ECHELON CORP - 10-K Annual Report

** 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. < /DIV>

The following table sets forth, for our Named Executive Officers, certain information concerning shares acquired upon the exercise of stock options during the year ended December 31, 2003, as well as exercisable and unexercisable options held as of December 31, 2003.

			Number of Securities Underlying Unexercised Options at December 31, 2003 (#)		Value of Unexercised In-the- Money Options at December 31, 2003 ($) **
	Shares Acquired on	Value Realized
Name	Exercise (#)	($) *	Exercisable	Unexercisable	Exercisable	Unexercisable

M. Kenneth Oshman	100,000	591,000	820,000	--	611,550	--
Beatrice Yormark	50,000	295,500	199,999	155,001	305,775	--
Oliver R. Stanfield	125,000	860,775	124,999	155,001	--	--
Frederik H. Bruggink	---	---	180,833	49,167	12,400	--
Peter A. Mehring	75,000	547,750	185,833	99,167	305,775	--

* 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 $11.14 per share closing price of our common stock on December 31, 2003, minus the aggregate exercise price. Only options that are in the money are included in this analysis. 


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Equity Compensation Plan Information 

The following table summarizes our company’s stock option plans as of December 31, 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	8,944,182	$16.49	3,601,792

Equity compensation plans not approved by stockholders	---	---	---


Total	8,944,182	$16.49	3,601,792

*      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 December 31, 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 our company. 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. For 2003, revenue attributable to the Contatore Elettronico project was approximately $75.8 million, or 64.2% of our total revenue. We expect the Contatore Elettronico project to account for the majority of our targeted revenue for 2004. 

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. Even if we should prevail in such a dispute, the costs incurred by Echelon and the diversion of time by key employees could adversely affect our company. If any dispute is not resolved in our favor or 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. From time to time, we have interpreted the contracts between our companies differently from Enel, which has led to disagreements. 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;


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Enel could decide to no longer pursue the Contatore Elettronico project to the extent we currently contemplate, or at all, or Enel could replace the LONWORKS technology used by Enel in the Contatore Elettronico project with other technology;
once 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 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. Any future public tenders 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;
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: 

disputes may arise with us regarding product quality or responsibility for costs incurred by the meter manufacturers relating to metering kits;
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
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.


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

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 delivery of our products for use in the project is completed, which we currently estimate will occur in early 2005, 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 and value added resellers 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, in July 2003, we 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 t
o move forward with a mass deployment, 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. If we incur penalties and/or damages with respect to sales of the NES system, such penalties and/or damages could have an adverse effect on our financial condition, revenues, and operating results. 

To be successful in our effort to sell our NES system, 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 in cash and the assumption of certain liabilities. Among the assets acquired was the right to use MTC’s developed electricity meter technology. However, as we have integrated their technology into our NES system, we have incurred and expect to continue 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 a significant portion of its metering infrastructure with a homogenous population of intelligent, networked meters. 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. 

Even if we are successful in penetrating the utility market with our NES system offering, competitors, including our own customers such as Enel, Enermet, Horstmann Controls, Kamstrup, and Milab, could develop and market their own multi-service metering systems. For example, Enel, our largest customer, could design a system that competes with our NES system using third party products instead of our products. Enel has significantly greater experience and financial, technical, and other resources than we have. 

In addition, we presently plan to sell our NES products to utilities either directly or through resellers or other partners.  If we sell the NES system directly to a utility, the utility may require us to assume responsibility for installing the NES system in the utility's territory, integrating the NES system into the utility's operating and billing system, overseeing management of the combined system, and undertaking other activities.  These are services that we generally would not be responsible for if we sold our NES products through a reseller or other partner, or if we sold directly to a utility that managed those activities on its own. To date, we have only insignificant experience with those services. As a result, if we sold directly to a utility that required us to provide those services, we may be required to contract with third parties to satisfy those obligations.  We cannot assure you that we would find appropriate third parties to provide those services on reaso
nable terms, or at all.  Assuming such responsibility for these or other services would add to the costs and risks associated with NES system installations, and could also negatively affect the timing of our revenues and cash flows related to these transactions.  

Lastly, sales of the NES system may also expose us to penalties and damages relating to late deliveries, late or improper installations or operations, failure to meet product specifications, failure to achieve performance specifications or otherwise. If we are unsuccessful in deploying this product, or otherwise fail to meet our financial targets for this product, our revenues and results of operations will be harmed. 


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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. These 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 unt
il 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 distributing 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 and our NES system. For example, in 2003 we announced a new product family that we refer to as Power Line Smart Transceivers. A sole source supplier, STMicroelectronics, manufactures these products. Additionally, Cypress, 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 Cypress, ON Semiconductor, and AMI Semiconductor. 

Our future success will also depend significantly on our ability to manufacture our products cost-effectively, in sufficient volumes and in accordance with quality standards. 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. For instance, quality problems at a contract equipment manufacturer could result in missed shipments to our customers and unusable invento
ry, thereby reducing our revenues and increasing our costs associated with inventory reserves. In addition, contract electronic manufacturers can themselves experience turnover and instability, exposing us to additional risks as well as missed commitments to our customers. 

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 c
ontract 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 material 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. 

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. 

As previously discussed, we currently purchase several key products and components only from sole or limited sources. For some of these suppliers, we do not maintain signed agreements that would obligate them to supply to us on negotiated terms. 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. 


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Although we recently achieved profitability, we have a history of losses and cannot guarantee that profits will increase or continue in the future. 

We generated a profit of $1.9 million for the year ending December 31, 2003. As of December 31, 2003, we had an accumulated deficit of $69.6 million. We have invested and continue to invest significant financial resources in product development, marketing and sales. 

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

timely installation of Enel’s Contatore Elettronico project;
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;
the ability of our contract electronic manufacturers to provide quality products on a timely basis, especially during periods where excess capacity in the contract electronic manufacturing market is reduced;
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, in a timely and cost-effective basis, new products that perform as designed;
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;
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, 2003, we had net operating loss carry forwards for federal income tax reporting purposes of about $83.5 million and for state income tax reporting purposes of about $8.7 million, which expire at various dates through 2022. In addition, as of December 31, 2003, we had tax credit carry forwards of about $10.5 million, $6.0 million of which expire at various dates through 2022. 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 reporte
d the net operating loss and credit carry forwards considering such limitations. We had deferred tax assets, including our net operating loss carry forwards and tax credits, totaling about $47.8 million as of December 31, 2003. 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 our NES system and additional utility customers and applications;
we may fail to meet stockholder expectation for revenue growth in our sales of LONWORKS Infrastructure products to OEMs and systems integrators;
the rates at which OEMs purchase our products and services may fluctuate;
our products may not be manufactured in accordance with specifications or our established quality standards, or may not perform as designed;


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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 in both our LONWORKS Infrastructure business and our NES business;
market acceptance of our products may decrease;
our customers may delay or cancel their orders;
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;
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;
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. 

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 86.5% of our total net revenues for the year ended December 31, 2003 and 88.2% of our total net revenues 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;
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 in 2003 also had a negative impact on our business. Any future outbreak of SARS, or other widespread communicable diseases, could similarly impact our operations, including the inability for our sales and operations personnel located in affected regions to travel and conduct business freely, the impact any such disease may have on one or more of the distributors for our products in those regions, and increased supply chain costs. Additionally, any future SARS or other health-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. 


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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. 

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 3.8% in 2003, 4.8% in 2002, and 5.9% in 2001. In addition, much of our sales and marketing expenses, as well as certain other costs, are incurred in currencies other than the U.S. Dollar. If the value of the U.S. Dollar declines as compared to the local currency where the expenses are incurred, our expenses, when translated back into U.S. Dollars, will increase. For example, using the currency rates in effect as of February 29, 2004, our 2003 costs and expenses, as reported in U.S. Dollars, would have increased by approximately $81
3,000. This would have resulted in a $0.02 reduction in earnings per share for 2003. 

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 customers may not pursue product opportunities based on their concerns regarding third party intellectual property rights, particularly patents and this could reduce the market opportunity for the sale of our products and services. 

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. For our LONWORKS Infrastructure business, 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 broade
r 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. Products from other companies such as Digi International, emWare, Ipsil, JumpTec, Lantronix, Microsoft, 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, in the utilities market, products from companies such as Actaris, Atos Origin, DCSI, Elster, Hexagram, Hunt Technologies, Itron, Iskraemeco, Nexus, and Ramar, each of which offers automatic meter readi
ng products for the utility industry, as well as metering systems from our customers such as Enel, Enermet, Horstmann Controls, Kamstrup, and Milab, could compete with our NES system. For example, Enel, our largest customer, could design a system that competes with our NES system using third party products instead of our products. Enel has significantly greater experience and financial, technical, and other resources than we have. 


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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/Bombardier, 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, as new versions are released, or as a result of the manufacturing process. In addition, our customers or their installation partners 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. In addition, we could decide to extend the warranty period, or incur other costs outside of our normal warranty coverage, to help address any known errors or failures in our products and mitigate the impact on our customers. 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, reduce our revenues, increase our expenses, and negatively impact our 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. For example, utility customers purchasing our NES system may require that we agree to indemnities or penalties in excess of the provisions we typically employ with our LONWORKS Infrastructure business. 

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 
liability for a claim exceeds our policy limits, our operating results and our financial position would be negatively affected. 


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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.

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 in past years, and many of our customers and potential customers have experienced 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. This is true of both our LONWORKS Infrastructure business and our new NES business. 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. 


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If we do not maintain adequate distribution channels for our LONWORKS Infrastructure business, or establish adequate distribution channels for our NES system business, our revenues could be harmed 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 10.2% of our total net revenues in 2003, 9.2% of our total net revenues in 2002, and 16.9% of our total net revenues in 2001. Worldwide sales to distributors, including those to EBV, accounted for approximately 14.6% of our total net revenues in 2003, 14.2% of our total net revenues in 2002, and 26.9% of our total net revenues in 2001. 

Our current agreement with EBV expires in December 2004. 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. 

In our NES system business, we market directly, as well as through selected value added resellers, or VARs, and integration partners. However, we believe that a significant portion of our NES system sales, if any, will be made through our VARs and integration partners, rather than directly by our company, since to date, our VARs and integration partners have greater experience in overseeing projects for utilities. As a result, if our relationships with our VARs and integration partners are not successful, or if we are not able to create similar distribution channels for our NES system business with other companies, our NES business may not be successful, which could harm our revenues and operating results. 

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. 


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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, our NES system offering to utilities is new. Also, 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 technologies 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. 

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, the success of our sales of our LONWORKS Infrastructure products and services to OEMs and systems integrators, or our ability to develop new customers for our NES business;
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. If the markets we target were to adopt voluntary standards that are incompatible with our products or technology, either inadvertently or by design, our revenues, operating results, and financial condition would be adversely affected. 


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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;
the deployment schedule for projects undertaken by systems integrators;
the actions of utility regulators or management boards regarding investments in metering systems; and
delays in installing, operating, and evaluating the results of NES system field trials.

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. If any of these factors prevent or substantially delay our ability to complete a transaction, our revenues and results of operations could be harmed.

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 February 29, 2004, we have 91 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 regi
stered 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 and it may take longer to receive a remedy from a court outside 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. 


	46

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. In general, these regulations limit the ability of companies 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, the FCC is considering changes to Part 15 rules that would accommodate high-speed power data communication devices. The FCC has further i
ndicated that they intend to prohibit these new high-speed power line devices from interfering with other power line devices, such as those sold by our company, which operate in other portions of the frequency spectrum. If the FCC fails to implement and/or enforce measures intended to protect against interference by these new high-speed power line devices, the operation of our products could be adversely affected, which would consequently have a negative impact on the market for our products, or require us to expend significant management, technical, and financial resources to make our products resistant to such interference. 

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. 

We are subject to changes in financial accounting standards, which may affect our reported financial results or the way we conduct business. 

Generally accepted accounting principles in the United States, including those affecting revenue recognition, have been the subject of frequent interpretations. As a result of the enactment of the Sarbanes-Oxley Act and the review of accounting policies by the Securities and Exchange Commission, as well as by national and international accounting standards bodies, the frequency of future accounting policy changes may accelerate. Such future changes in financial accounting standards, including pronouncements relating to revenue recognition, may have a significant effect on our reported results of operations, including results of transactions entered into before the effective date of the changes. 

If we are required to take a compensation expense for the value of options that we issue to our employees, our earnings would be harmed. 

We believe that stock options are a key element in our ability to attract and retain employees in the markets in which we operate. Recently, the FASB and members of the United States legislature have proposed changes to generally accepted accounting principles in the United States, or GAAP, that may require us to adopt a different method of accounting for use in determining the compensation expense related to our employee stock options. We currently use the intrinsic value method to measure compensation expense for stock-based awards to our employees. Under this standard, we generally do not consider stock option grants issued under our employee stock option plans to be compensation when the exercise price of the stock option is equal to or greater than the fair market value on the date of gra
nt. If any change to GAAP is adopted that requires us to apply a different method of accounting for the measurement of compensation expense related to our employee stock options, we could be required to take a compensation charge as options are issued or as they vest. This compensation charge would be based on a calculated value of the option using a methodology that has yet to be determined, and which may not correlate to the current market price of our stock. In the event such a compensation charge was required, our reported results of operations would be adversely affected and the trading price of our stock could be negatively impacted. 


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Our existing stockholders control a significant percentage of our stock, which will limit other stockholders’ ability to influence corporate matters. 

As of February 29, 2004, 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 35.9% 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. 

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 its 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 affect 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 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 

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 December 31, 2003, 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 expect our operating result
s 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 December 31, 2003, 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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 

The Financial Statements and Supplementary Data required by this item are set forth in Item 6 and at the pages indicated in Item 15(a). 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 

Not applicable. 

ITEM 9A. CONTROLS AND PROCEDURES 

Limitations on the Effectiveness of Controls 

  Our management, including our chief executive officer, or CEO, and our chief financial officer, or CFO, does not believe it is possible for our disclosure controls and procedures, or our internal controls over financial reporting, to prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company 
have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. 


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Scope of the Controls Evaluation 

  The CEO/CFO evaluation of our disclosure controls and procedures and our internal controls over financial reporting included a review of the controls’ objectives and design, the controls’ implementation by Echelon, and the effect of the controls on the information generated for use in this Annual Report. In the course of the controls evaluation, we sought to identify data errors, controls problems, or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-Q 
and Annual Report on Form 10-K. Our internal controls over financial reporting have been evaluated and will continue to be evaluated on a quarterly basis by our management and our internal audit personnel. In addition, consistent with our past practices, our internal controls over financial reporting are evaluated by personnel in our finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and procedures and our internal controls over financial reporting and to make modifications as necessary. Our intent in this regard is that the disclosure controls and procedures and the internal controls over financial reporting will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant. 

Among other matters, we sought in our evaluation to determine whether (i) there were any "significant deficiencies" or "material weaknesses" in the company’s internal controls over financial reporting, (ii) the company had identified any acts of fraud involving personnel who have a significant role in the company’s internal controls over financial reporting or (iii) whether there has been any change in our internal controls over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. This information was important both for the controls evaluation generally and because the Section 302 Certifications of the CEO and CFO require that the CEO and C
FO disclose certain information to our Board’s Audit Committee and to our independent accountants and to report on related matters in this section of the Annual Report. 

Our review of our internal controls over financial reporting was made within the context of the relevant professional auditing standards defining "internal controls over financial reporting," "reportable conditions," and "material weaknesses." As part of our evaluation of internal controls over financial reporting, we also address other, less significant control matters that we or our auditors identify, and we determine what revision or improvement to make, if any, in accordance with our on-going procedures. 

Conclusions Regarding Disclosure Controls and Procedures 

  Our CEO and our CFO, after evaluating our "disclosure controls and procedures" (as defined in the Securities Exchange Act of 1934, or the Exchange Act, Rules 13a-14(c) and 15-d-14(c)) as of a date (the "Evaluation Date") within 90 days before the filing of this Annual Report on Form 10-K, have concluded that as of the Evaluation Date, 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 Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms. 

Conclusions Regarding Internal Controls Over Financial Reporting 

  Subsequent to the Evaluation Date, there were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures, nor were there any significant deficiencies or material weaknesses in our internal controls. As a result, no corrective actions were required or undertaken. 


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PART III 

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 

We refer you to the information regarding Directors appearing under the caption "Election of Directors" and "Other Information - Compliance with Section 16 (a) Beneficial Ownership Reporting Compliance" in our proxy statement to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year ended December 31, 2003, which information is incorporated herein by reference; and to the information under the heading "Executive Officers of the Registrant" in Part I hereof. 

ITEM 11. EXECUTIVE COMPENSATION 

We refer you to the information under the caption "Executive Compensation" in our proxy statement to be filed with the Securities Exchange Commission within 120 days after the end of our fiscal year ended December 31, 2003, which we incorporate herein by reference. 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 

We refer you to the information appearing under the caption "Share Ownership by Principal Stockholders and Management" in our proxy statement to be filed with the Securities Exchange Commission within 120 days after the end of the our fiscal year ended December 31, 2003, which we incorporate herein by reference. 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 

We refer you to the information appearing under the caption "Other Information - Certain Transactions" in our proxy statement to be filed with the Securities Exchange Commission within 120 days after the end of our fiscal year ended December 31, 2003, which we incorporate herein by reference. 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 

We refer you to the information appearing under the caption "Audit and Related Fees" in our proxy statement to be filed with the Securities Exchange Commission within 120 days after the end of our fiscal year ended December 31, 2003, which we incorporate herein by reference. 


	51

PART IV 

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 

(a) The following documents are filed as part of this Form: 

1.   Financial Statements 

	Page

Independent Auditors’ Report	54
Consolidated Balance Sheets	55
Consolidated Statements of Operations	56
Consolidated Statements of Stockholders' Equity	57
Consolidated Statements of Comprehensive Income	57
Consolidated Statements of Cash Flows	58
Notes to Consolidated Financial Statements	59

2.     Financial Statement Schedule 

Schedule II Valuation and Qualifying Accounts    

78

All other schedules have been omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or the Notes thereto. 

3.    Exhibits 

Item 601 of Regulation S-K requires the following exhibits listed below. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K has been identified. 

Exhibit No.	Description of Document

3.2*	Amended and Restated Certificate of Incorporation of Registrant.
3.3	Amended and Restated Bylaws of Registrant.
4.1*	Form of Registrant’s Common Stock Certificate.
4.2*	Second Amended and Restated Modification Agreement dated May 15, 1997.
10.1*	Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers.
10.2*+	1997 Stock Plan and forms of related agreements.
10.3*+	1988 Stock Option Plan and forms of related agreements.
10.4*	Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2).
10.5*	Form of International Distributor Agreement.
10.6*	Form of OEM License Agreement.
10.7*	Form of Software License Agreement.
10.8*	International Distributor Agreement between the Company and EBV Elektronik GmbH as of December 1, 1997.
10.9*+	1998 Director Option Plan.
21.1*	Subsidiaries of the Registrant.
23.1	Consent of KPMG LLP.
24.1	Power of Attorney (see signature page).
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.

* Previously filed. 

+ Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. 


	52

(b) Reports on Form 8-K 

We filed the following reports on Form 8-K during the quarter ended December 31, 2003: 

On October 15, 2003, we filed a current report on Form 8-K dated October 14, 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 October 14, 2003, announcing our results of operations for the quarter ended September 30, 2003.


	53

INDEPENDENT AUDITORS’ REPORT 

The Board of Directors and Stockholders 
Echelon Corporation:

We have audited the accompanying consolidated balance sheets of Echelon Corporation and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity, comprehensive income, and cash flows for each of the years then ended. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in Item 15(a). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. The consolidated financial statements and financial statement schedule of Echelon Corporation and subsidiaries as of December 31, 2001 and for the year then ended as listed in Item 15(a) were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those consolidated financial statements and financial statement schedule, before the revision described in Note 4 to the financial statements, in their report dated January 15, 2002. 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Echelon Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. 

As discussed above, the 2001 consolidated financial statements of Echelon Corporation and subsidiaries as listed in Item 15(a) were audited by other auditors who have ceased operations. As described in note 4, these consolidated financial statements have been revised to include the transitional disclosures required by Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, which was adopted by the Company as of January 1, 2002. In our opinion, the disclosures for 2001 in note 4 are appropriate. However, we were not engaged to audit, review, or apply any procedur
es to the 2001 consolidated financial statements of Echelon Corporation and subsidiaries other than with respect to such disclosures, and accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole. 

/s/ KPMG LLP 

Mountain View, California 

January 20, 2004


	54

ECHELON CORPORATION 

CONSOLIDATED BALANCE SHEETS 

(in thousands, except share and per share amounts) 

	As of December 31,

		2003			2002


ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	18,667		$	34,941
Short-term investments		126,256			99,548
Accounts receivable, net of allowances of $1,374 in 2003 and $1,390 in 2002		20,110			22,930
Inventories		5,906			7,991
Other current assets		2,519			3,217

Total current assets		173,458			168,627


PROPERTY AND EQUIPMENT:
Computer and other equipment		16,137			13,716
Furniture and fixtures		2,688			2,604
Leasehold improvements		16,498			12,669

		35,323			28,989
Less: Accumulated depreciation and amortization		(16,225	)		(12,312	)

Net property and equipment		19,098			16,677
Goodwill		8,163			7,758
Restricted investments		10,867			10,526
Other long-term assets		2,542			3,904

	$	214,128		$	207,492


LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	6,922		$	5,993
Accrued liabilities		4,793			3,773
Deferred revenues		998			2,541

Total current liabilities		12,713			12,307


LONG-TERM LIABILITIES:
Deferred rent, net of current portion		491			167

Total long-term liabilities		491			167


COMMITMENTS AND CONTINGENCIES (Note 5)

STOCKHOLDERS’ EQUITY:
Convertible preferred stock, $0.01 par value:
Authorized—5,000,000 shares; none outstanding
Common stock, $0.01 par value:
Authorized—100,000,000 shares
Outstanding—40,409,956 shares in 2003 and 39,725,550 shares in 2002		407			400
Additional paid-in capital		272,323			268,883
Treasury stock		(3,191	)		(3,191	)
Accumulated other comprehensive income		1,007			445
Accumulated deficit		(69,622	)		(71,519	)

Total stockholders’ equity		200,924			195,018

	$	214,128		$	207,492

See accompanying notes to the consolidated financial statements. 


	55

ECHELON CORPORATION 

CONSOLIDATED STATEMENTS OF OPERATIONS 

(in thousands, except per share amounts) 

	For the Year Ended December 31,

		2003		2002		2001


REVENUES:
Product	$	117,153	$	121,454	$	74,777
Service		1,000		1,380		1,812

Total revenues		118,153		122,834		76,589


COST OF REVENUES:
Cost of product		49,407		57,059		34,842
Cost of service		2,650		2,880		2,347

Total cost of revenues		52,057		59,939		37,189

Gross profit		66,096		62,895		39,400


OPERATING EXPENSES:
Product development		35,113		21,456		17,028
Sales and marketing		18,597		17,291		15,787
General and administrative		12,108		9,711		6,942

Total operating expenses		65,818		48,458		39,757

Income/(loss) from operations		278		14,437		(357	)
Interest and other income, net		2,219		3,777		6,655

Income before provision for income taxes		2,497		18,214		6,298
PROVISION FOR INCOME TAXES		600		1,457		252

Net income	$	1,897	$	16,757	$	6,046

Income per share:
Basic	$	0.05	$	0.42	$	0.16

Diluted	$	0.05	$	0.41	$	0.15

Shares used in per share calculation:
Basic		40,070		39,468		38,443

Diluted		40,792		40,726		41,141

See accompanying notes to the consolidated financial statements. 


	56

ECHELON CORPORATION 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY 

(in thousands) 

	Common Stock		Treasury Stock				Accumulated Other
					Additional Paid-In	Deferred Compen-	Comprehen-sive Income/	Accumu- lated
	Shares	Amount	Shares	Amount	Capital	sation	(Loss)	Deficit	Total

BALANCE AT DECEMBER 31, 2000	38,050	$ 380	—	—	$263,248	$ (215)	$ (330)	$(94,322)	$168,761
Exercise of stock options and warrants, net of repurchases	968	10	—	—	2,539	—	—	—	2,549
Repurchase of stock	—	—	(265)	$(3,191)	—	—	—	—	(3,191)
Amortization of deferred compensation	—	—	—	—	—	184	—	—	184
Foreign currency translation adjustment	—	—	—	—	—	—	(327)	—	(327)
Unrealized holding gain on available-for-sale securities	—	—	—	—	—	—	695	—	695
Net income	—	—	—	—	—	—	—	6,046	6,046


BALANCE AT DECEMBER 31, 2001	39,018	390	(265)	(3,191)	265,787	(31)	38	(88,276)	174,717
Exercise of stock options and warrants, net of repurchases	973	10	—	—	3,096	—	—	—	3,106
Amortization of deferred compensation	—	—	—	—	—	31	—	—	31
Foreign currency translation adjustment	—	—	—	—	—	—	584	—	584
Unrealized holding loss on available-for-sale securities	—	—	—	—	—	—	(177)	—	(177)
Net income	—	—	—	—	—	—	—	16,757	16,757


BALANCE AT DECEMBER 31, 2002	39,991	400	(265)	(3,191)	268,883	--	445	(71,519)	195,018
Exercise of stock options and warrants, net of repurchases	684	7	—	—	3,440	—	—	—	3,447
Amortization of deferred compensation	—	—	—	—	—	—	—	—	—
Foreign currency translation adjustment	—	—	—	—	—	—	959	—	959
Unrealized holding loss on available-for-sale securities	—	—	—	—	—	—	(397)	—	(397)
Net income	—	—	—	—	—	—	—	1,897	1,897


BALANCE AT DECEMBER 31, 2003	40,675	$ 407	(265)	$(3,191)	$272,323	$ --	$ 1,007	$ (69,622)	$200,924

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME 

(in thousands) 

	For the Year Ended December 31,

		2003			2002			2001

Net income	$	1,897		$	16,757		$	6,046
Other comprehensive income/(loss), net of tax:
Foreign currency translation adjustment		959			584			(327	)
Unrealized holding gain/(loss) on available-for-sale securities, net of tax		(397	)		(177	)		695

Comprehensive income	$	2,459		$	17,164		$	6,414

See accompanying notes to the consolidated financial statements. 


	57

ECHELON CORPORATION 

CONSOLIDATED STATEMENTS OF CASH FLOWS 

(in thousands) 

	For the Year Ended December 31,

		2003			2002			2001


CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	1,897		$	16,757		$	6,046
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization		5,644			4,062			2,322
In-process research and development		9,808			400			--
Provision for doubtful accounts		10			55			210
Deferred compensation expense		--			31			184
Loss on disposal of fixed assets		8			7			74
Change in operating assets and liabilities:
Accounts receivable		2,810			6,161			(19,775	)
Inventories		2,085			2,325			(4,571	)
Other current assets		698			8,354			(6,353	)
Accounts payable		929			(2,183	)		3,209
Accrued liabilities		1,020			1,194			820
Deferred revenues		(1,543	)		1,445			(51	)
Deferred rent		324			120			44

Net cash provided by (used in) operating activities		23,690			38,728			(17,841	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments		(173,374	)		(86,647	)		(79,454	)
Proceeds from sales and maturities of available-for-sale short- term investments		146,269			75,342			24,857
Purchase of assets of Metering Technology Corporation		(11,000	)		--			--
Purchase of BeAtHome.com, Inc.		--			(5,811	)		--
Purchase of restricted investments		(341	)		(10,526	)		--
Changes in other long-term assets		576			358			(5,769	)
Capital expenditures		(6,500	)		(3,425	)		(15,256	)

Net cash used in investing activities		(44,370	)		(30,709	)		(75,622	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and warrants		3,447			3,106			2,549
Repurchase of common stock		--			--			(3,191	)

Net cash provided by (used in) financing activities		3,447			3,106			(642	)

EFFECT OF EXCHANGE RATES ON CASH		959			584			(327	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(16,274	)		11,709			(94,432	)
CASH AND CASH EQUIVALENTS:
Beginning of year		34,941			23,232			117,664

End of year	$	18,667		$	34,941		$	23,232

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	625		$	304		$	130

See accompanying notes to the consolidated financial statements. 


	58

ECHELON CORPORATION 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

December 31, 2003, 2002, and 2001 

1. ORGANIZATION OF THE COMPANY: 

Echelon Corporation (the "Company") was incorporated in California in February 1988 and was later reincorporated in Delaware in January 1989. The Company develops, markets and supports a wide range of hardware and software products and services that enable OEMs and systems integrators to design and implement open, interoperable, distributed control networks. The Company’s products are based on LONWORKS networking technology, an open standard for interoperable networked control developed by the Company. In a LONWORKS control network, intelligent control devices, called nodes, communicate using the Company’s LONWORKS protocol. The Company sells its products and services around the world to the building, industrial, transportation, utility/home and other automation markets. 

The Company is subject to certain risks and challenges including, among others: reliance on significant customers; fluctuation in operating results; dependence on key manufacturers and suppliers; competition; undetermined market acceptance of its products and interoperability in general; dependence on OEMs and distribution channels; dependence on key personnel; new products and rapid technological change; changes in the markets in which it operates; infringement of intellectual property rights of others; risks of product defects or misuse; history of losses; volatility of stock price; voluntary standards; lengthy sales cycle; limited protection of intellectual property rights; regulatory actions; international operations and currency fluctuations; 
control by existing stockholders; conflicts of interest with significant stockholders; and susceptibility to power outages. 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES: 

Principles of Consolidation 

The Company’s consolidated financial statements reflect operations of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated. 

Use of Estimates 

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. 

Reclassifications 

Certain reclassifications have been made to the prior year amounts to conform with the fiscal year 2003 presentation. 

Revenue Recognition 

The Company’s revenues are derived from the sale and license of its products and to a lesser extent, from fees associated with training, technical support, and custom software design services offered to its customers. Product revenues consist of revenues from hardware sales and software licensing arrangements. Revenues from software licensing arrangements accounted for approximately 4.6% of total revenues in 2003, 3.3% of total revenues in 2002, and 6.6% of total revenues in 2001. Service revenues consist of product 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 to the customer. For software licenses, these criteria are generally met upon shipment to the final end-user. Service revenue is recognized as the training services are performed, or ratably over the term of the support period. In the case of custom software development services, revenue is recognized when the customer accepts the software.  
 
59
 
In accordance with Statement of Position (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.&n
bsp; 
 
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 application 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. 
 
The Company typically sells its products and services to customers with net 30 day payment terms. In certain instances, payment terms may extend to as much as net 90 days. For a customer whose credit worthiness does not meet the Company’s minimum criteria, the Company may require partial or full payment prior to shipment. Alternatively, customers may be required to provide the Company with an irrevocable letter of credit prior to shipment. Customer payments for products delivered or services performed are generally not tied to milestones.
 
With the exception of sales to EBV, the Company’s sole distributor of its LONWORKS Infrastructure products in Europe, the Company’s customers are not entitled to return products for a refund. In general, during the manufacturing process, our products are tested to ensure they will perform to stated specifications. If we are unable to perform such a test, we defer revenue on those products when shipped until such time as the customer "accepts" the products or the period for acceptance testing has elapsed. In the case of customer software development, revenues ar
e deferred until the acceptance criteria, as defined in the agreement, have been met. Revenues generated from these types of arrangements have been immaterial to date. For all other transactions, the Company’s standard acceptance terms allow customers to inspect products when received. If, through an incoming inspection test, the customer determines the products do not meet stated design specifications, the Company permits the customer to return the product for repair or replacement under the Company’s standard warranty provisions. 
 
Under the terms of the Company’s distributor agreement with EBV, EBV is entitled to return certain products deemed to be excess inventory by EBV. These return rights are generally limited to 5% of the products purchased during the prior six months. At such time as EBV submits a request to return product, they are required to submit an order for new product of equal or greater value. The agreement also provides for price protection. In the event the Company lowers its prices for products sold to EBV, EBV is entitled to recover, in the form of a sales credit, the net price reduction based on its on hand inventory of the price affected products. Sales credits issued for price protection purposes have been immaterial to date. 
 
The Company also offers EBV, and certain other of its distributors, rebates and other sales incentives. During 2003, these rebates ranged from 1% to 5% of the value of products purchased. Other sales incentives are generally limited to one-time awards for design-in wins secured by the distributor. Qualification for these rebates and design-in awards are based upon certain objectives and criteria established by the Company. The Company accounts for the rights of return, price protection, rebates, and other sales incentives offered to its distributors in accordance with SFAS 48 and EITF 01-09.
 
In June 2000, the Company entered into a Research and Development and Technological Cooperation Agreement (the "R&D Agreement") with Enel Distribuzione S.p.A., a subsidiary of Enel S.p.A. ("Enel"), an Italian utility company. Under this agreement, the Company and Enel agreed to cooperate in the development of Enel’s meter management system, known as the "Contatore Elettronico," which, among other things, will replace existing stand-alone electricity meters with networked electricity meters throughout Enel’s service territory in Italy. The R&D Agreement has a term of five years, but can be cancelled by either party for a material breach by the other party that remains uncured for a period of 30 days. 
 
The Contatore Elettronico project includes solid-state electricity meters designed by a third party and Enel. The Company has entered into supply agreements with various third party contract manufacturers ("meter manufacturers") who manufacture the meters for Enel under contracts awarded by Enel through a public tender process. The meter manufacturers combine components purchased from the Company with other components to complete the manufacture of the meters for sale to Enel. The Company recognizes revenue associated with meter manufacturer component sales when the product is shipped to the meter manufacturer. The Company’s supply obligations for each meter manufacturer expire in June 2005, or at such earlier time as the Company completes the delivery of components to that meter manufact
urer for use under the meter manufacturer’s existing contract with Enel. 
 
60
 
The payment terms under the Company’s supply agreements vary by meter manufacturer. The terms range from open account basis with net thirty-day payment terms to sixty days with supporting letters of credit. The meter manufacturers place orders for components based on their then current production schedules. The meter manufacturers are under no obligation to purchase components from the Company, and each meter manufacturer could discontinue placing orders with the Company for future purchases at any time. 
 
The Company also sells a finished product, called a "concentrator product," directly to Enel. Enel’s need for concentrator products depends on the successful manufacture of electricity meters by the meter manufacturers. The Company sells concentrator products to Enel under a "Letter of Order," an Italian business equivalent of a purchase order. The Company recognizes revenue for concentrator product sales when the products are shipped to Enel. 
 
To date, there have been three Letters of Order for concentrator products. The term of these Letters of Order is based on the projected delivery of products noted in each Letter of Order. Deliveries have been completed for the first and second Letters of Order. Deliveries under the third Letter of Order are continuing and may continue through April 2005, although they can be cancelled by Enel at any time with six months advance notice. Reasons for cancellation would include cancellation of the Contatore Elettronico project or the failure of the concentrator product to perform as required in the Contatore Elettronico project. Under the third Letter of Order, Enel also has certain rights to reschedule shipments. In general, such rights require six months advance notice. The Letters of Order for 
the concentrator product have had various payment terms that generally equate to net ninety days. 
 
Enel and another subsidiary of Enel’s parent are developing Enel’s data center software, which manages the deployed equipment in the Contatore Elettronico project. The Company is not responsible for this data center software. Additionally, Enel is the system integrator for the Contatore Elettronico project. Accordingly, the Company is not responsible for the integration or software management maintenance issues associated with the data center software. 
 
For costs incurred under the R&D Agreement, there is no cost sharing arrangement among Enel, its contract manufacturers, and the Company. Each party is responsible for its own costs. Accordingly, the Company expenses R&D costs related to the Enel program as they are incurred. 
 
Cash and Cash Equivalents 

The Company considers bank deposits, money market investments and all debt and equity securities with an original maturity of three months or less to be cash and cash equivalents. 

Short-Term Investments 

The Company classifies its investments in marketable debt securities as available-for-sale in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and Equity Securities. Securities classified as available-for-sale are reported at fair market value with the related unrealized holding gains and losses, net of tax, being included in accumulated other comprehensive income (loss) in the accompanying consolidated statements of stockholders’ equity. 
 
61
 
As of December 31, 2003 and 2002, the Company’s available-for-sale securities had original contractual maturities of between three to twenty-four months, and from three to twenty-three months, respectively. As of December 31, 2003 and 2002, the average remaining term to maturity for the Company’s available-for-sale securities was seven and six months, respectively. The fair value of available-for-sale securities was determined based on quoted market prices at the reporting date for those instruments. The amortized cost basis, aggregate fair value and gross unrealized holding gains and losses for the Company’s available-for-sale short-term investments, by major security type, were as follows (in thousands): 

December 31, , 

2003 . 

2002 . 

Amortized Cost 

Aggregate 
Fair 
Value 

Unrealized 
Holding Gains 

Amortized Cost 

Aggregate 
Fair 
Value 

Unrealized 
Holding Gains 

U.S. corporate securities: 

Commercial paper  

$ 4,976 

$ 4,977 

$ 1 

$ 12,218 

$ 12,223 

$   5 

Corporate notes and bonds     

42,016 

42,091 

75 

52,569 

52,902 

333 

46,992 

47,068 

76 

64,787 

65,125 

338 

U.S. government securities    

79,132 

79,188 

56 

34,230 

34,423 

193 

Total investments in debt securities    

$126,124 

$126,256 

$ 132 

$ 99,017 

$ 99,548 

$ 531 

Inventories 

Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing overhead. When required, provisions are made to reduce excess and obsolete inventories to their estimated net realizable value. Inventories consist of the following (in thousands): 

December 31, , 

2003 

2002 

Purchased materials    

$1,680 

$1,432 

Work-in-process    

8 

19 

Finished goods    

4,218 

6,540 

$5,906 

$7,991 

Property and Equipment 

Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of two to five years for computer and other equipment and furniture and fixtures. Leasehold improvements are amortized over the shorter of the remaining lease term or the estimated useful life of the improvements using the straight-line method. 

Impairment of Long-Lived Assets Including Goodwill and Other Intangible Assets 

The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability is measured by comparing the asset’s carrying value to the future undiscounted cash flows the asset is expected to generate. If property, plant, and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the asset exceeds its fair market value. For the three years ended December 31, 2003, the Company has made no material adjustments to its long-lived assets. 

In July 2001, the FASB issued SFAS No. 142 ("SFAS 142"), Goodwill and Other Intangible Assets. The Company adopted SFAS 142 on January 1, 2002. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or whenever events or changes in circumstances indicate that they may be impaired. Prior to the year ended December 31, 2002, goodwill was amortized using the straight-line method over its estimated useful life. 

SFAS 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 1 to 4 years. 
 
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Restricted Investments 

Restricted investments consist of money market funds. These investments are carried at fair value and are collateral for a $10.0 million line of credit issued to the Company by its primary bank. As of December 31, 2003, the Company’s primary bank has issued, against the line of credit, two standby letters of credit totaling $8.0 million as security for real estate lease commitments discussed in Note 5. As of December 31, 2003, no amounts had been drawn against the line of credit or the letters of credit. 

Because the Company’s agreement with the lender prevents the Company from withdrawing these invested funds, they are considered restricted. The line of credit is maintained primarily for the purpose of providing standby letters of credit for specified obligations under the Company’s headquarter facility lease agreements. The restricted investments are classified as long-term as the Company intends to maintain the bank line of credit for which they are collateral for greater than one year.

Software Development Costs 

The Company capitalizes eligible computer software development costs upon the establishment of technological feasibility, which the Company has defined as completion of a working model. For the years ended December 31, 2003, 2002 and 2001, costs that were eligible for capitalization were insignificant and, thus, the Company has charged all software development costs to product development expense in the accompanying consolidated statements of operations. 

Accrued Liabilities 

Accrued liabilities consisted of the following (in thousands): 

December 31, , 

2003 

2002 

Accrued payroll and related costs    

$ 

2,663 

$ 

1,929 

Accrued marketing costs  

392 

481 

Other accrued liabilities   

1,738 

1,363 

$ 

4,793 

$ 

3,773 

Foreign Currency Translation 

The functional currency of the Company’s subsidiaries is the local currency. Accordingly, all assets and liabilities are translated into U.S. dollars at the current exchange rate as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rate prevailing during the period. Gains and losses resulting from the translation of the financial statements are included in accumulated other comprehensive income (loss) in the accompanying consolidated statements of stockholders’ equity. Currently, the Company does not employ a foreign currency hedge program utilizing foreign currency exchange contracts as the foreign currency transactions and risks to date have not been significant. 

Concentrations of Credit Risk 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade receivables. The Company has cash investment policies that limit the amount of credit exposure to any one financial institution and restrict placement of these investments to financial institutions evaluated as highly creditworthy. With the exception of amounts owed the Company on sales made to Enel and its contract manufacturers, concentrations of credit risk with respect to trade receivables are limited due to the Company’s large number of customers and their dispersion across many different industries and geographies. With respect to these trade receivables, the Company performs ongoing cred
it evaluations of its customers’ financial condition. Additionally, the Company establishes an allowance for doubtful accounts and sales return allowances based upon factors surrounding the credit risk of specific customers, historical trends and other available information. As of December 31, 2003 and 2002, about 71.2% and 76.8% of the total accounts receivable balance, respectively, were due from Enel and its contract manufacturers. As of December 31, 2003 and 2002, about 5.5% and 7.2% of the total accounts receivable balance, respectively, were due from EBV, the Company’s sole distributor of products in Europe. 
 
63
 
Computation of Basic and Diluted Net Income Per Share and Pro Forma Basic Net Loss Per Share 
 
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 years ended December 31, 2003, 2002 and 2001 (in thousands, except per share amounts): 

Year ended December 31, 

2003 

2002 

2001 

Net income (Numerator): 

Net income, basic & diluted  

$ 

1,897 

$ 

16,757 

$ 

6,046 

Shares (Denominator): 

Weighted average common shares outstanding 

40,070 

39,482 

38,500 

Weighted average common shares outstanding subject to repurchase

- 

(14 

) 

(57 

) 

Shares used in basic computation    

40,070 

39,468 

38,443 

Weighted average common shares outstanding subject to repurchase 

- 

14 

57 

Common shares issuable upon exercise of stock options (treasury stock method)  

722 

1,245 

2,398 

Common shares issuable upon exercise of warrants (treasury stock method)  

- 

- 

250 

Average unamortized deferred compensation    

- 

(1 

) 

(7 

) 

Shares used in diluted computation   

40,792 

40,726 

41,141 

Net income per share: 

Basic 

$ 

0.05 

$ 

0.42 

$ 

0.16 

Diluted 

$ 

0.05 

$ 

0.41 

$ 

0.15 

For the years ended December 31, 2003, December 31, 2002, and December 31, 2001, 6,204,994, 4,533,479, and 2,097,422 stock options, respectively, were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would be anti-dilutive. 
 
Income Taxes 

    Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognize
d in income in the period that includes the enactment date. 
 
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    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 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 income and earnings per share if 
the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. 

Year Ended December 31, 

2003 

2002 

2001 

Net income as reported    

$ 

1,897 

$ 

16,757 

$ 

6,046 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects    

- 

31 

184 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects    

(22,315 

) 

(32,822 

) 

(29,819 

) 

Pro forma net loss    

($20,418 

) 

($16,034 

) 

($23,589 

) 

Basic earnings/(loss) per share: 

As reported    

$ 

0.05 

$ 

0.42 

$ 

0.16 

Pro forma    

(0.51 

) 

(0.41 

) 

(0.61 

) 

Diluted earnings/(loss) per share: 

As reported    

$ 

0.05 

0.41 

0.15 

Pro forma    

(0.51 

) 

(0.41 

) 

(0.61 

) 
 
The weighted-average grant date fair value of options granted during 2003, 2002, and 2001 was $8.92, $12.91, and $13.16, 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: 
 
Year Ended December 31, 

2003 

2002 

2001 

Expected dividend yield    

0.0 

% 

0.0 

% 

0.0 

% 

Risk-free interest rate    

2.6 

% 

4.2 

% 

4.5 

% 

Expected volatility    

100.9 

% 

118.0 

% 

129.0 

% 

Expected life (in years)    

4.2 

4.4 

4.4 

Because the Company expects to grant additional stock options in the future, the above pro forma disclosures are not representative of pro forma effects on reported financial results for future years. 
 
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Comprehensive Income 

Comprehensive income for the Company consists of net income plus the effect of unrealized holding gains or losses on investments classified as available-for-sale and foreign currency translation adjustments. 

Recent Accounting Pronouncements 
 
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 disclose 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. 
 
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. 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. The Company has included additional disclosures in accordance with SFAS 148 earlier in this Note. 
 
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), or FIN 46R, Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities , which was issued in January 2003. The Company will be required to apply FIN 46R to variable interests in variable interest entities, or VIEs, created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN 46R will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities, and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and noncontrolling interests of the VIE. The Company does not expect the adoption of FIN 46R to have a material impact on its 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. Additionally, in August 2003, the EITF reached consensus on EITF Issue No. 03-5, or EITF 03-5, Applicability of AICPA Statement of Position 97-2, "Software Revenue Recognition," to Non-Software Deliverables in an Arrangement Containing More-than-Incidental Software. EITF 03-5 provides guidance on determining whether non-software deliverables are included within the scope of SOP 97-2, and accordingly, whether multiple element arrangements are to be accounted for in accordance with EITF 00-21 or SOP 97-2. The application of EITF 00-21 and EITF 03-5 did not have a material impact on the Company’s financial position, results of operations, or cash flows. 
 
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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. 

On December 17, 2003, the Staff of the Securities and Exchange Commission, or SEC, issued Staff Accounting Bulletin No. 104, or SAB 104, Revenue Recognition, which supersedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind the accounting guidance contained in SAB 101 related to multiple-element revenue arrangements that was superseded as a result 
of the issuance of EITF 00-21, Revenue Arrangements with Multiple Deliverables. Additionally, SAB 104 rescinds the SEC’s related Revenue Recognition in Financial Statements Frequently Asked Questions and Answers, which was issued with SAB 101 and was codified in SEC Topic 13, Revenue Recognition. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles
 of SAB 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The adoption of SAB 104 did not have a material effect on the Company’s financial position, results of operations, or cash flows. 
 
3. ACQUISITIONS: 
 
On April 11, 2003, the Company acquired certain assets from privately held Metering Technology Corporation ("MTC") of Scotts Valley, California for a total purchase price of $11.0 million paid in cash. 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 allocated the purchase price based upon the fair value of the assets acquired. 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 in process research and development, or IPR&D, and was charged to product development expenses 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 twelve months ended December 31, 2003, amortization expense related to this purchased technology was approximately $718,000, which was recorded in product development expenses. 
 
On January 31, 2002, the Company completed the acquisition of all of the outstanding capital stock of BeAtHome.com, Inc. ("BeAtHome®"), a Fargo, North Dakota based developer of remote management system hardware and software. The results of BeAtHome’s operations, as well as a one-time charge of $400,000 related IPR&D, have been included in the consolidated condensed financial statements since that date. As a result of the acquisition, the Company is integrating certain components of BeAtHome’s technology into its current and future product offerings, such as its Networked Energy Solutions offering and the Panoramix platform. The Company believes these enhancements will allow customers to more easily aggregate and process information from remote LONWORKS networks, thereby increasing overall network management capabilities. In exchange for all of the outstanding capital stock of BeAtHome, the Company paid approximately $5.9 million, comprised of cash payments totaling approximately $2.0 million to BeAtHome’s shareholders, the forgiveness of approximately $3.5 million in operating loans made to BeAtHome, and approximately $371,000 of third party expenses. 
 
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The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands). 

Current assets 

$ 

129 

Property and equipment 

373 

Other long-term assets 

8 

Intangible assets 

600 

Goodwill 

5,744 

Total assets acquired 

$ 

6,854 

Current liabilities 

961 

Total liabilities assumed 

$ 

961 

Net assets acquired 

$ 

5,893 

Of the $600,000 of acquired intangible assets, $400,000 was assigned to IPR&D and was charged to product development expenses upon the completion of the acquisition. The remaining $200,000 was assigned to purchased technology with a useful life of two years. For the twelve months ended December 31, 2003, amortization expense related to this purchased technology was approximately $100,000. 

4. GOODWILL AND INTANGIBLE ASSETS: 

The Company adopted SFAS 142 on January 1, 2002. As a result, the Company ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. During 2001, the Company recorded amortization expenses totaling approximately $320,000 against this balance. In lieu of amortization, SFAS 142 now requires that the Company perform an initial impairment review of its goodwill in 2002 and at least an annual impairment review thereafter. In accordance with these impairment review requirements, the Company completed a transitional impairment test in 2002, and an annual impairment review during the quarter ended March 31, 2003, and determined that there was no impairment. However, if as a result 
of impairment reviews that are performed from time to time in the future, it is determined that there has been an impairment of the goodwill or other intangible assets, the Company would be required to take an impairment charge. 

The following table provides a reconciliation of reported net income to adjusted net income for the year ended December 31, 2001 had SFAS 142 been effective January 1, 2001 (in thousands, except per share amounts): 
 
Year Ended December 31, 2001 

Amount 

Basic EPS 

Diluted EPS 

Reported net income 

$ 6,046 

$ 0.16 

$ 0.15 

Add back amortization expense (net of tax):    

Goodwill and workforce in place 

320 

0.01 

0.01 

Adjusted net income 

$ 6,366 

$ 0.17 

$ 0.16 

68
 
The changes in the carrying amount of goodwill, net for the years ended December 31, 2002 and 2003 are as follows (in thousands): 

Amount 

Balance as of December 31, 2001 

$ 1,637 

Reclass of workforce in place 

74 

Unrealized foreign currency translation gain 

303 

Goodwill resulting from BeAtHome acquisition 

5,744 

Balance as of December 31, 2002 

7,758 

Unrealized foreign currency translation gain 

405 

Balance as of December 31, 2003 

$ 8,163 

As of December 31, 2003, the Company’s intangible assets subject to amortization consisted of purchased technology with a net carrying value of approximately $620,000. For the years ending December 31, 2003, 2002 and 2001, amortization of these intangible assets was $1.1 million, $344,000, and $213,000, respectively. Estimated future amortization expense related to these intangible assets is $583,000 in 2004, and $35,000 in 2005. These future amortization estimates are subject to fluctuations resulting from exchange rate differences between the United States dollar and the European Euro. 

5. COMMITMENTS AND CONTINGENCIES: 

The Company leases its facilities under operating leases that expire on various dates through 2013. In December 1999, the Company entered into a lease agreement with a real estate developer for its new corporate headquarters in San Jose, California. This agreement requires minimum rental payments for ten years totaling approximately $20.6 million and also required that the Company provide a $3.0 million security deposit. The Company satisfied the security deposit requirement by causing to have issued a standby letter of credit ("LOC") in July 2000. The LOC is subject to annual renewals and is currently secured by a line of credit at the bank that issued the LOC. 

In October 2000, the Company entered into another lease agreement with the same real estate developer for an additional building at the new headquarter site. Construction on the second building was completed in May 2003, at which time monthly rental payments commenced. This second lease agreement also requires minimum rental payments for ten years totaling approximately $23.4 million. In addition, this second lease agreement also required a security deposit of $5.0 million. The Company satisfied this security deposit requirement by causing to have issued another LOC in October 2001. This LOC is also subject to annual renewals and is currently secured by a line of credit at the bank that issued it. 

As of December 31, 2003, future minimum lease payments under all operating leases were as follows (in thousands): 

2004   

$ 4,409 

2005    

4,441 

2006     

4,398 

2007     

4,443 

2008     

4,503 

Thereafter     

16,812 

Total    

$ 39,006 

Rent expense was approximately $4.9 million, $3.1 million, and $2.3 million for 2003, 2002, and 2001, respectively. The lease agreements provide for escalating rent payments over the term of the lease. Rent expense under these agreements is recognized on a straight-line basis. As of December 31, 2003, and December 31, 2002, the Company has accrued approximately $499,000 and $167,000, respectively, of deferred rent related to these agreements. As of December 31, 2003, $8,000 of the $499,000 deferred rent balance is reflected in accrued liabilities while the remaining $491,000 is classified as a long-term liability in the accompanying consolidated balance sheets. For the year ended December 31, 2002, the entire $167,000 deferred rent balance was classified as a long-term liability. 
 
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6. STOCKHOLDERS’ EQUITY AND EMPLOYEE STOCK OPTION PLANS: 

    Preferred Stock 

With the closing of the Company’s initial public offering ("IPO") in July 1998, all of the outstanding preferred stock automatically converted into 7,887,381 shares of common stock. Upon conversion of the outstanding preferred stock to common stock, such preferred stock was retired. As of December 31, 2003, the Company was authorized to issue 5,000,000 shares of new $0.01 par value preferred stock, of which none was outstanding as of December 31, 2003. 

Common Stock 

As of December 31, 2003, the Company was authorized to issue 100,000,000 shares of $0.01 par value common stock. 

In September 2001, the Company’s Board of Directors approved a stock repurchase program, which authorizes the Company to repurchase up to 2.0 million shares of the Company’s common stock. In September 2001, the Company repurchased 265,000 shares under the program at a cost of $3.2 million. No shares were repurchased during 2002 and 2003. The program expired in September 2003. 

In June 2000, the Company entered into a stock purchase agreement with Enel, which was completed on September 11, 2000. Under this agreement, Enel acquired 3,000,000 newly issued shares of the Company’s common stock that generated net proceeds of $130.7 million. 
 
Warrants 

In connection with the issuance of Series E preferred stock in 1997, warrants to purchase an aggregate of 400,000 shares of common stock at a per share exercise price of $5.00 were issued. At the date of issuance, the fair market value of these warrants was deemed to be immaterial. These warrants were exercisable at any time prior to expiration, which was defined as the earlier of May 15, 2002 or upon a change in control. Each warrant contained a cashless conversion right. As of May 15, 2002, all of these warrants had been exercised and none remained outstanding. 

    Stock Option Program Description 
 
The Company has two plans under which it grants options: the 1997 Stock Plan (the "1997 Plan") and the 1998 Director Option Plan (the "Director Option Plan"). A more detailed description of each plan can be found below. 
 
Stock option grants are designed to reward employees, officers, and directors for their long-term contribution to the Company and provide incentives for them to remain with the Company. The number and frequency of stock option grants is based on competitive practices, operating results of the Company, and government regulations. Since the inception of the 1997 Plan, the Company has granted options to all of its employees. 
 
1997 Stock Plan 

During 1997, the Company adopted the 1997 Stock Plan (the "1997 Plan") for employees, officers and directors. As of December 31, 2003, a total of 11,805,974 shares of Common Stock are reserved for issuance under the 1997 Plan. This plan includes annual increases on the first day of the Company’s fiscal year (beginning in 2000) not to exceed the lesser of (i) 5,000,000 shares or (ii) 5% of the outstanding shares on such date. Incentive stock options to purchase shares of common stock may be granted at not less than 100% of the fair market value. Options granted prior to June 15, 2000 and after May 5, 2003, generally have a term of five years from the date of grant, not to exceed ten years. Options granted June 15, 2000 through May 5, 2003, generally have a term of ten years. The exercise p
rice of nonstatutory stock options and stock purchase rights granted under the 1997 Plan is determined by the Administrator, but will also be at least equal to 100% of the fair market value per share of common stock on the grant or issue date, except that up to 10% of the aggregate number of shares reserved for issuance under the 1997 Plan (including shares that have been issued or are issuable in connection with options exercised or granted under the 1997 Plan) may have exercise prices that are from 0% to 100% of the fair market value of the common stock on the date of grant. Options generally vest ratably over four years. Fair market value is determined with reference to the closing price of the common stock as reported on the Nasdaq National Market on the date immediately preceding grant date. 

The 1997 Plan also allows for the issuance of options that are immediately exercisable through execution of a restricted stock purchase agreement. Shares purchased pursuant to a stock purchase agreement generally vest ratably over four years. In the event of termination of employment, the Company, at its discretion, may repurchase unvested shares at a price equal to the original issuance price. 
 
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    1998 Directors Option Plan 

Non-employee directors are entitled to participate in the 1998 Director Option Plan (the "Director Plan"). The Director Plan was adopted by the Board of Directors in May 1998 and became effective upon the closing of the stock offering in July 1998. The Director Plan has a term of ten years, unless terminated sooner by the Board. As of December 31, 2003, a total of 740,000 shares of Common Stock are reserved for issuance under the Director Plan. The plan provides for an increase each year equal to 100,000 shares or such lesser amount as the Board may determine. The plan also provides for the automatic grant of 25,000 shares of common stock (the "First Option") to each non-employee director on the date he or she first becomes a director. Each non-emp
loyee director is also automatically granted an option to purchase 10,000 shares (a "Subsequent Option") on the date of the Company’s Annual Stockholder Meeting provided that he or she is re-elected to the Board or otherwise remains on the Board, if on such date he or she shall have served on the Board for at least the preceding six months. Each First Option and each Subsequent Option shall have a term of five years and the shares subject to the option shall vest as to 25% of the shares subject to option on each anniversary of the date of grant for options granted before May 11, 1999 and 100% on the date of grant for options granted on or after May 11, 1999. The exercise price of each First Option and Subsequent Option shall be 100% of the fair market value per share of the common stock, generally determined with reference to the closing price of the common stock as reported on the Nasdaq National Market on the date preceding grant date. During 2003 and 2002, options to purchase an aggregate of 70,000 a
nd 95,000 shares, respectively, were granted under the Director Plan. The weighted average exercise prices for the option grants in 2003 and 2002, respectively, were $14.77 and $15.63. 

In the event of a merger of the Company with or into another corporation or the sale of substantially all of the assets of the Company, each option shall be assumed or an equivalent option may be substituted by the successor corporation. Following such assumption or substitution, if the optionee’s status as a director of the successor corporation terminates other than upon a voluntary resignation by the optionee, the option shall become fully exercisable, including as to shares as to which it would not otherwise be exercisable. If the outstanding options are not assumed or substituted, the options shall become fully vested and exercisable. Options granted under the Director Plan must be exercised within three months of the end of the optionee&
#146;s tenure as a director of the Company, or within twelve months after such director’s termination by death or disability, but in no event later than the expiration of the option’s five year term; provided, however, that shares subject to an option granted to a director who has served as a director with the Company for at least five years shall become fully vested and exercisable for the remainder of the option’s five year term upon such director’s termination. No option granted under the Director Plan is transferable by the optionee other than by will or the laws of descent and distribution, and each option is exercisable, during the lifetime of the optionee, only by such optionee. 

Accounting for 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 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. A detailed reconciliation of the effect on net income and earnings per share had th
e Company applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation can be found in Note No. 2, Summary of Significant Accounting Policies and Practices. 
 
71
 
General Option Information 
 
The following table summarizes option activity under all plans: 

Options Outstanding 

Options Available for Grant 

Number 
Outstanding 

Weighted-Average Exercise Price Per Share 

BALANCE AT DECEMBER 31, 2000    

3,595,053 

5,221,149 

$14.31 

Granted    

(2,560,225) 

2,560,225 

15.89 

Cancelled    

244,314 

(244,314) 

20.54 

Exercised    

--- 

(971,107) 

2.55 

Additional shares reserved    

2,002,484 

--- 

--- 

BALANCE AT DECEMBER 31, 2001    

3,281,626 

6,565,953 

$16.44 

Granted    

(2,282,750) 

2,282,750 

16.35 

Cancelled    

81,872 

(81,872) 

26.04 

Exercised    

--- 

(631,917) 

1.99 

Additional shares reserved    

2,037,668 

--- 

--- 

BALANCE AT DECEMBER 31, 2002    

3,118,416 

8,134,914 

$17.44 

Granted    

(2,346,245) 

2,346,245 

12.68 

Cancelled    

743,344 

(743,344) 

25.83 

Exercised    

--- 

(793,633) 

6.17 

Additional shares reserved    

2,086,277 

--- 

--- 

BALANCE AT DECEMBER 31, 2003    

3,601,792 

8,944,182 

$16.49 

The following table summarizes the stock options outstanding as of December 31, 2003: 

Options Outstanding 

Options Exercisable 

Exercise 
Price Range 

Number 
Outstanding at 
December 31, 2003 

Weighted 
Average 
Remaining 
Life 
(in years) 

Weighted 
Average 
Exercise 
Price 

Number 
Exercisable 
December 31, 
2003 

Weighted 
Average 
Exercise 
Price 

$6.25-$7.06 

863,345 

0.64 

$ 7.05 

863,345 

$ 7.05 

7.19-11.33 

463,784 

7.68 

10.06 

117,896 

8.61 

11.60-11.61 

998,997 

7.28 

11.61 

665,237 

11.61 

11.79-12.91 

1,636,182 

4.66 

12.90 

207,517 

12.89 

12.93-14.67 

623,836 

5.36 

13.63 

246,497 

13.38 

14.75-16.35 

1,775,227 

7.95 

16.25 

969,806 

16.20 

16.36-20.34 

808,002 

7.53 

17.45 

521,728 

17.24 

20.38-27.94 

591,250 

7.25 

24.46 

425,623 

24.45 

$30.25-$90.50 

1,183,559 

1.69 

32.21 

1,105,317 

32.16 

8,944,182 

5.46 

$ 16.49 

5,122,966 

$ 17.85 

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 the Company terminates before the unvested shares become fully vested, the Company has the right, at its discretion, to repurchase from the option holder any unvested shares at the exercise price paid by the option holder. As of December 31, 2003, there were no shares subject to repurchase by the Company. Of the 5,122,966 options exercisable as of December 31, 2003, 4,
807,128 were vested. 

Shares Reserved 

As of December 31, 2003, the Company had 12,545,974 shares of common stock reserved for future issuance under its Stock Option Programs. 
 
72
 
Deferred Compensation 

In connection with the issuance of stock options during 1998, the Company recorded deferred compensation in the aggregate amount of $755,000, representing the difference between the deemed fair value of the Company’s common stock and the exercise price of the stock options at the date of grant. The Company amortized the deferred compensation expense over the shorter of the period in which the employee provided services or the applicable vesting period, which was typically 48 months. For the years ended December 31, 2002 and December 31, 2001, amortization expense was $31,000 and $184,000, respectively. Deferred compensation is decreased in the period of forfeiture arising from the early termination of an option holder’s services. As of De
cember 31, 2002, the deferred compensation balance was fully amortized. 

7. INCOME TAXES: 

The provision for income taxes attributable to continuing operations is based upon income (loss) before income taxes from continuing operations as follows (in thousands): 

Year Ended December 31, 

2003 

2002 

2001 

Domestic    

$ 2,490 

$ 18,995 

$ 7,957 

Foreign   

7 

(781) 

(1,659) 

$ 2,497 

$ 18,214 

$ 6,298 

The provision for income taxes consists of the following (in thousands): 

Year Ended December 31, 

2003 

2002 

2001 

Federal:    

Current    

$ 220 

$ - 

$ 34 

Deferred   

- 

- 

- 

Total federal provision   

220 

- 

34 

State:   

Current    

47 

439 

111 

Deferred  

- 

- 

- 

Total state provision    

47 

439 

111 

Foreign:     

Current     

333 

1,018 

107 

Deferred   

- 

- 

- 

Total foreign provision  

333 

1,018 

107 

Total provision for income taxes 

$600 

$1,457 

$252 

73
 
The provision for income taxes differs from the amount estimated by applying the statutory Federal income tax rate to income before taxes as follows (in thousands): 

Year Ended December 31, 

2003 

2002 

2001 

Federal tax at statutory rate of 35% 

$ 

874 

$ 

6,375 

$ 

2,205 

State taxes, net of federal benefit    

11 

286 

72 

U.S.-Foreign rate differential

(55 

) 

976 

681 

Change in Valuation Allowance    

(278 

) 

(6,784 

) 

(2,936 

) 

Other non-deductible permanent differences 

48 

290 

224 

Others

-- 

314 

6 

Total provision for income taxes  

$ 

600 

$ 

1,457 

$ 

252 

The components of the net deferred income tax asset are as follows (in thousands): 
     
December 31, 

2003 

2002 

Net operating loss carry forwards   

$ 29,445 

$ 32,856 

Foreign net operating loss carry forwards   

2,149 

3,106 

Tax credit carry forwards    

9,179 

8,534 

Capitalized research and development costs    

319 

711 

Reserves and other cumulative temporary differences  

6,717 

2,832 

Gross deferred income tax assets    

47,809 

48,039 

Valuation allowance

(47,809) 

(48,039) 

Net deferred income tax assets  

$ -- 

$ -- 

As of December 31, 2003, the Company had net operating loss carryforwards of $83.5 million for Federal income tax reporting purposes and $8.7 million for State income tax reporting purposes, which expire at various dates through 2021. In addition, as of December 31, 2003, the Company had approximately $6.0 million and $4.5 million of tax credit carry forwards for increased research expenditures for Federal and California purposes, respectively. The Federal research tax credits will expire at various dates through 2022 and the state tax credit can be carried over indefinitely. 

As of December 31, 2003, part of our valuation allowance on deferred tax assets pertains to certain tax credits and net operating loss carry forwards resulting from the exercise of certain employee stock options. The valuation allowance will be reduced in the period in which we realize the benefit from the utilization of these credits and losses to reduce our income taxes payable on our income tax return. When realized, the tax benefit of these credits and losses will be accounted for as a credit to stockholders’ equity rather than as a reduction of income tax expense. In addition, the Internal Revenue Code of 1986, as amended, contains provisions that limit the net operating loss and credit carryforwards available for use in any given period 
upon the occurrence of certain events, including a significant change in ownership interests. The Company has performed an analysis of the ownership changes and has reported the net operating loss and credit carryforwards considering such limitations. 

As of December 31, 2003 and 2002, a valuation allowance has been recorded for the entire gross deferred tax asset as a result of uncertainties regarding the realization of the asset balance. The valuation allowance was decreased by $230,000 in 2003 and increased by $1.6 million in 2002. As of December 31, 2003 and 2002, the Company had no significant deferred tax liabilities. 

8. 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 December 31, 2003 and $229,000 as of December 31, 2002. 
 
74
 
9. RELATED PARTIES: 

In June 2000, the Company entered into a stock purchase agreement with Enel S.p.A., an Italian utility company ("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 will cooperate with Enel to integrate LonWorks technology into Enel’s remote metering management project in Italy. For the years ended December 31, 2003, 2002, and 2001, the Company recognized revenue of approximately $75.8 million, $81.6 million, and $31.0 million, respectively, related to products and services sold to Enel and
 its contract manufacturers. As of December 31, 2003 and 2002, approximately $15.3 million and $17.2 million, respectively, of these revenues were included in accounts receivable. 

10. SEGMENT DISCLOSURE: 
 
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. 
 
The Company operates in one principal industry segment: the design, manufacture and sale of products for the controls 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. Any given customer purchases a small 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 the Americas, Europe, Middle East and Africa ("EMEA") and Asia Pacific/ Japan ("APJ"). Each geographic area provides products and services as further described in Note 1. 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 has no long-lived assets, other than property and equipment and loans to certain key employees. Long-lived assets are attributed to geographic areas based on the country where the assets are located. Long-lived assets of about $37.2 million were domiciled in the United States as of December 31, 2003, and long-lived assets of about $29.7 million were domiciled in the United States as of December 31, 2002. Long-lived assets for all other locations are not material to the consolidated financial statements. Assets and the related depreciation and amortization are not being reported by geography because the information is not reviewed by the Executive Staff to make decisions about resources to be allocated to the geographic areas based on their performance. 

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 customer is domiciled. 
 
75
 
Summary information by geography for the years ended December 31, 2003, 2002 and 2001 is as follows (in thousands): 

Year Ended December 31, , 

2003 

2002 

2001 

Revenues from customers: 

Americas    

$ 

16,008 

$ 

14,470 

$ 

16,767 

EMEA    

87,088 

62,682 

42,608 

APJ    

15,057 

45,682 

17,206 

Unallocated     

-- 

-- 

8 

Total  

$ 

118,153 

$ 

122,834 

$ 

76,589 

Gross profit: 

Americas   

$ 

10,024 

$ 

8,484 

$ 

10,693 

EMEA    

48,241 

32,406 

19,349 

APJ    

7,830 

22,005 

9,350 

Unallocated     

-- 

-- 

8 

Total  

$ 

66,096 

$ 

62,895 

$ 

39,400 

Income (loss) from operations: 

Americas    

$ 

6,277 

$ 

4,952 

$ 

6,976 

EMEA    

44,415 

28,984 

16,128 

APJ    

4,466 

18,360 

5,613 

Unallocated    

(54,880 

) 

(37,859 

) 

(29,074 

) 

Total    

$

278 

$ 

14,437 

$ 

(357 

) 

Products sold to Enel and its contract manufacturers accounted for 64.2% of total revenues for the year ended December 31, 2003, 66.4% of total revenues for the year ended December 31, 2002, and 40.5% for the year ended December 31, 2001. In addition, EBV, the sole independent distributor of the Company’s products in Europe since December 1997, accounted for 10.2% of total revenues for 2003, 9.2% of total revenues for 2002, and 16.9% of total revenues for 2001. 
 
76
 
11. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED): 

The following tables set forth certain consolidated statement of operations data for each of the quarters in 2003 and 2002, as well as the percentage of our net revenues represented by each item. This information has been derived from our quarterly unaudited consolidated financial statements. The quarterly unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements included in this report and include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of such information when read in conjunction with our annual audited consolidated financial statements and notes appearing elsewhere in this report. The operating resu
lts for any quarter do not necessarily indicate the results for any subsequent period or for the entire fiscal year. 
 
Quarter Ended 

Q403 

Q303 

Q203 

Q103 

Q402 

Q302 

Q202 

Q102 

Consolidated Statement of Operations Data:
 
(in thousands, except per share data)

Net revenues: 

Product  

$ 

23,334 

$ 

30,447 

$ 

30,979 

$ 

32,393 

$ 

30,295 

$ 

33,073 

$ 

30,860 

$ 

27,226 

Service    

193 

285 

277 

245 

286 

277 

458 

359 

Total net revenues   

23,527 

30,732 

31,256 

32,638 

30,581 

33,350 

31,318 

27,585 

Cost of revenues: 

Cost of product    

9,786 

10,179 

14,034 

15,408 

14,483 

15,630 

14,111 

12,835 

Cost of service     

711 

597 

656 

686 

730 

699 

780 

671 

Total cost of revenues    

10,497 

10,776 

14,690 

16,094 

15,213 

16,329 

14,891 

13,506 

Gross profit    

13,030 

19,956 

16,566 

16,544 

15,368 

17,021 

16,427 

14,079 

Operating expenses: 

Product development     

7,079 

6,753 

16,186 

5,095 

5,055 

5,405 

5,376 

5,620 

Sales and marketing    

4,632 

4,662 

4,633 

4,670 

4,358 

4,354 

4,293 

4,286 

General and administrative     

2,954 

3,093 

3,125 

2,936 

2,839 

2,394 

2,226 

2,252 

Total operating expenses    

14,665 

14,508 

23,944 

12,701 

12,252 

12,153 

11,895 

12,158 

Income/(loss) from operations     

(1,635 

) 

5,448 

(7,378 

) 

3,843 

3,116 

4,868 

4,532 

1,921 

Interest and other income, net    

399 

537 

542 

741 

844 

922 

1,011 

1,000 

Income before provision for income taxes    

(1,236 

) 

5,985 

(6,836 

) 

4,584 

3,960 

5,790 

5,543 

2,921 

Provision for income taxes     

(716 

) 

1,496 

(547 

) 

367 

317 

463 

443 

234 

Net income   

($ 520 

) 

$ 

4,489 

($ 6,289 

) 

$ 

4,217 

$ 

3,643 

$ 

5,327 

$ 

5,100 

$ 

2,687 

Income per share: 

Basic      

($ 0.01 

) 

$ 

0.11 

($ 0.16 

) 

$ 

0.11 

$ 

0.09 

$ 

0.13 

$ 

0.13 

$ 

0.07 

Diluted   

($ 0.01 

) 

$ 

0.11 

($ 0.16 

) 

$ 

0.10 

$ 

0.09 

$ 

0.13 

$ 

0.12 

$ 

0.07 

Shares used in per share calculation: 

Basic      

40,337 

40,186 

39,954 

39,788 

39,685 

39,658 

39,443 

39,029 

Diluted     

40,337 

41,305 

39,954 

40,396 

40,557 

40,619 

40,818 

41,085 

77
 
SCHEDULE II 

ECHELON CORPORATION 
VALUATION AND QUALIFYING ACCOUNTS 
(in thousands) 

ALLOWANCE FOR DOUBTFUL ACCOUNTS, CUSTOMER RETURNS, AND SALES CREDITS 

Description 

Beginning 
Balance 

Charged to 
Revenues and 
Expenses 

Deductions 

Ending 
Balance 

Year ended December 31, 2001    

$ 1,895

172 

— 

$ 2,067 

Year ended December 31, 2002 

$ 2,067 

569 

— 

$ 2,636 

Year ended December 31, 2003    

$ 2,636 

(752) 

— 

$ 1,884 

78
 
SIGNATURES 

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

By: /s/ Oliver R. Stanfield 

Oliver R. Stanfield 
Executive Vice President and Chief Financial Officer 
(Duly Authorized Officer and Principal Financial 
and Accounting Officer) 

POWER OF ATTORNEY 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints M. Kenneth Oshman and Oliver R. Stanfield his true and lawful attorney-in-fact and agent, with full power of substitution and, for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby 
ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. 

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. 
 
Signatures 

Title 

Date 

/s/ M. Kenneth Oshman 

Chairman of the Board 
and Chief 
Executive Officer 
(Principal Executive 
Officer) 

March 12, 2004

M. Kenneth Oshman 

/s/ Oliver R. Stanfield 

Executive Vice President 
and Chief Financial 
Officer (Principal 
Financial and Principal Accounting 
Officer) 

March 12, 2004 

Oliver R. Stanfield 

/s/ Armas Clifford Markkula, Jr. 

Vice Chairman 

March 4, 2004 

Armas Clifford Markkula, Jr. 

/s/ Robert J. Finocchio, Jr. 

Director 

March 10, 2004

Robert J. Finocchio, Jr. 

/s/ Michael E. Lehman 

Director 

March 9, 2004

Michael E. Lehman 

/s/ Robert R. Maxfield 

Director 

March 4, 2004 

Robert R. Maxfield 

/s/ Richard M. Moley 

Director 

March 11, 2004

Richard M. Moley 

/s/ Arthur Rock 

Director 

March 4, 2004 

Arthur Rock 

/s/ Larry W. Sonsini 

Director 

March 11, 2004

Larry W. Sonsini 

79
 
EXHIBIT INDEX 

Exhibit 
No. 

Description of Document 

3.2* 

Amended and Restated Certificate of Incorporation of Registrant. 

3.3 

Amended and Restated Bylaws of Registrant. 

4.1* 

Form of Registrant’s Common Stock Certificate. 

4.2* 

Second Amended and Restated Modification Agreement dated May 15, 1997. 

10.1* 

Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers. 

10.2*+ 

1997 Stock Plan and forms of related agreements. 

10.3*+ 

1988 Stock Option Plan and forms of related agreements. 

10.4* 

Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2). 

10.5* 

Form of International Distributor Agreement. 

10.6* 

Form of OEM License Agreement. 

10.7* 

Form of Software License Agreement. 

10.8* 

International Distributor Agreement between the Company and EBV Elektronik GmbH as of 
December 1, 1997. 

10.9*+ 

1998 Director Option Plan. 

21.1* 

Subsidiaries of the Registrant. 

23.1 

Consent of KPMG LLP. 

24.1 

Power of Attorney (see signature page). 

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. 
 
*              Previously filed. 
+              Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. 
 
80

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
r	TRANSITION REPORT PURSUANT TO SECTION 13 Or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________ to __________.
Commission file number: 000-29748

ECHELON CORPORATION

(Exact name of registrant as specified in its charter)
Delaware		77-0203595
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
550 Meridian Avenue San Jose, California 95126
(Address of principal executive office and zip code)
(408) 938-5200
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock $0.01 par value
Name of each exchange which registered: NASDAQ National Market

		Page

	PART I
Item 1.	Business	3
Item 2.	Properties	16
Item 3.	Legal Proceedings	16
Item 4.	Submission of Matters to a Vote of Security Holders	16
	PART II
Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	17
Item 6.	Selected Financial Data	18
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 8.	Financial Statements and Supplementary Data	49
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	49
Item 9A.	Controls and Procedures	49
	PART III
Item 10.	Directors and Executive Officers of the Registrant	51
Item 11.	Executive Compensation	51
Item 12.	Security Ownership of Certain Beneficial Owners and Management	51
Item 13.	Certain Relationships and Related Transactions	51
Item 14.	Principal Accountant Fees and Services	51
	PART IV
Item 15.	Exhibits, Financial Statement Schedule, and Reports on Form 8-K	52

SIGNATURES		79
EXHIBIT INDEX		80

	Price Range

Year Ended December 31, 2003	High	Low

Fourth quarter	$15.33	10.15
Third quarter	18.73	11.89
Second quarter	15.00	10.35
First quarter	14.26	9.15

Year Ended December 31, 2002	High	Low

Fourth quarter	$15.75	8.41
Third quarter	16.00	8.36
Second quarter	20.84	11.10
First quarter	22.44	12.79

	Payments due by period


		Total		Less than 1 year		1-3 years		3-5 years		More than 5 years

Operating leases	$	39,006	$	4,409	$	8,839	$	8,946	$	16,812
Purchase commitments		10,238		10,238		--		--		--

Total	$	49,244	$	14,647	$	8,839	$	8,946	$	16,812

	Year Ended December 31,

		2003		2002		2001			2000			1999

Consolidated Statement of Operations Data:	(in thousands, except per share data)
Net revenues:
Product	$	117,153	$	121,454	$	74,777		$	47,261		$	37,546
Service		1,000		1,380		1,812			2,038			2,220

Total revenues		118,153		122,834		76,589			49,299			39,766

Cost of revenues:
Cost of product		49,407		57,059		34,842			18,225			14,297
Cost of service		2,650		2,880		2,347			2,017			1,529

Total cost of revenues		52,057		59,939		37,189			20,242			15,826


Gross profit		66,096		62,895		39,400			29,057			23,940


Operating expenses:
Product development		35,113		21,456		17,028			11,159			9,214
Sales and marketing		18,597		17,291		15,787			15,949			15,152
General and administrative		12,108		9,711		6,942			5,787			4,101
Non-recurring charge/(benefit)		--		--		--			(48	)		549

Total operating expenses		65,818		48,458		39,757			32,847			29,016


Operating income/(loss)		278		14,437		(357	)		(3,790	)		(5,076	)
Interest and other income, net		2,219		3,777		6,655			4,019			1,355

Income/(loss) before provision for income taxes		2,497		18,214		6,298			229			(3,721	)
Provision for income taxes		600		1,457		252			145			186

Net income/(loss)	$	1,897	$	16,757	$	6,046		$	84		$	(3,907	)


Income/(loss) per share (1):
Basic	$	0.05	$	0.42	$	0.16		$	0.00		$	(0.12	)

Diluted	$	0.05	$	0.41	$	0.15		$	0.00		$	(0.12	)


Shares used in per share calculation (1):
Basic		40,070		39,468		38,443			35,222			32,910

Diluted		40,792		40,726		41,141			39,734			32,910


Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments	$	144,923	$	134,489	$	111,653		$	150,793		$	24,304
Working capital		160,745		156,319		151,748			164,377			30,290
Total assets		214,128		207,492		185,654			175,676			39,711
Total stockholders’ equity		200,924		195,018		174,717			168,761			32,938

	Twelve Months Ended December 31,

	2003			2002			2001

Revenues:
Product		99.2	%		98.9	%		97.6	%
Service		0.8			1.1			2.4

Total revenues		100.0			100.0			100.0
Cost of revenues:
Cost of product		41.8			46.5			45.5
Cost of service		2.3			2.3			3.1

Total cost of revenues		44.1			48.8			48.6

Gross profit		55.9			51.2			51.4

Operating expenses:
Product development		29.7			17.5			22.2
Sales and marketing		15.7			14.1			20.6
General and administrative		10.3			7.9			9.1

Total operating expenses		55.7			39.5			51.9

Income (loss) from operations		0.2			11.7			(0.5	)
Interest and other income, net		1.9			3.1			8.7

Income before provision for income taxes		2.1			14.8			8.2
Provision for income taxes		0.5			1.2			0.3

Net income		1.6	%		13.6	%		7.9	%

Property and equipment	$	235
Intangible assets and IPR&D		10,765

Total assets acquired	$	11,000

		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	(2,346,245)	2,346,245	12.68
Cancelled	743,344	(743,344)	25.83
Exercised	---	(793,633)	6.17
Additional shares reserved	2,086,277	---	---

BALANCE AT DECEMBER 31, 2003	3,601,792	8,944,182	$16.49

	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	5.3	12.91	5/21/2008	428,015	945,802
Beatrice Yormark	80,000	3.5	12.91	5/21/2008	285,344	630,535
Oliver R. Stanfield	80,000	3.5	12.91	5/21/2008	285,344	630,535
Frederik 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

	December 31, ,

	2003 .			2002 .

	Amortized Cost	Aggregate Fair Value	Unrealized Holding Gains	Amortized Cost	Aggregate Fair Value	Unrealized Holding Gains

U.S. corporate securities:
Commercial paper	$ 4,976	$ 4,977	$ 1	$ 12,218	$ 12,223	$ 5
Corporate notes and bonds	42,016	42,091	75	52,569	52,902	333

	46,992	47,068	76	64,787	65,125	338

U.S. government securities	79,132	79,188	56	34,230	34,423	193


Total investments in debt securities	$126,124	$126,256	$ 132	$ 99,017	$ 99,548	$ 531

Current assets	$	129
Property and equipment		373
Other long-term assets		8
Intangible assets		600
Goodwill		5,744

Total assets acquired	$	6,854


Current liabilities		961

Total liabilities assumed	$	961


Net assets acquired	$	5,893

	Year Ended December 31, 2001

	Amount	Basic EPS	Diluted EPS


Reported net income	$ 6,046	$ 0.16	$ 0.15
Add back amortization expense (net of tax):
Goodwill and workforce in place	320	0.01	0.01

Adjusted net income	$ 6,366	$ 0.17	$ 0.16

		Amount


Balance as of December 31, 2001		$ 1,637
Reclass of workforce in place		74
Unrealized foreign currency translation gain		303
Goodwill resulting from BeAtHome acquisition		5,744

Balance as of December 31, 2002		7,758
Unrealized foreign currency translation gain		405
Balance as of December 31, 2003		$ 8,163

2004	$ 4,409
2005	4,441
2006	4,398
2007	4,443
2008	4,503
Thereafter	16,812

Total	$ 39,006

		Options Outstanding

	Options Available for Grant	Number Outstanding	Weighted-Average Exercise Price Per Share

BALANCE AT DECEMBER 31, 2000	3,595,053	5,221,149	$14.31
Granted	(2,560,225)	2,560,225	15.89
Cancelled	244,314	(244,314)	20.54
Exercised	---	(971,107)	2.55
Additional shares reserved	2,002,484	---	---

BALANCE AT DECEMBER 31, 2001	3,281,626	6,565,953	$16.44
Granted	(2,282,750)	2,282,750	16.35
Cancelled	81,872	(81,872)	26.04
Exercised	---	(631,917)	1.99
Additional shares reserved	2,037,668	---	---

BALANCE AT DECEMBER 31, 2002	3,118,416	8,134,914	$17.44
Granted	(2,346,245)	2,346,245	12.68
Cancelled	743,344	(743,344)	25.83
Exercised	---	(793,633)	6.17
Additional shares reserved	2,086,277	---	---

BALANCE AT DECEMBER 31, 2003	3,601,792	8,944,182	$16.49

Options Outstanding				Options Exercisable
Exercise Price Range	Number Outstanding at December 31, 2003	Weighted Average Remaining Life (in years)	Weighted Average Exercise Price	Number Exercisable December 31, 2003	Weighted Average Exercise Price

$6.25-$7.06	863,345	0.64	$ 7.05	863,345	$ 7.05
7.19-11.33	463,784	7.68	10.06	117,896	8.61
11.60-11.61	998,997	7.28	11.61	665,237	11.61
11.79-12.91	1,636,182	4.66	12.90	207,517	12.89
12.93-14.67	623,836	5.36	13.63	246,497	13.38
14.75-16.35	1,775,227	7.95	16.25	969,806	16.20
16.36-20.34	808,002	7.53	17.45	521,728	17.24
20.38-27.94	591,250	7.25	24.46	425,623	24.45
$30.25-$90.50	1,183,559	1.69	32.21	1,105,317	32.16

	8,944,182	5.46	$ 16.49	5,122,966	$ 17.85

	December 31,

	2003	2002


Net operating loss carry forwards	$ 29,445	$ 32,856
Foreign net operating loss carry forwards	2,149	3,106
Tax credit carry forwards	9,179	8,534
Capitalized research and development costs	319	711
Reserves and other cumulative temporary differences	6,717	2,832


Gross deferred income tax assets	47,809	48,039
Valuation allowance	(47,809)	(48,039)

Net deferred income tax assets	$ --	$ --

	Year Ended December 31, ,

		2003			2002			2001

Revenues from customers:
Americas	$	16,008		$	14,470		$	16,767
EMEA		87,088			62,682			42,608
APJ		15,057			45,682			17,206
Unallocated		--			--			8

Total	$	118,153		$	122,834		$	76,589


Gross profit:
Americas	$	10,024		$	8,484		$	10,693
EMEA		48,241			32,406			19,349
APJ		7,830			22,005			9,350
Unallocated		--			--			8

Total	$	66,096		$	62,895		$	39,400


Income (loss) from operations:
Americas	$	6,277		$	4,952		$	6,976
EMEA		44,415			28,984			16,128
APJ		4,466			18,360			5,613
Unallocated		(54,880	)		(37,859	)		(29,074	)

Total	$	278		$	14,437		$	(357	)

	Quarter Ended

	Q403			Q303		Q203			Q103		Q402		Q302		Q202		Q102

Consolidated Statement of Operations Data:	(in thousands, except per share data)
Net revenues:
Product	$	23,334		$	30,447	$	30,979		$	32,393	$	30,295	$	33,073	$	30,860	$	27,226
Service		193			285		277			245		286		277		458		359

Total net revenues		23,527			30,732		31,256			32,638		30,581		33,350		31,318		27,585

Cost of revenues:
Cost of product		9,786			10,179		14,034			15,408		14,483		15,630		14,111		12,835
Cost of service		711			597		656			686		730		699		780		671

Total cost of revenues		10,497			10,776		14,690			16,094		15,213		16,329		14,891		13,506

Gross profit		13,030			19,956		16,566			16,544		15,368		17,021		16,427		14,079

Operating expenses:
Product development		7,079			6,753		16,186			5,095		5,055		5,405		5,376		5,620
Sales and marketing		4,632			4,662		4,633			4,670		4,358		4,354		4,293		4,286
General and administrative		2,954			3,093		3,125			2,936		2,839		2,394		2,226		2,252

Total operating expenses		14,665			14,508		23,944			12,701		12,252		12,153		11,895		12,158

Income/(loss) from operations		(1,635	)		5,448		(7,378	)		3,843		3,116		4,868		4,532		1,921
Interest and other income, net		399			537		542			741		844		922		1,011		1,000

Income before provision for income taxes		(1,236	)		5,985		(6,836	)		4,584		3,960		5,790		5,543		2,921
Provision for income taxes		(716	)		1,496		(547	)		367		317		463		443		234

Net income		($ 520	)	$	4,489		($ 6,289	)	$	4,217	$	3,643	$	5,327	$	5,100	$	2,687

Income per share:
Basic		($ 0.01	)	$	0.11		($ 0.16	)	$	0.11	$	0.09	$	0.13	$	0.13	$	0.07

Diluted		($ 0.01	)	$	0.11		($ 0.16	)	$	0.10	$	0.09	$	0.13	$	0.12	$	0.07

Shares used in per share calculation:
Basic		40,337			40,186		39,954			39,788		39,685		39,658		39,443		39,029

Diluted		40,337			41,305		39,954			40,396		40,557		40,619		40,818		41,085

ALLOWANCE FOR DOUBTFUL ACCOUNTS, CUSTOMER RETURNS, AND SALES CREDITS

Description	Beginning Balance	Charged to Revenues and Expenses	Deductions	Ending Balance

Year ended December 31, 2001	$ 1,895	172	—	$ 2,067

Year ended December 31, 2002	$ 2,067	569	—	$ 2,636

Year ended December 31, 2003	$ 2,636	(752)	—	$ 1,884

Signatures	Title	Date


/s/ M. Kenneth Oshman	Chairman of the Board and Chief Executive Officer (Principal Executive Officer)	March 12, 2004
M. Kenneth Oshman

/s/ Oliver R. Stanfield	Executive Vice President and Chief Financial Officer (Principal Financial and Principal Accounting Officer)	March 12, 2004
Oliver R. Stanfield

/s/ Armas Clifford Markkula, Jr.	Vice Chairman	March 4, 2004
Armas Clifford Markkula, Jr.

/s/ Robert J. Finocchio, Jr.	Director	March 10, 2004
Robert J. Finocchio, Jr.

/s/ Michael E. Lehman	Director	March 9, 2004
Michael E. Lehman

/s/ Robert R. Maxfield	Director	March 4, 2004
Robert R. Maxfield

/s/ Richard M. Moley	Director	March 11, 2004
Richard M. Moley

/s/ Arthur Rock	Director	March 4, 2004
Arthur Rock

/s/ Larry W. Sonsini	Director	March 11, 2004
Larry W. Sonsini