RESULTS OF OPERATIONS

Net sales increased 14% to $7,616,000 for the quarter ended June 30, 2008, as compared to the same quarter a year ago. The increase was primarily a result of a $1,105,000 increase in net sales by our European subsidiaries overcoming a $881,000 decrease in pool lighting sales. Additionally, government sales were $534,000 for the quarter ended June 30, 2008, as compared to $14,000 for the same quarter a year ago. Net sales increased 6% to $12,453,000 for the six months ended June 30, 2008, as compared to the six months ended June 30, 2007. The increase was primarily a result of a $1,688,000 increase in nets sales by our European subsidiaries, as well as a $525,000 increase in government sales. These increases were offset by continued declines in pool lighting sales. Management is actively engaged in penetrating new pool lighting market channels.

EFO sales were $4,027,000 in the second quarter of 2008, or 53% of total net sales, compared to $1,477,000, or 22% of total net sales, in the second quarter of 2007. Through June 30, 2008, EFO sales were $6,112,000, or 49% of total net sales, compared to $2,609,000, or 22% of total net sales, through June 30, 2007. EFO sales in 2008 and 2007 include sales from EFO fiber optic lighting, EFO LED, EFO Controls, and EFO Government products. EFO fiber optic lighting sales in the second quarter of 2008 were $2,054,000 and $3,591,000 through the six months ended June 30, 2008. 2008 global sales are projected to increase significantly over 2007 primarily due to the projected doubling of EFO sales compared to 2007. However, the market for our products is highly dependent upon general economic conditions.

During the quarter ended June 30, 2008, $415,000 of revenue was recognized resulting from the delivery of certain milestones to E.I. DuPont de Nemours and Company as a part of the Very High Efficiency Solar Cell (“VHESC”) Consortium being funded by the Defense Advanced Research Project Agency (“DARPA”). Also during the quarter, $105,000 of revenue was recognized for statements of work as a contractor to Science Applications International Corporation (“SAIC”) to provide technical services and analysis tools in support of SAIC’s internal research and development program to create and understand new methods for the design and analysis of solar cell concentrators.

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Gross profit was $2,443,000 in the second quarter of 2008, a 7% increase compared to the same period in the prior year. Gross profit was $3,687,000 for the six months ended June 30, 2008, a 2% decrease as compared to the six months ended June 30, 2007. The gross profit margin as a percentage of sales decreased from 34% for the second quarter of 2007 to 32% for the second quarter of 2008, and decreased from 32% for the six months ended June 30, 2007 to 30% for the six months ended June 30, 2008. We expect gross profit margins to improve over the remainder of 2008 due to increased sales in new market channels, price increases in existing market channels, the introduction of new, higher margin products, and ongoing cost reduction initiatives being enacted on a global basis.

Research and development expenses were $684,000 in the second quarter of fiscal 2008, an increase of $9,000 compared with the second quarter of fiscal 2007. Gross research and development expenses for the second quarter of 2008 increased by 14%, as compared to the same period in the prior year. Gross research and development expenses for the six months ended June 30, 2008 increased by 30% as compared to the six months ended June 30, 2007. These increases were due to increased salaries and wages, project related expense, and legal fees related to intellectual property. Our research and development expenses are reduced on a percentage-of-completion basis under development contracts with the Department of Energy (“DOE”) that were signed in 2007, for a total of $1,500,000. Through June 30, 2008, net research and development expenses are $1,601,000 compared to $1,158,000 through June 30, 2007. The gross and net research and development spending along with credits from government contracts is shown in the following table (in thousands):

		Three months						Six months
		ended June 30,						ended June 30,
		2008			2007			2008			2007
Gross expenses for research and development		$	981		$	864		$	2,001		$	1,534
Deduct: credits from DOE contracts			(297	)		(189	)		(400	)		(376	)
Net research and development expense		$	684		$	675		$	1,601		$	1,158

Sales and marketing expenses decreased by 5% to $2,220,000 in the second quarter of fiscal 2008 as compared to $2,328,000 for the same period in fiscal 2007. Sales and marketing expenses decreased by 7% to $4,582,000 in the first six months of 2008 as compared to the same period in 2007. These decreases are a result of lower salaries and wages and associated with reorganization within the sales and marketing organization designed to increase sales effectiveness and efficiencies.

General and administrative expenses were $1,182,000 in the second quarter of fiscal 2008, an increase of $115,000 or 11% from 2007. General and administrative expenses were $2,552,000 for the first six months of 2008 compared to $2,145,000 for the same period in 2007. These increases are a result of higher professional and consulting fees related to audit, legal, and Sarbanes-Oxley compliance, as well as an increase in salaries and benefits.

We recorded a net loss of $1,639,000 in the second quarter of fiscal 2008 as compared to a net loss of $1,870,000 in the second quarter of fiscal 2007, a decrease of 12%. Net losses for the six months ending June 30, 2008 were $5,088,000 compared to losses of $4,476,000 for the first six months of 2007, an increase of 14%.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents

At June 30, 2008, our cash and cash equivalents were $12,249,000 as compared to $8,412,000 at December 31, 2007, a net cash increase of $3,837,000 during the first six months of 2008. This compares to a net cash increase of $1,269,000 for the same period in 2007.

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On March 14, 2008, we received an additional $9,335,000 in equity financing, net of expenses. The investment was made by several current Energy Focus shareholders, including four members of our Board of Directors. These investors agreed to an at-market purchase of approximately 3.1 million units for $3.205 per unit, based on the closing bid price of Energy Focus common shares on March 13, 2008 of $3.08. Each unit comprised one share of our common stock, par value $0.0001 per share, and one warrant to purchase one share of our common stock at an exercise price of $3.08 per share. The warrants were immediately separable from the units, immediately exercisable, and will expire March 14, 2013. This additional financing is being used to fund working capital requirements and perform additional research and development. The company received 100% of the funds from escrow on March 17, 2008. Among the investors were Ronald A. Casentini, John M. Davenport, John B. Stuppin and Philip Wolfson, all of whom were members of our Board of Directors at the time, and who invested approximately $100,000 in the aggregate.

Cash used in Operating Activities

Operating activities primarily consist 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 the six month ended June 30, 2008 by a net loss of $5,088,000, compared to a net loss of $4,476,000 for the comparable period in 2007. Net cash used by operating activities was $4,058,000 for the six months ended June 30, 2008, as compared to $4,085,000 in six months ended June 30, 2007.

Cash provided by (used in) Investing Activities

Investing activities used cash of $298,000 during the first six months of 2008, compared providing cash of $5,277,000 for the same period of 2007. During both periods, cash was used for the acquisition of fixed assets. The sale of short-term securities in 2007 provided cash to fund fixed asset purchases and operations.

Cash provided by (used in) Financing Activities

Financing activities contributed $8,262,000 to cash during the first six months of 2008. This net contribution was due primarily to cash proceeds from issuances of common stock and warrants to purchase common stock for $9,335,000, proceeds of credit line borrowings of $1,968,000, and the exercise of warrants and employee stock options for $130,000. For the same period in 2007, financing activities from the exercise of warrants and employee stock options were $385,000. $3,171,000 of cash was used to pay short and long-term borrowings in the six month period ended June 30, 2008, compared to $418,000 during the same period in 2007.

Our bank line of credit in the United States is based on an agreement with Silicon Valley Bank dated August 15, 2005. It was amended recently on January 29, 2008, March 14, 2008, April 30, 2008, and again on July 25, 2008. This most recent amendment has extended the credit agreement through September 15, 2008. We will use this extension to evaluate our cash reserves and determine a future course of action in regards to payment of our Silicon Valley Bank obligation. The total credit facility is for $5,000,000 and incorporates both a revolving line of credit and term loan component. The interest rate was 7.00% at June 30, 2008, and 7.75% at December 31, 2007. The rate is the same for both the term loan and line of credit in both periods. 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 we are required to comply with certain covenants with respect to effective net worth and financial ratios. As of June 30, 2008, we were in compliance with all covenant requirements. We had borrowings under the revolving line of credit of $160,000 at June 30, 2008, and $973,000 at December 31, 2007. The revolving line of credit is recorded as a current liability. We had total borrowings of $1,314,000 under the term loan portion of the agreement as of June 30, 2008, and $1,672,000 at December 31, 2007, which, according to the most recent amendment, has been classified as a current liability. We pay an unused line fee of 0.25% against any unused daily balance during the year.

Through our U.K. subsidiary, we maintain a bank overdraft facility of $498,000 (in U.K. pounds sterling, based on the exchange rate at June 30, 2008) under an agreement with Lloyds Bank Plc. There were no borrowings against this facility as of June 30, 2008, or December 31, 2007. The facility is renewed annually on January 1. The rate on the facility was 7.50% at June 30, 2008, and 7.75% at December 31, 2007.

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Through our German subsidiary, we maintain a credit facility under an agreement with Sparkasse Neumarkt Bank. This credit facility was put in place to finance the building of new offices in Berching, Germany, which are owned and occupied by our German subsidiary. As of June 30, 2008, we had borrowings of $368,000 (in Euros, based on the exchange rate at June 30, 2008) and $368,000 as of December 31, 2007 (in Euros, based on the exchange rate at December 31, 2007) against this credit facility. The interest rate was 5.49% at June 30, 2008, and 5.49% as of December 31, 2007. In addition, our German subsidiary has a revolving line of credit for $236,000 (in Euros, based on the exchange rate at June 30, 2008) with Sparkasse Neumarkt Bank. As of June 30, 2008, there were borrowings against this facility of $168,000 (in Euros, based on the exchange rate at June 30, 2008), compared to $186,000 at December 31, 2007 (in Euros, based on the exchange rate at December 31, 2007). The revolving facility is renewed annually on January 1. Interest rates on this line of credit were 10.75% at June 30, 2008, and 10.75% at December 31, 2007. The $168,000 revolving line of credit is a current liability.

We believe that our existing cash balances and funds available to us through our bank lines of credit together with funds that we anticipate to generate from our operations, will be sufficient to finance our currently anticipated working capital requirements and capital expenditure requirements for the next twelve months.  However, a sudden increase in product demand requiring a significant increase in manufacturing capability, or unforeseen adverse competitive, economic or other factors may impact our cash position, and thereby affect operations.  From time to time, we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements.  There can be no assurance that such funding, if needed, will be available on terms acceptable to us, or at all.  Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require that we relinquish rights to certain of our technologies or products.  Failure to generate sufficient revenues or to raise capital when needed could have a diverse impact on our business, operating results, and financial condition, as well as our ability to achieve intended business objectives.

CRITICAL ACCOUNTING POLICIES

The preparation of our 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 which we believe have the most significant impact on our financial statements include allowances for doubtful accounts, returns, warranties, valuation of inventories, and stock based compensation. For the detailed discussion of the application of policies critical to our business operations, see our Annual Report on Form 10-K for the year ended December 31, 2007.

RECENT ACCOUNTING PRONOUNCEMENTS

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. The adoption for financial assets did not have a material effect. Management is evaluating the potential effect that this guidance may have on our financial position or results of operations as it relates to non-financial assets.

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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). We have elected to not apply this fair value option to any of its existing assets or liabilities. However, we may adopt this guidance for assets or liabilities in the future as permitted under FAS No. 159.

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 us). Management is evaluating the potential effect that this guidance may have our overall financial position or results of operations.

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 the company). Early adoption is prohibited. Management is evaluating the potential effect that this guidance may have on our overall financial position or results of operations.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of June 30, 2008, we had $356,000 in cash held in foreign currencies based on the exchange rates at June 30, 2008. 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 is occasionally transferred in order to repay inter-company debts.

As of June 30, 2008, we had borrowings of $168,000 (in Euros, based on the exchange rate at June 30, 2008) against a credit facility secured by real property owned by our German subsidiary. As of December 31, 2007, we had $186,000 (in Euros, based on the exchange rate at December 31, 2007) borrowed against this credit facility.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.

 

We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management has recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet, and management believes they meet, reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily has been required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. Any design of disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

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Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures have been effective to ensure that material information relating to us, including our consolidated subsidiaries, has been made known to them by others within those entities.

(b)

Changes in internal control over financial reporting.

There were no known changes within our financial reporting internal control environment (as defined in Rule 13a-15(f) under the Exchange Act) identified during the second quarter which materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

From time to time, we become involved in ordinary routine litigation incidental to our business. Currently, we are not involved in any material litigation, and we do not anticipate becoming involved in any in the foreseeable future.

Item 1A. Risk Factors

There are no significant changes in risk factors from our Annual Report Form 10-K for the year ended December 31, 2007.

Item 6. Exhibits

 

Exhibit Number		Description of Documents
31.1		Rule 13a-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a) Certification of Chief Financial Officer.
32.1		Statement of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350).
32.2		Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350).

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		ENERGY FOCUS, INC.
Date: July 31, 2008	By:	/s/ Joseph G. Kaveski
		Joseph G. Kaveski
		Chief Executive Officer
	By:	/s/ Nicholas G. Berchtold
		Nicholas G. Berchtold
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

 

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Exhibit Index

Exhibit Number		Description of Documents
31.1		Rule 13a-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a) Certification of Chief Financial Officer.
32.1		Statement of Chief Executive Officer under Section 906 of the Sarbanes Oxley Act of 2002 (18 U.S.C. §1350).
32.2		Statement of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350).

 

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