UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended March 31, 2006
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from _____________ to ___________.
Commission File Number: 000-50542
HYDROGEN ENGINE CENTER, INC.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
NEVADA 82-0497807
(State or other jurisdiction (IRS Employer
of incorporation) Identification No.)
602 East Fair Street, Algona, Iowa 50511
(Address of principal executive offices)
Registrant's telephone number, including area code: (515) 295-3178
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the Registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 25,162,905 shares of Common Stock,
par value $.001 outstanding at April 21, 2006.
FORM 10-QSB
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited) . . . . . . . . . . . . . . . . . . . 3
Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005. . . . . . . . . 3
Consolidated Statements of Operations for the Three Months Ended
March 31, 2006 and 2005 and the period from inception (May 19, 2003)
through March 31, 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Consolidated Statements of Stockholders' Equity (Deficit) for the period
from inception (May 19, 2003) through March 31, 2006. . . . . . . . . . . . . . . . . . 6
Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2006 and 2005 and the period from inception (May 19, 2003)
through March 31, 2006. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . . . . . . . . 10
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Item 3. Quantitative and Qualitative Disclosure About Market Risk . . . . . . . . . . . . . 32
Item 4. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
PART II. OTHER INFORMATION
Item 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds . . . . . . . . . . . . 44
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . . . . . . . . . . 45
Notes About Forward-looking Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Signatures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
-2-
ITEM 1. FINANCIAL INFORMATION
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Balance Sheets
March 31, December 31,
ASSETS 2006 2005
---------- ----------
(Unaudited)
Current Assets
Cash and cash equivalents $ 969,506 $2,346,248
Accounts receivable 82,102 3,200
Related party receivable -- 26,257
Other receivables -- 103,695
Inventories 384,353 206,091
Prepaid expenses 166,108 77,723
---------- ----------
Total current assets 1,602,069 2,763,214
Property, Plant and Equipment
Land 196,124 196,124
Building 282,901 282,901
Equipment 452,998 280,780
Leasehold improvements 17,156 16,023
Construction in progress 1,606,417 1,322,798
---------- ----------
2,555,596 2,098,626
Less accumulated depreciation 58,395 39,818
---------- ----------
Net property and equipment 2,497,201 2,058,808
---------- ----------
Total Assets $4,099,270 $4,822,022
========== ==========
See accompanying notes.
-3-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Balance Sheets
March 31, December 31,
LIABILITIES AND EQUITY 2006 2005
---------- ----------
(Unaudited)
Current Liabilities
Current portion long-term debt $ 48,967 $ 24,984
Note payable, bank 262,647 262,647
Accounts payable 349,014 236,341
Accrued expenses 92,904 69,768
Construction payable 22,649 232,208
Deferred revenue 51,408 --
----------- -----------
Total current liabilities 827,589 825,948
Long-term debt, net of current maturities 805,334 791,541
Commitments and Contingencies
Stockholders' Equity
Preferred stock, $0.001 par value; 10,000,000 shares
authorized, none issued -- --
Common stock, $0.001 par value; 100,000,000 shares authorized,
25,162,905 shares issued and outstanding 25,163 25,158
Additional paid-in capital 5,443,461 4,837,602
Unearned stock-based compensation (700,914) (275,332)
Accumulated other comprehensive income - foreign currency (2,218) (2,207)
Deficit accumulated during the development stage (2,299,145) (1,380,688)
----------- -----------
Total stockholders' equity 2,466,347 3,204,533
----------- -----------
Total Liabilities and Stockholders' Equity $ 4,099,270 $ 4,822,022
=========== ===========
See accompanying notes.
-4-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Statements of Operations
(Unaudited)
Three months ended From
March 31, Inception
---------------------------- May 19, 2003)
2006 2005 to March 31, 2006
------------ ------------ ------------
Sales $ 28,590 $ 12,000 $ 72,150
Cost of Sales 15,676 4,761 39,220
------------ ------------ ------------
Gross Profit 12,914 7,239 32,930
------------ ------------ ------------
Operating Expenses
Sales and marketing 240,288 -- 361,862
General and administrative 607,969 39,550 1,411,472
Research and development 83,652 9,713 537,364
------------ ------------ ------------
931,909 49,263 2,310,698
------------ ------------ ------------
Operating Loss (918,995) (42,024) (2,277,768)
Other Income (Expense)
Interest income 13,498 -- 45,521
Interest expense (12,960) (4,566) (66,898)
------------ ------------ ------------
538 (4,566) (21,377)
------------ ------------ ------------
Net Loss $ (918,457) $ (46,590) $ (2,299,145)
============ ============ ============
Weighted-average shares outstanding 24,858,905 16,297,200
============ ============
Basic and diluted net loss per share $ (0.04) $ (0.00)
============ ============
See accompanying notes.
-5-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Statements of Stockholders' Equity (Deficit)
Deficit
Accumulated Accum.
Common Common Additional Unearned Other Com- During the
Stock Stock Paid-in Stock-Based prehensive Development
Shares Amount Capital Compensation Loss Stage Total
----------- ----------- ----------- ----------- ----------- ----------- -----------
Issuance of common stock to founder in
exch. for equip. & expenses incurred 2,000,000 $ 2,000 $ 98,165 $ -- $ -- $ -- $ 100,165
Net loss -- -- -- -- -- (65,642) (65,642)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance at December 31, 2003 2,000,000 2,000 98,165 -- -- (65,642) 34,523
Company-related expenses paid by
founder -- -- 39,187 -- -- -- 39,187
Net loss
-- -- -- -- -- (192,476) (192,476)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance at December 31, 2004 2,000,000 2,000 137,352 -- -- (258,118) (118,766)
Company-related expenses paid by
founder -- -- 12,135 -- -- -- 12,135
Exchange of previous shares by sole
shareholder of HEC Iowa (2,000,000) -- -- -- -- -- --
Shares in Green Mt. Labs acquired in
reverse merger 1,006,000 1,006 (1,006) -- -- -- --
Stock split of 3.8 to 1 prior to the 2,816,804 2,817 (2,817) -- -- -- --
Issuance of common stock to sole
shareholder of HEC Iowa 16,297,200 14,297 (14,297) -- -- -- --
Issuance of restricted common stock to
employees & directors 426,000 426 425,574 (275,332) -- -- 150,668
Issuance of common stock in connection
with the private placement, net of
expenses 3,948,500 3,949 3,590,940 -- -- -- 3,594,889
Issuance of common stock in connection
with conversion of debt
663,401 663 556,388 -- -- -- 557,051
Consultants compensation associated
with stock options
-- -- 133,333 -- -- -- 133,333
-----------
4.329,310
-----------
Comprehensive Loss
Foreign currency translation
-- -- -- -- (2,207) -- (2,207)
Net loss -- -- -- -- -- (1,122,570) (1,122,570)
----------
Total comprehensive loss (1,124,777)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance at December 31, 2005 25,157,905 25,158 4,837,602 (275,332) (2,207) (1,380,688) 3,204,533
- Continued -
See accompanying notes.
-6-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Statements of Stockholders' Equity (Deficit)
-Continued-
Deficit
Accumulated Accum.
Common Common Additional Unearned Other During the
Stock Stock Paid-in Stock-Based Comprehensive Development
Shares Amount Capital Compensation Loss Stage Total
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance at December 31, 2005 25,157,905 $ 25,158 $ 4,837,602 $ (275,332) $ (2,207) $(1,380,688) $ 3,204,533
Compensation expense related to stock
options since inception
-- -- 579,197 (579,197) -- -- --
Compensation associated with issuance
of restricted stock to employees and
directors -- -- -- 21,500 -- -- 21,500
Employee compensation associated with
stock options
-- -- -- 132,115 -- -- 132,115
Consultant compensation associated
with stock options
-- -- 21,667 -- -- -- 21,667
Issuance of stock related to option
exercises 5,000 5 4,995 -- -- -- 5,000
-- -- -- -- -- -- 3,394,815
Comprehensive Loss
Foreign currency translation -- -- -- -- (11) -- (11)
Net loss -- -- -- -- -- (918,457) (918,457)
----------
Total comprehensive loss (918,468)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Balance at March 31, 2006 (Unaudited) 25,162,905 $ 25,163 $ 5,443,461 $ (700,914) (2,218) (2,299,145) $2,466,347
=========== =========== =========== =========== =========== =========== ============
See accompanying notes.
-7-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Statements of Cash Flows
(Unaudited)
Three months
ended March 31, From Inception
-------------------------- (May 19, 2003)
2006 2005 to March 31, 2006
----------- ----------- -----------
Cash Flows from Operating Activities
Net loss $ (918,457) $ (46,590) $(2,299,145)
Adjustments to reconcile net loss to net cash
used in operations:
Depreciation 18,577 4,182 58,395
Compensation to directors and employees from
restricted stock 21,500 -- 172,168
Compensation to directors and employees from stock
options 132,115 -- 132,115
Compensation to consultants from stock options 21,667 -- 155,000
Change in assets and liabilities:
Accounts receivable (78,902) -- (82,102)
Related party receivables 26,257 -- --
Other receivables 3,695 -- --
Inventories (178,262) (8,114) (384,353)
Prepaid expenses (88,385) -- (166,108)
Accounts payable 112,673 6,468 452,650
Accrued expenses 23,136 4,484 92,904
Deferred revenue 51,408 -- 51,408
----------- ----------- -----------
Net cash used in operating activities (852,978) (39,570) (1,817,068)
Cash Flows from Investing Activities
Purchases of property, plant and equipment (131,997) -- (380,803)
Payments for construction in process (483,431) -- (1,574,021)
----------- ----------- -----------
Net cash used in investing activities (615,428) -- (1,954,824)
Cash Flows from Financing Activities
Proceeds from note payable, bank -- -- 650,000
Payments on note payable, bank -- -- (650,000)
Proceeds from long-term debt 100,000 30,000 1,172,052
Payments on long-term debt (13,325) -- (28,325)
Proceeds from exercise of stock options 5,000 -- 5,000
Issuance of common stock in private placement -- -- 3,948,500
Payments of expense in connection with private -- -- (353,611)
placement
----------- ----------- -----------
Net cash provided by financing activities 91,675 30,000 4,743,616
----------- ----------- -----------
Net Increase (Decrease) in Cash and Cash Equivalents (1,376,731) (9,570) 971,724
Effect of Exchange Rates on Cash and Cash Equivalents (11) -- (2,218)
Cash and Cash Equivalents - Beginning of Period 2,346,248 19,808 --
----------- ----------- -----------
Cash and Cash Equivalents - End of Period $ 969,506 $ 10,238 $ 969,506
=========== =========== ===========
- Continued -
See accompanying notes.
-8-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Consolidated Statements of Cash Flows
(Unaudited)
-Continued-
Three months ended March 31, From Inception
--------------------------------- (May 19, 2003)
2006 2005 to March 31, 2006
---------------- -------------- ------------
Supplemental Cash Flow Information
Interest paid $ 6,835 $ 4,566 $ 44,782
================ ============== ============
Supplemental Disclosure of Non-cash
Investing and Financing Activities
Additional paid-in capital contribution
for expenses paid by founder $ -- $ 5,263 $ 103,636
================ ============== ============
Issuance of common stock for equipment $ -- $ -- $ 47,851
================ ============== ============
Issuance of common stock for conversion
of debt $ -- $ -- $ 557,051
================ ============== ============
Acquisition of property, plant and
equipment through financing $ 51,101 $ -- $ 530,272
================ ============== ============
Payables for construction in progress $ 22,649 $ -- $ 254,857
================ ============== ============
Receivable for state loan $ -- $ -- $ 100,000
================ ============== ============
See accompanying notes.
-9-
HYDROGEN ENGINE CENTER, INC. AND SUBSIDIARIES
(a corporation in the development stage)
Notes to Consolidated Financial Statements
March 31, 2006
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Overview of Companies
- ---------------------
Hydrogen Engine Center, Inc., formerly known as Green Mountain Labs, Inc.
("Green Mt. Labs"), is a Nevada corporation. Green Mt. Labs was a
public-reporting shell company and, in connection with the Transactions
described below, changed its name to Hydrogen Engine Center, Inc. (the
"Company"). Also, as a result of the Transactions described below, the Company's
operations are those of its wholly owned subsidiaries, Hydrogen Engine Center,
Inc., an Iowa corporation ("HEC Iowa"), and Hydrogen Engine Center (HEC) Canada
Inc. ("HEC Canada").
HEC Iowa was incorporated on May 19, 2003 ("inception date") for the ultimate
purpose of commercializing internal combustion industrial engines. HEC Iowa's
operations are located in Algona, Iowa.
HEC Canada was incorporated as a Canadian corporation on August 25, 2005, with
the goal of establishing a research and development center to assist in the
development of alternative fuel and hydrogen engines. HEC Canada is located in
Quebec, Canada and works with Universite Du Quebec a Trois-Rivieras.
Green Mt. Labs was originally organized to acquire and develop mining claims;
however, these operations were discontinued in 1997.
Description of Business - A Corporation in the Development Stage
- ----------------------------------------------------------------
The Company is a manufacturer of engines and generators for use in the
industrial and power generation markets. These engines are designed to run on
alternative fuels including but not limited to gasoline, propane, natural gas,
ethanol and hydrogen. The engines and engine products are sold under the brand
name Oxx Power TM. Through March 31, 2006, the Company remains in the
development stage. This stage is characterized by minimal revenues with efforts
focused on fund raising and significant expenditures for the design and
development of the Company's products and manufacturing processes, and for the
construction of the Company's new facilities.
The Company has established a distribution system to sell its products. The
distribution system for the Company's engines is comprised of eight US
distributors and two Canadian distributors. Distributed generation systems are
sold direct.
-10-
Merger and Private Placement (the "Transactions")
- -------------------------------------------------
On August 30, 2005, Green Mt. Labs completed the acquisition of HEC Iowa. The
acquisition was made pursuant to an agreement and plan of merger entered into on
June 3, 2005, and revised on July 6, 2005 and July 29, 2005 (the "Merger
Agreement"). To accomplish the acquisition, Green Mt. Labs merged its newly
created, wholly-owned subsidiary, Green Mt. Acquisitions, Inc., with and into
HEC Iowa, with HEC Iowa being the surviving entity. As part of the acquisition,
Green Mt. Labs completed a 3.8 share to 1 share stock split which increased
outstanding shares of common stock from 1,006,000 to 3,822,804. Also under the
terms of the Merger Agreement, the Company issued 16,297,200 shares of
post-split common stock (representing 81% of the total outstanding shares
immediately following the transaction) to Theodore G. Hollinger, who was the
sole stockholder of HEC Iowa, in exchange for 100% of HEC Iowa's outstanding
capital stock (2,000,000 shares). As stated above, in connection with the
Transactions, Green Mt. Labs changed it name to Hydrogen Engine Center, Inc.
The Transactions have been accounted for as a recapitalization, which is
accounted for similar to the issuance of stock by HEC Iowa for the net assets of
Green Mt. Labs with no goodwill or other intangibles being recorded.
On October 11, 2005, the Company closed a private placement of the common stock.
The Company sold 3,948,500 shares of common stock, $.001 par value, for a total
of $3,948,500. Costs related to this offering amounted to $353,611. The Company
sold the shares in a private transaction at $1.00 per share, and the Company
relied on an exemption from registration pursuant to Regulation D, Rules
Governing the Limited Offer and Sale of Securities without Registration under
the Securities Act of 1933.
Principles of Consolidation
- ---------------------------
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries, HEC Iowa and HEC Canada. All intercompany
balances and transactions have been eliminated in consolidation.
Going Concern
- -------------
The financial statements have been prepared on the basis of accounting
principles applicable to a going concern. As a result, they do not include
adjustments that would be necessary if the Company was unable to continue as a
going concern and was therefore obligated to realize assets and discharge its
liabilities other than in the normal course of operations.
Since inception, the Company has incurred substantial operating losses and
expects to incur additional operating losses into the foreseeable future. The
Company has financed operations since inception, primarily through equity and
debt financings. At March 31, 2006, the Company has reported accumulated losses
of $2,299,145 and has cash and cash equivalents available to fund future losses
and developments of $969,506. The Company anticipates its expenses will
significantly increase as it commences operations in its new manufacturing
facility, including additional personnel, product development, inventory
-11-
purchases, and additional construction costs. Based on current projections,
existing capital will fund the Company's operations through June 2006. This
timeframe may be shorter if events occur which negatively effect the Company's
operations.
Continuing operations is dependent upon obtaining significant further financing.
Although the Company plans to offer its common stock or debt securities for sale
in 2006, there can be no assurance that the Company will successfully complete
an offering or that these proceeds, if completed, will be sufficient to satisfy
capital requirements. Also, there are no assurances that additional funding will
be available at terms acceptable to the Company. These conditions raise
substantial doubt about the ability to continue as a going concern.
Sales of the Company's products through March 31, 2006 have amounted to $72,150
and consisted of customized engines and parts. The Company is in the process of
completing Phase 1 of its manufacturing facility. Completion of this facility is
needed before production begins. The manufacturing facility is substantially
complete; however, the Company expects that the dyno room will not be complete
until June 2006. Even if the Company is able to manufacture its products, there
are no assurances they will be accepted by the market place. Also, the Company
estimates it may cost approximately $1 million per engine type to certify its
engines to meet certain laws and regulations. Currently, there are three engines
the Company plans to certify.
As the Company continues to ramp up its operations, it has entered into
significant commitments as described in Notes 3 and 13. The Company has entered
into several research and development arrangements with other organizations.
Each research and development agreement requires the Company to incur upfront
costs prior to receiving reimbursements from the other organizations.
Foreign Currency Translation
- ----------------------------
Results of operations and cash flows of foreign subsidiaries are translated to
U.S. dollars at average period currency exchange rates. Assets and liabilities
are translated at end-of-period exchange rates. Foreign currency translation
adjustments related to foreign subsidiaries using the local currency as their
functional currency are included in Other comprehensive income (loss).
Cash and Cash Equivalents
- -------------------------
The Company considers highly-liquid investments with a original maturity of
ninety days or less to be cash equivalents. The Company maintains its cash
balances in three institutions. At times throughout the year, the Company's cash
and cash equivalents balances may exceed amounts insured by the Federal Deposit
Insurance Corporation. The Company believes it is not exposed to any significant
credit risk on cash and cash equivalents.
Accounts Receivable
- -------------------
Accounts receivable are recorded at their estimated net realizable value. The
Company plans to follow a policy of providing an allowance for doubtful
accounts. However, based on the evaluation of receivables at March 31, 2006 and
-12-
December 31, 2005, the Company believes that such accounts will be collectible
and thus, an allowance is not necessary. Accounts are considered past due if
payment is not made on a timely basis in accordance with the Company's credit
policy. Accounts considered uncollectible are written off. Credit terms are
extended to customers in the normal course of business. The Company performs
ongoing credit evaluations of its customers' financial condition and, generally,
requires no collateral.
Inventories
- -----------
Inventories consist mainly of parts, finished engines and gensets that are
stated at the lower of cost (determined by the first-in, first-out method) or
market value.
Property, Plant and Equipment
- -----------------------------
Property, plant and equipment are recorded at cost. Once assets are placed in
service, depreciation is provided over estimated useful lives by use of the
straight-line method. Leasehold improvements are depreciated over the life of
the lease (Note 6). Depreciation expense was $18,577 and $4,182 for the three
months ended March 31, 2006 and 2005, respectively, and $58,395 from inception
(May 19, 2003) to March 31, 2006. Maintenance and repairs are expensed as
incurred; major improvements and betterments are capitalized.
Long-Lived Assets
- -----------------
The Company reviews its property, plant, and equipment for indicators of
impairment when events or changes in circumstances indicate that the carrying
value may not be recoverable. Cash flows expected to be generated by the related
assets are estimated over the asset's useful life based on updated projections.
If the evaluation indicates that the carrying amount of the asset may not be
recoverable, the potential impairment is measured based on a projected
discounted cash flow model. If an impairment loss exists, the amount of the loss
will be recorded in the consolidated statements of income. The Company has not
incurred any impairment losses.
Revenue Recognition
- -------------------
Revenue from the sale of the Company's products is recognized at the time title
and risk of ownership transfer to customers. This generally occurs upon shipment
to the customer or when the customer picks up the goods.
Sales and Marketing Costs
- -------------------------
Sales and marketing expenses include payroll, employee benefits, stock-based
compensation, and other costs associated with sales and marketing personnel and
advertising, promotions, tradeshows, seminars, and other marketing-related
programs. Sales and marketing expenses for the three months ended March 31, 2006
were $240,288. There were no sales and marketing expenses for the three months
ended March 31, 2005. There has been a total of $361,862 in sales and marketing
costs for the period from inception (May 19, 2003) to March 31, 2006. The
Company expenses advertising costs as they are incurred.
-13-
Research and Development Costs
- ------------------------------
The Company's research and development expenses include payroll, employee
benefits, stock-based compensation, and other costs associated with product
development. The Company has determined that technological feasibility for the
engines is reached shortly before the products are released to manufacturing.
Research and development costs were $83,652 and $9,713 for the three months
ended March 31, 2006 and 2005, respectively, and $537,364 from inception (May
19, 2003) to March 31, 2006.
Income Taxes
- ------------
The Company recognizes deferred taxes by the asset and liability method. Under
this method, deferred income taxes are recognized for differences between the
financial statement and tax bases of assets and liabilities at enacted statutory
tax rates in effect for the years in which the differences are expected to
reverse. The effect on deferred taxes of a change in tax rates is recognized in
income in the period that includes the enactment date. In addition, valuation
allowances are established, when necessary, to reduce deferred tax assets to the
amounts expected to be realized. The primary sources of temporary differences
are depreciation and net operating loss carryforwards.
Net Loss Per Share
- ------------------
The Company computes net loss per share under the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" ("SFAS
128"), and Securities and Exchange Commission Staff Accounting Bulletin No. 98
("SAB 98").
Under the provisions of SFAS 128 and SAB 98, basic loss per share is computed by
dividing the Company's net loss for the period by the weighted-average number of
shares of common stock outstanding during the period. Diluted net loss per share
excludes potential common shares since the effect is anti-dilutive.
The Company assumed the effects of the recapitalization, described in Note 1,
were effective at the beginning of the earliest reporting period when
calculating weighted-average shares outstanding.
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 amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expenses during
the reporting periods. Actual results could differ from those estimates.
-14-
Fair Value of Financial Instruments
- -----------------------------------
The carrying amounts reported in the balance sheet for cash and cash
equivalents, accounts receivable, accounts payable and accrued expenses
approximate their fair value due to the short-term nature of these instruments.
Stock-Based Compensation
- ------------------------
On January 1, 2006, the Company adopted the fair value recognition provisions of
Statement of Financial Accounting Standards (SFAS) No. 123(R). As prescribed in
SFAS No. 123(R), "Share-Based Payment," the Company elected to use the "modified
prospective method." The modified prospective method requires expense to be
recognized for all awards granted, modified or settled in the year of adoption.
Historically, the Company applied the intrinsic method as provided in Accounting
Principles Board {"APB") Opinion ("APB No.25"), Accounting for Stock Issued to
Employees, and related interpretations and accordingly, no compensation cost had
been recognized for stock options issued to employees in the prior year. In
March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107")
providing supplemental implementation guidance for SFAS 123(R). The Company has
applied the provisions of SAB 107 in its adoption of SFAS 123(R). As a result of
adopting the fair value method for stock compensation, all future awards will be
expensed over the stock options vesting period. The Company utilized the
Black-Scholes option pricing model to estimate the fair value of options.
The Company has determined, based on the Black-Scholes option pricing formula,
the weighted-average fair value of stock options granted at March 31, 2006 was
$5.24 per share, using a risk-free interest rate of 4.37% - 4.55%, expected life
of 5.5 years, 1.5% forfeiture rate, zero expected dividends and estimated
volatility of 112%.
The volatility calculation of 112 % is based on the 365-day average volatility
of a representative sample of eight (8) comparable companies in the alternative
fuel technology and services niches with market capitalizations between $45
million and $1.5 billion ("Representative Sample"), in addition to the Company's
actual history over an eight-month period. Because the Company has only a short
trading history, the Company has been required to estimate the potential
volatility of its common stock price. The Company has referred to the 365-day
volatility of the Representative Sample because management believes that the
volatility of these companies, along with the Company's history, is a reasonable
benchmark to use in estimating the expected volatility for the Company's common
stock.
Prior to the adoption of SFAS 123(R), the Company accounted for stock-based
awards to employees and directors using the intrinsic value method in accordance
with APB No. 25 as allowed under SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). As permitted by SFAS No. 123, the Company has
elected to follow APB No. 25 and related interpretations for its employee
stock-based compensation. Under APB No. 25, no compensation expense is
recognized at the time of option grant if the exercise price of the employee
stock option is fixed and equals or exceeds the fair value of the underlying
common stock on the date of grant and the number of shares to be issued pursuant
to the exercise of such option are known and fixed at the date of grant. The
Board of Directors determines the fair value of common stock.
-15-
The Company accounts for options issued to non-employees under SFAS No. 123 and
Emerging Issues Task Force Issue ("EITF") No. 96-18, "Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods, or Services." Therefore, the fair value of
options issued to non-employees is recorded as an expense and periodically
remeasured over the vesting terms.
The Company records restricted stock awards at the fair value as of the date of
grant and amortizes the expense over the vesting period as services are
performed.
The following table illustrates the effect on net loss as if the Company had
applied the fair value recognition provisions for stock-based employee
compensation of SFAS No. 123, as amended by SFAS No. 148, Accounting for
Stock-Based Compensation -- Transition and Disclosure.
Period from Inception
(May 19, 2003) to
March 31, 2006
Net loss, as reported $ (2,299,145)
Deduct: stock-based employee
compensation expense determined
under fair value based method (185,802)
--------------
Pro forma net loss $ (2,484,947)
==============
For purposes of pro forma disclosures, the estimated fair value of the options
granted is amortized to expense over the option vesting periods as services are
performed.
See Note 12 for further discussion of stock-based compensation.
Warrants
- --------
As described in Note 11, the Company has granted warrants to certain finders in
the private placement, entitling the finders to purchase 69,640 shares at $1.00
per share. Based on EITF 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settle in, a Company's Own Stock," the sale of the
warrants was reported in permanent equity and accordingly, there is no impact on
the Company's financial position and results of operation. Subsequent changes in
fair value will not be recognized as long as the warrants continue to be
classified as an equity instrument.
-16-
Recent Accounting Pronouncements
- --------------------------------
In November 2004, the FASB issued SFAS 151, "Inventory Costs." The Statement
requires that abnormal amounts of idle facility expense, freight, handling
costs, wasted materials and overhead expense be recognized as period costs. The
primary basis of accounting for inventory is cost. This Statement standardizes
the amount of idle facility expense that could be classified as inventory and
requires these expenses be recognized as period costs. The Company has
implemented SFAS 151 as of January 1, 2006. There was no effect on the financial
statements.
2. INVENTORY
Inventories are stated at the lower of cost or market value. Cost is determined
by the first-in, first-out method:
March 31, December 31,
2006 2005
------------ ------------
Component parts $ 285,899 $ 109,351
Work in process 20,984 12,302
Finished goods 77,470 84,438
------------ ------------
Total $ 384,353 $ 206,091
============ ============
3. CONSTRUCTION IN PROGRESS
The Company has incurred construction costs related to construction of a 30,000
square foot manufacturing facility of $1,495,832 at March 31, 2006, $1,473,184
of which had been paid, with an additional $22,648 in construction payable. The
Company had also incurred costs of $110,585 at March 31, 2006 for construction
improvements on another 30,000 square foot distribution/power generator facility
located adjacent to the manufacturing facility.
At May 15, 2006 the Company had incurred additional costs of $5,434 for the
manufacturing building and $202,780 for the distribution/power generator
building. The Company anticipates there will be approximately $30,000 in
additional costs for a fire alarm system and an exhaust system in the dyno room
of the manufacturing facility. The Company also estimates additional costs of
approximately $250,000 for improvements on the distribution/power generator
facility.
4. NOTES PAYABLE, BANK
On December 19, 2005, the Company obtained a short-term note for $500,000 from a
bank, of which $262,647 was used for the purchase of a building located adjacent
to the manufacturing building site. As of May 17, the Company had received
addition proceeds from this note in the amount of $190,314. The balance on this
note on May 15, 2006 is $452,961. The additional available funds are required to
be used for building improvements. Borrowings on this short-term note mature
December 16, 2006 and accrue interest at 5.89% with monthly interest payments
until maturity. The building serves as collateral for this note.
-17-
5. LONG-TERM DEBT
Long-term debt consists of the following:
March 31, December 31,
2006 2005
------------ ------------
Note payable to City of Algona. See (a) $ 190,000 $ 200,000
Note payable to Algona Area Economic Development Corporation. See (b) 146,124 146,124
Note payable to Algona Area Economic Development Corporation. See (c) 67,076 70,401
Notes payable to Iowa Department of Economic Development. See (d) 400,000 400,000
Note payable to finance company. See (e) 51,101 --
------------ ------------
854,301 816,525
Less amounts due within one year 48,967 24,984
------------ ------------
Totals $ 805,334 $ 791,541
============ ============
Future maturities of long-term debt at March 31, 2006 are as follows:
2007 $ 49,314
2008 24,171
2009 24,595
2010 165,639
2011 200,593
Thereafter 341,022
-------------
Total long-term debt $ 805,334
=============
(a) The Company obtained $200,000 from the City of Algona in September
2005. The note requires quarterly payments of $5,000 starting January
1, 2006 with the final payment due October 1, 2015. There is no
interest on this loan provided the Company creates and retains at least
42 new full-time positions for five years. If such requirements are not
met, interest on the loan will be payable at 10% per annum. The Company
is accruing interest on this note until the terms of the note have been
met. The loan is collateralized by land and building.
(b) On June 27, 2005, the Company executed a note payable of $146,124
from the Algona Area Economic Development Corporation in exchange for
land received to be used for the construction of the new facility. The
loan is a ten-year partially forgivable loan with interest at 8%,
conditioned upon the Company achieving performance targets as follows:
-18-
o $67,650 of principal and interest will be forgiven if the Company has
certified that it has created 50 new full-time equivalent jobs by June
1, 2010 and continuously retained those jobs in Algona, Iowa until June
1, 2015.
o $67,650 of principal and interest will be forgiven if the Company has
certified that it has created and continuously retained 50 additional
new full-time equivalent jobs by June 1, 2015.
o Balance of $10,824 due on June 1, 2015 without interest if paid by that
date.
o Payment of a wage for the retained jobs that is equal to or greater
than the average hourly wage for workers in Kossuth County, Iowa as
determined annually by Iowa Workforce Development.
The Company is accruing interest on this note until the terms of the
note have been met. The loan is secured by the real estate.
(c) On December 16, 2005, the Company assumed a no interest note
provided by the Algona Area Economic Development Corporation in the
amount of $117,500 in conjunction with the purchase of land and
building as described in note 4. This note was recorded at the fair
value of future payments using an interest rate of 10% which amounted
to $70,401, resulting in a total purchase price of the land and
building of $332,901. This note is secondary and subordinate to a
short-term note held by a bank (Note 4). The note requires quarterly
payments of $2,500 starting January 1, 2006 with the final payment due
July 1, 2017. The Company plans to use this building for parts
distribution and for distributed power generation manufacturing. The
Company must maintain the building, provide adequate insurance and is
responsible for the payment of property taxes.
(d) On June 28, 2005, the Iowa Department of Economic Development
("IDED") awarded the Company a Physical Infrastructure Assistance
Program ("PIAP") grant in the amount of $150,000. This is a five-year
forgivable loan and proceeds are to be used for the construction and
equipping of the 30,000 square foot manufacturing facility. The Company
received payment of this award in December 2005. Other terms of the
loan include a minimum contribution of $1,543,316 for building
construction, machinery and equipment, and working capital. In
addition, the Company must create 49 full-time equivalent positions,
with 38 positions at a starting wage exceeding $11.76 per hour, and an
average wage for all positions of $24.94 per hour. In order to qualify
for the job count, employees must be Iowa residents. The Company is
required to maintain the minimum employment level through the
thirteenth week after the project completion date. If requirements are
not met, the balance of the forgivable loan determined by IDED as due
and payable will be amortized over three years from the agreement
expiration date of July 31, 2010 at 6% interest per annum with equal
quarterly payments. IDED requires mid-year and end-of-year status
reports to ensure compliance. The Company is accruing interest on this
note until the terms of the note have been met. The note is secured by
a security agreement on its assets.
-19-
Also on June 28, 2005, IDED awarded the Company a Community Economic
Betterment Account ("CEBA") forgivable loan in the amount of $250,000.
This is a three-year forgivable loan and proceeds are to be used for
the construction of the plant. The Company received $150,000 of this
award in December 2005. The balance of the award, $100,000, was
received in January 2006. The terms of this award are the same as the
PIAP award explained in the previous paragraph. At the project
completion date, if the Company has fulfilled at least 50% of its job
creation/retention and wage obligation, $6,579 will be forgiven for
each new full-time equivalent job created and retained and maintained
for at least ninety days past the project completion date. The project
completion date of this award is July 30, 2010. Any balance (shortfall)
will be amortized over a two-year period, beginning at the project
completion date at 6% per annum from the date of the first CEBA
disbursement on the shortfall amount with that amount accrued as of the
project completion date, being due and payable immediately. If the
Company has a current loan balance, the shortfall balance and existing
balance will be combined to reflect a single monthly payment. The
Company is accruing interest on this note until the terms of the note
have been met. The note is secured by a security agreement on its
assets.
(e) On March 20, 2006, the Company acquired manufacturing equipment
through an equipment financing agreement with Wells Fargo Financial
Leasing, Inc. The note requires payments of $2,129 per month for 24
months. The equipment serves as collateral for the note.
6. OPERATING LEASES
The Company leases a building which is used for production, storage and office
space. The Company is responsible for insurance and repairs. This lease requires
monthly rental payments of $600 and expires on May 30, 2006. The Company has
extended this lease for an additional year. The lease will require monthly
payments of $650 per month from June 1, 2006 through May 31, 2007. The Company
has the option to extend the lease an additional year to May 31, 2008 for $700
per month. Rent expense under this lease was $1,800 for the three months ending
March 31, 2006 and 2005, and $21,000 for the period from inception (May 19,
2003) to March 31, 2006, respectively.
The following is a schedule of future non-cancelable lease obligations for the
building at March 31:
2007 $ 7,700
2008 8,300
2009 1,400
-----------
$ 17,400
-20-
7. RELATED PARTY TRANSACTIONS
One of the members of the Company's Board of Directors is the manager of an
engine parts distributor from which the Company purchases engine parts.
Purchases from this company totaled $17,685 and $4,589 for the three months
ending March 31, 2006 and 2005, respectively and $53,319 for the period from
inception (May 19, 2003) to March 31, 2006. The Company also has a payable of
$10,736 from this company at March 31, 2006.
Another member of the Board of Directors was a senior partner in a parts
distribution company prior to his employment with HEC. The Company has made
purchases from this company of $19,394 and $2,715 for the three months ended
March 31, 2006 and 2005, respectively and $93,185 for the period from inception
(May 19, 2003) to March 31, 2006. As of March 31, 2006 $80,205 was payable to
this parts company.
8. INCOME TAXES
The tax effects of significant items comprising the Company's net deferred tax
asset and the related valuation allowance as of March 31, 2006 and December 31,
2005 are as follows:
March 31, December 31,
2006 2005
------------- -------------
Deferred tax assets:
Net operating loss carryforward $ 840,000 $ 480,000
Other -- --
------------- -------------
840,000 480,000
Valuation allowance (840,000) (480,000)
------------- -------------
Net deferred tax asset recognized $ -- $ --
============= =============
Due to the Company's operating loss and lack of operating experience, a
valuation allowance was provided for the Company's net deferred tax assets at
March 31, 2006 and December 31, 2005.
As of March 31, 2006, the Company has net operating loss and research and
development carryforwards for federal and state income tax purposes of
approximately $2,050,000, which will begin to expire in 2018. The amount and
availability of the net operating loss carryforwards may be subject to annual
limitations set forth by the Internal Revenue Code.
The effective tax rate differs from the statutory rate of 34% primarily due to
certain stock-based compensation and merger-related costs not being deductible
for tax purposes and the increase in the deferred tax asset valuation allowance.
9. PREFERRED STOCK
The Company is authorized to issue 10,000,000 shares of preferred stock with
such designations, voting and other rights and preferences, as may be determined
from time to time by the Board of Directors.
-21-
10. COMMON STOCK
On September 1, 2005, the Company issued 426,000 shares of restricted stock to
directors and employees. 122,000 shares vested immediately, 86,000 shares vest
September 1, 2006, 86,000 shares vest September 1, 2007, 66,000 shares vest
September 1, 2008, and 66,000 shares vest September 1, 2009. All unvested shares
of restricted stock are subject to a risk of forfeiture upon termination of the
participant's service as a full-time consultant or employee prior to vesting.
During September 2005, the Company issued 3,948,500 shares in connection with a
private offering.
Unsecured convertible long-term debt payable to a stockholder and various other
parties totaling $557,051 was converted to 663,401 shares of common stock on
November 15, 2005, thus satisfying the debt requirements.
At March 31, 2006, of the 25,162,905 outstanding shares, 23,559,405 are
restricted.
11. WARRANTS
In August 2005, the Company issued warrants to purchase up to a total of 69,640
shares, for services rendered in connection with the private offering of stock.
These are warrants to purchase Company stock, for $1 per share for the first
three years, and $1.50 for years four and five. The warrants expire on the fifth
anniversary date from issuance.
12. STOCK-BASED COMPENSATION
The Company has an incentive stock-based compensation plan under which
participants may be granted options to purchase shares of the Company's common
stock or receive restricted stock. Restricted stock and options may be granted
with respect to 2,000,000 shares. During the three months ended March 31, 2006
the Company awarded grants for 121,000 shares. At March 31, 2006 the total
grants made under the plan totaled 1,381,000 shares leaving 619,000 shares
available for future grants. Of the shares which were the subject of these
grants, 426,000 were restricted stock, 595,000 were qualified incentive stock
options ("ISOs") and 360,000 were non qualified stock options ("NSOs"). The
shares of restricted stock vest as described above in Note 10. The ISOs that
have been granted under the Company's plan vested immediately as 106,000 shares,
and will vest as to 97,000 shares in 2006, as to 124,750 shares in 2007, as to
119,750 shares in 2008 and as to 119,750 shares in 2009 and 27,750 shares in
2010 and expire ten years from the date of grant. The NSOs vested immediately as
100,000 shares, and will vest as to 80,000 shares in 2006, as to 60,000 shares
in 2007, as to 60,000 shares in 2008 and as to 60,000 shares in 2009. NSOs as to
20,000 shares have been terminated. All options were granted at exercise prices
that either equaled or exceeded fair market value at the respective dates of
grant.
Total non-cash stock compensation expense for the three months ended March 31,
2006 was $175,282, which consisted of $132,115 of incentive stock options,
$21,667 of non-qualified stock options and $21,500 of restricted stock expense
recognized under SFAS 123(R).
-22-
A summary of ISOs and NSOs granted to employees and consultants under the
Company's incentive compensation plan at March 31, 2006 and December 31, 2005 is
presented below:
Weighted
Average
Exercise Price
Option Shares Per Share
------------- ---------------
Options granted September 1, 2005 794,000 $ 1.00
Options granted during the three months ended
December 31, 2005 60,000 $ 5.88
----------
Options outstanding December 31, 2005 854,000 $ 1.34
----------
Options granted during the three months ended
March 31, 2006 121,000 $ 6.32
Exercised (5,000) $ 1.00
Cancelled or forfeited (20,000) $ 1.00
----------
Options outstanding March 31, 2006 950,000 $ 1.46
==========
The following table summarizes information about stock options outstanding and
exercisable as of March 31, 2006:
Options Outstanding Options Exercisable
---------------------------------------------------- -----------------------------
Weighted
-Average Weighted-
Remaining Average Weighted-
Exercise Options Contractual Exercise Shares Average
Price Outstanding Life Price Exercisable Exercise Price
---------- ----------- ----------- ----------- ------------ --------------
$ 1.00 769,000 9.4 $ 1.00 199,000 $ 1.00
$ 5.38 71,000 9.8 $ 5.38 -- $ 5.38
$ 5.88 60,000 9.7 $ 5.88 12,000 $ 5.88
$ 7.65 50,000 9.9 $ 7.65 10,000 $ 7.65
----------- -----------
950,000 9.5 $ 1.46 221,000 $ 2.79
=========== ===========
13. COMMITMENTS AND CONTINGENCIES
Engine Certification
- --------------------
The Company plans to begin the certification of the 4.9 liter engine in second
quarter 2006. To certify an engine to meet regulations for exhaust emissions, an
engine must successfully pass stringent third-party testing. The Company
anticipates the cost of the testing to be approximately $1,000,000 per engine.
The Company expects to begin the certification process for the 7.5 liter engine
and the 2.45 liter engine in late 2006 or 2007.
Although engine certification is necessary for the Company to sell engines to
original equipment manufacturers, certification is not necessary for existing
equipment applications.
-23-
Product Performance - Warranty
- ------------------------------
Estimated warranty costs and additional service actions will be accrued at the
time an engine is sold to a distributor or end-user customer. Included in
warranty cost accruals will be costs for basic warranty coverage on engines
sold. The Company has not accrued warranty costs at March 31, 2006 and December
31, 2005 because of its limited history and the limited number of sales to date.
Component Parts Procurement
- ---------------------------
In November 2005, the Company issued purchase orders totaling approximately $1.7
million to an unrelated party for engine parts and mold and tooling fees. The
Company agreed to take shipments of parts over the next twelve months. As of May
15, 2006, the majority of the component parts appear to have met Company
specifications, and the Company anticipates deliveries to begin in July or
August 2006. The Company is dependent on this vendor for delivery of parts for
its 4.9 liter new engine program. Delivery of final products may be delayed,
thus delaying sales of new 4.9 liter engines to its distributor network.
14. SUBSEQUENT EVENTS
On April 4, 2006, the Company secured a $600,000 short-term note from a bank.
The note matures on April 4, 2007 and bears interest at the rate of 6%.
Principal and interest on the note are due April 4, 2007. The loan is secured by
real estate.
On May 15, 2006, the Company executed a statement of intent acknowledging its
commitment to provide $120,000 in funding over a three-year period to support
research by Propulsion Sciences Co. relating to the use of ammonia emulsions in
diesel fuels.
-24-
>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Going Concern
Our accompanying consolidated financial statements have been
prepared on a going concern basis, which contemplates our continuation of
operations, realization of assets and liquidation of liabilities in the ordinary
course of business. Since inception, we have incurred substantial operating
losses and expect to incur additional operating losses over the next several
months. As of March 31, 2006, we had an accumulated deficit of approximately
$2.3 million. Our accompanying financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
We have financed our operations since inception primarily through
equity and debt financings and loans from our officers, directors and
stockholders. Continuing our operations is dependent upon obtaining further
financing in June 2006. Although we intend to either register securities of the
Company to be offered for sale or enter into another private placement, there
can be no assurance that we will successfully complete this registration and
offering or that the proceeds of either offering if completed, would be
sufficient to satisfy our capital requirements. These conditions raise
substantial doubt about our ability to continue as a going concern.
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION
WITH THE OTHER FINANCIAL INFORMATION AND CONSOLIDATED FINANCIAL STATEMENTS AND
RELATED NOTES APPEARING IN THIS FORM 10-QSB. THIS DISCUSSION CONTAINS FORWARD
LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS WILL
DEPEND UPON A NUMBER OF FACTORS BEYOND OUR CONTROL AND COULD DIFFER MATERIALLY
FROM THOSE ANTICIPATED IN THE FORWARD LOOKING STATEMENTS. SOME OF THESE FACTORS
ARE DISCUSSED UNDER "RISK FACTORS" AND ELSEWHERE IN THIS FORM 10-QSB.
Merger
On August 30, 2005, Hydrogen Engine Center, Inc, an Iowa corporation
("HEC Iowa") merged with our newly formed subsidiary (the "Merger"). The Merger
was made pursuant to an agreement entered into on June 3, 2005, whereby we
agreed to merge our newly created, wholly-owned subsidiary, Green Mt.
Acquisitions, Inc., with and into HEC Iowa, with HEC Iowa being the surviving
entity. Following the Merger, we changed our name from Green Mt. Labs, Inc. to
Hydrogen Engine Center, Inc.
On July 6, 2005, we revised certain terms of the proposed Merger and,
accordingly, executed a revised and amended agreement and plan of merger. On
July 29, 2005, we added an addendum to the agreement. The revised agreement
provided for effecting a 3.8 shares for 1 share forward stock split of our
issued and outstanding common stock, instead of the previously announced 1.5
shares for 1 share split. The split was payable August 17, 2005 to stockholders
of record on August 16, 2005. As a result of the revised forward stock split,
our outstanding shares of common stock increased from 1,006,000 shares to
approximately 3,822,804 shares, representing 19% of the total outstanding shares
-25-
following consummation of the Merger. Under the terms of the merger agreement,
we issued 16,297,200 shares of post-split common stock (representing 81% of our
total outstanding shares (post-split) following the transaction) to Ted
Hollinger, who was prior to the Merger HEC Iowa's sole stockholder, in exchange
for 100% of HEC Iowa's then outstanding capital stock, and HEC Iowa has become
our wholly-owned subsidiary. In connection with the Merger, we have changed our
name to Hydrogen Engine Center, Inc.
We also commenced a private placement of up to four million shares of
our common stock at the offering price of $1.00 per share, which offering was
closed as of October 11, 2005 (the "Private Offering"). We sold 3,948,500 shares
of our common stock, $.001 par value, for a total of $3,948,500 to 93 investors,
which represents 15.69% of the 25,162,905 issued and outstanding shares of
common stock of the Company as of April 21, 2006. The shares were sold in
reliance upon an exemption from registration pursuant to Regulation D, Rules
Governing the Limited Offer and Sale of Securities without Registration under
the Securities Act of 1933.
The accompanying consolidated balance sheets as of March 31, 2006 and
December 31, 2005, and the consolidated statements of operations and
consolidated statements of cash flows for the three months ended March 31, 2006
and 2005, and from inception (May 19, 2003) to March 31, 2006, consolidate the
historical financial statements of the company with HEC Iowa after giving effect
to the Merger where HEC Iowa is the accounting acquirer and after giving effect
to the Private Offering.
Overview
As a result of the Merger, we own all of the issued and outstanding
shares of HEC Iowa and all of the issued and outstanding shares of Hydrogen
Engine Center (HEC) Canada, Inc. ("HEC Canada"). HEC Iowa is a development stage
company engaged in design, manufacture and distribution of flex-fuel internal
combustion engines for the industrial and power generation markets. The engines
run efficiently, with minor adjustments, on hydrogen, gasoline, propane, natural
gas or ethanol interchangeably or, with the addition of a fuel reformer, on
biodiesel ("flex-fuels"). The engines can run on regular grade hydrogen, or on
mixed gases such as natural gas and hydrogen. HEC Iowa expects to file core
technology patents covering the use of hydrogen fuel in any internal combustion
engine with zero or near zero emissions.
The Company has funded its operations from inception through March 31,
2006 through a series of financing transactions, including an investment of
$151,487 by Ted Hollinger; $3,948,500 in gross proceeds from the Private
Offering, and convertible loans in the amount of $662,401.
Results of Operations
Historical information prior to the Merger is that of HEC Iowa.
Because we are still developing our flex-fuel internal combustion
engines and related products, and just completed our manufacturing facility
during first quarter 2006, we have not realized significant revenues to date.
-26-
During the quarter ended March 31, 2006 we realized $28,590 from the sale of
four 4.9L gasoline remanufactured engines and one 6.8 L hydrogen engine. During
the quarter ended March 31, 2005, we realized $12,000 from the sale of one
hydrogen generator. Management believes that we may begin to realize increased
sales revenues by the third quarter of 2006, subject to timely receipt of parts
ordered from suppliers.
We are continuing our efforts toward commencement of full operations.
We expect to reach full production of our 4.9 L engines during third quarter
2006. The manufacturing portion of our new building was completed during first
quarter 2006. The dynamometer room is substantially complete, but has not yet
been approved for use by the Iowa State Fire Marshall. We expect to have that
approval by the end of second quarter 2006. We continue the process of hiring
new personnel and purchasing the inventory of parts we need to manufacture
engines in our new building.
Sales and marketing expense for the quarters ended 2006 and 2005 were
$240,288 and $0 respectively. We expect this number to increase significantly
during 2006 as we pursue national and international sales opportunities.
General and administrative expenses increased $568,419 from $39,550 for
the quarter ended March 31, 2005 to $607,969 for the quarter ended March 31,
2006. Management expects similar or greater increases for the year ending
December 31, 2006 in general and administrative expenses due to the anticipated
hiring of additional personnel, purchase of inventory, costs related to the new
facility and other efforts related to the commencement and expansion of our
operations.
Costs related to research and development increased $73,939 from $9,713
for the quarter ended March 31, 2005 to $83,652 for the quarter ended March 31,
2006. We have incurred $537,364 in costs related to research and development
since inception. Management expects research and development costs to continue
to increase during the remainder of 2006.
We recorded a net loss of $918,457 for the quarter ended March 31, 2006
compared to a net loss of $46,590 for the quarter ended March 31, 2005. We
recorded a net loss of $2,299,145 from inception (May 19, 2003) through March
31, 2006. We expect to continue to operate at a net loss until such time as we
can complete development of our initial engines and begin to realize a
substantial increase in sales.
Critical Accounting Policies
Our discussion and analysis of our financial position and results of
operations are based upon our condensed consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. The preparation of these condensed consolidated
financial statements requires us to make estimates and assumptions that affect
the reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the condensed consolidated financial
statements and the reported revenues and expenses during the period.
-27-
Merger and Stock-based Compensation
We consider certain accounting policies related to the recapitalization
of the Company and stock-based compensation to be critical to our business
operations and the understanding of our results of operations.
Liquidity and Capital Resources
Short-Term and Long-Term Debt Sources
- -------------------------------------
From inception through March 31, 2006, we have used $1,817,068 in cash
in our operating activities and $1,954,824 in capital expenditures. Cash for our
operations came from various financing transactions, including $3,948,500 in
gross proceeds from the Private Offering and convertible loans in the amount of
$662,401. We also received $400,000 in forgivable loans from the Iowa Department
of Economic Development, $200,000 from the City of Algona revolving loan fund
and $862,647 from bank financing. We incurred expenses in connection with the
merger of $353,611. Our aggregated net loss from inception through March 31,
2006 was $2,299,145. Our cumulative net loss has resulted principally from
expenditures related to research and development, as well as the commencement of
operations.
We have available credit with Iowa State Bank, secured by a mortgage on
Lot 1 of Snap-on Industrial Park in Algona, and represented by a promissory note
in the maximum amount of $500,000. As of March 31, 2006, $262,647 has been drawn
on the note. The note carries interest at the annual rate of 5.890%. Interest is
payable monthly and the note will mature on December 16, 2006. We anticipate
that this note will be rolled over into permanent financing upon maturity, but
cannot provide assurance that such financing will be available.
As of March 31, 2006, we had available credit with Farmers State Bank
in Algona, Iowa, to be secured by a mortgage on Lot 2 of Snap-on Industrial Park
in Algona, and represented by a promissory note in the maximum amount of
$600,000 at an annual adjustable rate of 6.00%. The Company drew on this credit
and executed a $600,000 promissory note on April 4, 2006. Principal and interest
on the note are due April 4, 2007.
At March 31, 2006, we had cash on hand of $969,506, and $2,346,248 at
December 31, 2005.
Inventories increased from $206,091 at December 31, 2005 to $384,353 at
March 31, 2006 due to the purchase of engines and parts.
Our accounts payable increased from $236,341 at December 31, 2005 to
$349,014 on March 31, 2006 primarily because of inventory and supply costs
associated with the start up.
We had accrued expenses of $92,904 at March 31, 2006 compared to
$69,768 at December 31, 2005.
-28-
At March 31, 2006, we had current assets of $1,602,069 and
stockholders' equity of $2,466,347, compared to current assets of $2,763,214 and
total a stockholders' equity of $3,204,533 at December 31, 2005.
Plan of Operation
- -----------------
We anticipate that our expenses will continue to increase significantly
as we work toward full operations, including additional personnel, product
development, inventory purchases, and construction costs. Accordingly,
management believes that current cash on hand will only be sufficient to satisfy
our cash requirements through June 2006. We will likely be required to raise
significant amounts of additional capital resources during the next quarter of
2006. We anticipate that a significant increase in sales of our products could
commence during the third quarter of 2006, subject to timely receipt of parts
ordered from suppliers and timely completion of our new facilities, which may
add to cash reserves. Additional cash will be needed to sustain operations, or
if management determines to accelerate the expansion of our operations. We
intend to seek additional funds through private or public sources and/or the
sale of securities. We anticipate offering shares of our Common Stock or debt
securities under a registered offering or a private placement during fiscal year
2006. There is no assurance that we will be able to raise the necessary capital
from such an offering, that funds will be available from any other source, or,
that even if they are available, that they will be available on terms that will
be acceptable to us.
We are a development stage enterprise and, as such, our continued
existence is dependent upon our ability to resolve our liquidity problems,
principally by obtaining additional debt or equity financing. We have yet to
generate a positive internal cash flow, and until meaningful sales of our
products begin, we are totally dependent upon debt and equity funding.
In the event that we are unable to obtain debt or equity financing or
we are unable to obtain financing on terms and conditions that are acceptable to
us, we may have to cease or severely curtail our operations. These factors raise
substantial doubt about our ability to continue as a going concern. So far, we
have been able to raise the capital necessary to reach this stage of product
development and have been able to obtain funding for operating requirements and
for construction of our manufacturing facilities, but there can be no assurance
that we will be able to continue to do so.
We anticipate that we can produce 10,000 base 4.9L engines at full
capacity, in our 30,000 square foot manufacturing facility and expect to be at
full capacity during third quarter 2006. Initial contact with our distributor
network has given us indications that we may not have the capacity to meet their
demands. We anticipate that if we are successful in obtaining funds through
private or public sources, we plan to explore the expansion of our present
facilities. An expansion will be necessary to provide needed space for the
assembly of our 7.5L engines and our 2.45L engines. We anticipate the cost for
an expansion of our production facilities, including equipment, to be
approximately $2.5 million. We also expect during the next 24 months to add
administrative facilities for an approximate cost of $1.5 million, an expansion
of our generator building for an approximate cost of $500,000, and possibly a
-29-
research facility for an approximate cost of $1.6 million. We anticipate our
capital expenditures for 2006 will be approximately $6.2 million, subject to
sufficient capital from anticipated financing.
The Validated for form and fit and durability of the 4.9L engine will
commence during second quarter 2006. We anticipate testing the durability of our
engines by running them on a dynamometer for a minimum of three hundred hours
before they are offered to our distributors for sale into the industrial engine
market. Durability testing will be ongoing from this point until a minimum of
3000 hours are achieved. Typically, durability testing would be considered a
success, once the stated production warranty hours are surpassed. We anticipate
the warranty on our 4.9L engines will be 3 years or 3,000 hours, whichever comes
first.
Our distributors will not be able to offer our engines for sale to
original equipment manufacturers for mobile applications until the engines have
passed U.S. Emissions Regulations which are defined and enforced by the
Environmental Protection Agency and California Air Resources Board. Stand-by and
replacement engines are not subject to these requirements. We anticipate
beginning the emissions certification process of our 4.9L engine in the second
quarter of 2006. It will cost approximately $1,000,000 to certify each engine in
our product line. We also anticipate beginning the certification process for our
7.5L and 2.45L engines in 2007. This testing procedure will be an expense of
research and development. We anticipate that our research and development costs
could be approximately $5.7 million (including $1.6 million in expenditures for
additional facilities) in 2006, subject to sufficient capital from anticipated
financing.
We are presently dependent on one vendor to supply a majority of the
components for our 4.9L engine. We are in the process of lining up second and
third sources for these components. We have issued blanket purchase orders
totaling approximately $1.7 million to this vendor for engine parts, and mold
and tooling fees. We anticipate that we will purchase approximately $3 million
in component parts from this vendor in 2006. We expect product flow and
production of the new 4.9L engines to begin during third quarter,
however,delivery of final products could be delayed, thus delaying sales of new
4.9 liter engines to our distributor network and delaying our ability to
generate revenue.
We are expanding our search for vendors who can manufacture component
parts to our specifications. We anticipate having other sources for our engine
parts by the end of 2006.
Employees
- ---------
We had 15 employees as of March 31, 2006 and 20 employees as of May 1,
2006. We expect to have 30-35 employees on or about July 1, 2006, in
anticipation of achieving full production of our 4.9L engines in our new
production facilities in Algona, Iowa during third quarter 2006.
-30-
Net Operating Loss
- ------------------
We have accumulated approximately $2.05 million of net operating loss
and research and development carryforwards as of March 31, 2006, which may be
offset against taxable income and income taxes in future years. The use of these
losses to reduce future income taxes will depend on the generation of sufficient
taxable income prior to the expiration of the net operating loss carryforwards.
The carryforwards will begin to expire in the year 2018. The amount and
availability of the net operating loss carryforwards may be subject to annual
limitations set forth by the Internal Revenue Code. Factors such as the number
of shares ultimately issued within a three-year look-back period; whether there
is a deemed more than 50 percent change in control; the applicable long-term tax
exempt bond rate; continuity of historical business; and subsequent income of
the Company all enter into the annual computation of allowable annual
utilization of the carryforwards.
-31-
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to the risk of loss arising from adverse changes in
foreign exchange rates and interest rates to a limited degree.
Foreign Exchange Risk
We are subject to foreign currency exchange rate risk from the
operations of HEC Canada, our Canadian subsidiary. Based on the size of this
subsidiary and our corresponding exposure to changes in the Canadian/U.S. dollar
exchange rate, we do not consider our market exposure relating to currency
exchange to be material at this time.
Interest Rate Risk
We are exposed to interest rate risk primarily on long-term debt. As
more fully described below and in our discussion of liquidity and capital
resources above in Item 2, we have the risk of increased interest on two bank
notes in the aggregate amount of $1.1 million. Also as more fully described
below and in our discussion of liquidity and capital resources above in Item 2,
we have received governmental forgivable loans and no-interest loans in the
aggregate amount of $863,624 that could, upon certain circumstances, result in
interest expense for the company.
o We have a note with Iowa State Bank, Algona, Iowa, in the amount of
$500,000 that carries a fixed annual rate of 5.890%. Interest is
payable monthly and the note will mature on December 16, 2006. We
anticipate that this note will be rolled over into permanent financing
upon maturity, but cannot provide assurance that such financing will be
available or on what terms.
o As of April 4, 2006, we have a loan from Farmers State Bank, Algona,
Iowa, in the amount of $600,000 that provides for interest at an annual
adjustable rate of 6.00%. Principal and interest on the note are due
April 4, 2007.
o The Company obtained $200,000 from the City of Algona in September
2005. There is no interest on this loan provided the Company creates
and retains at least 42 new full-time positions for five years. If such
requirements are not met, interest on the loan will be payable at 10%
per annum. The Company is accruing interest on this note until the
terms of the note have been met.
o On June 27, 2005, the Company executed a note payable of $146,124 from
the Algona Area Economic Development Corporation. The loan is a
ten-year partially forgivable loan with interest at 8%, conditioned
upon the Company achieving certain performance targets. The Company is
accruing interest on this note until the terms of the note have been
met.
o On December 16, 2005, the Company assumed a no interest note provided
by the Algona Area Economic Development Corporation in the amount of
$117,500. This note was recorded at the fair value of future payments
using an interest rate of 10%.
-32-
o On June 28, 2005, the Iowa Department of Economic Development ("IDED")
awarded the Company a grant in the amount of $150,000. If certain
requirements are not met, the balance of the forgivable loan determined
by IDED as due and payable will be amortized over three years from the
agreement expiration date of July 31, 2010 at 6% interest per annum
with equal quarterly payments. The Company is accruing interest on this
note until the terms of the note have been met.
o Also on June 28, 2005, IDED awarded the Company a Community Economic
Betterment Account ("CEBA") forgivable loan in the amount of $250,000.
If certain conditions are not met, any balance (shortfall) will be
amortized over a two-year period, beginning at the project completion
date at 6% per annum from the date of the first CEBA disbursement. The
Company is accruing interest on this note until the terms of the note
have been met.
-33-
ITEM 4. CONTROLS AND PROCEDURES
Our management, including our Chief Executive Officer (the principal
executive officer), Theodore G. Hollinger, and our Chief Financial Officer (the
principal financial officer), Sandra Batt, have reviewed and evaluated the
effectiveness of our disclosure controls and procedures (as defined in Rule
13a-15(e) under the Securities Exchange Act of 1934, as amended) as of March 31,
2006. Based upon this review and evaluation, these officers have concluded that
our disclosure controls and procedures are effective to ensure that information
required to be disclosed in the reports that we file or submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods required by the forms and rules of the Securities and Exchange
Commission; and to ensure that the information required to be disclosed by an
issuer in the reports that it files or submits under the Exchange Act is
accumulated and communicated to our management including our principal executive
officers, or persons performing similar functions, as appropriate to allow
timely decisions regarding required disclosure.
Our President and our Board of Directors are currently in the process
of working with our Chief Financial Officer to complete the design and
implementation of internal control and disclosure controls and procedures in
accordance with Sarbanes Oxley 404. Although this process, has not been
formalized we believe that the controls and procedures in place during the first
quarter have allowed us to secure information required to be disclosed, within
the time periods specified in the SEC's rules for the preparation of this
report.
-34-
PART II. OTHER INFORMATION
ITEM 1A. RISK FACTORS
RISK FACTORS
YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW TOGETHER WITH THE RISK
FACTORS DISCLOSED IN OUR FORM 10-KSB FOR THE YEAR ENDED DECEMBER 31, 2005. YOU
SHOULD ALSO CONSIDER ALL OF THE OTHER INFORMATION INCLUDED IN OUR FORM 10-KSB
AND IN THIS FORM 10-QSB WHEN EVALUATING THE COMPANY AND ITS BUSINESS. IF ANY OF
THE RISKS ACTUALLY OCCURS, OUR BUSINESS, FINANCIAL CONDITION, OR RESULTS OF
OPERATIONS COULD SUFFER. IN THAT CASE, THE PRICE OF OUR COMMON STOCK COULD
DECLINE AND OUR STOCKHOLDERS MAY LOSE ALL OR PART OF THEIR INVESTMENT.
We have a limited operating history and have not recorded an operating
profit since our inception. Continuing losses may exhaust our capital
resources and force us to discontinue operations.
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HEC Iowa was incorporated on May 19, 2003 and has a limited operating
history and has incurred net losses since inception, including $918,457 of
losses incurred during the quarter ended March 31, 2006. Prior to the Merger,
the Company (then known as "Green Mt. Labs, Inc.") had been inactive for several
years. The potential for us to generate profits depends on many factors,
including the following:
o the reliability of our suppliers;
o the costs of building, maintaining, and expanding our facilities and
our operations; and
o our ability to attract and retain a qualified work force in a small
town.
o the size and timing of future customer orders, milestone achievement,
product delivery and customer acceptance;
o success in maintaining and enhancing existing strategic relationships
and developing new strategic relationships with potential customers;
o our ability to protect our intellectual property;
o actions taken by competitors, including suppliers of traditional
engines, hydrogen fuel cells and new product introductions and pricing
changes;
We cannot assure you we will achieve any of the foregoing factors or
realize profitability in the immediate future or at any time.
-35-
Additional financing to proceed with our anticipated business activities
will be required during second quarter 2006. There can be no assurance that
financing will be available on terms beneficial to us, or at all.
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In order to proceed with our anticipated business activities we will
need to obtain additional financing. If we raise additional capital by selling
equity or equity-linked securities, these securities would dilute the ownership
percentage of our existing stockholders. Also, these securities could also have
rights, preferences or privileges senior to those of our common stock.
Similarly, if we raise additional capital by issuing debt securities, those
securities may contain covenants that restrict us in terms of how we operate our
business, which could also affect the value of our common stock. We have
financed our operations since inception primarily through equity and debt
financings and loans from our officers, directors and stockholders. Although we
expect to offer securities of the Company for sale during 2006, there can be no
assurance that we will successfully complete such an offering or that the
proceeds of the offering, if completed, would be sufficient to satisfy our
capital requirements.
We anticipate that if we are successful in obtaining funds through
private or public sources, we plan to explore the expansion of our present
facilities. An expansion will be necessary to provide needed space for the
assembly of our 7.5L engines and our 2.45L engines.
If we are not able to obtain the needed financing, our ability to
fulfill our business plans and reach full production capacity will be materially
impaired.
Reliance on principal supplier and contract manufacturer.
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We contract the manufacture of our products to third parties. In
certain cases, we do not have an alternative source of manufacturing, and a
suitable replacement would be time-consuming and expensive to obtain. If, for
any reason, one of our third party manufacturers is unable or refuses to produce
our products, our business, financial condition and results of operations would
be materially and adversely affected
We are presently dependent on one vendor to supply a majority of the
components for our 4.9L engine. We are in the process of lining up second and
third sources for these components. We have issued blanket purchase orders
totaling approximately $1.7 million to this vendor for engine parts, and mold
and tooling fees. We anticipate that we will purchase approximately $3 million
in component parts from this vendor in 2006. We expect product flow and
production of the new 4.9L engines to begin during third quarter, however,
delivery of final products could be delayed, thus delaying sales of new 4.9
liter engines to our distributor network and delaying our ability to generate
revenue.
We may experience significant and rapid growth if we are able to capitalize
on the expansion of the industrial engine and genset markets. If we are
unable to hire and train staff to produce our products, handle sales and
marketing of our products and manage our operations, such growth could
materially and adversely affect us.
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-36-
We intend to proceed with initiatives intended to capitalize on the
need for more efficient industrial engines, engines that use alternative fuels
and the interest in more environmentally friendly sources of power. This could
potentially lead to significant and rapid growth in the scope and complexity of
our business. Any inability on our part to manage such growth effectively will
have a material adverse effect on our product development, business, financial
condition and results of operations. Our ability to manage and sustain growth
effectively will depend, in part, on the ability of our relatively small
management team to implement appropriate management, operational and financial
systems and controls and to successfully hire, train, motivate and manage
employees. As of March 31, 2006 we had 15 employees. As of May 1, 2005, we had
20 employees. We hope to have 30-35 employees by July 1, 2006.
We may not be able to manage our growth effectively, which could adversely
affect our operations and financial performance.
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The ability to manage and operate our business as we execute our
development and growth strategy will require effective planning. Significant
rapid growth could strain our management and other resources, leading to
increased cost of operations, an inability to ship enough product to meet
customer demand and other problems that could adversely affect our financial
performance. We expect that our efforts to grow will place a significant strain
on personnel, management systems, infrastructure and other resources. We believe
that our management team is currently under considerable strain with the current
level of our growth and expansion. Our ability to manage future growth
effectively will require us to successfully attract, train, motivate, retain and
manage new employees and continue to update and improve our operational,
financial and management controls and procedures. If we do not manage our growth
effectively, our operations could be adversely affected, resulting in slower
growth and a failure to achieve or sustain profitability.
If we are unable to effectively and efficiently implement the necessary
internal controls and procedures, there could be an adverse effect on our
operations or financial results.
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Our President and our Board of Directors are currently in the process
of working with our Chief Financial Officer to complete the design and
implementation of internal controls and disclosure controls and procedures in
accordance with Sarbanes Oxley 404. Although this process, has not been
formalized we believe that the controls and procedures in place during the
fourth quarter have allowed us to secure information required to be disclosed,
within the time periods specified in the SEC's rules for the preparation of this
report.
Our future success depends on retaining our existing key employees and
hiring and assimilating new key employees. The loss of key employees or the
inability to attract new key employees could limit our ability to execute
our growth strategy, resulting in lost sales and a slower rate of growth.
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-37-
Our future success depends in part on our ability to retain key
employees including our executive officers and, in particular, our founder Ted
Hollinger. We currently do not carry "key man" insurance on our executives;
however, we are in the process of securing such insurance. It would be difficult
for us to replace any one of these individuals. In addition, as we grow we will
need to hire additional key personnel. We may experience difficulty in
recruiting experienced engineers, management personnel and others who are
interested in living and working in the Algona area.
We may experience labor shortages.
----------------------------------
Our production facilities are located in Algona, Iowa, a town with a
population of approximately 5,500 people. We may find it difficult to hire and
retain a workforce sufficient to meet our production needs and allow for
sustained growth of our operations. Our ability to hire and retain qualified
employees for our production facilities will be key to our success. Our
inability to do this may have a materially adverse effect on our future results.
We may experience production gaps or delays in the commencement of
production, which could materially and adversely impact our sales and
financial results and the ultimate acceptance of our products.
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We are in the process of transitioning to production in our newly
constructed facility. Because all of the production procedures and processes, as
well as the facility, are new to us and all of our employees, we could
experience unexpected delay in production during fiscal year 2006. Additionally,
it is possible that we could experience unforeseen quality control issues as we
ramp up to full production. Should any such delay or disruption occur in
transitioning to production, our anticipated sales will likely be materially and
adversely affected.
The products produced in our new facility could contain undetected
design faults despite our testing. We may not discover these faults or errors
until after a product has been used by our customers. Any faults or errors in
our products may cause delays in product introduction and shipments, require
design modifications or harm customer relationships, any of which could
adversely affect our business and competitive position.
We cannot assure you that there will be an active trading market for our
common stock.
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Even though our common stock is quoted on the OTC Bulletin Board, most
shares outstanding, including those issued pursuant to the Merger, are
"restricted securities" within the meaning of Rule 144 promulgated by the SEC
and are therefore subject to certain limitations on the ability of holders to
resell such shares. Restricted shares may not be sold or otherwise transferred
without registration or reliance upon a valid exemption from registration. Thus,
holders of restricted shares of our common stock may be required to retain their
shares for a long period of time.
If we cannot achieve commercial application of our hydrogen engine and
other products and technologies, we may not achieve profitability.
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-38-
Members of the public may be wary of hydrogen because hydrogen, as
compared to other fuels, has the largest flammability limit (4% to 77% of
hydrogen in air). This means that it takes very little hydrogen to start a fire.
On the other hand, hydrogen is a light gas. As such, if there is a hydrogen
leak, it will immediately diffuse into the surrounding air. With proper
precaution hydrogen could be as safe as any other fuel. The main benefit of
hydrogen as a fuel is that it produces no pollution or greenhouse gases when it
is used in an internal combustion engine. The development of a market for our
engines is dependent in part upon the development of a market for hydrogen as a
fuel, which may be impacted by many factors, including:
o consumer perception of the safety of hydrogen and willingness to use
engines powered by hydrogen;
o the cost competitiveness of hydrogen as a fuel relative to other fuels;
o the future availability of hydrogen as a fuel;
o adverse regulatory developments, including the adoption of onerous
regulations regarding hydrogen use or storage;
o barriers to entry created by existing energy providers; and
o the emergence of new competitive technologies and products.
Certain government regulations concerning electrical and hydrogen
generation, delivery and storage of fuels and other related matters may
negatively impact our business.
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Our business is subject to and effected by federal, state, local and
foreign laws and regulations. These may include state and local ordinances
relating to building codes, public safety, electrical and hydrogen production,
delivery and refueling infrastructure, hydrogen storage and related matters. The
use of hydrogen inside a building will require architectural and engineering
changes in the building to allow the hydrogen to be handled safely. We are
currently awaiting the approval of the State Fire Marshall for us to use the
dynamometer room where we intend to test our engines. As our engines and other
new products are introduced into the market commercially, governments may impose
new regulations. We do not know the extent to which any such regulations may
impact our business or the businesses of our customers' businesses. Any new
regulation may increase costs and could reduce our potential to be profitable.
The industry in which we operate is highly competitive and such competition
could affect our results of operations, which would make profitability even
more difficult to achieve and sustain.
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The power generation and alternative fuel industry is highly
competitive and is marked by rapid technological growth. Other competitors and
potential competitors include Ford Power Products, H2Car Co., Cummins, Daimler
Chrysler, General Motors, Mazda, Koehler and Generac. Many existing and
potential competitors have greater financial resources, larger market share, and
larger production and technology research capability, which may enable them to
-39-
establish a stronger competitive position than we have, in part through greater
marketing opportunities. The governments of the United States, Canada, Japan and
certain European countries have provided funding to promote the development and
use of fuel cells. Tax incentives have also been initiated in Japan, and have
been proposed in the United States and other countries, to stimulate the growth
of the fuel cell market by reducing the cost of these fuel cell systems to
consumers. Our business does not currently enjoy any such advantages and, for
that reason, may be at a competitive disadvantage to the fuel cell industry. If
we fail to address competitive developments quickly and effectively, we will not
be able to grow.
Our business could be adversely affected by any adverse economic
developments in the power generation industry and/or the economy in
general.
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We depend on the perceived demand for the application of our technology
and resulting products. Our products are focused on reducing CO(2) emissions and
upon the use of alternative fuels for industrial uses, such as ground support
vehicles, and for the power generation business. Therefore, our business is
susceptible to downturns in the airline industry and the genset portion of the
distributed power industry and the economy in general. Any significant downturn
in the market or in general economic conditions would likely hurt our business.
We believe that we carry a reasonable amount of insurance. However there
can be no assurance that our existing insurance coverage would be adequate
in term and scope to protect us against material financial effects in the
event of a successful claim.
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We could be subject to claims in connection with the products that we
sell. There can be no assurance that we would have sufficient resources to
satisfy any liability resulting from any such claim, or that we would be able to
have our customers indemnify or insure us against any such liability. There can
be no assurance that our insurance coverage would be adequate in term and scope
to protect us against material financial effects in the event of a successful.
claim. We currently do not carry directors and officers insurance. We may in the
future obtain such insurance, provided it can be obtained at reasonable prices.
However, there can be no assurance that such coverage, if obtained, would be
adequate in term and scope to protect us.
If we fail to keep up with changes affecting our technology and the markets
that we will ultimately service, we will become less competitive and future
financial performance would be adversely affected.
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In order to remain competitive and serve our potential customers
effectively, we must respond on a timely and cost-efficient basis to changes in
technology, industry standards and procedures and customer preferences. We need
to continuously develop new technology, products and services to address new
technological developments. In some cases these changes may be significant and
the cost to comply with these changes may be substantial. We cannot assure you
that we will be able to adapt to any changes in the future or that we will have
the financial resources to keep up with changes in the marketplace. Also, the
cost of adapting our technology, products and services may have a material and
adverse effect on our operating results.
-40-
Our business could be adversely affected by local, state, national, and
international laws or regulations.
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Our future success depends in part on laws and regulations that exist,
or are expected to be enacted around the world. Should these laws or regulations
take an adverse turn, this could negatively affect our business and anticipated
revenues. We cannot guarantee a positive outcome in direction, timing, or scope
of laws and regulations that may be enacted which will affect our business.
Our distributors will not be able to offer our engines for sale to
original equipment manufacturers for mobile applications until the engines have
passed U.S. Emissions Regulations which are defined and enforced by the
Environmental Protection Agency and California Air Resources Board. Stand-by and
replacement engines are not subject to these requirements. We anticipate
beginning the emissions certification process of our 4.9L engine during 2006. It
will cost approximately $1,000,000 to certify each engine in our product line.
We also anticipate beginning the certification process for our 7.5L and 2.45L
engines in 2007.
The hydrogen and power generation business may expose us to certain safety
risks and potential liability claims.
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Our business will expose us to potential product liability claims that
are inherent in hydrogen and products that use hydrogen. Hydrogen is a flammable
gas and therefore a potentially dangerous product. Any accidents involving our
engines or other hydrogen-using products could materially impede widespread
market acceptance and demand for our hydrogen-fueled engines. In addition, we
might be held responsible for damages beyond the scope of our insurance
coverage. We also cannot predict whether we will be able to maintain our
insurance coverage on acceptable terms, or at all.
We may be unable to protect our intellectual property adequately or cost
effectively, which may cause us to lose market share or reduce prices.
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Our future success depends in part on our ability to protect and
preserve our proprietary rights related to our technology and resulting
products. We cannot assure you that we will be able to prevent third parties
from using our intellectual property rights and technology without our
authorization. We do not currently own any patents, although one patent is
pending related to our technology. We anticipate making patent applications in
the future. We rely on trade secrets, common law trademark rights and trademark
registrations. We intend to protect our intellectual property via non-disclosure
agreements, contracts, and limited information distribution, as well as
confidentiality and work for hire, development, assignment, and license
agreements with our employees, consultants, third party developers, licensees
and customers. However, these measures afford only limited protection and may be
flawed or inadequate. Also, enforcing intellectual property rights could be
costly and time-consuming and could distract management's attention from
operating business matters.
-41-
Our intellectual property may infringe on the rights of others, resulting
in costly litigation.
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In recent years, there has been significant litigation in the United
States involving patents and other intellectual property rights. In particular,
there has been an increase in the filing of suits alleging infringement of
intellectual property rights, which pressure defendants into entering settlement
arrangements quickly to dispose of such suits, regardless of their merits. Other
companies or individuals may allege that we infringe on their intellectual
property rights. Litigation, particularly in the area of intellectual property
rights, is costly and the outcome is inherently uncertain. In the event of an
adverse result, we could be liable for substantial damages and we may be forced
to discontinue our use of the subject matter in question or obtain a license to
use those rights or develop non-infringing alternatives. Any of these results
would increase our cash expenditures, adversely affecting our financial
condition.
Being a public company involves increased administrative costs, which could
result in lower net income and make it more difficult for us to attract and
retain key personnel.
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As a public company, we incur significant legal, accounting and other
expenses that HEC Iowa did not incur as a private company. In addition, the
Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the
SEC, have required changes in corporate governance practices of public
companies. We expect that these new rules and regulations will increase our
legal and financial compliance costs and make some activities more time
consuming. For example, in connection with being a public company, we may have
to create several board committees, implement additional internal controls and
disclose controls and procedures, retain a transfer agent and financial printer,
adopt an insider trading policy and incur costs relating to preparing and
distributing periodic public reports in compliance with our obligations under
securities laws. These new rules and regulations could also make it more
difficult for us to attract and retain qualified members of our board of
directors, particularly to serve on our audit committee, and qualified executive
officers.
We do not anticipate paying dividends in the foreseeable future. This could
make our stock less attractive to potential investors.
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We anticipate that we will retain any future earnings and other cash
resources for future operation and development of our business and do not intend
to declare or pay any cash dividends in the foreseeable future. Any future
payment of cash dividends will be at the discretion of our board of directors
after taking into account many factors, including our operating results,
financial condition and capital requirements. Corporations that pay dividends
may be viewed as a better investment than corporations that do not.
Future sales or the potential for sale of a substantial number of shares of
our common stock could cause our market value to decline and could impair
our ability to raise capital through subsequent equity offerings.
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During 2006, we expect to register some or all of the unregistered
outstanding shares of our Common Stock. Sales of a substantial number of shares
of our common stock in the public markets, or the perception that these sales
may occur, could cause the market price of our common stock to decline and could
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materially impair our ability to raise capital through the sale of additional
equity securities. In addition to the shares of our common stock actually issued
and outstanding, another 619,000 shares are reserved for issuance under our new
incentive compensation plan, subject to shareholder approval.
The authorization and issuance of blank-check preferred stock may prevent
discourage a change in our management.
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Our amended certificate of incorporation authorizes the board of
directors to issue up to 10 million shares of preferred stock without
stockholder approval having terms, conditions, rights, preferences and
designations as the board may determine. The rights of the holders of our common
stock will be subject to, and may be adversely affected by, the rights of the
holders of any preferred stock that may be issued in the future. The issuance of
preferred stock, while providing desirable flexibility in connection with
possible acquisitions and other corporate purposes, could have the effect of
discouraging a person from acquiring a majority of our outstanding common stock.
It may be difficult for a third party to acquire us, and this could depress
our stock price.
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Nevada corporate law includes provisions that could delay, defer or
prevent a change in control of our company or our management. These provisions
could discourage information contests and make it more difficult for you and
other stockholders to elect directors and take other corporate actions. As a
result, these provisions could limit the price that investors are willing to pay
in the future for shares of our common stock. For example:
o Without prior stockholder approval, the board of directors has the
authority to issue one or more classes of preferred stock with rights
senior to those of common stock and to determine the rights, privileges
and preferences of that preferred stock;
o There is no cumulative voting in the election of directors; and
o Stockholders cannot call a special meeting of stockholders.
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the quarter ended March 31, 2006, the Company issued 5,000
shares to an employee who exercised options under the Company's 2005 Incentive
Compensation Plan. During fiscal year 2005 the Company issued 426,000 shares of
restricted stock to officers and directors under the Company's 2005 Incentive
Compensation Plan. Further information about awards under the 2005 Incentive
Compensation Plan is included in our Annual Report on Form 10-KSB filed with the
Commission on March 31, 2006, which report is incorporated herein by reference.
Information regarding unregistered sales of other equity securities under our
private placement of shares and use of proceeds is included in our Current
Report on Form 8-K filed with the Commission on September 6, 2005 and amended on
September 7, 2005 which report is incorporated herein by reference.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibit No. Description
31.1 Certification pursuant to Item 601(b)(31) of Regulation S-B,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002, by Theodore G. Hollinger, the Company's Chief
Executive Officer.
31.2 Certification pursuant to Item 601(b)(31) of Regulation S-B,
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002, by Sandra Batt, the Company's Chief Financial
Officer.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by
Theodore G. Hollinger, the Company's Chief Executive Officer.
32.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by
Sandra Batt, the Company's Chief Financial Officer.
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NOTES ABOUT FORWARD-LOOKING STATEMENTS
Statements contained in this current report which are not historical
facts, including some statements regarding the effects of the Merger, may be
considered "forward-looking statements" under the Private Securities Litigation
Reform Act of 1995. Forward-looking statements are based on current expectations
and the current economic environment. We caution readers that such
forward-looking statements are not guarantees of future performance. Unknown
risks and uncertainties as well as other uncontrollable or unknown factors could
cause actual results to materially differ from the results, performance or
expectations expressed or implied by such forward-looking statements.
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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 hereunto duly authorized.
HYDROGEN ENGINE CENTER, INC.
Date: May 19, 2006 By /s/ THEODORE G. HOLLINGER
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Theodore G. Hollinger
President and Chief Executive Officer
Date: May 19, 2006 By /s/ Sandra Batt
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Sandra Batt
Chief Financial Officer
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