General

          Digital Power Corporation designs, develops, manufactures, markets, and sells switching power supplies to industrial, telecommunication, data communication, medical, and military industries. We are a California corporation originally formed in 1969.  Our corporate office, which contains our administrative, sales, and engineering functions, is located in Fremont, California.  In addition, the Company has a wholly-owned subsidiary, Digital Power Limited (“DPL”), located in Salisbury, England, which designs, manufactures, and sells products for the European marketplace, including power conversion products for naval and military applications and DC/AC inverters for the telecommunications industry, under the label Gresham Power Electronics.

          We primarily sell our switching power supplies to industrial, telecommunication, data communication, medical, and military industries both in North America and Europe.  These industries have experienced pricing pressure that has adversely affected our operations and financial condition.  As a result, we incurred an operating loss during the first half of the year ended December 31, 2005.  The Company moved all its production to a Chinese subcontractor offering lower prices with shorter lead-times, and to Telkoor Telecom Ltd. (“Telkoor”), an Israeli Manufacturer and a major shareholder holding 43% of the outstanding shares of DPC.  Telkoor manufactures at longer lead times and at higher ‘total costs’ in comparison to the Chinese manufacturing partners.

          Power supplies are critical components of electronic equipment that supply, convert, distribute, and regulate electrical power.  The various subsystems within electronic equipment require a steady supply of direct current (DC) electrical power, usually at different voltage levels from the other subsystems within the equipment. In addition, the electronic components and subsystems require protection from the harmful surges and drops in electrical power that commonly occur over power lines.

          Power supplies satisfy these issues of allocation and protection by (i) converting alternating current (AC) electricity into direct current (DC); (ii) dividing a single input voltage into distinct and isolated output voltages; and (iii) regulating and maintaining such output voltages within a narrow range of values.

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          Products, which convert AC from a primary power source into DC, are generally referred to as “power supplies” and commonly referred to as AC/DC power supplies.  Products, which convert one level of DC voltage into a higher or lower level of DC voltage, are generally referred to as “DC/DC converters.”  “Switching” power supplies are distinguished from “linear” power supplies by the manner and efficiency with which the power supplies “step down” voltage levels.  A linear power supply converts an unregulated DC voltage to a lower regulated voltage by “throwing away” the difference between the two voltages as heat.  Consequently, the linear power supply is inherently inefficient – typically, only 45% efficient for a 5V output regulator.  By contrast, a switching power supply converts an unregulated DC voltage to a lower regulated voltage by storing the voltage difference in a magnetic field.  When the magnetic field grows to a pre-determined level, the unregulated DC is switched off and the output power is provided by the energy stored in the magnetic field.  When the field is sufficiently depleted, the unregulated DC is switched on again to deliver power to the output, while the excess voltage is again stored in the magnetic field.  As a result, the switching power supply is more efficient than the linear power supply – typically, 75% efficient for a 5V output regulator.

          One of the great advantages of switching power supplies and our designs, which we secure through Telkoor, in addition to their higher efficiency, is their high power density, or power-to-volume ratio, making them smaller than those of our competitors.

          Another advantage of our power supply products is the flexibility of design.  We have designed the base model power supply products so that they can be quickly and economically modified and adapted to the specific power supply needs of any OEM.  This “flexibility” approach has allowed us to provide samples of modified power supplies to OEM customers in only a few days after initial consultation, an important capability given the emphasis placed by OEMs on “time to market.” This “flexibility” approach also results in very low non-recurring engineering (NRE) expenses.  Because of reduced NRE expenses, we do not generally charge our original equipment manufacturer (“OEM”) customers for NRE related to tailoring a power supply to a customer’s specific requirements.  This gives us an advantage over our competitors, many of whom do charge their customers for NRE expenses.  Our marketing strategy is to exploit this combination of high power density, design flexibility, and short time-to-market to win an increasing share of the power supply market.

          In addition to the line of proprietary products offered, and in response to requests from OEMs, we also provide “value-added services.”  The term “value-added services” refers to our incorporation of an OEM’s selected electronic components, enclosures, and cable assemblies with our power supply products to produce a power subassembly that is compatible with the OEM’s own equipment, and specifically tailored to meet the OEM’s needs.  We purchase parts and components that the OEM itself would otherwise attach to, or integrate with, our power supply, and we provide the OEM with that integration and installation service, thus saving the OEM time and money.  We believe that this value-added service is well suited to those OEMs who wish to reduce their vendor base, and minimize their investment in manufacturing that leads to increased fixed costs.  Based on the value-added services, the OEMs do not need to build assembly facilities to manufacture their own power subassemblies and thus are not required to purchase individual parts from many vendors.

          Historically, as a result of our strategic collaboration with Telkoor, we were awarded an initial $1.6 million contract in 2004 for a military avionics application. The majority of the revenue generated from this contract was recognized in 2005 and will be completed in the first quarter of 2006.

Telkoor Telecom Ltd.

          Telkoor is a corporation organized and headquartered in Israel.  It is primarily engaged in developing; marketing, and selling power supplies and power systems for the Commercial and Military Markets.  Consistent with our total cost reduction efforts, and taking advantage of Telkoor’s strong engineering team, we have and will continue to utilize Telkoor to assist us in new product development.  Further, during the year ended December 31, 2005, we made significant progress in penetrating the United States and European markets with Telkoor’s products.  This effort generated sales of approximately 36% of our revenues for 2005.  We intend to continue to sell Telkoor’s products in the future to supplement our line of products.

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          In April 2005, the Company granted 70,000 options to Telkoor’s employees. The Company had accounted for its options to Telkoors’ employees under the fair value method of SFAS No. 123 and EITF 96-18. Those options vest primarily over four years. The fair value for these options was estimated using a Black-Scholes option-pricing model with the following weighted average assumptions for 2005: risk-free interest rates of 4.4%, dividend yields of 0%, volatility of 103.4%, and the contractual life of the options of 9.67 years. Compensation expenses of approximately $ 8,000 were recognized during the year ended December 31, 2005.

Digital Power Limited

          Digital Power Limited organized and headquartered in Salisbury, England, designs, manufactures, and distributes switching power supplies, uninterruptible power supplies, and power conversion and distribution equipment frequency converters for the commercial and military markets, under the name Gresham Power Electronics.  Uninterruptible power supplies (“UPS”) are devices that are inserted between a primary power source and the primary power input of the electronic equipment to be protected for the purpose of eliminating the effects of transient power anomalies or temporary outages.  A UPS consists of an inverter powered by a battery that is kept trickle-charged by rectified AC from an incoming power line.  In the event of a power interruption, the battery takes over without the loss of even a fraction of a cycle in the AC output of the UPS.  Frequency converters manufactured by DPL are used to convert a warship’s generated 60-cycle electricity supply to 400 cycles.  This 400-cycle supply is used to power critical equipment such as the ship’s gyro, compass, and weapons systems.  DPL also designs and manufactures Transformer Rectifiers for Naval use.  Typically, these provide battery supported back up for critical DC systems such as machinery and communications.  In addition, higher power rectifiers are used for helicopters on naval vessels.  DPL products, add diversity to our product line, provide greater access to the United Kingdom and European markets, and strengthen our engineering and technical resources.  For the year ended December 31, 2005, DPL contributed approximately 54% to our gross revenues.

The Market

          Geographically, we serve primarily the North American power electronics market with individual AC/DC power supplies and DC/DC converters ranging from 50 watts to 1200 watts of total output power.  DPL serves the United Kingdom and the European marketplace with AC/DC power supplies, uninterruptible power supplies, and frequency inverters. 

Customers

          Our products are sold in North America through a network of manufacturers’ representatives and distributors.  Our customers can generally be grouped into five broad industries, consisting of the industrial, telecommunication, data communication, medical, and the military.  We have a current base of approximately 400 active customers, some of which are served through our distributors.

          DPL products are sold primarily in the UK and in Europe.  The Company has been particularly successful in securing an export market in Spain for its defense products.  In the UK, our main customers include the UK Ministry of Defense, BAE Systems, Babcock Defense, and Ultra Electronics.   In Mainland Europe, we sell directly to Navantia in Spain, Martin Lighting in Denmark and Elma in Germany. We sell power supplies through European distributors with our greatest strength lying with Germany and Scandinavia.

Strategy

          Our strategy is to be the supplier of choice to OEMs requiring high-quality power solutions where power density (size), rapid modification, and time-to-market are critical to business success.  Target market segments include the industrial, telecommunication, and data communication, medical, and military industries.  While many of these segments would be characterized as computer-related, we do not participate in the personal computer (PC) power supply market because of the low margins arising out of the high volume and extremely competitive nature of that market.

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          We intend to continue our sales primarily to existing customers while simultaneously targeting sales to new customers.  We believe that our “flexibility and high density” power supplies allow customers a more effective choice between our products and products offered by other power supply competitors.  Our “flexibility and high density” series is designed around a standardized power platform, but allows the customer to specify output voltages tailored to its exact requirements within specific parameters.  Furthermore, OEMs are seeking power supplies with greater power density and higher efficiency.  Digital Power’s strategy in responding to this demand has been to offer increasingly smaller power supply units or packages.  OEMs typically had to settle for a standard power supply product with output voltages and other features predetermined by the manufacturer.  Alternatively, if the OEM’s product required a different set of power supply parameters, the OEM was forced to design this modification in-house, or pay a power supply manufacturer for a custom product.  Because custom-designed power supplies are development-intensive and require a great deal of time to design, develop, and manufacture, typically only OEMs with significant volume requirements can economically justify the expense and delay associated with in-house production.  Furthermore, since virtually every power conversion product intended for use in commercial applications requires certain independent safety agency testing at considerable expense, such as by Underwriters Laboratories, an additional barrier is presented to the smaller OEM.  By offering OEM customers a new choice with Digital Power’s “flexibility and high density” power supplies, we believe we have an advantage over our competitors.

Products and Products Strategy

          We have eleven series of base designs from which thousands of individual models can be produced.  Each series has its own printed circuit board (PCB) layout that is common to all models within the series, regardless of the number of output voltages (typically one to four) or the rating of the individual output voltages.  Simply changing the power transformer construction and a small number of output components can produce a broad range of output ratings, from 2.0 volts to 48 volts.  Designers of electronic systems can determine their total power requirements only after they have designed the system’s electronic circuitry and selected the components to be used in the system.  Because the designer has a finite amount of space for the system and may be under competitive pressure to further reduce its size, a burden is placed on the power supply manufacturer to maximize the power density of the power supply.  A typical power supply consists of a PCB, electronic components, a power transformer and other electromagnetic components, and a sheet metal chassis.  The larger components are typically installed on the PCB by means of pin-through-hole assembly where the components are inserted into pre-drilled holes and soldered to electrical circuits on the PCB.  Other components can be attached to the PCB by surface mount interconnection technology (SMT), which allows for a reduction in board size because the holes are eliminated and components can be placed on both sides of the board.  Our US100 series is an example of a product using this manufacturing technology.

          Digital Power’s “flexibility and high density” concept applies to all of our EF175/200, EF300/400, cpci, Strongbox, US, UP/SP, DP, and UPF product series.  Generally a common printed circuit board is usually shared by each model in a particular family, resulting in a reduction in parts inventory while allowing for rapid modifiability into thousands of output combinations.  The following is a description of our primary products.

          Four of our product offerings resulting from our strategic relationship with Telkoor is: the eF’s series,  CPCI’s series, Strong Box series, and custom products.

          The new 3.6KW Strongbox® is a single output front end with I 2 C data bus. It features 3 x 1200 watt cassettes.  The Strongbox is available in 24V and 48V outputs with active power factor correction.

          The EF series are high-density open frame power supplies, which most commonly come in 12,24 and 48 volt options with power factor correction.

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          The CPCI series are high-density enclosed central power supplies, which most commonly come in 5, 12, 24, and 48-volt options with power factor correction.

          The US50 series of power supplies consists of compact, economical, high efficiency, open frame switchers that deliver up to 50 watts of continuous power, or 60 watts of peak power, from one to four outputs.  The 90-264 VAC universal inputs allow them to be used worldwide without jumper selection.  Flexibility options include power good signal, an isolated V4 output, and UL544 (2 nd Ed.) safety approval.  All US50 series units are also available in 24VDC, or 48VDC inputs.  This optional DC input unit (DP50 series) maintains the same pin-out, size, and mounting as the US50 series.

          The US70 series of power supplies is similar to the US50 series, a compact, economical, highly efficient, open frame switcher that delivers up to 65 watts with a 70-watt peak.  This unit is offered with one to four outputs, a universal input rated from 90 to 264 VAC, and is only slightly larger than the US50 series.  The US70 series is differentiated from competitive offerings by virtue of its smaller size, providing up to four outputs while competitors typically are limited to three outputs.  Flexibility options include cover, power good signal, an isolated V4 output, and UL544 (2 nd Ed.) medical safety approval.  The DP70 is the same as the US70 except the input is 48 volts DC.  We also offer 24VDC input on this series where the model series changes to a DM.  This type of product is ideal for low profile systems, with the power supply measuring 3.2” x 5” x 1.5”.

          The US100/DP100 was the industry’s smallest 100-watt switcher when originally introduced.  Measuring only 5” x 3.3” x 1.5”, this series delivers up to 100 watts of continuous power, or 120 watt peak power, from one to four outputs.  The 90-264VAC universal input allows them to be used worldwide.  This product is ideal in applications where OEMs have upgraded their systems, requiring an additional 30-40 watts of output power, but being unable to accommodate a larger unit.  The US100 fits in the same form factor and does not require any tooling or mechanical changes by the OEM.  Flexibility options include a cover and adjustable post regulators on V3 and/or V4 outputs and UL2601-1 (2 nd Ed.) medical safety approval.  Fully customized models are also available.  All US100 series units are also available with 12VDC, 24VDC, or 48 VDC inputs.  This optional DC input unit (DP100) maintains the same pin-out, size, and mounting as the US100 series.

          The US250 series consists of economical, high efficiency, open frame switchers that deliver up to 250 watts of continuous power, or 300 watts of peak power, from one to four outputs.  The 115/230VAC auto-selectable input allows them to be used worldwide.  Flexibility options include cover, power fail/power good signal, enable/inhibit, and an isolated V3 output.  All US250 series units are also available with 12VDC, 24VDC, or 48VDC inputs.  This optional DC input unit (DP250) maintains the same pin-out, size, and mounting as the US250 series.

          The UP300 series consists of economical, high efficiency, open frame switchers that deliver up to 300 watts of continuous, or 325 watts of peak power, from one or two outputs.  The 115/230VAC auto-selectable input allows them to be used worldwide.  On-board EMI filtering is a standard feature.  Flexibility options include a cover, power fail/power good signal, and an isolated 2nd output.  This product can be used in network switching systems or other electronic systems where a lot of single output current, such as 5, 12, 24, or 48 volt current might be required.

          The UPF150/DP150 series is an open-frame switcher that delivers up to 150 watts of continuous power from one to four outputs.  In response to market condition for more functionality, the UPF 150 has both power factor correction and a Class B EMI filter as standard features.  All UPF150 series units are available with 24VDC, or 48VDC inputs.  This optional DC input unit (DP150) maintains the same pin-out, size, and mounting as the UPF150 series.

          The UPF 300 watts delivers up to 300 watts from one or two outputs and also includes power factor correction and measures 8” x 4.5” x 2”.

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DPL Products

          Gresham designs and manufactures a wide range of products for Naval applications.  These include:

          Static Frequency Converters – typically converts ship’s supply from 50/60Hz to 400Hz for gyros and weapons systems.  Power range is from 1kVA to 35kVA.

          DC Systems – converts main ship’s supply to 24VDC.  These systems normally supported by battery backup provide the vessel’s emergency DC supplies for machinery, communications, and other essential services.

          Transformer Rectifiers 28V to 400A.  Ratings of 10 and 15kVA provide DC power to enable the ship to start and service helicopters.  Gresham’s Transformers are in service with a number of Navy’s, including the Royal Navy, and are designated by Westland Helicopters in support of the Super Lynx.

          Inverters – 1kVA to 3.6 kVA typically convert DC to 440V 3phase 60 Hz for communications and emergency services.

          Circuit breaker monitoring and controls – modular system of controls for main circuit breakers based upon digital circuitry.  Modules available include over current, short circuit, low voltage, over and under frequency and an indicator module. Many are used in submarine service.

          Intelligent switch mode DC/DC power supplies in support of inboard submarine sonar.

          Filter boxes for secure communications.

          Navigation and signal panels – for the control and dimming of ship’s external navigation lights.

          DPL also manufactures a range of commercial inverters of its own design for telecoms applications. Rated at 250VA, 500VA, and 1kVA, these convert either 24V or 48V DC to AC.

          In addition to Digital Power and Telkoor products, DPL distributes a wide range of commercial uninterruptible power supplies.  Power ratings range from 500VA to 6kVA in a modular configurable range.  The Company also provides turnkey high power solutions for major business users.  Typically configured with generators for the support of substantial institutional systems, power ratings can extend to 300kVA

Manufacturing Strategy

          Consistent with our product flexibility strategy, we aim to maintain a high degree of flexibility in our manufacturing strategy through the use of strategically focused contract manufactures.  It is our belief that strategically focused contract manufacturers will meet our near term cost, delivery, and quality goals, while providing synergistic concepts.  In addition, we believe these relationships will eventually give us access to new markets and cross licensing arrangements that may be beneficial.  The competitive nature of the power supply industry has also placed continual downward pressure on selling prices.  In order to achieve our low cost manufacturing goals with labor intensive product, we also plan on continually increasing our supply base through the use of contract manufacturers in the Far East.  At present, our principal source in the Far East is Winco Power Technology (Winco).  In coordination with Telkoor, we are launching two additional contract manufacturers in China.  We are no longer subcontracting to a manufacturer located in Guadalajara, Mexico.

          We have contract manufacturing relationships with Winco to manufacture our products at facilities located in China on a turnkey basis.  Purchases from Winco are made pursuant to purchase orders.  For the year ended December 31, 2005, Digital Power purchased approximately 28% of its power supply requirements through Winco.  Our products are meeting the certification standards according to independent safety agency requirements.

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Regulatory Requirements

          Digital Power and its manufacturing partners are required to meet applicable regulatory, environmental, emissions, safety or other requirements where specified by the customer and accepted by Digital Power or as required by local regulatory or legal requirements. In July of 2006, the industry will be phasing in RoHs and Weee requirements in most geographical markets with specific emphasis on consumer based products.  These requirements may require the use of new components or finish goods to be built with RoHs and Wee compliant components potentially rendering existing or down revision finish goods inventory and component inventory to risk of obsolescence. In addition, there is some speculation that RoHs and Wee compliant components may be subject to longer lead-times and higher prices in the near term as the industry transitions to these new requirements

Digital Power Limited Manufacturing

          DPL operates from a 25,000 sq. ft leased facility located in Salisbury U.K.  The equipment designed and manufactured in Salisbury is different from the power supplies produced in China.  Full assembly, test, and quality assurance take place in-house.

          Sales and service support staff for the European network of distributors for Digital Power products are located within the building together with other functions, such as Engineering and Administration. 

Sales and Marketing

          Digital Power markets its products through a network of independent manufacturer’s representatives and distributors.  Each representative organization is responsible for managing sales in a particular geographic territory.  Generally, the representative has exclusive access to all potential customers in the assigned territory and is compensated by commissions at 5% of net sales after the product is shipped, received, and paid for by the customer.  Typically, either the representative organization or we may terminate the agreement with 30 days written notice.

          In certain territories, we have entered into agreements with distributors who buy and resell our products.  For the fiscal years ended December 31, 2005 and 2004, U.S. distributor sales accounted for 18.95% and 20.43%, respectively, of our total sales.  Over this same period, one distributor accounted for 13.01%, and 16.85%, respectively, of total sales.  In general, the agreements with distributors are subject to annual renewal and may be terminated upon 90 days written notice.  Although either party may terminate these agreements, in the event a distributor decides to terminate his agreement with us, we believe that we would be able to continue the sale of our products through direct sales to the customers of that distributor.  Usually the Company does not grant a right of return.  Revenues subject to certain stock rotation are deferred until the products are sold to the end customer or until the rotation rights expire.  Certain distributors are allowed, in the sixth month after the initial stock purchase, to rotate stock that has not been sold for other products.  This may be repeated each sixth month thereafter for 18 months, at no more than 25% of the distributor’s purchase during the previous six months.  For the past three years, stock rotations have not exceeded one percent of total sales.

          Our promotional efforts to date have included product data sheets, trade shows, and Internet Web sites.  Our future promotional activities will likely include space advertising in industry-specific publications, application notes, and enhancements to our existing Web sites.

          Our products are warranted to be free of defects for approximately twelve months from date of shipment. As of December 31, 2005, our warranty reserve was $73,000.

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Competition

          The merchant power supply manufacturing industry is highly fragmented and characterized by intense competition.  Our competition includes hundreds of companies located throughout the world, some of whom have advantages over us in terms of labor and component costs, and some of who may offer products comparable in quality to ours.  Many of our competitors, including Power One, Artesyn (Emerson) Technologies, Inc., ASTEC (Emerson) America, Lambda Electronics, and Meanwell Power Supplies have substantially greater fiscal and marketing resources and geographic presence than we do.  If we are successful in increasing our revenues, competitors may notice and increase competition with our customers.  We also face competition from current and prospective customers who may decide to design and manufacture internally power supplies needed for their products.  Furthermore, certain larger OEMs tend to contract only with larger power supply manufacturers.  This factor could become more problematic to us if consolidation trends in the electronics industry continue and some of the OEMs to whom we sell our products are acquired by larger OEMs.  To remain competitive, management believes that we must continue to compete favorably on the basis of value by providing reliable manufacturing, offering customer service and design engineering services, continuously improving quality and reliability levels, and offering flexible and reliable delivery schedules.  We believe we have a competitive position with our targeted customers who need a high-quality, compact product, which can be readily modified to meet the customer’s unique requirements.  However, there can be no assurance that we will continue to compete successfully in the power supply market.

Engineering and Product Development

          Our engineering and product development efforts are primarily directed toward modification of our standard power supply to provide a broad array of individual models.  Improvements are constantly sought in power density, adaptability, and efficiency, while we attempt to anticipate changing market demands for increased functionality, such as PFC and improved EMI filtering. 

          Historically, the Company has utilized Telkoor consultants and contract engineering for the majority of its new product developments, supported by the internal engineering staff for product engineering.  The Company intends to continue this strategy for engineering and development.   

Employees

          As of December 31, 2005, Digital Power had 32 employees located in the United States and the United Kingdom. 

Foreign Currency Fluctuations

          DPL conducts its financial operation using the United Kingdom pound sterling.  Therefore, we are subject to monetary fluctuations between the U.S. dollar and United Kingdom pound sterling.  For the years ended December 31, 2005, and 2004, we recorded a foreign currency translation loss adjustment of $132,000 and $81,000 respectively.

Raw Materials

          The raw materials for power supplies principally consist of electronic components.  These raw materials are available from a variety of sources and we are not dependent on any one supplier.  We generally allow our subcontractors to purchase components based on orders received or forecast to minimize our risk of unusable inventory.  To the extent necessary we may allow them to procure materials prior to orders received to obtain shorter lead times and to achieve quantity discounts following a risk assessment. (see regulatory requirements).

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Intellectual Property

          We rely upon a combination of trade secrets, industry expertise, confidential procedures, and contractual provisions to protect our intellectual property.  We believe that because our products are continually updated and revised, obtaining patents would be costly and not beneficial.

          On July 8, 2004, our trademark, “DP Digital Power – Powering our technologies,” was registered with the United States Patent and Trademark Office.