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Fuel Systems Solutions 10-K 2007
Form 10-K for Fiscal Year Ended December 31, 2006
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K

 


(Mark One)

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

For the fiscal year ended December 31, 2006

or

 

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

Commission File No.: 001-32999

 


FUEL SYSTEMS SOLUTIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 


 

Delaware   20-3960974

(State or Other Jurisdiction

Of Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

3030 South Susan Street, Santa Ana, California 92704

(Address of Principal Executive Offices, Including Zip Code)

(714) 656-1200

(Registrant’s telephone number, including area code)

 


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

None

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

Common Stock, $0.001 par value per share

 


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

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

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

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  x    Non-accelerated filer  ¨

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

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2007, was approximately $199.3 million based upon the closing sale price of the registrant’s common stock of $16.58 on June 29, 2007, the nearest trading date, as reported on the NASDAQ Stock Market.

As of September 30, 2007, the registrant had 15,490,877 shares of common stock, $0.001 par value per share, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.

 



Table of Contents

FUEL SYSTEMS SOLUTIONS, INC.

TABLE OF CONTENTS

 

          Page
     PART I     

Item 1.

   Business    8

Item 1A.

   Risk Factors    15

Item 1B.

   Unresolved Staff Comments    25

Item 2.

   Properties    25

Item 3.

   Legal Proceedings    26

Item 4.

   Submission of Matters to a Vote of Security Holders    26
   PART II   

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    27

Item 6.

   Selected Financial Data    28

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    36

Item 7A.

   Quantitative and Qualitative Disclosures about Market Risk    66

Item 8.

   Financial Statements and Supplementary Data    68

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    68

Item 9A.

   Controls and Procedures    68

Item 9B.

   Other Information    74
   PART III   

Item 10.

   Directors, Executive Officers and Corporate Governance    75

Item 11.

   Executive Compensation    78

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    90

Item 13.

   Certain Relationships and Related Transactions and Director Independence    93

Item 14.

   Principal Accountant Fees and Services    94
   PART IV   

Item 15.

   Exhibits and Financial Statement Schedules    95
   Signatures    100
   Index to Consolidated Financial Statements    F-1

 

2


Table of Contents

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. Statements about our plans, intentions and expectations are not historical facts but rather are based on current expectations, estimates and projections about our industry, our beliefs and assumptions. We use words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “estimate” and variations of these words and similar expressions to help identify forward-looking statements. These statements represent projections, beliefs and expectations based on current circumstances and conditions and in light of recent events and trends, and you should not construe these statements either as assurances of performances or as promises of a given course of action. Instead, various known and unknown factors are likely to cause our actual performance and management’s actions to vary, and the results of these variances may be both material and adverse. A list of the known material factors that may cause our results to vary, or may cause management to deviate from its current plans and expectations, is included in Item 1A “Risk Factors.” You should not place undue reliance on these forward-looking statements, which reflect our view only as of the date of the filing of this Annual Report.

EXPLANATORY NOTE

In this Form 10-K, Fuel Systems Solutions, Inc. is restating, for reasons described below, its consolidated balance sheet as of December 31, 2005 and its related consolidated statements of operations, stockholders’ equity and cash flows for the years ended December 31, 2005 and 2004. In addition, we are restating the unaudited quarterly consolidated financial information and condensed consolidated financial statements for the first three quarters in 2006 and each of the quarters in 2005. All financial information contained in this Form 10-K gives effect to these restatements. This Form 10-K also reflects the restatement of selected consolidated financial data as of December 31, 2004, as of and for the year ended December 31, 2003, as of and for the eight months ended December 31, 2002 and as of and for the fiscal year ended April 30, 2002, and opening accumulated deficit as of May 1, 2001. Our restatement, for all reasons described below, did not result in a change to our previously reported revenue, cash flow from operations or total cash and cash equivalents shown in our historical consolidated financial statements.

Our restatement reflects adjustments related to our voluntary stock option review, as more fully described below, for additional non-cash charges for stock-based compensation expense and related payroll tax and income tax effects. Our restatement information reflects the impact of recording adjustments in the fiscal year ended April 30, 1997 through the third quarter of the fiscal year ended December 31, 2006, related to our voluntary stock option review. In addition to the adjustments related to the stock option review, the restated consolidated financial statements presented in this Form 10–K include adjustments to correct an accounting error for the first three quarters in 2006 and each of the quarters in 2005, as of and for the year ended December 31, 2005 and for the year ended December 31, 2004. This correction relates to an error made in calculating the gross profit elimination for intercompany inventory remaining on the books of certain of our subsidiaries at period end, the impact of which decreased our net loss for the year ended December 31, 2005, increased our net loss for each of the years ended December 31, 2004 and December 31, 2003. We are also reflecting adjustments, as part of our restatement, to correct accounting errors in recording income tax expense, as more fully described below, for the first three quarters in 2006 and each of the quarters in 2005 and as of and for the year ended December 31, 2005. We have reflected the impact of the adjustments related to our voluntary stock option review on our income tax disclosure in the footnotes to the consolidated financial statements but have also corrected this income tax disclosure for errors in our disclosure of our deferred tax assets and valuation allowance, as more fully described below. Lastly, our restatement also reflects adjustments to correct for errors in account classification between selling, general and administrative expense, cost of revenue and other income (expense), net, as well as reclassifications on the balance sheet primarily between short-term and long-term relating to deferred tax balances and accrued expenses for compensation and between raw materials and finished goods.

We have not amended, and we do not intend to amend, any of our previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q affected by the restatements. The consolidated financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this Form 10-K, and the consolidated financial statements and related consolidated financial information contained in previously filed reports should not be relied upon.

As a result of our failure to file this report and other reports on a timely basis, we will not be eligible to use Form S-3 to register our securities with the SEC until all reports under the Securities Exchange Act of 1934, as amended, have been timely filed for at least 12 months.

 

3


Table of Contents

Restatement Related to Voluntary Stock Options Grant Review

In March 2007, our Board of Directors created a Special Committee to conduct a voluntary, internal review of the Company’s historical stock option grant practices and related accounting. The review covered options granted during the period from January 1996 through December 2006 (the “Review Period”). There were no option grants during 2005 and 2006. The Special Committee retained outside counsel and accounting experts to assist with this review.

On August 9, 2007, the Special Committee concluded its voluntary review of past stock option grant practices and determined that the original measurement dates of certain stock option grants, for financial accounting purposes, did not meet the requirements of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. Consequently, we revised the measurement dates consistent with the standards of APB No. 25 based on the best information available, and when the closing price of our stock at the original stated grant date was lower than the closing price on the revised measurement date, additional compensation expense was calculated. This resulted in additional stock-based compensation expense in each fiscal year from 1997 through 2005 which aggregated $8.0 million. In addition, the revised measurement dates resulted in additional stock-based compensation of $0.3 million for the nine months ended September 30, 2006 for expense recognized under the fair value method in accordance with SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”), which the Company adopted on January 1, 2006, because the exercise price for certain stock option grants prior to, but not vested as of January 1, 2006, differed from the fair market value on the revised measurement date, resulting in the calculation of increased fair values of said grants under the Black-Scholes option pricing model.

We also recorded stock-based compensation expense in each fiscal year from 1998 through 2006 for other stock option related errors that were identified, which aggregated $5.7 million. These items include:

 

   

the modification of stock options in connection with separation agreements for: (i) one director in fiscal year 1998 (ii) an officer in fiscal year 2000 and (iii) an officer in 2004 resulting in total additional expense of $0.5 million;

 

   

an adjustment of $0.3 million to reduce the amount previously recorded for the modification of stock options in connection with separation agreements for three officers in 2005 resulting from revised measurement dates for these stock option grants as noted above;

 

   

the modification of stock options for two officers in 2004 relating to their employment agreements resulting in additional expense of $1.3 million over the vesting period of the options from 2004 through the first nine months of 2006;

 

   

using fair value basis in accordance with SFAS No. 123 and the re-measurement principles under EITF 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, to account for non-employee grants to employees of a 50% owned subsidiary, BRC, in 2003 and 2004 until we acquired the remaining 50% of BRC on March 31, 2005 resulting in additional expense of $0.4 million;

 

   

accounting for a re-price in stock option grants for two grant dates under the variable accounting method resulting in additional expense of approximately $22,000;

 

   

recording expense of $0.5 million for the intrinsic value of options granted by a principal stockholder to three officers in June 1998 over the vesting period of the options through January 2001;

 

   

and, recording expense of $3.3 million for the impact of non-recourse loans granted to these three officers to cover the exercise of their stock options granted to them by the principal stockholder from March 2001 (the date of the loan) through July 2001 (the repayment date of the loan).

 

4


Table of Contents

As a result of the change in measurement dates described above, certain stock options granted then became issued at prices below fair market value on the revised measurement date and should have been classified as Non–Qualified Stock Options (“NQs”), rather than Incentive Stock Options (“ISOs”). Due to the differences in the tax treatment between ISOs and NQs, we under-reported or under–withheld certain payroll taxes for those NQ options. As part of the restatement, we have accrued liabilities and recorded charges to operating expenses for payroll tax contingencies and related penalties and interest. The tax liabilities, including interest and penalties, that we have recorded include the impact of the reclassification of these options for tax purposes as depicted in the pre–tax payroll tax adjustments column of the table below. Upon expiration of the related statute of limitations for payroll taxes, which we have determined to be three years, we recorded the reversal of the payroll tax liability and related penalties and interest.

The table below reflects the impact of the additional non-cash charges for stock-based compensation expense and related payroll tax liability and income tax impact on our consolidated statements of income from 1996 through September 30, 2006, including the corresponding cumulative adjustment to accumulative deficit as of May 1, 2001 on our consolidated balance sheets. Prior to this restatement, we had not recorded any non-cash stock-based compensation expense in our consolidated statements of income with the exception of $1.8 million recorded during 2005 for a modification of previous stock option awards for our former chief executive officer, our former vice president and chief operating officer for international operations and our former chief financial officer. All dollar amounts are presented in thousands except per share amounts.

 

          Pre-Tax
Stock-Based
Compensation
Expense
(Benefit)
Adjustments
   

Pre-Tax
Payroll
Related

Tax
Expense
(Benefit)
Adjustments

    Related
Income Tax
Expense
(Benefit)
Adjustments
    Net Expense
(Benefit)
After-Tax
Adjustments
 

Twelve months ended

   April 30, 1997    $ 21     $ —       $ (7 )   $ 14  

Twelve months ended

   April 30, 1998      272       8       (100 )     180  

Twelve months ended

   April 30, 1999      1,665       73       (625 )     1,113  

Twelve months ended

   April 30, 2000      1,139       745       (427 )     1,457  

Twelve months ended

   April 30, 2001      3,774       571       (533 )     3,812  
                                   

Cumulative effect at

   April 30, 2001      6,871       1,397       (1,692 )     6,576  

Twelve months ended

   April 30, 2002      2,054       1,708       (410 )     3,352  

Eight months ended

   December 31, 2002      378       136       1,098  (a)     1,612  

Twelve months ended

   December 31, 2003      1,022       (126 )     —         896  
                                   

Cumulative effect at

   December 31, 2003      10,325       3,115       (1,004 ) (b)     12,436  

Twelve months ended

   December 31, 2004      2,571       (967 )     —         1,604  

Three months ended

   March 31, 2005      (197 )     43       —         (154 )

Three months ended

   June 30, 2005      253       (1,573 )     —         (1,320 )

Three months ended

   September 30, 2005      231       215       —         446  

Three months ended

   December 31, 2005      358       4       —         362  
                                   

Twelve months ended

   December 31, 2005      645       (1,311 )     —         (666 )

Three months ended

   March 31, 2006      273       20       —         293  

Three months ended

   June 30, 2006      64       (388 )     —         (324 )

Three months ended

   September 30, 2006      143       7       —         150  
                                   

Nine months ended

   September 30, 2006      480       (361 )     —         119  

Total

      $ 14,021     $ 476     $ (1,004 )   $ 13,493  
                                   

(a) The Company recorded valuation allowance on its deferred tax assets during the eight months ended December 31, 2002 and as a result, as part of the restatement, the Company set up a valuation allowance during this period for any deferred tax assets which were established in earlier periods as part of the restatement.
(b) The Company previously recorded the tax benefit for tax deductions related to stock-based compensation as an increase to additional paid-in-capital in accordance with APB No. 25. To the extent this tax benefit relates to stock-based compensation recorded as part of our restatement of our financial statements, the tax benefit (previously recorded to additional paid-in-capital) was recorded as a decrease to income tax expense.

 

5


Table of Contents

For more information regarding the Special Committee’s findings and the restatement, please refer to Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Consolidated Financial Statements,” and Note 2 “Restatement of Previously Issued Consolidated Financial Statements” in Item 8. For further information regarding the Special Committee’s findings relating to stock option practices and our remedial measures, see Item 9A “Controls and Procedures.”

Restatement Related to Gross Profit Eliminations for Intercompany Inventory

In addition to the adjustments related to the stock option review, the restated consolidated financial statements presented in this Form 10–K include an adjustment to correct an accounting error for the first three quarters in 2006 and each of the quarters in 2005, as of and for the year ended December 31, 2005 and for the year ended December 31, 2004. This correction relates to an error made in calculating the gross profit elimination for intercompany inventory remaining on the books of certain of our subsidiaries at period end. The impact of the correction, net of taxes, decreased our net income by $0.1 million for the quarter ended March 31, 2006, increased our net income by $0.2 million for the quarter ended June 30, 2006, decreased our net income by $0.1 million for the quarter ended September 30, 2006, decreased our net loss by $0.1 million for the year ended December 31, 2005, increased our net loss by $0.1 million for the year ended December 31, 2004, and increased our net loss by $0.6 million for the year ended December 31, 2003. See Note 18 of the notes to the consolidated financial statements for discussion regarding the impact on the first three quarters in 2006 and each of the quarters in 2005.

Restatement Related to Income Taxes

We are also reflecting adjustments, as part of our restatement, to correct accounting errors in recording income tax expense for the first three quarters in 2006 and each of the quarters in 2005 and as of and for the year ended December 31, 2005.

Previously, we had taken the position that the foreign earnings for BRC S.r.L. (“BRC”), our Italian subsidiary, were permanently reinvested and therefore no residual U.S. income tax was recorded under APB Opinion No. 23, Accounting for Income Taxes – Special Areas. However, for U.S. income tax purposes, the loan from MTM S.r.L. (“MTM”), a subsidiary of BRC, to IMPCO Technologies, Inc. (“IMPCO”), our U.S. subsidiary, entered into in December 2004, is deemed to be a constructive dividend and therefore created taxable income that we did not previously recognize in our 2005 provision for income taxes. For the IMPCO loan interest payments to MTM, we are required to withhold U.S. tax on the payments, which we did not previously withhold. As a result, we have recorded an adjustment to increase income tax expense by $0.1 million for the nine months ended September 30, 2006 and $0.3 million for the year ended December 31, 2005. We also recorded an adjustment to increase income tax expense by $0.1 million for the year ended December 31, 2005 to correct for an error in recording deferred tax asset valuation allowance related to our BRC operations in December 31, 2005.

We have reflected the impact of the adjustments related to our voluntary stock option review and gross profit elimination for intercompany inventory on our income tax disclosure in the footnotes to the consolidated financial statements but have also corrected this income tax disclosure for errors in our disclosure of our deferred tax assets and valuation allowance by reducing both balances due to utilization of net operating loss carryovers because the loan from MTM is treated as a constructive dividend for U.S income tax purposes, as discussed above, and due to ownership changes which took place since 1999 leading us to conclude that certain of our federal net operating loss carryovers, federal tax credit carryovers, state net operating loss carryovers and state tax credit carryovers will expire unused due to limitations imposed under Internal Revenue Code Section 382 and 383. In the aggregate, the reduction we recorded resulted in a reduction to our deferred tax assets and a corresponding reduction to the related valuation reserve in the amount of $11.4 million.

 

6


Table of Contents

Correction of Account Classification

Our restatement also reflects adjustments to correct for errors in account classification between selling, general and administrative expense, cost of revenue and other income (expense), net. These adjustments primarily relate to the reclassification of other manufacturing costs of foreign subsidiaries which were included in selling, general and administrative expenses instead of cost of revenue, and costs related to the closure of our Cerritos facility which were classified as cost of revenue instead of selling, general and administrative expenses. We also corrected errors in classification on the balance sheet primarily between short-term and long-term for deferred tax balances and compensation related accrued expenses and between raw materials and finished goods.

Summary

The table below reflects the impact of the accounting errors that have been corrected, including 1) the additional non-cash charges for stock-based compensation expense and related payroll tax liability and income tax impact recorded in each fiscal year for the period commencing, May 1, 1996, through the quarter ended September 30, 2006, 2) the adjustment to the gross profit elimination for intercompany inventory recorded in each fiscal year for the period commencing from January 1, 2003 through the quarter ended September 30, 2006, and 3) the adjustment to income tax expense recorded in each fiscal year for the period commencing from January 1, 2005 through the quarter ended September 30, 2006. The adjustment to correctly classify costs between selling, general and administrative expense and cost of sales have not been reflected in the table below as they represent reclassification of costs that do not have an impact on our net income, earnings per share or equity. All dollar amounts are presented in thousands except per share amounts. Per share amounts may not total due to rounding.

 

         

Net
Income
(Loss)

As
Previously
Reported

    Pre-tax
(Expense)
Benefit
Adjustment
   

Pre-tax

Equity

Share In
Income

(loss) of
Unconsolidated
Affiliates
Adjustment

    Income
Tax
(Expense)
Benefit
Adjustment
   

Adjusted
Net

Income
(loss)

   

Diluted
EPS

As
Previously
Reported

    Adjustment     Adjusted
Diluted
EPS
 

Twelve months ended

   April 30, 1997    $ 2,644     $ (21 )   $ —       $ 7     $ 2,630     $ 0.86     $ (0.00 )   $ 0.86  

Twelve months ended

   April 30, 1998      4,270       (280 )     —         100       4,090       1.19       (0.04 )     1.15  

Twelve months ended

   April 30, 1999      5,800       (1,738 )     —         625       4,687       1.41       (0.25 )     1.16  

Twelve months ended

   April 30, 2000      3,065       (1,884 )     —         427       1,608       0.66       (0.32 )     0.34  

Twelve months ended

   April 30, 2001      (13,103 )     (4,345 )     —         533       (16,915 )     (2.37 )     (0.69 )     (3.06 )

Twelve months ended

   April 30, 2002      (27,236 )     (3,762 )     —         410       (30,588 )     (4.91 )     (0.60 )     (5.51 )

Eight months ended

   December 31, 2002      (28,394 )     (514 )     —         (1,098 )     (30,006 )     (3.95 )     (0.22 )     (4.17 )

Twelve months ended

   December 31, 2003      (6,900 )     (1,484 )     —         —         (8,384 )     (0.83 )     (0.18 )     (1.01 )
                                                                   

Cumulative effect at

   December 31, 2003      (59,854 )     (14,028 )     —         1,004       (72,878 )     (7.94 )     (2.30 )     (10.24 )

Twelve months ended

   December 31, 2004      (15,879 )     (1,739 )     —         —         (17,618 )     (1.71 )     (0.19 )     (1.90 )

Three months ended

   March 31, 2005      (2,181 )     8       —         (74 )     (2,247 )     (0.20 )     (0.01 )     (0.21 )

Three months ended

   June 30, 2005      1,172       1,481       (142 )     (77 )     2,434       0.08       0.09       0.17  

Three months ended

   September 30, 2005      (9,219 )     (220 )     11       (153 )     (9,581 )     (0.64 )     (0.03 )     (0.67 )

Three months ended

   December 31, 2005      (460 )     (581 )     91       (10 )     (960 )     (0.03 )     (0.04 )     (0.07 )
                                                                   

Twelve months ended

   December 31, 2005      (10,688 )     688       (40 )     (314 )     (10,354 )     (0.79 )     0.02       (0.77 )
                                                                   

Cumulative effect at

   December 31, 2005      (86,421 )     (15,079 )     (40 )     690       (100,850 )     (10.44 )     (2.47 )     (12.91 )

Three months ended

   March 31, 2006      3,699       (322 )     (80 )     (23 )     3,274       0.25       (0.03 )     0.22  

Three months ended

   June 30, 2006      1,278       408       (52 )     102       1,736       0.08       0.03       0.11  

Three months ended

   September 30, 2006      3,437       (191 )     46       (166 )     3,126       0.22       (0.02 )     0.20  
                                                                   

Cumulative effect at

   September 30, 2006    $ (78,007 )   $ (15,184 )   $ (126 )   $ 603     $ (92,714 )   $ (9.89 )   $ (2.49 )   $ (12.38 )
                                                                   

 

7


Table of Contents

PART I

 

Item 1. Business.

Overview

We design, manufacture and supply alternative fuel components and systems for use in the transportation, industrial and power generation industries on a global basis. Our components and systems control the pressure and flow of gaseous alternative fuels, such as propane and natural gas used in internal combustion engines. Our products improve efficiency, enhance power output and reduce emissions by electronically sensing and regulating the proper proportion of fuel and air required by the internal combustion engine. We also provide engineering and systems integration services to address our individual customer requirements for product performance, durability and physical configuration. For more than 48 years, we have developed alternative fuel products. We supply our products and systems to the market place through a global distribution network of several hundred distributors and dealers in 70 countries and 120 original equipment manufacturers, or OEMs.

We offer an array and combination of gaseous fuel components to assemble fuel conversion kits and systems for our customers, including:

 

   

fuel delivery—pressure regulators, fuel injectors, flow control valves, and other components designed to control the pressure, flow and/or metering of gaseous fuels;

 

   

electronic controls—solid-state components and proprietary software that monitor and optimize fuel pressure and flow to meet manufacturers’ engine requirements;

 

   

gaseous fueled internal combustion engines—engines manufactured by OEMs that are integrated with our fuel delivery and electronic controls; and

 

   

systems integration—systems integration support to integrate the gaseous fuel storage, fuel delivery and/or electronic control components and sub-systems to meet OEM and aftermarket requirements.

 

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Table of Contents

Automobile manufacturers, taxi companies, transit and shuttle bus companies, and delivery fleets are among our most active customers. Additionally, users of small and large industrial engines capitalize on the lower cost and pollutant benefits of using alternative fuels. For example, forklift and other industrial equipment users often use our products to operate equipment indoors resulting in lower toxic emissions. The wide availability of gaseous fuels in world markets combined with their lower emissions and cost compared to gasoline and diesel fuels is driving rapid growth in the global alternative fuel industry market. In 2006, 2005 and 2004, approximately 78%, 66% and 45% of our revenue, respectively, was derived from sales outside the United States.

We were incorporated in Delaware in 1985 after having provided automotive and alternative fuel solutions in a variety of organizational structures since 1958.

Reorganization

On August 23, 2006, our Company was reorganized pursuant to an Agreement and Plan of Reorganization by and among IMPCO Technologies, Inc. (“IMPCO”), Fuel Systems Solutions, Inc. (Fuel Systems”), a newly formed Delaware corporation, and IMPCO Merger Sub, Inc., a Delaware corporation formed solely for the purpose of consummating the reorganization. The agreement reorganized IMPCO’s capital structure into a holding company structure, pursuant to which (1) IMPCO contributed 100% of its holdings of the capital stock of BRC S.r.L. (“BRC”) to Fuel Systems; (2) IMPCO became a wholly owned subsidiary of Fuel Systems; and (3) the stockholders of IMPCO exchanged all of their shares of IMPCO for shares of Fuel Systems. Nasdaq began listing Fuel Systems’ common stock on the Nasdaq Global Market under a new trading symbol “FSYS” on August 25, 2006.

We believe that the reorganization, through the formation of our holding company Fuel Systems, with IMPCO and BRC being separate, stand-alone operating entities and wholly-owned subsidiaries of Fuel Systems, offers several advantages:

 

   

It promotes greater management accountability at the corporate and individual operating unit levels;

 

   

It creates greater flexibility to respond to customer needs; and

 

   

It aligns each operating subsidiary with specific core product lines and business segments.

As a result of this reorganization, the two market segments in which we operate are more closely aligned with our subsidiaries: IMPCO (industrial segment) and BRC (transportation segment).

As part of the reorganization, stockholders of IMPCO received one whole share of common stock of Fuel Systems in exchange for every two shares of IMPCO common stock owned at the time of the reorganization. Stockholders received cash for any fractional shares held equal to a proportionate interest in the gross proceeds of the sale on Nasdaq of the aggregate fractional shares.

All outstanding warrants to purchase IMPCO common stock became warrants to purchase one whole share of Fuel Systems’ common stock for every two shares of IMPCO common stock subject to such warrant terms, with any fractional shares treated in accordance with the warrant terms. All outstanding options to purchase IMPCO common stock became options to purchase one whole share of Fuel Systems’ common stock for every two shares of IMPCO common stock subject to such option, with any fractional shares rounded-up to the nearest whole number. The exercise price of the warrants and options following the reorganization became equal to twice the exercise price of such option or warrant immediately prior to the reorganization. The post-reorganization consolidated financial statements of Fuel Systems presented herein are presented on the same basis as and can be compared to the consolidated financial statements reported in IMPCO’s prior quarterly and annual reports filed with the SEC. All share numbers and per share amounts are stated for Fuel Systems and have given effect to the two-for-one exchange of IMPCO stock into Fuel Systems stock that was effected pursuant to the reorganization.

The reorganization transaction is described in detail in the proxy statement/prospectus on Form S-4, filed by Fuel Systems with the SEC on July 7, 2006 and declared effective that day. That filing also includes the full text of the certificate of incorporation of Fuel Systems.

Our periodic and current reports, and any amendments to those reports, are available, free of charge, as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission, or SEC, on our website: www.fuelsystemssolutions.com. The information on our website is not incorporated by reference into this report. You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street N E, Washington, D.C. 20549. You may obtain information on the

 

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operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding us at http://www.sec.gov.

Alternative Fuel Industry

Overview

Our business is focused on the alternative fuel industry. We believe three independent market factors—economics, energy independence and environmental concerns—are driving the growth of the market for alternative fuel technology. We believe the historic price differential between propane or natural gas and gasoline results in economic benefit to end users of alternative fuel technology. In transportation markets, the price of alternative fuels such as natural gas or propane is typically substantially less than the price of gasoline. By converting a liquid fueled internal combustion engine to run on propane or natural gas, customers can capitalize on this fuel price differential. End-users may recoup the cost of the conversion within six to eighteen months, depending on the fuel cost disparity prevailing at the time. Transportation companies in various countries, including Italy, Turkey, Poland, Australia, Brazil and many countries in Asia are also taking advantage of these economics.

In addition to economic benefits of alternative fuels to end-users, some governments have sought to create a demand for alternative fuels in order to reduce their dependence on imported oil and reduce their unfavorable balance of payments by relying on their natural gas reserves. Alternative fuel vehicles that operate on natural gas or propane can lessen the demand for gasoline.

Markets

We are directly involved in two market segments: transportation and industrial, which includes mobile and power generation equipment. These segments have seen growth in the use of clean-burning gaseous fuels due to the less harmful emissions effects of gaseous fuels and the cost advantage of gaseous fuels over gasoline and diesel fuels.

Transportation

According to the most recent statistics from the World LP Gas Association, the International Association for Natural Gas Vehicles, or IANGV, and the European Natural Gas Association, there are over 11.4 million propane, or LPG, vehicles and 5.7 million natural gas vehicles in use worldwide, either for personal mobility, fleet conveyance or public transportation. As the world’s vehicle population increases from 800 million to an estimated 1.3 billion by 2020, most growth will occur in developing countries within Asia, North Africa, and areas of the Middle East. These regions currently have the lowest ratio of vehicles per one thousand people, and are slated to grow rapidly over the next ten years as economic improvements stimulate personal vehicle ownership. The Energy Information Administration of the U.S. Department of Energy, the World Bank, the Office of Economic and Community Development, the fifteen countries of the European Union and the Asian Development Bank suggest that interest in expanding the use of alternative fuel vehicles is mounting in many parts of the developed and developing world. Growth projections, reported by the Energy Information Administration and the IANGV in comparison with current data available from the European Natural Gas Vehicle Association, indicate that over two million additional alternative fuel vehicles will be introduced worldwide by 2010. In Europe, alternative fuel vehicles have rapidly penetrated the transportation market. The European Union’s four largest natural gas-consuming members, the United Kingdom, Germany, France, and Italy, all have introduced incentives for gaseous-fueled vehicles. The European Union has established a target to replace 20% of their liquid fueled vehicles with gaseous fueled vehicles by 2020.

Asia is emerging as a significant growth market for alternative fuel vehicles. China, already the world’s second-largest energy consumer, will continue to grow in importance on world energy markets as many forecasts suggest that strong economic growth will drive up demand.

Industrial

Equipment such as forklifts, aerial platforms, sweepers, turf equipment, power generators and other mobile industrial equipment have long been workhorses of developed countries, and are a significant portion of our global activities. With developed countries such as the United States, and the countries in Asia and Europe seeking a broader consensus on regulation of emission sources in an attempt to further reduce air pollution, many countries have legislated and we believe will continue to legislate, emission standards for this type of equipment.

 

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With new emissions regulations being imposed, OEMs will require advanced technologies that permit the use of gaseous fuels in order to satisfy not only the regulation, but also the customers’ requirements for durability, performance and reliability. We have developed and are currently supplying a series of advanced technology alternative fuel systems to the industrial OEM market under the brand name Spectrum®. We and our industrial brands focus on serving the market with fuel systems, services and emission certified engine packages.

The World Energy Outlook 2006 projects the global primary energy demand to be over 50% higher in 2030 compared to 2003, an average annual rate of increase of 1.6%. Even though the earth’s energy resources are adequate to meet this demand, the amount of investment that will be needed to exploit these resources will be higher than in the past. For example, the World Energy Outlook 2006 estimated that an investment of $20 trillion is needed through 2030. Investment in the oil industry will also have to rise sharply, as demand rises and the surplus capacity in crude oil production and refining that has characterized the industry since the 1970s is completely used. Approximately 39% of the increase in gas demand is expected to come from the power generation sector, and 52% from the industrial sector, since natural gas is relatively more efficient compared to other energy sources and since it burns more cleanly than either coal or oil. Worldwide energy consumption of the industrial sector is expected to grow by 2.4% annually (compared to 1% annual expected growth in population) over the 2003-2030 period, according to U.S. Department of Energy’s International Energy Outlook 2006. The natural gas share of world energy consumption (on a Btu basis) is expected to rise from 24% to 26%. Gaseous fuels such as propane and natural gas have significant reserves available worldwide which are less costly to refine compared to crude oil and have historically been less expensive than liquid fuels. According to the U.S. Geological Survey’s World Petroleum Assessment 2000, a significant volume of natural gas remains to be discovered. China and India, the world’s most heavily populated nations, are actively developing their infrastructure to facilitate natural gas consumption and imports.

Competitive Advantages

Industry participants compete on price, product performance and customer support.

We believe we have developed a technological leadership position in the alternative fuel industry based on our experience in designing, manufacturing and commercializing alternative fuel delivery products and components; our relationships with leading companies in transportation; our knowledge of the power generation and industrial markets; our financial commitment to research and product development; and our proven ability to develop and commercialize new products. We believe our competitive strengths include:

 

   

Strong technological base;

 

   

Strong global distribution and OEM customer relationships;

 

   

Extensive manufacturing experience;

 

   

Established systems integration expertise; and

 

   

Positioned for global growth.

Customers and Strategic Relationships

IMPCO’s customers include some of the world’s largest OEMs and engine manufacturers, and BRC’s customers include some of the world’s largest automotive OEM’s.

We are working with a number of our customers to address their future product and application requirements as they integrate more advanced, certified gaseous fuel systems into their business strategies. Additionally, we continually survey and evaluate the benefits of joint ventures, acquisitions and strategic alliances with our customers and other participants in the alternative fuel industry to strengthen our global business position.

In 2006, no single customer represented more than 10% of our consolidated sales. In 2005 and 2004, Nacco Materials Handling Group represented approximately 14.5% and 21.2% of our consolidated sales. No other customer represented more than 10% of our consolidated sales in 2005 or 2004. During 2006, 2005 and 2004, sales to our top ten customers accounted for 36.5%, 40.2% and 54.3% of our consolidated sales, respectively. If several of these key customers were to reduce their orders substantially, we would suffer a decline in sales and profits, and those declines could be substantial.

 

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Products and Services

Our products include gaseous fuel regulators, fuel shut-off valves, fuel delivery systems, complete engine systems, and electronic controls for use in internal combustion engines for the transportation, industrial, and power generation markets. In addition to these core products, which we manufacture, we also design, assemble and market ancillary components required for complete systems operation on alternative fuels.

All of our products are designed, tested and validated in accordance with our own internal requirements, as well as tested and certified with major regulatory and safety agencies throughout the world, including Underwriters Laboratories in North America and TÜV in Europe. The following table describes the features of our products:

 

Products

  

Features

Fuel Metering

  

•        Designed to operate on propane, natural gas or digester gas fuels

 

•        Electronic control overlays allow integration with modern emissions monitoring systems for full emissions compliance capability

 

•        Designed for high resistance to poor fuel quality

Fuel Regulation

  

•        Reduces pressure of gaseous and liquid fuels

 

•        Vaporizes liquid fuels

 

•        Handles a wide range of inlet pressures

Fuel Shut-Off

  

•        Mechanically or electronically shuts off fuel supply to the regulator and engine • Available for low-pressure vapor natural gas and high-pressure liquid propane • Designs also incorporate standard fuel filtration to ensure system reliability

Electronics & Controls

  

•        Provides closed loop fuel control, allowing integration with existing sensors to ensure low emissions

 

•        Integrates gaseous fuel systems with existing engine management functions

Engine-Fuel Delivery Systems

  

•        Turnkey kits for a variety of engine sizes and applications

 

•        Customized applications interface per customer requirements

Fuel Systems

  

•        Complete vehicle and equipment systems for aftermarket conversion

 

•        Complete engine and vehicle management systems for heavy on-highway vehicles

  

•        Complete engine and vehicle management systems for off-highway and industrial engines used for material handling, power generation and industrial applications

 

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We have developed capabilities which we use to develop a broad range of products to satisfy our customers’ needs and applications. These capabilities/applications fall into the following categories:

 

Capabilities

  

Applications

Design and Systems Integration

  

•        Strong team of applications engineers for component, system and engine level exercises providing support to customers in the application of our gaseous fuel products

 

•        Applications engineering services for whole vehicle/machine integration outside of our products

 

•        Full three dimensional design modeling and component rapid prototyping services

Certification

  

•        Certification of component products and systems in line with the requirements of California Air Resources Board and Environmental Protection Agency for off-highway engines

 

•        Provide customers with the required tools to manage in-field traceability and other requirements beyond initial emission compliance

Testing and Validation

  

•        Component endurance testing

 

•        Component thermal and flow performance cycling

 

•        Engine and vehicle testing and evaluation for performance and emissions

Sub-System Assembly

  

•        Pre-assembled modules for direct delivery to customers’ production lines

 

•        Sourcing and integrating second and third tier supplier components

Training and Technical Service

  

•        Complete technical service support, including technical literature, web-based information, direct telephone interface (in all major countries) and on-site support

 

•        Training services through sponsored programs at approved colleges, at our facilities worldwide and on-site at customer facilities

Service Parts and Warranty Support

  

•        Access to service parts network, along with direct support in development of customers’ own internal service parts programs and procedures

 

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Sales and Distribution

We sell products through a worldwide network encompassing several hundred distributors and dealers in over 70 countries and through a sales force that develops sales with distributors, OEMs and large end-users. Our operations focus on OEM and aftermarket distributors in the transportation, industrial, and power generation markets. Of these markets, we believe that the greatest potential for immediate growth is in the Europe and Asia Pacific regions in the transportation OEM and aftermarket, and in North America in the industrial OEM and aftermarket.

During years 2006, 2005 and 2004, sales to distributors accounted for 63.6%, 62.2% and 32.0%, respectively, of our net revenue, and sales to OEM customers accounted for 36.4%, 37.8% and 68.0%, respectively, of our net revenue.

Distributors generally service the aftermarket business for the conversion of liquid fueled engines to gaseous fuels and small-volume OEMs are generally specialized and privately owned enterprises. Many domestic distributors have been our customers for more than 30 years and many of our export distributors have been our customers for more than 20 years.

Our IMPCO operations, consisting of our U.S. facility and foreign subsidiaries located in the Netherlands, Australia and Japan, as well as our BRC operations, consisting of our Italian facility and foreign subsidiaries in Argentina and Brazil, have sales, application, market development and technical service capabilities. Information regarding revenue, income and assets of each of our two business segments, IMPCO operations and BRC operations, and our revenue and assets by geographic area is included in Note 12 to the consolidated financial statements.

Manufacturing

We manufacture and assemble a majority of our products at our facilities in Santa Ana, California, and Cherasco, Italy and to a lesser extent at some of our other international facilities. Current manufacturing operations consist primarily of mechanical assembly and light machining. We rely on outside suppliers for parts and components and obtain components for products from a variety of domestic and foreign automotive and electronics suppliers, die casters, stamping operations, specialized diaphragm manufacturers and machine shops. In 2006, 2005 and 2004, Power Solutions, Inc. accounted for approximately 11.8%, 17.1% and 33.7% of our raw material purchases, respectively.

Material costs and machined die cast aluminum parts represent the major components of cost of sales. Coordination with suppliers for quality control and timely shipments is a high priority to maximize inventory management. We use a computerized material requirement planning system to schedule material flow and balance the competing demands of timely shipments, productivity and inventory management. Our California and Italy manufacturing facilities are ISO-9001 certified.

Research and Development

Our research and development programs provide the technical capabilities that are required for the development of systems and products that support the use of gaseous fuels in internal combustion engines. Our research and development is focused on fuel delivery and electronic control systems and products for motor vehicles, engines, forklifts, stationary engines and small industrial engines. Our research and development expenditures were approximately $8.1 million, $8.2 million and $4.7 million in 2006, 2005 and 2004, respectively.

Competition

Our key competitors in gaseous fuel delivery products, accessory components and engine conversions markets include Landi Group, Lovato Company, OMVL, S.r.L. and O.M.T. Tartarini, S.r.L. located in Europe, Aisan Industry Co. Ltd. and Nikki Company Ltd. in Japan and TeleflexGFI in the North America and Europe. These companies, together with us, account for a majority of the world market for alternative fuel products and services. In the future, we may face competition from traditional automotive component suppliers, such as the

 

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Bosch Group, Delphi Corporation, Siemens VDO Automotive AG, and Visteon Corporation, and from motor vehicle OEMs that develop fuel systems internally. Industry participants compete on price, product performance and customer support.

Product Certification

We must obtain emission compliance certification from the Environmental Protection Agency to sell certain of our products in the United States, from the California Air Resources Board to sell certain products in California, and meet European standards for emission regulations in that market. Each car, truck or van sold in the market must be certified before it can be introduced into commerce, and its products must meet component, subsystem and system level durability, emission, refueling and various idle tests. We have also obtained international emissions compliance certification in Argentina, Australia, Brazil, Canada, Chile, Europe, Russia, Mexico and Thailand. We strive to meet stringent industry standards set by various regulatory bodies. Approvals enhance the acceptability of our products in the worldwide marketplace. Many foreign countries also accept these agency approvals as satisfying the “approval for sale” requirements in their markets.

Employees

As of August 31, 2007, we employed approximately 845 persons, excluding those employed by our unconsolidated affiliate in Brazil, Italy and South Korea. Of these employees, 271 were employed in IMPCO operations, of which 77 are foreign employees, and 574 were employed in BRC operations. None of our employees are represented by a collective bargaining agreement. We consider our relations with our employees to be good.

Intellectual Property

We currently rely primarily on patent and trade secret laws to protect our intellectual property. We currently have four U.S. patents and four Italian patents issued. Our U.S. patents will expire on various dates through October 2008, and our Italian patents will expire on various dates until April 2026. We do not expect the expiration of our patents to have a material effect on our revenue.

We also rely on a combination of trademark, trade secret and other intellectual property laws and various contract rights to protect our proprietary rights. However, we cannot be sure that these intellectual property rights provide sufficient protection from competition. We believe that our intellectual property protected by copyright, trademark and trade secret protection is less significant than our intellectual property protected by patents.

Third parties may claim that our products and systems infringe their patents or other intellectual property rights. Identifying third-party patent rights can be particularly difficult, especially since patent applications are not published until 18 months after their filing dates. If a competitor were to challenge our patents, or assert that our products or processes infringe its patent or other intellectual property rights, we could incur substantial litigation costs, be forced to design around their patents, pay substantial damages or even be forced to cease our operations, any of which could be expensive and/or have an adverse effect on our operating results. Third party infringement claims, regardless of their outcome, would not only drain our financial resources, but also would divert the time and effort of our management and could result in our customers or potential customers deferring or limiting their purchase or use of the affected products or services until resolution of the litigation.

 

Item 1A. Risk Factors.

We currently have substantial debt that we may be unable to service.

We have significant debt service obligations. As of December 31, 2006, we had aggregate outstanding indebtedness of $18.9 million not including debt obligations for IMPCO from BRC of approximately $17.5 million under a loan agreement with MTM S.r.L. (the “MTM loan”), which have been eliminated in consolidation. The IMPCO U.S. operations LaSalle senior credit facility has a maximum borrowing limit of $9.0 million, which was limited based on our eligible accounts receivable and our eligible inventory as of December 31, 2006 to approximately $7.3 million. Of that amount, $5.2 million was outstanding as of December 31, 2006, leaving approximately $2.1 million unused and available.

Our debt subjects us to numerous risks, including the following:

 

   

we will be required to use a substantial portion of our cash flow from operations to pay interest on our debt, thereby reducing cash available to fund working capital, capital expenditures, strategic acquisitions, investments and alliances, and other general corporate requirements;

 

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our leverage may increase our vulnerability to general economic downturns and adverse competitive and industry conditions and may place us at a competitive disadvantage compared to those of our competitors who are less leveraged;

 

   

our debt service obligations may limit our flexibility to plan for, or react to, changes in our business and in the industry in which we operate;

 

   

our level of debt may make it difficult for us to raise additional financing on terms satisfactory to us; and

 

   

if we do not comply with the financial and other restrictive covenants in our debt instruments, any such failure could, if not cured or waived, have a material adverse effect on our ability to fulfill our obligations and on our business or prospects generally, including the possibility that our lenders might foreclose on our assets.

We have recently been in default under our IMPCO U.S. operations primary debt facility, and we cannot assure you that we will be able to avoid events of default or noncompliance in the future or to obtain amendments to our debt facilities.

The IMPCO U.S. operations LaSalle senior credit facility requires us to present it with accurate and timely financial reports. Due to the delay in preparing the current and restated historical financial statements included in this annual report on 10-K for 2006 and the quarterly reports for the first two quarters of 2007, we have been in breach of this requirement. In addition, the LaSalle senior credit facility requires us to maintain specified financial ratios and meet specific financial tests, such as requiring us to generate specified amounts of pre-tax income. Our recurring failure to comply with these covenants has resulted in defaults for which we have had to seek numerous waivers and amendments to our credit facility.

If we are unable to secure any necessary future waivers or amendments, LaSalle could require us to repay the amounts owed under the credit agreement immediately. If we are unable to make a required repayment and are not able to draw sufficient dividends or loans from our subsidiaries or refinance these borrowings, our lenders could foreclose on our assets and our business could be adversely impacted.

We cannot assure investors that the lenders will continue to agree to amend the financial covenants or grant further or continuing waivers in the future. In addition, amendments or waivers may be on terms that are different from and more onerous to us than the current terms of the senior credit facility. For example, in connection with granting us recent waivers, LaSalle has required that we make no payments to MTM under the loan between IMPCO and MTM. In order to avoid defaulting on the MTM loan, we have had to borrow additional principal amounts from MTM and use the additional indebtedness to make the required debt service payments.

Our senior credit facility with LaSalle expires on January 31, 2008. We might not be able to extend the maturity of the LaSalle senior credit facility, and we would have to draw dividends from our subsidiaries or refinance our indebtedness in order to repay the amounts owing under it.

IMPCO U.S. operations has historically depended on borrowings under our LaSalle senior credit facility to fund our liquidity and capital needs. As of September 30, 2007, the outstanding principal amount under the credit facility was $3.1 million. This credit facility expires on January 31, 2008. La Salle has indicated its intent to not renew our credit facility in the long term and they may or may not be willing to extend beyond that date while we transition to a new lender.

If we are unable to obtain additional or replacement financing by the expiration of the LaSalle senior credit agreement, we would have to draw dividends or obtain loans from our subsidiaries to repay the amounts owing or refinance the debt. Our ability to find replacement financing is hampered by the long delay in filing this annual report on Form 10-K for 2006 and the quarterly reports on Form 10-Q for the first two quarters of 2007, and our need to present the consolidated financial statements contained in these periodic reports to prospective lenders as part of the loan application process. As a result, we may not be able to secure a new credit facility on terms that are favorable to us before the expiration of the LaSalle senior credit facility and may not be able to secure a new credit facility by that time, if at all. If we cannot repay the amounts owning under the LaSalle senior credit facility, or if the Company cannot obtain the necessary waivers or amendments, or return to compliance with the LaSalle covenants and all other loan covenants, the Company’s lenders may foreclose on certain of our assets or take other legal action against us that, alone or in the aggregate, may have a material adverse effect on us.

 

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The terms of our debt may severely limit our ability to plan for or respond to changes in our business.

Our debt agreements contain a number of restrictive covenants that impose significant operating and financial restrictions on our operations. Among other things, these restrictions limit our ability to:

 

   

change our Chief Executive Officer;

 

   

incur liens or make negative pledges on our assets;

 

   

merge, consolidate, or sell our assets;

 

   

incur additional debt;

 

   

pay dividends, redeem capital stock or prepay other debt;

 

   

make investments and acquisitions;

 

   

make capital expenditures; or

 

   

amend our debt instruments and certain other material agreements.

Mariano Costamagna and Pier Antonio Costamagna have guaranteed our performance under the MTM loan and, in connection with those guarantees, we have pledged our BRC equity interest and made certain other concessions to them.

Because of certain requirements arising under Italian law, Mariano Costamagna (our Chief Executive Officer) and Pier Antonio Costamagna (Director of Mechanical Engineering of MTM S.r.L. (“MTM”)), whom we refer to as Founders of BRC, have jointly and severally guaranteed IMPCO’s performance under the MTM loan. In order to secure their recourse in the event that guaranty is exercised and the Founders are required to make payments of the amounts due, we have pledged to the Founders our entire interest in BRC. If IMPCO fails to perform the terms of the MTM loan and the Founders are required to fulfill their guarantees, the Founders may require us to reimburse them for their payments as guarantors, or they may take possession of our equity interest in BRC, or both. If the Founders were to take possession of the BRC equity interest in total or partial satisfaction of their rights under the pledge agreement, we would lose our rights to participate in BRC’s earnings and assets. This would have a material adverse effect upon our earnings and our assets. The terms of the MTM loan requires IMPCO to repay MTM the principal according to the following schedule, with a $5.0 million “balloon payment” of accrued interest and unpaid principal due on December 31, 2009:

 

Quarters Ending

   Quarterly
Payment
Amount
   Payment Per
Year

December 31, 2006 – paid in January 2007

   $ 650,000    $ 650,000

January 1, 2007 through December 31, 2007

     800,000      3,200,000

January 1, 2008 through December 31, 2008

     1,000,000      4,000,000

January 1, 2009 through December 31, 2009

     1,150,000      4,600,000

Balloon Payment due December 31, 2009

        5,000,000
         

Total payments

      $ 17,450,000
         

The internal review of our historical stock option granting practices, the restatement of certain of our historical consolidated financial statements, investigations by the SEC and related events have had, and will continue to have, an adverse effect on us.

On March 19, 2007, Fuel Systems announced that a Special Committee of its Board of Directors, with the assistance of independent legal counsel, was conducting a review of our stock option practices covering the period from 1996 to 2006. As described in the Explanatory Note immediately preceding Part I, Item 1, and in Note 2 to the Consolidated Financial Statements in this Form 10–K, the Special Committee reached a conclusion that incorrect measurement dates were used for financial accounting purposes for stock option grants in certain prior periods. As a result, we have recorded additional non-cash stock-based compensation expense, and related tax effects, related to certain stock option grants, and we have restated certain previously filed consolidated financial statements included in this Form 10–K.

 

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The stock option grant review and related activities have resulted in substantial expenses for legal, accounting, tax and other professional services, have diverted management’s attention from the day-to-day business, and could in the future harm our business, financial condition, results of operations and cash flows.

While we believe that we have made appropriate judgments in determining the correct revised measurement dates for our historical stock option grants and have appropriately corrected for the other option accounting errors that have been identified, the SEC may disagree with the manner in which we have accounted for and reported the financial impact. Accordingly, there is a risk we may have to further restate prior consolidated financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.

In addition, the stock option grant review and restatements of our prior consolidated financial statements have exposed us to greater risks associated with litigation, regulatory proceedings and government enforcement actions. We are unable to predict what action, if any, the SEC, or other regulatory bodies may pursue or what consequences such an action may have on us. We are also unable to predict the likelihood of or potential outcomes from litigation, other regulatory proceedings or government enforcement actions, if any, relating to our past stock option practices and the need to restate our historical consolidated financial statements. The resolution of these matters could be time-consuming and expensive, further distract management from other business concerns and harm our business. Furthermore, if we were subject to adverse findings in litigation, regulatory proceedings or government enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could harm our business and financial condition.

We cannot guarantee that we will be able to meet the appropriate deadlines or extended deadlines for our SEC filings in the future which results in our inability to use “short form” registration statements.

We filed our annual SEC reports late in each of the last four years. We have also filed several of our quarterly reports late during this period. While we have ultimately filed some of those reports under extended deadlines, others we have not. Our Form 10-K for the year ended December 31, 2006 and our Forms 10-Q for the periods ended March 31, 2007 and June 30, 2007 were significantly delayed due to our voluntary review of historical stock option grants. We cannot guarantee that we will be able to meet the appropriate deadlines or extended deadlines for our SEC filings in the future. As a result of our late filings, we are currently unable to file “short form” registration statements if we were to issue additional securities to the public, thereby increasing the cost of any securities issuances that we might consider. Furthermore, additional delays in our filings could jeopardize our common stock’s listing status on the Nasdaq Stock Market.

If we do not comply with the requirements of the NASDAQ Stock Market, our common stock may be delisted from the NASDAQ Stock Market.

We have received letters from the staff of the NASDAQ Stock Market stating that, as a result of the delayed filing of this Form 10-K, our March 31, 2007 Form 10-Q and our June 30, 2007 Form 10-Q, we are subject to delisting from the NASDAQ Stock Market. To date, NASDAQ has granted an exception to the listing requirement, pending further review, and subject to us filing our delinquent reports by specified dates. With the filing of this report and the filing of our Quarterly Reports on Form 10–Q for the quarters ended March 31, 2007 and June 30, 2007, we believe that we have remedied our non-compliance with Marketplace Rule 4310(c)(14). However, there can be no assurance that the Listing Council will decide to allow our common stock to remain listed on NASDAQ Stock Market. In addition, if the SEC disagrees with the manner in which we have accounted for the financial impact of past stock option grants, we could experience further delays in filing subsequent SEC reports that could result in delisting of our common stock from the NASDAQ Stock Market.

If our common stock is delisted from the NASDAQ Stock Market, it would subsequently trade on the Pink Sheets which may reduce the price of the our common stock and the liquidity available to our stockholders. In addition, the trading of our common stock on the Pink Sheets would materially adversely affect our access to the capital markets, and the limited liquidity and potentially reduced price of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to the company or at all.

 

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We have a history of significant cash outflows that may limit our ability to grow and may materially and adversely impact our prospective revenue and liquidity.

We have experienced net cash outflows. At December 31, 2006, our cash and cash equivalents totaled approximately $11.5 million and our working capital was $56.3 million. At December 31, 2005 our cash and cash equivalents totaled approximately $27.1 million and our working capital was $40.3 million. We have experienced significant cash outflows as a result of building inventory levels to reduce lead time. Based upon our eligible accounts receivable and our eligible inventory as of December 31, 2006, our funds available for borrowing under our senior secured credit facility were approximately $7.3 million, of which approximately $5.2 million was outstanding, leaving approximately $2.1 million unused and available. As of December 31, 2006, we had total stockholders’ equity of $110.8 million and an accumulated deficit of $109.1 million. If adequate funds are no longer available or are no longer available on acceptable terms, our ability to grow may be limited which may have a material and adverse effect on our results of operations and liquidity.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies in general and our company in particular have a history of depending upon and using broad based employee stock option programs to hire, to motivate and to retain employees in a competitive marketplace. We did not previously recognize compensation expense for stock options issued to employees or directors, except in limited cases involving modifications of stock options. We instead disclosed in the notes to our financial statements information about what such charges would be if they were expensed. The Financial Accounting Standards Board, or FASB, adopted a new accounting standard that required us to record equity-based compensation expense for stock options and employee stock purchase plan rights granted to employees based on the fair value of the equity instrument at the time of grant. We recorded these expenses beginning with our first quarter of 2006, as required, and recorded approximately $1.7 million in compensation expense for the year ended December 31, 2006. The change in accounting rules increases reported net loss or, when we are profitable, decreases reported earnings. This may negatively impact our future stock price. In addition, this change in accounting rules could impact the likelihood of our using broad based employee stock option plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace. However, we have not issued any stock options to employees since 2004 and, in 2006, our board of directors adopted a new bonus incentive plan that authorizes cash and restricted stock awards to employees, but does not authorize stock option awards.

We are dependent on certain key customers, and the loss of one or more customers could have a material adverse effect on our business.

A substantial portion of our business results from sales to key customers. In the year ended December 31, 2006, no one customer exceeded 10% of our consolidated sales. Sales to our top ten customers during the year ended December 31, 2006 accounted for approximately 36.5% of our consolidated sales. In 2005, Nacco Materials Handling Group represented approximately 14.5% of our consolidated sales. No other customer represented more than 10% of our consolidated sales in 2005. Sales to the top ten customers during 2005 accounted for approximately 40.2% of our consolidated sales. If several of these key customers were to reduce their orders substantially, we would suffer a decline in revenue and profits, and those declines could be material and adverse.

Mariano Costamagna’s employment agreement and the terms of the MTM loan may limit our board of directors’ ability to effect changes in our senior management.

Mariano Costamagna, BRC’s co-founder, our director, Chief Executive Officer and President, has entered into an employment agreement which is effective until May 31, 2009. Mariano Costamagna’s employment agreement provides for an initial base salary of $360,000 annually, as well as bonuses, benefits and expenses. If, during the term of his employment, we terminate Mr. Costamagna’s employment other than for “cause,” or if Mr. Costamagna resigns for “good reason,” we must pay Mr. Costamagna a severance payment equal to $5.0 million (subject to certain limited reductions if Mr. Costamagna sells more than 20% of the stock he has received in connection with our acquisition of BRC). The required severance payment may limit our board of directors’ ability to decide whether to retain or to replace Mr. Costamagna or to reallocate management responsibilities among our senior executives, a fact that may, in certain circumstances, have an adverse effect on our business, operations and financial condition. Moreover, the loan to us from MTM can be accelerated in the event that Mr. Costamagna’s employment is terminated for any reason (with limited exceptions for termination upon Mr. Costamagna’s death) or if we otherwise materially breach his employment agreement.

 

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We depend on third-party suppliers for key materials and components for our products.

We have established relationships with third party suppliers that provide materials and components for our products. A supplier’s failure to supply materials or components in a timely manner or to supply materials and components that meet our quality, quantity or cost requirements, combined with a delay in our ability to obtain substitute sources for these materials and components in a timely manner or on terms acceptable to us, would harm our ability to manufacture our products or would significantly increase our production costs, either of which would negatively impact our results of operations and business. In addition, we rely on a limited number of suppliers for certain proprietary die cast parts, electronics, software, catalysts as well as engines for use in our end products. In the year ended December 31, 2006, Power Solutions, Inc. supplied approximately 11.8% of our raw materials, as compared to 17.1% in 2005. Approximately 38.2% and 45.5% of our raw materials during the year ended December 31, 2006 and 2005, respectively, were supplied by ten entities. We could incur significant costs in the event that we are forced to utilize alternative suppliers.

We may experience unionized labor disputes at original equipment manufacturer facilities.

As we become more dependent on vehicle conversion programs with OEMs, we will become increasingly dependent on OEM production and the associated labor forces at OEM sites. For 2006 and 2005, direct OEM product sales accounted for 36.4% and 37.8% of IMPCO’s revenue, respectively. Labor unions represent most of the labor forces at OEM facilities. In the past, labor disputes have occurred at OEM facilities which adversely impacted our direct OEM product sales. Such labor disputes are likely to occur in the future and, if so, will negatively impact our sales and profitability.

We face risks associated with marketing, distributing, and servicing our products internationally.

In addition to the United States, we currently operate in Italy, Australia, the Netherlands, Japan, Brazil and Argentina, and market our products and technologies in other international markets, including both industrialized and developing countries. During 2006 and 2005, approximately 22% and 34% of our revenue, respectively, was derived from sales to customers located within the United States and Canada, and the remaining 78% and 66%, respectively, was derived from sales in Asia, Europe, and Latin America where economics and fuel availability make our products more competitive. Additionally, approximately 75% of our employees and 90% of our approximately 400 distributors and dealers worldwide are located outside the United States. Our combined international operations are subject to various risks common to international activities, such as the following:

 

   

our ability to maintain good relations with our overseas employees and distributors and to collect amounts owed from our overseas customers;

 

   

expenses and administrative difficulties associated with maintaining a significant labor force outside the United States, including without limitation the need to comply with employment and tax laws and to adhere to the terms of real property leases and other financing arrangements in foreign nations;

 

   

exposure to currency fluctuations;

 

   

potential difficulties in enforcing contractual obligations and intellectual property rights;

 

   

complying with a wide variety of laws and regulations, including product certification, environmental, and import and export laws;

 

   

the challenges of operating in disparate geographies and cultures;

 

   

political and economic instability;

 

   

restrictions on our ability to repatriate dividends from our subsidiaries; and

 

   

difficulties collecting international accounts receivable.

 

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Adverse currency fluctuations may hinder our ability to economically procure key materials and services from overseas vendors and suppliers, may affect the value of our debt, and may affect our profit margins.

We have significant operations outside of the United States. As a result, we engage in business relationships and transactions that involve many different currencies. Exchange rates between the U.S. dollar and the local currencies in these foreign locations where we do business can vary unpredictably. These variations may have an effect on the prices we pay for key materials and services from overseas vendors in our functional currencies under agreements that are priced in local currencies. If exchange rates with local currencies decline, our effective costs for such materials and services would increase, adversely affecting our profitability. Operating cash balances held at non-U.S. banks (which were 57.8% of our consolidated cash and cash equivalents at December 31, 2006) are not federally insured and therefore may pose a risk of loss to us.

Our financial results are significantly influenced by fluctuations in foreign exchange rates.

BRC recognized approximately a $1.9 million unrealized loss and a $3.5 million unrealized gain as a result of changes in foreign exchange rates during 2006 and 2005, respectively, in connection with MTM’s five-year $22.0 million loan agreement with IMPCO that is denominated in U.S. dollars. Of the approximately $3.5 million unrealized gain for the year ended December 31, 2005, we recognized approximately $2.3 million in other income for the nine months ended December 31, 2005 and approximately $0.6 million, which related to our share of the earnings of BRC prior to our acquisition of the second 50% of BRC on March 31, 2005, in equity share in income of unconsolidated affiliates. Fluctuations in foreign exchange rates in the future could impact the financial results and cause net income and earnings per share to decline dramatically. We may be unable to effectively hedge our exposure to this risk or significantly reduce our foreign exchange risk. BRC entered into a three-year foreign exchange forward contract on January 5, 2005 for the purpose of hedging the quarterly payments being made by IMPCO to BRC under the MTM loan leaving $13.6 million unhedged. However, we determined that the foreign exchange forward contract did not qualify for hedge accounting treatment. We recognize the gains and losses in fair value of these agreements from fluctuations between the euro and U.S. dollar in other income (loss) in our consolidated statements of operations. In 2006 and 2005, BRC recognized approximately $0.6 million income and $0.7 million expense, respectively, as an adjustment to the fair value of the foreign exchange forward contract.

We derive income from unconsolidated foreign companies that we do not control. We may never realize any value from our investment in our unconsolidated foreign subsidiary WMTM Equipamento de Gases Ltd (“ WMTM”), and WMTM may be unable to pay on amounts owed to our consolidated subsidiary MTM for the purchase of components or its loan owing to us.

Beginning April 1, 2005 and subsequent to the 100% acquisition of BRC, we recognize 50% of the earnings and losses of WMTM Equipamentos de Gases, Ltda, a Brazilian joint venture with an American partner, and 50% of the earnings and losses of MTE, S.r.L., an Italian company. A portion of our income is generated from the operations of these unconsolidated foreign subsidiaries in which we hold 50% interests. Although the agreements that govern our relationships with these entities provide us with some level of control over our investments, we do not have the ability to control their day-to-day operations or their management. As a result, we cannot control these entities’ ability to generate income.

WMTM’s losses over the period of our investment have exceeded the amount of our investment in WMTM. In addition, our consolidated subsidiary MTM sells components to WMTM, and the total amount owed by WMTM to MTM as of December 31, 2006 was approximately $2.0 million which was past due as of that date. Moreover, we extended the maturity date on our loan to WMTM ($3.6 million at December 31, 2006 of which we have reserved $0.3 million) from January 31, 2007 to January 31, 2010. As of December 31, 2006, amounts due to us by WMTM aggregated to $5.6 million of which $2.0 million was past due. We may never realize any value from our investment in WMTM, and WMTM may be unable to pay amounts owed to MTM for the purchase of components or its loan owing to us.

We are highly dependent on certain key personnel.

We are highly dependent on the services of Mariano Costamagna, our Chief Executive Officer, and Marco Seimandi, BRC’s Marketing Director. These two executives are extensively involved in, or directly or indirectly oversee, virtually every aspect of our day-to-day operations. Were we to lose the services of either of these executives, we would face a significant risk of declining revenue and/or operating income. Moreover, the loan to IMPCO from MTM can be accelerated in the event that Mariano Costamagna is terminated by us for any reason, with certain limitations for termination occasioned by his death or if we materially breach his employment agreement.

 

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We have identified material weaknesses in our internal controls over financial reporting that could cause investors to lose confidence in the reliability of our financial statements and result in a decrease in the value of our securities.

Our management has identified material weaknesses in our internal control over financial reporting as of December 31, 2006 arising from a combination of internal control deficiencies with respect to the period-end financial close, accounting for our investments in subsidiaries and joint ventures and revenue recognition processes of our Italian subsidiary, in our stock administration policies and practices, and in our period-end financial close process as discussed in “Management’s Report on Internal Control Over Financial Reporting” in Item 9A. In addition, due to the identification of material weaknesses in internal control over financial reporting, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2006 our disclosure controls and procedures were not effective.

Specifically, our management has identified the following material weaknesses:

 

   

We did not maintain effective internal control over the financial close process at BRC, our Italian subsidiary and BRC did not have an adequate number of accounting and finance personnel with sufficient technical expertise in U.S. GAAP. As a result, BRC did not have effective procedures to evaluate, analyze and review the financial information submitted by its consolidated and unconsolidated foreign operations and management and our independent auditors identified some control deficiencies and errors relating to revenue recognition and accounting for our investments in subsidiaries and joint ventures. We have determined that these control deficiencies represent material weaknesses in controls at BRC.

 

   

We did not maintain effective oversight controls to timely review and detect errors with regard to the accounting for certain historical stock option grants, which resulted in the restatement of our consolidated financial statements and related disclosures. Accordingly, management has determined that this control deficiency represents a material weakness.

 

   

We did not maintain effective internal control over the period-end financial close process, including but not limited to the elimination of intercompany profit in the consolidation of our consolidated financial statements and the determination of income tax expense and the related deferred tax assets and liabilities and income tax disclosures in our consolidated financial statements. Management has determined that this control deficiency represents a material weakness.

We will continue to evaluate, upgrade and enhance our internal controls. Because of inherent limitations, our internal control over financial reporting may not prevent or detect misstatements, errors or omissions. Also, projections of any evaluation of effectiveness of internal controls to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with our policies or procedures may deteriorate. We cannot be certain in future periods that other control deficiencies that may constitute one or more “significant deficiencies” (as defined by the relevant auditing standards) or material weaknesses in our internal control over financial reporting will not be identified. If we fail to maintain the adequacy of our internal controls, including any failure to implement or difficulty in implementing required new or improved controls, our business and results of operations could be harmed, the results of operations we report could be subject to adjustments, we could fail to be able to provide reasonable assurance as to our financial results or the effectiveness of our internal controls or meet our reporting obligations and there could be a material adverse effect on the price of our securities.

Moreover, because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Through the year ended December 31, 2006, we expended significant resources in connection with the Section 404 process. In future periods, we will likely continue to expend substantial amounts in connection with the Section 404 process and with ongoing evaluation of, and improvements and enhancements to, our internal control over financial reporting. These expenditures may make it difficult for us to control or reduce the growth of our general and administrative and other expenses, which could adversely affect our results of operations and the price of our securities.

 

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Our business is directly and significantly affected by regulations relating to vehicle emissions. If current regulations are repealed or if the implementation of current regulations is suspended or delayed, our revenue may decrease. In addition, we rely on emissions regulations, the adoption of which is out of our control, to stimulate our growth.

If regulations relating to vehicle emissions are amended in a manner that may allow for more lenient standards, or if the implementation of such standards is delayed or suspended, the demand for our products and services could diminish and our revenue could decrease. In addition, demand for our products and services may be adversely affected by the perception that emission regulations will be suspended or delayed.

We are subject to certification requirements and other regulations, and future more stringent regulations may impair our ability to market our products.

We must obtain product certification from governmental agencies, such as the EPA and the California Air Resources Board, to sell certain of our products in the United States, and must obtain other product certification requirements in Italy and other countries. A significant portion of our future sales will depend upon sales of fuel management products that are certified to meet existing and future air quality and energy standards. We cannot assure you that our products will continue to meet these standards. The failure to comply with these certification requirements could result in the recall of our products or civil or criminal penalties.

Any new government regulation that affects our alternative fuel technologies, whether at the foreign, federal, state, or local level, including any regulations relating to installation and service of these systems, may increase our costs and the price of our systems. As a result, these regulations may have a negative impact on our revenue and profitability and thereby harm our business, prospects, results of operations, or financial condition.

Declining oil prices may adversely affect the demand for our products.

We believe that our sales in recent periods have been favorably impacted by increased consumer demand promoted by rising oil prices. Further reductions in oil prices may occur, and demand for our products could decline in the event of fluctuating, and particularly decreasing, market prices.

Changes in tax policies may reduce or eliminate the economic benefits that make our products attractive to consumers.

In some jurisdictions, such as the United States and Australia, governments provide tax benefits for clean-air vehicles, including tax credits, rebates and reductions in applicable tax rates. In certain of our markets these benefits extend to vehicles powered by our systems. From time to time, governments change tax policies in ways that create benefits such as those for our customers. Reductions or eliminations in these benefits may adversely affect our revenue.

The potential growth of the alternative fuel products market will have a significant impact on our business.

Our future success depends on the continued global expansion of the gaseous fuel industry. Many countries currently have limited or no infrastructure to deliver natural gas and propane. Major growth of the international markets for gaseous fuel vehicles is significantly dependent on international politics, governmental policies and restrictions related to business management. In the United States, alternative fuels such as natural gas currently cannot be readily obtained by consumers for motor vehicle use and only a small percentage of motor vehicles manufactured for the United States are equipped to use alternative fuels. Users of gaseous fuel vehicles may not be able to obtain fuel conveniently and affordably, which may adversely affect the demand for our products. We do not expect this trend to improve in the United States in the foreseeable future. Our ability to attract customers and sell products successfully in the alternative fuel industry also depends significantly on the current price differential between liquid fuels and gaseous fuels. We cannot assure you that the global market for gaseous fuel engines will expand broadly or, if it does, that it will result in increased sales of our fuel system products. In addition, we have designed many of our products for gaseous fuel vehicles powered by internal combustion engines, but not for other power sources, such as electricity or alternate forms of power. If there is major growth in the market relating to those power sources, our revenue may not increase and may decline.

 

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We currently face and will continue to face significant competition, which could result in a decrease in our revenue.

We currently compete with companies that manufacture products to convert liquid-fueled internal combustion engines to gaseous fuels. Increases in the market for alternative fuel vehicles may cause automobile or engine manufacturers to develop and produce their own fuel conversion or fuel management equipment rather than purchasing the equipment from suppliers such as us. In addition, greater acceptance of alternative fuel engines may result in new competitors. Should any of these events occur, the total potential demand for our products could be adversely affected and cause us to lose existing business.

New technologies could render our existing products obsolete.

New developments in technology may negatively affect the development or sale of some or all of our products or make our products obsolete. Our inability to enhance existing products in a timely manner or to develop and introduce new products that incorporate new technologies, conform to increasingly stringent emission standards and performance requirements, and achieve market acceptance in a timely manner could negatively impact our competitive position. New product development or modification is costly, involves significant research, development, time and expense, and may not necessarily result in the successful commercialization of any new products.

We have a significant amount of intangible assets that may become impaired, which could impact our results of operations.

Approximately $10.4 million or 5.2% of our total assets at December 31, 2006 were net intangible assets, including technology, customer relationships, trade name, and approximately $40.0 million or 20.1% of our total assets at December 31, 2006 were goodwill that we acquired primarily from BRC. We amortize the intangible assets, with the exception of goodwill, based on our estimate of their remaining useful lives and their values at the time of acquisition. We are required to test goodwill for impairment at least on an annual basis, or earlier if we determine it may be impaired due to change in circumstances. We are required to test the other intangible assets with definite useful lives for impairment whenever events or changes in circumstances indicate that the carrying amounts of the intangible assets may not be recoverable. If impairment exists in any of these assets, we are required to write-down the asset to its estimated recoverable value as of the measurement date. Such impairment write-downs may significantly impact our results of operations.

Future sales of our common stock could adversely affect our stock price.

Substantial sales of our common stock, including shares issued upon exercise of our outstanding options and warrants, in the public market or the perception by the market that these sales could occur, could lower our stock price or make it difficult for us to raise additional equity. As of December 31, 2006, we had 15,180,481 shares of common stock outstanding, excluding 11,928 shares issued but held by us as treasury stock. Except for the 3,450,180 shares held by Mariano Costamagna and his family members and affiliates which are subject to the “volume”, “manner of sale” and other selling restrictions of Rule 144, all of these shares are currently freely tradable.

As of December 31, 2006 up to 90,352 shares of our common stock were issuable upon exercise of warrants outstanding as of that date. Furthermore, as of December 31, 2006, up to 619,529 shares were issuable upon the exercise of options, of which 328,398 were vested and exercisable. Subject to applicable vesting and registration requirements, upon exercise of these options the underlying shares may be resold into the public market. In the case of outstanding options and warrants that have exercise prices less than the market price of our common stock from time to time, investors would experience dilution. We cannot predict if future sales of our common stock, or the availability of our common stock for sale, will harm the market price of our common stock or our ability to raise capital by offering equity securities.

Class action litigation due to stock price volatility or other factors could cause us to incur substantial costs and divert our management’s attention and resources.

From January 1, 2006 through December 31, 2006, our stock price has fluctuated from a low of $9.96 to a high of $24.98. During the 52 weeks ended December 31, 2005, our stock price fluctuated from a low of $5.40 to a high of $16.62. In the past, securities class action litigation often has been brought against a company following periods of volatility in the market price of its securities. Companies in the technology industries are particularly vulnerable to this kind of litigation due to the high volatility of their stock prices. Accordingly, we may in the future be the target of securities litigation. Any securities litigation could result in substantial costs and could divert the attention and resources of our management.

 

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Our business is subject to seasonal influences.

Operating results for any quarter are not indicative of the results that may be achieved for any subsequent quarter or for a full year. In particular, net sales and operating income in Europe and the United States are typically lower during the third and fourth quarters of the year. Many of the factors which impact our operating results are beyond our control and difficult to predict. They include seasonal work patterns due to vacations and holidays, particularly in our European manufacturing facilities, and fluctuations in demand for the end-user products in which our products are placed.

 

Item 1B. Unresolved Staff Comments.

None.

 

Item 2. Properties.

Facilities

Our executive offices and our gaseous fuel products division are located in Santa Ana, California. We currently lease additional manufacturing, research and development and general office facilities, under leases expiring between 2007 and 2018, in the following locations set forth below:

 

Location

  

Principal Uses

   Square Footage

IMPCO Operations:

     

Santa Ana, California

   Corporate offices; manufacturing; design, development and testing    108,000

Sterling Heights, Michigan

   Sales, marketing application, development and assembly    78,000

Delfgauw, Holland

   Sales, marketing application, development and assembly    20,000

Melbourne, Australia

   Sales, marketing application, development and assembly    20,300

Sydney, Australia

   Sales, marketing and assembly    6,600

Fukuoka, Japan

   Sales, marketing and assembly    4,000

BRC Operations:

     

Cherasco, Italy

   Sales, marketing application, development and assembly    376,000
       

Total (1)

      612,900
       

(1) Properties leased by our unconsolidated affiliates, MTE SrL., WMTM Equipamento de Gases Ltd., and Jehin Engineering Ltd., are excluded from the above table.

Relocation of North American Headquarters and Production Facility

On September 6, 2005, we signed an agreement to sublease a 108,000 square foot building, including 20,000 square feet of office space, located in Santa Ana, California, for a term of 13 years beginning September 1, 2005. We relocated our combined corporate headquarters and IMPCO U.S. business operations from our location in Cerritos, California, to the Santa Ana facility in April 2006. The new location has sufficient space to enable us to modernize and consolidate most of our North American production and component engineering facilities and become more efficient; it also improves our professional image as a technology company. We installed new state-of-the-art production lines, machining and test equipment in the Santa Ana facility. As a global leader in the alternative fuels marketplace, our strategy is to use the improved efficiencies, capabilities and capacity to position us to better serve our markets and to take advantage of new products and new markets.

 

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The annual rent for the Santa Ana facility is $0.7 million, which is set to increase 3% every year pursuant to the terms of the agreement. The terms of the agreement also include rent abatement for the first three months, subject to certain conditions.

We also lease nominal amounts of office space in Argentina and France. We believe our facilities are presently adequate for our current core product manufacturing operations and OEM development programs and production.

Closure and Liquidation of Operations in Mexico

In the fourth quarter of 2005, we decided to liquidate our Mexico joint venture IBMexicano and agreed with our 50% joint venture partner to wind-down that business. We continue to sell in the Mexico market through independent distributors. As a result, in 2005 we recorded an impairment charge of approximately $0.9 million as a write-off our investment in IBMexicano. The closure was substantially complete by June 2006. Cash proceeds, or net realizable value, from this closure will be used to settle related party receivables, of which approximately $0.1 million remained on our consolidated balance sheet at December 31, 2006.

During 2005 and 2006, we proceeded on the plan to close our wholly owned Mexico subsidiary, IMPCO Mexicano. As a result, during 2005 we recorded approximately $1.3 million in additional inventory reserves and allowance for doubtful trade and related party receivables.

 

Item 3. Legal Proceedings.

From time to time, we may be involved in litigation relating to claims arising out of the ordinary course of our business. We are not a party to, and to our knowledge there are not threatened, any claims or actions against us, the ultimate disposition of which would have a material adverse effect on us. MTM is a defendant in a lawsuit brought by ICOM, S.r.L., filed in the local court at Milan, Italy. That lawsuit initially sought injunctive relief and damages for infringement of ICOM’s alleged exclusive rights to sell ring-style gaseous fuel tanks in Italy. The trial court initially denied the plaintiff’s motion for injunctive relief and subsequently denied the plaintiff’s damages claims. The case remains on appeal with the final hearing scheduled on March 4, 2008; we believe the plaintiff’s claims are without merit.

 

Item 4. Submission of Matters to a Vote of Security Holders.

No matters were submitted for the vote or approval of our security holders during the quarter ended December 31, 2006.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is traded on the NASDAQ Stock Market under the symbol “FSYS.” As of December 31, 2006, there were approximately 134 holders of record of our common stock. The high and low per share prices of our common stock as reported on the NASDAQ Stock Market were as follows:

 

     High    Low

Year Ended December 31, 2006

     

First Quarter

   $ 13.70    $ 9.96

Second Quarter

   $ 24.98    $ 12.04

Third Quarter

   $ 22.42    $ 11.08

Fourth Quarter

   $ 23.11    $ 11.68

Year Ended December 31, 2005

     

First Quarter 2005

   $ 15.50    $ 10.10

Second Quarter 2005

   $ 10.98    $ 5.40

Third Quarter 2005

   $ 16.62    $ 8.40

Fourth Quarter 2005

   $ 12.76    $ 9.00

Dividend Policy

We have not recently declared or paid dividends on our common stock, including during the past two fiscal years, and we currently expect to retain any earnings for reinvestment in our business. Accordingly, we do not expect to pay dividends in the foreseeable future. The timing and amount of any future dividends is determined by our board of directors and will depend on our earnings, cash requirements and the financial condition and other factors deemed relevant by our board of directors. In addition, IMPCO’s senior credit facility currently prohibits declaring or paying dividends.

Deferred Compensation Plan

The following table sets forth repurchases of our common stock in the open market during the fourth quarter of 2006 in order to provide for our obligations under Fuel Systems’ Deferred Compensation Plan.

 

Period

  

Total

Number of

Shares
Purchased

  

Average Price

Paid per Share

  

Total Number

of Shares
Purchased as
Part of
Publicly
Announced

Plans or
Programs

  

Maximum
Number of
Shares that

May be
Purchased
Under the
Plans or
Programs

October 1 to 31, 2006

   866    $ 12.89    n/a    n/a

November 1 to 30, 2006

   56    $ 18.58    n/a    n/a

December 1 to 31, 2006

   83    $ 18.71    n/a    n/a
                 

Total

   1,005    $ 13.69    n/a    n/a
                 

 

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Item 6. Selected Financial Data.

Please see the Explanatory Note to this annual report on Form 10–K and Note 2 of the Notes to Consolidated Financial Statements for more detailed information regarding the restatement of our consolidated financial statements as of and for the years ended December 31, 2005, 2004 and 2003, as of and for the eight months ended December 31, 2002, and as of and for the fiscal year ended April 30, 2002. We have not amended our previously filed annual reports on Form 10–K or quarterly reports on Form 10–Q for the periods affected by the restatement. The financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this annual report on Form 10–K, and the consolidated financial statements and related financial information contained in those previously filed reports should no longer be relied upon.

The following selected financial information for the years ended December 31, 2006, 2005, 2004 and 2003, the eight months ended December 31, 2002, and the fiscal year ended April 30, 2002, is derived from our audited and unaudited consolidated financial statements. The financial data below for the years ended December 31, 2006, 2005 and 2004 should be read in conjunction with the audited consolidated financial statements, related notes and other financial information included herein. The information presented in the following table has been adjusted to reflect the restatement of the Company’s consolidated financial results which is more fully described in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and Note 2 of the Notes to the Consolidated Financial Statements within this Form 10-K.

 

     Years Ended December 31,     Eight Months
Ended
December 31,
2002
    Fiscal Year
Ended
April 30,
2002
 

(in thousands, except per share data)

   2006     2005     2004     2003      
           (as restated)     (as restated)     (as restated)     (as restated)     (as restated)  
                       (unaudited)     (unaudited)     (unaudited)  

Statements of Operations:

            

Revenue

   $ 220,816     $ 174,539     $ 118,292     $ 74,740     $ 46,421     $ 67,676  

Cost of revenue

     166,663       134,357       93,534       54,294       34,221       46,425  
                                                

Gross profit

     54,153       40,182       24,758       20,446       12,200       21,251  

Operating expenses

            

Research and development expense

     8,056       8,155       4,719       3,904       2,639       5,929  

Selling, general and administrative expense

     25,920       26,510       20,005       18,507       11,042       20,220  

Amortization of intangible assets

     142       101       —         —         —         —    

Impairment loss of goodwill

     —         —         2,833       —         —         —    

Acquired in-process technology

     —         99       —         —         —         —    
                                                

Total operating expenses

     34,118       34,865       27,557       22,411       13,681       26,149  
                                                

Operating income (loss)

     20,035       5,317       (2,799 )     (1,965 )     (1,481 )     (4, 898 )

Loss on extinguishment of debt

     —         —         (6,752 )     —         —         —    

Other income (expense) and interest, net

     (2,576 )     (230 )     (5,509 )     (4,039 )     (883 )     (929 )
                                                

Income (loss) from continuing operations before tax and cumulative effect of a change in accounting principle

     17,459       5,087       (15,060 )     (6,004 )     (2,364 )     (5,827 )

Equity share in earnings (losses) of unconsolidated affiliates

     685       1,035       1,157       (1,107 )     —         —    

Impairment loss in unconsolidated affiliates

     (271 )     (1,045 )     (214 )     —         —         —    

Income tax (expense) benefit

     (9,293 )     (14,339 )     (2,325 )     (668 )     (24,386 )     1,501  

Minority interests in losses (earnings) of consolidated subsidiaries, net

     (1,668 )     (975 )     (1,176 )     (605 )     51       (224 )
                                                

Income (loss) from continuing operations, net of tax, before cumulative effect of a change in accounting principle (1)

     6,912       (10,237 )     (17,618 )     (8,384 )     (26,699 )     (4,550 )

Loss from discontinued operation, net of tax (2)

     —         —         —         —         (3,307 )     (26,038 )

Cumulative effect of a change in accounting principle, net of tax

     —         (117 )     —         —         —         —    
                                                

Net income (loss)

   $ 6,912     $ (10,354 )   $ (17,618 )   $ (8,384 )   $ (30,006 )   $ (30,588 )
                                                

 

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Net income (loss) per share (3):

             

Basic:

             

Income (loss) from continuing operations before cumulative effect of a change in accounting principle

   $ 0.46    $ (0.76 )   $ (1.89 )   $ (1.01 )   $ (3.71 )   $ (0.82 )

Loss from discontinued operation

   $ —      $ —       $ —       $ —       $ (0.46 )   $ (4.69 )

Per share effect of the cumulative effect of a change in accounting principle

   $ —      $ (0.01 )   $ —       $ —       $ —       $ —    
                                               

Net income (loss)

   $ 0.46    $ (0.77 )   $ (1.89 )   $ (1.01 )   $ (4.17 )   $ (5.51 )
                                               

Diluted:

             

Income (loss) from continuing operations before cumulative effect of a change in accounting principle

   $ 0.46    $ (0.76 )   $ (1.89 )   $ (1.01 )   $ (3.71 )   $ (0.82 )

Loss from discontinued operation

   $ —      $ —       $ —       $ —       $ (0.46 )   $ (4.69 )

Per share effect of the cumulative effect of a change in accounting principle

   $ —      $ (0.01 )   $ —       $ —       $ —       $ —    
                                               

Net income (loss)

   $ 0.46    $ (0.77 )   $ (1.89 )   $ (1.01 )   $ (4.17 )   $ (5.51 )
                                               

Balance Sheet Data:

             

Total current assets

   $ 120,007    $ 106,014     $ 43,255     $ 43,541     $ 35,243     $ 61,825  

Total assets

     198,512      175,853       97,729       100,548       75,978       124,547  

Total current liabilities

     63,756      65,718       30,995       25,105       27,278       36,215  

Long-term obligations

     23,978      23,738       24,774       22,017       2,319       7,661  

Stockholders’ equity

     110,778      86,397       41,960       53,426       46,381       80,671 (4)

(1) Includes in the years ended December 31, 2006, 2005, 2004 and 2003 and the eight months ended December 31, 2002, $0.2 million, $2.6 million, $8.4 million, $2.8 million, and $10.3 million, respectively, additions to valuation allowance to establish a reserve for the deferred tax assets that are unlikely to be realized in the next three years (see Note 5 of the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K).
(2) The financial results of Quantum Fuel Systems Worldwide, Inc. are shown as a loss on discontinued operations.
(3) See Note 9 of the Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for an explanation of the method used to determine the number of shares used to compute net loss per share.
(4) Adjusted for the cumulative effect of $572,000 as of May 1, 2001 related to the restatement of our consolidated financial statements as more fully described in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and Note 2 of the Notes of the Consolidated Financial Statements within this Form 10-K.

 

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The following tables reconcile selected historical consolidated financial data for the Company from the previously reported results to the restated results for years ended December 31, 2005, 2004 and 2003, the eight months ended December 31, 2002, and the fiscal year ended April 30, 2002. All dollar amounts are in thousands, except per share amounts.

 

     Year Ended December 31, 2005  

(in thousands, except per share data)

   As Previously Reported     Adjustment     As Restated  

Statements of Operations:

      

Revenue

   $ 174,539     $ —       $ 174,539  

Cost of revenue

     126,971       7,386 (a)(b)(e)(f)(g)(o)     134,357  
                        

Gross profit

     47,568       (7,386 )     40,182  

Operating expenses:

      

Research and development expense

     8,052       103 (a)     8,155  

Selling, general and administrative expense

     33,541       (7,031 )(a)(e)(f)     26,510  

Amortization of intangible assets

     1,334       (1,233 )(g)     101  

Acquired in-process technology

     99       —         99  
                        

Total operating expenses

     43,026       (8,161 )     34,865  
                        

Operating income (loss)

     4,542       775       5,317  

Other income (expense) and interest, net

     (143 )     (87 )(e)(o)     (230 )
                        

Income (loss) from continuing operations before tax and cumulative effect of a change in accounting principle

     4,399       688       5,087  

Equity share in earnings (losses) of unconsolidated affiliates

     1,075       (40 )(b)     1,035  

Impairment loss in unconsolidated affiliates

     (1,045 )     —         (1,045 )

Income tax (expense) benefit

     (14,025 )     (314 )(b)(c)(d)     (14,339 )

Minority interests in losses (earnings) of consolidated subsidiaries, net

     (975 )     —         (975 )
                        

Income (loss) from continuing operations, net of tax, before cumulative effect of a change in accounting principle

     (10,571 )     334       (10,237 )

Cumulative effect of a change in accounting principle, net of tax

     (117 )     —         (117 )
                        

Net income (loss)

   $ (10,688 )   $ 334     $ (10,354 )
                        

Net income (loss) per share:

      

Basic and diluted:

      

Income (loss) from continuing operations before cumulative effect of a change in accounting principle

   $ (0.78 )   $ 0.02     $ (0.76 )

Per share effect of the cumulative effect of a change in accounting principle

   $ (0.01 )     $ (0.01 )
                        

Net income (loss)

   $ (0.79 )   $ 0.02     $ (0.77 )
                        

Balance Sheet Data:

      

Total current assets

   $ 105,869     $ 145 (i)(j)(k)   $ 106,014  

Total assets

     176,845       (992 )(i)(j)     175,853  

Total current liabilities

     68,269       (2,551 )(h)(j)(l)(m)(p)     65,718  

Long-term obligations

     20,290       3,448 (l)(m)     23,738  

Stockholders’ equity

     88,286       (1,889 )(h)(i)(j)(p)     86,397  

(a) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses and related payroll tax liability (in thousands):

 

     Amount  

Cost of revenue

   $ 51  

Research and development expense

     103  

Selling, general and administrative expense

     (820 )
        

Total

   $ (666 )
        

 

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(b) Includes the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact (in thousands):

 

     Amount  

Cost of revenue

   $ (22 )

Equity share in (earnings) losses of unconsolidated affiliates

     40  

Income tax (benefit) expense

     (119 )
        

Total

   $ (101 )
        

 

(c) Includes the effect of restatement to increase income tax expense by $297,000 for U.S. withholding tax obligations on interest payments from IMPCO to BRC and alternative minimum tax for income inclusion on the loan from MTM to IMPCO.
(d) Includes the correction of an error in recording the deferred tax asset valuation allowance related to our BRC operations, increasing income tax expense by $136,000.
(e) Includes reclassification of $6,858,000 of certain costs previously classified as selling, general and administrative expense to cost of revenue of $6,826,000 and other expense of $32,000 to correct for an error in classification.
(f) Includes reclassification of $647,000 of certain costs associated with the closure of our Cerritos facility previously classified as cost of revenue to selling, general and administrative expense to correct for an error in classification.
(g) Includes reclassification of $1,233,000 of certain costs previously classified as amortization of intangible assets expense to cost of revenue.
(h) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses, related payroll tax liability and related income tax liability (in thousands):

 

     Amount  

Total current liabilities

   $ 837  

Stockholders’ equity

     (837 )

 

(i) Includes the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact (in thousands):

 

     Amount  

Total current assets

   $ (701 )

Total assets

     (741 )

Stockholders’ equity

     (741 )

 

(j) Includes the correction of an error in recording deferred tax asset valuation allowance related to our BRC operations (in thousands):

 

     Amount  

Total current assets

   $ (251 )

Total assets

     (251 )

Total current liabilities

     (237 )

Stockholders’ equity

     (14 )

 

(k) Includes reclassification of $1,097,000 of deferred tax assets from long-term to correct for an error in classification based on attributes that gave rise to the asset.
(l) Includes reclassification of $1,921,000 of deferred tax liability from current to long-term to correct for an error in classification based on attributes that gave rise to the liability.
(m) Includes reclassification of $1,527,000 of deferred compensation liability from accrued payroll obligations to long-term other liabilities to correct for an error in classification.
(o) Includes reclassification of $(55,000) of certain costs previously classified as cost of revenue to other income (expense) and interest, net to correct for an error in classification.
(p) Includes the effect of the restatement for income taxes (in thousands):

 

     Amount  

Total current liabilities

   $ 297  

Stockholders’ equity

     (297 )

 

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     Year Ended December 31, 2004  

(in thousands, except per share data)

   As Previously Reported     Adjustment     As Restated  

Statements of Operations:

      

Revenue

   $ 118,292     $ —       $ 118,292  

Cost of revenue

     91,554       1,980 (a)(b)(c)     93,534  
                        

Gross profit

     26,738       (1,980 )     24,758  

Operating expenses

      

Research and development expense

     4,634       85 (a)     4,719  

Selling, general and administrative expense

     20,331       (326 )(a)(c)     20,005  

Impairment loss of goodwill

     2,833       —         2,833  
                        

Total operating expenses

     27,798       (241 )     27,557  
                        

Operating income (loss)

     (1,060 )     (1,739 )     (2,799 )

Loss on extinguishment of debt

     (6,752 )     —         (6,752 )

Other income (expense) and interest, net

     (5,509 )     —         (5,509 )
                        

Income (loss) from continuing operations before equity share in earnings (losses), income tax and minority interest

     (13,321 )     (1,739 )     (15,060 )

Equity share in earnings (losses) of unconsolidated affiliates

     943       —         943  

Income tax (expense) benefit

     (2,325 )     —         (2,325 )

Minority interests in losses (earnings) of consolidated subsidiaries, net

     (1,176 )     —         (1,176 )
                        

Net income (loss)

   $ (15,879 )   $ (1,739 )   $ (17,618 )
                        

Net income (loss) per share:

      

Basic and diluted

   $ (1.71 )   $ (0.18 )   $ (1.89 )
                        

Balance Sheet Data:

      

Total current assets

   $ 43,978     $ (723 )(e)   $ 43,255  

Total assets

     98,452       (723 )(e)     97,729  

Total current liabilities

     28,847       2,148 (d)     30,995  

Long-term obligations

     24,774       —         24,774  

Stockholders’ equity

     44,831       (2,871 )(d)(e)     41,960  

(a) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses and related payroll tax liability (in thousands):

 

     Amount

Cost of revenue

   $ 58

Research and development expense

     85

Selling, general and administrative expense

     1,461
      

Total

   $ 1,604
      

 

(b) Includes an increase in cost of revenue of $135,000 from the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact.
(c) Includes reclassification of $1,787,000 of certain costs previously classified as selling, general and administrative expense to cost of revenue to correct for an error in classification.
(d) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses, related payroll tax liability and related income tax liability (in thousands):

 

     Amount  

Total current liabilities

   $ 2,148  

Stockholders’ equity

     (2,148 )

 

(e) Includes the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact (in thousands):

 

     Amount  

Total current assets

   $ (723 )

Total assets

     (723 )

Stockholders’ equity

     (723 )

 

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Table of Contents
     Year Ended December 31, 2003  

(in thousands, except per share data)

   As Previously Reported     Adjustment    

As Restated

(Unaudited)

 

Statements of Operations:

      

Revenue

   $ 74,740     $ —       $ 74,740  

Cost of revenue

     51,780       2,514 (a)(b)(c)     54,294  
                        

Gross profit

     22,960       (2,514 )     20,446  

Operating expenses

      

Research and development expense

     3,803       101 (a)     3,904  

Selling, general and administrative expense

     19,638       (1,131 )(a)(c)     18,507  
                        

Total operating expenses

     23,441       (1,030 )     22,411  
                        

Operating income (loss)

     (481 )     (1,484 )     (1,965 )

Other income (expense) and interest, net

     (4,039 )     —         (4,039 )
                        

Income (loss) from continuing operations before equity share in earnings (losses), income tax and minority interest

     (4,520 )     (1,484 )     (6,004 )

Equity share in earnings (losses) of unconsolidated affiliates

     (1,107 )     —         (1,107 )

Income tax (expense) benefit

     (668 )     —         (668 )

Minority interests in losses (earnings) of consolidated subsidiaries, net

     (605 )     —         (605 )
                        

Net income (loss)

   $ (6,900 )   $ (1,484 )   $ (8,384 )
                        

Net income (loss) per share:

      

Basic and diluted

   $ (0.83 )   $ (0.18 )   $ (1.01 )
                        

Balance Sheet Data:

      

Total current assets

   $ 44,129     $ (588 )(e)   $ 43,541  

Total assets

     101,136       (588 )(e)     100,548  

Total current liabilities

     21,990       3,115 (d)     25,105  

Long-term obligations

     22,017       —         22,017  

Stockholders’ equity

     57,129       (3,703 )(d)(e)     53,426  

(a) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses and related payroll tax liability (in thousands):

 

     Amount

Cost of revenue

   $ 40

Research and development expense

     101

Selling, general and administrative expense

     755
      

Total

   $ 896
      

 

(b) Includes and increase in cost of revenue of $588,000 from the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact.
(c) Includes reclassification of $1,886,000 of certain costs previously classified as selling, general and administrative expense to cost of revenue to correct for an error in classification.
(d) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses, related payroll tax liability and related income tax liability (in thousands):

 

     Amount  

Total current liabilities

   $ 3,115  

Stockholders’ equity

     (3,115 )

 

(e) Includes the effect of restatement related to gross profit eliminations for intercompany inventory and related income tax impact (in thousands):

 

     Amount  

Total current assets

   $ (588 )

Total assets

     (588 )

Stockholders’ equity

     (588 )

 

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Table of Contents
     Eight Months Ended December 31, 2002  

(in thousands, except per share data)

   As Previously Reported     Adjustment    

As Restated

(Unaudited)

 

Statements of Operations:

      

Revenue

   $ 46,421     $ —       $ 46,421  

Cost of revenue

     33,071       1,150 (a)(b)     34,221  
                        

Gross profit

     13,350       (1,150 )     12,200  

Operating expenses

      

Research and development expense

     2,635       4 (a)     2,639  

Selling, general and administrative expense

     11,922       (880 )(a)(b)     11,042  
                        

Total operating expenses

     14,557       (876 )     13,681  
                        

Operating income (loss)

     (1,207 )     (274 )     (1,481 )

Other income (expense) and interest, net

     (883 )     —         (883 )
                        

Income (loss) from continuing operations before tax and cumulative effect of a change in accounting principle

     (2,090 )     (274 )     (2,364 )

Income tax (expense) benefit

     (23,240 )     (1,146 )(a)     (24,386 )

Minority interests in losses (earnings) of consolidated subsidiaries, net

     51       —         51  
                        

Income (loss) from continuing operations, net of tax, before cumulative effect of a change in accounting principle

     (25,279 )     (1,420 )     (26,699 )

Loss from discontinued operation, net of tax

     (3,115 )     (192 )(a)     (3,307 )
                        

Net income (loss)

   $ (28,394 )   $ (1,612 )   $ (30,006 )
                        

Net income (loss) per share:

      

Basic and Diluted:

      

Income (loss) from continuing operations before cumulative effect of a change in accounting principle

   $ (3.52 )   $ (0.19 )   $ (3.71 )

Per share effect of loss from discontinued operation

     (0.43 )     (0.03 )     (0.46 )
                        

Net income (loss)

   $ (3.95 )   $ (0.22 )   $ (4.17 )
                        

Balance Sheet Data:

      

Total current assets

   $ 35,243     $ —       $ 35,243  

Total assets

     75,978       —         75,978  

Total current liabilities

     24,037       3,241 (c)     27,278  

Long-term obligations

     2,319       —         2,319  

Stockholders’ equity

     49,622       (3,241 )(c)     46,381  

(a) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses and related payroll tax liability and income tax liability (in thousands):

 

     Amount  

Cost of revenue

   $ (4 )

Research and development expense

     4  

Selling, general and administrative expense

     274  

Income tax (benefit) expense

     1,146  

Loss from discontinued operations, net of tax

     192  
        

Total

   $ 1,612  
        

 

(b) Includes reclassification of $1,154,000 of certain costs previously classified as selling, general and administrative expense to cost of revenue to correct for an error in classification.
(c) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses, related payroll tax liability and related income tax liability (in thousands):

 

     Amount  

Total current liabilities

   $ 3,241  

Stockholders’ equity

     (3,241 )

 

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     Fiscal Year Ended April 30, 2002  

(in thousands, except per share data)

   As Previously Reported     Adjustment    

As Restated

(Unaudited)

 

Statements of Operations:

      

Revenue

   $ 67,676     $ —       $ 67,676  

Cost of revenue

     44,542       1,883 (a)(b)     46,425  
                        

Gross profit

     23,134       (1,883 )     21,251  

Operating expenses

      

Research and development expense

     5,856       73 (a)     5,929  

Selling, general and administrative expense

     19,676       544 (a)(b)     20,220  
                        

Total operating expenses

     25,532       617       26,149  
                        

Operating income (loss)

     (2,398 )     (2,500 )     (4,898 )

Other income (expense) and interest, net

     (929 )       (929 )
                        

Income (loss) from continuing operations before tax and cumulative effect of a change in accounting principle

     (3,327 )     (2,500 )     (5,827 )

Income tax (expense) benefit

     1,331       170 (a)     1,501  

Minority interests in earnings (losses) of consolidated subsidiaries, net

     (224 )     —         (224 )
                        

Income (loss) from continuing operations, net of tax, before cumulative effect of a change in accounting principle

     (2,220 )     (2,330 )     (4,550 )

Loss from discontinued operation, net of tax

     (25,016 )     (1,022 )(a)     (26,038 )
                        

Net income (loss)

   $ (27,236 )   $ (3,352 )   $ (30,588 )
                        

Net income (loss) per share:

      

Basic and diluted:

      

Income (loss) from continuing operations before cumulative effect of a change in accounting principle

   $ (0.40 )   $ (0.42 )   $ (0.82 )

Loss from discontinued operation

     (4.51 )     (0.18 )     (4.69 )
                        

Net income (loss)

   $ (4.91 )   $ (0.60 )   $ (5.51 )
                        

Balance Sheet Data:

      

Total current assets

   $ 61,825     $ —       $ 61,825  

Total assets

     123,449       1,098 (c)     124,547  

Total current liabilities

     33,110       3,105 (c)     36,215  

Long-term obligations

     7,661       —         7,661  

Stockholders’ equity

     82,678       (2,007 )(c)     80,671  

(a) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses and related payroll tax liability and income tax liability (in thousands):

 

     Amount  

Cost of revenue

   $ 64  

Research and development expense

     73  

Selling, general and administrative expense

     2,363  

Income tax (benefit) expense from continuing operations

     (170 )

Loss from discontinued operations, net of tax

     1,022  
        

Total

   $ 3,352  
        

 

(b) Includes reclassification of $1,819,000 of certain costs previously classified as selling, general and administrative expense to cost of revenue to correct for an error in classification.
(c) Includes the effect of the restatement related to our voluntary stock option review for stock-based compensation expenses, related payroll tax liability and related income tax liability (in thousands):

 

     Amount  

Total assets

   $ 1,098  

Total current liabilities

     3,105  

Stockholders’ equity, including cumulative effect at May 1, 2001 of $572

     (2,007 )

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion includes forward-looking statements about our business, financial condition, and results of operations, including discussions about management’s expectations for our business. These statements represent projections, beliefs and expectations based on current circumstances and conditions and in light of recent events and trends, and you should not construe these statements either as assurances of performances or as promises of a given course of action. Instead, various known and unknown factors are likely to cause our actual performance and management’s actions to vary, and the results of these variances may be both material and adverse. A list of the known material factors that may cause our results to vary, or may cause management to deviate from its current plans and expectations, is included in Item 1A “Risk Factors.” The following discussion should also be read in conjunction with the consolidated financial statements and notes included herein.

Restatement Related to Voluntary Stock Options Grant Review

Background

In March 2007, our Board of Directors created a Special Committee to conduct a voluntary, internal review of the Company’s historical stock option grant practices and related accounting. The review covered options granted during the period from January 1996 through December 2006 (the “Review Period”). There were no option grants during 2005 and 2006. The Special Committee retained outside counsel and accounting experts to assist with this review.

On July 27, 2007, although the Special Committee had not yet completed its review, the Special Committee preliminarily concluded that different measurement dates should have been used for financial accounting purposes for certain stock option grants. At that time, the Company announced that it was more likely than not that the Company will need to restate historical financial statements to recognize non-cash stock-based compensation expense. Accordingly, the Company concluded that the Company’s previously issued consolidated financial statements and the related reports or interim reviews of its independent registered public accounting firm, and all earnings press releases and similar communication issued by the Company, should not be relied upon.

Scope of the Independent Investigation

The Special Committee retained outside counsel and accounting experts to assist with this stock option review which included the search and retrieval of electronic data from the Company’s computer and backup storage systems, review of reasonably available relevant physical and electronic documents and interviews with current and former employees and current and former members of the Company’s executive management and Board of Directors.

During the Review Period, the Company granted options to purchase a total of 2,718,507 shares of its common stock (adjusted for the two-for-one exchange on August 25, 2006 in connection with the Company’s reorganization, hereafter referred to as “adjusted shares”) on 37 different grant dates. The Company has specifically reviewed option grants on 14 of the 37 grant dates to determine what the proper measurement date should be for those grants in accordance with Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees. Grants of options to purchase an aggregate of 2,509,293 adjusted shares were issued on these 14 grant dates, constituting 92.3% of all the options granted during the Review Period.

For the remaining 23 grant dates not specifically reviewed, comprising options to purchase 209,217 adjusted shares, the Company performed a sensitivity analysis based on the potential stock-based compensation charge that might result from revised measurement dates. The Company did this by taking the average change in measurement date for the 14 grant dates specifically reviewed and selecting the highest closing price of the Company’s stock within that period of time for each of the 23 grant dates and determined the potential adjustment assuming all 23 grant dates had a revised measurement date. Based on the sensitivity analysis, the Company determined the potential adjustment would not be material to any given period or to the total stock-based compensation expense recorded.

 

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During the course of the investigation, the Special Committee also considered certain potential modifications of options granted during the Review Period, particularly those relating to changes in employment status for various recipients.

Findings of the Special Committee

On August 9, 2007, the Special Committee concluded its voluntary review of past stock option grant practices and determined that the original measurement dates of certain stock option grants, for financial accounting purposes, did not meet the requirements of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. Consequently, we revised the measurement dates consistent with the standards of APB No. 25 based on the best information available, and when the closing price of our stock at the original stated grant date was lower than the closing price on the revised measurement date, additional compensation expense was calculated. This resulted in additional stock-based compensation expense in each fiscal year from 1997 through 2005 which aggregated $8.0 million. In addition, the revised measurement dates resulted in additional stock-based compensation of $0.3 million for the nine months ended September 30, 2006 for expense recognized under the fair value method in accordance with SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”), which the Company adopted on January 1, 2006, because the exercise price for certain stock option grants prior to, but not vested as of January 1, 2006, differed from the fair market value on the revised measurement date, resulting in the calculation of increased fair values of said grants under the Black-Scholes option pricing model.

The Special Committee also determined that with respect to a single grant, the Special Committee concluded that the balance of evidence indicated that it had been purposefully misdated.

Adjustments to Measurement Dates

The need to revise the measurement dates for financial accounting purposes of certain stock option grants to meet the measurement date criteria of APB No. 25 is based on a number of different circumstances that can generally be summarized in the following categories:

Lack of Adequate Documentation: For a substantial number of grants issued by the Company during the Review Period, there is either no or inadequate documentation of Board approval actions that satisfy the requisites for establishing a measurement date under APB No. 25. Of the 14 specifically reviewed grant dates during the Review Period, there are documented approval actions by the Board of Directors with respect to particular grants for 8 dates. For grants to officers and directors which have no documented approval actions, the Company was able to use Form 4 filing dates, if they exist, or proxy filings. Otherwise, the Company used the best information available to select the measurement date for grants to officers, directors and rank and file employees which included contemporaneous lists that were substantially complete, signed stock option agreements if dated by the optionee or if the metadata of the document exists, e-mail communication or other employee communication such as a memorandum. If the stock options were granted prior to shareholder approval of the plan, the Company used the date of shareholder approval as the selected measurement date since the stock options could not be granted prior to shareholder approval.

No contemporaneous documentation of approval: For some grants which did have documented approval actions, there was no contemporaneous documentation to confirm that Board approval had occurred on the indicated grant date. Grant approval in each of these cases was documented by unanimous written consent, using the “as of” date in the signed consent as the approval date. The measurement dates were adjusted to conform to the date on which the last consent was received, as evidenced by the header on the sending telecopy, since the required granting actions, including approval, were not complete until the signed consents were returned to the Company.

Lack of finality of recipient list on company–wide grants: For other grants which had documented approval actions, the list of grant recipients and the number of options awarded to each recipient was not documented or determined with finality until a date subsequent to the original measurement date or in certain instances, the list was not available even though there was evidence of approval for a grant. Because the recipient list was not final until after the original grant date, the Company determined the revised measurement

 

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date for the grant based on the best information available, which included using Form 4 filing dates, if they exist, otherwise, for grants to officers, directors and rank and file employees, the Company used the metadata of the list that was complete or substantially complete, e–mail communication or other employee communications such as a memorandum.

Other Stock Option Related Items

We also recorded stock-based compensation expense in each fiscal year from 1998 through 2006 for other stock option related errors that were identified, which aggregated $5.7 million. These items include:

Modification of option terms: The Company modified stock option terms in connection with separation agreements for three individuals and did not previously record expense related to the modifications. Options for one director were accelerated in fiscal year April 30, 1998 resulting in expense of approximately $35,000. Options for an officer were allowed to continue to vest and the term of exercisability was extended in fiscal year April 30, 2000, resulting in additional expense of approximately $0.1 million. Lastly, options for an officer were modified during 2004 and further modified again in 2005 to accelerate the vesting and extend the term of exercisability, resulting in additional expense of $0.3 million in 2004 and $0.1 million in 2005.

The Company also modified stock option terms in connection with separation agreements for three individuals for which the Company had originally recorded stock-based compensation expense of $1.8 million in 2005. Due to the revision in measurement dates for some of these modified stock options, some stock-based compensation expense was recorded prior to the modification which reduced the expense recorded at the time of modification by $0.3 million.

The Company also modified stock option terms in connection with employment agreements for two officers in January 2004. The modification was to add a term to the employment agreement whereby upon termination, if the employee exercises in-the-money options within the term of the option agreement, the Company will reimburse the amount of the strike price of those options to the employee. In accordance with FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, (“FIN 44”), this is treated as a fixed cash bonus award accounted for as stock-based compensation. This resulted in additional expense until the employment agreements were terminated based on the vesting of the underlying options of $0.8 million, $0.3 million and $0.2 million in 2004, 2005 and the first nine months of 2006, respectively.

Non-employee grants: On two grant dates in 2003 and 2004, the Company granted options to employees of its 50% owned subsidiary, BRC. These BRC employees are considered non-employees of the Company and require fair value accounting in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. In addition, since they are non-employees, the value of their service would be used to value the options and would require the re-measurement principles under EITF 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, to determine the fair value each reporting period. This resulted in additional stock-based compensation expense of $0.4 million from 2003 through March 31, 2005, the date of the acquisition of the second 50% of BRC, when the BRC employees had a change in status from non-employee to employee. Under FIN 44, upon a change in status, there is a new measurement date for the options and, on a go forward basis, they are accounted under the new method based on the grantee status, in this case, employee under APB No. 25.

Option repricing: With respect to two grant dates, there is documentation of Board approval actions which contain a list of grantees, the number of options granted and the option price is known. The documentation satisfies the requisites for establishing a measurement date under APB No. 25. Based on other grant documentation available, it appears the options were repriced subsequent to the Board approval at a later date when the fair market value of the stock was at a lower price. As a result, under FIN 44, these grants are required to be accounted for under the variable accounting method which resulted in additional stock-based compensation expense of approximately $22,000 during fiscal years April 30, 2001 and 2002.

Options granted by a principal shareholder: On June 5, 1998, Questor Partners Fund LP and Questor Side-by-Side Partners LP (collectively “Questor”) acquired 709,981 adjusted shares of the Company’s common stock and 3,250 shares of preferred stock (convertible into 307,183 adjusted shares of common stock), giving Questor the ability (with the conversion) to hold 1,017,119 adjusted shares of common stock. In connection with the stock purchase, Questor granted 142,322 options to purchase the Company’s common stock at an exercise price of $27.50 to certain officers of the Company. The options vested twenty-five percent on June 30, 1999 and thereafter on each of the next three anniversaries of such date. The options were exercisable only after the

 

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preferred stock purchased by Questor is converted (or is convertible) into the Company’s common stock and also will become exercisable upon the earlier of (i) five years after the date of the purchase agreement and (ii) the sale by Questor of 50% or more shares of common stock owned by them on the date of the purchase. Subsequent to Questor’s acquisition of common stock, they held approximately 20% of the total outstanding common shares and 55% of the total outstanding preferred shares. In addition, Questor was represented on the board of directors with two of the six board seats.

Since Questor was a principal stockholder when they granted the options to purchase common stock to the Company’s officers, in accordance with AICPA Accounting Interpretation No. 25, Accounting for Stock Issued to Employees, Interpretation of APB No. 25, as part of the restatement, the Company recorded compensation expense of $0.5 million over the vesting period from June 5, 1998 through January 23, 2001 (see discussion below) related to the grant of these shares under APB No. 25 since they were issued with an exercise price below fair market value on the date of grant.

On January 23, 2001, Questor notified the officers that Questor had sold 50% or more of the shares of Common Stock it owned as of June 5, 1998, and per the agreement, the unvested options became fully vested and all vested options needed to be exercised in 60 days. Accordingly, the unamortized stock-based compensation was recorded to expense in January 2001 since all of the remaining options became fully vested. In March 2001 each of the officers exercised the Questor Options as described below.

Non-recourse loans for exercise of options: On March 15, 2001 each of the Company’s officers exercised their Questor Options to purchase IMPCO Common Stock at $27.50 per share. The Company extended loans to the officers for the full purchase price of an aggregate of $3.9 million. In accordance with EITF 95-16, Accounting for Stock Compensation Arrangements with Employer Loan Features Under APB No. 25, these loans are considered non-recourse notes. The officers had 60 days from January 23, 2001 to exercise these options. Since the loans to officers extended the original term of the option, the options are considered new awards with a new measurement date as of March 15, 2001. In addition, because the note is prepayable, the options are considered variable awards until the note is fully paid-off. As part of the restatement, the Company recorded $3.3 million of expense related to these option grants from March 2001 until the loan payoff in July 2001.

Tax Impact

As a result of the change in measurement dates described above, certain stock options granted during the Review Period were issued at prices below fair market value on the revised measurement date and should have been classified as Non–Qualified Stock Options (“NQs”), rather than Incentive Stock Options (“ISOs”). Due to the differences in the tax treatment between ISOs and NQs, the Company under-reported or under–withheld certain payroll taxes for those NQ options. As part of the restatement of the Company’s financial statements in this Form 10-K, the Company has accrued liabilities and recorded charges to operating expenses for payroll tax contingencies and related penalties and interest. The tax liabilities, including interest and penalties, that we have recorded include the impact of the reclassification of these options for tax purposes as depicted in the pre–tax payroll tax adjustments column of the table included in Accounting Impact below. Upon expiration of the related statute of limitations for payroll taxes, which we have determined to be three years, the Company recorded the reversal of the payroll tax liability and related penalties and interest.

While the Company has informed the Internal Revenue Service (“IRS”) regarding the payroll taxes liabilities resulting from changes in measurement dates for stock options, no formal settlement negotiations have taken place with the IRS. The actual payroll tax liability could be different from the tax liability accrued. The most significant assumption is the statute of limitations which the Company has determined to be three years. While the Company believes that they have a reasonable basis to conclude that the statute of limitations is three years, there are no assurances that it will prevail in this matter. The Company has an accrual of approximately $0.5 million for payroll related taxes as of December 31, 2006. The total reversals of accrued payroll tax liability and related penalties and interest through December 31, 2006 were approximately $3.3 million using the three year statute of limitations.

The Company recorded deferred tax assets as a result of the stock-based compensation expense recorded through the restatement based on unexercised and uncancelled stock options at the end of each reporting period.

Section 409A of the Internal Revenue Code, as amended, imposes additional taxes on our employees for stock options granted with an exercise price lower than the fair market value on the date of grant for all options or portions of options that vest after December 31, 2004. As a result of the change in measurement dates described above, certain stock options granted during the Review Period were issued at prices below fair market value on the revised measurement date. Management is considering possible ways to address the impact that Section 409A may have as a result of the exercise price of stock options being less than the fair market value of our common stock on the revised measurement dates. The Internal Revenue Service has issued transition rules under Section 409A that allow for a correction or cure for some of these options subject to Section 409A. The Company may offer non-officer employees who hold outstanding options the opportunity to cure their affected stock options. In connection with this cure, the Company may make cash bonus payments to our non-officer employees in an undetermined amount.

The Internal Revenue Code Section 162(m) limitations did not apply since no covered employee received compensation in excess of $1 million.

 

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Accounting Impact

The table below reflects the impact of the additional non-cash charges for stock-based compensation expense and related payroll tax liability and income tax impact on the Company’s consolidated statements of income from 1997 through the third quarter of 2006, including the corresponding cumulative adjustment to accumulated deficit as of April 30, 2001 on the Company’s consolidated balance sheets. Prior to this restatement, the Company had not recorded any non-cash stock-based compensation expense in its consolidated statements of income with the exception of $1.8 million recorded during 2005 for a modification of previous stock option awards for its former chief executive officer, its former vice president and chief operating officer for international operations and its former chief financial officer of the Company. All dollar amounts are presented in thousands except per share amounts.

 

          Pre-Tax
Stock-Based
Compensation
Expense
(Benefit)
Adjustments
    Pre-Tax
Payroll
Related Tax
Expense
(Benefit)
Adjustments
    Related
Income Tax
Expense
(Benefit)
Adjustments
   

Net

Expense
(Benefit)
After-Tax
Adjustments

 

Twelve months ended

   April 30, 1997    $ 21     $ —       $ (7 )   $ 14  

Twelve months ended

   April 30, 1998      272       8       (100 )     180  

Twelve months ended

   April 30, 1999      1,665       73       (625 )     1,113  

Twelve months ended

   April 30, 2000      1,139       745       (427 )     1,457  

Twelve months ended

   April 30, 2001      3,774       571       (533 )     3,812  
                                   

Cumulative effect at

   April 30, 2001      6,871       1,397       (1,692 )     6,576  

Twelve months ended

   April 30, 2002      2,054       1,708       (410 )     3,352  

Eight months ended

   December 31, 2002      378       136       1,098 (a)     1,612  

Twelve months ended

   December 31, 2003      1,022       (126 )     —         896  
                                   

Cumulative effect at

   December 31, 2003      10,325       3,115       (1,004 )(b)     12,436  

Twelve months ended

   December 31, 2004      2,571       (967 )     —         1,604  

Three months ended

   March 31, 2005      (197 )     43       —         (154 )

Three months ended

   June 30, 2005      253       (1,573 )     —         (1,320 )

Three months ended

   September 30, 2005      231       215       —         446  

Three months ended

   December 31, 2005      358       4       —         362  
                                   

Twelve months ended

   December 31, 2005      645       (1,311 )     —         (666 )

Three months ended

   March 31, 2006      273       20       —         293  

Three months ended

   June 30, 2006      64       (388 )     —         (324 )

Three months ended

   September 30, 2006      143       7       —         150  
                                   

Nine months ended

   September 30, 2006      480       (361 )     —         119  

Total

      $ 14,021     $ 476     $ (1,004 )   $ 13,493  
                                   

(a) The Company recorded valuation allowance on its deferred tax assets during the eight months ended December 31, 2002 and as a result, as part of the restatement, the Company set up a valuation allowance during this period for any deferred tax assets which were established in earlier periods as part of the restatement.
(b) The Company previously recorded the tax benefit for tax deductions related to stock-based compensation as an increase to additional paid-in-capital in accordance with APB No. 25. To the extent this tax benefit relates to stock-based compensation recorded as part of our restatement of our financial statements, the tax benefit (previously recorded to additional paid-in-capital) was recorded as a decrease to income tax expense.

 

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Procedural and Remedial Actions

As of the time of filing this Annual Report on Form 10-K, our management has completed the implementation of its remediation efforts related to the consolidated financial statement material weakness over stock-based compensation, including stock options, which include the following:

 

   

Specified members of the accounting and finance management team have, through the process of restating our financial statements for the results of our voluntary stock option review, received specialized hands-on training on U.S. GAAP and tax stock-based compensation issues, pronouncements, policies and procedures;

 

   

We have suspended the granting of stock options since November 2004, and do not intend to grant any stock options; and

 

   

We have formalized internal control improvements by documenting the accounting and operational policies and procedures over the granting, modification, cancellation and overall monitoring of stock-based compensation.

The Audit Committee and Board of Directors are also committed to the implementation of procedural enhancements in light of the Special Committee’s findings. These procedural enhancements include the following:

 

   

Seeking remittance of proceeds resulting from misdating from certain former executives;

 

   

Requiring corporate governance training for board members;

 

   

Requiring specialized training for the Company’s Chief Executive Officer and Chief Financial Officer; and

 

   

Formalizing job descriptions and scope of responsibilities for senior management.

We will begin seeking remittance of proceeds and complete the remaining procedural enhancements by the end of 2007.

Costs of the Review and Restatement

The Company has incurred substantial expenses related to the Special Committee’s review and the Company’s analysis of these stock option grants. We have incurred approximately $4.6 million in costs for legal fees, external audit firm fees and external consulting fees through September 30, 2007.

Regulatory Matters

The Company reported the Special Committee’s findings to the Securities and Exchange Commission and continues to cooperate with the Securities and Exchange Commission regarding matters relating to the Special Committee’s review of historical stock option grant practices.

The Company has received letters from the staff of the NASDAQ Stock Market stating that, as a result of the delayed filing of this Form 10-K, our March 31, 2007 Form 10-Q and our June 30, 2007 Form 10-Q, we are subject to delisting from the NASDAQ Stock Market. To date, NASDAQ has granted an exception to the listing requirement, pending further review, and subject to filing its delinquent reports by specified dates. With the filing of this report and the filing of the Company’s quarterly reports on Form 10-Q for the quarters ended March 31, 2007 and June 30, 2007, the Company believes that it has remedied the non-compliance with Marketplace Rule 4310(c)(14). However, there can be no assurance that the Listing Council will decide to allow the Company’s common stock to remain listed on NASDAQ Stock Market.

 

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Restatement Related to Eliminations for Intercompany Inventory

In addition to the adjustments related to the stock option review, the restated consolidated financial statements presented in this Form 10–K include an adjustment to correct an accounting error for the first three quarters in 2006 and each of the quarters in 2005 and as of and for the years ended December 31, 2005, 2004 and 2003. This correction relates to an error made in calculating the gross profit elimination for intercompany inventory remaining on the books of certain of our subsidiaries at period end. The impact of the correction, net of taxes, decreased our net income by $0.1 million for the quarter ended March 31, 2006, increased our net income by $0.2 million for the quarter ended June 30, 2006, decreased our net income by $0.1 million for the quarter ended September 30, 2006, decreased our net loss by $0.1 million for the year ended December 31, 2005, increased our net loss by $0.1 million for the year ended December 31, 2004, and increased our net loss by $0.6 million for the year ended December 31, 2003. See Note 18 of the notes to the consolidated financial statements for discussion regarding the impact on the first three quarters in 2006 and each of the quarters in 2005.

Restatement Related to Income Taxes

We are also reflecting adjustments, as part of our restatement, to correct accounting errors in recording income tax expense for the first three quarters in 2006 and each of the quarters in 2005 and as of and for the year ended December 31, 2005.

Previously, we had taken the position that the foreign earnings for BRC S.r.L. (“BRC”), our Italian subsidiary, were permanently reinvested and therefore no residual U.S. income tax was recorded under APB Opinion No. 23, Accounting for Income Taxes—Special Areas. However, for U.S. income tax purposes, the loan from MTM S.r.L. (“MTM”), a subsidiary of BRC, to IMPCO Technologies, Inc. (“IMPCO”), our U.S. subsidiary, entered into in December 2004, is deemed to be a constructive dividend and therefore created taxable income that we did not previously recognize in our 2005 provision for income taxes. For the IMPCO loan interest payments to MTM, we are required to withhold U.S. tax on the payments, which we did not previously withhold. As a result, we have recorded an adjustment to income tax expense of $0.1 million for the nine months ended September 30, 2006 and $0.3 million for the year ended December 31, 2005. We also recorded an adjustment to income tax expense of $0.1 million for the year ended December 31, 2005 to correct for an error in recording deferred tax asset valuation allowance related to our BRC operations in December 31, 2005.

We have reflected the impact of the adjustments related to our voluntary stock option review and gross profit elimination for intercompany inventory on our income tax disclosure in the footnotes to the consolidated financial statements but have also corrected this income tax disclosure for errors in our disclosure of our deferred tax assets and valuation allowance by reducing both balances due to utilization of net operating loss carryovers because the loan from MTM is treated as a constructive dividend for U.S income tax purposes, as discussed above, and due to ownership changes which took place since 1999 leading us to conclude that certain of our federal net operating loss carryovers, federal tax credit carryovers, state net operating loss carryovers and state tax credit carryovers will expire unused due to limitations imposed under Internal Revenue Code Section 382 and 383. In the aggregate, the reduction we recorded resulted in a reduction to our deferred tax assets and a corresponding reduction to the related valuation reserve in the amount of $11.4 million.

Correction of Account Classification

Our restatement also reflects adjustments to correct for errors in account classification between selling, general and administrative expense, cost of revenue and other income (expense), net. These adjustments primarily relate to the reclassification of other manufacturing costs of foreign subsidiaries which were included in selling, general and administrative expenses instead of cost of revenue, and costs related to the closure of our Cerritos facility which were classified as cost of revenue instead of selling, general and administrative expenses. We also corrected errors in classification on the balance sheet primarily between short-term and long-term for deferred tax balances and compensation related accrued expenses and between raw materials and finished goods.

 

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Summary

The table below reflects the impact of the accounting errors that have been corrected, including 1) the additional non-cash charges for stock-based compensation expense and related payroll tax liability and income tax impact recorded in each fiscal year for the period commencing, May 1, 1996, through the quarter ended September 30, 2006, 2) the adjustment to the gross profit elimination for intercompany inventory recorded in each fiscal year for the period commencing from January 1, 2003 through the quarter ended September 30, 2006, and 3) the adjustment to income tax expense recorded in each fiscal year for the period commencing from January 1, 2005 through the quarter ended September 30, 2006. The adjustment to correctly classify costs between selling, general and administrative expense and cost of sales have not been reflected in the table below as they represent reclassification of costs that do not have an impact on our net income, earnings per share or equity. All dollar amounts are presented in thousands except per share amounts. Per share amounts may not total due to rounding.

 

         

Net
Income
(Loss)

As
Previously
Reported

    Pre-tax
(Expense)
Benefit
Adjustment
   

Pre-tax

Equity

Share In
Income (loss)
of
Unconsolidated
Affiliates
Adjustment

    Income
Tax
(Expense)
Benefit
Adjustment
   

Adjusted
Net

Income

   

Diluted
EPS

As
Previously
Reported

    Adjustment     Adjusted
Diluted
EPS
 

Twelve months ended

   April 30, 1997    $ 2,644     $ (21 )   $ —       $ 7     $ 2,630     $ 0.86     $ (0.00 )   $ 0.86  

Twelve months ended

   April 30, 1998      4,270       (280 )     —         100       4,090       1.19       (0.04 )     1.15  

Twelve months ended

   April 30, 1999      5,800       (1,738 )     —         625       4,687       1.41       (0.25 )     1.16  

Twelve months ended

   April 30, 2000      3,065       (1,884 )     —         427       1,608       0.66       (0.32 )     0.34  

Twelve months ended

   April 30, 2001      (13,103 )     (4,345 )     —         533       (16,915 )     (2.37 )     (0.69 )     (3.06 )

Twelve months ended

   April 30, 2002      (27,236 )     (3,762 )     —         410       (30,588 )     (4.91 )     (0.60 )     (5.51 )

Eight months ended

   December 31, 2002      (28,394 )     (514 )     —         (1,098 )     (30,006 )     (3.95 )     (0.22 )     (4.17 )

Twelve months ended

   December 31, 2003      (6,900 )     (1,484 )     —         —         (8,384 )     (0.83 )     (0.18 )     (1.01 )
                                                                   

Cumulative effect at

   December 31, 2003      (59,854 )     (14,028 )     —         1,004       (72,878 )     (7.94 )     (2.30 )     (10.24 )

Twelve months ended

   December 31, 2004      (15,879 )     (1,739 )     —         —         (17,618 )     (1.71 )     (0.19 )     (1.90 )

Three months ended

   March 31, 2005      (2,181 )     8       —         (74 )     (2,247 )     (0.20 )     (0.01 )     (0.21 )

Three months ended

   June 30, 2005      1,172       1,481       (142 )     (77 )     2,434       0.08       0.09       0.17  

Three months ended

   September 30, 2005      (9,219 )     (220 )     11       (153 )     (9,581 )     (0.64 )     (0.03 )     (0.67 )

Three months ended

   December 31, 2005      (460 )     (581 )     91       (10 )     (960 )     (0.03 )     (0.04 )     (0.07 )
                                                                   

Twelve months ended

   December 31, 2005      (10,688 )     688       (40 )     (314 )     (10,354 )     (0.79 )     0.02       (0.77 )
                                                                   

Cumulative effect at

   December 31, 2005      (86,421 )     (15,079 )     (40 )     690       (100,850 )     (10.44 )     (2.47 )     (12.91 )

Three months ended

   March 31, 2006      3,699       (322 )     (80 )     (23 )     3,274       0.25       (0.03 )     0.22  

Three months ended

   June 30, 2006      1,278       408       (52 )     102       1,736       0.08       0.03       0.11  

Three months ended

   September 30, 2006      3,437       (191 )     46       (166 )     3,126       0.22       (0.02 )     0.20  
                                                                   

Cumulative effect at

   September 30, 2006    $ (78,007 )   $ (15,184 )   $ (126 )   $ 603     $ (92,714 )   $ (9.89 )   $ (2.49 )   $ (12.38 )
                                                                   

 

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Reorganization

On August 23, 2006, our Company was reorganized pursuant to an Agreement and Plan of Reorganization by and among IMPCO, Fuel Systems, a newly formed Delaware corporation, and IMPCO Merger Sub, Inc., a Delaware corporation formed solely for the purpose of consummating the reorganization. The agreement reorganized IMPCO’s capital structure into a holding company structure, pursuant to which (1) IMPCO contributed 100% of its holdings of the capital stock of BRC to Fuel Systems; (2) IMPCO became a wholly owned subsidiary of Fuel Systems; and (3) the stockholders of IMPCO exchanged all of their shares of IMPCO for shares of Fuel Systems. Nasdaq began listing Fuel Systems’ common stock on the Nasdaq Global Market under a new trading symbol, “FSYS” on August 25, 2006.

We believe that the reorganization, through the formation of the holding company, Fuel Systems, with IMPCO and BRC being separate, stand-alone operating entities and wholly owned subsidiaries of Fuel Systems, offers several advantages:

 

   

It promotes greater management accountability at the corporate and individual operating unit levels;

 

   

It creates greater flexibility to respond to customer needs; and

 

   

It aligns each operating subsidiary with specific core product lines and business segments.

As part of the reorganization, stockholders of IMPCO received one whole share of common stock of Fuel Systems in exchange for every two shares of IMPCO common stock owned at the time of the reorganization. Stockholders received cash for any fractional shares held equal to a proportionate interest in the gross proceeds of the sale on Nasdaq of the aggregate fractional shares.

All outstanding warrants to purchase IMPCO common stock became warrants to purchase one whole share of Fuel Systems’ common stock for every two shares of IMPCO common stock subject to such warrant terms, with any fractional shares treated in accordance with the warrant terms. All outstanding options to purchase IMPCO common stock became options to purchase one whole share of Fuel Systems’ common stock for every two shares of IMPCO common stock subject to such option, with any fractional shares rounded-up to the nearest whole number. The exercise price of the warrants and options following the reorganization became equal to twice the exercise price of such option or warrant immediately prior to the reorganization. The post-reorganization consolidated financial statements of Fuel Systems presented herein are presented on the same basis as and can be compared to the consolidated financial statements reported in IMPCO’s prior quarterly and annual reports filed with the SEC. All share numbers and per share amounts are stated for Fuel Systems and have given effect to the two-for-one exchange of IMPCO stock into Fuel Systems stock that was effected pursuant to the reorganization.

The reorganization transaction is described in detail in the proxy statement/prospectus on Form S-4, filed by Fuel Systems with the SEC on July 7, 2006 and declared effective that day. That filing also includes the full text of the certificate of incorporation of Fuel Systems.

Overview

We design, manufacture and supply alternative fuel components and systems to the transportation, industrial and power generation industries on a global basis. Our components and systems control the pressure and flow of gaseous alternative fuels, such as propane and natural gas, for use in internal combustion engines. Our products improve efficiency, enhance power output and reduce emissions by electronically sensing and regulating the proper proportion of fuel and air required by the internal combustion engine. We also provide engineering and systems integration services to address our individual customer requirements for product performance, durability and physical configuration. For more than 49 years, we have developed alternative fuel products. We supply our products and systems to the market place through a global distribution network of hundreds of distributors and dealers in 70 countries and 120 original equipment manufacturers.

 

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Prior to August 23, 2006, we have previously presented our operations in three business segments: U.S. Operations, International Operations and BRC Operations. On August 23, 2006, the stockholders of IMPCO adopted the Agreement and Plan of Reorganization pursuant to which IMPCO and BRC immediately became separate, stand-alone operating entities and wholly owned subsidiaries of Fuel Systems Solutions, Inc. (see “Reorganization” above). Therefore, our management believes that presentation of operating results in two business segments, IMPCO operations and BRC operations, is more appropriate.

Under our new system of reporting operations, IMPCO operations manufactures and sells products for use primarily in the industrial market through its U.S. and foreign facilities in the Netherlands, Australia and Japan and distribution channels, including complete certified engines, fuel systems, parts and conversion systems, for applications in the transportation, material handling, stationary and portable power generator markets. This new operating segment is a combination of our previously-reported U.S. operations and International operations segments. BRC operations manufactures and sells products for use primarily in the transportation market through its Italy and foreign facilities in Argentina and Brazil. Corporate expenses consist of general and administrative expenses at the corporate level, which became the Fuel Systems level after the reorganization. Intercompany sales between and within IMPCO operations and BRC operations have been eliminated in the results reported.

We acquired BRC on March 31, 2005 and included the results of BRC’s operations with our consolidated results beginning with the second quarter of 2005 and with our balance sheet as of March 31, 2005. As of December 31, 2004, we no longer consolidated our operations in Mexico and India as part of our International operations segment. Instead, during 2005 we accounted for these operations using the equity method of accounting since we had 50% ownership in these entities and lack effective control over their operations. In the fourth quarter of 2005, we decided to liquidate our Mexico operations and began the process of liquidation in the first quarter of 2006. We closed our Mexico operations in June 2006. We also converted our joint venture in India into independent distributorships in order to reduce the administrative costs of maintaining the joint venture while continuing to sell our products in these markets. We sold our 50% share in our joint venture in India to the other 50% owner in April 2006.

Net income was $6.9 million on revenue of approximately $220.8 million in 2006 as compared to net loss of $10.4 million on revenue of approximately $174.5 million in 2005. Operating income increased by approximately $14.7 million to $20.0 million, compared to $5.3 million for the same period in 2005. For the year ended December 31, 2006, we recorded approximately $2.4 million in inventory reserve resulting from a specific review of inventory with approximately $2.4 million attributed to BRC. BRC also recorded a $1.9 million unrealized loss in currency fluctuations between the dollar and the euro during 2006. We cannot predict nor assure readers that the 2006 operating performance of IMPCO or BRC will continue into 2007 or be as favorable for future reporting periods or fiscal years. We cannot predict nor assure readers that movements in foreign exchange will be either unfavorable (as in 2006) or favorable (as in 2005) for future reporting periods or fiscal years.

Net loss was $10.4 million on revenue of approximately $174.5 million in 2005 as compared to net loss of $17.6 million on revenue of approximately $118.3 million in 2004. The net loss for 2005 includes an increase in income tax expense of $12.0 million and $1.9 million of additional compensation expenses in connection with the extension of the terms of options issued to our former Chief Executive Officer and former Chief Operating Officer for IMPCO. We also recorded additional provision for slow moving inventory and uncollectible accounts totaling $0.4 million in our Mexico operation reflecting the declining level of business in that market. During the fourth quarter of 2005, we recorded an impairment charge of approximately $1.0 million for our equity investment in our 50%-owned affiliate in Mexico, IBMexicano. We did not believe that there would be adequate cash flows generated from IBMexicano to support its carrying value in our consolidated financial statements. Anticipating the closure and liquidation of our wholly owned subsidiary in Mexico in the first half of 2006, we wrote off the cumulative foreign currency translation adjustment of $0.5 million which had been previously deferred during the course of consolidating our wholly owned Mexico subsidiary. These losses in 2005 were partially offset by a strong operating performance by our BRC Operations in which revenue on a twelve month basis were $94.5 million or 61.3% higher than 2004 revenue and net income was $10.4 million or 225.0% higher over the same period. Our share in these earnings was $1.6 million and $9.0 million during 2004 and 2005, respectively, or an increase of $7.4 million. BRC also recorded a $2.2 million transaction gain in currency fluctuations between the dollar and the euro during 2005.

 

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Net loss for the year ended December 31, 2004 of $17.6 million included a loss on the extinguishment of debt of $6.8 million on the payoff of the Bison Loan in December 2004; an increase in income tax expense of $1.7 million; a write-off of goodwill totaling $2.8 million for reduction of business in Japan and Mexico; a change in accounting estimate for excess and obsolete inventories resulting in a charge of $1.3 million; additional costs incurred for preparation and auditing for Sarbanes-Oxley Act of 2002 of approximately $0.6 million; and severance costs of personnel reductions of approximately $0.8 million in conjunction with the board approved transition plan for the integration of IMPCO and BRC.

Recent Developments

2006 Incentive Bonus Plan

In August 2006, our stockholders approved the 2006 Incentive Bonus Plan. Under the plan, the compensation committee of our Board of Directors may grant bonus awards (in the form of cash, restricted stock or a combination of both) to some or all of IMPCO’s and BRC’s employees based on the divisions’ profitability and the attainment of individual employee’s performance goals. Based on profitability of both IMPCO and BRC for 2006, some employees were paid bonuses in May 2007. A portion of the bonus was paid in cash and a portion in restricted stock totaling 19,935 shares of restricted stock. The restricted stock vests 25% on the date of the grant and the balance in three equal annual installments. Accordingly, we have recorded an expense of $0.9 million compensation expense during 2006, of which $0.1 million relates to the portion of the restricted stock that was fully vested at the date of grant.

Relocation of North American Headquarters

On September 6, 2005, we signed an agreement to sublease a 108,000 square foot building, including 20,000 square feet of office space, located in Santa Ana, California, for a term of 13 years beginning September 1, 2005. We relocated our combined corporate headquarters and IMPCO U.S. business operations from our former location in Cerritos, California, to the Santa Ana facility in April 2006. We believe the new location has sufficient space to modernize and consolidate most of our North American production and component engineering facilities. We have installed new state-of-the-art production lines, machining, and test equipment in the Santa Ana facility. As a global leader in the alternative fuels marketplace, our strategy is to use the improved efficiencies, capabilities and capacity to position us to better serve our markets and to take advantage of new products and new markets.

The annual rent for the Santa Ana facility is $0.7 million, which is set to increase 3% every year pursuant to the terms of the agreement. The terms of the sublease agreement also include rent abatement for the first three months, subject to certain conditions. In connection with this relocation, we recognized approximately $0.9 million in expenses during 2005, consisting of approximately $0.1 million for accelerated amortization of leasehold improvements and furniture and fixtures, approximately $0.3 million for the recognition of incremental rent expense for the Santa Ana facility prior to the exit of the Cerritos facility in early 2006, $0.2 million for relocation and set-up costs and approximately $0.3 million for the fair value of the remaining lease obligation of the Cerritos facility which extends until 2009. During 2006, we incurred $0.2 million for incremental rent expense for the Santa Ana facility prior to the exit of the Cerritos facility in April 2006 and revised the estimated cost for the sublease of the Cerritos facility and recorded an additional expense of approximately $0.2 million. During the year ended December 31, 2006, we incurred approximately $1.9 million in cash outflows including approximately $1.7 million in leasehold improvements in the new facility.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, goodwill, taxes, inventories, warranty obligations, long-term service contracts, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

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Revenue Recognition.

We recognize revenue upon transfer of title and risk of loss, generally when products are shipped provided there is persuasive evidence of an arrangement, the sales price is fixed or determinable, and management believes collectibility is reasonably assured. We consider arrangements with extended payment terms not to be fixed or determinable unless they are secured under an irrevocable letter of credit arrangement guaranteed by a reputable financial institution, and accordingly, we defer such revenue until amounts become due and payable. The costs of shipping and handling, when incurred, are recognized in the cost of goods sold. We provide for returns and allowances as circumstances and facts require.

Sales to our unconsolidated subsidiaries are made on terms similar to those prevailing with unrelated customers as noted above. We defer a pro rata portion of the gross profit on sales for the inventory of the unconsolidated subsidiaries until the inventory is sold to a third party customer.

Allowance for Doubtful Accounts.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We estimate the allowance for doubtful accounts based on historical experience and any specific customer collection issues that have been identified through management’s review of outstanding accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Warranty.

We provide for the estimated cost of product warranties at the time revenue is recognized based, in part, on historical experience. While we engage in product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability may be required. We believe that our warranty experience is within the industry norms. Our standard warranty period is 18 to 24 months from the date of delivery to the customer depending on the product. The warranty obligation on our certified engine products can vary from three to five years depending on the specific part and the actual hours of usage.

Inventory Reserves.

We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Goodwill.

We account for goodwill in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 142 requires that goodwill not be amortized but instead be tested at least annually for impairment, or more frequently when events or changes in circumstances indicate that the assets might be impaired. Management considers each subsidiary to be a reporting unit for purposes of testing for impairment. This impairment test is performed annually during the fourth quarter.

A two-step test is used to identify the potential impairment and to measure the amount of goodwill impairment, if any. The first step is to compare the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill is considered not impaired; otherwise, goodwill is impaired and the loss is measured by performing step two. Under step two, the impairment loss is measured by comparing the implied fair value of the reporting unit goodwill with the carrying amount of goodwill.

We operate wholly-owned and majority-owned subsidiaries. We record goodwill at the time of purchase for the amount of the purchase price over the fair values of the assets and liabilities acquired. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an

 

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inability to recover the carrying value of the goodwill, thereby possibly requiring an impairment charge in the future. During 2004, we recorded a $2.8 million impairment loss of goodwill for our operations in Mexico and Japan. The annual reviews performed in the fourth quarters of 2006 and 2005 resulted in no impairment to goodwill.

Intangible Assets.

We amortize intangible assets acquired if they are determined to have definite useful lives. Certain intangible assets, such as acquired technology and trade names, are amortized on a straight-line basis, our best estimate of the pattern of economic benefits, over their estimated reasonable useful lives. Certain other intangible assets such as customer relationships are amortized using an accelerated method since the value of customer relationships is expected to decline at a faster rate.

Deferred Taxes.

Based upon the substantial net operating loss carryovers and expected future operating results, we conclude that it is more likely than not that substantially all of the deferred tax assets in the United States at December 31, 2006 may not be realized within the foreseeable future. The balance of the total valuation allowance was $24.3 million as of December 31, 2006. In addition, we expect to provide a full valuation allowance on future tax benefits realized in the United States until we can sustain a level of profitability that demonstrates our ability to utilize the assets.

As of December 31, 2006, undistributed earnings, except with respect to our 51% interest in IMPCO-BERU Technologies B.V., are considered to be indefinitely reinvested and, accordingly, no provision for United States federal and state income taxes is provided thereon. Residual U.S. taxes have been accrued (applied as a reduction to net operating loss carry-forwards) on approximately $23.9 million of earnings of BRC (for the MTM loan) and $1.3 million of earnings of IMPCO Technologies Fuel Systems, Pty. Limited, the Australian subsidiary of IMPCO (for an intercompany transaction) as such amounts were deemed to be a constructive dividend creating taxable income for U.S. income tax purposes; upon distribution of earnings in the form of dividends, or otherwise, in excess of these amounts, we may be subject to United States income taxes. In addition, the Company would be subject to withholding taxes payable to various foreign countries. To the extent we have repaid the MTM loan (we have repaid $5.3 million as of October 3, 2007, which is net of our recent $2.3 million in short term borrowings from MTM), such amounts could be drawn as a dividend from BRC without U.S. income tax consequences.

Foreign Currency Agreements.

We recognize changes in the fair value of a foreign currency agreement as a component of other income and expense on the consolidated statement of operations, unless the agreement qualifies under hedge accounting. If hedge accounting applies, changes in the fair value of the hedging agreement would be deferred as a component of stockholders’ equity. We also record foreign currency transaction gains and losses as other income and expense on the condensed consolidated statement of operations.

Stock-Based Compensation Expense.

Effective January 1, 2006, we adopted SFAS No. 123R, Share-Based Payment (“SFAS 123R”) using the modified prospective method. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and therefore only recognize compensation cost for those shares expected to vest over the service period of the award. Prior to SFAS 123R adoption, we accounted for share-based payments under APB No. 25.

Calculating stock-based compensation expense requires the input of highly subjective assumptions, including the expected term of the share-based awards, expected stock price volatility, and expected pre-vesting option forfeitures. We base these estimates on historical experience. The assumptions used in calculating the fair value of share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options expected to vest. If our actual forfeiture rate is materially different from our estimate, the share-based compensation expense could be significantly different from what we have recorded in the current period.

 

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Results of Operations

Years Ended December 31, 2006 and 2005

The following table sets forth our revenue and operating income (in thousands):

 

     Revenue  
     Years Ended December 31,  
     2006     2005  

IMPCO Operations (1)

   $ 109,134     $ 101,263  

BRC Operations (2)

     111,682       73,276  
                

Total

   $ 220,816     $ 174,539  
                
     Operating Income  
     Years Ended December 31,  
     2006     2005  
           (as restated)  

IMPCO Operations

   $ 12,385     $ 4,200  

BRC Operations (2) (3)

     15,846       8,635  

Corporate Expenses (4) (5)

     (8,196 )     (7,518 )
                

Total

   $ 20,035     $ 5,317  
                

(1) IMPCO operations is a combination of our previously-reported U.S. operations and international operations segments.
(2) The Company consolidated BRC’s income statement beginning April 1, 2005. During the first quarter of 2005, we accounted for BRC on an equity basis.
(3) Includes $0.1 million of IPR&D expense for the year ended December 31, 2005 relating to the acquisition of BRC.
(4) Represents corporate expense not allocated to either of the business segments.
(5) For the year ended December 31, 2005, includes $1.9 million for compensation, lifetime medical benefits and for modifications to previously granted stock option awards to two former executive officers of IMPCO.

The following tables set forth our product revenue by application and by geographical areas across all reporting segments for fiscal years 2006 and 2005 (in thousands):

 

     Years Ended December 31,  
     2006     2005  

Revenue:

    

Transportation

   $ 137,061    62.1 %   $ 91,437    52.4 %

Industrial

     83,755    37.9 %     83,102    47.6 %
                          

Total

   $ 220,816    100.0 %   $ 174,539    100.0 %
                          

 

     Years Ended December 31,  
     2006     2005  

Revenue:

    

North America

   $ 49,586    22.5 %   $ 59,826    34.3 %

Europe

     119,026    53.9 %     87,689    50.2 %

Asia & Pacific Rim

     41,967    19.0 %     19,319    11.1 %

Latin America

     10,237    4.6 %     7,705    4.4 %
                          

Total

   $ 220,816    100.0 %   $ 174,539    100.0 %
                          

Total revenue increased approximately $46.3 million, or 26.5%, to $220.8 million in 2006 from $174.5 million in 2005. The increase in revenue for 2006 was the result of $38.4 million increase in BRC operations revenue recorded during the year, as well as an increase of $7.9 million in revenue from our IMPCO operations. BRC revenue was consolidated for the entire year of 2006, but in the prior year, was only consolidated in the period from April 1 through December 31 after the acquisition of the second 50% of BRC on March 31, 2005. Revenue in the transportation market increased in 2006 by $45.6 million, or 49.9%, due to the inclusion of BRC, which serves the transportation market exclusively. The industrial market increased by $0.7 million, or 0.8%.

 

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For the year ended December 31, 2006, operating income increased $14.7 million, to $20.0 million from $5.3 million for the year ended December 31, 2005. This increase is partially attributed to the inclusion of BRC’s results for the entire year in 2006, while for 2005, was only consolidated in the period from April 1 through December 31 after the acquisition of the second 50% of BRC on March 31, 2005. To a lesser extent, the absence of operating losses from our Mexico operations in 2006 also contributed to the favorable comparison to 2005. In addition, cost-cutting measures implemented in 2005, which included the relocation of our research and development facility in Seattle, Washington to IMPCO’s operations in California, resulted in improvements in operating income. Further contributing to the improvement between the two periods was the absence in 2006 of approximately $1.9 million in compensation and severance-related costs for two former executive officers recorded in 2005, partially offset by approximately $2.4 million in inventory reserve resulting from a specific review of inventory with approximately $2.4 million attributed to BRC, the increase of approximately $1.5 million in stock-based compensation expense as a result of the adoption of SFAS 123R in 2006, and an accrual of $0.9 million for the 2006 Incentive Bonus Plan, which was approved by stockholders on August 23, 2006.

IMPCO Operations. Data for 2005 has been reclassified to reflect our new presentation of operating segments (IMPCO operations is a combination of our previously-reported U.S. operations and international operations segments). During 2006, revenue increased by approximately $7.9 million, or 7.8%, to $109.1 million, from $101.3 million during 2005. The increase in revenue during 2006 was primarily due to a $7.0 million increase in revenue from the transportation market related to increased in demand in the second half of the year related to energy initiatives effective in Australia for liquified petroleum gas or LPG vehicles and a $0.9 million increase in revenue from the industrial market.

Operating income for 2006 increased by approximately $8.2 million, from $4.2 million in the same period in 2005. The improvement was mainly due to benefits realized from cost reductions implemented in 2005, which included the relocation of our research and development facility in Seattle, Washington to IMPCO’s U.S. operations in California. In addition, the absence of expenses related to our Mexico operations, which were closed at the end of 2005 also contributed to the improvement in operating income, as well as the absence of a charge for a change in estimate of the write-off related to the planned liquidation of our Mexico operations. These amounts were partially offset by a $0.6 million accrual for the 2006 Incentive Bonus Plan which was approved by stockholders on August 23, 2006.

BRC Operations. BRC operations became a business segment in the second quarter of 2005. In 2006, its revenue was $111.7 million, an increase of approximately $38.4 million, or 52.4%, as compared to 2005. The increase in revenue in 2006 is partially attributed to the inclusion of BRC revenue for the entire twelve-month period in 2006, whereas in 2005, BRC was initially reported as a 50% equity-method investment until April 1, 2005, at which time it was consolidated. In addition, BRC has also experienced growth in the transportation market attributed in part to increases experienced by consumers in gasoline prices, which has oriented automotive manufacturers to promote gaseous fuel equipment.

BRC’s operating income for 2006 was $15.9 million, $7.2 million higher than in 2005. BRC operations became an operating segment of our business in the second quarter of 2005, so the earlier period in the comparison included only nine months. The increase was mainly due the increase in revenue partially offset by the inclusion of an expense for an increase in inventory reserve of $2.4 million resulting from a specific review of inventory, by a $0.3 million accrual for the 2006 Incentive Bonus Plan which was approved by stockholders on August 23, 2006 and amortization and depreciation expense resulting from purchase price allocation. Approximately $2.5 million and $1.8 million in amortization and depreciation expenses related to intangible assets and step-up in fair value of fixed assets acquired in the acquisition of the remaining 50% of BRC were also included in the BRC operations for the years 2006 and 2005, respectively.

We completed the purchase price allocation of the BRC acquisition in the fourth quarter of 2005 and allocated approximately $12.5 million and $5.1 million to intangible assets and fixed assets, respectively, with estimated useful lives ranging from seven to eleven years for the intangible assets and five to eight years for the fixed assets. For 2006 and 2005, respectively, we recorded amortization expense of approximately $1.8 million and $1.3 million for the intangible assets, and approximately $0.7 million and $0.5 million for depreciation of the step-up in fair value of fixed assets. In future years, the amount of amortization and depreciation will vary due to future changes to the remaining useful lives, movements in the exchange rate between the U.S. dollar and the euro, and the use of an accelerated amortization schedule for the fair value allocated to customer relationships; however, we estimate that the amount of combined amortization and depreciation during 2007 will be approximately $2.5 million.

 

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Corporate Expenses. Corporate expenses consist of general and administrative expenses at the corporate level to support our business segments in areas such as executive management, finance, human resources, management information systems, legal and accounting services, and investor relations. Corporate expenses for the fiscal year ended December 31, 2006 were approximately $8.2 million compared to approximately $7.5 million in the prior year. Corporate expenses in 2005 included recognition of expense of approximately $1.5 million in compensation expense related to 1.3 million stock options granted in prior fiscal years to a former officer and $0.4 million in severance related costs paid to former officers in 2005 as well as stock-based compensation expense related to vesting of stock options of $0.9 million. Stock-based compensation expense was approximately $1.7 million in 2006 resulting from the adoption of SFAS 123R on January 1, 2006. Corporate expenses in 2006 increased due to $0.3 million in increased costs associated with our reorganization and $0.4 million in increased costs related to our Sarbanes Oxley Act Section 404 compliance efforts to include BRC in 2006 since BRC was not required to be included in our compliance efforts in 2005.

Interest Income. Interest income was approximately $0.5 million in 2006 and approximately $0.3 million in 2005. The increase is due to higher yields on marketable securities in 2006 as compared to 2005.

Interest Expense. Interest expense was approximately $1.2 million in 2006 and approximately $1.0 million in 2005. The increase in interest expense was due to the higher variable interest rate on our revolving credit facility for IMPCO U.S. operations with La Salle Business Credit, LLC. In addition, the increase was also due to increased usage on our BRC revolving credit facilities used to fund working capital due to growth in the business during 2006 as compared to 2005.

Other Income and Expense. Other income and expense is primarily composed of unrealized foreign exchange gains and losses between the U.S. dollar and the euro with respect to “marking to market” of the MTM loan balance, and the gains and losses with respect to the fair value determination of the related foreign exchange hedging agreement since the agreement did not qualify for hedge accounting. In the year ended December 31, 2006, we recognized approximately $1.9 million in unrealized losses on foreign exchange in connection with the MTM loan between the U.S. dollar and the euro, offset by a gain on the foreign currency agreement of approximately $0.6 million. In the year ended December 31, 2005, we recognized approximately $2.9 million in unrealized gains on foreign exchange in connection with the MTM loan between the U.S. dollar and the euro (consisting of approximately $2.3 million recorded in other income and approximately $0.6 million recorded in equity in earnings from unconsolidated subsidiaries) offset by a recognized loss on the foreign currency agreement of approximately $0.7 million.

We routinely conduct transactions in currencies other than our reporting currency, the U.S. dollar. We cannot estimate or forecast the direction or the magnitude of any foreign exchange movements with any currency that we transact in; therefore, we do not measure or predict the future impact of foreign currency exchange rate movements on our consolidated financial statements.

Income of Equity Share in Unconsolidated Affiliates. During the year ended December 31, 2006, we recognized our share in the income of BRC’s unconsolidated affiliates in the amount of $0.7 million. Since our acquisition of the initial 50% of BRC in July 2003, we began accounting for BRC’s operating results using the equity method whereby we recognized 50% of the earnings of BRC in our financial statements. During the first quarter of 2005, we continued this accounting treatment until we completed the acquisition of the remaining 50% of BRC on March 31, 2005. For periods following March 31, 2005, we fully consolidated the results of BRC and eliminated all intercompany transactions. During the first quarter of 2005, we recognized income of approximately $1.2 million, net of an elimination of an intercompany gain of $0.2 million, based on $2.7 million of income reported by BRC. In addition to our share in the earnings of BRC, we recognized our share in the losses of our 50% owned joint ventures in Mexico and India of approximately $0.3 million, recorded amortization expense of approximately $0.2 million of the step-up in the fair value of the fixed assets of BRC acquired in connection with the initial 50% acquisition in 2003 and recorded our share in earnings of BRC’s unconsolidated affiliates for the nine months ended December 31, 2005 of $0.3 million.

Provision For Income Taxes. During 2006, we recognized a tax provision for approximately $9.3 million as compared to $14.3 million in the prior year. In 2006, income tax expense for our foreign operations was approximately $9.1 million based on an estimated effective annual tax rate of 43%. For 2005, income tax expense for our foreign operations, excluding Mexico operations, was approximately $5.5 million based on an

 

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effective annual tax rate of 39%. The increase in tax expense from prior year is predominantly attributed to the increase in pretax earnings in 2006 and the increase in effective annual tax rate is due to increase in valuation allowances for deferred tax assets related to Brazil and Argentina.

IMPCO U.S. operations recorded a tax provision of approximately $0.2 million for the year ended December 31, 2006 of which $0.1 million is related to foreign tax withheld on dividends received from our Netherlands subsidiary, an increase in deferred tax liabilities due to the amortization of goodwill for income tax purposes, that is not offset against the deferred tax asset in the determination of the required valuation allowance, as well as state taxes due. The remaining $0.1 million relates to U.S. tax withholding obligations on IMPCO interest payments to MTM under the MTM loan. We expect to reduce the valuation allowance if we are profitable or provide a full valuation allowance on future tax benefits realized in the United States if we have additional losses until we can sustain a level of profitability that demonstrates our ability to utilize the assets. We will continue to evaluate the recoverability of the deferred tax assets each quarter. In 2005, IMPCO U.S. operations recorded an increase in the valuation allowance for deferred taxes of approximately $2.6 million to reserve the carrying value of net deferred tax assets because we determined that the likelihood of recoverability of the net deferred tax asset was less than the “more likely than not” threshold as defined by SFAS No. 109, Accounting for Income Taxes. The increase in valuation allowance was offset by approximately $1.9 million representing goodwill temporary differences included in deferred tax liability on the consolidated balance sheet at December 31, 2005.

Years Ended December 31, 2005 and 2004

The following table sets forth our revenue and operating income (in thousands):

 

     Revenue  
     Years Ended December 31,  
     2005     2004  

IMPCO Operations

   $ 101,263     $ 118,292  

BRC Operations (1)

     73,276       —    
                

Total

   $ 174,539     $ 118,292  
                
     Operating Income (Loss)  
     Years Ended December 31,  
     2005     2004  
     (as restated)     (as restated)  

IMPCO Operations

   $ 4,200     $ 3,085  

BRC Operations (2) (3) (4)(5)

     8,635       —    

Corporate Expenses (6)

     (7,518 )     (5,884 )
                

Total

   $ 5,317     $ (2,799 )
                

(1) Includes BRC revenue for the nine months ended December 31, 2005.
(2) Includes BRC operating income for the nine months ended December 31, 2005.
(3) The results of BRC were accounted for using the equity method in our financial results for the year ended December 31, 2004 and for the first quarter of 2005.
(4) Includes $0.1 million of in-process R&D expense in 2005 related to the acquisition of BRC.
(5) Includes approximately $1.3 million in amortization expense in 2005 for intangible assets acquired from BRC.
(6) Represents corporate expenses not allocated to any of the operating segments.

The following tables set forth our product revenue by application and by geographical areas across all reporting segments for fiscal years 2005 and 2004 (in thousands):

 

     Years Ended December 31,  
     2005     2004  

Revenue:

    

Transportation

   $ 91,437    52.4 %   $ 26,951    22.8 %

Industrial

     83,102    47.6 %     91,341    77.2 %
                          

Total

   $ 174,539    100.0 %   $ 118,292    100.0 %
                          

 

     Years Ended December 31,  
     2005     2004  

Revenue:

    

North America

   $ 59,826    34.3 %   $ 65,206    55.1 %

Europe

     87,689    50.2 %     29,519    25.0 %

Asia & Pacific Rim

     19,319    11.1 %     14,258    12.0 %

Latin America

     7,705    4.4 %     9,309    7.9 %
                          

Total

   $ 174,539    100.0 %   $ 118,292    100.0 %
                          

 

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Total revenue increased approximately $56.2 million, or 47.5%, to $174.5 million in 2005 from $118.3 million in 2004. The increase in revenue for 2005 was the result of $73.3 million of BRC revenue recorded during the nine month-period from April 1, 2005 to December 31, 2005, offset by a decline of $17.0 million in revenue from our IMPCO operations. The decline in the IMPCO operations revenue was due to the end of an OEM program and a leveling off of shipments of our certified engine packages and fuel systems that were the primary source of revenue growth in 2004. IMPCO operations revenue also declined due the reorganization of our Mexico and India operations in December 2004. These operations were reported in 2005 under the equity method. Revenue in the transportation market increased in 2005 by $64.4 million, or 239%, due to the inclusion of BRC, which serves the transportation market exclusively. The industrial market declined by $8.2 million, or 9.0%, due primarily to the end of an OEM program and reduced level of shipments of certified engines in U.S. operations.

Total operating income increased by $8.1 million to $5.3 million in 2005 from an operating loss of $2.8 million in 2004. The increase in operating income was due to the $56.2 million increase in revenue offset by a $40.8 million increase in cost of revenue and a $7.3 million increase in operating expenses. The higher revenue and expense are attributable to the inclusion of BRC in our consolidated results.

IMPCO Operations. During 2005, revenue decreased by approximately $17.0 million, or 14.4%, to $101.3 million, from $118.3 million during the same period in the prior year. The decrease in revenue during 2005 was primarily due to a $8.2 million decrease in revenue from the industrial market and a $8.8 million decrease in revenue from the transportation market. During 2004, revenue from the industrial market was higher than in 2005 due to shipments of our certified engine systems to customers required to comply with the EPA regulations effective January 1, 2004 that imposed more stringent emissions requirements on certain “off-road” vehicles. During 2005, shipments of our certified engine systems into distribution were lower than during the same period in the prior year because the initial demand for certified engines was met during 2004. The decline in the transportation market revenue is primarily due to the completion of a vehicle conversion program in 2004 that did not recur in 2005. The decrease in revenue during 2005 was also due in part to the reduction in our ownership in Mexico and India to 50%, as we changed to the equity method to recognize the results of operations in these countries.

For 2005, IMPCO operations recorded operating income of $4.2 million compared to operating income of $3.0 million during the same period in the prior year. Operating income was higher in 2005 due to $3.5 million in lower operating expenses, $14.0 million in lower cost of revenue, offset by $17.0 million in lower revenue. Operating expenses in 2005 included $1.5 million for accelerated amortization of leasehold improvements resulting from the close of the Seattle facility, a $0.9 million increase in the allowance for doubtful accounts related to a receivable from our 50% owned Mexico joint venture, which we liquidated, and $0.4 million in additional inventory reserves for obsolete returned equipment our Mexico operations.

BRC Operations. BRC operations became an operating segment of our business in the second quarter of 2005. BRC’s revenue and operating income for the nine months ended December 31, 2005 were approximately $73.3 million and $9.0 million, respectively, including approximately $1.8 million in amortization and depreciation expenses related to intangible assets and step-up in fair value of fixed assets acquired in the acquisition of the remaining 50% of BRC.

We completed the purchase price allocation of the BRC acquisition in the fourth quarter of 2005 and allocated approximately $12.5 million and $5.1 million to intangible assets and fixed assets, respectively, with estimated useful lives ranging from seven to eleven years for the intangible assets and five to eight years for the fixed assets. For 2005, we recorded amortization expense of approximately $1.3 million for the intangible assets and approximately $0.5 million for depreciation of the step-up in fair value of fixed assets.

Corporate Expenses. Corporate expenses consist of general and administrative expenses that support our operating segments in areas such as executive management, finance, human resources, management information systems, professional legal and accounting services, and investor relations. Corporate expenses for

 

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the fiscal year ended December 31, 2005 were approximately $7.5 million compared to approximately $5.9 million in the prior year. Higher corporate expenses were incurred due to stock-based compensation expense of $1.5 million related to three of our former officers, $0.4 million in severance related costs paid to former officers in 2005, and $1.6 million in increased outside professional fees related to our filings with the SEC and our compliance under the Sarbanes Oxley Act of 2002.

Interest Expense. Interest expense for 2005 was approximately $1.0 million compared to approximately $5.6 million for 2004, a decrease of $4.6 million, or 81.7%. This decrease is due primarily to the prepayment of the Bison loan in December 2004 for $22.0 million, which included a prepayment penalty of $1.0 million and accrued interest of $1.0 million. Interest costs in 2004 under the Bison loan were approximately $4.9 million and the interest rate in December 2004 was 18.75%. In December 2004 and prior to the remaining 50% acquisition of BRC, IMPCO concluded a loan agreement with MTM, S.r.L., a wholly-owned subsidiary of BRC, in which IMPCO borrowed $22.0 million to effectively prepay the Bison Loan. Interest costs under this loan agreement are determined based on the 3-month EURIBOR plus 1.5%, which totaled approximately 3.7% at December 31, 2004 and at March 31, 2005. Beginning with March 31, 2005, we consolidated BRC and consequently we eliminated the MTM loan upon consolidation. In December 2004, MTM borrowed approximately $11.8 million from Unicredit Banca Medio Credito SpA. and is required to make quarterly payments over a 5 year period of approximately $0.6 million. Interest expense under this loan agreement is based on the 3-month EURIBOR plus 1%, or 3.2% at December 31, 2004 and 4% at December 31, 2005. Interest expense recorded under the MTM loan for the nine months ended December 31, 2005 was approximately $0.3 million.

Other Income and Expense. In connection with the MTM loan and the foreign exchange agreement by BRC during the first quarter of 2005 for the purpose of hedging the quarterly payments due under the MTM loan, we recognized in other income and expense unrealized foreign exchange gains and losses with respect to “mark to market” of the MTM loan balance, and gains and losses with respect to the fair value determination of the related foreign agreement because the agreements did not qualify for hedge accounting. In the year ended December 31, 2005, we recognized approximately $2.9 million in unrealized gains on foreign exchange in connection with the MTM loan between the U.S. dollar and the euro (consisting of $2.3 million recorded in other income and $0.6 million recorded in equity in earnings from unconsolidated subsidiaries) offset by a recognized loss on the foreign currency agreement of approximately $0.7 million.

We routinely conduct transactions in currencies other than our reporting currency, the U.S. dollar. We cannot estimate or forecast the direction or the magnitude of any foreign exchange movements with any currency that we transact in; therefore, we do not measure or predict the future impact of foreign currency exchange rate movements on our consolidated financial statements.

Income of Equity Share in Unconsolidated Affiliates. For 2005 and 2004, we recognized income of approximately $1.0 million and $1.2 million, respectively, as our share in the income of unconsolidated affiliates. Prior to the second quarter of 2005, we recognized our share in the earnings of BRC, and, accordingly, we recorded income of approximately $1.0 million in the first quarter of 2005. During the remainder of 2005, we fully consolidated BRC and did not record any income in this account. During the fourth quarter of 2005, we recognized an impairment loss of our 50% investment in IBMexicano in the amount of approximately $0.9 million and a loss in MIL of approximately $0.1 million. During 2005, we recognized our share in the losses of IBMexicano in the amount of $0.2 million. During 2004, we recognized income of $1.6 million for our share in the earnings of BRC and $0.2 million in losses for the write-off of investments in Egypt and China.

Provision for Income Taxes. In 2005, the estimated effective annual tax rate was 282% compared to (15)% for the prior year. During 2005, we recognized a tax provision for approximately $14.3 million as compared to $2.3 million in the prior year. The increase from prior year is predominantly attributed to valuation allowance, reduction of tax attributes and increase in foreign taxes. In 2005 and 2004, for the U.S. operations, we recorded an increase in the valuation allowance for deferred taxes of approximately $2.6 million and $8.4 million, respectively, to reserve the carrying value of net deferred tax assets because we determined that the likelihood of recoverability of the net deferred tax asset was less than the “more likely than not” threshold as defined by SFAS No. 109, Accounting for Income Taxes.

 

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Quarters Ended September 30, 2006 and 2005 (Unaudited)

The restated unaudited quarterly financial statements are included in note 18 in the notes to consolidated financial statements.

The following table sets forth our revenue and operating income (in thousands) with 2005 data reclassified to reflect our new presentation of operating segments:

     Revenue Three Months
Ended September 30,
 
     2006     2005  
     (as restated)     (as restated)  

IMPCO Operations (1)

   $ 27,746     $ 26,081  

BRC Operations

     27,691       22,992  
                

Total

   $ 55,437     $ 49,073  
                
     Operating Income
Three Months Ended
September 30,
 
     2006     2005  
     (as restated)     (as restated)