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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
______________
 
FORM 10-Q
______________
(Mark one)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

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

For the transition period from _______________ to _______________
 
000-29748
(Commission file number)
______________
 
ECHELON CORPORATION
(Exact name of registrant as specified in its charter)
______________

Delaware
(State or other jurisdiction of incorporation or organization)
77-0203595
(IRS Employer Identification Number)
 
550 Meridian Avenue
San Jose, CA 95126
(Address of principal executive office and zip code)

(408) 938-5200
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
 
Yes x No o

As of October 31, 2003, 40,296,345 shares of the Registrant’s common stock were outstanding.

 
 
   
 
 
ECHELON CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003

INDEX

 
 
 
Page
     
Part I.
 
FINANCIAL INFORMATION
 
Item 1.
 
Financial Statements
 
 
 
Condensed Consolidated Balance Sheets as of September 30, 2003 (unaudited) and December 31, 2002
3
 
 
Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2003 and September 30, 2002 (unaudited)
4
 
 
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and September 30, 2002 (unaudited)
5
 
 
Notes to Condensed Consolidated Financial Statements (unaudited)
6
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
13
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
40
Item 4.
 
Controls and Procedures
 40 
 
 
 
 
Part II.
 
OTHER INFORMATION
 
Item 6.
 
Exhibits and Reports on Form 8-K
41
 
 
 
 
SIGNATURE
41
EXHIBIT INDEX
42

 
FORWARD-LOOKING INFORMATION
 
This report contains forward-looking statements within the meaning of the U.S. federal securities laws that involve risks and uncertainties. Certain statements contained in this report are not purely historical including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future that are forward-looking. These statements include those discussed in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including "Liquidity and Capital Resources," "New Accounting Standards" and "Factors That May Affect Future Results of Operations," and elsewhere in this report. These statements include statements concerning projected revenues, international revenues, expenses, gross profit, i ncome, product development and market acceptance of our products.

In this report, the words "anticipate," "believe," "expect," "intend," "future," "moving toward" and similar expressions also identify forward-looking statements. Our actual results could differ materially from those forward-looking statements contained in this report as a result of a number of risk factors including, but not limited to, those set forth in the section entitled "Factors That May Affect Future Results of Operations" and elsewhere in this report. You should carefully consider these risks, in addition to the other information in this report and in our other filings with the SEC. All forward-looking statements and reasons why results may differ included in this report are made as of the date of this report, and we assume no obligation to update any such forward- looking statement or reason why such results might differ.

 
  2  
 
 
PART I. FINANCIAL INFORMATION

Item 1.   Financial Statements

ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

(Unaudited)

 
  
September 30,
2003
December 31,
2002
   
 
 
ASSETS
   
 
    
 
  
 
    
 
    
 
  
CURRENT ASSETS:
   
 
    
 
  
Cash and cash equivalents
 
$
34,514
 
$
34,941
 
Short-term investments
   
112,742
   
99,548
 
Accounts receivable, net
   
18,848
   
22,930
 
Inventories
   
5,372
   
7,991
 
Other current assets
   
2,926
   
3,217
 
   
 
 
Total current assets
   
174,402
   
168,627
 
   
 
 
 
    
 
    
 
  
Property and equipment, net
   
18,491
   
16,677
 
Goodwill
   
7,981
   
7,758
 
Restricted investments
   
10,832
   
10,526
 
Other long-term assets
   
2,697
   
3,904
 
   
 
 
 
    
 
    
 
  
TOTAL ASSETS
 
$
214,403
 
$
207,492
 
   
 
 
 
    
 
    
 
  
LIABILITIES AND STOCKHOLDERS’ EQUITY
   
 
    
 
  
 
    
 
    
 
  
CURRENT LIABILITIES:
   
 
    
 
  
Accounts payable
 
$
7,458
 
$
5,993
 
Accrued liabilities
   
5,229
   
3,773
 
Deferred revenues
   
1,151
   
2,541
 
   
 
 
Total current liabilities
   
13,838
   
12,307
 
   
 
 
 
    
 
    
 
  
LONG-TERM LIABILITIES:
   
 
    
 
  
Deferred rent
   
397
   
167
 
   
 
 
Total long-term liabilities
   
397
   
167
 
 
    
 
    
 
  
STOCKHOLDERS’ EQUITY:
   
 
    
 
  
Common stock
   
405
   
400
 
Additional paid-in capital
   
271,513
   
268,883
 
Treasury stock
   
(3,191
)
 
(3,191
)
Accumulated other comprehensive income
   
542
   
445
 
Accumulated deficit
   
(69,101
)
 
(71,519
)
   
 
 
Total stockholders’ equity
   
200,168
   
195,018
 
   
 
 
 
    
 
    
 
  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
214,403
 
$
207,492
 
   
 
 
 
See accompanying notes to condensed consolidated financial statements.

 
  3  
 
 
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)


 
  
Three Months Ended
September 30,
Nine Months Ended
September 30,
   
 
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
REVENUES:
   
 
    
 
    
 
    
 
  
Product
 
$
30,447
 
$
33,073
 
$
93,819
 
$
91,159
 
Service
   
285
   
277
   
807
   
1,094
 
   
 
 
 
 
Total revenues
   
30,732
   
33,350
   
94,626
   
92,253
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
COST OF REVENUES:
   
 
    
 
    
 
    
 
  
Cost of product
   
10,179
   
15,630
   
39,621
   
42,576
 
Cost of service
   
597
   
699
   
1,939
   
2,150
 
   
 
 
 
 
Total cost of revenues
   
10,776
   
16,329
   
41,560
   
44,726
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
GROSS PROFIT
   
19,956
   
17,021
   
53,066
   
47,527
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
OPERATING EXPENSES:
   
 
    
 
    
 
    
 
  
Product development
   
6,753
   
5,405
   
28,034
   
16,401
 
Sales and marketing
   
4,662
   
4,354
   
13,965
   
12,933
 
General and administrative
   
3,093
   
2,394
   
9,154
   
6,872
 
   
 
 
 
 
Total operating expenses
   
14,508
   
12,153
   
51,153
   
36,206
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
INCOME FROM OPERATIONS
   
5,448
   
4,868
   
1,913
   
11,321
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
INTEREST AND OTHER INCOME, NET
   
537
   
922
   
1,820
   
2,933
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
INCOME BEFORE PROVISION FOR INCOME TAXES
   
5,985
   
5,790
   
3,733
   
14,254
 
 
    
 
    
 
    
 
    
 
  
PROVISION FOR INCOME TAXES
   
1,496
   
463
   
1,316
   
1,140
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
NET INCOME
 
$
4,489
 
$
5,327
 
$
2,417
 
$
13,114
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
NET INCOME PER SHARE:
   
 
    
 
    
 
    
 
  
Basic
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.33
 
   
 
 
 
 
Diluted
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.32
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
SHARES USED IN COMPUTING NET INCOME PER SHARE:
   
 
    
 
    
 
    
 
  
Basic
   
40,186
   
39,658
   
39,980
   
39,388
 
   
 
 
 
 
Diluted
   
41,305
   
40,619
   
40,767
   
40,769
 
   
 
 
 
 
 
See accompanying notes to condensed consolidated financial statements.

 
  4  
 
 
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
  
Nine Months Ended
September 30,
   
 
    
2003

 

 
2002
 
   
 
 
 
    
 
    
 
  
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
   
 
    
 
  
Net income
 
$
2,417
 
$
13,114
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
   
 
    
 
  
Depreciation and amortization
   
3,921
   
2,893
 
In-process research and development
   
9,808
   
400
 
Provision for doubtful accounts
   
6
   
66
 
Deferred compensation expense
   
--
   
31
 
Change in operating assets and liabilities:
   
 
    
 
  
Accounts receivable
   
4,076
   
(3,028
)
Inventories
   
2,619
   
308
 
Other current assets
   
291
   
3,702
 
Accounts payable
   
1,465
   
(409
)
Accrued liabilities
   
1,456
   
913
 
Deferred revenues
   
(1,390
)
 
207
 
Deferred rent
   
230
   
93
 
   
 
 
Net cash provided by operating activities
   
24,899
   
18,290
 
   
 
 
 
    
 
    
 
  
CASH FLOWS USED IN INVESTING ACTIVITIES:
   
 
    
 
  
Purchase of available-for-sale short-term investments
   
(122,994
)
 
(57,850
)
Proceeds from maturities and sales of available-for-sale short-term investments
   
109,800
   
49,536
 
Unrealized gains (losses) on securities
   
(328
)
 
(104
)
Purchase of certain assets of Metering Technology Corporation
   
(11,000
)
 
--
 
Purchase of BeAtHome.com, Inc.
   
--
   
(5,811
)
Purchase of restricted investments
   
(306
)
 
(10,696
)
Change in other long-term assets
   
1,053
   
380
 
Capital expenditures
   
(4,612
)
 
(2,477
)
   
 
 
Net cash used in investing activities
   
(28,387
)
 
(27,022
)
   
 
 
 
    
 
    
 
  
CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
   
 
    
 
  
Proceeds from issuance of common stock related to the exercise of employee stock options
   
2,635
   
2,782
 
   
 
 
Net cash provided by financing activities
   
2,635
   
2,782
 
   
 
 
 
    
 
    
 
  
EFFECT OF EXCHANGE RATE CHANGES ON CASH
   
426
   
405
 
   
 
 
 
    
 
    
 
  
NET DECREASE IN CASH AND CASH EQUIVALENTS
   
(427
)
 
(5,545
)
 
    
 
    
 
  
CASH AND CASH EQUIVALENTS:
   
 
    
 
  
Beginning of period
   
34,941
   
23,232
 
   
 
 
End of period
 
$
34,514
 
$
17,687
 
   
 
 
 
    
 
    
 
  
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
   
 
    
 
  
Cash paid for income taxes
 
$
500
 
$
387
 
   
 
 
 
See accompanying notes to condensed consolidated financial statements.

 
  5  
 
 
ECHELON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.     Basis of Presentation:
 
The condensed consolidated financial statements include the accounts of Echelon Corporation (the "Company"), a Delaware corporation, and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

While the financial information furnished is unaudited, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2002 included in its Annual Report on Form 10-K.

2.      Summary of Significant Accounting Policies:

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition

The Company’s revenues are derived primarily from the sale and license of its products and, to a lesser extent, from service revenues. Product revenues consist of revenues from hardware sales and software licensing arrangements. Revenues from software licensing arrangements accounted for 4.0% of total revenues for the quarter ended September 30, 2003 and 9.2% for the same period in 2002; and 3.9% of total revenues for the nine months ended September 30, 2003 and 6.7% for the same period in 2002. Service revenues consist of product technical support (including software post-contract support services), training, and custom software development services.

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectibility is probable and there are no post-delivery obligations. For hardware sales, including sales to distributors and third party manufacturers, these criteria are generally met at the time of shipment. For software licenses, these criteria are generally met upon shipment to the final end-user.

In accordance with Statement of Position 97-2, or SOP 97-2, Software Revenue Recognition, revenue earned on software arrangements involving multiple elements is allocated to each element based upon the relative fair values of the elements. The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date. In these instances, the amount of revenue deferred at the time of sale is based on vendor specific objective evidence ("VSOE") of the fair value for each undelivered element. If VSOE of fair value does not exist for each undelivered element, all revenue attributable to the multi-element arrangement is deferred until sufficient VSOE of fair value exists for each undelivered element or all elements have been delivered.

The Company currently sells a limited number of products that are considered multiple element arrangements under SOP 97-2. Revenue for the software license element is recognized at the time of delivery of the applicable product to the end-user. The only undelivered element at the time of sale consists of post-contract customer support ("PCS"). The VSOE for this PCS is based on prices paid by the Company’s customers for stand-alone purchases of these PCS packages. Revenue for the PCS element is deferred and recognized ratably over the PCS service period. The costs of providing these PCS services are expensed when incurred.

 
  6  
 
 
The Company accounts for the rights of return, price protection, rebates, and other sales incentives offered to its distributors in accordance with Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists .

Service revenue is comprised of PCS, training, and custom software development services. PCS revenue is recognized ratably over the term of the support period. Training revenue is recognized when the training services are performed. In the case of custom software development services, revenue is recognized when the customer accepts the software.
 
Cash, Cash Equivalents and Short-Term Investments
 
The Company considers bank deposits, money market investments and all debt and equity securities with an original maturity of ninety days or less as cash and cash equivalents. The Company classifies its investments in debt and equity securities as available-for-sale in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. As of September 30, 2003, the Company’s available-for-sale securities had contractual maturities from three to twenty-four months and an average maturity of six months. The fair value of available-for-sale securities was determined based on quoted market prices at the reporting date for those in struments.
 
Computation of Net Income Per Share
 
Net income per share has been calculated under SFAS No. 128, or SFAS 128, Earnings per Share. SFAS 128 requires companies to compute earnings per share under two different methods (basic and diluted). Basic net income per share is calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted net income per share is calculated by adjusting the weighted average number of outstanding shares assuming conversion of all potentially dilutive stock options and warrants under the treasury stock method.

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the quarter and nine months ended September 30, 2003 and September 30, 2002 (in thousands, except per share amounts):

 
Three Months Ended
September 30,
Nine Months Ended
September 30,
   
 
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
Net income (Numerator):
   
 
    
 
    
 
    
 
  
Net income, basic & diluted
 
$
4,489
 
$
5,327
 
$
2,417
 
$
13,114
 
   
 
 
 
 
Shares (Denominator):
   
 
    
 
    
 
    
 
  
Weighted average common shares outstanding
   
40,186
   
39,679
   
39,980
   
39,409
 
Weighted average common shares outstanding
   
 
    
 
    
 
    
 
  
subject to repurchase
   
-
 
  
(21
)
 
-
   
(21
)
   
 
 
 
 
Shares used in basic computation
   
40,186
   
39,658
   
39,980
   
39,388
 
Weighted average common shares outstanding
   
 
    
 
    
 
    
 
  
subject to repurchase
   
-
   
21
   
-
   
21
 
Common shares issuable upon exercise of stock
   
 
    
 
    
 
    
 
  
options (treasury stock method)
   
1,119
   
940
   
787
   
1,361
 
Average unamortized deferred compensation
   
-
   
-
   
-
   
(1
)
   
 
 
 
 
Shares used in diluted computation
   
41,305
   
40,619
   
40,767
   
40,769
 
   
 
 
 
 
Net income per share:
   
 
    
 
    
 
    
 
  
Basic
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.33
 
   
 
 
 
 
Diluted
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.32
 
   
 
 
 
 

For the three months and nine months ended September 30, 2003, stock options in the amount of 4,799,632 and 6,062,644, respectively, were not included in the computation of diluted earnings per share. For the three months and nine months ended September 30, 2002, stock options in the amount of 5,241,636 and 4,401,545, respectively, were not included in the computation of diluted earnings per share. These options were excluded from the calculation because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect of their inclusion would be anti-dilutive.
 
 
  7  
 
 

Stock-Based Employee Compensation Plans

The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock issued to Employees, and related Interpretations. With the exception of deferred compensation expense recorded in 2002, which was attributable to options granted during 1998, no stock-based employee compensation cost is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net incom e and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

 
  
Three Months Ended
September 30,
Nine Months Ended
September 30,
   
 
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Net income as reported    
  
$
4,489
 
$
5,327
 
$
2,417
 
$
13,114
 
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects
   
-
   
-
   
-
   
31
 
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
   
(5,037
)
 
(8,064
)
 
(17,064
)
 
(24,966
)
   
 
 
 
 
Pro forma net loss    
  
$
(548
)
$
(2,737
)
$
(14,647
)
$
(11,821
)
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Basic net income (loss) per share:
   
 
    
 
    
 
    
 
  
As reported
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.33
 
   
 
 
 
 
Pro forma
 
$
(0.01
)
$
(0.07
)
$
(0.37
)
$
(0.30
)
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Diluted net income (loss) per share:
   
 
    
 
    
 
    
 
  
As reported
 
$
0.11
 
$
0.13
 
$
0.06
 
$
0.32
 
   
 
 
 
 
Pro forma
 
$
(0.01
)
$
(0.07
)
$
(0.37
)
$
(0.30
)
   
 
 
 
 

The weighted-average grant date fair value of options granted during the three months ended September 30, 2003 and September 30, 2002 was $10.61 and $10.16, respectively. The weighted-average grant date fair value of options granted during the nine months ended September 30, 2003 and September 30, 2002 was $8.92 and $13.05, respectively. Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
 
 
  
Three Months Ended
 September 30,
Nine Months Ended
September 30,
   
 
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Expected dividend yield    
    
0.0
%
 
0.0
%
 
0.0
%
 
0.0
%
Risk-free interest rate    
    
3.1
%
 
3.6
%
 
2.5
%
 
4.2
%
Expected volatility    
    
103.9
%
 
117.4
%
 
101.0
%
 
118.4
%
Expected life (in years)    
    
4.2
   
4.5
   
4.2
   
4.4
 
 
Recently Issued Accounting Standards

In November 2002, the FASB issued FASB Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disc lose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company adopted FIN 45 on January 1, 2003. The adoption did not have a material impact on the Company’s financial position, results of operations, or cash flows.
 
 
  8  
 
 
 In December 2002, the FASB issued SFAS No. 148, or SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123 . SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensati on. In addition, SFAS 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company is required to follow the prescribed format and provide the additional disclosures required by SFAS 148 in its annual financial statements for the year ending December 31, 2002 and must also provide the disclosures in its quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ending March 31, 2003. The adoption of SFAS 148 did not have an effect on the Company’s financial position or results of operations as the Company did not adopt the fair value method of accounting for stock-based employee compensation.
 
In January 2003, the FASB issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the varia ble interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to entities created before February 1, 2003 in the first fiscal year or interim period ending after December 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of FIN 46 did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In January 2003, the EITF published EITF No. 00-21, or EITF 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. EITF 00-21 is effective for revenue arrang ements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In April 2003, the FASB issued SFAS No. 149, or SFAS 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. In particular, SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative. It also clarifies when a derivative contains a financing component that warrants special reporting in the statemen t of cash flows. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material impact on the Company’s financial position or results of operations as it does not currently hold any derivative instruments or engage in hedging activities.

In May 2003, the FASB issued SFAS No. 150, or SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. This statement is effective for interim periods beginning after June 15, 2003. As the Company has no instruments which management believes are subject to SFAS 150, the adoption of SFAS 1 50 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

 
  9  
 
 
3.      Inventories:

Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing overhead. Inventories consist of the following (in thousands):

 
  
September 30,
2003
December 31,
2002
   
 
 
 
    
 
    
 
  
Purchased materials
 
$
2,873
 
$
1,432
 
Work-in-process
   
18
   
19
 
Finished goods
   
2,481
   
6,540
 
   
 
 
 
  
$
5,372
 
$
7,991
 
   
 
 
4.  Accrued Liabilities:
 
             Accrued liabilities consist of the following (in thousands):

 
  
September 30,
2003
December 31,
2002
   
 
 
 
    
 
    
 
  
Accrued payroll and related costs
 
$
2,235
 
$
1,929
 
Accrued marketing costs
   
557
   
481
 
Other accrued liabilities
   
2,437
   
1,364
 
   
 
 
 
  
$
5,229
 
$
3,774
 
   
 
 
 
5.    Segment Disclosure:

In 1998, the Company adopted SFAS No. 131, or SFAS 131, Disclosures about Segments of an Enterprise and Related Information. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing business performance. The Company’s chief operating decision-making group is the Executive Staff, which is comprised of the Chief Executive Officer, the Chief Operating Officer, and their direct reports. SFAS 131 also requires disclo sures about products and services, geographic areas, and major customers.

The Company operates its business as one reportable segment: the design, manufacture and sale of products for the control network industry, and markets its products primarily to the building automation, industrial automation, transportation, and utility/home automation markets. The Company’s products are marketed under the LonWorks ® brand name, which provides the infrastructure and support required to implement and deploy open, interoperable, control network solutions. All of the Company’s products either incorporate or operate with the Neuron® Chip and/or the LonWorks protocol. The Company also provides services to customers which consist of technical support and training courses covering its LonWorks network technology and products. The Company offers about 90 products and services that together constitute the LonWorks system. In general, any given customer purchases a subset of such products and services that are appropriate for that customer’s application.

The Company manages its business primarily on a geographic basis. The Company’s geographic areas are comprised of three main groups: the Americas; Europe, Middle East and Africa ("EMEA"); and Asia Pacific/ Japan ("APJ"). Each geographic area provides products and services as further described in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company evaluates the performance of its geographic areas based on profit or loss from operations. Profit or loss for each geographic area includes sales and marketing expenses and other charges directly attributable to the area and excludes certain expenses that are managed outside the geographic area. Costs excluded from area profit or loss primarily consist of unallocated corporate expenses, comprised of product development costs, corporate marketing costs and other general and administrative expenses, which are separately managed. The Company’s long-lived assets include property and equipment, restricted investments, goodwill, loans to certain key employees, purchased technology, and deposits on its leased facilities. Long-lived assets are attributed to geographic areas based on the country where the assets are located. As of September 30, 2003 and December 31, 2002, long-lived assets of about $37.0 million and $36.3 million, respectively, were domiciled in the United States. Long-lived assets for all other locations are not material to the consolidated financial statements. Assets and the related depreciation and amortization are not reported by geography because that information is not reviewed by the Executive Staff when making decisions about resource allocation to the geographic areas based on their performance.

 
  10  
 
 
In North America, the Company sells its products through a direct sales organization. Outside North America, direct sales, applications engineering and customer support are conducted through the Company’s operations in EMEA and APJ. Revenues are attributed to geographic areas based on the country where the products are shipped. Summary information by geography for the quarters and nine months ended September 30, 2003 and 2002 is as follows (in thousands):
 

 
  
Three Months Ended
September 30,
Nine Months Ended
September 30,
   
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
Revenues from customers:
   
 
    
 
    
 
    
 
  
Americas
 
$
4,085
 
$
3,800
 
$
11,860
 
$
10,956
 
EMEA
   
24,341
   
16,744
   
69,749
   
42,263
 
APJ
   
2,239
   
12,806
   
13,017
   
39,034
 
Unallocated
   
67
   
0
   
0
   
0
 
   
 
 
 
 
Total
 
$
30,732
 
$
33,350
 
$
94,626
 
$
92,253
 
   
 
 
 
 
Gross profit:
   
 
    
 
    
 
    
 
  
Americas
 
$
2,573
 
$
2,301
 
$
7,369
 
$
6,457
 
EMEA
   
15,884
   
8,404
   
39,067
   
22,440
 
APJ
   
1,433
   
6,316
   
6,630
   
18,630
 
Unallocated
   
66
   
0
   
0
   
0
 
   
 
 
 
 
Total
 
$
19,956
 
$
17,021
 
$
53,066
 
$
47,527
 
   
 
 
 
 
Income (loss) from operations:
   
 
    
 
    
 
    
 
  
Americas
 
$
1,651
 
$
1,471
 
$
4,609
 
$
3,732
 
EMEA
   
14,935
   
7,671
   
36,166
   
19,911
 
APJ
   
575
   
5,444
   
4,168
   
15,892
 
Unallocated
   
(11,713
)
 
(9,718
)
 
(43,030
)
 
(28,214
)
   
 
 
 
 
Total
 
$
5,448
 
$
4,868
 
$
1,913
 
$
11,321
 
   
 
 
 
 

 
Products sold to Enel S.p.A., an Italian utility company ("Enel") and its designated manufacturers accounted for 64.2% of total revenues for the quarter ended September 30, 2003 and 69.5% for the same period in 2002; and 67.1% of total revenues for the nine months ended September 30, 2003 and 66.4% for the same period in 2002. For the quarter ended September 30, 2003, 99.9% of the revenues under the Enel program were derived from products shipped to customers in EMEA and the remaining 0.1% were derived from products shipped to customers in APJ. For the nine months ended September 30, 2003, 88.4% of the Enel program revenues were derived from products shipped to customers in EMEA and the remaining 11.6% to customers in APJ.

EBV Elektronik GmbH, or EBV, the sole independent distributor of the Company’s products in Europe, accounted for 10.8% of total revenues for the quarter ended September 30, 2003 and 7.9% for the same period in 2002; and 8.9% of total revenues for the nine months ended September 30, 2003 and 9.3% for the same period in 2002.

6.    Income Taxes:

The provision for income taxes for the quarter and nine months ended September 30, 2003 and 2002 includes a provision for federal, state and foreign taxes based on the annual estimated effective tax rate applied to the Company and its subsidiaries for the year. The difference between the statutory rate and the Company’s effective tax rate is primarily due to the impact of foreign taxes and the utilization of net operating losses not previously benefited.

7.      Related Party:

In September 2000, the Company entered into a stock purchase agreement with Enel. At the same time, the Company also entered into a research and development agreement with an affiliate of Enel. Under the terms of the R&D agreement, the Company is cooperating with Enel to integrate LonWorks technology into Enel’s remote metering management project in Italy. For the quarter and nine months ended September 30, 2003, the Company recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $19.7 million and $63.5 million respectively, $13.7 million of which is inc luded in Accounts Receivable at September 30, 2003. For the quarter and nine months ended September 30, 2002, the Company recognized revenue from products sold to Enel and its designated manufacturers of approximately $23.2 million and $61.3 million respectively, $26.4 million of which was included in Accounts Receivable at September 30, 2002.

 
  11  
 
 
8.      Stock Repurchase Program:

In September 2001, the Company’s board of directors approved a stock repurchase program, which expired in September 2003. During the quarter ended September 30, 2003, no shares were repurchased under the program. Since inception of the repurchase plan, the Company has repurchased a total of 265,000 shares of its common stock at a cost of $3.2 million.
 
9.     Acquisition:
 
On April 11, 2003, the Company acquired certain assets from privately held Metering Technology Corporation ("MTC") of Scotts Valley, California for $11.0 million. The assets acquired do not constitute a business as defined in SFAS No. 141, Business Combinations . As such, no goodwill has been recorded in conjunction with this transaction.

The Company obtained a third-party valuation of the assets acquired from MTC for purposes of the purchase price allocation. The result of this third-party valuation indicated that the total fair value of the assets acquired was considerably less than the $11.0 million purchase price. The excess of the purchase price over the fair value of the assets acquired has been allocated to the identified intangible assets in accordance with the requirements of SFAS No. 141 and SFAS No. 142, Goodwill and Other Intangible Assets. The following is a final allocation of the purchase price (in thousands):

Property and equipment
 
$
235
 
Intangible assets and IPR&D
   
10,765
 
   
 
 
    
 
  
Total assets acquired
 
$
11,000
 
   
 
 
Of the acquired intangible assets of approximately $10.8 million, $9.8 million has been assigned to IPR&D and was expensed on the date the assets were acquired. The remaining $957,000 has been assigned to purchased technology and is being amortized over its estimated useful life of 1 year. For the three and nine month periods ended September 30, 2003, amortization expense related to this purchased technology was approximately $239,000 and $478,000, respectively.

10.  Warranty Reserves:

When evaluating the reserve for warranty costs, management takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical return rates, historical costs of repair, and knowledge of new products introduced. Estimated reserves for warranty costs are recorded at the time of shipment. The reserve for warranty costs was $205,000 as of September 30, 2003 and $229,000 as of December 31, 2002.
 
 
  12  
 
 
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto, included elsewhere in this Quarterly Report, as well as management’s discussion and analysis of financial condition and results of operations included in our Form 10-K for the year ended December 31, 2002.

The following discussion contains forward-looking statements including, without limitation, statements regarding our liquidity position and our expected overall growth that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below in "Factors That May Affect Future Results of Operations" and elsewhere in this Quarterly Report.

Overview

Echelon Corporation was incorporated in California in February 1988, and reincorporated in Delaware in January 1989. We are based in San Jose, California, and maintain offices in nine foreign countries throughout Europe and Southeast Asia. We develop, market and support a wide array of products and services based on our LonWorks technology that enable Original Equipment Manufacturers ("OEMs") and systems integrators to design and implement open, interoperable, distributed control networks. We offer these hardware and software products to OEMs and systems integrators in the building, industrial, transportation, util ity/home and other automation markets. We also provide a variety of technical training courses related to our products and the underlying technology. Some of our customers also rely on us to provide customer support on a per-incident or annual contract basis.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our investments, allowance for doubtful accounts, revenues, inventories, asset impairments, income taxes, commitments and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reaso nable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies relate to those policies that are most important to the presentation of our financial statements and require the most difficult, subjective and complex judgments.

Estimating Sales Returns and Allowances. We sell our products and services to OEMs, systems integrators, and our other customers directly through our sales force and indirectly through distributors around the world. Sales to certain distributors are made under terms allowing limited rights of return. Sales to EBV, our largest distributor, accounted for 10.8% of total net revenues for the quarter ended September 30, 2003 and 7.9% for the same period in 2002; and 8.9% of total net revenues for the nine months ended September 30, 2003 and 9.3% for the same period in 2002. Worldwide sales to distributors, including those to EBV, accounted for approximately 15.8% of total net revenues for the quarter ended September 30, 2003 and 12.0% of total net revenues for the same period in 2002; and 12.8% of total net revenues for the nine months ended September 30, 2003 and 14.7% of total net revenues for the same period in 2002.

Net revenues consist of product and service revenues reduced by estimated sales returns and allowances. Provisions for estimated sales returns and allowances, which are based on historical trends, contractual terms and other available information, are recorded at the time of sale. As part of our revenue recognition policy, management must make estimates of potential future product returns related to product revenues in the current period. Management analyzes historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances.

 
  13  
 
 
To estimate potential product returns from distributors other than EBV, management analyzes historical returns and the specific contractual return rights of each distributor. In the case of EBV, we further refine this analysis by reviewing month-end inventory levels at EBV, shipments in transit to EBV, EBV’s historical sales volume by product, and forecasted sales volumes for some of EBV’s larger customers. Significant management judgments and estimates must be made and used in connection with establishing these distributor-related sales returns and other allowances in any accounting period. Material differences may result in the amount and timing of our revenues for any period if management revises its judgments or estimates.

Other material sales-related estimates include our allowance for sales discounts and rebates that we identify and reserve for at the time of sale. Our allowances for sales returns and other sales-related reserves were approximately $1.4 million as of September 30, 2003, and $2.1 million as of December 31, 2002.

Allowance for Doubtful Accounts. We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer's inability to meet its financial obligations to us, we record a specific allowance against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, customer credit-worthiness, changes in our customers’ payment patterns and our historical experience. If the financial condition of our custom ers were to deteriorate or if economic conditions worsened, additional allowances may be required in the future. Our allowance for doubtful accounts was $580,000 as of September 30, 2003 and $570,000 as of December 31, 2002.

Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analyses of sales levels by product and projections of future demand. Inventories on hand, in excess of one year’s forecasted demand, are not valued. In addition, we write off inventories that we consider obsolete. We adjust remaining inventory balances to approximate the lower of our cost or market value. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made. Our reserve for excess and o bsolete inventory was approximately $1.5 million as of September 30, 2003 and $1.6 million as of December 31, 2002.

Warranty Reserves. When evaluating the reserve for warranty costs, management takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical return rates, historical costs of repair, and knowledge of new products introduced. If any of these factors change materially in the future, we may be required to increase our warranty reserve. Our reserve for warranty costs was $205,000 as of September 30, 2003 and $229,000 as of December 31, 2002.

Deferred Income Taxes. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Based on our historical net operating losses, and the uncertainty of our future operating results, we have recorded a valuation allowance that fully reserves our deferred tax assets. If we later determine that, more likely than not, some or all of the net deferred tax assets will be realized, then we would reverse some or all of the previously provided valuation allowance. Our deferred tax asset valuation allowance was $48.0 million as of December 31, 2002.

Valuation of Goodwill and Other Intangible Assets. We assess the impairment of goodwill and identifiable intangible assets on an annual basis and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

·  significant underperformance relative to expected historical or projected future operating results;
·  significant changes in the manner or use of the acquired assets or the strategy for our overall business;
·  significant negative industry or economic trends; and
·  significant changes in the composition of the intangible assets acquired.

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net goodwill and other intangible assets amounted to $8.9 million as of September 30, 2003.

 
  14  
 
 
We adopted SFAS 142 on January 1, 2002, and, as a result, ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. The balance of goodwill as of September 30, 2003 was $8.0 million. We review goodwill for impairment annually during the quarter ending March 31. If, as a result of an annual or any other impairment review that we perform in the future, we determine that there has been an impairment of our goodwill or other intangible assets, we would be required to take an impairment charge. Such a charge could have a material adverse impact on our financial position and/or operating results.
 
Results of Operations
 
The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and September 30, 2002:

 
  
Three Months Ended
 September 30, 
Nine Months Ended
September 30,
   
 
 
 
    
2003

 

 
2002

 

 
2003

 

 
2002
 
   
 
 
 
 
Revenues:
   
 
    
 
    
 
    
 
  
Product    
    
99.1
%
 
99.2
%
 
99.1
%
 
98.8
%
Service    
    
0.9
   
0.8
   
0.9
   
1.2
 
   
 
 
 
 
Total revenues    
    
100.0
   
100.0
   
100.0
   
100.0
 
Cost of revenues:
   
 
    
 
    
 
    
 
  
Cost of product    
    
33.1
   
46.9
   
41.9
   
46.2
 
Cost of service    
    
2.0
   
2.1
   
2.0
   
2.3
 
   
 
 
 
 
Total cost of revenues    
    
35.1
   
49.0
   
43.9
   
48.5
 
   
 
 
 
 
Gross profit    
    
64.9
   
51.0
   
56.1
   
51.5
 
   
 
 
 
 
Operating expenses:
   
 
    
 
    
 
    
 
  
Product development    
    
22.0
   
16.2
   
29.6
   
17.8
 
Sales and marketing    
    
15.1
   
13.0
   
14.8
   
14.0
 
General and administrative    
    
10.1
   
7.2
   
9.7
   
7.4
 
   
 
 
 
 
Total operating expenses    
    
47.2
   
36.4
   
54.1
   
39.2
 
   
 
 
 
 
Income from operations    
    
17.7
   
14.6
   
2.0
   
12.3
 
Interest and other income, net    
    
1.8
   
2.8
   
1.9
   
3.2
 
   
 
 
 
 
Income before provision for income taxes    
    
19.5
   
17.4
   
3.9
   
15.5
 
Provision for income taxes    
    
4.9
   
1.4
   
1.4
   
1.2
 
   
 
 
 
 
Net income    
    
14.6
%
 
16.0
%
 
2.5
%
 
14.3
%
   
 
 
 
 

Revenues
 
Total Revenues. Total revenues were $30.7 million for the quarter ended September 30, 2003, and $33.4 million for the same period in 2002. The $2.6 million decrease between the two quarters was the result of a $3.4 million reduction in Enel program related revenues offset by an $824,000 increase in non-Enel program revenue. For the nine months ended September 30, 2003, total revenues grew by $2.4 million, or 2.6%, to $94.6 million from $92.3 million in the same period of 2002. The increase in revenues between the two nine month periods was primarily the result of a $2.2 million increase in product revenues sold under the Enel program, with a $165,000 increase in non-Enel program reven ue.

Enel program revenues. Products sold to Enel and its designated manufacturers accounted for $19.7 million, or 64.2% of total revenues for the quarter ended September 30, 2003, and $23.2 million, or 69.5% for the same period in 2002. For the nine months ended September 30, 2003, Enel program revenues accounted for $63.5 million, or 67.1% of total revenues, as compared to $61.3 million, or 66.4% for the same period in 2002. The $3.4 million decrease in Enel program revenues between the two quarters was primarily attributable to a reduction in the number of electricity meter components (also referred to as metering kit products) sold to Enel’s meter manufacturers at lower average se lling prices, offset by an increase in the number of data concentrator products sold. The reduction in metering kit product sales was the result of the meter manufacturer’s transition to a new version of the metering kit. The $2.2 million increase between the two nine month periods was attributable to an increase of shipments of data concentrator and metering kit products offset by decreases in the selling price for both of these items. Under the terms of our agreement with Enel, pricing for these products is reduced based on the cumulative number of units shipped. We sell our products to Enel and its designated manufacturers in United States dollars. Therefore, the associated revenues are not subject to foreign currency risks.

 
  15  
 
 
 In May 2003, we announced a contractual dispute with Enel relating to the transition from the current version of the metering kit that we sell to Enel’s meter manufacturers to the next generation of metering kit. As a result of this dispute, we deferred approximately $2.7 million of Enel program related revenues that otherwise would have been recognized in the second quarter of 2003. In July 2003, we announced that the dispute with Enel had been resolved. As a result, we were able to recognize the $2.7 million of deferred revenue in the third quarter of 2003. Had we not deferred the $2.7 million of Enel program revenue, the decrease in Enel program revenues from the second quarter to the third quarter would have been significantly mo re pronounced.

If the Enel program achieves its targeted volumes for 2003, we expect that total revenues attributable to the project will account for approximately 65% of our total revenue for the year. We believe that fourth quarter 2003 Enel program revenues will decrease more significantly from third quarter levels as Enel’s meter manufacturers complete their transition from the second version to the third version of the metering kit and Enel re-aligns its inventory of data concentrator products. If, after 2003, the program continues to move forward under Enel’s current roll-out plan, we believe that revenue attributable to the project will continue to account for a material portion of our overall revenues during 2004. Once the project is completed, or if it were cancelled prior to its completio n, we would experience a significant drop in our overall revenue, which would have a material negative impact on our financial position and results of operations. Given our significant dependence on one customer at this time, we continue to seek opportunities to expand our customer base. In 2002, we formed a new sales and marketing organization that has been tasked with identifying other customers for our networked energy services products. However, we can give no assurance that their efforts will be successful.

Non-Enel program revenues. Non-Enel program revenues accounted for $11.0 million, or 35.8% of total revenues for the quarter ended September 30, 2003, and $10.2 million, or 30.5% for the same period in 2002. For the nine months ended September 30, 2003, non-Enel program revenues accounted for $31.2 million, or 32.9% of total revenues, as compared to $31.0 million, or 33.6% for the same period in 2002. The $824,000, or 8.1%, increase in non-Enel program revenues between the two quarters was primarily attributable to increased sales of our control and connectivity, network services, and LonPoint® products. The $165,000 increase between the two nine-month periods is primarily attrib utable to increased sales of our i .LON®, network services, and LonPoint products, offset by decreases in sales of our control and connectivity products, development tool products, and customer support and training services. To a lesser extent, the impact of exchange rates on sales made in foreign currencies, principally the Japanese Yen, also contributed to the increase between the two nine month periods.

Product revenues. Product revenues decreased by $2.6 million, or 7.9%, to $30.5 million in the third quarter of 2003 from $33.1 million for the same period in 2002. The decrease in product revenues between the two quarters was attributable to the $3.4 million decrease in Enel program revenues offset by an $818,000 increase in non-Enel product revenues. For the nine months ended September 30, 2003, product revenues increased $2.7 million, or 2.9%, to $93.8 million from $91.2 million for the same period in 2002. The increase in product revenues between the two nine month periods was primarily attributable to increased Enel program revenues, and to a lesser extent, by increased sales of non-Enel products.

Service revenues . Service revenues increased $8,000, or 2.9%, to $285,000 in the third quarter of 2003 from $277,000 in the third quarter of 2002. For the nine months ended September 30, 2003, service revenues declined by $287,000, or 26.2%, to $807,000 from $1,094,000 in the same period of 2002. The decrease in service revenues between the two nine month periods was the result of continued decreases in customer support and training revenues. We believe that the ongoing worldwide economic downturn has forced many of our customers to curtail spending for training and support. We do not expect our service revenues to improve so long as these economic conditions continue.

 
  16  
 
 
EBV revenues. Sales to EBV, our largest distributor and the sole independent distributor of our products in Europe, accounted for $3.3 million, or 10.8% of our total revenues for the quarter ended September 30, 2003, and $2.6 million, or 7.9% of our total revenues for the same period in 2002. For the nine months ended September 30, 2003, sales to EBV accounted for $8.5 million, or 8.9% of our total revenues, compared to $8.6 million, or 9.3% of total revenues for the same period in 2002. Our contract with EBV expires in December 2003. While we expect that our agreement with EBV will be renewed at that time, if EBV does not renew its agreement with us, or renews on less favorable terms to us, our revenues could decrease and our financial position could be harmed. We currently sell our products to EBV in United States dollars. Therefore, the associated revenues are not subject to foreign currency risks.

Gross Profit

Gross profit is equal to revenues less cost of goods sold. Cost of goods sold for product revenues includes costs associated with the purchase of components, subassemblies, and finished goods, as well as allocated labor, overhead, and manufacturing variances associated with the packaging, preparation, and shipment of products. Cost of goods sold for service revenues consists of employee-related costs such as salaries and fringe benefits as well as other direct costs incurred in providing training, customer support, and custom software development services.

During the third quarter of 2003, gross profit increased 17.2% to $20.0 million from $17.0 million in the second quarter of 2002. For the nine months ended September 30, 2003, gross profit increased 11.7% to $53.1 million from $47.5 million in the same period of 2002. As a percentage of revenues, gross profit increased to 64.9% in the third quarter of 2003 from 51.0% in the same period of 2002. Gross profit as a percentage of revenues increased to 56.1% for the nine months ended September 30, 2003, from 51.5% for the same period in 2002.

Gross profit, as a percentage of revenues, improved during the third quarter of 2003 due primarily to the recognition of approximately $3.0 million of Enel program related revenue with no corresponding cost of goods sold. This $3.0 million, $2.7 million of which was deferred from the second quarter of 2003 to the third quarter of 2003, is attributable to the surcharge Enel agreed to pay us for continuing to ship a former version of the metering kit to Enel’s meter manufacturers. Without this $3.0 million surcharge, gross profit, as a percentage of revenues, would have been 61.1% for the quarter ended September 30, 2003, and 54.6% for the nine months ended September 30, 2003. In addition to the $3.0 million surcharge, gross margins for both the three and nine month periods ended September 30, 2003 were favorably impacted by the mix of products sold as well as one-time reductions in certain overhead charges and manufacturing variances. We expect that, during the fourth quarter of 2003, gross profit as a percentage of revenues will return to recent levels.

Operating Expenses

Product development . Product development expenses consist primarily of payroll and related expenses for development personnel, expensed material, and facility costs associated with the development of new technologies and products. Product development expenses for the third quarter of 2003 grew by $1.3 million, or 24.9%, to $6.8 million from $5.4 million in the same quarter of 2002, representing 22.0% of total revenues for the second quarter of 2003 and 16.2% of total revenues for the same period in 2002. Product development expenses for the nine months ended September 30, 2003 grew by $11.6 million, or 70.9%, to $28.0 million from $16.4 million in the same period of 2002, representin g 29.6% of total revenues for the nine months ended September 30, 2003 and 17.8% of total revenues for the same period in 2002.

The increase in product development expenses for both the quarter and nine months was due primarily to the asset acquisition transaction with Metering Technology Corporation, or MTC, that occurred during the second quarter of 2003. For additional information relating to this transaction, please refer to Note 9 in the Notes to Condensed Consolidated Financial Statements. For the three months ended September 30, 2003, total product development costs associated with the MTC transaction and ongoing operations amounted to $1.5 million, and consisted of $1.2 million of ongoing day-to-day operating expenses (primarily payroll and facilities costs for the nineteen former MTC employees who joined Echelon), and $239,000 of amortization expense related to the purchased technology acquired from MTC. For t he nine months ended September 30, 2003, total product development costs associated with the MTC transaction and ongoing operations amounted to approximately $12.5 million. This $12.5 million included a charge of $9.8 million related to in-process research and development taken in the second quarter of 2003, $2.2 million of ongoing day-to-day operating expenses, and $478,000 of purchased technology related amortization expense.

 
  17  
 
 
We expect that, for the remainder of 2003, our quarterly product development expenses will be somewhat higher than historical levels due in part to the added costs of the employees who were formerly MTC personnel and the ongoing amortization of the purchased technology acquired from MTC.

Sales and marketing. Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales personnel, travel and entertainment, advertising and product promotion and facilities costs associated with our sales and support offices. Sales and marketing expenses for the third quarter of 2003 increased by $308,000, or 7.1%, to $4.7 million from $4.4 million in the same quarter of 2002, representing 15.2% of total revenues for the third quarter of 2003 and 13.1% of total revenues for the same period in 2002. Sales and marketing expenses for the nine months ended September 30, 2003 increased $1.0 million, or 8%, to $1 4.0 million from $12.9 million in the same period of 2002, representing 14.8% of total revenues for the nine months ended September 30, 2003 and 14.0% for the same period in 2002.

The increase in sales and marketing expenses for both the quarter and nine months ended September 30, 2003, was primarily due to the impact of foreign currency exchange rate fluctuations between the United States dollar and the local currency in several of the foreign countries in which we operate. For the quarter ended September 30, 2003, approximately $115,000 of the $308,000 increase over 2002 expenses was attributable to foreign currency exchange rate fluctuations. For the nine months ended September 30, 2003, approximately $511,000 of the $1.0 million increase over 2002 amounts was attributable to these rate fluctuations. Additional items affecting the increase in sales and marketing expenses during the quarter ended September 30, 2003 as compared to the same period in 2002 were increased salary and other compensation related expenses, increased costs for third party service providers, offset by reduced travel and entertainment expenses. For the nine months ended September 30, 2003, additional items affecting the increase in sales and marketing expenses over the same period in 2002 were increased salary and other compensation related expenses, increased costs for third party service providers, and recruiting expenses, offset by reductions in travel and entertainment expenses.

We expect that, as long as foreign currency exchange rates remain steady for the remainder of 2003, our quarterly sales and marketing expenses will remain at or slightly above current levels. If, however, the United States dollar were to strengthen against the foreign currencies where we do business, our sales and marketing expenses could decrease slightly. Conversely, if the dollar were to weaken against these currencies, our expenses would rise.

General and administrative. General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, insurance, professional fees and other general corporate expenses. General and administrative expenses in the third quarter of 2003 increased by $699,000, or 29.2%, to $3.1 million from $2.4 million in the same quarter of 2002, representing 10.1% of total revenues for the third quarter of 2003 and 7.2% of total revenues for the same period in 2002. General and administrative expenses for the nine months ended September 30, 2003 increased by $2.3 million, or 33.2%, to $9.2 million from $6.9 million in the same period o f 2002, representing 9.7% of total revenues for the nine months ended September 30, 2003 and 7.4% of total revenues for the same period in 2002.

Included in general and administrative expenses for the quarter ended September 30, 2003 were approximately $730,000 in rent, depreciation, and other expenses attributable to our new second building at our corporate headquarters facility in San Jose. For the nine months ended September 30, 2003, costs related to this second building amounted to $1.2 million. Excluding the costs associated with the new building, general and administrative expenses were approximately $31,000 lower in the quarter ended September 30, 2003 as compared to the same period in 2002. Contributing to this reduction were decreases in travel and entertainment costs, fees paid to external service providers, and bad debt charges, offset by increased salary and other compensation related costs. For the nine months ended Septe mber 30, 2003, general and administrative costs, not including costs associated with the new San Jose facility, increased by $1.1 million over the same period in 2002. This increase related primarily to increases in salaries and other compensation related costs, fees paid to external service providers (relating to the MTC transaction), business insurance costs, and director expenses, offset by reductions in travel and entertainment costs and bank charges.

We expect that, for the remainder of 2003, quarterly general and administrative costs will remain at or slightly above their current levels.

 
  18  
 
 
Interest and Other Income, Net

Interest and other income, net primarily reflects interest earned by our company on cash and short-term investment balances. In addition, foreign exchange translation gains and losses related to short-term intercompany balances are also reflected in this amount. Interest and other income, net for the second quarter of 2003 decreased by $385,000, or 41.8%, to $537,000 from $922,000 in 2002. Interest and other income, net for the nine months ended September 30, 2003 decreased by $1.1 million, or 37.9%, to $1.8 million from $2.9 million for the same period in 2002.

Although the average amount of our invested cash increased for both the quarter and nine months ended September 30, 2003 as compared to the same periods in 2002, the impact of the Federal Reserve Board’s short-term interest rate reductions, which began in late 2001 and have continued through 2003, have had a negative impact on our interest income. As short-term investments we purchased in 2001 and 2002 come to maturity, we have been forced to re-invest these funds in instruments with lower effective yields, thus reducing interest income. In addition, during the third quarter of 2003, the impact of foreign exchange translation losses on our short-term intercompany balances also contributed to the decline in interest and other income for the three and nine months ended September 30, 2003. < /FONT>

As long as interest rates remain low, we expect that our interest income will remain low as compared to historical levels. In addition, future fluctuations in the exchange rates between the United States dollar and the currencies in which we maintain our short-term intercompany balances (principally the European Euro and the British Pound Sterling) will also affect our interest and other income, net.

Provision for Income Taxes

The provision for income taxes for the quarter and nine months ended September 30, 2003 includes a provision for federal, state and foreign taxes based on our annual estimated effective tax rate for the year. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes and the beneficial impact of deferred taxes resulting from the utilization of net operating losses. Income taxes for the quarter and nine months ended September 30, 2003 primarily consist of minimum taxes related to profitable foreign subsidiaries, federal minimum taxes, and various state minimum taxes. Income taxes were $1.5 million for the quarter ended September 30, 2003 and $463,000 for the same period in 2002. Income taxes were $1.3 million for the nine months ended Se ptember 30, 2003, and $1.1 million for the same period in 2002.

Our effective tax rate for the fourth quarter of 2003 will fluctuate significantly from historical levels as our income and sources of income change.

Liquidity and Capital Resources

Since our inception, we have financed our operations and met our capital expenditure requirements primarily from the sale of preferred stock and common stock, although recently we have also been able to finance our operations through operating cash flow. From inception through September 30, 2003, we raised $271.9 million from the sale of preferred stock and common stock.

Net cash provided by operating activities. Net cash provided by operating activities has historically been driven by net income levels combined with depreciation and amortization, in-process research and development charges, and fluctuations in operating asset and liability balances. Net cash provided by operating activities was $24.9 million for the nine months ended September 30, 2003, a $6.6 million increase from the comparable period in 2002. For the nine months ended September 30, 2003, net cash provided by operating activities was generated primarily from net income of $2.4 million; depreciation, amortization, and in-process research and development of $13.7 million; and changes in the following operating assets and liabilities: decreases in accounts receivable (primarily related to the Enel program), inventories, and other current assets, as well as increases in accounts payable, and accrued liabilities. Partially offsetting this was a decrease in deferred revenues. For the nine months ended September 30, 2002, net cash provided by operating activities of $18.3 million was generated primarily from net income of $13.1 million; depreciation, amortization, and in-process research and development of $3.3 million, and changes in the following operating assets and liabilities: a decrease in current assets partially offset by an increase in accounts receivable.

Net cash used for investing activities. Net cash used for investing activities has historically been driven by transactions involving our short-term investment portfolio, capital expenditures, changes in our long-term assets, and acquisitions. Net cash used for investing activities was $28.4 million for the nine months ended September 30, 2003, a $1.4 million increase from the comparable period in 2002. For the nine months ended September 30, 2003, net cash used for investing activities was primarily the result of purchases of available-for-sale short-term investments, our $11.0 million purchase of certain assets of MTC, and capital expenditures of $4.6 million, offset by a $1.1 milli on reduction in long-term assets. For the nine months ended September 30, 2002, net cash used for investing activities of $27.0 million was principally due to the purchase of $10.7 million of restricted investments required by our bank to collateralize certain credit facilities issued to us, net cash paid of $5.8 million for BeAtHome.com, Inc., purchases of available-for-sale short-term investments, and capital expenditures of $2.5 million.

 
  19  
 
 
Net cash provided by financing activities. Net cash provided by financing activities has historically been driven by the proceeds from issuance of common and preferred stock offset by transactions under our stock repurchase program (see Note 8 to the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for additional information on our stock repurchase program). Net cash provided by financing activities was $2.6 million for the nine months ended September 30, 2003, a $147,000 decrease from the comparable period in 2002. For the nine months ended September 30, 2003, net cash provided by financing activities was comprised of proceeds from the exerci se of stock options by employees. For the nine months ended September 30, 2002, net cash provided by financing activities of $2.8 million was comprised of proceeds from the exercise of stock options by employees and, to a lesser extent, by the proceeds from the exercise of stock warrants by some of our warrant holders who are also directors of our company.

As of September 30, 2003, our principal sources of liquidity included cash, cash equivalents and short-term investments of $147.3 million ($114.4 million as of September 30, 2002) and trade accounts receivable of $18.8 million ($22.9 million as of September 30, 2002). As of September 30, 2003, we had working capital, defined as current assets less current liabilities, of $160.6 million ($151.8 million as of September 30, 2002). We believe that our existing sources of liquidity will satisfy our projected working capital and other cash requirements for at least the next twelve months. However, in the unlikely event that we would require additional financing within this period, such financing may not be available to us in the amounts or at the times that we require, or on acceptable terms. If we fail to obtain additional financing, when and if necessary, our business would be harmed.

Related Party Transactions

During the quarters ended September 30, 2003 and 2002, the law firm of Wilson Sonsini Goodrich & Rosati, P.C. acted as principal outside counsel to our company. Mr. Sonsini, a director of our company, is a member of Wilson Sonsini Goodrich & Rosati, P.C.

From time to time, M. Kenneth Oshman, our Chairman of the Board and Chief Executive Officer, uses private air travel services for business trips for himself and for any employees accompanying him. These private air travel services are provided by certain entities controlled by Mr. Oshman or Mr. Markkula, a director of our company. Our net cash outlay with respect to such private air travel services is no greater than comparable first class commercial air travel services. Such net outlays to date have not been material.

In September 2000, we entered into a stock purchase agreement with Enel pursuant to which Enel purchased 3.0 million newly issued shares of our common stock for $130.7 million (see Note 7 to the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for additional information on our transactions with Enel). The closing of this stock purchase occurred on September 11, 2000. At the closing, Enel had agreed that it would not, except under limited circumstances, sell or otherwise transfer any of those shares for a specified time period. That time period expired September 11, 2003. As of October 31, 2003, Enel had not disposed of any of its 3.0 million shares.

Under the terms of the stock purchase agreement, Enel has the right to nominate a member of our board of directors. Enel appointed Mr. Francesco Tatò as its representative to our board of directors in September 2000. As a consequence of the expiration of Mr. Tatò’s mandate as Enel’s Chief Executive Officer, Mr. Tatò resigned as Board member in all of Enel’s subsidiaries and affiliates, including Echelon. His resignation from our board of directors was effective in June 2002. Enel has reserved its right to nominate a new member of our board of directors. During the term of service of Enel’s representative on our board of directors from September 2000 to September 2002, Enel’s representative abstained from resolutions on any matter relating to Enel.

At the time we entered into the stock purchase agreement with Enel, we also entered into a research and development agreement with an affiliate of Enel. Under the terms of the research and development agreement, we are cooperating with Enel to integrate our LonWorks technology into Enel’s remote metering management project in Italy. We recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $19.7 million for the quarter ended September 30, 2003 and $63.5 million for the nine months ended September 30, 2003, $13.7 million of which was included in Accounts Rec eivable at September 30, 2003. We recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $23.2 million for the quarter ended September 30, 2003 and $61.3 million for the nine months ended September 30, 2002, $26.4 million of which was included in Accounts Receivable at September 30, 2002.

 
  20  
 
 
Recently Issued Accounting Standards

In November 2002, the FASB issued FASB Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disc lose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. We adopted FIN 45 on January 1, 2003. The adoption did not have a material impact on our financial position, results of operations, or cash flows.
 
In December 2002, the FASB issued SFAS No. 148, or SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123. SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We are required to follow the prescribed format and provide the additional disclosures required by SFAS 148 in our annual financial statements for the year ending December 31, 2002 and must also provide the disclosures in our quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ending March 31, 2003. The adoption of SFAS 148 did not have an effect on our financial position or results of operations as we did not adopt the fair value method of accounting for stock-based employee compensation.
 
In January 2003, the FASB issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the varia ble interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to entities created before February 1, 2003 in the first fiscal year or interim period ending after December 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of FIN 46 did not have a material impact on our financial position, results of operations, or cash flows.

In January 2003, the EITF published EITF No. 00-21, or EITF 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. EITF 00-21 is effective for revenue arrang ements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on our financial position, results of operations, or cash flows.

In April 2003, the FASB issued SFAS No. 149, or SFAS 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. In particular, SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative. It also clarifies when a derivative contains a financing component that warrants special reporting in the statemen t of cash flows. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial position or results of operations as we do not currently hold any derivative instruments or engage in hedging activities.

 
  21  
 
 
In May 2003, the FASB issued SFAS No. 150, or SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. This statement is effective for interim periods beginning after June 15, 2003. As we have no instruments which management believes are subject to SFAS 150, the adoption of SFAS 150 did n ot have a material effect on our financial position, results of operations, or cash flows.

Equity Based Compensation

We have two plans under which we grant options: the 1997 Stock Plan, or the "1997 Plan," and the 1998 Director Option Plan, or the "Director Option Plan." A more detailed description of each plan can be found in our Annual Report on Form 10-K for the year ended December 31, 2002.

Stock option grants are designed to reward employees, officers, and directors for their long-term contribution to our company and to provide incentives for them to remain with our company. The number and frequency of stock option grants is based on competitive practices, our operating results, and government regulations. Since the inception of the 1997 Plan, we have granted options to all of our employees.
 
 
  22  
 
 
Distribution and Dilutive Effect of Options

The following table illustrates the grant dilution and exercise dilution:

 
  
Nine Months Ended
Year Ended December 31,
   

 September 30,
 
    
2003

 

 
2002

 

 
2001

 

 
2000
 
   
 
 
 
 
Shares of common stock outstanding    
    
40,263,373
   
39,725,550
   
38,753,360
   
38,049,696
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Options granted    
    
2,233,745
   
2,282,750
   
2,560,225
   
1,789,975
 
Options cancelled    
    
(482,067
)
 
(81,872
)
 
(244,314
)
 
(320,905
)
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Net options granted    
    
1,751,678
   
2,200,878
   
2,315,911
   
1,469,070
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Grant dilution *        
    
4.4
%
 
5.5
%
 
6.0
%
 
3.9
%
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Options exercised    
    
647,050
   
631,917
   
971,107
   
1,810,262
 
   
 
 
 
 
Exercise dilution **    
    
1.6
%
 
1.6
%
 
2.5
%
 
4.8
%
   
 
 
 
 
 
*      The percentage for grant dilution is computed based on options granted less options cancelled as a percentage of total outstanding shares of common stock.
 
**    The percentage for exercise dilution is computed based on options exercised as a percentage of total outstanding shares of common stock.

The following table summarizes the options granted to our Named Executive Officers, whose names can be found under the section entitled "Executive Options" below. For the years ended December 31, the Named Executive Officers represent our Chief Executive Officer and the four other most highly paid executive officers whose salary and bonus for the respective fiscal year were in excess of $100,000. For the nine months ended September 30, 2003, our Named Executive Officers include the same group of individuals as was reported for the year ended December 31, 2002.

 
  
Nine Months Ended
Year Ended December 31,
   

September 30,
 
    
2003

 

 
2002

 

 
2001

 

 
2000
 
   
 
 
 
 
Options granted to the Named Executive Officers    
    
380,000
   
540,000
   
450,000
   
280,000
 
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Options granted to the Named Executive Officers as a % of net options granted 
    
21.7
%
 
24.7
%
 
19.4
%
 
19.1
%
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Options granted to the Named Executive Officers as a % of outstanding shares    
    
 
0.9
%
 
1.4
%
 
1.2
%
 
0.7
%
   
 
 
 
 
 
    
 
    
 
    
 
    
 
  
Cumulative options held by Named Executive Officers as a % of total outstanding options    
    
21.3
%
 
23.8
%
 
24.8
%
 
32.7
%
   
 
 
 
 

 
  23  
 
 
General Option Information

The following table summarizes option activity under all plans since December 31, 2002 (prices are weighted average prices):

 
  
 
Options Outstanding
     
 
  
Options
 Available for
 Grant
Number
Outstanding
Weighted-Average Exercise Price
Per Share
BALANCE AT DECEMBER 31, 2002    
    
3,118,416
   
8,134,914
 
$
17.44
 
Granted    
    
(2,233,745
)
 
2,233,745
   
12.68
 
Cancelled    
    
482,067
   
(482,067
)
 
29.49
 
Exercised    
    
---
   
(647,050
)
 
6.31
 
Additional shares reserved    
    
2,086,277
   
---
   
---
 
   
 
     
BALANCE AT SEPTEMBER 30, 2003    
    
3,453,015
   
9,239,542
 
$
16.44
 
   
 
       

The following table summarizes the stock options outstanding as of September 30, 2003:

 
  
Exercisable
Unexercisable
Total
 
 
 
As of September 30, 2003
 
 
 
Shares (#)
Weighted
Average
Exercise
Price ($)
 
 
Shares (#)
Weighted
Average
Exercise
Price ($)
 
Shares (#)
Weighted
Average
Exercise
Price ($)
 
 
 
 
 
 
 
In-the-Money
   
1,742,114
 
$
8.63
   
814,695
 
$
11.13
   
2,556,809
 
$
9.43
 
Out-of-the-Money *
   
3,441,378
   
22.20
   
3,241,355
   
15.84
   
6,682,733
   
19.12
 
   
       
       
       
Total Options Outstanding    
    
5,183,492
 
$
17.64
   
4,056,050
 
$
14.90
   
9,239,542
 
$
16.44
 
   
       
       
       

* Out-of-the-Money options are those options with an exercise price equal to or above the closing price of $11.90 at the end of the quarter.

Certain options issued under the 1997 Plan may be exercised at any time prior to their expiration, even if those options have not yet vested. Shares issued upon exercise of unvested options are considered unvested shares. Once issued, the unvested shares continue vesting in accordance with original option’s vesting schedule. If the option holder’s employment or service with our company terminates before the unvested shares become fully vested, we have the right, at our discretion, to repurchase from the option holder any unvested shares at the exercise price paid by the option holder. As of September 30, 2003, there were no exercised shares subject to repurchase by our company. Of the 5,183,492 options exercisable as of September 30, 2003, 4,697,543 were vested.

 
  24  
 
 
Executive Options

The following table sets forth certain information with respect to stock options granted to our Named Executive Officers during the nine-month period ended September 30, 2003. All option grants were made under the 1997 Plan.
 
 
Individual Grants
 
 
 
 
 
Number of Securities Underlying Options
% of Total Options Granted to Employees in Fiscal
Exercise Price Per
 
Expiration
Potential Realizable Value At Assumed Annual Rates of Stock Price Appreciation for Option Term ($) **
 
Name
Granted
Year *
Share ($)
Date
5%
10%
             
M. Kenneth Oshman    
120,000
5.4
12.91
5/21/2008
428,015
945,802
Beatrice Yormark
80,000
3.6
12.91
5/21/2008
285,344
630,535
Oliver R. Stanfield
80,000
3.6
12.91
5/21/2008
285,344
630,535
Frederick H. Bruggink
50,000
2.2
12.91
5/21/2008
178,340
394,084
Peter A. Mehring
50,000
2.2
12.91
5/21/2008
178,340
394,084
 
 
 
 
 
 
 
 
*      Based on a total of 2,233,745 options granted to all employees during the nine months ended September 30, 2003.
**   Potential gains are net of the exercise price but before taxes associated with the exercise. The 5% and 10% assumed annual rates of compounded stock appreciation based upon the deemed fair market value are for illustrative purposes only and do not represent our estimate or projection of the future common stock price. Actual gains, if any, on stock option exercises are dependent on several factors, including our future financial performance, overall market conditions, and the option holder’s continued employment with our Company. There can be no assurance that the amounts reflected in this table will be achieved.

The following table sets forth, for our Named Executive Officers, certain information concerning shares acquired upon the exercise of stock options during the nine months ended September 30, 2003, as well as exercisable and unexercisable options held as of September 30, 2003.

 
 
 
  
 
 
 
Number of Securities Underlying Unexercised Options at September 30, 2003 (#)
Value of Unexercised In-the-Money Options at September 30, 2003 ($) **
     

Shares Acquired on 

    

Value Realized 

  
 		  
 		  
Name

 

 
Exercise (#)
 

 
($) *

 

 Exercisable

 

 Unexercisable

 

Exercisable

 

 Unexercisable

 
  
 
 
 
 
 
 
M. Kenneth Oshman    
    
100,000
   
591,000
   
820,000
   
--
   
725,550
   
--
 
Beatrice Yormark
   
50,000
   
295,500
   
187,498
   
167,502
   
371,535
   
5,740
 
Oliver R. Stanfield
   
125,000
   
860,775
   
112,498
   
167,502
   
8,760
   
5,740
 
Frederick H. Bruggink
   
---
   
---
   
173,957
   
56,043
   
36,360
   
5,740
 
Peter A. Mehring
   
75,000
   
547,750
   
178,957
   
106,043
   
371,535
   
5,740
 

*     The value realized is based on the closing price of our common stock on the date of exercise, minus the per share exercise price, multiplied by the number of shares exercised.

**    The value of underlying securities is based on the $11.90 per share closing price of our common stock on September 30, 2003, minus the aggregate exercise price. Only options that are in the money are included in this analysis.

 
  25  
 
 
Equity Compensation Plan Information

The following table summarizes our Company’s stock option plans as of September 30, 2003.

Plan Category
 
Number of Securities to be Issued Upon Exercise of Outstanding Options
Weighted-Average Exercise Price of Outstanding Options
Number of Securities Remaining Available for Issuance Under Stock Option Plans *
 
 
 
 
 
    
 
    
 
    
 
  
Equity compensation plans approved by stockholders    
    
9,239,542
 
$
16.44
   
3,453,015
 
 
    
 
    
 
    
 
  
Equity compensation plans not approved by stockholders    
    
---
   
---
   
---
 
   
 
 
 
 
    
 
    
 
    
 
  
Total    
    
9,239,542
 
$
16.44
   
3,453,015
 
   
 
 
 

*      Both the 1997 Plan and the Director Plan provide for annual increases to the number of shares authorized for issuance under the plan. The amounts reflected in this table represent balances remaining available for future stock option issuance as of September 30, 2003.

Accounting for Stock-Based Employee Compensation Plans

We account for stock-based employee compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock issued to Employees, and related Interpretations. With the exception of deferred compensation expense recorded in 2002, which was attributable to options granted during 1998, no stock-based employee compensation cost is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Factors That May Affect Future Results of Operations

Interested persons should carefully consider the risks described below in evaluating Echelon. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our common stock could decline.

Our future results would be significantly harmed if our project with Enel is terminated or is not successful.

In September 2000, we entered into a research and development agreement with an affiliate of Enel S.p.A., an Italian utility company. Under the terms of the agreement, we agreed to work with Enel to integrate our LonWorks technology into Enel’s Contatore Elettronico remote metering management project in Italy. During the third quarter of 2003, revenue attributable to the Contatore Elettronico project was approximately $19.7 million, or 64.2% of our total revenue. We expect the Contatore Elettronico project to account for the majority of our targeted revenue for 2003.
 
We face a number of risks as we continue this project, including:

·      a dispute could develop between Enel and our company regarding product suitability, quality, price, quantities, scope of the parties obligations, or other issues. If any dispute is not resolved in a timely manner, the project, or revenue generated from the project, could be delayed, could become less profitable to us, could result in damages or losses, or either we or Enel could seek to terminate the research and development agreement. For example, as a result of a dispute regarding the compensation owed to us for the transition from the second version of metering kit to the third generation of metering kit, which dispute has since been resolved, we deferred approximately $2 .7 million of revenue from the second quarter to the third quarter of 2003;
 
 
  26  
 
 
·      once they have been manufactured, electricity meters, data concentrators, or other products used in the Contatore Elettronico project may not be installed by Enel in accordance with Enel’s scheduled roll-out plan. Also, Enel could also decide to reduce its inventories of electricity meters or data concentrators. As a result, excess inventories could develop for periods of time, which could result in the delay or cancellation of additional product shipments to Enel and the contract equipment manufacturers that Enel has selected to manufacture electricity meters for the project;
·      Enel may not successfully develop or maintain the management center software to monitor and control the electricity meters and other products used in the Contatore Elettronico project, or the management center software that Enel develops may not be scalable enough to support the estimated 27 million meters that Enel intends to install as part of the project. As a result, Enel might reduce purchases of electricity meters or other products, thereby reducing future shipments of our products;
·      under the Contatore Elettronico project, each order for electricity meters must be made by public tender. The next public tender for electricity meters may not be completed in a timely fashion, and this may delay production of electricity meters with an associated delay in shipments of products by us to Enel’s contract equipment manufacturers;
·      Enel could decide to no longer pursue the Contatore Elettronico project to the extent we currently contemplate, or at all, and Enel could then seek to curtail or terminate the project;
·      the research and development agreement between Enel and our company might be terminated if, among other things, either party materially breaches its obligations under the agreement;
·      third parties may contest part or all of our agreement with Enel, or the Contatore Elettronico project in general. For example, the European Union and/or the Italian government could require a change in the system architecture or the sources of supply in order to satisfy rules regarding competition, thereby delaying or changing the scope of the project; or
·      our research and development activities under the Contatore Elettronico project might be unsuccessful, or the products we develop might not be commercially exploitable or yield economic returns.
 
Any of these factors would cause our revenues and income to suffer, which would significantly and adversely affect our financial condition and operating results.
 
The performance of the contract equipment manufacturers that Enel has selected to manufacture electricity meters could affect our project with Enel.
 
Enel has selected several contract equipment manufacturers, or meter manufacturers, to manufacture electricity meters for the Contatore Elettronico project. We sell a product called a metering kit to these meter manufacturers as part of this project. Our shipments of metering kits depend to a large extent on the production of electricity meters. In addition, the sales of our data concentrator products to Enel depend, in part, on the production of electricity meters. Our success under the Contatore Elettronico project could be affected by the meter manufacturers for many reasons, including:

·      the meter manufacturers may experience a loss of production in 2003 as they transition from manufacturing electricity meters using our current form of metering kit to a newer form of metering kit based upon our PL 3120® Power Line Smart Transceiver, or during the transition from the then current design of electricity meter to a newer design of electricity meter;
·      disputes may arise with us regarding responsibility for costs incurred by the meter manufacturers as they transition from one form of metering kit to another;
·      if the meter manufacturers fail to meet their intended production or quality levels, fail to pay us in accordance with agreed-upon payment terms for products we ship to them, or breach any of their agreements with us, we could elect to cancel orders for products from meter manufacturers, delay shipment of products to meter manufacturers, or otherwise fail to achieve our revenue targets for the Contatore Elettronico project;
·      the meter manufacturers may not achieve their intended production levels;
·      we may be prohibited by government trade sanctions from selling metering kits to one or more meter manufacturers;
·      the meter manufacturers may not be able to maintain product quality at the levels required to successfully install electricity   meters;
·      the meter manufacturers may not maintain sufficient net working capital to fund production of electricity meters or may fail to provide letters of credit that we mandate; and
 
 
  27  
 
 
·      the meter manufacturers may experience excess raw material and finished goods inventories if they fail to achieve intended production and/or quality levels and may therefore reduce future purchases of our products until their inventories return to acceptable levels.

Additionally, if any of Enel’s meter manufacturers were to experience cash flow problems resulting from one or more of the above listed failures, or any other factor, we could be forced to provide a bad debt reserve for some or all of the unpaid balances that meter manufacturer owed us for products we previously shipped to them. Given the volume of products that Enel’s meter manufacturers purchase from us, any bad debt provision we would be required to make would most likely be a material amount, and therefore, would have an adverse affect on our financial condition and operating results.
 
We depend on a limited number of key manufacturers and use contract electronic manufacturers for most of our products requiring assembly. If any of these manufacturers terminates or decreases its relationships with us, we may not be able to supply our products and our revenues would suffer.
 
The Neuron Chip is an important component that our customers use in control network devices. In addition, the Neuron Chip is an important device that we use in many of our products. Neuron Chips are currently manufactured and distributed by Toshiba and Cypress Semiconductor under license agreements we maintain with them. The agreements, among other things, grant Toshiba and Cypress the worldwide right to manufacture and distribute Neuron Chips using technology licensed from us, and require us to provide support, as well as unspecified updates to the licensed technology, over the terms of the agreements. The Cypress agreement expires in April 2009, and the Toshiba agreement expires in January 2010. However, we cannot be certain that these manufacturers will continue to supply Neuron Chips until these contracts expire, and we currently have no other source of supply for Neuron Chips. If either Toshiba or Cypress were to cease designing, manufacturing, and distributin g Neuron Chips, we could be forced to rely on a sole supplier for Neuron Chips. If both Toshiba and Cypress were to exit this business, we would attempt to find a replacement. This would be an expensive and time-consuming process, with no guarantee that we would be able to find an acceptable alternative source.
 
We also maintain manufacturing agreements with other semiconductor manufacturers for the production of key products, including those used in the Enel program. For example, we recently announced a new product family that we refer to as Power Line Smart Transceivers. A sole source supplier, STMicroelectronics, manufactures these products. Additionally, ON Semiconductor and AMI Semiconductor are sole source suppliers of components we sell to Enel’s meter manufacturers. We currently have no other source of supply for Power Line Smart Transceivers or the components manufactured by ON Semiconductor and AMI Semiconductor.

Our future success will also depend significantly on our ability to manufacture our products cost-effectively and in sufficient volumes. For most of our products requiring assembly, we use contract electronic manufacturers, including WKK Technology, Able Electronics, and TYCO TEPC/Transpower. These contract electronic manufacturers procure material and assemble, test, and inspect the final products to our specifications. This strategy involves certain risks. By using third parties to manufacture our products, we have reduced control over quality, costs, delivery schedules, product availability, and manufacturing yields. In addition, contract electronic manufacturers can themselves experience turnover and instability, exposing us to additional risks as well as missed commitments to our customer s. We will also face risks if and when we transition between contract electronic manufacturers. For example, we may have to move raw material and in-process inventory between locations in different parts of the world. Also, we would be required to re-establish acceptable manufacturing processes with a new work force. We could also be liable for excess or unused inventory held by contract manufacturers for use in our products. This inventory may become obsolete as a result of engineering changes that we make. In addition, we may no longer need this inventory because of factors such as changes in our production build plans, miscommunication between us and a contract manufacturer or errors made by a contract manufacturer in ordering material for use in our products. Under our contracts with these contract electronic manufacturers, we would become liable for all or some of these excess or obsolete inventories in the event our manufacturing agreement with them is cancelled and they are unable to return the materi al to their suppliers.

The failure of any key manufacturer to produce products on time, at agreed quality levels, and fully compliant with our product, assembly and test specifications could adversely affect our revenues and gross profit, and could result in claims against us by our customers.

Once the Enel project is completed or terminated, our overall revenue will decline significantly if we do not expand our customer base.

 
  28  
 
 
If Enel continues to deploy its Contatore Elettronico project in accordance with its scheduled rollout plan, we expect that revenues from the Enel project will continue to account for a significant portion of our overall revenues through 2004. Once the project is completed, or if it is otherwise terminated, our revenues from Enel and its meter manufacturers will become negligible. Accordingly, we continue to seek new revenue opportunities with other utility companies around the world.

In May 2002, we formed a Service Provider Group tasked with selling our networked energy services, or NES, system to utility companies around the world. We believe that utility companies generally require a lengthier sales cycle than do most of our other customers. In most instances, one or more field trials of our products may be required before a final decision is made by the utility. For example, we recently entered into an agreement with Continuon Netbeheer, a utility grid operator located in the Netherlands, to perform a limited field trial of our NES system within their service territory. Even if the Continuon field trial or other field trials are successful, we may not be able to negotiate mutually agreeable terms with the utility. If the utility decides to move forward with a mass depl oyment, there is generally an extended development and integration effort required in order to incorporate the new technology into the utility’s existing infrastructure. Due to the extended sales cycle and the additional development and integration time required, we cannot assure you that we will be able to find a replacement for the Enel project before the Enel project is terminated or completed. If we are not able to replace the revenues generated by the Enel project, our revenues and results of operations will be harmed.

Our future utility market product offerings may not be accepted by our targeted customers, or may fail to meet our financial targets.

To be successful in our NES efforts, we intend to continue investing significant resources in the development of the NES system. For example, in April 2003 we acquired certain assets of Metering Technology Corporation, or MTC, in exchange for $11.0 million and the assumption of certain liabilities. Among the assets acquired was the right to use MTC’s developed electricity meter technology. However, in order to integrate their technology into our NES system, we expect to incur significant development costs.

We cannot assure you that our NES system will be accepted in the utility market place. For example, in order to realize all of the benefits of the NES system, a utility must replace its metering infrastructure with a homogenous population of intelligent, networked meters. To date, Enel is the only utility we know of that has committed to such an endeavor. We also cannot assure you that, if accepted by the utilities, our NES system will generate economic returns that meet our financial targets. For example, revenues from our NES system offering may be lower than we anticipate. Additionally, the gross margins we receive from our NES system offering may not be as high as for our other products. If we are unsuccessful in deploying this product, or otherwise fail to meet our financial targets for t his product, our revenues and results of operations will be harmed.

We have a history of losses, and we may incur losses in the future.

We generated a profit of $4.5 million for the quarter ending September 30, 2003. As of September 30, 2003, we had an accumulated deficit of $69.1 million. We have invested and continue to invest significant financial resources in product development, marketing and sales.

In April 2003, we completed the acquisition of certain assets, including intellectual property, of Metering Technology Corporation, or MTC. The assets acquired do not constitute a business as defined in SFAS No. 141, Business Combinations. As a result, we expensed approximately $10.0 million of the $11.0 million purchase price during the second quarter of 2003, and an additional $239,000 related to the amortization of the purchased technology in the third quarter of 2003. We will continue to amortize the remaining $478,000 related to purchased technology over the balance of 2003 and into the fir st quarter of 2004. (Please refer to Note 9 of the Unaudited Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for additional information.) Additionally, since May 2003, we have been paying rent for additional facilities and amortizing certain leasehold improvements pursuant to a lease agreement we signed in 2000. We believe that reduced Enel program revenues, coupled with increases in our product development, marketing and sales, and facilities expenses, will result in a loss during the fourth quarter of 2003.

Our future operating results will depend on many factors, including:

·      timely installation of Enel’s Contatore Elettronico project;
·      costs associated with business acquisitions, including up-front in-process research and development charges and ongoing amortization expenses related to other identified intangible assets;
 
 
  29  
 
 
·      ongoing operational expenses associated with our acquisition of BeAtHome, our acquisition of certain assets of MTC, and any future business acquisitions;
·      adoption of our NES solution and other products by service providers for use in utility and/or other home automation projects;
·      return of worldwide economic growth, particularly in certain industries such as semiconductor manufacturing equipment;
·      growth in acceptance of our products by OEMs, systems integrators, service providers and end-users;
·      the level of competition that we face;
·      our ability to attract new customers in light of increased competition;
·      our ability to develop and market new products in a timely and cost-effective basis, or at all;
·      results of impairment tests that we will perform from time to time in the future, in accordance with SFAS 142, with respect to goodwill and other identified intangible assets that we acquired in the past or that we may acquire in the future. If the results of these impairment tests indicate that an impairment event has taken place, we will be required to take an asset impairment charge that could have a material adverse effect on our operating results; and
·      general economic conditions.
 
As of December 31, 2002, we had net operating loss carry forwards for federal income tax reporting purposes of about $93.1 million and for state income tax reporting purposes of about $8.7 million, which expire at various dates through 2021. In addition, as of December 31, 2002, we had tax credit carry forwards of about $9.7 million, $6.0 million of which expire at various dates through 2021. The Internal Revenue Code of 1986, as amended, contains provisions that limit the use in future periods of net operating loss and credit carry forwards upon the occurrence of certain events, including significant changes in ownership interests. We have performed an analysis of our ownership changes and have reported the net operating loss and credit carry forwards considering such limitations. We had defe rred tax assets, including our net operating loss carry forwards and tax credits, totaling about $48.0 million as of December 31, 2002. We have recorded a valuation allowance for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance, our history of losses and the variability of our operating results.

Fluctuations in our operating results may cause our stock price to decline.

Our quarterly and annual results have varied significantly from period to period, and we have, on occasion, failed to meet securities analysts’ expectations. Our future results may fluctuate and may not meet analysts’ expectations in some future period. As a result, the price of our common stock could fluctuate or decline. Some factors that could cause this variability, many of which are outside of our control, include the following:

·      revenues from the Enel project may fail to meet analysts’ expectations or our revenue and earnings guidance;
·      we may fail to meet stockholder expectations relating to additional utility customers and applications;
·      costs associated with business acquisitions, including up-front in-process research and development charges and ongoing amortization expenses related to other identified intangible assets;
·      ongoing operational expenses associated with our acquisition of BeAtHome, our acquisition of certain assets of MTC, and any future business acquisitions;
·      the results of impairment tests that we will perform from time to time in the future, in accordance with SFAS 142, with respect to goodwill and other identified intangible assets that we acquired in the past or that we may acquire in the future. If the results of these impairment tests indicate that an impairment event has taken place, we will be required to take an asset impairment charge that could have a material adverse effect on our operating results;
·      the rates at which OEMs purchase our products and services may fluctuate;
·      we may fail to introduce new products on a timely basis or before the end of an existing product’s life cycle;
·      downturns in any customer’s or potential customer’s business, or declines in general economic conditions, could cause significant reductions in capital spending, thereby reducing the levels of orders from our customers;
·      we may face increased competition;
·      market acceptance of our products may decrease;
·      our customers may delay or cancel their orders;
 
 
  30  
 
 
·      the mix of products and services that we sell may change to a less profitable mix;
· shipment and payment schedules may be delayed;
·      our pricing policies or those of our competitors may change;
·      our product distribution may change; and
·      product ratings by industry analysts and endorsements of competing products by industry groups could hurt the market acceptance of our products.

In addition, our expense levels are based, in significant part, on the future revenues that we expect. Consequently, if our revenues are less than we expect, our expense levels could be disproportionately high as a percentage of total revenues, which would negatively affect our profitability and cause our stock price to decline.

Since we depend on sole or a limited number of suppliers, any shortage or interruptions of supply would adversely affect our revenues and/or gross profits.

We currently purchase several key products and components only from sole or limited sources. In the past, we have occasionally experienced shortages or interruptions in supply for certain of these items, which caused us to delay shipments beyond targeted or announced dates. If we experience any shortage of products or components of acceptable quality, or any interruption in the supply of these products or components, or if we are not able to procure these products or components from alternate sources at acceptable prices and within a reasonable period of time, our revenues, gross profits or both could decrease. In addition, under the terms of some of our contracts with our customers, we may also be subject to penalties if we fail to deliver our products on time.
 
We face operational and financial risks associated with international operations.

Our international sales and marketing operations are located in nine countries around the world. Revenues from international sales, which include both export sales and sales by international subsidiaries, accounted for about 86.7% of our total net revenues for the quarter ended September 30, 2003 and 88.6% of our total net revenues for the same period in 2002; and 87.5% of our total revenues for the nine months ended September 30, 2003, and 88.1% for the same period in 2002. We expect that international sales will continue to constitute a significant portion of our total net revenues.

Our operations and the market price of our products may be directly affected by economic and political conditions in the countries where we do business. In addition, we may not be able to maintain or increase the international demand for our products. Additional risks inherent in our international business activities generally include the following:

·      international terrorism and anti-American sentiment, particularly in emerging markets;
·      currency fluctuations;
·      unexpected changes in regulatory requirements, tariffs and other trade barriers;
·      costs of localizing products for foreign countries and lack of acceptance of non-local products in foreign countries;
·      longer accounts receivable payment cycles;
·      difficulties in managing international operations;
·      labor actions generally affecting individual countries, regions, or any of our customers which could result in reduced demand for our products;
·      potentially adverse tax consequences, including restrictions on repatriation of earnings; and
·      the burdens of complying with a wide variety of foreign laws.

The outbreak of severe acute respiratory syndrome, or SARS, that began in China, Hong Kong, Singapore, and Vietnam earlier this year also had a negative impact on our business. Any future outbreak of SARS could similarly impact our operations, including the inability for our sales and operations personnel located in SARS affected regions to travel and conduct business freely, the impact SARS may have on one or more of the distributors for our products in those regions, and increased supply chain costs. Additionally, any future SARS-related disruptions at our third-party contract manufacturers or other key suppliers, many of whom are located in China and other parts of southeast Asia, could affect our ability to supply our customers with products in a timely manner.

Differing vacation and holiday patterns in other countries, particularly in Europe, may also affect the amount of business that we transact in other countries in any given quarter, the timing of our revenues, and our ability to forecast projected operating results for such quarter.

 
  31  
 
 
Fluctuations in the value of currencies in which we conduct our business relative to the U.S. Dollar could cause currency translation adjustments. The portion of our revenues conducted in currencies other than the U.S. Dollar, principally the Japanese Yen, was about 4.0% for the quarters ended September 30, 2003 and 2002; and 3.3% for the nine months ended September 30, 2003 and 4.8% for the same period in 2002.

The use of the Euro as the standard currency in participating European countries may also impact our ability to transact sales in U.S. Dollars. We have agreed with EBV, our European distributor, that upon notice from EBV, we will sell our products to EBV in Euros rather than U.S. Dollars. We do not know when or if EBV will give such notice. If fewer of our sales in Europe are transacted in U.S. Dollars, we may experience an increase in currency translation adjustments, particularly as a result of general economic conditions in Europe as a whole. We do not currently engage in currency hedging transactions or otherwise cover our foreign currency exposure.

Our business may suffer if it is alleged or found that we have infringed the intellectual property rights of others .

Although we attempt to avoid infringing known proprietary rights of third parties in our product development efforts, from time to time we may receive notice that a third party believes that we may be infringing certain patents or other intellectual property rights of that third party. Responding to those claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. In that case, we may elect or be required to redesign our products so that they do not incorporate any intellectual property to which the third party has or claims rights. As a result, some of our product offerings could be delayed, or we could be required to cease distributing some of our products. In the alternati ve, we could seek a license for the third party’s intellectual property, but it is possible that we would not be able to obtain such a license on reasonable terms, or at all. Any delays that we might then suffer or additional expenses that we might then incur could adversely affect our revenues, operating results and financial condition.

Our markets are highly competitive. Many of our competitors have longer operating histories and greater resources than we do. If we are unable to effectively compete in the industry, our operating results could be harmed.

Competition in our markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions and rapid changes in customer requirements. To maintain and improve our competitive position, we must continue to develop and introduce, on a timely and cost-effective basis, new products, features and services that keep pace with the evolving needs of our customers. The principal competitive factors that affect the markets for our control network products include the following:

·      our customer service and support;
·      our ability to develop and introduce new products on a timely basis;
·      our product reputation, quality, and performance; and
·      the price and features of our products such as adaptability, scalability, functionality, ease of use, and the ability to integrate with other products.

In each of our markets, we compete with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses. Our competitors include some of the largest companies in the electronics industry, such as Siemens in the building and industrial automation industries, and Allen-Bradley (a subsidiary of Rockwell) and Groupe Schneider in the industrial automation industry. Many of our competitors, alone or together with their trade associations and partners, have significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition, and broader product offerings. As a result, these competitors may be able to devote greater resources to the development, marketing, and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, proprietary control systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. Microsoft has announced a specification that it refers to as SCP (Simple Control Protocol) that is targeted at the networking of everyday devices. Microsoft has announced its intent to focus this capability on home networking applications. Products from other companies such as Digi International, emWare, Ipsil, JumpTec, Lantronix, and Wind River Systems, as well as certain micro-controller manufacturers including Motorola, Texas Instruments, Micro Chip, and Philips, all of which promote directly connecting devices to the Internet, could also compete with our products. In addition, products from companies such as Actaris, DCSI, Hexagram, Hunt Technologies, Itron, Nexus, Ramar, and Schlumberger Sema, each of which offers automatic meter reading (AMR) products for the utility industry, could compete with our broader networked energy services offerings to the utility marketplace.

 
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Many of our competitors develop, support, and promote alternative control systems. If we are unable to promote and expand acceptance of our open, interoperable control system, our revenues and operating results may be harmed.

Many of our current and prospective competitors are dedicated to promoting closed or proprietary systems, technologies, software and network protocols or product standards that differ from or are incompatible with ours. In some cases, companies have established associations or cooperative relationships to enhance the competitiveness and popularity of their products, or to promote these different or incompatible technologies, protocols and standards. For example, in the building automation market, we face widespread reluctance by vendors of traditional closed or proprietary control systems, who enjoy a captive market for servicing and replacing equipment, to use our interoperable technologies. We also face strong competition by large trade associations that promote alternative technologies and standards in their native countries, such as the Konnex Association in Belgium, and the European Installation Bus Association in Germany, each of which has over 100 members and licensees. Other examples include various industry groups who promote alternative open standards such as BACnet in the building market, DALI in the lighting controls market, Echonet in the home control market, and a group comprised of Asea Brown Boveri, ADtranz AB, Siemens, GEC Alstrom and other manufacturers that support an alternative rail transportation protocol to our LonWorks protocol. Our technologies, protocols, or standards may not be successful in any of our markets, and we may not be able to compete with new or enhanced products or standards introduced by existing or future competitors.

Defects in or misuse of our products may delay our ability to generate revenues and may increase our liabilities and expenses.

Our products may contain undetected errors or failures when first introduced or as new versions are released. In addition, our customers may improperly install or implement our products. Furthermore, because of the low cost and interoperable nature of our products, LonWorks technology could be used in a manner for which it was not intended.
 
If errors or failures are found in our products, we may not be able to successfully correct them in a timely manner, or at all. Such errors or failures could delay our product shipments and divert our engineering resources while we attempt to correct them. As a result, errors or failures in our products, or the improper installation or implementation of our products by third parties, could harm our reputation and operating results.
 
To address these issues, the agreements we maintain with our customers typically contain provisions intended to limit our exposure to potential errors and omissions claims as well as any liabilities arising from them. In certain very limited instances, these agreements require that we be named as an additional insured on our customer’s insurance policies. However, our customer contracts and additional insured coverage may not effectively protect us against the liabilities and expenses associated with errors or failures attributable to our products.
 
To help reduce our exposure to these types of claims, we currently maintain errors and omissions insurance. However, it is possible that such insurance may not be available in the future or, if available, may be insufficient in amount to cover any particular claim. During 2000, the total limit for claims under these policies was $17.0 million. Since then, we have reduced the total limit for errors and omissions claims to $11.0 million because we believed the premiums our insurers requested were excessive. We believe that insurance premiums for errors and omissions coverage will continue to increase for the foreseeable future, which could result in increased costs or reduced limits. Consequently, if we elect to reduce our coverage, we may face increased exposure to these types of claims. If lia bility for a claim exceeds our policy limits, our operating results and our financial position would be negatively affected.

We promote an open technology platform that could increase our competition.

LonWorks technology is open, meaning that many of our technology patents are broadly licensed without royalties or license fees. As a result, our customers are capable of developing hardware and software solutions that compete with some of our products. Because some of our customers are OEMs that develop and market their own control systems, these customers in particular could develop competing products based on our open technology. For instance, all of the network management commands required to develop software that competes with our LNS software are published. This could decrease the demand for our products and increase the competition that we face.

 
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Downturns in the control network technology market and related markets may decrease our revenues and margins.
 
 The market for our products depends on economic conditions affecting the broader control network technology and related markets. Downturns in these markets may cause our OEMs and system integrators to delay or cancel projects, reduce their production or reduce or cancel orders for our products. In this environment, customers may experience financial difficulty, cease operations or fail to budget for the purchase of our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, and price pressures, causing us to realize lower revenues and margins. In particular, capital spending in the technology sector has decreased over the past three years, and many of our customers and potential customers have experienc ed declines in their revenues and operations. In addition, concerns with respect to terrorism and geopolitical issues in the Middle East and Asia have added more uncertainty to the current economic environment. We cannot predict the impact of these events, or of any related military action, on our customers or business. We believe that, in light of these events, some businesses may further curtail or may eliminate capital spending on control network technology altogether. If capital spending in our markets continues to decline, it may be necessary for us to gain significant market share from our competitors in order to achieve our financial goals and maintain profitability.

The undetermined market acceptance of our products makes it difficult to evaluate our future prospects.

We face a number of risks as an emerging company in a rapidly changing and developing new market, and you must consider our prospects in light of the associated risks. Our future operating results are difficult to predict due to many factors, including the following:

·      our targeted markets have not yet accepted many of our products and technologies;
·      many of our customers do not fully support open, interoperable networks, and this reduces the market for our products;
·      we may not anticipate changes in customer requirements and, even if we do so, we may not be able to develop new or improved products that meet these requirements in a timely manner, or at all;
·      the markets in which we operate require rapid and continuous development of new products, and we have failed to meet some of our product development schedules in the past;
·      potential changes in voluntary product standards around the world can significantly influence the markets in which we operate; and
·      our industry is very competitive and many of our competitors have far greater resources and may be prepared to provide financial support from their other businesses in order to compete with us.

If our OEMs do not employ our products and technologies our revenues could decrease significantly.

To date, a substantial portion of our product sales has been to OEMs. The product and marketing decisions made by OEMs significantly affect the rate at which our products are used in control networks. We believe that because OEMs in certain industries receive a large portion of their revenues from sales of products and services to their installed base, these OEMs have tended to moderate the rate at which they incorporate LonWorks technology into their products. They may believe that a more rapid transition to LonWorks technology could harm their installed base business. Furthermore, OEMs that manufacture and promote products and technologies that compete or may compete with us may be particularly reluctant to employ our products and technologies to any significant extent, if at all. We may not be able to maintain or improve the current rate at which our products are accepted by OEMs and others, which could decrease our revenues.

If we do not maintain adequate distribution channels, our revenues could decrease significantly.

Currently, significant portions of our revenues are derived from sales to distributors, including EBV, the sole independent distributor of our products to OEMs in Europe. Sales to EBV, our largest distributor, accounted for 10.8% of our total net revenues for the quarter ended September 30, 2003 and 7.9% of our total net revenues for the same period in 2002; and 8.9% of our total net revenues for the nine months ended September 30, 2003 and 9.3% for the same period in 2002.

 
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Our current agreement with EBV expires in December 2003. If EBV, or any other existing or future distributor, fails to dedicate sufficient resources and efforts to marketing and selling our products, our revenues could decrease. If EBV significantly reduces its inventory levels for our products, both our revenues and customer service levels would decrease. If we do not maintain our agreement with EBV, we would be required to locate another distributor or add our own pan-European distribution capability to meet the needs of our customers. In that event, our business could be harmed during the transition period as EBV’s inventory of our products was sold but not replaced.

If OEMs fail to develop interoperable products or if our targeted markets do not accept our interoperable products, we may be unable to generate sales of our products.
 
Our future operating success will depend, in significant part, on the successful development of interoperable products by OEMs and us, and the acceptance of interoperable products by systems integrators and end-users. We have expended considerable resources to develop, market and sell interoperable products, and have made these products a cornerstone of our sales and marketing strategy. We have widely promoted interoperable products as offering benefits such as lower life-cycle costs and improved flexibility to owners and users of control networks. However, OEMs that manufacture and market closed systems may not accept, promote or employ interoperable products, since doing so may expose their businesses to increased competition. In addition, OEMs might not, in fact, successfully develop intero perable products, or their customers might not accept their interoperable products. If OEMs fail to develop interoperable products, or our markets do not accept interoperable products, our revenues and operating results will suffer.

Our executive officers and technical personnel are critical to our business, and if we lose or fail to attract key personnel, we may not be able to successfully operate our business.

Our performance depends substantially on the performance of our executive officers and key employees. Due to the specialized technical nature of our business, we are particularly dependent on our Chief Executive Officer, our Chief Operating Officer, and our technical personnel. Our future success will depend on our ability to attract, integrate, motivate and retain qualified technical, sales, operations and managerial personnel. Competition for qualified personnel in our business areas is intense, and we may not be able to continue to attract and retain qualified executive officers and key personnel necessary to enable our business to succeed. Our product development and marketing functions are largely based in Silicon Valley, which is typically a highly competitive marketplace. It may be part icularly difficult to recruit, relocate and retain qualified personnel in this geographic area. Moreover, the cost of living, including the cost of housing, in Silicon Valley is known to be high. Because we are prohibited from making loans to executive officers under recent legislation, we will not be able to assist potential key personnel as they acquire housing or incur other costs that might be associated with joining our company. In addition, if we lose the services of any of our key personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel may decide to leave, and we may incur increased operating expenses in finding and compensating their replacements.

The market for our products is new and rapidly evolving. If we are not able to develop or enhance products to respond to changing market conditions, our revenues will suffer.

Customer requirements for control network products can change as a result of innovations or changes within the building, industrial, transportation, utility/home and other industries. For example, new or different standards within industry segments may be adopted, giving rise to new customer requirements. These customer requirements may or may not be compatible with our current or future product offerings. Our future success depends in large part on our ability to continually enhance our existing product offerings, lower the market price for our products, and develop new products that maintain technological competitiveness. We may not be successful in modifying our products and services to address these requirements and standards. For example, certain of our competitors may develop competing t echnologies based on Internet Protocols (IP) that could have, or could be perceived to have, advantages over our products in remote monitoring or other applications. As another example, many competitors promote media types, such as radio frequency (wireless) and fiber optics that, even if used with LonWorks technology, could displace sales of certain of our transceiver products. If we are not able to develop or enhance our products to respond to these changing market conditions, our revenues and results of operations will suffer.

In addition, due to the nature of development efforts in general, we often experience delays in the introduction of new or improved products beyond our original projected shipping date for such products. Historically, when these delays have occurred, we experienced an increase in our development costs and a delay in our ability to generate revenues from these new products. We believe that similar new product introduction delays in the future could also increase our costs and delay our revenues.

 
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The trading price of our stock has been volatile, and may fluctuate due to factors beyond our control.
 
The trading price of our common stock is subject to significant fluctuations in response to numerous factors, including:

·    significant stockholders may sell some or all of their holdings of our stock. For example, Enel presently owns 3,000,000 shares, or approximately 7.4% of our outstanding common stock. As of September 11, 2003, Enel is generally free to sell these shares at its discretion;
·    investors may be concerned about the success of our project with Enel, or our ability to develop new customers for utility applications;
·    competitors may announce new products or technologies;
·    our quarterly operating results may vary widely;
·    we or our customers may announce technological innovations or new products; and
·    securities analysts may change their estimates of our financial results.

In addition, the market price of securities of technology companies, especially those in rapidly evolving industries such as ours, has been very volatile in the past. This volatility in any given technology company’s stock price has often been unrelated or disproportionate to the operating performance of that particular company.

In the future, we may be the target of securities class action lawsuits or other litigation, which could be costly and time consuming to defend.

In the past, following a period of volatility in the market price of a company’s stock, securities class action lawsuits have often been instituted against such companies. In the future, we may become the target of similar litigation. If such a lawsuit were brought against us, regardless of its outcome, we would incur substantial costs and our management resources would be diverted in defending such litigation.

Voluntary standards that are established in our markets could limit our ability to sell our products and reduce our revenues.
 
Standards bodies, which are formal and informal associations that attempt to set voluntary, non-governmental product standards, are influential in many of our target markets. Some of our competitors have attempted to use voluntary standards to reduce the market opportunity for our products, or to increase the market opportunity for their own products, by lobbying for the adoption of voluntary standards that would exclude or limit the use of products that incorporate our technology. We participate in many voluntary standards organizations around the world in order to both help prevent the adoption of exclusionary standards and to promote voluntary standards for our products. However, we do not have the resources to participate in all voluntary standards processes that may affect our markets. Th e adoption of voluntary standards that are incompatible with our products or technology could limit the market opportunity for our products.

As a result of our lengthy sales cycle, we have limited ability to forecast the amount and timing of specific sales. If we fail to complete or are delayed in completing transactions, our revenues could vary significantly from period to period.
 
The sales cycle between initial customer contact and execution of a contract or license agreement with a customer can vary widely. For example, OEMs typically conduct extensive and lengthy product evaluations before making initial purchases of our products. They may further delay subsequent purchases of our products due to the OEMs’ own prolonged product development and product introduction periods. Delays in our sales cycle can also result from, among other things:
 
·     changes in our customers’ budgets;
·   changes in the priority our customers assign to control network development;
·   the time it takes for us to educate our customers about the potential applications of and cost savings associated with
         our products; and
·   the deployment schedule for projects undertaken by systems integrators.
 
 
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We generally have little or no control over these factors, which may cause a potential customer to favor a competitor’s products, or to delay or forgo purchases altogether.
 
We have limited ability to protect our intellectual property rights.

Our success depends significantly upon our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect these intellectual property rights, all of which afford only limited protection. As of October 31, 2003, we have 90 issued U.S. patents, 6 pending U.S. patent applications, and various foreign counterparts. It is possible that patents will not issue from these pending applications or from any future applications or that, if issued, any claims allowed will not be sufficiently broad to protect our technology. If any of our patents fail to protect our technology, our competitors may find it easier to offer equivalent or superior technology. We have regis tered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. If we fail to properly register or maintain our trademarks or to otherwise take all necessary steps to protect our trademarks, the value associated with the trademarks may diminish. In addition, if we fail to take all necessary steps to protect our trade secrets or other intellectual property rights, we may not be able to compete as effectively in our markets.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or services or to obtain and use information that we regard as proprietary. Any of the patents, trademarks, copyrights or intellectual property rights that have been or may be issued or granted to us could be challenged, invalidated or circumvented, and any of the rights granted may not provide protection for our proprietary rights. In addition, we cannot assure you that we have taken or will take all necessary steps to protect our intellectual property rights. Third parties may also independently develop similar technology without breach of our trade secrets or other proprietary rights. We have licensed in the past and may license in the future our key technologies to third parties. In addition, the laws of some foreign countries, including several in which we operate or sell our products, do not protect proprietary rights to as great an extent as do the laws of the United States. For example, certain of our products are licensed under shrink-wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions.

From time to time, litigation may be necessary to defend and enforce our proprietary rights. As a result of this litigation, we could incur substantial costs and divert management resources, which could harm our business, regardless of the final outcome. Despite our efforts to safeguard and maintain our proprietary rights both in the United States and abroad, we may be unsuccessful in doing so. Also, the steps that we take to safeguard and maintain our proprietary rights may be inadequate to deter third parties from infringing, misusing, misappropriating, or independently developing our technology or intellectual property rights; or to prevent an unauthorized third party from copying or otherwise obtaining and using our products or technology.

Regulatory actions could limit our ability to market and sell our products.

Many of our products and the industries in which they are used are subject to U.S. and foreign regulation. Government regulatory action could greatly reduce the market for our products. For example, the power line medium, which is the communications medium used by some of our products, is subject to special regulations in North America, Europe and Japan. These regulations limit the ability of companies in general to use power lines as a communication medium. In addition, some of our competitors have attempted to use regulatory actions to reduce the market opportunity for our products or to increase the market opportunity for their own products. For example, in the late 1990s, CEMA, a trade association that developed a competing home automation protocol, was successful in persuading the FCC to mandate use of CEMA’s protocol in analog television and set-top box applications. We were a petitioner in litigation arising from a related FCC proceeding concerning commercial availability of these "navigation devices." Although these specific FCC and judicial proceedings are not a significant threat to our digital and Internet-based products, changes in existing regulations or the issuance of new regulations in the future could adversely affect the market for our products or require us to expend significant management, technical and financial resources to make our products compliant with the new rules.

 
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Compliance with new rules and regulations concerning corporate governance may be costly and time-consuming, which could harm our operating results and business.
 
The Sarbanes-Oxley Act, or the Act, which was signed into law in October 2002, mandates, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements. The Act also imposes increased civil and criminal penalties on a corporation, its chief executive and chief financial officers, and members of its Board of Directors, for securities law violations. In addition, the Nasdaq National Market, on which our common stock is traded, has adopted and is considering the adoption of additional comprehensive rules and regulations relating to corporate governance. These rules, laws, and regulations have increased the scope, complexity, and cost of our corporate governance, reporting, and disclosure practices. Because compliance with these new rules, laws, and regulations will be costly and time-consuming, our management’s attention could be diverted from managing our day-to-day business operations, and our operating expenses could increase. We also expect these developments will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer, and Chief Financial Officer face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business.

Our existing stockholders control a significant percentage of our stock, which will limit other stockholders’ ability to influence corporate matters.
 
As of October 31, 2003, our directors and executive officers, together with certain entities affiliated with them (including, for this purpose, Enel, which has the right to nominate a director to our Board of Directors), beneficially owned 36.0% of our outstanding stock.

Under the stock purchase agreement with Enel, which transaction was completed September 11, 2000, Enel purchased 3.0 million newly issued shares of our common stock and was granted the right to nominate a director to our Board of Directors. As a condition to the closing of the stock purchase agreement, our directors and our Chief Financial Officer agreed to enter into a voting agreement with Enel in which each of them agreed to vote the shares of our company’s common stock that they beneficially owned or controlled in favor of Enel’s nominee to our Board of Directors. In addition, under the terms of the stock purchase agreement, Enel has agreed to (i) vote (and cause any of its affiliates that own shares of our common stock to vote) all of its shares in favor of the slate of director nominees recommended by the Board of Directors, and (ii) vote (and endeavor to cause any of its affiliates that own shares of our common stock to vote) a number of shares equal to at least that percentage of shares voted by all other stockholders for or against any specified matter, as recommended by the Board of Directors. The specified matters are the election of accountants, the approval of company option plans, and any proposal by any of our stockholders (unless the proposal could be prejudicial to Enel or the required voting would interfere with Enel’s fiduciary duties to its own shareholders).

As a result, our directors and executive officers, together with certain entities affiliated with them, may be able to control substantially all matters requiring approval by our stockholders, including the election of all directors and approval of certain other corporate matters.

Potential conflicts of interest could limit our ability to act on opportunities that are adverse to a significant stockholder or its affiliates.

From time to time, we may enter into a material contract with a person or company that owns a significant amount of our company’s stock. As circumstances change, we may develop conflicting priorities or other conflicts of interest with the significant stockholder with regard to the contract, or the significant stockholder may exert or attempt to exert a significant degree of influence over our management and affairs. The significant stockholder might exert or attempt to exert this influence in its capacity as a significant stockholder or, if the significant stockholder has a representative on our board of directors, through that board member.

 
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For example, we have entered into the Contatore Elettronico project with an affiliate of Enel. Enel currently owns 3.0 million shares of our common stock, representing approximately 7.4% of our outstanding common stock. Enel also has the right to nominate a member of our board of directors as long as Enel owns at least 2.0 million shares of our common stock. As a consequence of the expiration of his mandate as Enel’s Chief Executive Officer, Mr. Francesco Tatò resigned as a board member in all of Enel’s subsidiaries and affiliates, including Echelon. Mr. Tatò served on our board of directors as a representative of Enel from September 2000 until September 2002. Enel has reserved i ts right to nominate a new member of our board of directors, who must be approved by us, to fill the vacancy created by the resignation of Enel’s former board representative to our board of directors. During the term of service of Enel’s former board representative from September 2000 to September 2002, Enel’s representative on our board abstained from resolutions on any matter relating to Enel. A member of our board of directors who is also an officer of or is otherwise affiliated with Enel may decline to take action in a manner that might be favorable to us but adverse to Enel. Conflicts that could arise might concern the Contatore Elettronico project with Enel and other matters where Enel’s interest may not always coincide with our interests or the interests of our other stockholders. Any of those conflicts could affect our ability to complete the Contatore Elettronico project on a timely basis, could increase our expenses or reduce our profits in connection with the project, could aff ect our ability to obtain approval for or complete other projects or plans that are in conflict with Enel’s goals, and could otherwise significantly and adversely affect our financial condition and results of operations.

Natural disasters or power outages could disrupt our business.

We must protect our business and our network infrastructure against damage from earthquake, flood, hurricane and similar events, as well as from power outages. Many of our operations are subject to these risks, particularly our operations located in California. We have already experienced temporary power losses in our California facilities due to power shortages that have disrupted our operations, and we may in the future experience additional power losses that could disrupt our operations. While the impact to our business and operating results has not been material, it is possible that power losses will adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will increase significantly. Similarly, a natural disaster or other unanticipate d problem could also adversely affect our business by, among other things, harming our primary data center or other internal operations, limiting our ability to communicate with our customers, and limiting our ability to sell our products.
 
 
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Item 3.    Quantitative and Qualitative Disclosures About Market Risk
 
We have not experienced any material change in our exposure to interest rate and foreign currency risks since the date of our Annual Report on Form 10-K for the year ended December 31, 2002.

Market Risk Disclosures. The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments to hedge these exposures.

Interest Rate Sensitivity. We maintain a short-term investment portfolio consisting mainly of fixed income securities with a weighted average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market rates were to increase immediately and uniformly by 10 percent from levels at September 30, 2003 and September 30, 2002, the fair value of the portfolio would decline by an immaterial amount due primarily to the fact that current interest rates are at historically low levels. We currently intend to hold our fixed income investments until maturity, and therefore we would not expe ct our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. If necessary, we may sell short-term investments prior to maturity to meet the liquidity needs of the company.

Foreign Currency Exchange Risk. We have international subsidiaries and operations and are, therefore, subject to foreign currency rate exposure. To date, our exposure to exchange rate volatility has not been significant. Due to our modest exposure to foreign currency fluctuations, if foreign exchange rates were to fluctuate by 10% from rates at September 30, 2003, and September 30, 2002, our financial position and results of operations would not be materially affected. However, it is possible that there would be a material impact in the future.

Item 4.    Controls and Procedures

Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified in Securities and E xchange Commission rules and forms, and (ii) is accumulated and communicated to Echelon’s management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

Changes in internal control over financial reporting . There were no changes in our internal controls over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
 
 
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PART II. OTHER INFORMATION
 
Item 6.            Exhibits and Reports on Form 8-K
 
  (a)  Exhibits

Exhibit
  No.
 
        Description of Document
31.1
Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32
Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
  (b)                Reports on Form 8-K
 
  We filed the following reports on Form 8-K during the quarter ended September 30, 2003:

1.     On July 11, 2003, we filed a current report on Form 8-K dated July 15, 2003, under Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 9 (Regulation FD Disclosure), to reference and furnish as an exhibit a press release dated July 10, 2003, disclosing the resolution of a contractual dispute with Enel S.p.A.

2.     On July 17, 2003, we filed a current report on Form 8-K dated July 10, 2003, under Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 9 (Regulation FD Disclosure), to reference and furnish as an exhibit a press release dated July 15, 2003, announcing our results of operations for the quarter ended June 30, 2003.


SIGNATURE
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
ECHELON CORPORATION
       
Date:    November 13, 2003 
 
By:
/s/ Oliver R. Stanfield
 
 
 
Oliver R. Stanfield,
Executive Vice President Finance and Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)
 
 
 
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EXHIBIT INDEX


Exhibit
No.
 
Description of Document
31.1
Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32
Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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