UNITED STATES
SECURITIES AND EXCHANGE COMMISSION 
Washington, D.C. 20549 
FORM 10-K 
 
 
 
þ
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2007
 
 
 
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
 
Commission file number 0-24230
ENERGY FOCUS, INC.
(Exact name of registrant as specified in its charter)
 
 
 
DELAWARE
 
94-3021850
(State of incorporation)
 
(I.R.S. Employer Identification No.)
32000 Aurora Road
Solon, Ohio 44139
(Address of principal executive officers, including zip code)

Registrant’s telephone number, including area code: 440.715.1300

Securities registered pursuant to Section 12(b) of the Act: None

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

Title of Each Class
Common Stock, Par Value $0.0001
Series A Participating Preferred Stock Purchase Rights

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act of 1933. Yes o No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange 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 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 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. þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.
 
 
 
Large accelerated filer o
 
Accelerated filer þ
Non-accelerated filer o (Do not check if a smaller reporting company)
 
Smaller reporting company o 
 
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 

Aggregate market value (on basis of closing bid price) of voting stock held by nonaffiliates as of June 29, 2007: $72,640,030
 
Number of the registrant’s shares of common stock outstanding as of February 29, 2008: 11,645,719

Documents Incorporated by Reference
 
Portions of the proxy statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission are incorporated by reference into Part III of this report.

 
TABLE OF CONTENTS
 
 
PART 1
 
   
Page
Item 1.
Business
3
Item 1A.
Risk Factors
9
Item 1B.
Unresolved Staff Comment Letters
10
Item 2.
Properties
10
Item 3.
Legal Proceedings
10
Item 4.
Submission of Matters to a Vote of Security Holders
10
 
PART II
 
Item 5.
Market for the Registrant’s Common Equity, Related Stockholder Matter and Issuer Purchase of Equity Securities
12
Item 6.
Selected Financial Data
13
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation
14
Item 8.
Financial Statements and Supplementary Data
23
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
46
Item 9A.
Control and Procedures
46
Item 9B.
Other Information
48
 
PART III
 
Item 10.
Directors, Executive Officers, Promoters and Control Persons of the Registrant
49
Item 11.
Executive Compensation
49
Item 12.
Security Ownership of Certain Beneficial Owners and Management
49
Item 13.
Certain Relationship and Related Transactions
49
Item 14.
Principal Accounting Fees and Services
49
 
PART IV
 
Item 15.
Exhibits and Financial Schedule
50
Exhibit Index
 
51
Signatures
 
54
 
2

 
PART I
 
Item 1. Business
 
Energy Focus Inc. and subsidiaries (Energy Focus) design, develop, manufacture, and market lighting systems for wide-ranging use in both the general commercial market and the pool market. Energy Focus’s patented EFO system offers energy savings, heat dissipation and maintenance cost benefits of significance over conventional lighting for multiple applications

 
·
Overview
 
We operate within a single industry segment. Our company is engaged in the manufacture, marketing and installation of lighting systems where it serves two principal markets; commercial/industrial lighting and pool lighting. Our business strategy revolves around our patented and proprietary technology called “EFO,” which first was introduced in 2004 and since then has been well accepted by the market. The EFO technology is an energy-efficient alternative to MR-16 halogen lamps and fluorescent lights used for lighting in retail and commercial settings. The cost savings are in the range of 80% in electricity; in addition, the EFO lighting provides full-spectrum light closely simulating daylight colors.

Our proprietary, large-diameter fiber cables used in EFO technology are designed to emit light either at the end of the fiber as a point of light or along the length of the fiber. This feature has been well regarded by architectural and design firms and has resulted in the winning of several design awards in 2007. The fiber cables have been fashioned into unique hanging pendant lights or purely decorative products of myriad shapes, providing an opportunity to beautify interior space in a distinctive way. These lights have no glare, voltage, or heat, and they are very aesthetically pleasing. In May 2007, our company was named by an Ohio-based magazine as of one of the three top companies for “new product development and innovation” and received the Manny Award for manufacturing excellence. Additionally, our EFO lights emit neither ultraviolet rays nor infrared rays and therefore have numerous application possibilities in art museums, art galleries, and upscale homes where protection of objects of art is an important goal.

Our long-term strategy is to further penetrate the lighting market, which is estimated to be over $100 billion in size. We believe that the available EFO market is over $5 billion, and our goal is to transform Energy Focus into a profitable company with increased sales and well-established marketing channels both at home and abroad. Our greatest opportunity continues to be in the commercial and industrial segment. The passage of the Energy Independence and Security Act of 2007 by President Bush created a natural market for our energy-efficient products. Under this act, all incandescent light bulbs must use 25% to 30% less energy than today’s products by the years 2012 - 2014. Since many of our EFO products already are 80% more efficient than incandescent bulbs, our focus is to increase the public’s knowledge of our technology and to establish comprehensive distribution channels so that demand can be fulfilled quickly.

We will continue to focus on market niches where the benefits of our technology are most compelling. These market niches include retailers, department stores, supermarkets, marine applications, and museums. A Lighting Academy is in the final phase of construction in Solon, Ohio, and is expected to be completed during the first quarter of 2008. At the Academy, lighting specialists, designers, and installers will attend courses on EFO technology and witness the technology in a variety of application settings, which will further help cement our relationship with our niche markets.

 
·
Products

We produce and market a wide variety of fiber optic lighting systems in two general markets: (1) commercial lighting and (2) pool lighting. We are making in-roads in the government and military lighting area as well. Our products generally fall into two broad categories—fiber optic systems and LED lighting systems—and all of our fiber optic lighting systems are comprised of three components: illuminators, fiber cables, and fixtures. In addition, we also produce customized components such as underwater lenses, color-changing electric pool lights, landscape lighting fixtures, and a line of lighted water features, including waterfalls and laminar-flow water fountains.

The key features of our products are as follows:
 
 
·
Many of our products meet the lighting efficiency standards mandated for the year 2020.
     
 
·
Our products qualify for tax incentives for commercial and residential consumers in certain states.
     
 
·
Our products make use of proprietary optical systems that enable high efficiencies.
     
 
·
Certain utility companies have embraced our technology as an energy-efficient alternative and are promoting our EFO products to their customers.
     
 
·
Our products are presently in use in U.S. Navy ships. Installation was completed in 2007 on one ship, and two others were completed in 2006.
     
 
·
The heat source of the lighting fixtures usually is physically separated from the lamps, providing a “cool” light. This unique feature has special application in grocery stores, where reduction of food spoilage and melting due to heat is an important goal. In 2007, Southern California Edison confirmed that our patented product “EFO-Ice” used only 25% of the energy of comparable fluorescent lighting systems and 33% of the energy of comparable LED systems.
     
 
·
Our products have been featured in magazines and trade journals, including LD+A, Architectural Lighting, Architectural Record, Display and Design Ideas, and Visual Merchandising and Store Design.
 
3

 
Key Features of Our EFO Technology
 
Components of EFO Technology:
 
Illuminator.Most of our commercial EFO illuminators deploy our specially designed metal halide HID lamps. These lamps provide long life and maximum brightness. Our EFO technology efficiently can separate the light from a single metal halide lamp into multiple lower light levels appropriate for a wide variety of applications.
 
Fiber Cables. Our patented, large-core fiber have outstanding clarity and consistency with low attenuation for fiber optic lighting applications. By combining our compound parabolic collector, or CPC, technology with our large-core fibers, our system delivers light ranging from 35 to 70 lumens per watt, compared to approximately eight to 15 lumens per watt for a system using traditional MR-16 halogen lamps.
 
Fixtures. We produce a broad assortment of aesthetic fixtures that allow the customer to easily adjust the direction and beam spread of the light for optimal light concentration.
 
Key Benefits of Our EFO System
 
Energy Efficiency. Our EFO system can provide our customers with accent lighting that also satisfies government and other regulatory regulations for energy-efficient lighting. EFO technology enables customers to comply with ASHRAE-IESNA Standard 90.1 and Title 24, qualify for the tax incentives available under the Energy Policy Act of 2005, and meet LEED certification requirements without sacrificing intensity and light quality. The following table highlights the electrical savings of one watt EFO accent light compared to competing lighting technologies:
 
Light Source
   
Number
equivalent
in 70-Watt
EFO
   
Total Watts
   
Estimated Energy
Savings %
 
70W EFO HID accent light
   
1
   
70W
   
 
26W compact fluorescent down light
   
4
   
104W
   
33
%
25W ceramic metal halide accent light
   
5
   
125W
   
44
%
50W MR-16 halogen accent light
   
8
   
400W
   
83
%
60W incandescent down light
   
7
   
420W
   
83
%
 
 The EFO technology delivers over 80% energy savings versus halogen or other incandescent lighting systems commonly used in similar applications. For example, Cinemark Theaters (a nationwide movie theater chain) reduced its energy consumption from 5,140 watts to 1,120 watts by installing our EFO systems in selected facilities.
 
Color. Today, our EFO system is available in a range of color temperatures and renderings consistent with the lighting industry, which includes color temperatures of warm white (3,000k), neutral white (3,500k), cool white (4,100k), and daylight (5,500k). Both 70+ CRI and an 80+ CRI option is available. CRI is a measure of the degree of color shift that objects undergo when illuminated by the light source as compared with those objects when illuminated by a reference source of comparable correlated color temperature. The maximum CRI is 100. The warm white lamps have a color temperature that is suitable for interior space, while the daylight color temperature matches the color temperature of the light entering spaces through windows. Because we control the design of the lamp, reflector, and fixture, we can tune the system to deliver a balanced, full-spectrum white light.
 
Elimination of Virtually all Heat Radiation. Our EFO system is designed to prevent the infrared and ultraviolet radiation emitted by the lamp from being funneled through the fiber. As a result, the light output emits virtually no infrared or ultraviolet light, which produce heat when absorbed by the target, and the only heat generated is from light output itself, which is negligible. In contrast, halogen lamps produce approximately nine watts of heat energy for every one watt of light.
 
Cost Savings. Our EFO system significantly is able to reduce maintenance and replacement costs that normally are attributed to traditional lighting systems. Our EFO systems contain lamps with a long life cycle and need fewer lamps to light a given area. For example, a customer would have to replace 20-40 MR-16 halogen lamps for every one EFO lamp annually, based on average retail usage. In addition, because the EFO lamp is physically separated from the light fixture, when used in applications such as freezer cases, the quality of light and the life of the EFO lamp are not affected by the freezing temperature. The EFO lamp does not radiate heat in the freezer and the freezer does not need to be emptied to change the lamp, as is the case with fluorescent lamps.
 
Strategy
 
Our objective is to become the leading provider of energy-efficient lighting systems. To achieve this objective, we intend to pursue the following strategies:
 
·
Capitalize on the growing need for low-cost, energy-efficient lighting systems. We intend to continue to devote significant resources to our product development efforts to maximize the energy efficiency and quality of our lighting systems while reducing costs and enabling our customers to meet more stringent government regulations. Further, we plan to continue to develop new proprietary technologies and integrate new and potentially more efficient lighting sources into our lighting systems.
 
·
Focus on increased market penetration where the benefits of our technology are most compelling. We intend to broaden the penetration of our products within retail and supermarket operators, who share similar needs for highly efficient, flexible accent lighting solutions. To reach our target markets, we also intend to focus our direct sales force of experienced lighting salespeople on selected markets and niches.
 
4

 
·
Develop and expand strategic relationships. To expedite the awareness of our EFO technology, we actively are pursuing strategic relationships with distributors, lighting designers, and contractors who distribute, recommend, and/or install lighting systems. We also are cultivating relationships with fixture manufacturers and other participants in the general lighting market. For example, we have entered into two strategic distribution relationships with TCP, Inc. and Eco Engineering to further enhance our penetration into certain broad-based lighting markets. Additionally, we are in the final stages of completing the Lighting Academy in Solon, Ohio, where lighting specialists, designers and installers will be able to attend courses on EFO lighting technology and installation as well as view our energy-efficient technology in a variety of applications and settings.
 
Sales, Marketing, and Distribution of our Products  
 
Our products are sold through a combination of a direct sales force paid on commission, independent sales representatives, and various distributors in different geographic markets throughout the world. Our distributorsobligation to us is not contingent upon the resale of our product and as such does not prohibit revenue recognition. We have been successful in hiring experienced salespeople from leading firms in the industry. As of December 31, 2007, we had approximately 140 sales and independent sales representatives throughout the United States and Europe. In 2007, the position of vice president of sales and marketing (pool products) was filled by Steve Gasperson, an individual with eight years of experience with the company. He is a marketing expert with over twenty years of relevant experience, and in his new role, he will be overseeing the ongoing expansion of pool lighting products.

Within the commercial lighting business unit, we are focusing our efforts on large retailers, and our recent successes include the “W” Hotels, Wal-Mart (Mexico), Bath and Body Works, and significant expansions into Albertson’s Food Retailers and Whole Foods. Our typical sales process includes a testing phase, which starts with a demonstration of our products to key executives, followed by a prototype installation in one store and then to multiple stores. Finally, we install in all of the stores within the same chain.

Our ten largest customers accounted for 28% of our net sales. In 2007, there was no single customer who accounted for more than 10% of net sales.
 
Manufacturing and Suppliers
 
We produce our lighting systems through a combination of internal and outsourced manufacturing and assembly. Our internal lighting system manufacturing consists primarily of fiber processing, final assembly, testing, and quality control. We use independent contractors to manufacture some components and sub-assemblies and have worked with a number of our vendors to design custom components to meet our specific needs. We manage inventories of domestically produced component parts on a just-in-time basis when practicable. Our quality assurance program provides for testing of all sub-assemblies at key stages in the assembly process as well as testing of finished products.

Some of our products are manufactured off shore, resulting in cost savings. Under a Production Share Agreement initiated in 2003 and renewed in August 2007, we conduct contract assembly in Mexico through North American Production Sharing Inc. and Industrias Unidas de BC, SA de CV, or North American. Under this agreement, North American provides administrative and manufacturing services, including labor services and the use of manufacturing facilities in Mexico, for the manufacturing and assembly of certain fiber optic systems and related equipment and components. Since 2004, we have been assembling products from ECDS, located in Cochin, India. These products are received on a purchase order basis, primarily by ocean shipment, and, in some cases, by air freight.

We manufacture our large core fiber products in our Solon, Ohio, facility, using either an extrusion process or a cast process.

Mitsubishi currently is the exclusive supplier of our small-diameter stranded fiber. In sales volume, our products that incorporate small-diameter stranded fiber historically have been the single largest fiber product that we sell and represent significant sales volume. We expect to maintain our relationship with Mitsubishi for the supply of small-diameter fiber.

Advanced Lighting Technologies, Inc. (ADLT), a leading supplier of metal halide light sources, has a collaborative relationship with Energy Focus. We rely on ADLT for furnishing of our lamps, reflectors, and power supplies. In April 2006, we entered into several new agreements with ADLT regarding mutual development collaboration for the continued improvement in our lamp technology and for support of our coating technologies. These agreements also provided for the purchase of certain coating equipment, the provision to us of certain other services, the continued supply to us of products manufactured by ADLT, and a cross-license of certain intellectual property.
 
Research and Development
 
Research and development has been a key focus of our company; accordingly, we have committed substantial resources to it. Our R&D team, located in Ohio, is dedicated to continuous improvement and innovation of EFO systems. We also have engineers based in California, focused on development of pool products.
 
We purchased the base technology of the EFO system in 2000 from Unison Fiber Optic Lighting Systems, LLC. Subsequently, we won government awards and contracts and now have proprietary and commercial rights on the technology developed from those government contracts.
 
Research and development expense for the years ended December 31, 2007, 2006, and 2005 were $2,907,000, $2,341,000, and $2,190,000, respectively, net of credits from the government.
 
5

 
Our recent achievements include:
 
2007: In August 2007, the VHESC Consortium (Very-High-Efficiency Solar Cells) reported a world record of 42.9% conversion efficiency on photovoltaic devices (PV). Energy Focus is a member of this consortium, and these solar cells make use of our proprietary optics technology. In November, we were awarded a $1-million contract with Dupont to develop advanced solar cell technologies. Additionally, we were awarded additional Phase II contracts for two Defense Advance Research Project Agency (DARPA) Small Business Innovation Research (SBIR) projects to research lamp coating technologies and an extruded, large-core fiber processing method. The two DOE Phase II contracts are for a total of $1,500,000. Lastly, we were awarded the prestigious DARPA Tech Award for Excellence in recognition of our outstanding achievement for bridging the technology gap between inefficient traditional light sources and advanced high-efficiency light systems.
 
2006: We entered into a DARPA agreement with the Navy for supplying our lighting on three ships. Revenues from these ship installations totaled $1,979,000.
 
2005: We won a Phase II SBIR Award from the Department of Energy for an additional $1,500,000. These additional awards were for the continuation of work originally won in 2004, incorporating additional R&D work on an instant version of EFO, and developing a fast cure for the fiber production process.
 
In October, we also won initial SBIR funding from the Department of Defense under DARPA totaling $200,000 to further explore improvements to lamp coatings and to further research materials and processing techniques for the company’s continuously extruded large-core fiber processing method.
 
In September, we entered into a third-party agreement with ADLT, where ADLT would provide consulting and other R&D services. This step augmented our internal research department efforts with several collaborations with suppliers and other third parties.
 
2004: In June, we won two Phase I SBIR Awards from the Department of Energy. One award was for work on an instant version of EFO, and the other was to develop a fast cure for the fiber production process. These awards were for an initial amount of $200,000 to cover two years of the project completion phase.
 
Also in June, we received $1,000,000 in funding from DARPA. This project had certain milestones that had to be achieved within a given timeframe for developing an LED version of the HED lighting for the EFO system. We achieved both milestones and received the full $1,000,000 at the end of 2005.
 
Intellectual Property   
 
We believe that the success of our business depends primarily on our technical innovations, marketing abilities, and responsiveness to customer requirements, rather than on patents, trade secrets, trademarks, copyrights, and other intellectual property rights. Nevertheless, we have a policy of seeking to protect our intellectual property through patents, license agreements, trademark registrations, confidential disclosure agreements, and trade secrets. As of December 31,2007, our intellectual property portfolio consisted of 51 issued United States and foreign patents, various pending United States patent applications, and various pending Patent Cooperation Treaty, or PCT, patent applications filed with the World Intellectual Property Organization that serve as the basis of national patent filings in countries of interest. A total of 28 applications are pending. As of March 11, 2008, our intellectual property portfolio consisted of 58 issued United States and foreign patents, various pending United States patent applications, and various pending Patent Cooperation Treaty, or PCT, patent applications filed with the World Intellectual Property Organization that serve as the basis of national patent filings in countries of interest. A total of 51 applications are pending. Our issued patents expire at various times between August 2008 and June 2025. Generally, the term of patent protection is 20 years from the earliest effective filing date of the patent application. There can be no assurance, however, that our issued patents are valid or that any patents applied for will be issued. There can be no assurance that our competitors or customers will not copy aspects of our fiber optic lighting systems or obtain information that we regard as proprietary. There also can be no assurance that others will not independently develop products similar to ours. The laws of some foreign countries in which we sell or may sell our products do not protect proprietary rights to products to the same extent as do the laws of the United States.

We are aware that a large number of patents and pending patent applications exist in the field of fiber optic technology and LED lighting. We are also aware that certain competitors hold and have applied for patents related to fiber optic lighting and LED lighting. Although, to date, we have not been involved in litigation challenging our intellectual property rights, we have in the past received communications from third parties asserting rights over our patents or that our technology infringes intellectual property held by such third parties. Based on information currently available to us, we do not believe that any such claims involving our technology or patents are meritorious. However, we may be required to engage in litigation to protect our patent rights or to defend against the claims of others. There can be no assurance that third parties will not assert claims that our products infringe third-party patents or other intellectual property rights or that, in case of a dispute, licenses to such technology will be available, if at all, on reasonable terms. In addition, we may need to take legal action to enforce our intellectual property rights in the future. In the event of litigation to determine the validity of any third-party claims or claims by us against third parties, such litigation, whether or not determined in our favor could result in significant expense to us and divert the efforts of our technical and management personnel from productive tasks. Also, in the event of an adverse ruling in such litigation, we might be required to expend significant resources to develop non-infringing technology or to obtain licenses to the infringing technology, and the licenses may not be available on acceptable terms. In the event of a successful claim against us and our failure to develop or license a substitute technology, our operating results could be adversely affected.
 
Backlog
 
We typically ship standard products within a few days after receipt of order. Custom products are shipped within 30-60 days of receipt of order. Generally, there is not a significant backlog of orders except at year-end. Our backlog at the end of 2007 was $983,000, compared to $1,143,000 at the end of 2006.
 
6

 
Competition
 
Our products compete with conventional electric lighting systems and with a variety of lighting products, including conventional light sources such as incandescent light bulbs as well as metal halide lamps, LEDs, compact fluorescent lamps, and decorative neon lighting. Our EFO systems compete with conventional electrical lighting systems, other fiber optic lighting systems, and alternative energy-efficient lighting products such as compact fluorescent lighting. Our traditional commercial lighting products compete with other lighting products primarily in the areas of down lighting, accent lighting, and signage lighting. Our pool lighting products compete with other sources of pool lighting in the areas of in-pool lighting, including colored and color-changing underwater lighting, and pool accent lighting. Principal competitive factors include price, performance, ease of installation, and maintenance requirements.
 
Our EFO systems compete with conventional electrical lighting technologies and with other sources of accent and down lighting such as ceramic metal halide, halogen, and incandescent bulbs. Our EFO systems compete with traditional electrical lighting systems and other fiber optic systems in markets where energy efficiency, ease of installation, and lower maintenance costs are principal competitive factors. Our EFO systems also compete with manufacturers of lamps and fixtures who may sell their products to end-users as a system or as individual components.
 
We expect that our ability to compete effectively with conventional lighting technologies, other fiber optic lighting products and new lighting technologies that may emerge will depend substantially upon achieving greater performance and reducing the cost of our EFO systems. Principal competitors in the EFO market include large lamp manufacturers and lighting fixture companies whose financial resources substantially exceed ours. These conventional lighting companies may introduce new or improved products that may reduce or eliminate some of the competitive advantages of our products. We anticipate that the primary competition to our EFO systems will come from new technologies that offer increased energy efficiency, lower maintenance costs and/or lower heat radiation. In certain applications we compete with LED systems produced by large lighting companies such as Phillips and General Electric.
 
In traditional commercial lighting, we compete primarily with local and regional lighting manufacturers that, in many cases, are more established in their local markets than we are. In traditional commercial lighting, fiber optic lighting products are offered by a number of smaller companies, some of which compete aggressively on price. Some of these competitors offer products with performance characteristics similar to those of our products. Additionally, some conventional lighting companies now manufacture or license fiber optic lighting systems that compete with our products. Schott, a German glass fiber company, markets fiber optic systems in the United States. Many companies compete with us in Asia, including Phillips, Mitsubishi, Bridgestone, and Toray. Mitsubishi also sells our BritePak fiber cables in Japan. In addition, we compete with Toray in the stranded, small-diameter optical fiber in the special effects lighting market.
 
In the pool market, we face competition from suppliers and distributors who bundle lighting and non-lighting products and sell these packages to pool builders and installers. In addition, we face competition directly from manufacturers who produce their own lighting systems and components. For example, in the pool market, competitive products are offered by Pentair’s American Products Division, a major manufacturer of pool equipment and supplies, as well as Super Vision International. In the spa business, spa manufacturers install LED lighting systems during the manufacturing process. We intend to develop new fiber optic lighting products that are complementary to traditional pool lights currently sold by pool equipment suppliers. To maximize the sales of these new products, we plan to leverage our well-established presence in the pool lighting market.
 
Employees
 
As of December 31, 2007, we had 102 full-time employees, 19 of whom are located in the United Kingdom, 12 in Germany, and 71 in the U.S.A. We have 26 employees dedicated to developing technology, research, and product development. We also have 20 people involved with sales and sales support.

No employees are subject to any collective bargaining agreement, and we believe our employee relations to be good.

Business Segment
 
The company operates in a single industry segment where it serves two principal markets; commercial/industrial lighting and pool lighting. It markets its products for worldwide distribution primarily through independent sales representatives and distributors in North America, Europe, and the Far East.
 
Available Information
 
Our Web site is http://www.energyfocusinc.com. We make available free of charge, on or through our Web site, our annual, quarterly, and current reports, as well as any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the SEC. Information contained on our Web site is not part of this report.
 
7

 
FORWARD-LOOKING STATEMENTS

When used in this report, the words “expects,” “anticipates,” “estimates,” “plans,” “intends,” and similar expressions are intended to identify forward-looking statements. These statements include, but are not limited to, statements as to our competitive position; future operating results; net sales growth; expected operating expenses and capital expenditures; gross product margin improvement; sources of revenues; anticipated credits from government contracts; product development and enhancements; liquidity and cash reserves; our reliance upon a limited number of customers; our accounting policies; the effect of recent accounting announcements; the development and marketing of new products; relationships with customers and distributors; relationships with, dependence upon, and the ability to obtain components from suppliers; as well as our remarks concerning our ability to compete in the fiber optic lighting market; the evolution and future size of the fiber optic lighting market; seasonal fluctuations; plans for and expected benefits of outsourcing and offshore manufacturing; trends in the price and performance of fiber optic lighting products; the benefits and performance of our lighting products; the adequacy of our current facilities; our strategy with regard to protecting our proprietary technology; our ability to retain qualified employees; and the risks set forth below under Item 1A, “Risk Factors.” These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statement is based.
Fiberstars®, BritePak®, OptiCore™, Lightly Expressed®, Jazz Light™, FX Light™, FX Spa Light™, Fiberstars EFO®, and E-enlightened Innovations ™, are our registered trademarks. We also refer to trademarks of other corporations and organizations in this document.
 
All references to “Energy Focus,” “we,” “us,” “our,” or “the company” means Energy Focus, Inc. and its subsidiaries, except where it is made clear that the term means only the parent company.
 
8


Item 1A. Risk Factors 
 
Global Economic Risk: The company may be adversely impacted by weakness in general economic conditions including the onset of recession and increase in inflation. General recession may contribute towards our inability to increase sales, whereas inflation may cause the cost of material and labor to go up. Specifically, the downturn in housing construction may adversely affect the sale of pool products, whereas the consumer credit crunch may cause retail sales to decrease, thereby halting further construction of retail outlets—our primary commercial market.
 
We have significant international activities and customers and plan to continue these efforts. This subjects us to additional business risks, including logistical complexity, political instability, and the general economic conditions in those markets. Because the market for our products tends to be highly dependent upon general economic conditions, a decline in general economic condition likely would harm our operating results.
 
Risks we face in conducting business internationally include the following:
 
·
multiple, conflicting, and changing laws and regulations, export and import restrictions, employment laws, regulatory requirements, and other government approvals, permits, and licenses;
 
·
difficulties and costs in staffing and managing foreign operations such as our offices in Germany and the United Kingdom;
 
·
difficulties and costs in recruiting and retaining individuals skilled in international business operations;
 
·
increased costs associated with maintaining international marketing efforts;
 
·
potentially adverse tax consequences; political and economic instability, including wars, acts of terrorism, political unrest, boycotts, curtailments of trade, and other business restrictions; and
 
·
currency fluctuations.
 
In addition, we face additional risks in the Asia/Pacific region associated with disease, increased political tensions between countries in that region, potentially reduced protection for intellectual property rights, government-fixed foreign exchange rates, relatively uncertain legal products, and developing telecommunications infrastructures. In addition, some countries in this region, such as China, have adopted laws, regulations, and policies that impose additional restrictions on the ability of foreign companies to conduct business in that country or otherwise place them at a competitive disadvantage in relation to domestic companies.
 
Liquidity Risk: The company has incurred net losses in each of the past five years. The $11,300,000 loss in 2007 has been the largest loss in the company’s history. Throughout those years, the company has relied upon its cash reserves and current assets, provided by equity financing, along with bank credit to furnish funds for operations and development and make up for the absence of positive cash flow. In 2007, management instituted several measures to reverse the trend of losses, including determined expense reduction and the hiring of a new chief financial officer, as well as the development and implementation of a strategic sales, marketing, and long-term growth strategy. Management is concerned, however, that despite continuing efforts to increase income and manage expenses, the company may not have sufficient cash and liquid assets to remain in business throughout 2008 without obtaining additional external financing. Therefore, management intends to pursue the raising of additional financing in 2008. On March 14, 2008, the company raised approximately $9,500,000 in equity financing, net of expenses, in a private placement of shares of common stock and warrants to existing shareholders. This additional financing will be used to fund working capital, pay debt and perform additional research and development. The company received the funds on March 17, 2008. Management believes that this additional financing, when combined with current cash reserves and current assets, will be sufficient to fund on-going operations for the next 12 months.
 
Competitive Risk: Competition continues to increase in the commercial decorative, accent, and pool lighting markets, as well as in the energy-efficient lighting markets. A number of companies offer directly competitive products, including color halogen lighting for swimming pools and incandescent and fluorescent lighting for commercial decorative and accent lighting. We also compete with LED products in water lighting and other lighted signs. In addition, many of our competitors in the pool market bundle their lighting products with other pool- related products, which many customers find to be an attractive alternative. Our competitors include large and well-established companies such as General Electric, Sylvania, Philips, Schott, 3M, Bridgestone, Pentair, Mitsubishi, and OSRAM/Siemens.
 
Furthermore, many of our competitors have substantially greater financial, technical, and marketing resources than we do. We may not be able to adequately respond to technological developments or fluctuations in competitive pricing. We anticipate that any future growth in energy-efficient lighting will be accompanied by continuing increases in competition, which could adversely affect our operating results if we cannot compete effectively. To stay competitive, we must continue to allocate sufficient resources to research and development, which could negatively impact our gross margins. If we are unable to provide more efficient lighting technology than our competitors do, our operating results will be adversely affected.
 
Technological Risk: The EFO system offers a new full-spectrum lamp for use in retail stores. However, since the technology used is fairly untested we may need to incorporate certain design changes before it becomes widely applicable. Also, a substantial portion of our R&D resources have been devoted to the development of EFO technologies. If future revenue generation is not ramped up, we may not be able to off-set the cost involved in developing these technologies.
 
In the past, we have experienced design defects and product failure. Our EFO systems experienced defects related to the power supply in the illuminator, and our pool products experienced defects with our circuit sequencing color wheel. We cannot guarantee that we will not experience defects or compatibility issues in components or products in the future. Errors or defects in our products also could result in product liability claims. We estimate warranty and other returns and accrue reserves for such costs at the time of sale. Any estimates, reserves, or accruals may be insufficient to cover sharp increases in product returns, and such returns may harm our operating results.
 
Supplier Risk: The company currently buys all of its small diameter stranded fiber, the main component of its product, from one supplier. The company also relies on a sole supplier for certain lamps, reflectors, remote control devices, and power supplies. In the event of disruption in the supply chain, the company may incur losses due to delay or cancellation of orders.
 
9

 
Facility Risk: The large-core fiber manufacturing unit is housed in a single facility in Solon, Ohio. Moreover, only one machine is able to produce the patented fiber optics used in a majority of EFO products. In the event of physical damage or any other event leading to the temporary shut down of the unit, we may not be able to meet our pending production schedule. This, is turn, may adversely affect our revenue generation process, thereby negatively impacting net income.
 
Third-Party Risk: Three strategic pieces of equipment are operated by third parties. Failure to properly maintain the equipment and/or the creation of any delays or inabilities to meet our production requirements on the part of any of these suppliers will result in disruption of promised delivery to our clients.
 
Credit Risk: The company sells its products primarily through distributors and contractors in North America, Europe, and the Far East. While the company performs periodic credit evaluations of its customers, it generally does not require collateral. The company therefore faces credit risk in the event that its customers are unable to pay. The company maintains an allowance for potential credit loss as a buffer against this risk.
 
Intellectual Property Risk: As of December 31, 2007, our intellectual property portfolio consisted of 51 issued United States and foreign patents, various pending United States patent applications, and various pending Patent Cooperation Treaty, or PCT, patent applications filed with the World Intellectual Property Organization that serve as the basis of national patent filings in countries of interest. As of December 31, 2007 a total of 28 applications were pending.

Our issued patents expire at various times between August 2008 and June 2025. Generally, the term of patent protection is 20 years from the earliest effective filing date of the patent application.

There can be no assurance, however, that our issued patents are valid or that any patents applied for will be issued. There can be no assurance that our competitors or customers will not copy aspects of our fiber optic lighting systems or obtain information that we regard as proprietary. There also can be no assurance that others will not independently develop products similar to ours. The laws of some foreign countries in which we sell or may sell our products do not protect proprietary rights to products to the same extent as do the laws of the United States.
 
Key Employee Risk: Our future success will depend to a large extent on the continued contributions of certain employees, such as our current chief executive officer, chief financial officer, chief operations officer, and chief technical officer. These and other key employees would be difficult to replace. Our future success also will depend on our ability to attract and retain qualified technical, sales, marketing and management personnel, for whom competition is very intense. The loss of—or failure to attract, hire, and retain— any such persons could delay product development cycles, disrupt our operations or otherwise harm our business or results of operations. In addition, we plan to restructure our internal sales force to generate more sales. However if this plan is not implemented well, then planned sales may not occur, and the anticipated revenues may not be realized.
 
Risk of Losing Governmental Funding for Research: Historically, approximately 54% of our EFO research and development efforts have been supported directly by government funding. In 2007, approximately 46% of our EFO research and development funding came from government sources and was contracted for short periods, usually one to two years. If government funding is reduced or eliminated, there is no guarantee that we would be able to continue to fund our research and development efforts in EFO technology and products at their current levels, if at all. If we are unable to support our EFO research and development efforts, there is no guarantee that we would be able to develop enhancements to our current products or develop new products.
 
Litigation Risk: At any given time, the company may be subject to litigation, the disposition of which may have a material adverse effect upon our business, financial condition, or results of operation. Information regarding the company’s current legal proceeding is presented in Part I, Item 3.

Foreign Risk: We use plants in Mexico, India, and Taiwan to manufacture and assemble many of our pool products. The supply of these finished goods may be impacted by local political or social conditions as well as the financial strength of the companies with which we do business.

Item 1B. Unresolved Staff Comment Letters

None
 
Item 2. Property
 
Our principal executive offices and commercial lighting manufacturing and assembly facilities are located in a 79,000 square foot facility in Solon, Ohio, under a lease agreement expiring in 2011. 10,000 square feet of this space is subleased to another tenant through June 2008. We also have leased sales facilities in Pleasanton, California, and Berkshire, United Kingdom. We also own a sales/assembly facility in Berching, Germany. In addition, we have a contract manufacturing facility near Tijuana, Mexico. We believe that our current facilities are adequate to support our current and anticipated operations.
 
Item 3. Legal Proceedings
 
From time to time, we occasionally become involved in ordinary routine litigation incidental to our business. We currently are not involved in any material litigation, and we do not anticipate becoming involved in any in the foreseeable future.
 
Item 4. Submission of Matters to a Vote of Security Holders
 
During the fourth quarter of the year ended December 31, 2007, there were no matters submitted to a vote of security holders.
 
10

 
Supplemental Item: Executive Officers of the Registrant
 
Pursuant to Form 10-K, General Instructions G (3), the following information on Executive Officers is included as an additional item in Part I:
 
Name
 
Age
 
Current Position and Business Experience
         
John Davenport
 
62
 
Chief Executive Office and Director - July 2005 to present. Chief Operating Officer - July 2003 to July 2005. Vice President and Chief Technology Officer - November 1999 to July 2003. Prior to joining Energy Focus, Mr. Davenport served as the president of Unison Fiber Optic Lighting Systems, LLC from 1998 to 1999. Before that, Mr. Davenport served at GE Lighting in various capacities for 25 years.
         
Nicholas Berchtold
 
41
 
Chief Financial Officer and Vice President of Finance - July 31, 2007, to present. Prior to joining Energy Focus, Mr. Berchtold was the division controller at Wellman Products Group, a division of Hawk Corporation, from 2000 to 2007, where he was responsible for global financial reporting and analysis. Additionally, he served as the corporate assistant controller at Olympic Steel, Inc. from 1997 to 2000.
         
Roger Buelow
 
35
 
Chief Technology Officer, General Manager, and Vice President - July 2005 to present. Vice President Engineering from February 2003 to July 2005. Prior to joining Energy Focus, Mr. Buelow was the director of engineering at Unison Fiber Optic Lighting Systems, LLC from 1998 to 1999.
         
Eric Hilliard
 
40
 
Chief Operating Officer - November 2006 to present. Business Manager at Saint Gobain - Flight Structures Business from 2002 to 2006. Additionally, he served at Goodrich Aerospace Company and HJ Heinz Company for 7 years from 1994 to 2002
 
11

 
PART II
 
Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters
 
Our common stock trades on the Nasdaq National Market under the symbol “EFOI.” The following table sets forth the high and low sales prices for our common stock from its consolidated transaction reporting system.

 
 
High
 
Low
 
First quarter 2006
 
$
9.33
 
$
7.61
 
Second quarter 2006
   
9.09
   
6.91
 
Third quarter 2006
   
8.85
   
6.75
 
Fourth quarter 2006
   
7.95
   
5.42
 
               
First quarter 2007
 
$
8.75
 
$
5.20
 
Second quarter 2007
   
7.52
   
5.60
 
Third quarter 2007
   
7.85
   
4.60
 
Fourth quarter 2007
   
9.95
   
4.80
 
 
There were approximately 108 holders of record of our common stock as of February 29, 2008, and we estimate that at that date there were approximately 800 additional beneficial owners.

We have not declared or paid any cash dividends and do not anticipate paying cash dividends in the foreseeable future.
 
Stockholder Matters
 
There were no reportable transactions for equity securities that required stockholder approval during 2007 since there were no sales or purchases of stock during 2007. Options and warrants exercised during 2007 were all issued prior to calendar year 2007.
 
12

 
Item 6. Selected Financial Data
 
The Selected Operations and Balance Sheet Data set forth below have been derived from our Consolidated Financial Statements. It should be read in conjunction with the information appearing under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7 of this report and the Consolidated Financial Statements and related notes found in Item 8 of this report.
 
SELECTED CONSOLIDATED FINANCIAL DATA
 
(IN THOUSANDS, EXCEPT PER-SHARE DATA)

YEARS ENDED DECEMBER 31,
 
2007
 
2006
 
2005
 
2004
 
2003
 
OPERATING SUMMARY
                     
Net sales
 
$
22,898
 
$
27,036
 
$
28,337
 
$
29,731
 
$
27,238
 
Gross profit
   
6,282
   
7,785
   
10,626
   
11,511
   
10,341
 
As a percentage of net sales
   
27.4
%
 
28.8
%
 
37.5
%
 
38.7
%
 
38.0
%
Research and development expenses
   
2,907
   
2,341
   
2,190
   
1,188
   
1,279
 
As a percentage of net sales
   
12.7
%
 
8.7
%
 
7.7
%
 
4.0
%
 
4.7
%
Sales and marketing expenses
   
9,789
   
9,774
   
9,595
   
8,595
   
7,188
 
As a percentage of net sales
   
42.8
%
 
36.2
%
 
33.9
%
 
28.9
%
 
26.4
%
General and administrative expenses
   
4,651
   
4,956
   
3,135
   
2,459
   
2,435
 
As a percentage of net sales
   
20.3
%
 
18.3
%
 
11.1
%
 
8.3
%
 
8.9
%
Restructure expenses
   
456
   
734
   
3,120
   
   
 
As a percentage of net sales
   
2.0
%
 
2.7
%
 
11.0
%
 
%
 
%
Loss before tax
   
(11,127
)
 
(9,537
)
 
(7,314
)
 
(762
)
 
(594
)
As a percentage of net sales
   
(48.6
)%
 
(35.3
)%
 
(25.8
)%
 
(2.6
)%
 
(2.2
)%
Net loss
   
(11,317
)
 
(9,650
)
 
(7,423
)
 
(704
)
 
(608
)
As a percentage of net sales
   
(49.4
)%
 
(35.7
)%
 
(26.2
)%
 
(2.4
)%
 
(2.2
)%
Net loss per share
                               
Basic
 
$
(.98
)
$
(0.85
)
$
(0.90
)
$
(0.10
)
$
(0.10
)
Diluted
 
$
(.98
)
$
(0.85
)
$
(0.90
)
$
(0.10
)
$
(0.10
)
Shares used in per-share calculation:
                               
Basic
   
11,500
   
11,385
   
8,223
   
7,269
   
5,993
 
Diluted
   
11,500
   
11,385
   
8,223
   
7,269
   
5,993
 
                               
FINANCIAL POSITION SUMMARY
                               
Total assets
 
$
28,869
 
$
40,592
 
$
46,209
 
$
27,018
 
$
24,119
 
Cash, cash equivalents, and short-term
                               
investments
   
8,412
   
15,968
   
23,578
   
3,609
   
4,254
 
Working capital
   
12,512
   
22,410
   
31,530
   
14,541
   
12,449
 
Credit line borrowings
   
1,159
   
1,124
   
47
   
   
 
Current portion of Long-term borrowings
   
1,726
   
778
   
342
   
38
   
30
 
Long-term borrowings
   
314
   
1,862
   
1,089
   
484
   
521
 
Shareholders’ equity
   
21,618
   
30,880
   
38,184
   
21,202
   
18,950
 
Common shares outstanding
   
11,623
   
11,394
   
11,270
   
7,351
   
6,317
 
 
13

 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
We manufacture and sell fiber optic and LED lighting systems, and our business is involved in two specific markets: commercial lighting and pool lighting. Our patented system, used by both product lines, is called the “EFO” system. The EFO system delivers higher energy savings, heat dissipation, and lower maintenance cost. These features provide a distinct advantage over our competitors’ products, and we have been able to successfully cater to a niche market. Our products are a good fit for the lighting needs of supermarkets, retail stores, the U.S. Navy, museums, and other specialized markets, including but not limited to hotel chains, dock lighting, and casinos. Also, the lighted fiber optic cables, an integral part of the lighting system, are aesthetically pleasing and have been warmly welcomed by design firms.

Even though our net sales have been trending downward during the past years, the sales from our EFO systems, our patented product, have been progressively improving. The EFO-generated sales were $7,011,000 in 2007, $5,316,000 in 2006, and $3,645,000 in 2005. The EFO systems have been well received by architectural and design firms and are now marketed in Europe, Russia, and the Middle East.

In August 2007, our company was awarded the prestigious Defense Advanced Research Project Agency (DARPA) Award for small business innovation. This award brings awareness in the marketplace about our technological contribution, which we hope will result in increased sales. In 2007 and 2006, a modified version of our EFO system was fitted to three Navy ships. This project was funded through a government grant from DARPA. During the first quarter of 2007, we became a subcontractor to the University of Delaware for conducting research on Very-High-Efficiency Solar Cells (VHESC). This is a prestigious assignment that we hope will bring awareness about our technological strengths.

Trends and Uncertainties: The following is a summary of trends and uncertainties that affected our financial performance in 2007:

Economic Trends: During the second half of 2007, the U.S. economy was adversely affected by continued deterioration in the housing market and extraordinary volatility in the fixed-income markets. These problems affected our 2007 results in varying degrees. Certain geographic regions were impacted more significantly than others, and this had some influence on the seasonal and regional business conducted by our pool business. Economic decline in the construction industry affected sales negatively in both the pool and commercial lighting markets.

Management Team: During 2007, we experienced turnover in several senior management positions. We believe that we have a new management team focused on addressing the issues of declining sales and increasing revenue through improved marketing channels while reducing expenses. We expect our operations to benefit from the expertise of the new leaders who joined our organization in 2007.

Sales Plans: We introduced a new product category called “EFO LED” as part of our EFO systems. Initial feedback is that it has been well accepted by the market and is expected to contribute positively to future sales growth. In 2008, we constructed a new showroom at our headquarters in Solon, Ohio, to showcase our products to architects and designers. This effort too will help bolster sales in the future. We recently entered into partnership with TCP, Inc., of Aurora, Ohio, and Eco Engineering, LLC of Cincinnati, Ohio, to distribute a broad range of our products to their national customers. This is a significant step for increasing sales in the future and is in addition to the previously used marketing channels of commission-based sales representatives. We believe that this step will positively affect our sales in the near future.

Liquidity: Due to continued losses and sales declines in 2007, management intends to pursue the raising of additional equity financing in 2008. On March 14, 2008, the company raised approximately $9,500,000 in equity financing, net of expenses, in a private placement of shares of common stock and warrants to existing shareholders. This additional financing will be used to fund working capital, pay debt and perform additional research and development. The company received the funds on March 17, 2008. Management believes that this additional financing, when combined with current cash reserves and current assets, will be sufficient to fund on-going operations for the next 12 months.
 
United States Bank Borrowings: We currently have $2,645,000 in borrowings outstanding with Silicon Valley Bank which become due on February 29, 2008. On March 14, 2008, our company entered into a sixth amendment with Silicon Valley Bank which extends our due date to April 30, 2008.
 
14

 
Results of Operations
 
Net Sales
 
Our net sales decreased 15% to $22,898,000 in 2007, compared to $27,036,000 in 2006. Net sales were $28,337,000 in 2005.
 
In 2007, sales of pool products, excluding EFO products, decreased by 25%, or $2,956,000, and commercial lighting products, excluding EFO products, decreased by 29%, or $2,877,000. This decrease was partially offset by improved sales of EFO products—an increase of 32%, or $1,695,000, compared to the year before. The decrease in pool lighting sales was due to a $2,533,000, or 23%, drop in sales of in-ground pool products and also a $423,000, or 46%, decrease in sales of Jazz lighting products. However, Jazz lighting products are no longer considered a core product for the future, and the decrease was anticipated.

Our sales breakdowns, by product lines, with EFO products as a separate line item, are as follows:

Product Line Breakdown
(in thousands) 
 
   
Year Ended December 31,
 
   
2007
 
2006
 
2005
 
EFO
 
$
7,011
 
$
5,316
 
$
3,645
 
Traditional Pool
   
9,002
   
11,958
   
14,744
 
Traditional Commercial Lighting
   
6,885
   
9,762
   
9,948
 
Total
 
$
22,898
 
$
27,036
 
$
28,337
 
 
EFO sales reported in 2006 and 2005 have been restated for comparability with EFO products included in 2007.
 
The increased sales of EFO products were a result of organic sales growth and the introduction of certain new EFO products in 2007. These new products were an addition to the existing EFO fiber optic product and contributed $3,970,000, or 57%, in sales out of the total EFO sales of $7,011,000.

In 2006, net sales decreased by 5% to $27,036,000, compared to $28,337,000 in 2005. The 2006 decrease was a result of lower sales of pool products, excluding EFO, of 19%, or $2,786,000, and commercial lighting products of 2%, or $186,000, which partially was offset by increased sales of EFO products of 46%, or $1,671,000, including $1,478,000 of new EFO pool products. The decrease in traditional pool lighting sales was due primarily to decrease in sales from our in-ground and jazz lighting products. The decrease in traditional commercial lighting sales was due to lower sales in the U.S. and Germany.

During 2007, $234,000 of revenue was recognized on a percentage-of-completion basis for milestones completed as a subcontractor to the University of Delaware for continuing research on Very-High-Efficiency Solar Cells. 

International sales accounted for approximately 35% of net sales in 2007, as compared to 31% of net sales in 2006 and 33% in 2005. The falling exchange rate for U.S. dollars helped boost the international sales reported this year. The breakdown of our international sales is as follows:

International Sales
(in thousands)

   
Year Ended December 31,
 
   
2007
 
2006
 
2005
 
United States Domestic
 
$
14,949
 
$
18,776
 
$
19,123
 
Germany
   
3,136
   
2,998
   
3,399
 
U.K.
   
4,265
   
4,817
   
4,775
 
Others
   
548
   
445
   
1,040
 
Total Sales
 
$
22,898
 
$
27,036
 
$
28,337
 

 
15

 
Gross Profit
 
We had gross profit of $6,282,000 in 2007, a decrease of 19%, compared to $7,785,000 in 2006. Total gross profit as a percentage of total net sales was 27% in 2007, compared to 29% in 2006.

In 2006, we had gross profit of $7,785,000, compared to $10,626,000in 2005. As a percentage of sales, the gross profit for 2006, was 29% compared to 38% in 2005. Lower margins from commercial lighting and pool sales contributed towards much of the decline in both 2007 and 2006.
 
Operating Expenses
 
Research and Development 
 
Research and development expenses were $2,907,000 in 2007, a 24% increase from $2,341,000 in 2006.
 
Overall, we decreased gross spending in research and development expense on personnel and project costs related to partially subsidized government awards and on improvements for existing products. This spending continued to be offset by expense credits for funds received in 2007, under various government awards for which we are the sole beneficiary of such research. The gross research and development spending along with credits from government contracts is shown in the following table:
 
 
 
Year ended December 31,
 
 
 
2007
 
2006
 
2005
 
 
 
(in thousands)
 
Gross R& D Expense and Government Reimbursement:
                   
Gross Expenses for R&D
 
$
3,424
 
$
3,556
 
$
4,485
 
Deduct: Incurred and Accrued Credits from Government Contracts
 
(517
)
(1,215
)
(2,295
)
Net R&D Expenses
 
$
2,907
 
$
2,341
 
$
2,190
 
                     
Total Credits Received and Revenue Recognized on Government Projects:
                   
Incurred and Accrued Credits from Government Contracts
 
$
517
 
$
1,215
 
$
2,295
 
Revenue Recognized for Completed Deliveries
   
542
   
1,979
   
 
Net Credits Received and Revenue Recognized
 
$
1,059
 
$
3,194
 
$
2,295
 
 
Credits received from government contracts for research for which we are the beneficiary during the fiscal year are recorded as a reduction to research and development expense. The net of payments to subcontractors amounted to $517,000 in 2007, compared to $1,215,000 in 2006, and $2,295,000 in 2005. Gross expenses for research and development decreased by $132,000 in 2007, a 4% decrease compared to 2006. Net research and development expenses were 12.7% of sales in 2007, compared to 8.7% of sales in 2006, and 7.7% in 2005.
 
This decrease in credits from 2005 to 2006 was due to the completion of the AMCOM contract and associated credits in 2005. Gross expenses for research and development decreased by $929,000 from 2005 to 2006 due to the re-allocation of some research and development staff to building milestone deliverables under the Navy ship installation contract and their associated costs being included in cost of sales in 2006, whereas there was no such activity or re-classed expenses in 2005.
 
When the government contract is for the delivery of a product or service, we recognize revenue from those government projects according to percentage of completion method or actual deliveries made. Costs related to the completion of the sale are charged to cost of sales. In 2007, revenue recognized from completed deliveries was $542,000. The revenue recognized for completed deliveries of products or services was $1,979,000 in 2006 and none in 2005. For further information on our revenue recognition policy, please refer to “Critical Accounting Policies and Estimates” within this section of the report.
 
Net credits received from government reimbursement are the combination of revenue and credits against gross research and development costs. In 2007, our net credits were $1,059,000, compared to $3,194,000 in 2006 and $2,295,000 in 2005.
 
16

 
Sales and Marketing
 
Sales and marketing expenses were $9,789,000 in 2007, compared to $9,774,000 in 2006. While the net dollar amounts are similar for both years, in terms of percentage of sales, it was 43% in 2007 and 36% in 2006. In 2007, sales expenses for the pool product line amounted to $2,676,000, or 27% of total marketing cost, whereas the commercial lighting line was $7,113,000, or 73% of total marketing costs.

In 2006, sales and marketing expenses were $9,774,000, a 2% increase compared to the $9,595,000 in 2005. Last year’s increase was due in part to an increase of $734,000 in EFO sales and marketing offset by lower commissions of $443,000, and lower pool sales and marketing of $120,000 in 2006.
 
General and Administrative
 
General and administrative expenses were 20% of sales in 2007, 18% of sales in 2006, and 11% of sales in 2005. General and administrative expenses were $4,651,000 in 2007, a $305,000 or 6% decrease as compared to $4,956,000 in 2006. This year’s lower general and administrative expense was largely a result of a $241,000 decrease in stock-based compensation compared to 2006, as well as management’s efforts to reduce overall costs.
 
General and administrative cost reduction efforts during 2007 were offset by a one-time charge of $409,000 for severance, $172,000 of which was in the general and administrative expenses category. The rest of the severance expenses were related to other line items such as sales and marketing and restructuring expenses. In 2007, we also incurred a non-recurring general and administrative charge of $342,000 in the third quarter and for bad debts due to a change in policy for calculating the reserve. Without these two non-recurring charges, the general and administrative expenses for 2007 would have been $4,150,000, a decrease of 10% from 2006.
 
General and administrative expenses were $4,956,000 in 2006, a $1,821,000 increase as compared to $3,135,000 in 2005. The 2006 increase was due to higher costs associated with complying with the Sarbanes-Oxley Act of 2002, option expenses associated with implementing FAS 123 (R), accounting fees, investor relations costs, and legal fees. We became an accelerated filer with the SEC as a result of our market capitalization as of June 30, 2006. As a result, we were required to comply with Section 404 of the Sarbanes-Oxley Act of 2002 beginning with our fiscal year ending December 31, 2006. Our outside costs to comply with Section 404 were approximately $500,000, independent of additional audit fees.
 
The restructuring expenses in 2007 were $456,000, compared to $734,000 in 2006, a decrease of 38 %. In 2005, our restructuring expenses were $3,120,000. The 2007 cost is associated with relocating the fiber production operation from Mexico to Solon, Ohio. The 2006 and 2005 restructuring costs were for the relocation from Fremont, California to Solon, Ohio.
 
In June 2005, we announced the relocation of our headquarters from Fremont, California, to Solon, Ohio. We had indicated that the cost of the restructure would be approximately $3,500,000 and would result in approximately $2,000,000 in savings. In 2005, we spent approximately $3,100,000 on restructuring expenses.
 
Other Income and Expenses
 
We had interest income of $605,000 and interest expense of $321,000 in 2007. Interest income consists of interest earned on deposits and marketable securities and gains on securities sales. Interest expense is for bank interest on equipment loans and on a building loan in Germany for our corporate offices there. Our interest income was $760,000 in 2006, compared to $138,000 in 2005. Our interest expense was $277,000 in 2006, compared to $39,000 in 2005.

We have certain long-term leases. Payments due under these leases are disclosed below in Note 8 and in the Consolidated Financial Statements and related notes included elsewhere in this report.
 
Income Taxes 
 
We have a full valuation allowance against our deferred tax assets in the United States and Germany. There was a tax expense of $13,000 for our U.K. operations in 2007. There were no tax expenses or benefits for our United States or German operations. In 2007, all expected benefits were offset by an increase in our valuation allowance. We had a tax expense of $177,000 in the U.S., resulting from a tax liability associated with tax treatment for goodwill.

For 2006, we had a full valuation allowance against our deferred tax assets in the United States and Germany. There was no operating statement tax expense or benefit for our German operation in 2006 as any expected benefit was offset by an increase in our valuation allowance. We had a tax expense of $75,000 in the U.S resulting from a tax liability associated with the tax treatment for goodwill. In addition we had a $38,000 tax expense shown for 2006 is a result of tax expense for our United Kingdom operations which experienced a profit of 2006.

For 2005, we had a full valuation allowance against our deferred tax assets in the United States. There was no operating statement tax expense or benefit for our United States operations in 2005 as any expected benefit was offset by an increase in our valuation allowance. The $109,000 tax expense shown for 2005, is a result of tax expense for our United Kingdom and German operations which experienced a profit of 2005
 
Net Loss
 
The net loss was $11,317,000, an increase of 17% from our net loss of $9,650,000 in 2006.

For 2006, the net loss of $9,650,000, which was an increase of 30% compared to the net loss of $7,423,000 in 2005.
 
17

 
Liquidity and Capital Resources
 
Cash and Cash Equivalents
 
At December 31, 2007, our cash and cash equivalents were $8,412,000, compared to $3,705,000 at December 31, 2006. We had $314,000 in long-term borrowings and $2,885,000 in short-term borrowings as of December 31, 2007. We had $1,862,000 in long-term borrowings and $1,902,000 in short-term borrowings as of December 31, 2006. We did not have any short-term securities at December 31, 2007. We had $12,263,000 in short-term securities at December 31, 2006.
 
Operating Activities
 
Net cash used by operating activities primarily consists of net loss adjusted by non-cash items, including depreciation, amortization, stock-based compensation, and the effect of changes in working capital. Cash decreased during 2007, by a net loss of $11,317,000, compared to net losses of $9,650,000 and $7,423,000 for 2006, and 2005 respectively. After adjustments, net cash used by operating activities was $7,502,000 in 2007, compared to $7,184,000 for 2006 and $3,472,000 in 2005.
 
In 2007, all short-term investments were converted to cash. Further, our efforts to reduce accounts receivable and inventory provided cash of $2,411,000 and $947,000, respectively during 2007. Cash was also used during 2007 to decrease accounts payable by $1,942,000. In 2006, cash decreased by $2,457,000 due to a reduction in accruals, largely due to paying off restructuring expenses accrued in 2005 and increased by $1,510,000 and $558,000 due to increases in accounts payables and a reduction in prepaids, respectively. During 2005, cash increased by $722,000 due to a reduction in accounts receivable and by $363,000 due to a reduction in inventories. Accrued liabilities added to cash in 2005 through an increase of $1,830,000 largely as a result of scheduled payments outstanding on restructuring expenses.
 
Cash Provided by Investing Activities
 
There was a net contribution of cash of $11,842,000 in 2007, largely due to net sales of short-term securities, totaling $12,351,000. In 2006, the contribution of cash was $2,058,000 in investing activities, also due to net sales of short-term investments totaling $5,761,000 and partially offset by the acquisition of fixed assets of $3,703,000. This compares to a net utilization of cash of $19,921,000 in investing activities in 2005, primarily due to the investments made in short-term securities and the acquisition of fixed assets.
 
Cash Provided by Financing Activities
 
In 2007, the net contribution to cash from financing activities was $407,000, compared to $2,908,000 in 2006 and $25,749,000 in 2005. Proceeds from stock issuances provided $964,000 in cash in 2007. Also in 2007, additional bank borrowings of $289,000 were reduced by debt payments of $908,000. During 2006, the net cash contribution primarily was due to our receipt of $2,686,000 in proceeds from bank borrowings, of which $1,609,000 was used to finance the purchase of manufacturing equipment. During 2005, the net cash contribution was primarily due to proceeds received from issuances of common stock.

As a result of the cash used in operating activities and the cash provided by financing and investing activities, there was a net increase in cash in 2007 of $4,707,000 that resulted in an ending cash balance of $8,412,000 as of December 31, 2007. This compares to a net decrease in cash of $1,849,000 in 2006, resulting in an ending cash balance of $3,705,000 at the end of 2006, and a net increase in cash of $1,945,000 in 2005, resulting in an ending cash balance of $5,554,000 at the end of 2005.

We have a bank line of credit agreement with Silicon Valley Bank effective August 15, 2005. It was further amended September 25, 2006, and extended through August 15, 2007, and again on October 31, 2007, extending the agreement to December 31, 2007. This credit facility is for $5,000,000 and is secured by our assets and intellectual property. At December 31, 2007, the interest rate was 7.75%. It has a minimum tangible net worth covenant that we must meet going forward. On December 31, 2005, this agreement was amended and restated to include an additional $3,000,000 term-loan line of credit for equipment purchases. This agreement calls for repayment of principle in equal amounts over four years from the date of purchase of the equipment and has an interest rate of prime plus 0.5% if the quick ratio is greater than 1.5, and prime plus 1.5% if the quick ratio is at or below 1.5. Borrowings under the Silicon Valley Agreement are collateralized by our assets and intellectual property. Specific borrowings under the revolver are tied to accounts receivable and inventory balances, and we are required to comply with certain covenants with respect to effective net worth and financial ratios. The company had borrowings of $973,000 under the revolving line of credit at December 31, 2007, $1,000,000 borrowings at December 31, 2006, and no borrowings as of December 31, 2005. We had total borrowings under the term-loan portion of the agreement of $1,672,000 as of December 31, 2007, $2,261,000 as of December 31, 2006, and $1,092,000 as of December 31, 2005. We pay an unused line fee of 0.25% against any unused daily balance during the year.
 
On January 29, 2008, the company entered into a fifth amendment, retroactive to December 30, 2007. Under this new agreement, all advances become due on February 29, 2008. On March 14, 2008, our company entered into a sixth amendment with Silicon Valley Bank which extends the due date to April 30, 2008.

Through our U.K. subsidiary, we maintain a bank overdraft facility of $496,000 (in U.K. pounds sterling, based on the exchange rate at December 31, 2007) under an agreement with Lloyds Bank Plc. There were no borrowings against this facility as of December 31, 2007 and 2006, respectively. The facility is renewed annually on January 1.

Through our German subsidiary, we maintain a credit facility under an agreement with Sparkasse Neumarkt Bank. This credit facility is in place to finance our building of new offices in Berching, Germany, owned and occupied by our German subsidiary. As of December 31, 2007, we had borrowings of $368,000 (in Euros, based on the exchange rate at December 31, 2007) against this credit facility. In addition, our German subsidiary has a revolving line of credit for $219,000 (in Euros, based on the exchange rate at December 31, 2007) with Sparkasse Neumarkt Bank. As of December 31, 2007, there were borrowings of $186,000 against this facility and borrowings of $124,000 against this facility at December 31, 2006. The revolving facility is renewed annually on January 1.
 
18


On November 8, 2005, the company closed a follow-on offering, selling 2,500,000 new shares of common stock at a price of $8.25. The purchase price of the common stock was set at $8.25 per share on November 2, 2005, which was approximately a 5% discount on the closing price on that day. On November 11, 2005, the company announced that the underwriters had exercised their option to sell an additional 452,497 shares of common stock for $8.25 as part of the offering. The gross amount raised was $24.4 million from the selling of 2,952,497 new shares (before costs and expenses). The net amount received by the company after deducting 6% in underwriters’ fees and legal, accounting, and other costs was $22.2 million.

On March 14, 2008, the company raised approximately $9,500,000 in equity financing, net of expenses, in a private placement of shares of common stock and warrants to existing shareholders. This additional financing will be used to fund working capital, pay debt and perform additional research and development. The company received 100% of the funds (net of fees) on March 17, 2008. Management believes that this additional financing, when combined with current cash reserves, will be sufficient to fund on-going operations for the next 12 months.
 
Contractual Obligations
 
The following summarizes our contractual obligations as of December 31, 2007, consisting of current and future payments for borrowings by our German subsidiary, borrowings under an equipment term loan in the United States, and minimum lease payments under operating leases, as well as the effect that these obligations are expected to have on our liquidity and cash flow in future periods (in thousands).
 
     
Borrowings
by German
Subsidiary
   
Borrowings
under
Equipment
Term Loan
   
Non-
Cancelable
Operating
Leases
 
2008
 
$
240
 
$
1,672
 
$
935
 
2009
   
57
   
   
945
 
2010
   
60
   
   
797
 
2011
   
64
   
   
282
 
Thereafter
   
133
   
   
297
 
 
 
$
554
 
$
1,672
 
$
3,256
 
 
The company also has $973,000 for credit line borrowings, in the United States, recorded as a current liability at December 31, 2007. 
 
Off-Balance Sheet Arrangements
 
We had no off-balance sheet arrangements as of December 31, 2007 or 2006.
 
19

 
 
Critical Accounting Policies and Estimates
 
The preparation of financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies, and the reported amounts of revenue and expenses in the financial statements. Material differences may result in the amount and timing of revenue and expenses if different judgments or different estimates were utilized. Critical accounting policies, judgments, and estimates that we believe have the most significant impact on our financial statements are set forth below:

 
·
Revenue recognition;
     
 
·
Allowances for doubtful accounts, returns and discounts;
     
 
·
Long-lived assets;
     
 
·
Valuation of inventories;
     
 
·
Accounting for income taxes; and
     
 
·
Share-Based compensation
 
Revenue Recognition
 
Revenue is recognized when it is realized or realizable, has been earned, and when all of the following has occurred:
 
 
·
Persuasive evidence or an arrangement exists, e.g., a sales order, a purchase order, or a sales agreement.
 
 
·
Shipment has occurred (the standard shipping term is F.O.B. ship point) or services provided on a percentage-of-completion basis or installation have been completed.
 
 
·
Price to the buyer is fixed or determinable.
 
 
·
Collectibility is reasonably assured.
 
Revenue from product sale generally is recognized upon shipping because of the following:
 
 
·
All sales made by the company to its customer base are non-contingent, meaning that they are not tied to that customer’s resale of products.
 
 
·
Standard terms of sale contain shipping terms of F.O.B. ship point, meaning that title is transferred when shipping occurs.
 
 
·
There are no automatic return provisions that allow the customer to return the product in the event that the product does not sell within a defined timeframe.
 
Revenue from installation services, including design and integration services and other services (where product sales are not incorporated into the contract), is recognized upon the following:
 
 
·
Percentage-of-completion method using the ratio of labor cost incurred to the total final estimated labor cost. Under this method, revenue recognized reflects the portion of anticipated revenue that has been earned.
 
Revenue from product sales that incorporate specifically defined installation services is recognized as follows:
 
 
·
product sale at completion of installation and
 
 
·
installation service at completion of installation
 
We warrant our products against defects or workmanship issues. We set up allowances for estimated returns, discounts, and warranties upon recognition of revenue and these allowances are adjusted periodically to reflect actual and anticipated returns, discounts, and warranty expenses. Our distributorsobligation to us is not contingent upon the resale of our product and as such does not prohibit revenue recognition.
 
Allowances for Doubtful Accounts, Returns, and Discounts
 
We establish allowance for doubtful accounts for probable losses, based on past history, current economic conditions, and contractual terms. The specific components are as follows:
 
 
·
Allowance for doubtful accounts for accounts receivable, and
 
 
·
Allowance for sales returns
 
20

 
In 2007, the total allowance was $848,000, with $698,000 related to accounts receivable and $150,000 related to sales return. In 2006, the total allowance had a balance of $600,000 with $355,000 related to accounts receivable and $245,000 related to sales return.

The company reviews these allowance accounts periodically and adjusts them according to current conditions.
 
Long-lived Assets

The company has $4,359,000 in goodwill in 2007, which represents 15% of total assets. We test goodwill for impairment annually, and at December 31, 2007, it was determined that no impairment occurred. The first test for impairment requires us to make an assessment of our book value versus our market capitalization value. Since our market value was greater than book value, no further impairment testing was required. If these values change in the future, additional analysis would be required, and we may incur non cash charges for impairment of goodwill.

Valuation of Inventories

We state inventories at the lower of standard cost (which approximates actual cost determined using the first-in-first-out method) or market. We establish provisions for excess and obsolete inventories after evaluation of historical sales, current economic trends, forecasted sales, product lifecycles, and current inventory levels. During 2007, 2006, and 2005, we charged $677,000, $868,000, and $196,000, respectively, to cost of sales for excess and obsolete inventories. Adjustments to our estimates, such as forecasted sales and expected product lifecycles, could harm our operating results and financial position.

Accounting for Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax liability in each of the jurisdictions in which we do business. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We then must assess the likelihood that these deferred tax assets will be recovered from future taxable income and, to the extent that we believe that recovery is not certain or is unknown, we must establish a valuation allowance.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. At December 31, 2007, we have recorded a full valuation allowance against our deferred tax assets in the United States and Germany, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating losses carried forward. The valuation allowance is based upon our estimates of taxable income by jurisdiction and the period over which our deferred tax assets will be recoverable.

Share-Based Payments
 
In December 2004, the FASB issued FAS No. 123 (revised 2004) or FAS 123(R), “Share-Based Payments.” FAS 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. The company has applied FAS 123(R) using the modified prospective method. Under this method, the company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. The company could have elected to adopt FAS 123(R) by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in the pro forma disclosures that had been required by FAS 123. FAS 123(R) was first effective for the company for its year ending December 31, 2006. In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107), which provides interpretive guidance related to the interaction between FAS 123(R) and certain SEC rules and regulations. It also provides the SEC staff’s views regarding valuation of share based payment arrangements. The application of FAS 123(R) with SAB 107 had the effect of increasing stock-based compensation expense and reducing earnings by $877,000 in 2007 and $1,118,000 in 2006.
 
We measure all employee stock-based awards as an expense based on the grant-date fair value of these awards. Effective January 1, 2006, we began to recognize expense for all stock-based awards granted on or after that date and for all previous unvested awards using the modified prospective method. The fair value of options is estimated using the Black-Scholes option pricing model. Weighted average assumptions used in the model include the expected life of the options, volatility, and risk-free interest rate. The volatility estimates are calculated using historical pricing experience.
 
21

 
Recently Issued Accounting Pronouncements
 
Accounting Pronouncements Adopted in 2007

Accounting for uncertain tax positions. In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), an interpretation of Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes” (SFAS 109), regarding accounting for income tax uncertainties effective for fiscal years beginning after December 15, 2006 (effective January 1, 2007, for the company). FIN 48 applies to all tax positions related to income taxes subject to SFAS 109 on Accounting for Income Taxes. The impact of adopting the positions of this interpretation did not have a material impact on the company’s overall financial position or results of operations.

Accounting Pronouncements Pending Adoption at December 31, 2007

Fair value measurements. In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (FAS 157), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This guidance applies only when other guidance requires or permits assets or liabilities to be measured at fair value; it does not expand the use of fair value in any new circumstances. FAS 157 will be effective for fiscal years beginning after November 15, 2007 (effective January 1, 2008, for the company). In February 2008, the FASB issued Staff Position FAS 157-1, which provides that FAS 157 does not apply under FAS 13, “Accounting for Leases,” and other accounting pronouncements that address fair value measurements for leases. In February 2008, the FASB also issued Staff Position FAS 157-2, which delays the effective date of FAS 157 for all nonfinancial assets and liabilities, except those recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). For items within the scope of Staff Position FAS 157-2, the effective date will be for fiscal years beginning after November 15, 2008. Early adoption of FAS 157 for nonfinancial assets and liabilities within the scope of the new guidance is permitted. Management is evaluating the potential effect that this guidance may have on the company’s overall financial position or results of operations.

Fair value option for financial assets and financial liabilities. In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (FAS 159). This guidance provides an option to selectively report financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS No. 159 will be effective for fiscal years beginning after November 15, 2007 (effective January 1, 2008, for the company). The company has elected not to apply this fair value option to any of its existing assets or liabilities. However, the company may adopt this guidance for assets or liabilities in the future as permitted under FAS No. 159.

Business Combinations. In December 2007, the FASB issued FAS No. 141(R), “Business Combinations” (FAS 141(R)). The new pronouncement requires the acquiring entity in a business combination to recognize only the assets acquired and liabilities assumed in a transaction (e.g., acquisition costs must be expensed when incurred), establishes the fair value at the date of acquisition as the initial measurement for all assets acquired and liabilities assumed, and requires expanded disclosures. FAS 141(R) will be effective for fiscal years beginning after December 15, 2008 (January 1, 2009, for the company). Early adoption is prohibited. Management is evaluating the potential effect that this guidance may have on the company’s overall financial position or results of operations.

Noncontrolling Interests. In December 2007, the FASB issued FAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51” (FAS 160). The new pronouncement requires all entities to report noncontrolling (minority) interests in subsidiaries as a component of shareholders’ equity. FAS No. 160 will be effective for fiscal years beginning after December 15, 2008 (January 1, 2009, for company). Early adoption is prohibited. Management is evaluating the potential effect that this guidance may have on the company’s overall financial position or results of operations.
 
Item 7A. Qualitative and Quantitative Disclosures About Market Risk

As of December 31, 2007, we had $1,129,000 in cash held in foreign currencies based on the exchange rates at December 31, 2007. The balances for cash held overseas in foreign currencies are subject to exchange rate risk. We have a policy of maintaining cash balances in local currencies unless an amount of cash occasionally is transferred in order to repay inter-company debts.

As of December 31, 2007, we had borrowings of $186,000 (in Euros, based on the exchange rate at December 31, 2007) against a credit facility secured by real property owned by our German subsidiary. As of December 31, 2006, we had $124,000 (in Euros, based on the exchange rate at December 31, 2006,) borrowed against this credit facility.
 
22

 
Item 8. Financial Statements and Supplementary Data
 
TABLE OF CONTENTS
 
 
Page
Report of Independent Registered Public Accounting Firm
24
   
Consolidated Balance Sheets as of December 31, 2007 and 2006
25
 
 
Consolidated Statements Of Operations for the years ended December 31, 2007, 2006 and 2005
26
 
 
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2007, 2006 and 2005
27
 
 
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2007, 2006, and 2005
28
 
 
Consolidated Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and 2005
29
 
 
Notes to Consolidated Financial Statements for December 31, 2007, 2006 and 2005
30
 
23

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
Energy Focus, Inc.

We have audited the accompanying consolidated balance sheets of Energy Focus, Inc (a Delaware corporation) and subsidiaries (collectively the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audit of the basic financial statements included the financial statement schedule listed in the index under Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Energy Focus, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2006, the Company adopted SFAS 123(R) “Share-Based Payment” as revised.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Energy Focus, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 17, 2008 expressed an unqualified opinion thereon.

/s/ GRANT THORNTON LLP


Cleveland, Ohio
March 17, 2008
 
24

 
ENERGY FOCUS, INC.
CONSOLIDATED BALANCE SHEETS, December 31,
(amounts in thousands except share and per-share amounts)
 
 
 
2007
 
2006
 
ASSETS
         
Current assets:
 
 
 
 
 
Cash and cash equivalents
 
$
8,412
 
$
3,705
 
Short-term investments
   
   
12,263
 
Accounts receivable, net of allowances for doubtful accounts of $698 in 2007 and $355 in 2006
   
3,454
   
6,185
 
Inventories, net
   
6,888
   
7,708
 
Prepaids and other current assets
   
381
   
324
 
Total current assets
   
19,135
   
30,185
 
Fixed assets, net
   
5,316
   
5,978
 
Goodwill, net
   
4,359
   
4,247
 
Other assets
   
59
   
182
 
Total assets
 
$
28, 869
 
$
40,592
 
               
LIABILITIES
             
Current liabilities:
         
 
Accounts payable
 
$
2,265
 
$
4,202
 
Accruals and other current liabilities
   
1,473
   
1,671
 
Credit line borrowings
   
1,159
   
1,124
 
Current portion of long-term bank borrowings
   
1,726
   
778
 
Total current liabilities
   
6,623
   
7,775
 
Other deferred liabilities
   
62
   
 
Deferred tax liabilities
   
252
   
75
 
Long-term bank borrowings
   
314
   
1,862
 
Total liabilities
   
7,251
   
9,712
 
Commitments and contingencies (Note 8).
   
       
               
SHAREHOLDERS’ EQUITY
             
Preferred stock, par value $0.0001 per share:
   
   
 
Authorized: 2,000,000 shares in 2007 and 2006
   
   
 
Issued and outstanding: no shares in 2007and 2006
   
   
 
Common stock, par value $0.0001 per share:
   
   
 
Authorized: 30,000,000 shares in 2007 and 2006
   
   
 
Issued and outstanding: 11,623,000 shares in 2007 and 11,394,000 shares in 2006
   
1
   
1
 
Additional paid-in capital
   
55,682
   
53,841
 
Accumulated other comprehensive income
   
815
   
601
 
Accumulated deficit
   
(34,880
)
 
(23,563
)
Total shareholders’ equity
   
21,618
   
30,880
 
Total liabilities and shareholders’ equity
 
$
28,869
 
$
40,592
 
 
The accompanying notes are an integral part of these financial statements
 
25

 
ENERGY FOCUS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
For the years ended December 31,
(amounts in thousands except per-share amounts) 
 
     
2007
   
2006
   
2005
 
Net sales
 
$
22,898
 
$
27,036
 
$
28,337
 
Cost of sales
   
16,616
   
19,251
   
17,711
 
Gross profit
   
6,282
   
7,785
   
10,626
 
Operating expenses:
                   
Gross research and development
   
3,424
   
3,556
   
4,485
 
Deduct credits from government contracts
   
(517
)
 
(1,215
)
 
(2,295
)
Net research and development expense
   
2,907
   
2,341
   
2,190
 
Sales and marketing
   
9,789
   
9,774
   
9,595
 
General and administrative
   
4,651
   
4,956
   
3,135
 
Restructuring expenses
   
456
   
734
   
3,120
 
Total operating expenses
   
17,803
   
17,805
   
18,040
 
Loss from operations
   
(11,521
)
 
(10,020
)
 
(7,414
)
Other income (expense):
                   
Other income
   
110
   
   
1
 
Interest Income
   
605
   
760
   
138
 
Interest expense
   
(321
)
 
(277
)
 
(39
)
Net loss before income taxes
   
(11,127
)
 
(9,537
)
 
(7,314
)
Income tax provision
   
(190
)
 
(113
)
 
(109
)
Net loss
 
$
(11,317
)
$
(9,650
)
$
(7,423
)
Net loss per share—basic and diluted
 
$
(0.98
)
$
(0.85
)
$
(0.90
)
Shares used in per share calculation—basic and diluted
   
11,500
   
11,385
   
8,223
 
 
The accompanying notes are an integral part of these financial statements.
 
26

 
ENERGY FOCUS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
For the years ended December 31,
(amounts in thousands)

   
2007
 
2006
 
2005
 
Net loss
 
$
(11,317
)
$
(9,650
)
$
(7,423
)
Other comprehensive income:
                   
Foreign currency translation adjustments
   
283
   
507
   
(636
)
Net unrealized (loss) gain on securities
   
(69
)
 
53
   
16
 
Comprehensive loss
 
$
(11,103
)
$
(9,090
)
$
(8,043
)
 
The accompanying notes are an integral part of these financial statements.
 
27

 
ENERGY FOCUS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
For the years ended December 31, 2007, 2006, and 2005
(amounts in thousands)
 
   
Common Stock
 

Additional
Paid-In
 

Unearned
Stock-Based
 
Notes
Receivable
from
 
Accumulated
Other
Comprehensive
 
Retained
Earnings
(Accumulated
     
   
Shares
 
Amount
 
Capital
 
Compensation
 
Shareholder
 
Income
 
Deficit)
 
Total
 
Balances, December 31, 2004
   
7,351
 
$
1
 
$
27,520
 
$
(490
)
$
 
$
661
 
$
(6,490
)
$
21,202
 
Issuance of common stock S-3 Filing
   
2,952
         
22,174
                           
22,174
 
Exercise of common stock warrants
   
587
         
408
         
(62
)
             
346
 
Issuance of common stock under
                                                 
employee stock purchase plan
   
4
         
31
                           
31
 
Exercise of common stock options
   
376
         
2,131
                           
2,131
 
Unearned stock-based compensation
               
53
   
(53
)
                   
 
Amortization of unearned stock- based compensation
               
197
   
146
                     
343
 
Net unrealized gain on securities
                                 
16
         
16
 
Foreign currency translation adjustment
                                 
(636
)
       
(636
)
Net loss
                                       
(7,423
)
 
(7,423
)
Balances, December 31, 2005
   
11,270
 
$
1
 
$
52,514
 
$
(397
)
$
(62
)
$
41
 
$
(13,913
)
$
38,184
 
Reclassification of unearned
                                                 
Stock-based compensation upon
                                                 
FAS 123R adoption
               
(397
)
 
397
                     
 
Additional Costs from 2005 S-3 Filing
               
(45
)
                         
(45
)
Exercise of common stock warrants
   
14
         
62
                           
62
 
Exercise of common stock options
   
106
         
563
                           
563
 
Issuance of common stock under employee stock purchase plan
   
4
         
26
                           
26
 
Note Receivable from shareholder
                           
62
               
62
 
Stock-based compensation
               
1,118
                           
1,118
 
Net unrealized gain on securities
                                 
53
         
53
 
Foreign currency translation adjustment
                                 
507
         
507
 
Net loss
                                                   
(9,650
)
 
(9,650
)
Balances, December 31, 2006
   
11,394
 
$
1
 
$
53,841
 
$
 
$
 
$
601
 
$
(23,563
)
$$
30,880
 
                                                 
Exercise of common stock warrants
   
86
         
295
                           
295
 
Exercise of common stock options
   
140
         
651
                           
651
 
Issuance of common stock under employee stock purchase plan
   
3
         
18
                           
18
 
Stock-based compensation
               
877
                           
877
 
Net unrealized loss on securities
                                 
(69
)
       
(69
)
Foreign currency translation adjustment
                                 
283
         
283
 
Net loss
                                                   
(11,317
)
 
(11,317
)
Balances, December 31, 2007
   
11,623
 
$
1
 
$
55,682
 
$
 
$
 
$
815
 
$
(34,880
)
$
21,618
 
 
The accompanying notes are an integral part of these financial statements.
 
28

 
ENERGY FOCUS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31,
(amounts in thousands)
 
 
 
2007
 
2006
 
2005
 
Cash flows from operating activities:
 
 
 
 
 
 
 
Net loss
 
$
(11,317
)
$
(9,650
)
$
(7,423
)
Adjustments to reconcile net loss to net cash used in operating activities:
         
   
 
Depreciation and amortization
   
1,236
   
1,197
   
1,145
 
Provision for doubtful accounts receivable
   
387
   
151
   
76
 
Stock-based compensation
   
877
   
1,118
   
345
 
Unrealized loss (gain) from marketable securities
   
69
   
(53
)
 
(16
)
Gain on sale of fixed asset
   
(1
)
 
   
 
Deferred Taxes
   
177
   
63
   
 
Changes in assets and liabilities:
               
 
Accounts receivable, trade
   
2,411
   
127
   
722
 
Inventories
   
947
   
351
   
363
 
Prepaid and other current assets
   
(54
)
 
558
   
(313
)
Other assets
   
131
   
(99
)
 
56
 
Accounts payable
   
(1,942
)
 
1,510
   
(257
)
Accruals and other current liabilities
   
(423
)
 
(2,457
)
 
1,830
 
Total
   
3,815
   
2,466
   
3,951
 
Net cash used in operating activities
   
(7,502
)
 
(7,184
)
 
(3,472
)
Cash flows from investing activities:
         
   
 
Sale of short-term investments
   
49,441
   
114,595
   
27,767
 
Purchase of short-term investments
   
(37,090
)
 
(108,834
)
 
(45,768
)
Proceeds from sale of fixed assets
   
33
   
   
 
Acquisition of fixed assets
   
(542
)
 
(3,703
)
 
(1,920
)
Net cash provided by (used in) investing activities
   
11,842
   
2,058
   
(19,921
)
Cash flows from financing activities:
   
   
   
 
Proceeds from issuances of common stock
   
964
   
651
   
24,680
 
Repayment of loan made to shareholder
   
   
62
   
 
Proceeds from credit line borrowings
   
129
   
1,077
   
 
Proceeds from long-term borrowings
   
160
   
1,609
   
1,069
 
Payments of Line of Credit
   
(107
)
 
   
 
Payments of long-term borrowings
   
(801
)
 
(491
)
 
 
Other Liabilities
   
62
   
   
 
Net cash provided by financing activities
   
407
   
2,908
   
25,749
 
Effect of exchange rate changes on cash
   
(40
)
 
369
   
(411
)
Net increase (decrease) in cash and cash equivalents
   
4,707
   
(1,849
)
 
1,945
 
Cash and cash equivalents, beginning of year
   
3,705
   
5,554
   
3,609
 
Cash and cash equivalents, end of year
 
$
8,412
 
$
3,705
 
$
5,554
 
Supplemental Information
         
   
 
Interest Paid
 
$
334
 
$
248
 
$
39
 
Non-cash investing activities
                   
Fully depreciated assets disposed of
 
$
205
 
$
79
 
$
1,083
 
 
The accompanying notes are an integral part of these financial statements.
 
29

ENERGY FOCUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007, 2006, and 2005
 
 
1.
Nature of Operations 
 
Energy Focus, Inc. (“the company”) develops and assembles lighting products using fiber optic technology for commercial lighting and swimming pool lighting applications. The company markets its products for worldwide distribution primarily through independent sales representatives, distributors, and swimming pool builders.
 
 
2.
Summary of Significant Accounting Policies 
 
Basis of Presentation
 
The consolidated financial statements (“financial statements”) include the accounts of the company and its subsidiaries. All significant inter-company balances and transactions have been eliminated.

Liquidity

Due to continued losses and sales declines in 2007, the company has actively pursued the raising of additional equity financing in 2008. On March 14, 2008, the company publicly announced that it received an additional $9,500,000 in equity financing net of expenses. This additional financing will be used to fund working capital, pay debt and perform additional research and development. The company received the funds on March 17, 2008. The company believes that this additional financing, when combined with current cash reserves and current assets, will be sufficient to fund on-going operations for the next 12 months.
 
Use of Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Estimates include, but are not limited to, the establishment of reserves for accounts receivable, sales returns, inventory obsolescence, and warranty claims; the useful lives for property, equipment, and intangible assets; and stock-based compensation. Actual results could differ from those estimates.
 
Revenue Recognition
 
Revenue is recognized when it is realized or realizable, has been earned, and when all of the following has occurred:
 
 
·
Persuasive evidence or an arrangement exists, e.g., a sales order, a purchase order, or a sales agreement.
 
 
·
Shipment has occurred (the standard shipping term is F.O.B. ship point) or services provided on a percentage-of-completion basis or installation has been completed.
 
 
·
Price to the buyer is fixed or determinable.
 
 
·
Collectibility is reasonably assured.
 
Revenue from product sale generally is recognized upon shipping because of the following:
 
 
·
All sales made by the company to its customer base are non-contingent, meaning that they are not tied to that customer’s resale of products.
 
 
·
Standard terms of sale contain shipping terms of F.O.B. ship point, meaning that the title is transferred when shipping occurs.
 
 
·
There is no automatic return provision that allows the customer to return the product in the event the product does not sell within a defined timeframe.
 
Revenue from installation services, including design and integration services and other services (where product sales are not incorporated into the contract), is recognized upon the following:
 
 
·
Percentage-of-completion method using the ratio of labor cost incurred to the total final estimated labor cost. Under this method, revenue recognized reflects the portion of anticipated revenue that has been earned.
 
Revenue from product sales that incorporate specifically defined installation services is recognized as follows:
 
 
·
product sale at completion of installation and
 
 
·
installation service at completion of installation

Energy Focus warrants its products against defects or workmanship issues. We set up allowances for estimated returns, discounts, and warranties upon recognition of revenue, and these allowances are adjusted periodically to reflect actual and anticipated returns, discounts, and warranty expenses. The distributors’ obligation to us is not contingent upon the resale of the company’s product and as such does not prohibit revenue recognition.
30

 
ENERGY FOCUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007, 2006, and 2005
 
Cash Equivalents
 
The company considers all highly liquid investments purchased with original maturity of three months or fewer to be cash equivalent. The company has $7,283,000 in cash on deposit with Silicon Valley Bank in the U.S.A. The remaining cash of the company is on deposit with European based banks in the U.K. and Germany. The cash in the U.S.A. is invested in money market funds that earned an annual interest of 2.5% per annum.
 
Short-Term Investments
 
At December 31, 2007, we had no short-term investments. All monies were invested in money market funds and therefore classified as cash or cash equivalents.

The company’s short-term investments are classified as available-for-sale, which are stated at estimated fair value. The company has determined that its short-term investments are available to support current operations and, accordingly, has classified such short-term investments as current assets without regard for contractual maturities. The unrealized gains or losses on these short-term investments are included in accumulated other comprehensive income as a separate component of shareholders’ equity until realized.
 
The change in net unrealized holding loss on securities available for sale in the amount of $69,000 has been charged to other comprehensive income for the year ended December 31, 2007. The cost of securities sold is based upon the specific identification method.
 
Proceeds from the sale of available securities during 2007 were $49,441,000. Gross gains of $241,000 were realized on the sales of available for sale securities during 2007. Proceeds from the sale of available securities during 2006 were $108,800,000. Gross gains of $562,000 were realized on the sales of available for sale securities during 2006. Gross gains in both years are included as a component of Interest Income.
 
Inventories
 
The company states inventories at the lower of standard cost (which approximates actual cost determined using the first-in-first-out method) or market. The company establishes provisions for excess and obsolete inventories after evaluation of historical sales, current economic trends, forecasted sales, product lifecycles, and current inventory levels. Charges to cost of sales for excess and obsolete inventories amounted to $677,000, $868,000, and $196,000 in 2007, 2006, and 2005, respectively.
 
Accounts Receivable
 
The company’s customers currently are concentrated in the United States and Europe. In the normal course of business, the company extends unsecured credit to its customers related to the sale of its products. Typical credit terms require payment within 30 days from the date of delivery or service. The company evaluates and monitors the creditworthiness of each customer on a case-by-case basis. The company provides allowances for sales returns and doubtful accounts based on its continuing evaluation of its customers’ ongoing requirements and credit risk. The company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. The company does not require collateral from its customers.
 
Income Taxes
 
As part of the process of preparing its consolidated financial statements, the company estimates its income tax liability in each of the jurisdictions in which it does business. This process involves estimating the company’s actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheet. The company then assesses the likelihood that these deferred tax assets will be recovered from future taxable income and, to the extent to which the company believes that recovery is more likely than not, or is unknown, the company establishes a valuation allowance.
 
Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against such deferred tax assets. At December 31, 2007, the company recorded a full valuation allowance against deferred tax assets in the United States and Germany due to uncertainties related to its ability to utilize those deferred tax assets. The valuation allowance is based on estimates of taxable income by jurisdiction and the periods over which its deferred tax assets could be recoverable.
 
Long-Lived Assets
 
Goodwill represents the excess of acquisition cost over the fair value of tangible and identified intangible net assets of the businesses acquired. Goodwill is not amortized but is subjected to an annual impairment test. Fixed assets are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the related assets (two to five years). Leasehold improvements are amortized on a straight-line basis over their estimated useful lives or the lease term, whichever is shorter, generally three to seven years. When events or changes in circumstances indicate that assets may be impaired, an evaluation is performed comparing the estimated future undiscounted cash flows associated with the asset to the asset’s carrying amount to determine whether a write-down to market value or discounted cash flow is required.
 
Fair Value of Financial Instruments
 
Carrying amounts of certain financial instruments including cash and cash equivalents, accounts receivable, and accounts payable approximate fair value due to their short maturities. Based on borrowing rates currently available to the company for loans with similar terms, the carrying value of long-term debt obligations also approximates fair value.
 
31

 
ENERGY FOCUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2007, 2006, and 2005
 
Certain Risks and Concentrations
 
The company invests its excess cash in deposits and high-grade short-term securities with a major financial institution that is insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $100,000 and the Securities Investor Protection Corporation (“SIPC”) up to $500,000 of primary net equity protection including $100,000 for claims for cash. At times, the cash balances exceed the amounts insured by the FDIC. As of December 31, 2007, the company does not have any short-term securities investments. The company has not experienced any losses in such accounts and believes that it is not exposed to significant risk of loss.

The company sells its products primarily to commercial lighting distributors and residential pool distributors and pool installation contractors in North America, Europe, and the Far East. The company performs ongoing credit evaluations of its customers and generally does not require collateral. Although the company maintains allowances for potential credit losses that it believes to be adequate, a payment default on a significant sale could materially and adversely affect its operating results and financial condition. At December 31, 2007 and 2006, one customer accounted for 8.1% and 6% of accounts receivable, respectively. One customer accounted for 7.1%, 11%, and 11% of net sales in 2007, 2006, and 2005, respectively.

The company currently buys all of its small-diameter stranded fiber, the main component of most of its products, from one supplier. There is a limited number of fiber suppliers, and even if an alternative supplier were obtained, a change in suppliers could cause delays in manufacturing and a possible loss of sales, which would adversely affect operating results.

The company also relies on sole source suppliers for certain lamps, reflectors, remote control devices, and power supplies. Although the company cannot predict the effect that the loss of one or more of such suppliers would have on the company, such loss could result in delays in the shipment of products and additional expenses associated with redesigning products. It also could have a material adverse effect on the company’s operating results.
 
Research and Development
 
Research and development expenses include salaries, contractor and consulting fees, supplies and materials, as well as costs related to other overhead such as depreciation and facilities costs. Research and development costs are expensed as they are incurred.

The company treats government and other third-party funding for whom it is the primary beneficiary of such work conducted as a credit to research and development costs.

In addition, the company receives payments from government and other third parties for the completion of deliveries of product and/or services. These payments are recorded as revenue, and the corresponding costs associated with the production of the product or services are charged to the cost of sales in the same period in which the revenue is recognized.
 
Earnings Per Share
 
Basic loss per share is computed by dividing net loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted loss per share is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental shares upon exercise of stock options.
 
A reconciliation of the numerator and denominator of basic and diluted loss per share is provided as follows (in thousands, except per-share amounts):

   
Years Ended December 31,
 
   
2007
 
2006
 
2005
 
Numerator—Basic and Diluted loss per share
             
Net loss
 
$
(11,317
) $
(9,650
)
$
(7,423
)
Denominator—Basic and Diluted loss per share
                   
Weighted average shares outstanding
   
11,500
   
11,385
   
8,223
 
Basic and diluted loss per share
 
$
(0.98
) $
(0.85
)
$
(0.90
)
 
The shares outstanding used for calculating basic and diluted loss per share for a portion of the year 2005 included 156,375 shares of common stock, issuable for no cash consideration upon exercise of certain exchange provisions of warrants held by ADLT a