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ZBB ENERGY CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report includes forward-looking statements based on our current management's expectations. There can be no assurance that actual results, outcomes or business conditions will not differ materially from those projected or suggested in such forward-looking statements as a result of various factors, including, the risks and uncertainties discussed in the Risk Factors section of this Annual Report on Form 10-K. OVERVIEW ZBB Energy Corporation ("We," "Us," "Our," "ZBB" or the "Company") develops, licenses, and manufactures modular, scalable and environmentally friendly power systems (ZBB EnerSystem) based upon the Company's proprietary zinc bromide rechargeable electrical energy storage technology. We provide advanced electrical power management platforms targeted at the growing global need for distributed renewable energy, energy efficiency, power quality, and grid modernization. We have developed a portfolio of intelligent power management platforms that directly integrate multiple renewable and conventional onsite generation sources with rechargeable zinc bromide flow batteries and other storage technology. We also offer advanced systems to directly connect wind and solar equipment to the grid and systems that can form various levels of micro-grids. We have also developed hybrid vehicle control systems and power quality products. These platforms provide a wide range of renewable energy solutions in global markets for utility, governmental, commercial, industrial and residential customers. Anhui Meineng Store Energy Co., Ltd. (the "JV Company" or "Meineng Energy") was established in late 2011 to develop, produce, sell, distribute and service advanced storage batteries and power electronics in China. The JV Company assembles and manufactures the Company's products for sale in the power management industry on an exclusive basis in mainland China and on a non-exclusive basis in Hong Kong and Taiwan. Our investment in the JV Company was made through ZBB PowerSav Holdings Limited ("Hong Kong Holdco"), a Hong Kong limited liability company, a holding company formed with PowerSav New Energy Holdings Limited . We own 60% of Hong Kong Holdco's equity interests. We have the right to appoint a majority of the members of the Board of Directors of Hong Kong Holdco and Hong Kong Holdco has the right to appoint a majority of the members of the Board of Directors of the JV Company. Our indirect interest in the JV Company equals approximately 30%. The Company's President and Chief Operating Officer ("President and COO") has served as the Chief Executive Officer of Meineng Energy since December 2011. The President and COO owns an indirect 6% equity interest in Meineng Energy. Pursuant to a management services agreement Hong Kong Holdco will provide certain management services to the JV Company in exchange for a management services fee equal to five percent of the JV Company's net sales for the five year period beginning on the first day of the first quarter in which the JV Company achieves operational breakeven results and three percent of the JV Company's new sales for the subsequent three years, provided the payment of such fees will terminate upon the JV Company completing an initial public offering on a nationally recognized securities exchange. On December 16, 2013, we entered into a Research and Development Agreement (the "R&D Agreement") with Lotte Chemical Corporation ("Lotte") pursuant to which we agreed to develop and provide to Lotte a Zinc Bromide chemical flow battery system, including a Zinc Bromide chemical flow battery module and related software (the "Product"), on the terms and conditions set forth in the R&D Agreement (the "Project"). The Project is scheduled to continue until December 16, 2015, unless extended by the mutual agreement of the Company and Lotte. Subject to the satisfaction of certain specified milestones, Lotte is required to make payments to us under the R&D Agreement totaling $3,000,000 over the term of the Project. 17-------------------------------------------------------------------------------- In April 2011, we entered into a Collaboration Agreement (the "Collaboration Agreement") with Lotte, pursuant to which the Company and Lotte collaborated on the technical development of our third generation Zinc Bromide flow battery module (the "Version 3 Battery Module") and Lotte received a fully paid-up, exclusive and royalty-free license to sell and manufacture the Version 3 Battery Module in Korea and a non-exclusive royalty-bearing license to sell the Version 3 Battery Module in Japan, Thailand, Taiwan, Malaysia, Vietnam and Singapore. On December 16, 2013 we entered into an Amended License Agreement with Lotte (the "Amended License Agreement"). Pursuant to the Amended License Agreement, we granted to Lotte, (1) an exclusive and royalty-free limited license in Korea to use the Company's Zinc Bromide flow battery module, Zinc Bromide flow battery stack and the technical information and know how related to the intellectual property arising from the Project (collectively, the "Technology") to manufacture or sell a Zinc Bromide flow battery (the "Lotte Product") in Korea and (2) a non-exclusive (a) royalty-free limited license for Lotte and its affiliates to use the Technology internally in all locations other than China and Korea to manufacture the Lotte Product and (b) royalty-bearing limited license to sell the Lotte Product in all locations other than China, the United States and Korea. Lotte is required to pay us a total license fee of $3,000,000 under the Amended License Agreement plus up to an additional $1,000,000 if certain specific milestones are successfully achieved. In addition, Lotte is required to make ongoing royalty payments to the Company equal to a single digit percentage of Lotte's sales of the Lotte Product outside of Korea until December 31, 2019. The license fees are subject to a 16.5% non-refundable Korea withholding tax. NEW ACCOUNTING PRONOUNCEMENTS Refer to Note 1 of the Notes to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of our financial statements conforms to accounting principles generally accepted in the United States of America, which requires management, in applying our accounting policies, to make estimates and judgments that have an important impact on our reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of our financial statements. On an on-going basis, management evaluates its estimates including those related to bad debts, inventory valuations, warranty obligations, asset impairments and income taxes. Management bases its estimates and judgments on historical experience and on various other factors 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 management's estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America and related disclosures require management to make estimates and assumptions. CRITICAL ACCOUNTING ESTIMATES Revenue Recognition Application of the accounting principles related to the measurement and recognition of revenue requires the Company to make judgments and estimates. Even for the same product, the Company has to interpret contract terms to determine the appropriate accounting treatments. When services, installation and training, etc. are rendered with product sales, the Company determines whether the deliverables should be treated as separate units of accounting. When there are multiple transactions with the same customer, significant judgments are made to determine whether separate contracts are considered as part of one arrangement according to the contract's terms and conditions. When the installed equipment is accepted by the customer in different periods, the Company determines whether the completed project is able to be used by the customer, whether the receivable is collectible and whether revenue is recognized by stages. Revenue recognition is also impacted by various factors, including the credit-worthiness of the customer. Estimates of these factors are evaluated periodically to assess the adequacy of the estimates. If the estimates were changed, revenue would be impacted. Excess and Obsolete Inventory We determine the amount of inventory that is excess and obsolete using estimates of future demand for individual components of raw materials and finished goods. To determine excess and obsolete inventory, we compare listings of existing piece parts and finished goods to future product demand and usage requirements. We record a full valuation allowance for inventory quantities on hand in excess of two year's expected usage. 18 -------------------------------------------------------------------------------- We believe our accounting estimate related to excess and obsolete inventory is a critical accounting estimate because it requires us to make assumptions about future sales volumes and product mix, which can be highly uncertain. Changes in these estimates can have a material effect on our financial statements. Accrued Expenses Accrued expenses consist of the Company's present obligations related to various expenses incurred during the period and includes a reserve for estimated contract losses, other accrued expenses, and warranty obligations. Warranty Provision The Company's products are generally covered by a warranty for 12 or 18 months. The Company accrues for warranty costs as part of costs of sales based on associated material costs, technical labor costs, and associated overheads. If the Company experiences an increase in warranty claims compared with historical experience, or if the cost of servicing warranty claims is greater than expected, the Company's gross margin could be adversely affected. Stock Based Compensation The Company's Board of Directors approves grants of stock options to employees to purchase our common stock. Stock compensation expense is recorded based upon the estimated fair value of the stock option at the date of grant. The accounting estimate related to stock-based compensation is considered a critical accounting estimate because estimates are made in calculating compensation expense including expected option lives, forfeiture rates and expected volatility. Expected option lives and forfeiture rates may be different from estimates and may result in potential future adjustments which would impact the amount of stock-based compensation expense recorded in a particular period. RESULTS OF OPERATIONS Year ended June 30, 2014 compared with the year ended June 30, 2013 Revenue: Our revenues for the years ended June 30, 2014 and June 30, 2013 were $7,851,607 and $7,723,699, respectively. The increase of $127,908 was the result of a $906,817 increase in engineering and development revenues and a $3,000,000 increase in license revenues from a one-time upfront license fee under our Amended License Agreement with Lotte, partially offset by a $3,778,909 decrease in product sales as compared to the year ended June 30, 2013. Costs and Expenses: Total costs and expenses for the years ended June 30, 2014 and June 30, 2013 were $16,648,862 and $19,322,998, respectively. This decrease of $2,674,136 in the year ended June 30, 2014 was primarily due to the following factors: · $3,379,730 decrease in costs of product sales principally due to decreased product sales but also includes an increase of approximately $860,000 in cost of product sales related to our product upgrade initiative, as described below; · $1,024,175 increase in selling, general, and administrative expenses due primarily to an increase of approximately $746,000 in expenses related to our product upgrade initiative and $495,000 in non-refundable Korea withholding tax related to the one-time upfront license fee under our Amended License Agreement with Lotte, partially offset by decreases in travel and recruitment expenses of $129,000 and $65,000, respectively; · $349,456 decrease in depreciation and amortization which resulted from full amortization of the Company's intangible assets early in the third quarter of fiscal year 2014. Intangible asset amortization expense decreased from $732,048 for the year ended June 30, 2013 to $411,073 for the year ended June 30, 2014. Subsequent to commercialization, installation and commissioning of units in the field, the Company has garnered meaningful insights that have resulted in system design modifications and other general upgrades that have improved the performance, efficiency, and reliability of its systems. In the interest of enhancing customer satisfaction, the Company launched an initiative to implement these improvements at certain locations of its installed base during fiscal 2015. Total costs and expenses for the year ended June 30, 2014 includes an estimated remaining charge of approximately $1.7 million, allocated between the cost of product sales and selling, general, and administrative expenses, based upon project status and where the project falls within the respective contractual warranty period related to the product upgrade initiative. The offsetting reserve for this initiative is included in accrued expenses as of June 30, 2014. 19 --------------------------------------------------------------------------------Other Expense: Total Other Expense for the years ended June 30, 2014 decreased by $209,791 to $798,456 from $1,008,247 for the year ended June 30, 2013 primarily as a result of a $121,886 decrease in equity in loss of investee company, a $39,270 decrease in interest expense, and a $45,896 decrease in other expense. Income Taxes (Benefit): The benefit for income taxes during the year ended June 30, 2014 decreased by $72,493 to $82,411 from $154,904 for the year ended June 30, 2013. Benefit for income taxes represents an estimate of a refundable research and development tax credit we expect to receive from the government of Australia for the fiscal year ended June 30, 2014 related to qualified expenditures we incurred during the year ended June 30, 2014. Net Loss: Our net loss for the year ended June 30, 2014 decreased by $3,023,497 to $8,855,418 from the $11,878,915 net loss for the year ended June 30, 2013. This decrease in loss was primarily the result of the increases in revenues related to a one-time upfront license fee under the Lotte Amended License Agreement and decrease in costs and expenses as described above. Liquidity and Capital Resources Since our inception, our research, advanced engineering and development, and operations have been primarily financed through debt and equity financings, and engineering, government and other research and development contracts. Total capital stock and paid in capital as of June 30, 2014 was $103,251,304. We had a cumulative deficit of $89,788,242 as of June 30, 2014 compared to a cumulative deficit of $80,932,824 as of June 30, 2013. At June 30, 2014 we had net working capital of $8,723,032 compared to a June 30, 2013 working capital deficit of $175,857. Our shareholders' equity as of June 30, 2014 and June 30, 2013, exclusive of noncontrolling interests, was $11,863,187 and $3,822,202, respectively. On March 19, 2014, the Company completed an underwritten public offering of its common stock at a price to the public of $2.25 per share. The Company sold a total of 6,325,000 shares of its common stock in the offering for aggregate proceeds of approximately $14.2 million. The Company received approximately $13.0 million of net proceeds from the offering, after deducting the underwriting discount and expenses. On September 26, 2013, the Company entered into a Securities Purchase Agreement with certain investors providing for the sale of 3,000 shares of Series B Convertible Preferred Stock (the "Preferred Stock"). Shares of Preferred Stock were sold for $1,000 per share (the "Stated Value") and accrue dividends on the Stated Value at an annual rate of 10%. At June 30, 2014 the Preferred Stock was convertible into a total of 2,918,942 shares of common stock of the Company ("Common Stock") at a conversion price equal to $0.95. Upon any liquidation, dissolution or winding up of the Corporation, holders of Preferred Stock are entitled to receive out of the assets of the Company an amount equal to two times the Stated Value, plus any accrued and unpaid dividends thereon. The net proceeds to the Company, after deducting $90,127 of offering costs, were $2,909,873. At June 30, 2014 the liquidation preference of the Preferred Stock was $5,347,994. At June 30, 2014, our principal sources of liquidity were our cash and cash equivalents which totaled $10,430,622, accounts receivable of $1,051,024, and expected collections on the Lotte R&D Agreement. On August 27, 2014, we completed an underwritten public offering of our common stock at a price to the public of $1.12 per share. We sold a total of 13,248,000 shares of our common stock in the offering for aggregate proceeds of approximately $14.2 million. We received approximately $13.5 million of net proceeds from the offering, after deducting the underwriting discount and expenses. We believe that cash and cash equivalents on hand, expected collections on the Lotte R&D Agreement and other potential sources of cash, will be sufficient to fund our current operations through fiscal year 2015. However, unless we are able to increase our revenues and achieve profitability we will likely require additional investment capital to fund our operations. If we are unable to obtain additional required funding, we may not be able to: · remain in operation; · execute our growth plan; · take advantage of future opportunities; or · respond to customers and competition. 20--------------------------------------------------------------------------------Operating Activities Our operating activities used net cash of $5,686,482 for the year ended June 30, 2014. Cash used in operations resulted from a net loss of $9,513,300 reduced by $2,782,433 in non-cash adjustments and by $1,044,385 in net changes to working capital. Non-cash adjustments included $962,361 of stock-based compensation expense, and $1,147,624 of depreciation and amortization expense. Net decreases in working capital were primarily due to increases in accounts receivable of $604,099 and accrued expenses of $1,872,642, offset by decreases in inventories of $1,219,306 and in customer deposits of $1,453,117. Investing Activities Our investing activities used net cash of $61,444 for the year ended June 30, 2014, primarily for purchases of property and equipment. Financing Activities Our financing activities provided net cash of $15,010,094 for the year ended June 30, 2014. Net cash provided by financing activities was comprised principally of $3,000,000 in proceeds from the issuance of preferred stock, less preferred stock issuance costs of $96,967, and $14,231,250 in proceeds from the issuance of common stock, less common stock issuance costs of $1,194,786. During the year ended June 30, 2014 we made repayments of $929,403 of principal on bank loans and notes payable. Off-Balance Sheet Arrangements We had no off-balance sheet arrangements as of June 30, 2014. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. 21-------------------------------------------------------------------------------- Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS ZBB ENERGY CORPORATION TABLE OF CONTENTS Page Report of Independent Registered Public Accounting Firm 24 Consolidated Balance Sheets as of June 30, 2014 and 2013 25 Consolidated Statements of Operations for the Years ended June 30, 2014 and 26 2013 Consolidated Statements of Comprehensive Loss for the Years ended June 30, 27 2014 and 2013 Consolidated Statements of Changes in Equity for the Years ended June 30, 28 2014 and 2013 Consolidated Statements of Cash Flows for the Years ended June 30, 2014 and 29 2013 Notes to Consolidated Financial Statements 30 22-------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders, Audit Committee and Board of Directors ZBB Energy Corporation Menomonee Falls, Wisconsin We have audited the accompanying consolidated balance sheets of ZBB Energy Corporation (the "Company") as of June 30, 2014 and 2013, and the related consolidated statements of operations, comprehensive loss, changes in equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of its internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ZBB Energy Corporation as of June 30, 2014 and 2013 and the results of its operations and cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 3 to the consolidated financial statements, the Company's recurring operating losses, operating cash flow deficits, and accumulated deficit of $89,788,242 raise substantial doubt about the Company's ability to continue as a going concern. In order to sustain continued operations and meet its obligations, the Company is dependent on the availability of future funding and achieving profitability. Management's plans in regard to these matters are also described in Note 3 to the consolidated financial statements. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Baker Tilly Virchow Krause, LLP Milwaukee, Wisconsin September 29, 2014 23-------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Consolidated Balance Sheets June 30, 2014 June 30, 2013 Assets Current assets: Cash and cash equivalents $ 10,360,721 $ 1,096,621 Restricted cash on deposit 69,901 60,000 Accounts receivable, net 1,051,024 446,925 Inventories, net 1,352,970 2,459,776 Prepaid expenses and other current assets 295,814 224,542 Refundable income tax credit 91,191 137,228 Total current assets 13,221,621 4,425,092 Long-term assets: Property, plant and equipment, net 4,382,203 5,179,707 Investment in investee company 1,646,240 2,304,122 Intangible assets, net - 411,073 Goodwill 803,079 803,079 Total assets $ 20,053,143 $ 13,123,073 Liabilities and Equity Current liabilities: Bank loans and notes payable $ 351,142 $ 885,786 Accounts payable 589,642 570,932 Accrued expenses 2,621,479 785,532 Customer deposits 741,145 2,194,262 Accrued compensation and benefits 195,181 164,437 Total current liabilities 4,498,589 4,600,949 Long-term liabilities: Bank loans and notes payable, net of current maturities 2,045,127 2,395,802 Total liabilities 6,543,716 6,996,751 Commitments and contingencies (Note 12) Equity Series B redeemable convertible preferred stock ($0.01 par value, $1,000 face value) 10,000,000 authorized, 3,000 and 0 shares issued, 2,575 and 0 shares outstanding, preference in liquidation of $5,347,994 and $0 as of June 30, 2014 and June 30, 2013, respectively 26 - Common stock ($0.01 par value); 150,000,000 authorized, 25,651,389 and 17,707,341 shares issued and outstanding as of June 30, 2014 and June 30, 2013, respectively 964,828 885,389 Additional paid-in capital 102,286,450 85,464,055 Accumulated deficit (89,788,242 ) (80,932,824 ) Accumulated other comprehensive loss (1,599,875 ) (1,594,418 ) Total ZBB Energy Corporation Equity 11,863,187 3,822,202 Noncontrolling interest 1,646,240 2,304,120 Total equity 13,509,427 6,126,322 Total liabilities and equity $ 20,053,143 $ 13,123,073 See accompanying notes to consolidated financial statements. 24-------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Consolidated Statements of Operations Year ended June 30, 2014 2013 Revenues Product sales $ 3,526,607 $ 7,305,516 Engineering and development 1,325,000 418,183 License 3,000,000 - Total Revenues 7,851,607 7,723,699 Costs and Expenses Cost of product sales 2,895,547 6,275,277 Cost of engineering and development 206,102 153,762 Advanced engineering and development 5,244,953 5,266,418 Selling, general, and administrative 7,259,683 6,235,508 Depreciation and amortization 1,042,577 1,392,033 Total Costs and Expenses 16,648,862 19,322,998 Income (Loss) from Operations (8,797,255 ) (11,599,299 ) Other Income (Expense) Equity in loss of investee company (657,882 ) (779,768 ) Interest income 5,635 2,896 Interest expense (147,105 ) (186,375 ) Other income (expense) 896 (45,000 ) Total Other Income (Expense) (798,456 ) (1,008,247 ) Loss before benefit for Income Taxes (9,595,711 ) (12,607,546 ) Benefit for Income Taxes (82,411 ) (154,904 ) Net loss (9,513,300 ) (12,452,642 ) Net loss attributable to noncontrolling interest 657,882 573,727 Net Income (Loss) Attributable to ZBB Energy Corporation (8,855,418 ) (11,878,915 ) Preferred Stock Dividend (222,009 ) - Net Loss Attributable to Common Shareholders $ (9,077,427 ) $ (11,878,915 ) Net Loss per share Basic and diluted $ (0.46 ) $ (0.74 ) Weighted average shares-basic and diluted 19,853,579 16,082,001 See accompanying notes to consolidated financial statements. 25-------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Consolidated Statements of Comprehensive Loss Year ended June 30, 2014 2013 Net loss $ (9,513,300 ) $ (12,452,642 ) Foreign exchange translation adjustments (5,457 ) (9,497 ) Comprehensive loss (9,518,757 ) (12,462,139 ) Net loss attributable to noncontrolling interest 657,882 573,727 Comprehensive Loss Attributable to ZBB Energy Corporation $ (8,860,875 ) $ (11,888,412 ) See accompanying notes to consolidated financial statements. 26 -------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Consolidated Statements of Changes in Equity Accumulated Series B Preferred Stock Common Stock Other Additional Accumulated Comprehensive Noncontrolling Shares Amount Shares Amount Paid-in Capital Deficit (Loss) Interest Balance: June 30, 2012 - $ - 14,595,120 $ 729,773 $ 80,363,519 $ (69,053,909 ) $ (1,584,921 ) $ 2,872,348 Net loss (11,878,915 ) (573,727 ) Net currency translation adjustment (9,497 ) Issuance of common stock, net of costs and underwriting fees 3,112,311 155,616 4,315,276 Stock-based compensation 785,260 Issuance of subsidiary shares to noncontrolling interest 5,500 Balance: June 30, 2013 - - 17,707,431 885,389 85,464,055 (80,932,824 ) (1,594,418 ) 2,304,121 Net loss (8,855,418 ) (657,882 ) Net currency translation adjustment (5,457 ) Issuance of common stock, net of costs and underwriting fees 6,325,000 63,250 12,973,214 Stock-based compensation 245,570 2,456 959,905 Issuance of preferred stock, net of costs and underwriting fees 3,000 30 2,388,756 Conversion of preferred stock (425 ) (4 ) 470,171 4,701 (4,696 ) Issuance of warrants 498,793 Issuance of warrants to underwriter 15,455 Exercise of warrants 903,217 9,032 (9,032 ) Balance: June 30, 2014 2,575 $ 26 25,651,389 $ 964,828 $ 102,286,450 $ (89,788,242 ) $ (1,599,875 ) $ 1,646,240 See accompanying notes to consolidated financial statements. 27-------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Consolidated Statements of Cash Flows Year ended June 30, 2014 2013 Cash flows from operating activities Net loss $ (9,513,300 ) $ (12,452,642 ) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation of property, plant and equipment 736,551 798,424 Amortization of intangible assets 411,073 732,049 Stock-based compensation 962,361 785,260 Equity in loss of investee company 657,882 779,768 Amortization of discounts and debt issuance costs on notes payable 14,566 14,566 Non-cash expense attributed to accretion of note payable - 45,000 Changes in assets and liabilities Accounts receivable, net (604,099 ) 33,638 Inventories 1,219,306 96,445 Prepaids and other current assets (85,838 ) (51,660 ) Refundable income taxes 46,037 48,317 Accounts payable 18,710 (1,328,097 ) Accrued compensation and benefits 30,744 (170,932 ) Accrued expenses 1,872,642 (467,475 ) Customer deposits (1,453,117 ) 878,953 Net cash used in operating activities (5,686,482 ) (10,258,386 ) Cash flows from investing activities Proceeds (expenditures) for property and equipment (51,543 ) (137,601 ) Deposits of restricted cash (9,901 ) - Net cash used in investing activities (61,444 ) (137,601 ) Cash flows from financing activities Proceeds from issuance of notes payable - 938,250 Repayments of bank loans and notes payable (929,403 ) (1,654,593 ) Debt issuance costs - (29,113 ) Proceeds from issuance of preferred stock and warrants 3,000,000 - Preferred stock issuance costs (96,967 ) - Proceeds from issuance of common stock 14,231,250 4,648,499 Common stock issuance costs (1,194,786 ) (177,607 ) Proceeds from noncontrolling interest - 5,500 Net cash provided by financing activities 15,010,094 3,730,936 Effect of exchange rate changes on cash and cash equivalents 1,932 (1,545 ) Net increase (decrease) in cash and cash equivalents 9,264,100 (6,666,596 ) Cash and cash equivalents - beginning of period 1,096,621 7,763,217 Cash and cash equivalents - end of period $ 10,360,721 $ 1,096,621 Cash paid for interest $ 147,106 $ 173,876 Cash received from foreign income tax credit 133,996 198,309 Supplemental non-cash investing and financing activities: Inventory transferred to assets held for lease $ - $ 355,986 Interest deferred and added to principal balance of note payabe - 44,084 See accompanying notes to consolidated financial statements. 28-------------------------------------------------------------------------------- ZBB ENERGY CORPORATION Notes to Consolidated Financial Statements June 30, 2014 and 2013 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business ZBB Energy Corporation ("ZBB," "we," "us," "our" or the "Company") develops, licenses, and manufactures distributed energy storage solutions based upon the Company's proprietary zinc bromide rechargeable electrical energy storage technology and proprietary power electronics systems. ZBB was incorporated in Wisconsin in 1998 and is headquartered in Wisconsin, USA with offices also located in Perth, Western Australia. The Company provides advanced electrical power management platforms targeted at the growing global need for distributed renewable energy, energy efficiency, power quality, and grid modernization. The Company has developed a portfolio of intelligent power management platforms that directly integrate multiple renewable and conventional onsite generation sources with rechargeable zinc bromide flow batteries and other storage technology. The Company also offers advanced systems to directly connect wind and solar equipment to the grid and systems that can form various levels of micro-grids, hybrid vehicle control systems, and power quality regulation solutions. Together, these platforms provide a wide range of renewable energy system solutions in global markets for utility, governmental, commercial, industrial and residential customers. The consolidated financial statements include the accounts of the Company and those of its wholly-owned subsidiary ZBB Energy Pty Ltd. (formerly known as ZBB Technologies, Ltd.) which has an advanced engineering and development facility in Perth, Australia, and its sixty percent owned subsidiary ZBB PowerSav Holdings Limited located in Hong Kong which was formed in connection with the Company's investment in a China joint venture. Basis of Presentation The accompanying consolidated financial statements include the accounts of the Company and its wholly and majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States ("US GAAP"). All significant intercompany accounts and transactions have been eliminated in consolidation. Fair Value of Financial Instruments The Company's financial instruments consist of cash and cash equivalents, restricted cash on deposit, accounts receivable, accounts payable, and bank loans and notes payable. The carrying amounts of the Company's financial instruments approximate their respective fair values due to the relatively short-term nature of these instruments, except for bank loans and notes payable. The carrying amount of the bank loans and notes payable approximates fair value due to the interest rate and terms approximating those available to us for similar obligations. The Company accounts for the fair value of financial instruments in accordance with Accounting Standards Codification ("ASC") 820. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The degree of judgment utilized in measuring the fair value of assets and liabilities generally correlates to the level or pricing observability. ASC 820 describes a fair value hierarchy based on the following three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. Level 2 inputs are inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly, for similar assets or liabilities in active markets. Level 3 inputs are unobservable inputs for the asset or liability and such the prices or valuation techniques require inputs that are both significant to the fair value measurement and are unobservable. Cash and Cash Equivalents The Company considers all highly liquid investments with maturities of three months or less to be cash equivalents. The Company maintains its cash deposits in fully insured accounts at financial institutions predominately in the United States, Australia, and Hong Kong. The Company has not experienced any losses in such accounts. 29--------------------------------------------------------------------------------Restricted Cash on Deposit The Company had $69,901 and $60,000 in restricted cash on deposit as of June 30, 2014 and June 30, 2013, respectively, as collateral for certain credit arrangements. Accounts Receivable Credit is extended based on an evaluation of a customer's financial condition. Accounts receivable are stated at the amount the Company expects to collect from outstanding balances. The Company records allowances for doubtful accounts based on customer-specific analysis and general matters such as current assessments of past due balances and economic conditions. The Company writes off accounts receivable against the allowance when they become uncollectible. Accounts receivable are stated net of an allowance for doubtful accounts of $10,878 and $0 as of June 30, 2014 and June 30, 2013, respectively. The composition of accounts receivable by aging category is as follows as of June 30, 2014 and June 30, 2013: As of June 30, 2014 2013 Current $ 902,545 $ 236,296 30-60 days - 50,000 60-90 days - - Over 90 days 148,479 160,629 Total $ 1,051,024 $ 446,925 Inventories Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. The Company provides inventory write-downs based on excess and obsolete inventories determined primarily by future demand forecasts. The write-down is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and charged to the provision for inventory, which is a component of cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Property, Plant and Equipment Land, building, equipment, computers, furniture and fixtures are recorded at cost. Maintenance, repairs and betterments are charged to expense as incurred. Depreciation is provided for all plant and equipment on a straight-line basis over the estimated useful lives of the assets. The estimated useful lives used for each class of depreciable asset are: Estimated Useful Lives Manufacturing equipment 3 - 7 years Office equipment 3 - 7 years Assets held for lease 18 months Building and improvements 7 - 40 years The Company completed a review of the estimated useful lives of specific assets for the year ended June 30, 2014 and determined that there were no changes in the estimated useful lives of assets. Investment in Investee Company Investee companies that are not consolidated, but over which the Company exercises significant influence, are accounted for under the equity method of accounting. Whether or not the Company exercises significant influence with respect to an investee depends on an evaluation of several factors including, among others, representation on the investee company's board of directors and ownership level, which is generally a 20% to 50% interest in the voting securities of the investee company. Under the equity method of accounting, an investee company's accounts are not reported in the Company's consolidated balance sheets and statements of operations; however, the Company's share of the earnings or losses of the investee company is reflected in the caption ''Equity in loss of investee company" in the consolidated statements of operations. The Company's carrying value in an equity method investee company is reported in the caption ''Investment in investee company'' in the Company's consolidated balance sheets. When the Company's carrying value in an equity method investee company is reduced to zero, no further losses are recorded in the Company's consolidated financial statements unless the Company guaranteed obligations of the investee company or has committed additional funding. When the investee company subsequently reports income, the Company will not record its share of such income until it equals the amount of its share of losses not previously recognized. 30 --------------------------------------------------------------------------------Intangible Assets Intangible assets generally result from business acquisitions. The Company accounted for the acquisition of substantially all of the net assets of Tier Electronics LLC by assigning the purchase price to identifiable tangible and intangible assets and liabilities. Assets acquired and liabilities assumed were recorded at their estimated fair values. Intangible assets consist of a non-compete agreement, license agreement, and trade secrets. Amortization is recorded for intangible assets with determinable lives. Intangible assets are amortized using the straight-line method over the three year estimated useful lives of the respective assets. Goodwill Goodwill is recognized as the excess cost of an acquired entity over the net amount assigned to assets acquired and liabilities assumed. Goodwill is not amortized but reviewed for impairment annually as of June 30 or more frequently if events or changes in circumstances indicate that its carrying value may be impaired. These conditions could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. The first step of the impairment test requires the comparing of a reporting unit's fair value to its carrying value. If the carrying value is less than the fair value, no impairment exists and the second step is not performed. If the carrying value is higher than the fair value, there is an indication that impairment may exist and the second step must be performed to compute the amount of the impairment. In the second step, the impairment is computed by estimating the fair values of all recognized and unrecognized assets and liabilities of the reporting unit and comparing the implied fair value of reporting unit goodwill with the carrying amount of that unit's goodwill. The Company determined fair value as evidenced by market capitalization, and concluded that there was no need for an impairment charge as of June 30, 2014 and June 30, 2013. Impairment of Long-Lived Assets In accordance with Financial Accounting Standards Board ("FASB") ASC Topic 360, "Impairment or Disposal of Long-Lived Assets," the Company assesses potential impairments to its long-lived assets including property, plant, equipment and intangible assets when there is evidence that events or changes in circumstances indicate that the carrying value may not be recoverable. If such an indication exists, the recoverable amount of the asset is compared to the asset's carrying value. Any excess of the asset's carrying value over its recoverable amount is expensed in the statement of operations. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate. Management has determined that there were no long-lived assets impaired as of June 30, 2014 and June 30, 2013 (see Notes 5 and 6). Accrued Expenses Accrued expenses consist of the Company's present obligations related to various expenses incurred during the period and includes a reserve for estimated contract losses, other accrued expenses, and warranty obligations. The increase of approximately $1.8 million to $2,621,479 at June 30, 2014 from $785,532 at June 30, 2013 is principally the result of the Company's product upgrade initiative established late in the fourth quarter of fiscal 2014. The total estimated remaining liability of the product upgrade initiative is approximately $1.7 million. Of the $1.7 million approximately $807,000 was recorded as a reserve for estimated contract losses for projects in process at year end, another $746,000 was recorded as other accrued expenses for estimated costs to be incurred on projects outside the warranty period, and the remaining $147,000 estimated for projects within the warranty period are accounted for in the Company's current warranty obligation reserve. Subsequent to commercialization, installation and commissioning of units in the field, the Company garnered meaningful insights that have resulted in system design modifications and other general upgrades that have improved the performance, efficiency, and reliability of its systems. In the interest of enhancing customer satisfaction, the Company launched the product upgrade initiative to implement these improvements at certain locations of its installed base over fiscal 2015. Warranty Obligations The Company typically warrants its products for twelve months after installation or eighteen months after date of shipment, whichever first occurs. Warranty costs are provided for estimated claims and charged to cost of product sales as revenue is recognized. Warranty obligations are also evaluated quarterly to determine a reasonable estimate for the replacement of potentially defective materials of all energy storage systems that have been shipped to customers. 31 -------------------------------------------------------------------------------- While the Company actively engages in monitoring and improving its evolving battery and production technologies, there is only a limited product history and relatively short time frame available to test and evaluate the rate of product failure. Should actual product failure rates differ from the Company's estimates, revisions are made to the estimated rate of product failures and resulting changes to the liability for warranty obligations. In addition, from time to time, specific warranty accruals may be made if unforeseen technical problems arise. As of June 30, 2014 and June 30, 2013, included in the Company's accrued expenses were $731,910 and $479,873 respectively, related to warranty obligations. Such amounts are included in accrued expenses in the accompanying consolidated balance sheets. The following is a summary of accrued warranty activity: Year ended June 30, 2014 2013 Beginning balance $ 479,873 $ 418,557 Accruals for warranties during the period 741,412 404,096 Settlements during the period (673,588 ) (95,543 ) Adjustments relating to preexisting warranties 184,213 (247,237 ) Ending balance $ 731,910 $ 479,873 Revenue Recognition Revenues are recognized when persuasive evidence of a contractual arrangement exits, delivery has occurred or services have been rendered, the seller's price to buyer is fixed and determinable, and collectability is reasonably assured. The portion of revenue related to installation and final acceptance, is deferred until such installation and final customer acceptance are completed. From time to time, the Company may enter into separate agreements at or near the same time with the same customer. The Company evaluates such agreements to determine whether they should be accounted for individually as distinct arrangements or whether the separate agreements are, in substance, a single multiple element arrangement. The Company evaluates whether the negotiations are conducted jointly as part of a single negotiation, whether the deliverables are interrelated or interdependent, whether the fees in one arrangement are tied to performance in another arrangement, and whether elements in one arrangement are essential to another arrangement. The Company's evaluation involves significant judgment to determine whether a group of agreements might be so closely related that they are, in effect, part of a single arrangement. Our collaboration agreements typically involve multiple elements or deliverables, including upfront fees, contract research and development, milestone payments, technology licenses or options to obtain technology licenses, and royalties. For these arrangements, revenues are recognized in accordance with FASB ASC 605-25, Revenue Recognition - Multiple Element Arrangements. The Company's revenues associated with multiple element contracts is based on the selling price hierarchy, which utilizes vendor-specific objective evidence ("VSOE") when available, third-party evidence ("TPE") if VSOE is not available, and if neither is available then the best estimate of the selling price is used. The Company utilizes best estimate for its multiple deliverable transactions as VSOE and TPE do not exist. To be considered a separate element, the product or service in question must represent a separate unit under SEC Staff Accounting Bulletin 104, and fulfill the following criteria: the delivered item(s) has value to the customer on a standalone basis; there is objective and reliable evidence of the fair value of the undelivered item(s); and if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. For arrangements containing multiple elements, revenue from time and materials based service arrangements is recognized as the service is performed. Revenue relating to undelivered elements is deferred at the estimated fair value until delivery of the deferred elements. If the arrangement does not meet all criteria above, the entire amount of the transaction is deferred until all elements are delivered. The portion of revenue related to engineering and development is recognized ratably upon delivery of the goods or services pertaining to the underlying contractual arrangement or revenue is recognized as certain activities are performed by the Company over the estimated performance period. The Company charges shipping and handling fees when products are shipped or delivered to a customer, and includes such amounts in net revenues. The Company reports its revenues net of estimated returns and allowances. Revenues from government funded research and development contracts are recognized proportionally as costs are incurred and compared to the estimated total research and development costs for each contract. In many cases, the Company is reimbursed only a portion of the costs incurred or to be incurred on the contract. Government funded research and development contracts are generally multi-year, cost-reimbursement and/or cost-share type contracts. The Company is generally reimbursed for reasonable and allocable costs up to the reimbursement limits set by the contract. 32-------------------------------------------------------------------------------- Total revenues of $7,851,607 and $7,723,699 were recognized for the years ended June 30, 2014 and June 30, 2013, respectively. For the year ended June 30, 2014 two significant customers comprised 66% and 11% of total revenues. For the year ended June 30, 2013 four significant customers comprised 20%, 15%, 15%, and 13% of total revenues. The Company had three significant customers with outstanding accounts receivable balances of $375,000, $365,000, and $188,000 (35%, 35%, and 18% of accounts receivable, net) and two significant customers with outstanding accounts receivable balances of $148,479 and $146,200 (33% and 33% of accounts receivable, net) at June 30, 2014 and June 30, 2013, respectively. Engineering, Development, and License Revenues We assess whether a substantive milestone exists at the inception of our agreements. In evaluating if a milestone is substantive we consider whether: · Substantive uncertainty exists as to the achievement of the milestone event at the inception of the arrangement; · The achievement of the milestone involves substantive effort and can only be achieved based in whole or in part on our performance or the occurrence of a specific outcome resulting from our performance; · The amount of the milestone payment appears reasonable either in relation to the effort expended or the enhancement of the value of the delivered item(s); · There is no future performance required to earn the milestone; and · The consideration is reasonable relative to all deliverables and payment terms in the arrangement. If any of these conditions are not met, we do not consider the milestone to be substantive and we defer recognition of the milestone payment and recognize it as revenue over the estimated period of performance, if any. On December 13, 2011, the Company entered into a joint development and license agreement with a global technology company to jointly develop flow batteries. The objective of the joint development agreement is to develop low cost, high energy density grid scale flow battery stacks and systems that could lead to a significant cost reduction for grid level storage. The Company recognizes revenue under this agreement upon achievement of certain performance milestones. The Company recognized $200,000 and $400,000 of revenue under this agreement for the years ended June 30, 2014 and June 30, 2013, respectively. On April 8, 2011, the Company entered into a Collaboration Agreement (the "Collaboration Agreement") with Honam Petrochemical Corporation, now known as Lotte Chemical Corporation ("Lotte"), pursuant to which the Company and Lotte collaborated on the technical development of the Company's third generation Zinc Bromide flow battery module (the "Version 3 Battery Module") and Lotte received a fully paid-up, exclusive and royalty-free license to sell and manufacture the Version 3 Battery Module in Korea and a non-exclusive royalty-bearing license to sell the Version 3 Battery Module in Japan, Thailand, Taiwan, Malaysia, Vietnam and Singapore. On December 16, 2013, the Company and Lotte entered into a Research and Development Agreement (the "R&D Agreement") pursuant to which the Company has agreed to develop and provide to Lotte a Zinc Bromide chemical flow battery system, including a Zinc Bromide chemical flow battery module and related software (the "Product"), on the terms and conditions set forth in the R&D Agreement (the "Project"). The Project is scheduled to continue until December 16, 2015, unless extended by the mutual agreement of the Company and Lotte. Subject to the satisfaction of certain specified milestones, Lotte is required to make payments to the Company under the R&D Agreement totaling $3,000,000 over the term of the Project. ZBB will recognize revenue based upon a Performance Based Method pursuant to the model described in FASB ASC 980-605-25, where revenue is recognized based on the lesser of the amount of nonrefundable cash received or the amounts due based on the proportional amount of the total effort expected to be expended on the contract that has been provided to date as there does not exist substantial doubt that the milestones will be achieved. The Company recognized $1,125,000 of revenue under this agreement in the year ended June 30, 2014 and $0 in the year ended June 30, 2013. Additionally, on December 16, 2013, the Company and Lotte entered into an Amended License Agreement (the "Amended License"). Pursuant to the Amended License Agreement, the Company granted to Lotte, (1) an exclusive and royalty-free limited license in Korea to use the Company's Zinc Bromide flow battery module, Zinc Bromide flow battery stack and the technical information and know how related to the intellectual property arising from the Project (collectively, the "Technology") to manufacture or sell a Zinc Bromide flow battery (the "Lotte Product") in Korea and (2) a non-exclusive (a) royalty-free limited license for Lotte and its affiliates to use the Technology internally in all locations other than China and Korea to manufacture the Lotte Product and (b) royalty-bearing limited license to sell the Lotte Product in all locations other than China, the United States and Korea. Lotte is required to pay the Company a total license fee of $3,000,000 under the Amended License Agreement plus up to an additional $1,000,000 if certain specific milestones are successfully achieved. In addition, Lotte is required to make ongoing royalty payments to the Company equal to a single digit percentage of Lotte's sales of the Lotte Product outside of Korea until December 31, 2019. The license fees are subject to a 16.5% non-refundable Korea withholding tax. The Company recognized $3,000,000 of a one-time upfront license fee in revenue under this agreement in the year ended June 30, 2014 and $0 in the year ended June 30, 2013. Overall, there were $3,750,000 of payments received and $4,125,000 of revenue recognized under the Lotte agreements in the year ended June 30, 2014. 33 -------------------------------------------------------------------------------- Included in engineering and development revenues were $1,325,000 and $400,000 for the years ended June 30, 2014 and June 30, 2013, respectively, related to collaborative agreements. Engineering and development costs related to the collaboration agreements totaled $206,102 and $153,762 for the years ended June 30, 2014 and June 30, 2013, respectively. As of June 30, 2014 and June 30, 2013, the Company had no unbilled amounts from engineering and development contracts in process. The Company had received $0 and $45,300 in customer payments for engineering and development contracts, representing deposits in advance of performance of the contracted work, as of June 30, 2014 and June 30, 2013, respectively. Advanced Engineering and Development Expenses The Company expenses advanced engineering and development costs as incurred. These costs consist primarily of labor, overhead, and materials to build prototype units, materials for testing, development of manufacturing processes and include consulting fees and other costs. To the extent these costs are separately identifiable, incurred and funded by advanced engineering and development type agreements with outside parties, they are shown separately on the consolidated statements of operations as a "Cost of engineering and development." Stock-Based Compensation The Company measures all "Share-Based Payments," including grants of stock options, restricted shares and restricted stock units to be recognized in its consolidated statement of operations based on their fair values on the grant date, which is consistent with FASB ASC Topic 718, "Stock Compensation," guidelines. Accordingly, the Company measures share-based compensation cost for all share-based awards at the fair value on the grant date and recognition of share-based compensation over the service period for awards that are expected to vest. The fair value of stock options is determined based on the number of shares granted and the price of the shares at grant, and calculated based on the Black-Scholes valuation model. The Company compensates its outside directors primarily with restricted stock units ("RSUs") rather than cash. The grant date fair value of the restricted stock unit awards is determined using the closing stock price of the Company's common stock on the day prior to the date of the grant, with the compensation expense amortized over the vesting period of restricted stock unit awards, net of estimated forfeitures. The Company only recognizes expense to its statements of operations for those options or shares that are expected ultimately to vest, using two attribution methods to record expense, the straight-line method for grants with only service-based vesting or the graded-vesting method, which considers each performance period, for all other awards. See Note 9. Advertising Expense Advertising costs of $66,086 and $167,166 for the years ended June 30, 2014 and June 30, 2013, respectively, were charged to selling, general, and administrative expenses as incurred. Income Taxes The Company records deferred income taxes in accordance with FASB ASC Topic 740, "Accounting for Income Taxes." This ASC Topic requires recognition of deferred income tax assets and liabilities for temporary differences between the tax basis of assets and liabilities and the amounts at which they are carried in the financial statements, based upon the enacted tax rates in effect for the year in which the differences are expected to reverse. The Company establishes a valuation allowance when necessary to reduce deferred income tax assets to the amount expected to be realized. There were no net deferred income tax assets recorded as of June 30, 2014 and June 30, 2013. The Company applies a more-likely-than-not recognition threshold for all tax uncertainties as required under FASB ASC Topic 740, which only allows the recognition of those tax benefits that have a greater than fifty percent likelihood of being sustained upon examination by the taxing authorities. The Company's U.S. Federal income tax returns for the years ended June 30, 2010 through June 30, 2014 and the Company's Wisconsin and Australian income tax returns for the years ended June 30, 2011 through June 30, 2014 are subject to examination by taxing authorities. 34 --------------------------------------------------------------------------------Foreign Currency The Company uses the United States dollar as its functional and reporting currency, while the Australian dollar and Hong Kong dollar are the functional currencies of its foreign subsidiaries. Assets and liabilities of the Company's foreign subsidiaries are translated into United States dollars at exchange rates that are in effect at the balance sheet date while equity accounts are translated at historical exchange rates. Income and expense items are translated at average exchange rates which were applicable during the reporting period. Translation adjustments are accumulated in accumulated other comprehensive loss as a separate component of equity in the consolidated balance sheets. Loss per Share The Company follows the FASB ASC Topic 260, "Earnings per Share," provisions which require the reporting of both basic and diluted earnings (loss) per share. Basic earnings (loss) per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings (net loss) per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. In accordance with the FASB ASC Topic 260, any anti-dilutive effects on net income (loss) per share are excluded. For the years ended June 30, 2014 and 2013 there were 8,618,574 and 3,338,776 shares of common stock underlying convertible preferred stock, options, restricted stock units and warrants that are excluded, respectively. Concentrations of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and accounts receivable. The Company maintains significant cash deposits primarily with three financial institutions. All deposits are fully insured as of June 30, 2014. The Company has not previously experienced any losses on such deposits. Additionally, the Company performs periodic evaluations of the relative credit ratings of these institutions as part of its banking strategy. Concentrations of credit risk with respect to accounts receivable are limited due to accelerated payment terms in current customer contracts and creditworthiness of the current customer base. Use of Estimates The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. It is reasonably possible that the estimates we have made may change in the near future. Significant estimates underlying the accompanying consolidated financial statements include those related to: · the timing of revenue recognition; · the allowance for doubtful accounts; · provisions for excess and obsolete inventory; · the lives and recoverability of property, plant and equipment and other long-lived assets, including goodwill and other intangible assets; · contract costs, losses, and reserves; · warranty obligations; · income tax valuation allowances; · stock-based compensation; and · valuation of warrants. Reclassifications Certain amounts previously reported have been reclassified to conform to the current presentation. Segment Information The Company has determined that it operates as one reportable segment. 35 --------------------------------------------------------------------------------Recent Accounting Pronouncements From time to time, new accounting pronouncements are issued by the FASB or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption. In August 2014, the FASB issued ASU 2014-15 - Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern (Subtopic 205-40). The update requires management to perform a going concern assessment if there is substantial doubt about an entity's ability to continue as a going concern within one year of the financial statement issuance date. Under the new standard, the definition of substantial doubt incorporates a likeliness threshold of "probable" that is consistent with the current use of the term defined in US GAAP for loss contingencies (Topic 450 - Contingencies). Management will need to consider conditions that are known and reasonably knowable at the financial statement issuance date and determine whether the entity will be able to meet its obligations within the one-year period. Additional disclosures are required if it is probable that the entity will be unable to meet its current obligations. The amendments in this ASU will be effective for annual periods ending after December 15, 2016. Early adoption is permitted. The Company does not expect adoption of this guidance will have a significant impact on its consolidated financial statements. In June 2014, the FASB issued ASU 2014-12 - Compensation - Stock Compensation (Topic 718). The amendments require that entities should treat performance targets that can be met after the requisite service period of a share-based payment award as performance conditions that affect vesting and, accordingly, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation expense should be recognized in the period in which it becomes probable that the performance target will be achieved. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. The Company is required to adopt this standard beginning July 1, 2016. ASU 2014-12 does not contain any new disclosure requirements. The Company does not expect the adoption of ASU 2014-14 to have a material effect on our financial position, results of operations or cash flows. In May 2014, the FASB issued ASU 2014-09 - Revenue from Contracts with Customers (Topic 606). The amendments outline a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersede most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the revenue model to contracts within its scope, an entity identifies the contract(s) with a customer, identifies the performance obligations in the contract, determines the transaction price, allocates the transaction price to the performance obligations in the contract and recognizes revenue when the entity satisfies a performance obligation. ASU 2014-09, which includes additional disclosure requirements regarding revenue, cash flows and obligations related to contracts with customers, will be effective for annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The guidance permits companies to either apply the requirements retrospectively to all prior periods presented, or apply the requirements in the year of adoption, through a cumulative adjustment. The Company is currently evaluating the effect that implementation of this update will have on its consolidated financial position and results of operations upon adoption. In April 2014, the FASB issued ASU 2014-08 - Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The update changes the requirements for reporting discontinued operations in Subtopic 205-20. To be classified as a discontinued operation, the disposal of a component or group of components must represent a strategic shift that has, or will have, a major effect on an entity's operations and financial results. Examples include a disposal of a major geographic area, a major line of business or a major equity method investment. The amendments in this ASU are effective prospectively for reporting periods beginning on or after December 15, 2014, with early adoption permitted. The adoption of this standard update affects presentation only and, as such, is not expected to have a material impact on the Company's consolidated financial statements. In July 2013, the FASB issued ASU 2013-11 - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which requires an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, similar tax loss, or a tax credit carryforward. To the extent the tax benefit is not available at the reporting date under the governing tax law or if the entity does not intend to use the deferred tax asset for such purpose, the unrecognized tax benefit should be presented as a liability and not combined with deferred tax assets. ASU 2013-11 is effective for annual periods, and interim periods within those years, beginning after December 15, 2013. The amendments are to be applied to all unrecognized tax benefits that exist as of the effective date and may be applied retrospectively to each prior reporting period presented. The Company expects no material impact to its financial statements as a result of adopting this pronouncement. In April 2013, the FASB issued ASU 2013-07 - Presentation of Financial Statements (Topic 205) - Liquidation Basis of Accounting. The amendments require an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is imminent. Liquidation is imminent when the likelihood is remote that the entity will return from liquidation and either (a) a plan for liquidation is approved by the person or persons with the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties or (b) a plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy). If a plan for liquidation was specified in the entity's governing documents from the entity's inception (for example, limited-life entities), the entity should apply the liquidation basis of accounting only if the approved plan for liquidation differs from the plan for liquidation that was specified at the entity's inception. The amendments require financial statements prepared using the liquidation basis of accounting to present relevant information about an entity's expected resources in liquidation by measuring and presenting assets at the amount of the expected cash proceeds from liquidation. The entity should include in its presentation of assets any items it had not previously recognized under US GAAP but that it expects to either sell in liquidation or use in settling liabilities (for example, trademarks). The amendments are effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein. Entities should apply the requirements prospectively from the day that liquidation becomes imminent. Early adoption is permitted. The adoption is not expected to have an impact on the Company's consolidated financial statements in its present condition. 36-------------------------------------------------------------------------------- In March 2013, the FASB issued ASU 2013-05 - Foreign Currency Matters (Topic 830) - Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Group of Assets within a Foreign Entity or of an Investment in a Foreign Entity. These amendments provide guidance on releasing cumulative translation adjustments when a reporting entity (parent) ceases to have a controlling financial interest in a subsidiary or a group of assets that is a non-profit activity or a business within a foreign entity. In addition, these amendments provide guidance on the release of cumulative translation adjustments in partial sales of equity method investments and in step acquisitions. The amendments are effective for fiscal years and interim reporting periods within those years, beginning after December 15, 2013. The amendments should be applied prospectively to derecognition events occurring after the effective date. Prior periods should not be adjusted. Early adoption is permitted. If an entity elects to early adopt the amendments, it should apply them as of the beginning of the entity's fiscal year of adoption. The Company is required to adopt this standard beginning July 1, 2014. The Company does not anticipate these changes to have an impact on its consolidated financial statements. In February 2013, the FASB issued ASU 2013-04 - Liabilities (Topic 405) - Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date. These amendments provide guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date, except for obligations addressed within existing guidance in U.S. GAAP. Examples of obligations within this guidance are debt arrangements, other contractual obligations, and settled litigation and judicial rulings. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. These amendments shall be applied retrospectively to all prior periods presented for those obligations within the scope of this Subtopic that exist at the beginning of an entity's fiscal year of adoption. Early adoption is permitted. The adoption of these amendments is not expected to have a material effect on the Company's consolidated financial statements. In February 2013, the FASB issued ASU No. 2013-02 - Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under US GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under US GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under US GAAP that provide additional detail about those amounts. This guidance is effective prospectively for reporting periods beginning after December 15, 2012. The Company adopted this guidance in the third quarter of fiscal year 2013. This new guidance did not impact the Company's presentation, financial position, and results of operations. In July 2012, the FASB issued ASC update No. 2012-02 - Intangibles - Goodwill and Other (Topic 350), Testing Indefinite-Lived Intangible Assets for Impairment ("ASC 2012-02"). Under the amendments in this update, a company has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. If after assessing the qualitative factors, a company determines it does not meet the more-likely-than-not threshold, a company is required to perform the quantitative impairment test by calculating the fair value of an indefinite-lived intangible asset and comparing the fair value with the carrying amount of the asset. The amendments in this update were effective for annual and interim impairment test performed for fiscal years beginning after September 15, 2012 (early adoption permitted). The Company adopted this guidance in the second quarter of fiscal year 2013. The adoption of this update had no impact on its financial statements. NOTE 2 - CHINA JOINT VENTURE On August 30, 2011, the Company entered into agreements providing for establishment of a joint venture to develop, produce, sell, distribute and service advanced storage batteries and power electronics in China (the "Joint Venture"). Joint Venture partners include ZBB PowerSav Holdings Limited ("Holdco"), AnHui Xinlong Electrical Co. and Wuhu Huarui Power Transmission and Transformation Engineering Co. The Joint Venture was established upon receipt of certain governmental approvals from China which were received in November 2011. 37 -------------------------------------------------------------------------------- The Joint Venture operates through a jointly-owned Chinese company located in Wuhu City, Anhui Province named Anhui Meineng Store Energy Co., Ltd. ("Meineng Energy"). Meineng Energy intends to initially assemble and ultimately manufacture the Company's products for sale in the power management industry on an exclusive basis in mainland China and on a non-exclusive basis in Hong Kong and Taiwan. The Company's President and Chief Operating Officer ("President and COO") has served as the Chief Executive Officer of Meineng Energy since December 2011. The President and COO owns an indirect 6% equity interest in Meineng Energy. In connection with the Joint Venture, on August 30, 2011 the Company and certain of its subsidiaries entered into the following agreements: · Joint Venture Agreement of Anhui Meineng Store Energy Co., Ltd. (the "China JV Agreement") by and between ZBB PowerSav Holdings Limited, a Hong Kong limited liability company ("Holdco"), and Anhui Xinrui Investment Co., Ltd, a Chinese limited liability company; and · Limited Liability Company Agreement of ZBB PowerSav Holdings Limited by and between ZBB Cayman Corporation and PowerSav New Energy Holdings Limited (the "Holdco Agreement"). In connection with the Joint Venture, upon establishment of Meineng Energy, the Company and certain of its subsidiaries entered into the following agreements: · Management Services Agreement by and between Meineng Energy and Holdco (the "Management Services Agreement"); · License Agreement by and between Holdco and Meineng Energy (the "License Agreement"); and · Research and Development Agreement by and between the Company and Meineng Energy (the "Research and Development Agreement"). Pursuant to the China JV Agreement, Meineng Energy was capitalized with approximately $13.6 million of equity capital. The Company's only capital contributions to the Joint Venture were the contribution of technology to Meineng Energy via the License Agreement and $200,000 in cash. The Company's indirect interest in Meineng Energy equaled approximately 33%. The Company's investment in Meineng Energy was made through Holdco. Pursuant to the Holdco Agreement, the Company contributed to Holdco technology via a license agreement with an agreed upon value of approximately $4.1 million and $200,000 in cash in exchange for a 60% equity interest and PowerSav agreed to contribute to Holdco $3.3 million in cash in exchange for a 40% equity interest. The initial capital contributions (consisting of the Company's technology contribution and one half of required cash contributions) were made in December 2011. The subsequent capital contributions (consisting of one half of the required cash contribution) were made on May 16, 2012. For financial reporting purposes, Holdco's assets and liabilities are consolidated with those of the Company and PowerSav's 40% interest in Holdco is included in the Company's consolidated financial statements as a noncontrolling interest. For the years ended June 30, 2014 and June 30, 2013, Meineng Energy had a net loss of $3,038,432 and $2,649,763, respectively. The Company's basis in the technology contributed to Holdco is $0 due to US GAAP requirements related to research and development expenditures. The difference of approximately $4.1 million in the Company's basis in this technology and the valuation of the technology by Meineng Energy is accounted for by the Company through the elimination of the amortization expense recognized by Meineng Energy related to the technology. The Company has the right to appoint a majority of the members of the Board of Directors of Hong Kong Holdco and Hong Kong Holdco has the right to appoint a majority of the members of the Board of Directors of Meineng Energy. Pursuant to the Management Services Agreement, Holdco will provide certain management services to Meineng Energy in exchange for a management services fee equal to five percent of Meineng Energy's net sales for the five year period beginning on the first day of the first quarter in which the JV Company achieves operational breakeven results and three percent of Meineng Energy's net sales for the subsequent three years, provided the payment of such fees will terminate upon Meineng Energy completing an initial public offering on a nationally recognized securities exchange. To date, no management service fee revenues have been recognized by Holdco. Pursuant to the License Agreement, Holdco granted to Meineng Energy (1) an exclusive royalty-free license to manufacture and distribute the Company's ZBB EnerStore, zinc bromide flow battery, version three (V3) (50KW) and ZBB EnerSection, power and energy control center (up to 250KW) (the "Products") in mainland China in the power supply management industry and (2) a non-exclusive royalty-free license to manufacture and distribute the Products in Hong Kong and Taiwan in the power supply management industry. Pursuant to the Research and Development Agreement, Meineng Energy may request the Company to provide research and development services upon commercially reasonable terms and conditions. Meineng Energy would pay the Company's fully-loaded costs and expenses incurred in providing such services. 38 --------------------------------------------------------------------------------The Company had product sales of $853,663 and $987,621 to Meineng Energy during the years ended June 30, 2014 and June 30, 2013, respectively. The operating results for Meineng Energy for the years ended June 30, 2014 and June 30, 2013 are summarized as follows: Year ended June 30, 2014 2013 Revenues $ 285,631 $ - Gross Profit (loss) (309,406 ) - Income (loss) from operations (3,002,192 ) (2,615,055 ) Net Income (loss) (3,038,432 ) (2,649,763 ) NOTE 3 - GOING CONCERN The accompanying consolidated financial statements have been prepared on the basis of a going concern which contemplates that the Company will be able to realize assets and discharge its liabilities in the normal course of business. Accordingly, they do not give effect to any adjustments that would be necessary should the Company be required to liquidate its assets. The Company incurred a net loss of $8,855,418 attributable to ZBB Energy Corporation for year ended June 30, 2014, and as of June 30, 2014 has an accumulated deficit of $89,788,242 and total ZBB Energy Corporation equity of $11,863,187. The ability of the Company to settle its total liabilities of $6,543,716 and to continue as a going concern is dependent upon increasing revenues and achieving profitability. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. We believe that cash and cash equivalents on hand at June 30, 2014, expected collections on the Lotte R&D Agreement and other potential sources of cash, will be sufficient to fund our current operations through fiscal year 2015. However, there can be no assurances that unforeseen circumstances will not require the Company to raise additional investment capital to fund its operations. If the Company is unable to obtain additional required funding, the Company's financial condition and results of operations may be materially adversely affected and the Company may not be able to continue operations. NOTE 4 - INVENTORIES Inventories are comprised of the following as of June 30, 2014 and June 30, 2013: As of June 30, 2014 2013 Raw materials $ 1,054,197 $ 1,181,557 Work in progress 298,773 1,278,219 Total $ 1,352,970 $ 2,459,776 NOTE 5- PROPERTY, PLANT & EQUIPMENT Property, plant, and equipment are comprised of the following as of June 30, 2014 and June 30, 2013: As of June 30, 2014 2013 Land $ 217,000 $ 217,000 Building and improvements 3,520,872 3,520,872 Manufacturing equipment 3,710,127 3,819,533 Office equipment 399,583 403,541 Assets held for lease - 355,986 Construction in process - 24,300 Total, at cost 7,847,582 8,341,232Less, accumulated depreciation (3,465,379 ) (3,161,525 ) Property, Plant & Equipment, Net $ 4,382,203 $ 5,179,707 39--------------------------------------------------------------------------------The Company recorded depreciation expense of $736,551 and $798,424 for the years ended June 30, 2014 and June 30, 2013, respectively. NOTE 6 - INTANGIBLE ASSETS Intangible assets are comprised of the following as of June 30, 2014 and June 30, 2013: As of June 30, 2014 2013 Non-compete agreement $ 310,888 $ 310,888 License agreement 288,087 288,087 Trade secrets 1,599,122 1,599,122 Total, at cost 2,198,097 2,198,097Less, accumulated amortization (2,198,097 ) (1,787,024 ) Intangible Assets, Net $ - $ 411,073 NOTE 7 - GOODWILL The Company acquired ZBB Technologies, Inc., a former wholly-owned subsidiary, through a series of transactions in March 1996. ZBB Technologies Inc. was subsequently merged with and into ZBB Energy Corporation on January 1, 2012. The goodwill amount of $1.134 million, the difference between the price paid for ZBB Technologies, Inc. and the net assets of the acquisition, amortized through fiscal 2002, resulted in the net goodwill amount of $803,079 as of June 30, 2014 and June 30, 2013. NOTE 8 - BANK LOANS AND NOTES PAYABLE Bank loans and notes payable consisted of the following at June 30, 2014 and June 30, 2013: As of June 30, 2014 2013 Bank loan payable of principal and interest at a rate equal to prime plus 1.50%, as defined, subject to a floor of 4.75% with principal due at maturity on January 1, 2014; collateralized by accounts receivable and inventory related to a specific customer contract; paid in full during fiscal 2014. $ - $ 213,750 Note payable to the seller of Tier Electronics LLC of $495,000 payable on January 21, 2014. Interest accrued at a rate of 8% and was payable monthly. The promissory note was collateralized by the Company's membership interest in its wholly-owned subsidiary Tier Electronics LLC; paid in full during fiscal 2014. See note (a) below. - 495,000 Note payable to Wisconsin Department of Commerce payable in monthly installments of $23,685, including interest at 2%, with the final payment due May 1, 2018; collateralized by equipment purchased with the loan proceeds and substantially all assets of the Company not otherwise collateralized. The Company is required to maintain and increase a specified number of employees, and the interest rate is increased in certain cases for failure to meet this requirement. See note (b) below. 1,069,793 1,136,195 Bank loan payable in fixed monthly payments of $6,800 of principal and interest at a rate of 0.25% below prime, as defined, subject to a floor of 5% with any principal due at maturity on June 1, 2018; collateralized by the building and land. 624,760 673,339 Note payable in fixed monthly installments of $6,610 of principal and interest at a rate of 5.5% with any principal due at maturity on May 1, 2028; collateralized by the building and land. 701,716 734,228 Bank loan payable in monthly installments of $21,000 of principal and interest at a rate equal to prime, as defined, subject to a floor of 4.25%; paid in full during fiscal 2014. - 29,076 $ 2,396,269 $ 3,281,588 (a) If the federal capital gains tax rate exceeded 15% and or the State of Wisconsin capital gains tax rate exceeded 5.425% at any time prior to the payment in full of the unpaid principal balance and accrued interest on the promissory note, then the principal amount of the promissory note was to be retroactively increased by an amount equal to the product of (a) the aggregate amount of federal and state capital gain realized by the Seller or Seller's sole member, as applicable, in connection with the acquisition, multiplied by (b) the difference between (i) the combined federal and State of Wisconsin capital gains tax rate as of the date of calculation, minus (ii) the combined federal and State of Wisconsin capital gains tax rate of 20.425% as of January 21, 2011. Any adjustment to the principal amount of the promissory note was to be effected by increasing the amount of the last payment due under the promissory note without affecting the next regularly scheduled payment(s) under the promissory note. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed, effectively raising the top rate for capital gains to 20%. The Company recorded an additional $45,000 of principal due under this note as other expense for the year ended June 30, 2013. (b) As of April 2013, the Wisconsin Department of Commerce granted the Company a 12 month deferral of the required installment payments of $22,800. On March 1, 2014, fifty equal monthly installments of $23,685 commenced through April 1, 2018 with the final installment due on May 1, 2018. Maximum aggregate annual principal payments for fiscal periods subsequent to June 30, 2014 are as follows: 40 -------------------------------------------------------------------------------- 2015 $ 351,142 2016 361,060 2017 371,402 2018 358,384 2019 105,832 2020 and thereafter 848,449 $ 2,396,269 NOTE 9 - EMPLOYEE AND DIRECTOR EQUITY INCENTIVE PLANS The Company previously adopted the 2002 Stock Option Plan ("2002 Plan") in which a stock option committee could grant up to 1,000,000 shares to key employees or non-employee members of the board of directors. The options vest in accordance with specific terms and conditions contained in an employment agreement. If vesting terms and conditions are not defined in an employment agreement, then the options vest as determined by the stock option committee. If the vesting period is not defined in an employment agreement or by the stock option committee, then the options immediately vest in full upon death, disability, or termination of employment. Vested options expire upon the earlier of either the five year anniversary of the vesting date or termination of employment. No shares are available to be issued under the 2002 Plan. The Company also previously adopted the 2007 Equity Incentive Plan ("2007 Plan") that authorized the board of directors or a committee to grant up to 300,000 shares to employees and directors of the Company. Unless defined in an employment agreement or otherwise determined, the options vest ratably over a three-year period. Options expire 10 years after the date of grant. No shares are available to be issued under the 2007 Plan. In November 2010, the Company adopted the 2010 Omnibus Long-Term Incentive Plan ("Omnibus Plan") which authorizes the board of directors of a committee to grant up to provide stock options, stock appreciation rights, restricted stock, restricted stock units, unrestricted stock, other stock-based awards and cash awards. The Omnibus Plan authorized up to 800,000 shares plus shares of Common Stock underlying any outstanding stock option of other award granted by any predecessor employee stock plan of the Company that is forfeited, terminated, or cancelled without issuance of shares, to employees, officers, non-employee members of the board of directors, consultants, and advisors. Unless otherwise determined, the options vest ratably over a three-year period. Options expire 8 years after the date of grant. At the annual meeting of shareholders held on November 7, 2012 the Company's shareholders approved an amendment of the Omnibus Plan which increased the number of shares of the Company's common stock available for issuance pursuant to awards under the Omnibus Plan by 900,000 shares and the creation of the 2012 Non-Employee Director Equity Compensation Plan ("2012 Director Equity Plan"), under which the Company may issue up to 700,000 RSU awards and other equity awards to our non-employee directors pursuant to the Company's director compensation policy. As of June 30, 2014, there are a total of 615,309 shares available to be issued under the Omnibus Plan and 19,304 shares available to be issued under the 2012 Director Equity Plan. In aggregate for all plans, at June 30, 2014 the Company had a total of 1,419,068 options outstanding and 1,346,812 RSUs. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing method. The Company uses historical data to estimate the expected price volatility, the expected option life and the expected forfeiture rate. The Company has not made any dividend payments nor does it have plans to pay dividends in the foreseeable future. The following assumptions were used to estimate the fair value of options granted during the years ended June 30, 2014 and June 30, 2013 using the Black-Scholes option-pricing model: Year ended June 30, 2014 2013 Expected life of option (years) 4 4 Risk-free interest rate 0.95 - 1.27% 0.46 - 0.61% Assumed volatility 94.35 - 111.20% 96.28 - 104.13% Expected dividend rate 0% 0% Expected forfeiture rate 4.91 - 5.62% 4.19 - 6.66% Time-vested and performance-based stock awards, including stock options and RSUs are accounted for at fair value at date of grant. Compensation expense is recognized over the requisite service and performance periods. 41 -------------------------------------------------------------------------------- During the years ended June 30, 2014 and June 30, 2013, the Company's results of operations include compensation expense for stock options and restricted stock units ("RSUs") granted under its various equity incentive plans. The amount recognized in the financial statements related to stock-based compensation was $962,361 and $785,260, based on the amortized grant date fair value of options and RSUs during the years ended June 30, 2014 and June 30, 2013, respectively. Information with respect to stock option activity is as follows: Average Number Weighted Remaining of Average Contractual Life Options Exercise Price (in years) Balance at July 1, 2012 847,813 $ 6.25 Options granted 142,710 1.88 Options forfeited (205,239 ) 5.05 Balance at June 30, 2013 785,284 5.78 5.34 Options granted 699,850 1.33 Options forfeited (66,066 ) 13.23 Balance at June 30, 2014 1,419,068 $ 3.23 6.09 The following table summarizes information relating to the stock options outstanding at June 30, 2014: Outstanding Exercisable Average Weighted Average Weighted Range of Number Remaining Average Number Remaining Average Exercise of Contractual Life Exercise of Contractual Life Exercise Prices Options (in years) Price Options (in years) Price 0.76 to $ $2.50 819,194 7.42 $ 1.42 57,656 5.70 $ 2.01 2.51 to $ $5.00 207,434 5.13 3.88 175,969 5.08 3.87 5.01 to $ $7.50 377,440 3.90 6.24 347,974 3.85 6.28 7.51 to $ $17.95 15,000 1.58 17.95 15,000 1.58 17.95 Balance at June 30, 2014 1,419,068 6.09 3.23 596,599 4.33 5.45 During the year ended June 30, 2014 options to purchase 699,850 shares were granted to employees exercisable at $0.76 to $1.90 per share based on service based vesting terms from July 2013 through June 2017 and exercisable at various dates through June 2022. During the year ended June 30, 2013 options to purchase 142,710 shares were granted to employees exercisable at prices from $1.75 to $1.90 per share based on various service and performance based vesting terms from July 2012 through June 2016 and exercisable at various dates through June 2021. The aggregate intrinsic value of outstanding options totaled $246,850 and was based on the Company's adjusted closing stock price of $1.67 as of June 30, 2014. A summary of the status of unvested employee stock options as of June 30, 2014 and June 30, 2013 and changes during the years then ended is presented below: Weighted Average Average Number Grant Date Remaining of Fair Value Contractual Life Options Per Share (in years) Balance at July 1, 2012 449,499 $ 4.70 Options granted 142,710 1.88 Options vested (158,389 ) 4.75 Options forfeited (171,152 ) 4.21 Balance at June 30, 2013 262,668 3.44 Options granted 699,850 1.33 Options vested (127,586 ) 3.55 Options forfeited (12,463 ) 3.38 Balance at June 30, 2014 822,469 $ 1.63 7.08 42-------------------------------------------------------------------------------- Total fair value of options granted for the years ended June 30, 2014 and June 30, 2013 was $665,414 and $167,282, respectively. At June 30, 2014, there was $545,092 in unrecognized compensation cost related to unvested stock options, which is expected to be recognized over a weighted average period of 1.7 years. The Company compensates its directors with RSUs and cash. On April 9, 2014, the Company's President and CEO was awarded 200,000 RSUs which vested immediately upon grant. On December 20, 2013, 455,696 RSUs were granted to the Company's directors in partial payment of directors fees through November 2014 under the 2012 Director Equity Plan. As of June 30, 2014, 566,775 of the RSUs had vested and there were $335,502 in directors' fees expense settled with RSU's for the year ended June 30, 2014. On May 1, 2013, the Company's President and CEO and Chief Operating Officer were awarded 200,000 RSUs each which would have vested on the satisfaction of certain performance targets. The RSU's were forfeited on December 31, 2013 resulting in a credit to selling, general and administrative expense of $406,000 during the year ended June 30, 2014. On January 14, 2014, the Company's President and CEO and Chief Operating Officer were awarded 500,000 RSUs of which 100,000 vested immediately upon grant, and the remaining 400,000 were cancelled prior to June 30, 2014. As of June 30, 2014 there were 140,588 unvested RSUs outstanding which will vest through January 15, 2016 and $125,022 in unrecognized compensation cost related to unvested RSUs which are expected to be recognized through January 15, 2016. Shares of common stock related to vested RSUs are to be issued six months after the holder's separation from service with the Company. The table below summarizes the status of restricted stock unit balances: Weighted Number of Average Restricted Valuation Stock Units Price Per Unit Balance at July 1, 2012 489,687 $ 3.60 RSUs granted 970,000 1.30 RSUs forfeited (320,000 ) 1.30 Shares issued (8,000 ) 1.70 Balance at June 30, 2013 1,131,687 2.30 RSUs granted 1,660,695 0.99 RSUs forfeited (1,200,000 ) 1.10 Shares issued (245,570 ) 1.61 Balance at June 30, 2014 1,346,812 $ 1.87 NOTE 10 - WARRANTS At June 30, 2014, the following warrants to purchase the Company's common stock were outstanding and exercisable: · 81,579 warrants exercisable at $0.95 per share and which expire in September 2016 issued as placement agent's compensation in connection with the sale of $3 million of preferred stock on September 27, 2013 as described in Note 11. · 1,710,526 warrants exercisable at $0.95 per share and which expire in September 2016 issued in connection with Securities Purchase Agreements entered into with certain investors providing for the sale of a total of $3 million of preferred stock on September 27, 2013 described in Note 11. On March 26, 2014, 1,447,369 warrants were exercised via a cashless exercise resulting in the issuance of 850,169 shares of common stock of the Company. · 15,000 warrants exercisable at $2.10 per share which expire in July 2015 issued as partial payment for services. · 306,902 warrants exercisable at $2.375 per share and which expire in June 2017 issued in connection with the Underwriting Agreement entered into with MDB Capital Group, LLC as part of underwriting compensation which provided for the sale of $12 million of common stock on June 19, 2012 as described in Note 11. On March 19, 2014, 272,159 warrants were exercised via a cashless exercise resulting in the issuance of 53,048 shares of common stock of the Company. · 511,604 warrants exercisable at $2.65 per share and which expire in May 2017 issued in connection with Securities Purchase Agreements entered into with certain investors providing for the sale of a total of $2,465,000 of Zero Coupon Convertible Subordinated Notes on May 1, 2012. · 12,100 warrants exercisable at $5.00 per share which expire March 2015 through July 2015 issued as partial payment for services. 43-------------------------------------------------------------------------------- · 224,375 warrants exercisable at $5.20 per share and which expire in September 2015 issued to certain purchasers of Company shares in March 2010. · 71,667 warrants exercisable at $6.65 per share and which expire in August 2015 issued to certain purchasers of Company shares in August 2009. The table below summarizes warrant balances: Weighted Average Number of Exercise Price Warrants Per Share Balance at July 1, 2012 1,400,506 3.15 Warrants granted 21,300 2.95 Warrants expired - - Warrants exercised - - Balance at June 30, 2013 1,421,806 $ 3.15 Warrants granted 3,239,474 0.95 Warrants expired (8,000 ) 2.80 Warrants exercised (1,719,528 ) 1.18 Balance at June 30, 2014 2,933,752 $ 1.88 NOTE 11 - EQUITY On March 19, 2014, the Company completed an underwritten public offering of its common stock at a price to the public of $2.25 per share. The Company sold a total of 6,325,000 shares of its common stock in the offering for aggregate proceeds of approximately $14.2 million. The Company received approximately $13.0 million of net proceeds from the offering, after deducting the underwriting discount and expenses. On October 31, 2013, the Company effected a reverse stock split of its common stock by a ratio of 1-for-5 (the "Reverse Split"). As a result of the Reverse Split every five outstanding shares of Common Stock became one share of common stock. No fractional shares were issued in connection with the Reverse Split. A shareholder who would otherwise have been entitled to receive a fractional share of common stock received a cash payment equal to the closing sales price of the Company's Common Stock on October 31, 2013 as reported on the NYSE MKT times the amount of the fractional share. The Reverse Split did not change the number of shares of common or preferred stock that the Company is authorized to issue, or the par value of the Company's common or preferred stock. The Reverse Split resulted in a proportionate adjustment to the per share exercise price and the number of shares of common stock issuable upon the exercise of outstanding warrants and stock options, as well as the number of shares of common stock eligible for issuance under the Omnibus Plan and the 2012 Director Equity Plan. All of the information in these financial statements has been presented to reflect the impact of the 1-for-5 Reverse Split on a retroactive basis. On September 26, 2013 the Company entered into a Securities Purchase Agreement with certain investors providing for the sale of 3,000 shares of Series B Convertible Preferred Stock (the "Preferred Stock"). Certain Directors of the Company purchased 500 shares. Shares of Preferred Stock were sold for $1,000 per share (the "Stated Value") and accrue dividends on the Stated Value at an annual rate of 10%. The net proceeds to the Company, after deducting $96,966 of offering costs, were $2,903,034. During the year ended June 30, 2014, 425 shares of Preferred Stock were converted into 470,171 shares of common stock of the Company. At June 30, 2014, 2,575 shares of Preferred Stock were convertible into 2,918,942 shares of common stock of the Company ("Common Stock") at a conversion price equal to $0.95. Upon any liquidation, dissolution or winding up of the Corporation, holders of Preferred Stock are entitled to receive out of the assets of the Company an amount equal to two times the Stated Value, plus any accrued and unpaid dividends thereon. At June 30, 2014 the liquidation preference of the Preferred Stock was $5,347,994. In connection with the purchase of the Preferred Stock, investors received warrants to purchase a total of 3,157,897 shares of Common Stock at an exercise price of $0.95. The warrants are exercisable at any time prior to September 27, 2016. During the year ended June 30, 2014, 1,447,368 warrants were exercised via a cashless exercise resulting in the issuance of 850,169 shares of common stock of the Company. In addition, the Company issued a total of 81,579 warrants to a placement agent in connection with the transaction. These warrants expire on September 27, 2016. On March 13, 2013, the Company entered into a common stock purchase agreement (the "Aspire Purchase Agreement") with Aspire Capital Fund, LLC, an Illinois limited liability company, under which Aspire Capital committed over a two year period to purchase up to $10 million of ZBB Energy common stock based on prevailing market prices over a period preceding each sale, subject to certain terms and conditions. 44-------------------------------------------------------------------------------- On March 19, 2013 the Company issued 345,098 shares to Aspire Capital in consideration for Aspire Capital's entry into the Aspire Purchase Agreement and Aspire Capital purchased 588,235 shares for $1,000,000 pursuant to the agreement at $1.70 per share. On March 25, 2013 and March 26, 2013, Aspire Capital purchased a total of 992,720 shares pursuant to the Aspire Purchase Agreement at a price per share of $1.50 for a total purchase price of $1,500,000. Aspire Capital purchased 100,000 shares at a per share price of $1.5175 for a total purchase price of $151,750 on April 4, 2013; 90,000 shares at a per share price of $1.6655 for a total purchase price of $149,895 on April 12, 2013; and 70,000 shares at a per share price of $1.4595 for a total purchase price of $102,165 on May 3, 2013. Through June 30, 2014, the Company had issued a total of $2,903,190 of shares of common stock under this facility and $7,096,810 remained available. In accordance with applicable NYSE MKT rules, shareholder approval would have been required for the Company to sell in excess of 3,104,341 shares pursuant to the Aspire Purchase Agreement. Through June 30, 2014, the Company had issued a total of 2,186,053 shares pursuant to the Aspire Purchase and had the ability to sell up to 918,288 additional shares under the Aspire Purchase Agreement. The Company has not made any additional sales to Aspire under the Agreement since June 30, 2013. The Aspire Purchase Agreement was terminated on August 18, 2014. Refer to Note 15 - Subsequent Events for additional detail. NOTE 12 - COMMITMENTS Leasing Activities The Company leases its Australian research and development facility from a non-related Australian company under the terms of a lease that expires October 31, 2016. The rental rate was $75,596 per year (A$72,431) and was subject to an annual CPI adjustment. Rent expense was $93,434 and $102,420 for the years ended June 30, 2014 and June 30, 2013, respectively. In July of 2011 the Company renewed the lease on its Australian research and development facility through October 2016 at a rental rate of $95,855 per year (A$95,000) subject to an annual CPI adjustment. The Company also leased a building from an officer of its subsidiary, Tier Electronics LLC, who is also a shareholder and was a director, under a lease agreement that was due to expire on December 31, 2014. Subsequently a lease termination agreement was entered into on October 20, 2013, which terminated the lease effective December 31, 2013 for a fee of $21,000. The rent expense for the years ended June 30, 2014 and June 30, 2013 was $63,000 and $84,000. The Company was required to pay real estate taxes and other occupancy costs related to the facility. The future payments required under the terms of the leases for fiscal periods subsequent to June 30, 2014 are as follows: 2015 $ 94,543 2016 31,514 $ 126,057 Employment Contracts The Company has entered into employment contracts with executives and management personnel. The contracts provide for salaries, bonuses and stock option grants, along with other employee benefits. The employment contracts generally have no set term and can be terminated by either party. There is a provision for payments of up to six months of annual salary as severance if the Company terminates a contract without cause, along with the acceleration of certain unvested stock option grants. NOTE 13 - RETIREMENT PLANS All Australian based employees are entitled to varying degrees of benefits on retirement, disability, or death. The Company contributes to an accumulation fund on behalf of the employees under an award which is legally enforceable. For U.S. employees, the Company has a 401(k) plan. All active participants are 100% vested immediately. Expenses under these plans were $134,831 and $138,254 for the years ended June 30, 2014 and June 30, 2013, respectively. NOTE 14 - INCOME TAXES The provision (benefit) for income taxes consists of the following: 45 -------------------------------------------------------------------------------- As of June 30, 2014 2013 Current $ (82,411 ) $ (154,904 ) Deferred - -Provision (benefit) for income taxes $ (82,411 ) $ (154,904 ) The Company accounts for income taxes using an asset and liability approach which generally requires the recognition of deferred income tax assets and liabilities based on the expected future income tax consequences of events that have previously been recognized in the Company's financial statements or tax returns. In addition, a valuation allowance is recognized if it is more likely than not that some or all of the deferred income tax assets will not be realized in the foreseeable future. Deferred income tax assets are reviewed for recoverability based on historical taxable income, the expected reversals of existing temporary differences, tax planning strategies and projections of future taxable income. As a result of this analysis, the Company has provided for a valuation allowance against its net deferred income tax assets as of June 30, 2014 and June 30, 2013. The Company's combined effective income tax rate differed from the U.S. federal statutory income rate as follows: As of June 30, 2014 2013 Income tax expense/(benefit) computed at the U.S. federal statutory rate -34% -34% Foreign tax expense/(benefit) -1% -1% Change in valuation allowance 34% 34% Total -1% -1% Significant components of the Company's net deferred income tax assets as of June 30, 2014 and June 30, 2013 were as follows: As of June 30, 2014 2013 Federal net operating loss carryforwards $ 22,238,624 $ 19,777,894 Federal - other 2,737,404 2,273,021 Wisconsin net operating loss carryforwards 2,747,275 2,482,692 Australia net operating loss carryforwards 1,497,779 1,398,139 Deferred income tax asset valuation allowance (29,221,082 ) (25,931,746 ) Total deferred income tax assets $ - $ - The Company has U.S. federal net operating loss carryforwards of approximately $65.4 million as of June 30, 2014, that expire at various dates between June 30, 2017 and 2034. The Company also has $2.7 million in other federal deferred tax assets comprised of charitable contributions carryforwards and intangible amortization. The Company has U.S. federal research and development tax credit carryforwards of approximately $223,000 as of June 30, 2014 that expire at various dates through June 30, 2033. As of June 30, 2014, the Company has approximately $52.7 million of Wisconsin net operating loss carryforwards that expire at various dates between June 30, 2014 and 2028. As of June 30, 2014, the Company also has approximately $5.0 million of Australian net operating loss carryforwards available to reduce future taxable income of its Australian subsidiaries with an indefinite carryforward period. A reconciliation of the beginning and ending balance of unrecognized income tax benefits is as follows: As of June 30, 2014 2013 Beginning balance $ 193,097 $ 208,593 Effect of foreign currency translation $ 3,486 $ (15,496 ) Ending balance $ 196,583 $ 193,097 The Company's issuance of additional shares of common stock has constituted an ownership change under Section 382 of the Internal Revenue Code which places an annual dollar limit on the use of net operating loss ("NOL") carryforwards and other tax attributes that may be utilized in the future. The calculation of the annual limitation of usage is based on a percentage of the equity value immediately after any ownership change. The annual amount of tax attributes that may be utilized after the change in ownership is limited. Previous issuances of additional shares of common stock also resulted in ownership changes and the annual amount of tax attributes from previous years is limited as well. The extent of any limitations on the usage of net operating losses has not been determined. 46 --------------------------------------------------------------------------------NOTE 15 - SUBSEQUENT EVENTS On July 1, 2014, Holdco amended and restated the Management Services Agreement (the "Agreement") with Meining Energy. Pursuant to the Agreement, Holdco will provide certain management services in exchange for a management services fee. The contractual start date for the management fee was amended to begin on the first day of the first quarter in which Meining Energy achieves operational break-even, as defined in the Agreement. On August 12, 2014, Meineng Energy received a cash investment of 20,000,000 RMB (approximately $3.2 million) from Wuhu Fuhai-Haoyan Venture Investment, L.P., a branch of Shenzhen Oriental Fortune Capital Co., Ltd., for a post-closing equity position of 8%. Subject to receipt of required governmental approval for this investment, which is expected in October or November 2014, this investment capital will be used to fund ongoing operations and development of the China market, and provides Meineng Energy a 250,000,000 RMB (approximately $42 million) post-closing valuation. Following this investment, the Company's indirect investment in Meining Energy equals approximately 30%. On March 13, 2013, the Company entered into a Common Stock Purchase Agreement ("Purchase Agreement") with Aspire Capital Fund, LLC, an Illinois limited liability company ("Aspire Capital"), which provided that, upon the terms and subject to the conditions and limitations set forth therein, Aspire Capital was committed to purchase up to an aggregate of $10 million of shares of the Company's common stock over the two-year term of the Purchase Agreement. On August 18, 2014, the Company provided notice to Aspire Capital electing to terminate the Purchase Agreement. On August 27, 2014, the Company completed an underwritten public offering of its common stock at a price to the public of $1.12 per share. The Company sold a total of 13,248,000 shares of its common stock in the offering for aggregate proceeds of approximately $14.8 million. The Company received approximately $13.5 million of net proceeds from the offering, after deducting the underwriting discount and expenses. |