In 2007 the Sonex technical team continued to work with our licensee Insitu, Inc. on pre-production engineering and qualification testing in anticipation of the 2008 introduction of Insitu's successful ScanEagle® unmanned aerial vehicle (UAV) powered by a small, two-stroke heavy fuel engine (HFE) incorporating Sonex Combustion System (SCS) technology.  Insitu also tasked Sonex with conducting evaluation tests of engines being considered for HFE conversion by Sonex for Insitu's new, larger model UAV.  In addition, Sonex experience and capabilities with small engines led to additional testing services for another defense contractor to evaluate candidate gasoline engines to power a UAV.

In September 2007 Sonex successfully achieved technical objectives on heavy fuel with our multi-cylinder, four-stroke, Sonex Controlled Auto Ignition (SCAI^TM) combustion process demonstration under long-term funding from the Defense Advanced Research Projects Agency (DARPA).  In an adapted automotive diesel engine, Sonex demonstrated the piston-enabled SCAI combustion process operating on JP-8 heavy fuel at high power levels.  The fully lean-burn SCAI process was run with full control over the entire operating range, which is essential to a wide range of applications on any fuel, and should allow the design of lighter weight HFEs.  DARPA declined to provide funding for continuing SCAI HFE piston development, but the Company is pursuing funding from other sources.  The outcomes from the DARPA project on heavy fuel also relate to the use of SCAI with gasoline and could have significant potential for commercial application in the automotive market.

On January 31, 2008, the U.S. District Court for the Eastern District of Pennsylvania granted the Company's Motion to Dismiss a lawsuit filed by investors seeking the return of $175,000 in equity investments made in Sonex during 2004.  This lawsuit, originally filed in February 2005, was re-filed after initially being dismissed in July 2006.  The Court has again ruled that the Plaintiffs failed to state any of their claims as a matter of law.  The Court dismissed the claims in their entirety with prejudice, meaning that the Plaintiffs would be barred from making such claims in the future.  The Plaintiffs have the right to file an appeal.  Sonex has since filed a Motion seeking award of legal fees.

Each of these topics is more fully described below and in the financial summary that follows.  In 2008 we are seeking continuing revenue opportunities from technology development and demonstration projects and engineering and testing services, as well as licenses for other SCS HFE^TM applications and SCAI piston technology.  In addition, we are working to develop an appropriate strategy for maximizing shareholder value now that our stock no longer trades publicly.

Business relationship with Insitu:

Since 2005 the Company has worked on an application of the SCS HFE^TM technology with Insitu, Inc. of Bingen, Washington (www.insitu.com), a pioneer developer of long-range, unmanned, autonomous aircraft for military and commercial activities.  Insitu has developed the long endurance, low cost ScanEagle® UAV in partnership with The Boeing Company.  (ScanEagle® is a registered trademark of the Boeing Company.)  ScanEagle has been used to provide services for the U.S. Marine Corps, U.S. Navy, and Australian Army in the Middle East since being deployed in 2004.

In November 2006 the Company signed a License Agreement with Insitu for the SCS HFE technology applicable to UAVs with HFEs that are twenty horsepower or less.  Sonex received up-front cash payments for a non-refundable advance royalty and an exclusivity fee, and will receive per unit royalties from Insitu for each engine produced over a certain volume.  The amount of the royalty is dependent on engine size and is subject to adjustment depending on engine volumes and the emergence of competitive HFEs in the licensed field.  Sonex is free to license its HFE technology for use in UAVs powered by engines exceeding 20 hp, or on any size HFE for non-UAV use such as in all-terrain vehicles, pumps, outboard engines, small watercraft, and generator sets.  Sonex and Insitu also entered into a Collaboration Agreement in November 2006 under which the parties planned to consult and cooperate to identify potential new projects including the continued development and commercial application of the SCS HFE technology.  This agreement provided for significant minimum consulting fees payable to Sonex through November 2008.

As reported on Insitu's website, Insitu plans to be the first to market with an HFE in the Small Tactical Unmanned Aerial System class vehicle early in 2008.  Insitu also announced the introduction of its new, larger UAV known as the Integrator^TM.  In an interview published in the August 20, 2007 print edition of Defense News, also available on Insitu's website, Insitu President and CEO Steven Sliwa stated that the Integrator will start out with a gasoline engine and then move to heavy fuel using the Sonex HFE technology.

Sonex Four-Stroke HFE Technology; Agreement with DARPA:

The SCS for four-stroke engines improves the combustion of fuels through design modification of the pistons to achieve chemical/turbulent enhancement of combustion.  The SCAI form of the SCS for four-stroke, direct injected (DI) engines is a low emissions, high economy combustion process.  The SCAI allows ignition and combustion of low cetane heavy fuels by controlled auto-ignition at moderate compression ratios, and operates at controlled peak cylinder pressures, which should allow the design of lighter weight HFEs rather than the heavy weight required by normal diesel engines.  In addition, the SCAI operating on heavy fuels has the potential to deliver fuel economy approaching that of a diesel engine, and 25% to 30% lower fuel consumption than a gasoline engine.

From late 2002 to November 2007 the Company worked under an agreement with the Defense Advanced Research Projects Agency (DARPA) for the development of a multi-cylinder, four-stroke, HFE combustion process for lightweight piston engines to comply with the Department of Defense (DoD) policy directive that mandates heavy fuel for all engines.  Sonex progressively adapted its previously developed and documented SCAI single cylinder laboratory engine results to three different multi-cylinder automotive engines for four-stroke, DI, HFE development, qualification and application of the SCAI for the DoD.  SCS SCAI development work was pursued using a two-piece, screw-assembled, piston to facilitate design refinement.

In the final phase of this effort, Sonex adapted a Mercedes-Benz 3.2-liter, turbocharged, in-line, 6-cylinder, 201 horsepower automotive diesel engine.  In September 2007 Sonex successfully demonstrated to DARPA the laboratory SCAI HFE operating on JP-8 heavy fuel at power levels up to 250 hp with significant reductions in fuel consumption when compared to a gasoline engine.  In addition, exhaust emissions were reduced, validating the potential of the patented piston embodiments to manage levels of emissions in-cylinder.  The fully lean-burn SCAI process was run with full control over the entire operating range to 4,500 rpm, which is essential to a wide range of applications on any fuel.

The Sonex/DARPA agreement concluded in November 2007.  DARPA declined to entertain proposals from Sonex for continuing SCAI HFE piston development; however, the Company is pursuing funding from other military and commercial sources.  Management believes the outcome of a focused SCAI HFE effort will enhance the utility of military UAVs as well as other applications.  The four-stroke SCS SCAI process for heavy fuel operation is based on unthrottled air flow and high rates of heat release which enable low rates of fuel consumption, particularly at less than peak power, to provide a trade-off in fuel weight relative to mission duration and/or sensor-data link payloads.  The outcomes from the DARPA project on heavy fuel also relate to the use of SCAI with gasoline and could have significant potential for commercial application in the automotive market, as described in the following section.

The SCAI Process for Improving Fuel Mileage on Gasoline

In December 2007 President Bush signed into law the Energy Independence and Security Act of 2007, which increases the U.S. Corporate Average Fuel Economy (CAFÉ) standard to 35 mpg by 2020.  This standard challenges the automotive industry to achieve significant technological advancements and to produce products desired by the vehicle-buying public.  Based on the recent accomplishments at Sonex, it appears the SCAI combustion process can contribute significantly to 35 mpg CAFÉ power plant strategies.

The SCAI sparkless, fully unthrottled, compression ignition combustion process has been advanced on kerosene-based heavy fuel through the DARPA program over the past five years as described previously.  Sonex submits that its patented piston embodiments have the potential to enable a fuel mileage improvement of 25% to 30% in gasoline engines as well as to address the exhaust emissions challenges inherent to a new class of higher performance engines known as gasoline direct injection (GDI) engines.  (In GDI engines, the fuel injectors are located in the combustion chamber rather than in the intake manifold as in conventional gasoline engines.)  GDI engines are being introduced by automotive manufacturers to maximize power for a given displacement and reduce fuel consumption by 3%.  A reduction in fuel consumption of 25% to 30% in GDI engines, however, requires a cost-effective breakthrough in lean-burn combustion technology.  Sonex believes its SCAI combustion process provides the lean-burn breakthrough needed based on preliminary SCAI-GDI dynamometer data which show a reduction of at least 25%.

It is important to point out that SCAI is not homogeneous charge, compression ignition (HCCI), which is referred to by researchers as a future engine technology.  The SCAI-GDI and HCCI exhibit similar fuel consumption, but the real difference is the ability of SCAI-GDI to control the combustion process dynamically over the entire load and rpm needed for automotive applications.  HCCI inherently operates over a narrow range of rpm and load.  The SCAI-GDI operates by fuel injection timing and piston-produced auto-ignition chemistry to achieve full control over the combustion process for real world automotive applications.

Sonex has designed a three-phase program, expected to cost $1 million, to pursue commercialization of the SCAI combustion process for gasoline engines.  In the first phase, Sonex believes it can accomplish a six-month program to produce compelling SCAI combustion process engine data of a fuel mileage improvement of 25% to 30% in GDI engines.  The compelling data will be the basis of Phase 2 marketing to the automotive industry as a patent and know-how licensing opportunity that yields significant financial return in Phase 3 based on the U.S. market of 16 million new gasoline powered vehicles per year.

In Phase 1 of the proposed GDI venture, the SCAI-GDI piston design from the DARPA program will be refined to determine the ideal control parameters needed for SCAI-GDI engines with outstanding fuel consumption and emissions.  Sonex is seeking partners and other funding arrangements to support the SCAI-GDI program.  In a separate document available upon request, an SCAI-GDI investment structure is proposed which contemplates formation of an investment entity to enter into an agreement with Sonex to conduct the SCAI-GDI program.

Michael I. Keller, the consultant who serves as the Company’s Director of Business Development, has expended considerable effort in formulating the SCAI-GDI program, including contacting potential component suppliers and potential investors.  Mr. Keller intends to form an investment entity to conduct the SCAI-GDI program.  At his request, in October 2007 the Company entered into a Letter of Intent with Mr. Keller pursuant to which Sonex received a cash payment of $5,000 and agreed not to enter into a transaction for the development and commercialization of the SCAI-GDI opportunity with any other party, and Mr. Keller agreed not to demand payment of unpaid consulting fees, for a period of ninety days.  In January 2008 the parties renewed this arrangement for another ninety days upon the payment of an additional $5,000 by Mr. Keller

Financial Summary:

COMPARATIVE CONDENSED BALANCE SHEETS

(Unaudited)

                                                                                                   December 31,                           

                                                                               2007                    2006                    2005      

Current assets:

  Cash and equivalents                                   $        82,528      $      213,674      $        31,545

  Accounts receivable                                               84,355                14,132

  Prepaid expenses                                                   21,569                19,929                17,802

  Total current assets                                             188,452              247,735                 49,347

Patents, net of accumulated amortization             106,914              116,205               125,577

Property and equipment, net of

   accumulated depreciation                                     62,589                64,095                 56,607

   Total assets                                                 $      357,955      $      428,035       $      231,531

Current liabilities:

Accounts payable & other accrued liabilities  $          8,362      $        15,295       $        27,772

Business credit card balances                                   3,391                18,073                 42,940

Deferred revenue                                                                                                             26,576

Capital lease obligations                                                                                                  16,727

Notes and interest payable to shareholders                                        40,000               197,989

Note payable to equipment vendor                             2,043                  3,048                   3,983

Deferred compensation                                       1,817,127           1,776,494            1,649,566

Total current liabilities                                          1,830,923           1,852,910            1,965,553

Stockholders' equity/(deficit):

Paid-in capital                                                    22,247,179         22,247,179          22,247,179

Accumulated deficit                                          (23,720,147)       (23,672,054)       (23,981,201)

Total stockholders' equity/(deficit)                      (1,472,968)         (1,424,875)         (1,734,022)

   Total liabilities and stockholders' equity       $      357,955      $      428,035       $      231,531

                            COMPARATIVE CONDENSED STATEMENTS OF OPERATIONS

                                                                         (Unaudited)

                                                                                         Year ended December 31,                 

                                                                                2007                   2006                   2005       

Revenue:

  Services                                                        $        403,859    $          25,816    $       199,896

  Technology development contracts                        213,089              723,688             227,552

  Licensing                                                                   17,598              507,579

  Engine sales and commissions                               12,930                10,722               81,990

                                                                                  647,476           1,267,805             509,438

Costs and expenses                                               (699,850)            (961,689)           (875,051)

Interest income                                                             4,281                  3,031                  1,227

Net income (loss)                                            $      (48,093)     $       309,147     $      (364,386)

Financial position:

As reflected in the financial summary, the Company was able to pay substantial liabilities and earn a profit in 2006 directly as a result of the November 2006 signing of the license and collaboration agreements with Insitu.  In 2007 Sonex generated additional service revenue from Insitu under the collaboration agreement, as well as service revenue from another defense contractor and technology development and demonstration revenue from DARPA.  The Company's expenses exceeded its revenue in 2007.   Because continued revenue generation is not assured, the Company is unlikely to earn a profit in 2008.

The cash generated from the Insitu agreements permitted Sonex to repay during 2006 most of the approximately $198,000 in loans from shareholders Mike Keller and Denny Gulick and nearly $43,000 in business credit card balances outstanding as of the beginning of 2006.  The Company also has been able to make significant payments on compensation obligations.  The remaining balances of the loans from shareholders were paid in full during 2007.

Substantial amounts of unpaid compensation, however, remain outstanding.  Company officers Andy Pouring and George Ponticas, and consultant Mike Keller continue to defer all of their current compensation.  The Company would not have been able to remain in operation without these continued compensation deferrals.  Mr. Ponticas has been receiving regular payments, and Dr. Pouring and Mr. Keller have been receiving occasional payments, on unpaid compensation.  Payment of $1,146,082 of the unpaid compensation due to these individuals as of December 31, 2007 is now secured by the Company's patents.

Management is assessing the future needs of the Company and is working to develop an appropriate strategy for moving forward, including how best to maximize shareholder value.  With the signing in November 2006 of its first technology licensing agreement and approaching production roll-out by Insitu of the SCS HFE powered ScanEagle, Sonex has demonstrated the commercial viability of its small HFE technology in UAVs.  The Company is seeking to capitalize on this success by finding additional licensees for other SCS HFE applications and SCAI piston technology.  In order to fund the Company while that objective is pursued while recognizing that it will be some time before significant additional royalty revenue, if any, is generated from the Insitu license, management will be looking for continuing revenue opportunities from technology development and demonstration projects and engine testing services. 

There is no assurance that the Company will be able to generate significant revenues from the commercialization of its technology and ultimately achieve profitable operations.  Combined with the significant financial liabilities that remain, there is still substantial doubt about the Company’s ability to continue in operation for the long-term.

Management is working to develop an appropriate strategy for moving forward to maximize shareholder value now that the stock no longer trades publicly.  The cost of re-registering the stock with the SEC to make it eligible for public trading is very high, as is the cost to maintain that status due to ongoing compliance expenses.  The Company will seek to realize tangible value for its stock by exploring collaboration with larger companies or strategic corporate transactions of some form, and will be receptive to credible approaches from other companies or major investors.

Revenue from services:

In 2005 the Company generated revenue for engineering and engine testing services performed for U.S. Department of Defense (DoD) contractors.  The majority of such services in 2005 related primarily to small gasoline engines used to power UAVs being deployed in Iraq, and was performed on an accelerated schedule at the request of the DoD.  There was little such revenue generated in 2006, with $25,000 of the total representing the up-front payment received upon execution of the collaboration agreement with Insitu 

Subsequent work for Insitu primarily has been in the form of testing services for the ScanEagle SCS HFE performance refinement, endurance and other pre-production issues.  The collaboration agreement provided for minimum consulting fees to Sonex of $240,000 over two years through November 2008.  Subsequent to the $25,000 up-front payment in November 2006, minimum fees of $178,000 have been invoiced through December 2007, although amounts invoiced for actual services have exceeded the minimum fees for the period. 

Service revenue in 2007 from DoD contractors other than Insitu has been generated primarily from a contractor which has tasked Sonex to evaluate candidate gasoline engines for potential conversion to heavy fuel operation to power a UAV.

Revenue from technology development contracts:

The Company's two primary technology development and demonstration customers have been DARPA and Insitu.  Sonex began working with DARPA in 2002 and with Insitu in 2005.  As detailed previously, the DARPA project was for a multi-cylinder HFE demonstration.  The original funding awarded in September 2002 was $744,246.  In July 2004 the Company was awarded funding of $192,932 for a first follow-on task, and in June 2005 was awarded funding of $300,000 for a second follow-on task.  The latest addition to the DARPA agreement was for $143,859 in June 2007 to complete the final task, bringing the total funding to date under this agreement to $1,381,037.  Work under this agreement concluded in November 2007.

Technology development and demonstration revenue from Insitu in 2005 and 2006 related to the initial development of a prototype combustion system to convert the ScanEagle's gasoline engine to heavy fuel operation and subsequent tasks to develop, fabricate and qualify pre-production, flight ready SCS HFEs.  Sonex hopes to be tasked in 2008 to develop a prototype HFE combustion system for Insitu’s new Integrator line of UAVs.

In early January 2006 the Company began work on a contract with another defense contractor to develop an SCS HFE laboratory prototype design for another current production small gasoline engine for potential use in a military UAV.  Under this agreement, the Company was to conduct performance testing and limited durability testing with the objective of receiving a follow-on contract for the development, fabrication and qualification of pre-production, flight ready engines.  In March 2006 prior to demonstration by Sonex of the preliminary SCS HFE design, the customer terminated the contract because of concerns about the design of the gasoline engine selected by the customer and potential availability problems of that engine.  Through the date of termination, Sonex earned $199,447.

Licensing revenue:

Nearly all reported licensing revenue has been generated from Insitu.  Sonex received cash payments for a non-refundable advance royalty and an exclusivity fee totaling $500,000 in 2006.  Licensing revenue in 2006 also included $7,579 for reimbursement by Insitu to Sonex under the license and collaboration agreements for all fees and costs required to maintain its patents.  The $17,598 in licensing revenue reported for 2007 consists of patent cost reimbursements from Insitu of $12,598, and the $5,000 received upon signing of the Letter of Intent with Mr. Keller relating to the SCAI-GDI opportunity.  As a result of the payment by Insitu of the advance royalty in 2006, Sonex will not earn additional royalties unless and until Insitu’s production volumes exceed certain levels, which may not occur for some time, if at all.  The amount of the royalty is dependent on engine size and is subject to adjustment depending on the volume of engines produced and the emergence of competitive HFEs in the licensed field.

Engine Sales:

In 2005 the Company generated revenue from the sale of a small quantity of two-stroke gasoline engines manufactured by Limbach Flugmotoren, GmbH & Co. KG of Germany (website: www.limflug.de).  Since late 2004, Sonex has been the exclusive U.S. and Canadian distributor of Limbach two- and four-stroke gasoline engines, which are high quality, lightweight, and reliable engines used in UAVs, powered gliders and very light aircraft.  The Company is not in a position to devote significant resources to market Limbach engines.  As a result, related revenue in 2006 and 2007 has been insignificant.

Litigation:

On January 31, 2008, the remaining active legal action against the Company, a securities fraud lawsuit filed in February 2005 in Federal Court in Pennsylvania that was amended and refiled after initially being dismissed in July 2006, was dismissed for the second time.  The original Complaint alleging federal and state securities fraud was filed by Bruce W. Majer of Plymouth Meeting, PA, Allen W. Fortna of Whitehall, PA, and the Hermitage Partnership of Philadelphia, PA (together, referred to as the “Investors” or the “Plaintiffs”) seeking the return of $175,000 in equity investments made in Sonex during a private placement in 2004, plus unspecified compensatory and punitive damages.  The Investors believed they were induced to purchase securities based on a series of alleged misrepresentations and omissions, and was filed against Sonex, its former President, CEO and director Roger D. Posey, former director Jim Z.I. Williams, current CFO, Secretary and director George E. Ponticas, and Dr. Andrew A. Pouring, current Sonex Chairman of the Board, CEO and President.  Mr. Majer is a former colleague of Mr. Posey, while Mr. Fortna is Mr. Majer's brother-in law.

Sonex management always has maintained that the claims are without merit, that many of the allegations in the Complaint contained factual inaccuracies, and that documents supplied to the Plaintiffs fully disclosed the risks of an investment in Sonex.  It is the opinion of management that the Plaintiffs attempted to orchestrate a securities fraud claim to escape what they had come to perceive as a downside investment.  Prior to investing in Sonex in 2004, each of the Investors executed subscription agreements in which they attested that they had read Company filings, including the December 31, 2003 Annual Report, which fully and clearly disclosed the poor financial condition of Sonex at that time.  The Investors specifically attested that they understood that an investment in Sonex was speculative and involved a high degree of risk, yet their Complaint claims the Company's financial condition was misrepresented.

In March 2005 the Company filed a Motion to Dismiss the Complaint.  In July 2006 the Court granted the Company's Motion to Dismiss, ruling that the Plaintiffs failed to state any of their claims as a matter of law.  In August 2006, the Investors amended and re-filed their Complaint by adding more details to their allegations.  In September 2006 the Company filed a Motion to Dismiss the Amended Complaint.  In November 2006 the Plaintiffs filed an Opposition to the Company's Motion to Dismiss, and in early December 2006 the Company filed its Reply in Support of its Motion to Dismiss.  No action was taken by the Court until the dismissal of the Amended Complaint on January 31, 2008. 

As explained in the Memorandum and Order of Dismissal, the Court found that the additional details in the Amended Complaint failed to give merit to the original claims.  In essence, the Amended Complaint collapsed under the weight of the total mix of information and cautionary statements available at the time of the investments.  The Court noted that “Sonex disclosed its true nature to the [Plaintiffs] in the written materials they were given prior to investing. … The Plaintiffs decided to invest despite these warnings, and their economic losses are theirs to bear.”

The Court ruled that the Plaintiffs failed to state any of their claims as a matter of law and dismissed the Amended Complaint in its entirety with prejudice, meaning that the Plaintiffs would be barred from making such claims in the future; however, the Plaintiffs have 30 days in which to file an appeal.  The Investors will maintain ownership of the 700,000 shares of Sonex common stock they acquired in the private placement in 2004.

Although Sonex has prevailed in this matter, the Company has had to divert resources towards defending the legal action brought by Mr. Majer and his co-investors.  Beginning in late 2004 when the Plaintiffs first demanded return of their investments followed by the filing of the Complaint in February 2005, management has had to devote a significant amount of time to respond, and the Company has incurred legal fees of approximately $108,500, with additional legal fees to be incurred in closing the case.   The diversion of resources to respond to this action was a contributing factor in the Company’s inability to maintain its filings with the SEC, eventually leading to the loss of public trading of Sonex stock.

The Court is required by the Private Securities Litigation Reform Act to perform a review under Rule 11 of the Federal Rules of Civil Procedure to determine whether or not to impose sanctions for abusive litigation by awarding legal fees to the prevailing party.  On February 14, 2008, the Company filed a Motion and supporting memorandum asking the Court to consider the Plaintiffs' compliance with Rule 11 as it relates to the original and Amended Complaints, and requesting award to the Company of legal fees and expenses incurred to date as well as amounts continuing to be incurred in this action.  The filing of this Motion suspends the 30-day deadline for the Plaintiffs to file an appeal, if any, of the dismissal.

Caution Regarding Forward-Looking Statements

This document contains information in the form of "forward-looking" statements within the meaning of the Private Securities Litigation Act of 1995 (the "Act").  Such statements are based on current expectations, estimates, projections and assumptions by management with respect to, among other things, trends affecting the Company's financial condition or results of operations and the impact of competition. Words such as "expects", "anticipates", "plans", "believes", "estimates", variations of such words, and similar expressions are intended to identify such statements that include, but are not limited to, projections of revenues, earnings, cash flows and contract awards.  Such statements are not guarantees of future performance and involve risks and uncertainties, all of which are difficult to predict and many of which are beyond the control of the Company.  In order to obtain the benefits of the "safe harbor" provisions of the Act for any such forward-looking statements, the Company cautions readers about significant factors which, among other things, have in some cases affected the Company's actual results and are in the future likely to affect the Company's actual results and cause them to differ materially from those expressed in any such forward-looking statements. Accordingly, readers are cautioned not to place undue reliance on such forward-looking statements.