanding, December 31, 2004			164,000			$	5.40
Granted			310,000			$	4.35
Exercised			—				—
Forfeited			(38,000	)		$	7.64
Outstanding December 31, 2005			436,000			$	4.46
Granted			46,000			$	4.60
Exercised			—				—
Forfeited			(151,000	)		$	4.84
Outstanding June 30, 2006			331,000			$	4.39
Exercisable, June 30, 2006			175,000			$	4.96

The weighted-average remaining contractual life of the options outstanding at June 30, 2006 was 7.4 years. The exercise prices of the options outstanding at June 30, 2006 ranged from $4.35 to $8.10. The weighted-average remaining contractual life of the options outstanding at December 31, 2005 was 7 years. The exercise prices of the options outstanding at December 31, 2005 also ranged from $4.35 to $8.10. Options exercisable were 175,000 and 255,000, at June 30, 2006 and December 31, 2005, respectively.

Valuation and Expense Information under SFAS 123

Prior to the adoption of Statement of Financial Accounting Standards No. 123(R) “Accounting for Stock-Based Compensation-Revised “(SFAS 123(R)), at March 31, 2006, the Company would not have recognized compensation expense for employee share-based awards, when the price of such awards equaled the market price of the underlying stock on the date of the grant. The Company previously had adopted the provisions of Statement of SFAS 123 as amended by SFAS 148, “Accounting for Stock Based Compensation, Transition and Disclosure” (SFAS 148) through disclosure only. The Company did not have any share based awards for the three and six months ended June 30, 2005, and consequently, there is no pro forma effect of share based awards for the first two quarters of 2005.

NOTE 2 — Notes Payable, Long-Term Debt and Other Financing

Notes payable and long-term debt is comprised of the following:

		Jun 30 2006				Dec 31 2005
		(unaudited)
Secured note payable to Credit Managers Association of California, bearing interest at prime plus 3% per annum in 2005 and through maturity. The prime rate resets once a year at April 30. At June 30, 2006, interest was being accrued at a rate of 10.75%. Principal and unpaid interest due in April 2016.			1,238,000				2,321,000
Secured note payable to Coca Cola Enterprises in the original amount of $40,000, bearing interest at 5% per annum. Principal and unpaid interest due now.			40,000				40,000
Secured note payable to a financial institution in the original amount of $33,000, bearing interest at 8% per annum, payable in 36 equal monthly installments.			—				2,000
Less current maturities			1,278,000				2,363,000
Long-term portion			40,000				42,000
		$	1,238,000			$	2,321,000

NOTE 3 – Stockholders’ Equity

During the three months ended June 30, 2006, the Company recorded 8,220 shares of restricted common stock as common stock subscribed, valued at $30,000, to the Board of Directors at an average price of $3.65 per share for board meetings and committee meetings during the second quarter of 2006.

In the second quarter of 2006, and in accordance with the Directors Compensation Plan, the Company issued 5,880 shares of restricted common stock, valued at $30,000, to the Board of Directors as the share based portion of their compensation.

NOTE 4 – Related Party Transactions

During the three months ended June 30, 2006, the Company purchased approximately $79,000 in components, materials, and services from Hyundai Heavy Industries (HHI), a joint venture party. The Company did not have any outstanding payable balances owed to HHI on June 30, 2006.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SPECIAL NOTE REGARDING STATEMENTS OF EXPECTED FUTURE PERFORMANCE

Certain statements in this Form 10-Q under Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere constitute “forward-looking statements” within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “Exchange Act”). In addition, the Company may from time to time make oral forward-looking statements. Words such as “may”, “will”, “should”, “could”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential” or “contribute” or similar words are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions; the impact of competitive products and pricing; success of operating initiatives; development and operating costs; advertising and promotional efforts; adverse publicity; acceptance of new product offerings; consumer trial and frequency; changes in business strategy or development plans; availability, terms and deployment of capital; availability of qualified personnel; commodity, labor, and employee benefit costs; changes in, or failure to comply with, government regulations; weather conditions; construction schedules; and other factors referenced in this Form 10-Q and in Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. Because of these and other factors that may affect the Company’s operating results, past financial performance should not be considered an indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. The Company expressly disclaims any intent or obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof, or to reflect the occurrence of unanticipated events.

Revenue Outlook

While customer relationships have continued to move more slowly than originally anticipated, we believe that commercial relationships will continue to develop and will lead to further orders in the second half of 2006 and beyond. These orders are expected to exceed the total revenues from the first half of the year. The revenue outlook for 2006 will depend on securing a number of orders during the third quarter of 2006 for which proposals have recently been submitted as well as securing further orders where commercial relationships are currently at a less developed stage.

Section 404 Sarbanes-Oxley Act of 2002

Based on current guidance for the Securities and Exchange Commission (the “SEC”), the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 will be effective for the Company’s fiscal year ending December 31, 2007. In order to comply with the Act, the Company is in the process of centralizing most accounting and many administrative functions at its corporate headquarters in an effort to control the cost of maintaining its control systems. Current proposals being considered at the SEC may exempt the Company from the final requirements of Section 404 and as a result, the Company has delayed extensive and costly documentation and testing of its internal controls pending further guidance from the SEC. Should these requirements be imposed on the Company, management will likely incur substantial additional expenses and diversion of management’s time in the remaining periods of fiscal year 2006 to comply with Section 404. During the course of these activities, the Company may identify certain internal control issues which management believes should be improved. These improvements, if necessary, will likely include further formalization of policies and procedures, improved segregation of duties, additional information technology system controls and additional monitoring controls. Although management does not believe that any of these matters will result in material weaknesses being identified in the Company’s internal controls as defined by the Public Company Accounting Oversight Board, no assurances can be given regarding the outcome of these efforts. Additionally, control weaknesses may not be identified in a timely enough manner to allow remediation prior to the issuance of the auditor’s report on internal controls over financial reporting. Any failure to adequately comply could result in sanctions or investigations by regulatory authorities, which could harm the Company’s business or investors’ confidence in the Company.

Off-Balance Sheet Arrangements

The Company is not engaged in any “off-balance sheet arrangements” within the meaning of Item 303(a)(4)(ii) of Regulation S-K.

CRITICAL ACCOUNTING POLICIES

In the ordinary course of business, the Company has made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of its financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ significantly from those estimates under different assumptions and conditions. The Company believes that the following discussion addresses the Company’s most critical accounting policies, which are those that are most important to the portrayal of the Company’s financial condition and results of operations The Company constantly re-evaluates these significant factors and makes adjustments where facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the necessary estimates inherent in the preparation of financial statements. Estimates and assumptions include, but are not limited to, customer receivables, inventories, equity investments, fixed asset lives, contingencies and litigation. The Company has also chosen certain accounting policies when options were available, including:

Cash and Short Term Investments

We seek to maximize interest return on our cash reserves while minimizing risk. Therefore, we purchased two certificates of deposit in the first quarter of 2006, of equal value, and both from a single financial establishment. The first certificate was purchased at the end of January, has a term of 6 months, and earns an annual percentage rate of 5%. The second certificate was purchased at the beginning of February, has a one year term, and earns an interest rate of 5.25%. Cash and short term investments represent 74% of our total assets at June 30, 2006.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The assessment of the ultimate realization of accounts receivable including the current credit-worthiness of each customer is subject to a considerable degree to the judgment of our management. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory

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

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

Warranty

We accrue for warranty and claim costs based upon our estimate of future exposure. Factors such as limited historical experience are considered in our estimate. In addition, the nature of the product, the limited number of units produced and the research and development nature of the product may increase the risk of warranty obligation. Actual warranty and claims costs are deducted from the accrual when incurred.

Stock-Based Compensation

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including stock options related to our Employee Stock Option Plan (the “Employee Stock Option Plan”) based on their fair values. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), which we previously followed in accounting for stock-based awards. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) to provide guidance on SFAS 123(R). We have applied SAB 107 in its adoption of SFAS 123(R).

We adopted SFAS 123(R) using the modified prospective transition method as of and for the three months ended March 31, 2006. In accordance with the modified prospective transition method, our financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in our Statement of Operations during the three months ended June 30, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of, December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123. We use share-based compensation to compensate certain executives and employees. If we issue stock related to this compensation, it could have a dilutive effect on our earnings per share. In addition, factors such as interest rates, the value of our stock and its volatility can significantly impact the compensation expense.

Contract Services Revenue and Cost Recognition

We are required to make judgments based on historical experience and future expectations, as to the reliability of shipments made to its customers. These judgments are required to assess the propriety of the recognition of revenue based on Staff Accounting Bulletin (“SAB”) No. 101 and 104, “Revenue Recognition,” and related guidance. We make these assessments based on the following factors: i) customer-specific information, ii) return policies, and iii) historical experience for issues not yet identified. Under FAS Concepts No. 5, revenues are not recognized until earned.

We manufacture proprietary products and other products based on design specifications provided by its customers. Revenue from sales of products are generally recognized at the time title to the goods and the benefits and risks of ownership passes to the customer which is typically when products are shipped based on the terms of the customer purchase agreement. Revenue relating to long-term fixed price contracts is recognized using the percentage of completion method. Under the percentage of completion method, contract revenues and related costs are recognized based on the percentage that costs incurred to date bear to total estimated costs. Changes in job performance, estimated profitability and final contract settlements may result in revisions to cost and revenue, and are recognized in the period in which the revisions are determined. Contract costs include all direct materials, subcontract and labor costs and other indirect costs. General and administrative costs are charged to expense as incurred. At the time a loss on a contract becomes known, the entire amount of the estimated loss is accrued. The aggregate of costs incurred and estimated earnings recognized on uncompleted contracts in excess of related billings is shown as a current asset, and billings on uncompleted contracts in excess of costs incurred and estimated earnings is shown as a current liability.

These accounting policies were applied consistently for all periods presented. Our operating results would be affected if other alternatives were used.

GENERAL

We believe we are 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.

Our HybridPower hybrid electric drive system provides all the functionality 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 may include 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. 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 light/medium-duty drive systems include:

•		30kW, 60kW, 90kW all-electric drives
•		90kW series-hybrid drive
•		any combination of these systems based on customer requirements.

Our heavy-duty electric drive systems include:

•		120kW all-electric drive
•		120/60kW peak series hybrid system
•		240/60kW peak series hybrid system
•		90kW peak mild, pre-transmission parallel hybrid system
•		100kW peak post-transmission parallel hybrid systems
•		100kW peak pre-transmission parallel hybrid system.

Our drive systems, in conjunction with, internal combustion engines, microturbines, fuel cells, flywheels, and generator 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.

During the quarter ended June 30, 2006, we continued to develop and/or produce electric and hybrid electric drive systems and components for such customers as First Auto Works of China, Ford Motor Company (Ford), Hyundai Motor Car (Hyundai), the U.S. Military, International Truck and Engine (IC Corp.), Wrightbus Ltd. (Wrightbus), Tomoe of Japan and several other domestic and international vehicle and bus manufacturers. We also continue to advance its technologies and products for greater market penetration for 2006, and beyond. In addition, 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.

In June of 2006, we delivered a second functional Hybrid Drive school bus to IC Corp. It is expected that this bus will be displayed in numerous shows throughout the United States during 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.

Wrightbus, one of the largest low-floor bus manufacturers in the United Kingdom, continues to purchase our diesel genset-powered, series hybrid drive systems for their medium and large bus applications. Our systems have been integrated into six of Wrightbus’ Hybrid Buses and were introduced into London’s public bus fleet in early February 2006. We understand that these buses continue to operate on a seven day per week, eighteen hour per day schedule. We anticipate the results of this project will be increased Hybrid volumes in this arena.

Enova has begun implementing the necessary processes and procedures to become ISO/QS certified in 2006. The certification will be valuable to optimize internal processes and efficiencies, as well as secure Enova’s position as a production supplier to major Original Equipment Manufacturers.

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 June we announced that Hyundai is using its Hybrid Drive components to power a Fuel Cell Bus and two Hyundai Tucsons being featured at the World Cup Soccer tournament in Germany. Hyundai is an official sponsor of the World Cup Soccer tournament through 2014. At this year’s event, Hyundai has thirty two buses in use. One of the thirty two Hyundai Buses is hybrid powered by our 240kW Induction Motor and High Voltage Motor Control Unit. In addition to the bus, the Tucson’s contain our 80kW Induction Motor and Control Unit. Our alliance with Hyundai has been critical to the development of hybrid systems such as the ones being used in the fuel cell bus and Tucson’s.

Throughout the quarter we hosted and visited numerous potential customers from the Pick Up and Delivery, Medium Duty and Heavy Duty markets. 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 that 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 2006.

Research and Development Programs

We continue to pursue government and commercially sponsored development programs for both ground and marine heavy-duty drive system applications. In 2006, we continued the integration of a fuel cell powered step-van similar to the Hydrogenics program for the Hawaii Center for Advanced Transportation Technologies (HCATT) and the U.S. Air Force. We intend to establish new development programs with the Hawaii Center for Advanced Transportation Technologies in mobile and marine applications as well as other state and federal government agencies as funding becomes available.

Our development contract with EDO Corporation of New York for the design and fabrication of a high voltage DC-DC power conversion system utilizing a Capstone microturbine as the primary power source for the U.S. Navy unmanned minesweeper project also continues to progress during 2006. The electronics package will include our advanced power components including a new, enhanced 50V, 700A DC-DC power converter, our Battery Care Unit and Hybrid Control Unit which will power the minesweeper’s electromagnetic detection system. Our power management and conversion system will be used to provide on-board power to other accessories on the platform.

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 period ended June 30, 2006 and the year ended December 31, 2005 were financed by development contracts and product sales, as well as from working capital reserves.

During the six months ended June 30, 2006, our operations required $2,764,000 more in cash than was generated. We continue to increase marketing and development spending as well as administrative expenses necessary for expansion to meet customer demand. Accounts receivable at June 30, 2006 decreased by $1,111,000, from $2,173,000, or approximately 51% from the balance at December 31, 2005 (net of write-offs). The decrease was primarily due to collections made on outstanding receivables from Tomoe Manufacturing in the first quarter of 2006.

Inventory balances decreased by $154,000 from $1,016,000 to $862,000 when comparing the period end balances at June 30, 2006 and December 31, 2005. During the fourth quarter of 2005, we completed several large development contracts, including the Tomoe project. Conversely, in the first half of 2006, we were focused more on internal research and development as well as sales and marketing activities. As such, inventory did not experience significant turnover when comparing quarter on quarter.

Prepaid expenses and other current assets increased by $204,000 net of amortization at June 30, 2006 from the December 31, 2005 balance of $182,000, or 112%. The increase is attributable to interest receivable on two certificate of deposits, purchased early in the first quarter of 2006.

Fixed assets increased by $38,000, net of depreciation and writeoffs at June 30, 2006 from the December 31, 2005 balance of $576,000. In the first half of 2006, we purchased $153,000 in new property and equipment. We recognized $113,000 of depreciation expense for the six months ended June 30, 2006.

Equity method investments decreased by $42,000 in the first half of 2006 from $1,649,000 at December 31, 2005, which reflects our pro-rata share of losses attributable to our forty percent investment interest in the Hyundai-Enova Innovative Technology Center (ITC). For the first half of 2006, the ITC generated a net loss of approximately $105,000 resulting in a charge to us of $42,000 utilizing the equity method of accounting for our interest in the ITC.

Other assets decreased by $56,000 when comparing the June 30, 2006 balance of $134,000 with the December 31, 2005 balance of $190,000. The decrease is occurring as a result of amortization of the Ford Value Participation Agreement and our other intellectual property assets.

Accounts payable at June 30, 2006 decreased by $1,211,000, to $185,000 from $1,396,000 at December 31, 2005. During the fourth quarter of 2005, the Company completed several large development contracts, including the Tomoe project. Conversely, in the first half of 2006, we were focused more on internal research and development as well as sales and marketing activities. As such, the Company did not incur significant trade payables resulting from inventory purchases. Meanwhile, we continued to pay our trade payables in the due course.

Other accrued expenses decreased by $27,000 when comparing the balance at June 30, 2006 from the balance of $302,0000 at December 31, 2005. This fluctuation is primarily due to the net effect of the payment of certain un-invoiced inventory receipts, which had been accrued for at December 31, 2005, combined with additional accrual of costs associated with the first phase of our Great Plains implementation project.

Accrued interest decreased by $447,000 for the first half of 2006, a decrease of 40% from the balance of $1,113,000 at December 31, 2005. The decrease was due to the settlement of certain components of interest payable on the Note due the Credit Managers Association of California, combined with interest accrued on the remaining balance of notes payable.

RESULTS OF OPERATIONS

Net revenues for the six months ended June 30, 2006 were $760,000 as compared to $2,014,000 for the corresponding period in 2005. Net revenues were $452,000 for the three months ended June 30, 2006 as compared to $1,322,000 for the same period in 2005. Net production sales for the six months ended June 30, 2006 decreased to $341,000 from $1,309,000 in the same period in 2005. Net production sales for the three months ended June 30, 2006 decreased to $291,000 from $817,000 for the corresponding period in 2005. Research and development revenues decreased to $419,000 in the first six months of 2006, from $705,000 during the same period in 2005. For the three months ending June 30, 2006, research and development revenues decreased to $161,000 from $505,000 for the same period in 2005. In the first quarter and six months of 2006, our revenues derived mostly from production type contracts with Hyundai Motor Corporation and the State of Hawaii. The decrease in revenues in the first half of 2006 from the first half of 2005 was a result of contracts that were completed or near completion in 2005. During the first six months of 2006, we focused on establishing new customer relationships and submitting proposals. As a result, we have been awarded contracts with, but have not yet recognized revenues from, IC Corp. for nineteen school buses, Phoenix Motor Car for ten sport utility trucks and Ford Motor Company for four High Voltage Energy Converters (HVEC). We have additional proposals with other potential customers who have not yet made final decisions.

Cost of revenues 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. Cost of revenues for the three and six months ended June 30, 2006 decreased $110,000 and $220,000, or 14% and 11% respectively from $1,024,000 and $1,594,000 respectively, for the same period in 2005. As a percentage, cost of revenues did not decrease in the same proportion as sales when comparing the three and six months ended 2006 to the equivalent period in 2005. This is primarily attributable to continued product development initiatives. We anticipate there may be an increase in cost of sales for products due to potential weakening of the U.S. dollar. While we do not transact in foreign currencies, our suppliers are overseas and may raise our input prices in response to a weaker value of our functional currency, which is the U.S. Dollar.

Internal research, development and engineering expenses increased in the three and six months ended June 30, 2006 to $308,000 and $632,000 as compared with $178,000 and $395,000 respectively, for the same period in 2005. We continue to develop several new products such as our post transmission parallel hybrid drive system and enhancements to our diesel generator set which account for a majority of the increase during the first quarter and half of 2006 when compared to the same period in 2005. We continue to allocate increased resources to the development of our parallel hybrid drive systems, upgraded proprietary control software, enhanced DC-DC converters and advanced digital inverters and other power management firmware.

Selling, general and administrative expenses increased by $801,000 to $1,959,000 for the six months ended June 30, 2006 from the previous year’s comparable reporting period. For the three months ended June 30, 2006, selling, general and administrative expenses increased by $485,000 to $1,035,000 when comparing with the three months ended June 30, 2005. The increase during the first half and quarter of 2006 when compared to the same periods in 2005 is attributable to additional costs associated with marketing, engineering and technical staff. We also have experienced increased expenditures related to stricter regulatory oversight in conjunction with the Sarbanes-Oxley Act of 2002. We have incurred additional cost in our efforts to remediate certain material weaknesses, as described in Item 4 “Controls and Procedures.” Furthermore, we are in the process of upgrading our accounting and reporting software, thus further contributing to the general and administrative cost increase. Management believes that as we move toward sustainable production, our cost structure will become more efficient.