UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





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





For the quarterly period ended September 30, 2010





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





000-28867


(Commission file number)











ENERGY COMPOSITES CORPORATION


(Exact name of registrant as specified in its charter)





Nevada
88-0409170(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)





4400 Commerce Drive, Wisconsin Rapids, WI  54494


(Address of principal executive offices) (Zip Code)





(715) 421-2060


(Registrant’s telephone number, including area code)





(Former name, former address and former fiscal year, if changed since last report)





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 ý   No o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o   No o (not required)





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





Large accelerated filer  o
Accelerated filer  oNon-accelerated filer  o
Smaller reporting company  ý





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





Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  46,659,800 shares as of November 10, 2010





ENERGY COMPOSITES CORPORATION





FORM 10-Q


FOR THE QUARTER ENDED


SEPTEMBER 30, 2010





INDEX





PagePART I.  FINANCIAL INFORMATIONItem 1.
Financial Statements:Consolidated Balance Sheets (Unaudited)
2Consolidated Statements of Operations (Unaudited)
3Consolidated Statements of Cash Flows (Unaudited)
4Notes to Consolidated Financial Statements (Unaudited)
5Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
20Item 3.
Quantitative and Qualitative Disclosures about Market Risk
26Item 4.
Controls and Procedures
26PART II.  OTHER INFORMATIONItem 1.
Legal Proceedings
28Item 1A.
Risk Factors
28Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
28Item 3.
Defaults Upon Senior Securities
28Item 5.
Other Information
28Item 6.
Exhibits
29SIGNATURES
30


1


ENERGY COMPOSITES CORPORATIONCONSOLIDATED BALANCE SHEETS(Unaudited)


(Audited)September 30,


December 31,2010


2009ASSETSCurrent assets:Cash

$
125,396


$
281,809Accounts receivable, net of allowance for doubtfulaccounts of $67,000 in 2010 and $191,000 in 2009


1,214,883



2,512,934Accounts receivable - related party


7,115



1,860Inventories, net


525,401



592,987Other current assets


45,627



120,123Prepaid consulting expense


2,268,000



-Total current assets


4,186,422



3,509,713Property and equipment, net


6,223,368



5,914,803Other assets:Intangible assets, net


51,725



58,218Prepaid consulting expense, net of current portion


2,268,000



-Total other assets


2,319,725



58,218Total assets

$
12,729,515


$
9,482,734LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities:Current portion of long-term debt obligations

$
1,312,868


$
533,545Line of credit – bank


34,000



117,512Short-term notes payable


550,000



1,720,000Accounts payable


880,592



468,374Accounts payable - related party


161,506



188,356Accrued expenses


242,855



259,549Accrued payroll and payroll taxes


376,730



288,782Customer deposits


28,030



84,399Total current liabilities


3,586,581



3,660,517Long-term liabilities:Long-term debt obligations, net of current portion


3,524,318



5,363,986Deferred income - land purchase


429,494



-Total long-term liabilities


3,953,812



5,363,986Total liabilities


7,540,393



9,024,503Stockholders' equity (deficit):Common stock - $.001 par value; 100,000,000 sharesauthorized, 46,653,554 and 42,115,205 shares issuedand outstanding, respectively


46,654



42,115Additional paid-in capital


18,439,607



10,365,292Accumulated deficit


(13,297,139
)


(9,949,176
)Total stockholders' equity


5,189,122



458,231Total liabilities and stockholders' equity

$
12,729,515


$
9,482,734


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


2





ENERGY COMPOSITES CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)


(Unaudited)For the Three Months Ended

September 30,


For the Nine Months Ended

September 30,2010


2009


2010


2009Revenue

$
1,876,355


$
1,861,409


$
4,700,951


$
6,210,734Cost of goods sold


1,487,659



1,502,393



3,614,924



5,235,857Gross profit


388,696



359,016



1,086,027



974,877Selling, general and administrative expenses


1,271,081



978,014



3,669,095



2,752,176Loss from operations


(882,385
)


(618,998
)


(2,583,068
)


(1,777,299
)Other income (expense):Interest expense


(233,969
)


(237,709
)


(765,326
)


(1,689,625
)Interest income


222



2,686



431



14,480Total other income (expense)


(233,747
)


(235,023
)


(764,895
)


(1,675,145
)Loss before provision (benefit) for income taxes


(1,116,132
)


(854,021
)


(3,347,963
)


(3,452,444
)Income tax benefit


-



(306,000
)


-



(1,334,000
)Net loss

$
(1,116,132
)

$
(548,021
)

$
(3,347,963
)

$
(2,118,444
)Net loss per common share - basic and diluted

$
(0.03
)

$
(0.01
)

$
(0.08
)

$
(0.05
)Weighted average shares outstanding - basic and diluted


43,704,159



42,097,929



42,723,134



42,030,708














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






3






ENERGY COMPOSITES CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)For the Nine Months Ended September 30,2010


2009Cash flows from operating activities:Net loss

$
(3,347,963
)

$
(2,118,444
)Adjustments to reconcile net loss to net cashprovided by (used in) operating activities:Depreciation and amortization


352,635



325,549(Gain) loss on asset disposal


3,205



(650
)Amortization of debt discount for imputed interest


3,179



2,935Amortization of discount for warrants and beneficial conversionfeature on convertible debt


431,735



1,327,291Amortization of prepaid consulting expense


189,000



-Discount for stock sold under employee stock purchase plan


2,900



-Stock issued for interest payments


77,357



73,948Stock issued for employee and director compensation


197,500



165,623Stock option compensation expense


383,074



-Deferred income taxes


-



(1,334,000
)Changes in operating assets and liabilities:Accounts receivable, net


1,298,051



1,078,102Accounts receivable - related party


(5,255
)


(1,366
)Inventories, net


67,586



255,909Other current assets


74,496



(19,246
)Accounts payable


412,218



(941,001
)Accounts payable - related party


(26,850
)


185,991Accrued expenses


(16,694
)


25,772Accrued payroll and payroll taxes


87,948



64,316Customer deposits


(56,369
)


(386,166
)Net cash provided by (used in) operating activities


127,753



(1,295,437
)Cash flows from investing activities:Purchase of property and equipment


(228,418
)


(444,949
)Proceeds from sale of property and equipment


-



650Net cash used in investing activities


(228,418
)


(444,299
)Cash flows from financing activities:Net borrowings (repayments) from line of credit - bank


(83,512
)


97,934Financing costs paid for long-term debt


-



(3,320
)Net borrowings (repayments) from short-term notes payable


(670,000
)


400,000Payments on long-term debt


(359,489
)


(347,292
)Proceeds from stock issuance


466,430



-Proceeds from exercise of warrants


590,823



-Net cash provided by (used in) financing activities


(55,748
)


147,322Net decrease in cash and cash equivalents


(156,413
)


(1,592,414
)Cash and cash equivalents:Beginning of period


281,809



2,985,289End of period

$
125,396


$
1,392,875





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








4






ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS




Note 1.  Nature of Business and Significant Accounting Policies





Basis of Presentation





The accompanying unaudited consolidated financial information has been prepared by Energy Composites Corporation (“Company” or “ECC”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (“SEC”).  Accordingly, it does not include all the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of this financial information have been included.  Financial results for the interim periods presented are not necessarily indicative of the results that may be expected for the fiscal year as a whole or any other interim period.  This financial information should be read in conjunction with the December 31, 2009 audited consolidated financial statements and notes included in the Company’s Form 10-K filed on March 31, 2010.





Nature of Business





ECC is a manufacturer, installer and marketer of fiberglass products which are sold throughout the United States, but primarily in the Midwest.  The Company also has a service division that provides installation and repair of various tank and piping systems.  The Company serves the paper, petro-chemical, water, waste-water, bio-fuel and power industries.





Principles of Consolidation





The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries ECC Corrosion, Inc. (“ECC-C”), formerly known as Advanced Fiberglass Technologies, Inc. (“AFT”), and Innovative Composite Solutions, LLC (“ICS”), after elimination of all intercompany accounts, transactions, and profits.





Concentrations of Risk





Cash Deposits:The Company maintains its cash in high-quality financial institutions.  The balances, at times, may exceed the federally insured limits.





Credit Risk and Major Customers:  Financial instruments that may subject the Company to significant concentrations of credit risk consist primarily of trade receivables.  The Company grants credit to its customers throughout the United States in the normal course of business.  Customer creditworthiness is routinely monitored and collateral is not required. The following is a schedule of significant sales to customers for the nine months ended September 30, 2010 and 2009 and significant customer accounts receivable balances at September 30, 2010 and 2009:





Percentage ofPercentage of

Trade AccountsTotal Sales

ReceivableCustomer

2010

2009

2010

20091

18.7%

5.8%

14.8%

2.2%2

10.7

0.6

38.3

-3

2.0

49.8

4.3

54.931.4%

56.2%

57.4%

57.1%





Labor Force:  A significant part of the Company’s production labor force is covered by two collective bargaining agreements which expire in May 2012.





5
 
 ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Cash and Cash Equivalents





For purposes of balance sheet presentation, the Company considers all unrestricted demand deposits, money market funds, savings funds and investments with an original maturity of three months or less to be cash and cash equivalents.





Segment Reporting





Through September 30, 2010, the Company provided products and services into one reportable operating segment, Industrial Tank and Piping. The results of our distribution company, ICS, are immaterial for purposes of segment reporting and are included in the Industrial Tank and Piping segment. The detail of products and service activity in this operating segment is further described in Note 13.





Recent Accounting Pronouncements





In October 2009, the Financial Accounting Standards Board (“FASB”) issued guidance on the accounting for multiple-deliverable revenue arrangements. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable; eliminates the residual method of allocation and requires arrangement consideration to be allocated at the inception of the arrangement to all deliverables using the relative selling price method; and requires a vendor to determine its best estimate of selling price in a manner consistent with that used to determine the selling price of the deliverable on a stand-alone basis. This guidance also expands the required disclosures related to a vendor’s multiple-deliverable revenue arrangements. The guidance is effective beginning January 1, 2011 with early adoption permitted. The Company does not believe the adoption of this standard will have a material impact on its consolidated results of operations, financial condition, cash flows, or disclosures.





In January 2010, the FASB issued ASU 2010-02, “Consolidation (Topic 810): Accounting and Reporting for Decreases in Ownership of a Subsidiary.”  This amendment to Topic 810 clarifies, but does not change, the scope of current US GAAP.  It clarifies the decrease in ownership provisions of Subtopic 810-10 and removes the potential conflict between guidance in that Subtopic and asset de-recognition and gain or loss recognition guidance that may exist in other US GAAP.  An entity will be required to follow the amended guidance beginning in the period that it first adopts Financial Accounting Standard (FAS) 160 (now included in Subtopic 810-10).  For those entities that have already adopted FAS 160, the amendments are effective at the beginning of the first interim or annual reporting period ending on or after December 15, 2009.  The amendments should be applied retrospectively to the first period that an entity adopted FAS 160.  There is no effect on the Company’s financial statements from the current adoption of this guidance.





In January 2010, the FASB issued ASU 2010-6, “Improving Disclosures about Fair Value Measurements.”  This update requires additional disclosure within the roll forward of activity for assets and liabilities measured at fair value on a recurring basis, including transfers of assets and liabilities between Level 1 and Level 2 of the fair value hierarchy and the separate presentation of purchases, sales, issuances and settlements of assets and liabilities within Level 3 of the fair value hierarchy.  In addition, the update requires enhanced disclosures of the valuation techniques and inputs used in the fair value measurements within Levels 2 and 3.  The new disclosure requirements are effective for interim and annual periods beginning after December 15, 2009, except for the disclosure of purchases, sales, issuances and settlements of Level 3 measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010.  As ASU 2010-6 only requires enhanced disclosures, the Company does not expect that the adoption of this update will have a material effect on its financial statements.











6





ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Note 2.   Liquidity and Capital Resources





At September 30, 2010, the Company had cash on hand of $125,396, a working capital deficiency of $1,668,159 net of Prepaid Consulting Expense, a net loss of $3,347,963 for the nine months ended September 30, 2010 and an accumulated deficit of $13,297,139. The Company is continuing its efforts to improve its overall financial condition and results of operations, including obtaining additional financing and restructuring certain debt arrangements, some of which are disclosed as follows:




On March 8, 2010, the Company’s Board of Directors approved the temporary reduction of the exercise price of outstanding warrants to $2.50 per share from $5.00 per share. The temporary exercise price reduction was valid from March 22, 2010 through May 6, 2010.  After May 6, 2010, the warrants reverted back to their original terms.  As of May 6, 2010, the Company had received $590,823 related to the exercise of 236,329 warrants to purchase its common stock at $2.50 per share from current warrant holders.




On August 3, 2010, the Company’s Board of Directors approved a debt for equity exchange transaction between M&W Fiberglass, LLC, an entity wholly owned by the Company's majority shareholders Jamie L. and Jennifer L. Mancl, and the Company. The transaction, which closed on August 13, 2010, resulted in the conversion of the outstanding principal and interest under the existing long-term note with M&W Fiberglass to common shares of the Company at $2.50 per share. The principal balance of the note converted at August 13, 2010 was $970,770 and accrued interest was $5,455 which upon conversion resulted in the issuance of 390,490 restricted common shares of ECC. The exchange resulted in a $970,770 reduction in the Company’s long-term debt obligations and an addition to stockholder's equity of $976,225.




On August 23, 2010, the Company entered into a Subscription Agreement with its founder and majority shareholder, Jamie L. Mancl, pursuant to which Mr. Mancl agreed to make a $450,000 equity investment in the Company. Pursuant to the agreement, Mr. Mancl purchased 180,000 shares of the Company's common stock at a price of $2.50 per share.






On September 7, 2010, the Company issued 207,506 restricted shares of common stock as payment in full of unsecured, short-term notes payable to five private investors (primarily existing shareholders) in connection with financing to fund operations. The principal balance of the notes and accrued interest converted under the agreements was $500,000 and $18,763, respectively. The exchange resulted in a $500,000 reduction in short-term debt obligations and a $518,763 addition to stockholder's equity.






The Company also needs to receive additional financing within the near term in order to continue its pace of selling, general and administrative spending and keep the WindFiberTM project moving forward.  If additional funding is not received within the next three months, the Company will have to reduce selling, general and administrative costs, including costs associated with the WindFiberTM project.




Note 3.  Inventories





Inventories consist of the following:


September 30, 2010


December 31, 2009Raw materials

$
325,872


$
312,710Work in progress


199,529



289,731Finished goods


-



-Obsolescence reserve


-



(9,454
)Total

$
525,401


$
592,987











7





ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS








Note 4.  Prepaid Consulting Expense







On August 24, 2010, the Company’s Board of Directors approved the issuance of 3,375,000 restricted shares of common stock to Diversified Equities Partners, LLC, an entity owned by a minority shareholder of ECC, as a non-refundable retainer for financial advisory consulting services to be rendered through September 30, 2012.  These shares were valued at $4,725,000 using the closing market price of our stock on August 24, 2010 of $1.40 per share and recorded to Additional Paid-In Capital and the debit recorded to Prepaid Consulting Expense.  The expense will be amortized over the 25 month period of the contract.  $189,000 was recorded to expense under the contract for the three and nine months ended September 30, 2010.







Note 5.  Property and Equipment, Net





Property and equipment are as follows:





September 30, 2010


December 31, 2009Land and improvements

$
577,369


$
82,572Buildings and improvements


3,868,980



3,787,784Machinery and equipment


2,509,171



2,496,015Vehicles and trailers


373,015



369,717Computer equipment


249,285



224,166Furniture and office equipment


138,128



108,2067,715,948



7,068,460Less accumulated depreciation


(1,492,580
)


(1,153,657
)Net property and equipment

$
6,223,368


$
5,914,803





Depreciation expense was $116,774 and $117,838 for the three months ended September 30, 2010 and 2009, respectively.  Depreciation expense was $346,142 and $313,215 for the nine months ended September 30, 2010 and 2009, respectively.





Real Estate Purchase





On April 30, 2010, the Company purchased approximately 94 acres of land from the City of Wisconsin Rapids as part of the Company’s WindFiberTM expansion.  The purchase price of the land was $47,735.  Because the purchase price of the real estate was well below estimated fair market values, the real estate was recorded at its estimated fair market value of $5,000 per acre.  The excess fair market value of $429,494 was recorded to Deferred Income – Land Purchase and will be amortized over the life of the planned manufacturing plant to be built once funding is obtained.

















8





ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS








Note 6.  Intangible Assets





Intangible assets are as follows:


September 30, 2010


December 31, 2009Non-compete agreement

$
5,000


$
5,000Customer list


74,434



74,434Deferred financing costs


69,338



69,338148,772



148,772Less accumulated amortization


(97,047
)


(90,554
)Net intangible assets

$
51,725


$
58,218





Amortization expense was $2,136 and $3,382 for the three months ended September 30, 2010 and 2009, respectively.  Amortization expense was $6,493 and $12,334 for the nine months ended September 30, 2010 and 2009, respectively.  Estimated amortization expense for the next five years is as follows:





2010 - remaining

$
2,1602011


6,6842012


5,3962013


4,8722014


3,172Thereafter


29,441Total

$
51,725





Note 7.  Financing Arrangements





Line of Credit – Bank





The Company utilizes a line of credit with Nekoosa Port Edwards State Bank (“NPESB”) that provides for maximum borrowings of $250,000, bears interest at a fixed rate of 6.75% at September 30, 2010 and matures in December 2010.  The line is secured by all business assets of ECC-C (formerly AFT), an assignment of life insurance on the officer/stockholder, a junior mortgage on land and buildings, and an unlimited guaranty by ECC.  The Company had a balance of $34,000 and $117,512 on the line of credit at September 30, 2010 and December 31, 2009, respectively.





Short-Term Notes Payable





The Company uses short-term notes from NPESB for purposes of bulk purchases of inventory and project financing in addition to utilizing its line of credit.  The underlying inventory and customer purchase orders serve as specific collateral for these notes.  In addition, the short-term notes are also typically secured by all business assets of the Company.  The notes bear interest at fixed rates.  The notes are typically twelve months or less.  The Company had $550,000 and $1,250,000 of outstanding notes payable to NPESB with weighted average interest rates of 6.75% as of September 30, 2010 and December 31, 2009.





The Company also utilizes unsecured, short-term financing from private investors (primarily existing shareholders) to fund operations.  These twelve month notes bear interest at 6.0%.  The Company had $0 and $470,000 of outstanding notes payable to these private investors at September 30, 2010 and December 31, 2009, respectively.








9


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Long-Term Debt Obligations





Long-term debt obligations are as follows:


September 30, 2010

December 31, 2009NPESB - a term loan secured by 15 ton deck crane, interest rate of 7.25%, due October 2010, monthly payments of $948

$ -

$6,827NPESB – a term loan secured by all general business assets of ECC-C (formerly AFT) and unlimited continuing guarantee of ECC; interest rate of 6.75%, due on demand, monthly payments of $898

38,393

44,355NPESB - an industrial revenue bond term loan, secured by equipment and unlimited continuing guarantee of ECC; contains restrictive financial covenants, interest rate of 5.75%, due July 2014, monthly payment of $7,266

296,350

347,525NPESB - an industrial revenue bond term loan, secured by equipment and unlimited continuing guarantee of ECC; contains restrictive financial covenants, interest rate of 5.75%, due July 2014, monthly payment of $7,266

290,117

341,559City of Wisconsin Rapids, a term loan, secured by all assets and unlimited continuing guarantee of ECC; contains various operating covenants, interest rate 2%, due April 2012, monthly payment of $4,499

359,130

393,935Yale Financial Services, a capital lease term loan, secured by two Yale forklifts, interest rate 7.7%, due October 2010, monthly payment of $657

1,299

6,350City of Wisconsin Rapids, a $75,000 term loan, secured by ECC and ECC-C (formerly AFT) guarantees; imputed interest at 8% resulting in an original issue discount with an unamortized balance of $20,098 at September 30, 2010, balloons in August 2014

54,902

51,724NPESB – an industrial revenue bond term loan, secured by real estate, ECC and ECC-C (formerly AFT) guarantees; contains restrictive financial covenants, interest rate of 5.50%, due July 2027, monthly payment of $20,776

2,717,046

2,788,630M&W LLC (related party) – an unsecured term loan, interest rate of 4.775%, due December 2015, quarterly payment of $24,493; repaid through issuance of common stock in August 2010

-

996,340NPESB – a term loan secured by all general business assets of ECC-C (formerly AFT) and an unlimited continuing guarantee of ECC; due January 2012, interest rate of 6.75%, monthly payments of $13,405

204,442

311,514Convertible notes payable ($1,230,000 face value) – see Note 8

875,507

608,7724,837,186

5,897,531Less current portion of long-term obligations – includes

$830,000 of face value convertible notes

(1,312,868)

(533,545)Total long-term debt obligations, net of current portion

$3,524,318

$5,363,986








10


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Maturities of long-term debt obligations are as follows:





2010 - remaining

$
148,2612011


1,679,5182012


575,2322013


277,8422014


206,404Thereafter


2,304,422Total

$
5,191,679





On March 13, 2009, the Company executed an amendment to the credit agreement for the three industrial revenue bonds held by NPESB.  The amendment to the credit agreement includes the redefinition of the covenants attached to the bonds.  Under the terms of the amended credit agreement, the covenants apply to the Company and its subsidiaries on a consolidated basis.  The quarterly covenants require the consolidated Company to maintain (a) a Debt Service Coverage Ratio of not less than 1.25 to 1 and (b) a Total Indebtedness to Equity Ratio of not more than 3.5 to 1.0.





Debt Service Coverage Ratio is defined as the ratio of (i) EBITDA for the 12-month period ending on the measurement date to (ii) interest expenses plus principal payments coming due during the 12-month period beginning on the day after measurement.  EBITDA is defined as net income after taxes plus a) interest expense, b) federal, state and local taxes, c) depreciation and amortization expenses, and d) extraordinary losses minus extraordinary gains. The Company did not calculate this ratio at September 30, 2010 because the Company had recorded negative EBITDA for the previous 12-month period.





Total Indebtedness to Equity Ratio is defined as the ratio of all liabilities or obligations to Equity.  Equity is defined as the total of all assets of the Company minus the aggregate of all liabilities, all determined in accordance with generally accepted accounting principles consistent with those followed in preparation of the financial statements. This ratio at September 30, 2010 has been calculated by the Company as follows:





Total current liabilities

$
3,586,581Long-term debt obligations, net of current portion


3,524,318Total indebtedness

$
7,110,899Total stockholders' equity

$
5,189,122Total indebtedness to equity


1.4





As of December 31, 2009, the Company was not in compliance with the restrictive financial covenants and as of September 30, 2010, the Company was not in compliance with the Debt Service Coverage Ratio covenant relating to the industrial revenue bonds. However, on December 31, 2009, the Company received a letter from the lender waiving compliance with these covenants through September 30, 2010.  The next measurement date of these covenants will be December 31, 2010.  If the Company is not in compliance with the covenants at December 31, 2010, the Company will request another waiver from NPESB.





Note 8.  Convertible Notes Payable





In August 2008, the Company began a private placement offering of Units, each Unit consisting of (i) a 3-year, 6% convertible debenture with a conversion price of $2.50 (the “Conversion Price”) per share (subject to adjustment for stock splits and stock dividends) (the “Debentures”), and (ii) a number of warrants equal to the number of shares issuable upon conversion of the principal amount of the Convertible Debenture (the “Warrants”).  This placement offering was in anticipation of the AFT reverse acquisition taking place which became effective on October 14, 2008.




11


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Each Warrant is immediately exercisable into shares of common stock for a term of 3 years at $5.00 per share.  The Warrants also provide anti-dilution protection for the following events: reorganization, reclassification, consolidation, merger or sale; subdivision, combination or other dividend of the Company’s Common Stock.





The private placement was closed on December 14, 2008.  Debentures in the aggregate principal amount of $6,370,000 were sold which included the issuance of 2,548,000 Warrants.  The Debentures are considered to be conventional convertible debt.





The issued Warrants were deemed to have a relative fair market value of $4,068,422 which was recorded as a discount to the face value of the Debentures and as a credit to Additional Paid-In Capital and will be accreted to interest expense over the 3-year term of the warrants using the effective interest method.  The Company used the Black-Scholes-Merton pricing model as a method for determining the estimated fair value of the Warrants.





The proceeds of the Debentures were allocated based on the relative fair value of the Debentures and Warrants as of the commitment date.  The Company then calculated the intrinsic value of the beneficial conversion feature embedded in the Debentures and because the amount of the beneficial conversion feature exceeded the fair value allocated to the Debentures, the amount of the beneficial conversion feature to be recorded was limited to the proceeds allocated to the Debentures.  Accordingly, the beneficial conversion feature was calculated to be $2,301,578 and was recorded as an additional discount on the Debentures and a credit to Additional Paid-In Capital of $1,412,578 and a credit of $889,000 to deferred income tax liability.  The Company is accreting the beneficial conversion feature to interest expense over the 3-year term of the debt using the effective interest method.





The following table summarizes the convertible note balance as of September 30, 2010:





Balance at January 1, 2008

$
-Plus: gross proceeds received in 2008


6,370,000Less value assigned to:Warrants


(4,068,422
)Beneficial conversion feature allotted to:Additional paid-in capital


(1,412,578
)Deferred income tax liability


(889,000
)Sub-total of assigned values


(6,370,000
)Plus: accretion of original issue discount from warrants and beneficial conversion feature


5,583,772Less: conversion of debt to common stock


(4,975,000
)Balance at December 31, 2009


608,772Plus: accretion of original issue discount from warrants and beneficial conversion feature


431,735Less: conversion of debt to common stock


(165,000
)Balance at September 30, 2010 (face value $1,230,000)

$
875,507





All outstanding convertible debentures at September 30, 2010 totaling $1,230,000 mature at various dates in 2011 and are included in the long-term debt maturities table found in Note 7.





The effective annual interest rate for the nine months ended September 30, 2010 was 49%.  The rate is higher than the stated rate of 6% due to the amortization of the discount recorded against the debt for the detachable warrants and beneficial conversion feature.




12
 
 ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  Note 9.  Stockholders’ Equity




Converted Debt




In conjunction with the private placement of convertible debt in 2008, $165,000 and $1,075,000 of the debt was converted to common shares of the Company during the nine months ended September 30, 2010 and 2009, respectively, at $2.50 per share.  A total of 87,292 and 459,605 common shares were issued for the debt and related interest on the debt during the nine months ended September 30, 2010 and 2009, respectively.




Warrants




On March 8, 2010, the Board of Directors of the Company approved the temporary reduction of the exercise price of currently outstanding common stock purchase warrants from $5.00 per share to $2.50 per share to raise additional capital for the Company. The exercise price reduction was valid from March 22, 2010 through May 6, 2010.  Shares issued during the exercise price reduction period are restricted shares subject to SEC Rule 144.  After May 6, 2010, any outstanding warrants reverted back to their original terms.  During the three months ended June 30, 2010, the Company received $590,823 related to the exercise of 236,329 warrants to purchase our common stock at $2.50 per share from current warrant holders.  As of September 30, 2010, there were 2,311,671 warrants outstanding.




Debt Exchange Transactions




On August 3, 2010, the Company’s Board of Directors approved a debt for equity exchange transaction between M&W Fiberglass, LLC (an entity wholly owned by the Company’s majority shareholders Jamie L. and Jennifer L. Mancl) and the Company. The transaction, which closed on August 13, 2010, resulted in the conversion of the outstanding principal and interest under the existing long-term note with M&W Fiberglass to common shares of the Company at $2.50 per share. The principal balance of the note converted at August 13, 2010 was $970,770 and accrued interest was $5,455 which upon conversion resulted in the issuance of 390,490 restricted common shares of ECC. The exchange resulted in a $970,770 reduction in the Company's long-term debt obligations and an addition to stockholder's equity of $976,225.




On September 7, 2010, the Company issued 207,506 restricted shares of common stock as payment in full of unsecured, short-term notes payable to five private investors (primarily existing shareholders) in connection with financing to fund operations. The principal balance of the notes and accrued interest converted under the agreements was $500,000 and $18,763, respectively. The exchange resulted in a $500,000 reduction in short-term debt obligations and a $518,763 addition to stockholder's equity.




Stock Issuances




On August 23, 2010, the Company entered into a Subscription Agreement with its founder and majority shareholder, Jamie L. Mancl, pursuant to which Mr. Mancl made a $450,000 equity investment in the Company. Pursuant to the agreement, Mr. Mancl purchased 180,000 shares of the Company's common stock at a price of $2.50 per share.




As detailed in Note 4, on August 24, 2010, the Company’s Board of Directors approved the issuance of 3,375,000 restricted shares of common stock to Diversified Equities Partners, LLC, an entity owned by a minority shareholder of ECC, as a non-refundable retainer for financial advisory consulting services to be rendered through September 30, 2012.  These shares were valued at $4,725,000 using the closing market price of our stock on August 24, 2010 of $1.40 per share and recorded to Additional Paid-In Capital and the debit recorded to Prepaid Consulting Expense.  The expense will be amortized over the 25 month period of the contract.  $189,000 was recorded to expense under the contract for the three and nine months ended September 30, 2010.




13


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


During the year ended December 31, 2009, the Company issued 49,272 restricted common shares to officers valued at $150,000 for services rendered. Of these shares, 12,136 shares (valued at $37,500) remained unvested until April 28, 2010 and were recorded as deferred compensation.  For the nine months ended September 30, 2010, amortization of the deferred compensation related to these shares totaled $12,500.  All of the remaining shares vested immediately.  On April 28, 2010, the Company issued 18,337 restricted common shares to an officer valued at $75,000 for services rendered.  Of these shares, 9,168 shares (valued at $37,500) remain unvested until April 28, 2011 and were recorded as deferred compensation.  For the nine months ended September 30, 2010, amortization of the deferred compensation related to these shares totaled $15,625, leaving an unamortized balance of $21,875 at September 30, 2010.




Pursuant to the Company’s Director Compensation Plan, the Company, on June 22, 2010, issued 33,730 restricted common shares to directors valued at $131,875 for services rendered for the time period June 2009 through May 2010 which had been accrued for on a monthly basis.  An accrual for $60,000 for director stock compensation for the period June 2010 through September 2010 has been recorded to accrued expenses. This accrued expense will be settled with common stock of the Company in June 2011.  The monthly accrual is determined using an average of the share price on the last trading day of each month over the requisite service period.




Employee Stock Purchase Plan




On July 7, 2010, the Company issued 9,665 shares of common stock valued at $19,330 pursuant to the Company’s Employee Stock Purchase Plan which was approved by the Board of Directors in April 2009.  The shares were purchased by the employees at a 15% discount to the lower of the closing price on the first day and the last day of the plan offering period for a total discount of $2,900.




Stock Option Awards




During the nine months ended September 30, 2010, the Company made stock option awards under the 2008 Stock Incentive Plan to 29 employees of the Company totaling 705,000 shares of the Company valued at $1,489,800 using the Black-Scholes-Merton pricing model.  These awards vest ratably over a 4 year period. The Company recorded expense related to these stock option awards of $159,003 and $383,074 for the three and nine months ended September 30, 2010, respectively.  The Company had $0 stock option expense for the three and nine months ended September 30, 2009.




Note 10.  Income Taxes




Income taxes are provided for using the liability method of accounting. A deferred tax asset or liability is recorded for all temporary differences between financial and tax reporting.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  Deferred tax assets and liabilities are adjusted for the effect of changes in tax laws and rates on the date of enactment.




The Company accounts for income taxes pursuant to FASB guidance.  This guidance prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a tax position must be more-likely-than not to be sustained upon examination by taxing authorities. The Company believes its income tax filing positions and deductions will be sustained upon examination and, accordingly, no reserves, or related accruals for interest and penalties have been recorded at September 30, 2010 and December 31, 2009.  In accordance with the guidance, the Company has adopted a policy under which, if required to be recognized in the future, interest related to the underpayment of income taxes will be classified as a component of interest expense and any related penalties will be classified in operating expenses in the statements of operations.  The Company’s remaining open tax years subject to examination include the years ended December 31, 2008 through 2009.




14


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


The income tax provision consisted of the following for the three months ended September 30, 2010 and 2009:





September 30,2010


2009Currently payable (refundable)

$
-


$
-Deferred tax benefit


(456,000
)


(306,000
)Valuation allowance


456,000



-Total income tax benefit

$
-


$
(306,000
)





The income tax provision consisted of the following for the nine months ended September 30, 2010 and 2009:





September 30,2010


2009Currently payable (refundable)

$
-


$
-Deferred tax benefit


(1,293,000
)


(1,334,000
)Valuation allowance


1,293,000



-Total income tax benefit

$
-


$
(1,334,000
)





Deferred tax components included in the Company’s balance sheet at September 30, 2010 and December 31, 2009 are as follows:





September 30, 2010


December 31, 2009Current deferred tax assets

$
96,000


$
143,000Long-term deferred tax assets


4,659,000



3,319,000Valuation allowance on net deferred tax assets


(4,755,000
)


(3,462,000
)Net deferred tax assets

$
-


$
-





Note 11.  Related Party Transactions




As detailed in Note 4, on August 24, 2010, the Company’s Board of Directors approved the issuance of 3,375,000 restricted shares of common stock to Diversified Equities Partners, LLC, an entity owned by a minority shareholder of ECC, as a non-refundable retainer for financial advisory consulting services to be rendered through September 30, 2012.  These shares were valued at $4,725,000 using the closing market price of our stock on August 24, 2010 of $1.40 per share and recorded to Additional Paid-In Capital and the debit recorded to Prepaid Consulting Expense.  The expense will be amortized over the 25 month period of the contract.  $189,000 was recorded to expense under the contract for the three and nine months ended September 30, 2010.




For the nine months ended September 30, 2010 and 2009, the Company paid interest expense to M&W Fiberglass (“M&W”) which is 100% owned by Jamie Lee Mancl, ECC’s majority shareholder, on the building promissory note of $28,871 and $36,856, respectively.





For the nine months ended September 30, 2010, the Company incurred interest expense on short-term promissory notes from shareholders totaling $18,067.





ECC-C (formerly AFT) purchased fiberglass pipe fittings from Fiberglass Piping & Fitting Company (“FPF”) which is 100% owned by Jamie Lee Mancl, ECC’s majority shareholder, totaling $68,283 and $355,032 for the nine months ended September 30, 2010 and 2009, respectively. As of September 30, 2010, the Company has an accounts payable balance of $161,506 owed to FPF and an accounts receivable balance of $7,115 due from FPF related to product sold to FPF.





15


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 12.  Commitments and Contingencies





Operating Leases





The Company has entered into various operating leases expiring through April 2013 for equipment, vehicles and temporary lodging. At September 30, 2010, the monthly payment for all operating leases totals $5,963.





Future minimum operating lease payments for all leases for the years ending December 31 are as follows:




2010 - remaining

$
15,2232011


46,3762012


28,5172013


4,5972014


-$
94,713





Purchase Commitments





At September 30, 2010, the Company had purchase commitments for capital expenditures in the amount of $184,667. These outstanding contractual obligations are not recognized as liabilities in the consolidated financial statements as the amounts represent future obligations for equipment purchases at September 30, 2010.





Legal Proceedings





The Company is subject to legal proceedings and claims arising in the ordinary course of business.  As of the date hereof, in the opinion of management, the resolution of such matters will not have a material effect on the Company’s financial position, results of operations, or cash flow.





Note 13.  Sales and Cost of Sales





The following information summarizes the net sales and related cost of sales/services for the Company’s product and service offerings.  The Company does not consider the product sales and service components of their business to be reportable operating segments because the financial results of each component is not separately evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance.








Three Months Ended September 30, 2010Products &


Service &Components


Installation


TotalNet sales

$
1,541,548


$
334,807


$
1,876,355Cost of sales


1,282,734



204,925



1,487,659Gross profit

$
258,814


$
129,882


$
388,696Three Months Ended September 30, 2009Products &


Service &Components


Installation


TotalNet sales

$
827,428


$
1,033,981


$
1,861,409Cost of sales


711,803



790,590



1,502,393Gross profit

$
115,625


$
243,391


$
359,016








16


ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Nine Months Ended September 30, 2010Products &


Service &Components


Installation


TotalNet sales

$
2,985,035


$
1,715,916


$
4,700,951Cost of sales


2,726,859



888,065



3,614,924Gross profit

$
258,176


$
827,851


$
1,086,027Nine Months Ended September 30, 2009Products &


Service &Components


Installation


TotalNet sales

$
4,450,443


$
1,760,291


$
6,210,734Cost of sales


4,029,904



1,205,953



5,235,857Gross profit

$
420,539


$
554,338


$
974,877





Note 14.  Earnings (Loss) Per Share





The Company computes earnings per share using two different methods, basic and diluted, and presents per share data for all periods in which statements of operations are presented. Basic earnings per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed by dividing net income (loss) by the weighted average number of common stock and common stock equivalents outstanding.





The following tables provide a reconciliation of the numerators and denominators used in calculating basic and diluted earnings (loss) per share for the three months ended September 30, 2010 and 2009:


2010


2009Basic earnings (loss) per share calculation:Net income (loss) to common shareholders

$
(1,116,132
)

$
(548,021
)Weighted average of common shares outstanding


43,704,159



42,097,929Basic net earnings (loss) per share

$
(0.03
)

$
(0.01
)Diluted earnings (loss) per share calculation:Net income (loss) to common shareholders

$
(1,116,132
)

$
(548,021
)Weighted average of common shares outstanding


43,704,159



42,097,929Convertible debentures (1)


-



-Warrants (2)


-



-Options (3)


-



-Diluted weighted average common shares outstanding


43,704,159



42,097,929Diluted net income (loss) per share

$
(0.03
)

$
(0.01
)





17




ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS







The following tables provide a reconciliation of the numerators and denominators used in calculating basic and diluted earnings (loss) per share for the nine months ended September 30, 2010 and 2009:


2010


2009Basic earnings (loss) per share calculation:Net income (loss) to common shareholders

$
(3,347,963
)

$
(2,118,444
)Weighted average of common shares outstanding


42,723,134



42,030,708Basic net earnings (loss) per share

$
(0.08
)

$
(0.05
)Diluted earnings (loss) per share calculation:Net income (loss) to common shareholders

$
(3,347,963
)

$
(2,118,444
)Weighted average of common shares outstanding


42,723,134



42,030,708Convertible debentures (1)


-



-Warrants (2)


-



-Options (3)


-



-Diluted weighted average common shares outstanding


42,723,134



42,030,708Diluted net income (loss) per share

$
(0.08
)

$
(0.05
)





(1)
At September 30, 2010 and 2009, there were outstanding convertible debentures equivalent to 492,000 and 568,000 common shares, respectively.  The convertible debentures are anti-dilutive at September 30, 2010 and 2009 and therefore, have been excluded from diluted earnings per share.


(2)
At September 30, 2010 and 2009, there were outstanding warrants equivalent to 2,311,671 and 2,548,000 common shares.  The warrants are anti-dilutive at September 30, 2010 and 2009 and therefore, have been excluded from diluted earnings per share.


(3)
At September 30, 2010 and 2009, there were outstanding options equivalent to 630,000 and 0 common shares, respectively.  The options are anti-dilutive at September 30, 2010 and therefore, have been excluded from diluted earnings per share.





Note 15.  Subsequent Events





Financing Transactions





On October 27, 2010, the Company issued a new unsecured short-term note to M&W Fiberglass, LLC (an affiliated entity) for $25,000.  The note carries a term of 60 days and an annual fixed interest rate of 6.00%.





On October 29, 2010, the Company issued a new unsecured short-term note to White Horse Ltd, LLC, an entity owned by one of the Company’s directors, for $120,000.  The note carried a term of 30 days and an annual fixed interest rate of 6.00%.  The note was paid on November 2, 2010.








18





ENERGY COMPOSITES CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 16.  Supplemental Disclosure of Cash Flow Information





Nine months ended September 30,2010


2009Supplemental disclosure of cash flow information:Cash paid for interest

$
261,629


$
295,104Non-cash investing and financing activities:Purchase of property and equipment with long-term debt

$
-


$
9,412Increase in land and deferred income due to discounted land purchased from the City of Wisconsin Rapids

$
429,494


$
-Convertible debt converted to common stock

$
165,000


$
1,075,000Long-term note converted to common stock

$
970,770


$
-Short-term notes converted to common stock

$
500,000


$
-Issuance of common stock for prepaid consulting fees

$
4,725,000


$
-








19


Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations





The discussion contained herein contains “forward-looking statements” that involve risk and uncertainties.  These statements may be identified by the use of terminology such as “believes,” “expects,”  “may,” “should” or “anticipates” or expressing this terminology negatively or similar expressions or by discussions of strategy.  The cautionary statements made in our Annual Report on Form 10-K, filed March 31, 2010, should be read as being applicable to all related forward-looking statements wherever they appear in this Form 10-Q.  Our actual results could differ materially from those discussed in this report.  The following discussion should be read in conjunction with the financial statements and the related notes included herein as Item 1.





Accounting Policies and Estimates





The methods, estimates and judgments that we use in applying our critical accounting policies have a significant impact on the results that we report in our financial statements.  Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain.  We also have other policies that we consider key accounting policies, such as those for revenue recognition; however, these policies typically do not require us to make estimates or judgments that are difficult or subjective.





We have identified the accounting policies that we consider critical in Note 1 “Nature of Business and Significant Accounting Policies” of the notes to our financial statements included in this report.  The accounting policies and estimates described in this report should be read in conjunction with Note 1 “Nature of Business and Significant Accounting Policies,” of the notes to our consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009, which includes a discussion of the policies identified in this report and other significant accounting policies.





Overview





Energy Composites Corporation (“we,” “us,” “our,” or the “Company”), a Nevada corporation, is a manufacturer of composite structures and vessels for a range of clean technology industries.  Based on our research of companies in this sector, we believe we have the Midwest’s largest and most automated manufacturing capabilities with our world-class, automated 73,000 square foot climate-controlled manufacturing facility in Wisconsin Rapids, Wisconsin.





The Company has two operating subsidiaries as follows:





ECC Corrosion, Inc (“ECC-C”).  Formerly known as Advanced Fiberglass Technologies (“AFT”), this entity was incorporated in the state of Wisconsin on January 1, 2005, following nearly ten years operating as M&W Fiberglass, LLC (“M&W”).  Founded in 1995 by Jamie Lee Mancl, M&W was the operating entity that developed and operated AFT’s business.  In January 2005, M&W transferred all operating assets and liabilities into a newly formed S-Corporation: AFT.  M&W, solely owned by Jamie Lee Mancl, retained ownership of AFT’s former manufacturing facility.  In February 2007, M&W sold AFT’s former manufacturing facility to the city of Wisconsin Rapids.  M&W and AFT then purchased and developed our current manufacturing facility by obtaining $4,000,000 of financing in the form of industrial revenue bonds.  On December 31, 2008, we purchased the manufacturing facility from M&W by assuming the industrial revenue bonds, paying M&W $500,000 in cash and delivering a promissory note to M&W for $1,045,328.   On September 1, 2010, AFT changed its name to ECC Corrosion, Inc.





Innovative Composite Solutions, LLC (“ICS”).  In June 2009, further executing our growth strategy, we established ICS as a wholly-owned subsidiary of Energy Composites Corporation.  ICS serves as our distribution arm for resins and composite materials.  As of September 30, 2010, the operating results of ICS are immaterial to the Company and are included in the Industrial Tank and Piping reporting segment under the Products category.





20


Results of Operations





The following information summarizes the net sales and related cost of sales/services for our product and service offerings.  We do not consider the product sales and service components of our business to be reportable operating segments because the financial results of each component are not separately evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance.








Three Months Ended September 30, 2010Products &


Service &Components


Installation


TotalNet sales

$
1,541,548


$
334,807


$
1,876,355Cost of sales


1,282,734



204,925



1,487,659Gross profit

$
258,814


$
129,882


$
388,696Three Months Ended September 30, 2009Products &


Service &Components


Installation


TotalNet sales

$
827,428


$
1,033,981


$
1,861,409Cost of sales


711,803



790,590



1,502,393Gross profit

$
115,625


$
243,391


$
359,016










Nine Months Ended September 30, 2010Products &


Service &Components


Installation


TotalNet sales

$
2,985,035


$
1,715,916


$
4,700,951Cost of sales


2,726,859



888,065



3,614,924Gross profit

$
258,176


$
827,851


$
1,086,027Nine Months Ended September 30, 2009Products &


Service &Components


Installation


TotalNet sales

$
4,450,443


$
1,760,291


$
6,210,734Cost of sales


4,029,904



1,205,953



5,235,857Gross profit

$
420,539


$
554,338


$
974,877





Revenue





During the three months ended September 30, 2010, we recorded revenue from product sales of $1,541,548, an increase from the three month period ended September 30, 2009 of $714,120 or 86%.  Revenue from field services was $334,807 for the three months ended September 30, 2010, a decrease from the three-month period ended September 30, 2009 of $699,174 or 68%.  The increase in product revenue during the quarter was driven by the completion of two large diameter flue gas desulfurization units and five XLCRTM-lined bone maceration tanks.  The decrease in service revenue during the third quarter is largely attributable to previously delayed maintenance activity having been completed in the second quarter of this year. During the nine months ended September 30, 2010, we recorded revenue from product sales of $2,985,035, a decrease from the nine month period ended September 30, 2009 of $1,465,408 or 33%.  Revenue from field services was $1,715,916 for the nine months ended September 30, 2010, a decrease from the nine month period ended September 30, 2009 of $44,375 or 3%.  The decrease in product and service revenue during the nine month period ended September 30, 2010 was largely driven by the absence of a major contract and reduced or delayed service orders from our leading corrosion customers.





21
 
 
 This was partially offset by smaller product contracts from new customers.  The Company completed deliveries for a major tank and piping contract with a chlor-alkali producer during the nine months ended September 30, 2009 valued at approximately $3.1 million.




Cost of goods sold





The primary components of cost of goods sold are raw materials used in manufacturing, manufacturing labor, and manufacturing overhead.  The primary raw materials used in our manufacturing processes are isophathalic, polyester, and vinyl-ester resins and fiberglass.  Manufacturing labor includes wages, employment taxes, employee benefits, and union expenses.  The major components of manufacturing overhead are utilities and depreciation associated with our manufacturing facility and equipment, travel and lodging expense associated with field service activities and manufacturing supplies.





For the three and nine month periods ended September 30, 2010, cost of goods sold decreased to $1,487,659 and $3,614,924, respectively, resulting in gross profit of $388,696 and $1,086,027, respectively.  For the three and nine month periods ended September 30, 2009, cost of goods sold was $1,502,393 and $5,235,857, respectively, resulting in gross profit of $359,016 and $974,877, respectively.  The improvement in gross profit for the three and nine month periods ended September 30, 2010 was driven by higher margin product mix, labor efficiencies realized with the implementation of the Company’s enterprise resource planning system in May 2010 and a lower requirement of more expensive pipefitter labor in 2010 compared to 2009.  These factors were partially offset by the lower sales volume in 2010.





For the three and nine months ended September 30, 2010, our cost of materials was 31% and 28% of revenue, respectively.  This compares to cost of materials of 20% and 26% for the three and nine months ended September 30, 2009.  Our cost of labor was 28% of revenue for the three and nine months ended September 30, 2010 compared to labor cost of 41% and 38% of revenue for the three and nine months ended September 30, 2009, respectively. Manufacturing overhead was 20% and 21% of revenue during the three and nine months ended September 30, 2010, respectively, compared to 19% and 20% for the three and nine months ended September 30, 2009.





Selling, general & administrative expenses





Selling, general and administrative expenses increased to $1,271,081 during the three months ended September 30, 2010 from $978,014 during the three months ended September 30, 2009.  Selling, general and administrative expenses increased to $3,669,095 during the nine months ended September 30, 2010 from $2,752,176 during the nine months ended September 30, 2009.  The increase in our selling, general and administrative expenses is primarily driven by our continued investment in our growth strategy, notably our investment in our WindFiberTM strategy, increased sales and sales support staff, and non-cash stock compensation.  We recorded employee and director stock and stock option compensation expense of $222,753 during the three months ended September 30, 2010, compared to $46,250 during the three months ended September 30, 2009.  Additionally, we recorded $189,000 of stock compensation expense during the three months ended September 30, 2010 related to a consulting agreement with Diversified Equities Partners, LLC (“Diversified”) whereby Diversified will provide financial advisory services through September 2012.  Employee and director stock and stock option compensation expense was $770,199 during the nine months ended September 30, 2010, compared to $165,623 during the nine months ended September 30, 2009.





Other income (expense)




Other income and expense consists of interest income and interest expense which includes non-cash amortization of deferred financing costs and non-cash amortization of beneficial conversion features and warrant discounts associated with convertible debt.  Total interest expense for the three months ended September 30, 2010 and 2009 was $233,969 and $237,709, respectively.  Non-cash amortization of debt discounts for warrants and beneficial conversion feature related to the convertible debt was $131,400 and $118,333 for the three months ended September 30, 2010 and 2009, respectively.  Total interest expense for the nine months ended September 30, 2010 and 2009 was $765,326 and $1,689,625, respectively.  Non-cash amortization of debt discounts for warrants and beneficial conversion feature related to the convertible debt was $431,735 and $1,327,291 for the nine months ended





22
 
  September 30, 2010 and 2009, respectively.  The remaining decrease in interest expense in 2010 compared to 2009 is attributable to decreased long-term and short-term debt levels resulting from scheduled loan payments as well as two debt for equity exchange transactions executed during the quarter and lower levels of outstanding convertible debt in 2010 compared to the prior year.  The two debt for equity exchange transactions are further detailed in the Liquidity and Capital Resources section below.




Interest expense is partially offset by bank interest income.  For the three months ended September 30, 2010 and 2009, interest income was $222 and $2,686, respectively.  For the nine months ended September 30, 2010 and 2009, interest income was $431 and $14,480, respectively.




Net loss before provision (benefit) for income taxes





The Company’s loss before income tax benefit increased to $1,116,132 during the three months ended September 30, 2010 from $854,021 during the three months ended September 30, 2009.  For the nine months ended September 30, 2010, the loss before income tax benefit decreased to $3,347,963 from $3,452,444 during the nine months ended September 30, 2009.   The primary driver of the increase in our net loss before income tax for the three month period ended September 30, 2010 was the increase in stock compensation expense which was partially offset by the improvement in gross profit.  The primary driver of the improvement in net loss before income tax for the nine month period ended September 30, 2010 was the significant improvement in gross profit and the significant decrease in non-cash amortization of debt discounts for warrants and beneficial conversion feature related to the convertible debt.  These improvements in net loss were partially offset by increased selling, general and administrative expenses most notably non-cash stock compensation expense and expenses related to investments made in our WindFiberTM strategy as detailed above.





Income tax benefit





For the three and nine months ended September 30, 2010, net income tax benefit was recorded relative to net operating losses generated and timing differences between financial and income tax reporting of $456,000 and $1,293,000, respectively.  Significant components of the income tax benefit include the net operating losses, fair value of warrants and temporary timing differences of fixed assets, WindFiberTM start-up costs, accruals and reserves.  This net income tax benefit was offset by a full valuation allowance of $456,000 and $1,293,000 resulting in a net income tax benefit of $0 for the three and nine months ended September 30, 2010.





For the three and nine months ended September 30, 2009, net income tax benefit was recorded relative to net operating losses and timing differences between financial and income tax reporting of $306,000 and $1,334,000, respectively.  A valuation allowance was not recorded during the three and nine months ended September 30, 2009, therefore the net income tax benefit was $306,000 and $1,334,000 for the three and nine months ended September 30, 2009, respectively.





Net loss





Net loss increased to $1,116,132 for the three months ended September 30, 2010 from $548,021 during the three months ended September 30, 2009.  Net loss increased to $3,347,963 for the nine months ended September 30, 2010 from $2,118,444 during the nine months ended September 30, 2009.  The increase in our 2010 net loss stems largely from applying a full valuation allowance against our deferred tax assets, increases in our stock compensation expenses and from our continued investment in our growth strategy.   Expenses related to our WindFiberTM growth strategy have totaled $647,294 for the nine months ended September 30, 2010 compared to $284,093 for the nine months ended September 30, 2009.  ICS has recorded operating losses of $176,556 for the nine months ended September 30, 2010 compared to $132,038 for the nine months ended September 30, 2009.  Additionally, to capitalize on our expanding manufacturing capabilities, we have added both sales representatives and new sales territories and expanded our marketing programs.





With these expenditures, we believe we have increased our visibility in our existing markets and have captured attention from major targeted customers within the wind energy market.  While recessionary economic pressures persist, we have seen signs that the capital goods economy may be strengthening.  We announced on July 26, 2010 that the Company has been awarded a major contract to supply fiberglass tanks in 2011 to a Canadian





23
 
  client valued at approximately $3.8 million.  We continue to pursue our four-part strategy to expand and diversify our business.  We believe that increasing our involvement in the wind energy industry and other market segments will also position our Company to profit when and as the economy recovers and expands.





Liquidity and Capital Resources





Our liquidity and capital resources continue to be driven by our growth strategy as well.  We have invested in our plant and equipment to significantly diversify our manufacturing capability, both in-house and on-client-site.  As a result of our expansion efforts, we believe we are well positioned to take advantage of market opportunities and to introduce our products and services into emerging markets like wind energy.





Our primary sources of liquidity to fund our growth strategy are short and long-term term financing arrangements and equity issuances.  The Company is currently in need of additional equity and debt financing to support its working capital deficit and to allow the Company to proceed with its growth strategy.  If the Company does not receive this additional financing in the near term, the Company will have to curtail selling, general and administrative spending.  The Company is continuing its efforts to improve the overall financial condition and results, including obtaining additional financing and restructuring certain debt arrangements as described below.





As of September 30, 2010, cash and cash equivalents totaled $125,396 and the Company had a working capital deficit of $1,668,159 exclusive of Prepaid Consulting Expense.  The Company’s working capital deficit has increased because $830,000 of the $1,230,000 outstanding from the 2008 issuance of convertible debt will mature within 12 months unless converted to common stock before maturity.  Due to the project-oriented, custom fabrication nature of our current operating business ECC Corrosion, which receives sporadic customer payments as opposed to steady cash flow, we expect to continue to have a need to borrow on a short-term unsecured basis to meet working capital requirements for the near future.  While ECC has been successful in obtaining such financing on relatively favorable terms, there is no assurance that we will be able to secure this type of financing in the future.





Operating Cash Flows





Operating activities provided $127,753 during the nine months ended September 30, 2010 compared to cash used of $1,295,437 during the nine months ended September 30, 2009.  The improvement in net cash flow from operating activities in 2010 relative to 2009 was due primarily to the timing and management of cash requirements associated with accounts payable and accounts receivable, and customer deposits made during the period as progress payments on certain fabrication contracts.  This was partially offset by a timing difference between periods in work-in-process inventories related to ongoing and upcoming contracts, the timing of accrued expenses, and the increase in the overall net loss for the nine months ended September 30, 2010.





Investing Cash Flows





Investing activities used $228,418 and $444,299 of cash for the nine months ended September 30, 2010 and 2009, respectively.  The primary use of cash in investing activities in 2010 has been investments made in building designs related to our planned wind blade plant in Wisconsin Rapids, additional manufacturing equipment in our corrosion business, and the purchase of 94 acres of land for our planned wind blade manufacturing plant.  The primary use of cash in investing activities in 2009 was the purchase of additional manufacturing equipment supporting plant and field service activities, as well as the purchase of office equipment for added office staff positions.





Financing Cash Flows





Financing activities used $55,748 during the nine months ended September 30, 2010.  Proceeds from financing activities, detailed below, were offset by net payments on short-term debt and lines of credit totaling $753,512 and net payments on long-term debt totaling $359,489 for the nine months ended September 30, 2010.  For the nine months ended September 30, 2009, financing activities provided $147,322 comprised of net borrowings from short-term notes of $497,934 and net payments on long-term debt and financing costs of $350,612.







24




Warrant Exercise




On March 8, 2010, the Board of Directors of the Company approved the temporary reduction of the exercise price of currently outstanding common stock purchase warrants from $5.00 per share to $2.50 per share. The exercise price reduction was valid from March 22, 2010 through May 6, 2010.  Shares issued during the exercise price reduction period were restricted shares subject to SEC Rule 144.  After May 6, 2010, any outstanding warrants reverted back to their original terms.  As of May 6, 2010, the Company received $590,823 related to the exercise of 236,329 warrants to purchase our common stock at $2.50 per share from current warrant holders.




Subscription Agreement




On August 23, 2010, the Company entered into a Subscription Agreement with its founder and majority shareholder, Jamie L. Mancl, pursuant to which Mr. Mancl made a $450,000 equity investment in the Company. Pursuant to the agreement, Mr. Mancl purchased 180,000 shares of the Company's common stock at a price of $2.50 per share.  These shares were restricted shares subject to SEC Rule 144.




Employee Stock Purchase Plan




Proceeds to the Company from stock purchased under the ECC Employee Stock Purchase Plan totaled $16,430 for the nine months ended September 30, 2010.




Debt Exchange Transactions




On August 3, 2010, the Company’s Board of Directors approved a debt for equity exchange transaction between M&W Fiberglass, LLC (an entity wholly owned by the Company’s majority shareholders Jamie L. and Jennifer L. Mancl) and the Company. The transaction, which closed on August 13, 2010, resulted in the conversion of the outstanding principal and interest under the existing long-term note with M&W Fiberglass to common shares of the Company at $2.50 per share. The principal balance of the note converted at August 13, 2010 was $970,770 and accrued interest was $5,455 which upon conversion resulted in the issuance of 390,490 restricted common shares of ECC. The exchange resulted in a $970,770 reduction in the Company's long-term debt obligations and also results in a reduction in cash required for principal and interest payments of $97,972 annually through 2014, and $729,822 in 2015.




On August 3, 2010, the Company’s Board of Directors also approved a debt for equity exchange transaction between five private investors (primarily existing shareholders) and the Company. The transaction, which closed on September 7, 2010, resulted in the conversion of the outstanding principal and interest under existing short-term notes to common shares of the Company at $2.50 per share. The principal balance of the notes converted at September 7, 2010 was $500,000 along with accrued interest of $18,763.  This resulted in a $500,000 reduction in the Company's short-term debt obligations.




Debenture Financing





From August 2008 to December 2008, we raised $6,370,000 by selling units, each unit consisting of (i) a 3-year, 6% convertible debenture (the “Debentures”) with a conversion price of $2.50 per share (subject to adjustment for stock splits and stock dividends), and (ii) a number of warrants equal to the number of shares issuable upon conversion of the principal amount of the Debenture (the “Warrants”).  The Debentures sold included the issuance of 2,548,000 Warrants.  Each Warrant is exercisable into shares of common stock for a term of 3 years at $5.00 per share.  The Warrant also provides anti-dilution protection for the following events: reorganization, reclassification, consolidation, merger or sale; subdivision, combination or dividend of our common stock.





At September 30, 2010, Debentures totaling $1,230,000 remain outstanding and will become due during the third and fourth quarter of 2011.  $5,140,000 of Debentures has been converted to common stock as of September 30, 2010.  Many Debenture holders have elected to receive interest in the form of stock, lowering our





25
 
 cash outlays for debt service on the Debentures.  We believe that the growth of our business through the implementation of our growth strategy will improve the value of our stock and motivate the remaining Debenture holders to convert their debt into stock which will further reduce our cash requirements to settle the debt in 2011.  We also anticipate that the Debenture holders will exercise their Warrants when and if the value of our stock increases above $5.00 per share.  The money we raise from the exercise of Warrants, if any, will be used to continue our growth strategy.





Other Debt Activity





On October 27, 2010, the Company issued a new unsecured short-term promissory note to M&W Fiberglass, LLC for $25,000.  The note carries a term of 60 days and an annual fixed interest rate of 6.00%.





On October 29, 2010, the Company issued a new unsecured short-term promissory note to White Horse Ltd, LLC, an entity owned by one of the Company’s directors, for $120,000.  The note carries a term of 30 days and an annual fixed interest rate of 6.00%.  The note was paid on November 2, 2010.





Leases





The Company has entered into various operating leases expiring through April 2013 for equipment, vehicles and temporary lodging.  At September 30, 2010, the monthly payment for all operating leases totals $5,963.





Going Forward





While we have begun to implement our four-part growth strategy, defined in our 2009 Annual Report on Form 10-K, we continue to require additional equity and debt financing over the next twelve months to support working capital requirements of our existing businesses, the construction of a new wind blade production plant, the equipping of the production lines and the training of employee-associates.  While we are targeting a substantial portion of our financing requirements through subsidized or otherwise advantaged debt financing, it will be necessary to support such financing with supplemental equity.  If our cash flow from operations is insufficient to fund debt service and other obligations, we will be required to increase our borrowings, reduce or delay capital expenditures, and seek additional capital or refinance our indebtedness.  There can be no assurance, however, that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under revolving credit facilities.  If we are unable to obtain new financing in the near term, we will have to curtail our selling, general and administrative expenditures, including those associated with the WindFiberTM strategy.





Off-Balance Sheet Arrangements





As of September 30, 2010, we did not have any off-balance sheet arrangements.





Item 3.   Quantitative and Qualitative Disclosures about Market Risk




Not applicable to smaller reporting companies.





Item 4.   Controls and Procedures





Under the supervision and with the participation of our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”) as of the end of the period covered by this report.  Based on this evaluation, the officers concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to our management including our principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.






26





There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.











27


PART II.  OTHER INFORMATION





Item 1.      Legal Proceedings





From time to time we are involved in litigation and other proceedings arising in the ordinary course of our business, including actions with respect to contract claims, labor and employment claims and other matters.  Although litigation and other proceedings are inherently uncertain and their results cannot be predicted with certainty, we believe that the resolution of our current pending matters will not have a material adverse effect on our business, financial conditions or results of operations.  Regardless of the outcome, litigation can have an adverse impact on us because of defense costs, diversion of management resources and other factors.  In addition, it is possible that an unfavorable resolution in litigation or other proceedings could in the future materially and adversely affect our financial position or results of operations in a particular period.





Item 1A.   Risk Factors





Not applicable to smaller reporting companies.





Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds





During the third quarter of 2010, we issued the unregistered securities set forth in the table below.





Date
Persons or Class of Persons
Securities
ConsiderationJuly 1, 2010
26 accredited investors
6,566 shares of common stock
$16,380 of accrued interest paid to debenture holdersAugust 3, 2010
Executive officer
390,490 shares of common stock
$976,225 long-term note and accrued interest exchanged at $2.50 per shareAugust 23, 2010
Executive officer
180,000 shares of common stock
$450,000 common stock purchase at $2.50 per shareAugust 24, 2010
Consultant
3,375,000 shares of common stock
$4,275,000 for services to be rendered at $1.40 per shareSeptember 7, 2010
5 accredited investors
207,506 shares of common stock
$518,763 short-term note and accrued interest exchanged at $2.50 per shareJuly through September
3 accredited investors
36,465 shares of common stock
Conversion of $90,000 of Debenture principal and $1,162 of accrued interest





No underwriters were used in the above stock transactions.  We relied upon the exemption from registration contained in Section 4(2) and/or Rule 506 as to all of the transactions as the investors were deemed to be sophisticated with respect to the investment in the securities due to their financial condition and involvement in our business or were accredited investors.  Restrictive legends were placed on the certificates evidencing the securities issued in all of the above transactions.





Item 3.      Defaults Upon Senior Securities





None.





Item 5.      Other Information





None.





28


Item 6.      Exhibits





Regulation

S-K Number
Document3.1
Articles of Merger effective October 14, 2008 (1)3.2
Amended and Restated Articles of Incorporation effective October 14, 2008 (1)3.3
Amended and Restated Bylaws adopted October 14, 2008 (1)4.1
Form of Debenture (2)4.2
Form of Warrant (2)10.1
Share Exchange Agreement dated June 26, 2008 (3)10.2
First Amendment to Share Exchange Agreement dated August 8, 2008 (4)10.3
2008 Stock Incentive Plan (1)10.4
Industrial Development Revenue Bonds, Bond Agreement dated February 28, 2007 (1)10.5
Industrial Development Revenue Bonds, Promissory Note 2007A dated February 28, 2007 (1)10.6
Industrial Development Revenue Bonds, Promissory Note 2007B dated February 28, 2007 (1)10.7
Industrial Development Revenue Bonds, Promissory Note 2007C dated February 28, 2007 (1)10.8
Industrial Development Revenue Bonds, Credit Agreement dated February 28, 2007 (1)10.9
Industrial Development Revenue Bonds, Construction Mortgage, Assignment Of Leases And Rents and Fixture Filing dated February 28, 2007 (1)10.10
Industrial Development Revenue Bonds, Security Agreement dated February 28, 2007 (1)10.11
Option Agreement dated June 18, 2008 (1)10.12
Purchase and Supply Agreement dated October 13, 2008 (1)10.13
Unsecured Promissory Note dated December 31, 2008 (5)10.14
Assignment and Assumption Agreement dated December 31, 2008 (6)10.15
Amendment to the Credit Agreement dated March 13, 2009 (7)10.16
Employee Stock Purchase Plan (8)10.17
Debt Exchange Agreement (9)31.1
Rule 13a-14(a) Certification of Jamie L. Mancl31.2
Rule 13a-14(a) Certification of Jeffrey S. Keuntjes32.1
Certification of Jamie L. Mancl Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
Certification of Jeffrey S. Keuntjes Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002




(1)
Filed as an exhibit to the Current Report on Form 8-K dated October 14, 2008, filed October 17, 2008.


(2)
Filed as an exhibit to the Current Report on Form 8-K dated December 15, 2008, filed December 19, 2008.


(3)
Filed as an exhibit to the Current Report on Form 8-K dated June 26, 2008, filed June 27, 2008.


(4)
Filed as an exhibit to the Definitive Information Statement on Schedule 14C, filed September 24, 2008.


(5)
Filed as an exhibit to the Current Report on Form 8-K/A dated December 31, 2008, filed January 26, 2009.


(6)
Filed as an exhibit to the Current Report on Form 8-K dated December 31, 2008, filed January 6, 2009.


(7)
Filed as an exhibit to the Annual Report for the year ended December 31, 2008 on Form 10-K filed March 31, 2009.


(8)
Filed as an exhibit to the Current Report on Form 8-K dated June 2, 2009, filed June 5, 2009.


(9)
Filed as an exhibit to the Current Report on Form 8-K dated August 13, 2010, filed August 19, 2010.





29


SIGNATURES





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





ENERGY COMPOSITES CORPORATIONDated:  November 12, 2010
By:
/s/ Jamie L. ManclJamie L. Mancl, PresidentDated:  November 12, 2010
By:
/s/ Jeffrey S. KeuntjesJeffrey S. Keuntjes, Vice President – Finance