ECHELON CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

______________

FORM 10-Q

______________

(Mark one)

[X]

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

For the quarterly period ended September 30, 2004

[ ]

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

For the transition period from _______________ to _______________

000-29748

(Commission file number)

______________

ECHELON CORPORATION

(Exact name of registrant as specified in its charter)

______________

Delaware 77-0203595

(State or other jurisdiction (IRS Employer

incorporation or organization) Identification Number)

550 Meridian Avenue

San Jose, CA 95126

(Address of principal executive office and zip code)

(408) 938-5200

(Registrant’s telephone number, including area code)

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

Yes x No o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes x No o

As of October 31, 2004, 41,191,817 shares of the Registrant’s common stock were outstanding.


	1

ECHELON CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

INDEX

		Page
Part I.	FINANCIAL INFORMATION
Item 1.	Unaudited Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2004 and September 30, 2003	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and September 30, 2003	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4.	Controls and Procedures	48

Part II.	OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K	50

SIGNATURE		50
EXHIBIT INDEX		51

FORWARD-LOOKING INFORMATION

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

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


	2

PART I. FINANCIAL INFORMATION

ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ECHELON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

	September 30, 2004			December 31, 2003
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	34,954		$	18,667
Short-term investments		126,296			126,256
Accounts receivable, net		12,599			20,110
Inventories		7,556			5,906
Other current assets		1,941			2,519
Total current assets		183,346			173,458

Property and equipment, net		17,454			19,098
Goodwill		8,130			8,163
Restricted investments		11,105			10,867
Other long-term assets		2,197			2,542

TOTAL ASSETS	$	222,232		$	214,128

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	7,661		$	6,922
Accrued liabilities		4,223			4,793
Deferred revenues		1,845			998
Total current liabilities		13,729			12,713

LONG-TERM LIABILITIES:
Deferred rent		745			491
Total long-term liabilities		745			491

STOCKHOLDERS’ EQUITY:
Common stock		415			407
Additional paid-in capital		277,425			272,323
Treasury stock		(3,191	)		(3,191	)
Accumulated other comprehensive income		468			1,007
Accumulated deficit		(67,359	)		(69,622	)
Total stockholders’ equity		207,758			200,924

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	222,232		$	214,128

See accompanying notes to condensed consolidated financial statements.


	3

ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

	Three Months Ended September 30,					Nine Months Ended September 30,
		2004			2003		2004		2003
REVENUES:
Product	$	22,556		$	30,447	$	77,467	$	93,819
Service		185			285		598		807
Total revenues		22,741			30,732		78,065		94,626

COST OF REVENUES:
Cost of product		9,397			10,179		32,744		39,621
Cost of service		466			597		1,478		1,939
Total cost of revenues		9,863			10,776		34,222		41,560

GROSS PROFIT		12,878			19,956		43,843		53,066

OPERATING EXPENSES:
Product development		6,227			6,753		18,623		28,034
Sales and marketing		4,572			4,662		14,660		13,965
General and administrative		3,123			3,093		9,855		9,154
Total operating expenses		13,922			14,508		43,138		51,153

INCOME (LOSS) FROM OPERATIONS		(1,044	)		5,448		705		1,913

INTEREST AND OTHER INCOME, NET		609			537		1,755		1,820

INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES		(435	)		5,985		2,460		3,733

INCOME TAX EXPENSE (BENEFIT)		(35	)		1,496		197		1,316

NET INCOME (LOSS)	$	(400	)	$	4,489	$	2,263	$	2,417

NET INCOME (LOSS) PER SHARE:
Basic	$	(0.01	)	$	0.11	$	0.06	$	0.06
Diluted	$	(0.01	)	$	0.11	$	0.06	$	0.06

SHARES USED IN COMPUTING NET INCOME (LOSS) PER SHARE:
Basic		41,183			40,186		40,826		39,980
Diluted		41,183			41,305		40,963		40,767

See accompanying notes to condensed consolidated financial statements.


	4

ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Nine Months Ended September 30,
		2004			2003

CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
Net income	$	2,263		$	2,417
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		3,719			3,921
In-process research and development		--			9,808
Provision for doubtful accounts		(37	)		6
Change in operating assets and liabilities:
Accounts receivable		7,548			4,076
Inventories		(1,650	)		2,619
Other current assets		578			291
Accounts payable		739			1,465
Accrued liabilities		(570	)		1,456
Deferred revenues		847			(1,390	)
Deferred rent		254			230
Net cash provided by operating activities		13,691			24,899

CASH FLOWS USED IN INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments		(111,622	)		(122,994	)
Proceeds from maturities and sales of available-for-sale short-term investments		111,129			109,472
Purchase of assets of Metering Technology Corporation		--			(11,000	)
Purchase of restricted investments		(238	)		(306	)
Change in other long-term assets		(146	)		1,053
Capital expenditures		(1,551	)		(4,612	)
Net cash used in investing activities		(2,428	)		(28,387	)

CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Proceeds from issuance of common stock		5,110			2,635
Net cash provided by financing activities		5,110			2,635

EFFECT OF EXCHANGE RATE CHANGES ON CASH		(86	)		426

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		16,287			(427	)

CASH AND CASH EQUIVALENTS:
Beginning of period		18,667			34,941
End of period	$	34,954		$	34,514

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	725		$	500

See accompanying notes to condensed consolidated financial statements.


	5

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation:

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

While the financial information furnished is unaudited, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2003 included in its Annual Report on Form 10-K.

2. Summary of Significant Accounting Policies:

Use of Estimates in the Preparation of Financial Statements

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

Revenue Recognition

The Company’s revenues are derived 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 5.7% of total revenues for the quarter ended September 30, 2004 and 4.0% for the same period in 2003; and 4.8% of total revenues for the nine months ended September 30, 2004 and 3.9% for the same period in 2003. Service revenues consist of product technical support (including software post-contract support services), training, and custom software development services.

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

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

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


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

Service revenue is 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.

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 as cash and cash equivalents.

Short-Term Investments

The Company classifies its investments in debt and equity securities as available-for-sale in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. As of September 30, 2004, the Company’s available-for-sale short-term investment securities had contractual maturities from five to twenty-four months and an average maturity of seven months. The fair value of available-for-sale securities was determined based on quoted market prices at the reporting date for those instruments. As of September 30, 2004, the amortized cost basis, aggregate fair val ue, and gross unrealized holding losses by major security type were as follows (in thousands):

	Amortized Cost		Aggregate Fair Value		Unrealized Holding Losses
U.S. corporate securities:
Commercial paper	$	14,018	$	14,016	$	2
Corporate notes and bonds		40,431		40,284		147
		54,449		54,300		149
U.S. government securities		72,167		71,996		171
Total investments in debt and equity securities	$	126,616	$	126,296	$	320

Computation of Net Income Per Share

Net income per share has been calculated under Statement of Financial Accounting Standards No. 128, or SFAS 128, Earnings per Share. SFAS 128 requires companies to compute earnings per share under two different methods (basic and diluted). Basic net income per share is calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted net income per share is calculated by adjusting the weighted average number of outstanding shares assuming conversion of all potentially dilutive stock options and warrants under the treasury stock method.


	7

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the three months and nine months ended September 30, 2004 and September 30, 2003 (in thousands, except per share amounts):

	Three Months Ended September 30,					Nine Months Ended September 30,
		2004			2003		2004		2003
Net income (Numerator):
Net income (loss)	$	(400	)	$	4,489	$	2,263	$	2,417
Shares (Denominator):
Weighted average common shares outstanding		41,183			40,186		40,826		39,980
Shares used in basic computation		41,183			40,186		40,826		39,980
Common shares issuable upon exercise of stock
options (treasury stock method)		--			1,119		137		787
Shares used in diluted computation		41,183			41,305		40,963		40,767
Net income per share:
Basic	$	(0.01	)	$	0.11	$	0.06	$	0.06
Diluted	$	(0.01	)	$	0.11	$	0.06	$	0.06

For the three months ended September 30, 2004, no diluted net loss per share calculation was performed, as the inclusion of potentially dilutive stock options would be anti-dilutive. The number of potentially dilutive stock options excluded from this calculation for the three months ended September 30, 2004 was 3,415. For the nine months ended September 30, 2004, stock options in the amount of 9,157,651 were not included in the computation of diluted earnings per share. For the three and nine months ended September 30, 2003, stock options in the amount of 4,799,632 and 6,062,644, respectively, were not included in the computation of diluted earnings per share. These options were excluded from the 2003 and 2004 calculations because the options’ exercise price was g reater than the average market price of the common shares and therefore, the effect of their inclusion would be anti-dilutive.

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. Comprehensive income for the three and nine months ended September 30, 2004 and September 30, 2003 is as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003

Net income/(loss)	$	(400	)	$	4,489		$	2,263		$	2,417
Other comprehensive income/(loss), net of tax:
Foreign currency translation adjustment		55			157			(78	)		274
Unrealized holding gain/(loss) on available-for-sale securities		122			(117	)		(418	)		(212	)
Comprehensive income/(loss)	$	(223	)	$	4,529		$	1,767		$	2,479


	8

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. 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 Statement of Financial Accounting Standards No. 123, or SFAS 123 , Accounting for Stock-Based Compensation, to stock-based employee compensation.

	Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003

Net income (loss) as reported	$	(400	)	$	4,489		$	2,263		$	2,417
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(7,484	)		(5,037	)		(17,679	)		(17,064	)
Pro forma net loss	$	(7,884	)	$	(548	)	$	(15,416	)	$	(14,647	)

Basic net income/(loss) per share:
As reported	$	(0.01	)	$	0.11		$	0.06		$	0.06
Pro forma	$	(0.19	)	$	(0.01	)	$	(0.38	)	$	(0.37	)

Diluted net income/(loss) per share:
As reported	$	(0.01	)	$	0.11		$	0.06		$	0.06
Pro forma	$	(0.19	)	$	(0.01	)	$	(0.38	)	$	(0.37	)

The weighted-average grant date fair value of options granted during the three months ended September 30, 2004 and September 30, 2003 was $3.96 and $10.61, respectively. The weighted-average grant date fair value of options granted during the nine months ended September 30, 2004 and September 30, 2003 was $6.01 $8.92, respectively. Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003

Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		3.1	%		3.1	%		2.4	%		2.5	%
Expected volatility		71.4	%		103.9	%		78.3	%		101.0	%
Expected life (in years)		3.7			4.2			3.6			4.2

Recently Issued Accounting Standards

In March 2004, the FASB issued EITF Issue No. 03-1, or EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company does not currently expect the adoption of EITF 03-1 will have a material impact on its financial position, results of operations, or cash flows.


	9

In June 2004, the FASB issued EITF Issue No. 02-14, or EITF 02-14, Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock. EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means. EITF 02-14 states that the investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influe nce over the operating and financial policies of the investee. The accounting provisions of EITF 02-14 are effective for reporting periods beginning after September 15, 2004. The Company does not currently expect the adoption of EITF 02-14 will have a material impact on its financial position, results of operations, or cash flows.

3. Inventories:

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

	September 30, 2004		December 31, 2003

Purchased materials	$	1,158	$	1,680
Work-in-process		63		8
Finished goods		6,335		4,218
	$	7,556	$	5,906

4. Accrued Liabilities:

Accrued liabilities consist of the following (in thousands):

	September 30, 2004		December 31, 2003

Accrued payroll and related costs	$	2,313	$	2,663
Other accrued liabilities		1,910		2,130
	$	4,223	$	4,793

5. Segment Disclosure:

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

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

The Company manages its business primarily on a geographic basis. The Company’s geographic areas are comprised of three main groups: the Americas; Europe, Middle East and Africa (“EMEA”); and Asia Pacific/ Japan (“APJ”). Each geographic area provides products and services as further described in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company evaluates the performance of its geographic areas based on profit or loss from operations. Profit or loss for each geographic area includes sales and marketing expenses and other charges directly attributable to the area and excludes certain expenses that are managed outside the geographic area. Costs excluded from area profit or loss primarily consist of unallocated corporate expenses, c omprised of product development costs, corporate marketing costs and other general and administrative expenses, which are separately managed. The Company’s long-lived assets include property and equipment, restricted investments, goodwill, loans to certain key employees, purchased technology, and deposits on its leased facilities. Long-lived assets are attributed to geographic areas based on the country where the assets are located. As of September 30, 2004, and December 31, 2003, long-lived assets of about $35.8 million and $37.2 million, respectively, were domiciled in the United States. Long-lived assets for all other locations are not material to the consolidated financial statements. Assets and the related depreciation and amortization are not reported by geography because that information is not reviewed by the Executive Staff when making decisions about resource allocation to the geographic areas based on their performance.


	10

In North America, the Company sells its products through a direct sales organization. Outside North America, direct sales, applications engineering and customer support are conducted through the Company’s operations in EMEA and APJ. Revenues are attributed to geographic areas based on the country where the products are shipped. Summary information by geography for the quarters and nine months ended September 30, 2004 and 2003 is as follows (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenues from customers:
Americas	$	4,164		$	4,085		$	12,406		$	11,860
EMEA		14,619			24,341			57,316			69,749
APJ		3,958			2,239			8,343			13,017
Unallocated		--			67			--			--
Total	$	22,741		$	30,732		$	78,065		$	94,626
Gross profit:
Americas	$	2,767		$	2,573		$	8,130		$	7,369
EMEA		7,867			15,884			30,650			39,067
APJ		2,244			1,433			5,063			6,630
Unallocated		--			66			--			--
Total	$	12,878		$	19,956		$	43,843		$	53,066
Income (loss) from operations:
Americas	$	1,767		$	1,651		$	4,916		$	4,609
EMEA		6,514			14,935			26,440			36,166
APJ		1,375			575			2,070			4,168
Unallocated		(10,700	)		(11,713	)		(32,721	)		(43,030	)
Total	$	(1,044	)	$	5,448		$	705		$	1,913

Products sold to Enel S.p.A., an Italian utility company (“Enel”) and its designated manufacturers accounted for 51.0% of total revenues for the quarter ended September 30, 2004 and 64.2% for the same period in 2003; and 56.1% of total revenues for nine months ended September 30, 2004 and 67.1% for the same period in 2003. For the quarter ended September 30, 2004, 80.9% of the revenues under the Enel program were derived from products shipped to customers in EMEA and the remaining 19.1% were derived from products shipped to customers in APJ. For the nine months ended September 30, 2004, 93.5% of the revenues derived from products shipped under the Enel program were from customers in EMEA and the remaining 6.5% from customers in APJ.

EBV, the sole independent distributor of the Company’s products in Europe, accounted for 16.5% of total revenues for the quarter ended September 30, 2004 and 10.8% for the same period in 2003; and 15.2% of total revenues for the nine months ended September 30, 2004 and 8.9% for the same period in 2003.

6. Income Taxes:

The provision for income taxes for the three months and nine months ended September 30, 2004 and 2003 includes a provision for Federal, state, and foreign taxes based on the annual estimated effective tax rate applied to the Company and its subsidiaries for the year. The difference between the statutory rate and the Company’s effective tax rate is primarily due to the impact of foreign taxes and the utilization of net operating losses not previously benefited.


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7. Related Party:

In September 2000, the Company entered into a stock purchase agreement with Enel. At the same time, the Company also entered into a research and development agreement with an affiliate of Enel. Under the terms of the R&D agreement, the Company is cooperating with Enel to integrate LONWORKS technology into Enel’s remote metering management project in Italy. For the quarter and nine months ended September 30, 2004, the Company recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $11.6 million and $43 .8 million respectively, $8.8 million of which is included in Accounts Receivable at September 30, 2004. For the quarter and nine months ended September 30, 2003, the Company recognized revenue from products sold to Enel and its designated manufacturers of approximately $19.7 million and $63.5 million respectively, $13.7 million of which was included in Accounts Receivable at September 30, 2003.

On May 3, 2004, the Company announced that Enel filed a request for arbitration to resolve a dispute regarding the Company’s marketing and supply obligations under the R&D Agreement. The arbitration is to take place in London. Enel claims that the R&D Agreement obligates the Company to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel Echelon to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. The Company believes it has fulfilled its obligations under the R&D Agreement, including any obligation with respect to the sal e of products and with respect to joint marketing. The Company believes that Enel’s claims are without merit and intends to vigorously defend itself in the arbitration proceedings.

8. Stock Repurchase Program:

In March and August 2004, the Company’s board of directors approved a stock repurchase program. During the quarter and nine months ended September 30, 2004, no shares were repurchased under the program. As of September 30, 2004, 3,000,000 shares are available for repurchase. The stock repurchase program will expire in March 2005.

9. Employee Stock Option Exchange Program:

On September 21, 2004, the Company announced a voluntary employee stock option exchange program (the “Exchange Program”) whereby eligible employees have an opportunity to exchange some or all of their outstanding options for a predetermined number of new stock options. The Company’s Chief Executive Officer, President and Chief Operating Officer, and Executive Vice President and Chief Financial Officer, along with members of the Board of Directors, are not eligible to participate in the Exchange Program.

Under the Exchange Program, participating eligible employees will receive one new stock option for each exchanged option with an exercise price less than $12.00 per share. For exchanged options with an exercise price equal to or greater than $12.00 per share, participants will receive between 0.2 and 0.67 new options for each option exchanged, depending on the exercise price of the exchanged option.

The exercise price of the new options will generally be equal to the fair market value of the Company’s common stock on the date of grant, except for those new options granted to eligible executive officers, in which case the exercise price of the new options will be the greater of the fair market value of the Company’s common stock on the date of grant, or 115% of the closing price of the Company’s stock on the date the exchanged options are cancelled. In addition, in order to comply with local laws, new options granted to participating employees in certain foreign jurisdictions may also have exercise prices that are higher than the fair market value of the Company’s common stock on the date of grant.

New options granted under the Exchange Program will have a term equal to the greater of the remaining term of the exchanged options, or 2 years from the new option grant date. New options will be subject to a one-year cliff vesting schedule, at which time the new option will be vested to the same percentage as the exchanged option would have been on that date. After one year, the new options will continue to vest and become exercisable as to 1/48^th of the shares subject to the new option on each monthly anniversary of the new option grant date. All vesting of the new options is subject to the participating employee’s con tinued employment with the Company on each relevant vesting date.


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On October 21, 2004, in accordance with the Exchange Program, the Company accepted and cancelled options to purchase 3,816,812 shares of its common stock and promised to grant approximately 2,327,334 new options to participating employees. The Company expects to grant the new stock options on April 22, 2005, which is the first business day that is six months and one day after cancellation of the exchanged options. No financial or accounting impact to the Company’s financial position, results of operations, or cash flows for the three or nine months ended September 30, 2004, was associated with this transaction.

10. Warranty Reserves:

When evaluating the reserve for warranty costs, management takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical return rates, historical costs of repair, and knowledge of new products introduced. Estimated reserves for warranty costs are recorded at the time of shipment. The reserve for warranty costs was $249,000 as of September 30, 2004 and $205,000 as of December 31, 2003.


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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto, included elsewhere in this Quarterly Report. In many cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential”, “intend”, or “continue”, or the negative of such terms and other comparable terminology. The following discussion contains forward-looking statements that involve risks and uncertainties including, without limitation, statements regarding our liquidity position, our expected overall growth, our revenues, our anticipated customer support sales, our ant icipated gross margin, our anticipated operating expenses, and our exposure to foreign currency fluctuations. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below in “Factors That May Affect Future Results of Operations” and elsewhere in this Quarterly Report.

Overview

Echelon Corporation was incorporated in California in February 1988, and reincorporated in Delaware in January 1989. We are based in San Jose, California, and maintain offices in nine foreign countries throughout Europe and Asia. We develop, market and support a wide array of products and services based on our LONWORKS technology that enable original equipment manufacturers, or OEMs, and systems integrators to design and implement open, interoperable, distributed control n etworks. We offer these hardware and software products to OEMs and systems integrators in the building, industrial, transportation, utility/home and other automation markets.

We sell certain of our products to Enel and certain suppliers of Enel for use in Enel’s electricity meter management project known as the Contatore Elettronico. We refer to Echelon’s revenues from sales to Enel and Enel’s suppliers as “Enel Project” revenue. We have been investing in products for use by electricity utilities in the management of electricity distribution. We refer to this revenue as networked energy services, or NES, revenue. We refer to all other revenue as LONWORKS Infrastructure revenue. We also provide a variety of t echnical training courses related to our products and the underlying technology. Some of our customers also rely on us to provide customer support on a per-incident or term contract basis.

Critical Accounting Estimates

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

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

Sales Returns and Allowances. We sell our products and services to OEMs, systems integrators, and our other customers directly through our sales force and indirectly through distributors around the world. Sales to certain distributors are made under terms allowing limited rights of return. Sales to EBV, our largest distributor, accounted for 16.5% of total net revenues for the quarter ended September 30, 2004 and 10.8% for the same period in 2003; and 15.2% of total net revenues for the nine months ended September 30, 2004 and 8.9% for the same period in 2003. Worldwide sales to distributors, including those to EBV, accounted for approximately 17.0% of total net revenues for the quarter ended September 30, 2004 and 15.8% of total net revenues for the same period in 2003; and 21.4% of total net revenues for the nine months ended September 30, 2004 and 12.8% for the same period in 2003.


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Net revenues consist of product and service revenues reduced by estimated sales returns and allowances. Provisions for estimated sales returns and allowances are recorded at the time of sale, and are based on management’s estimates of potential future product returns related to product revenues in the current period. In evaluating the adequacy of our sales returns and other allowances, management analyzes historical returns, current and historical economic trends, contractual terms, and changes in customer demand and acceptance of our products.

To estimate potential product returns from distributors other than EBV, management analyzes historical returns and the specific contractual return rights of each distributor. In the case of EBV, we further refine this analysis by reviewing month-end inventory levels at EBV, shipments in transit to EBV, EBV’s historical sales volume by product, and forecasted sales volumes for some of EBV’s larger customers. Significant management judgments and estimates must be made and used in connection with establishing these distributor-related sales returns and other allowances in any accounting period. Actual results could differ materially from these estimates.

Other than standard warranty repair work, Enel and its designated contract meter manufacturers do not have rights to return products we ship to them. However, our agreement with Enel contains an “acceptance” provision, whereby Enel, or its designated meter manufacturer, is entitled to inspect products we ship to them to ensure the products conform, in all material respects, to the product’s specifications. Once the product has been inspected and approved by Enel, or its designated meter manufacturer, or if the acceptance period lapses before Enel inspects, approves, or disapproves the products, the goods are considered accepted. Prior to shipping our products to Enel, we perform, or have our suppliers perform, detailed reviews and tests to ensure the products have been manufactured in compliance wit h the specifications in our agreements with Enel and will meet all of Enel’s acceptance criteria. We do not ship products unless they have passed these reviews and tests. As a result, we record revenue for these products upon shipment to Enel. If Enel were to subsequently reject, in accordance with the terms of our agreements with them, any material portion of a shipment for not meeting the agreed upon specifications, we would defer the revenue on that portion of the transaction until such time as Enel and we were able to resolve the discrepancy. Such a deferral could have a material negative impact on the amount and timing of our Enel related revenues.

We also provide for an allowance for sales discounts and rebates that we identify and reserve for at the time of sale. This reserve is primarily related to our estimate of future point of sale, or POS, credits to be issued to EBV. Under our arrangement with EBV, we have agreed to issue POS credits on sales they make to certain volume customers. We base this estimate on EBV’s historical and forecasted sales volumes to those customers. Significant management judgments and estimates must be made and used in connection with establishing these reserves for POS credits in any accounting period. Actual results could differ materially from these estimates.

Our allowances for sales returns and other sales-related reserves were approximately $1.7 million as of September 30, 2004, and $1.4 million as of December 31, 2003.

Allowance for Doubtful Accounts. We typically sell our products and services to customers with net 30-day payment terms. In certain instances, payment terms may extend to as many as net 90 days. For a customer whose credit worthiness does not meet our minimum criteria, we may require partial or full payment prior to shipment. Alternatively, customers may be required to provide us with an irrevocable letter of credit prior to shipment.

We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer's inability to meet its financial obligations to us, we record a specific allowance against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. These determinations are made based on several sources of information, including, but not limited to, a specific customer’s payment history, recent discussions we have had with the customer, updated financial information for the customer, and publicly available news related to that customer. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, the credit-wo rthiness of our overall customer base, changes in our customers’ payment patterns, and our historical experience. If the financial condition of our customers were to deteriorate, or if general economic conditions worsened, additional allowances may be required in the future, which could materially impact our results of operations and financial condition. Our allowance for doubtful accounts was $400,000 as of September 30, 2004 and $500,000 as of December 31, 2003.


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Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analyses of sales levels by product and projections of future demand. Inventories on hand, in excess of one year’s forecasted demand, are not valued. In addition, we write off inventories that we consider obsolete. We consider a product to be obsolete when one of several factors exists. These factors include, but are not limited to, our decision to discontinue selling an existing product, the product has been re-designed and we are unable to rework our existing inventory to update it to the new version, or our competitors introduce new products that make ou r products obsolete. We adjust remaining inventory balances to approximate the lower of our cost or market value. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

Warranty Reserves. We evaluate our reserve for warranty costs based on a combination of factors. In circumstances where we are aware of a specific warranty related problem, for example a product recall, we reserve an estimate of the total out-of-pocket costs we expect to incur to resolve the problem, including, but not limited to, costs to replace or repair the defective items and shipping costs. When evaluating the need for any additional 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 warranty-related return rates, historical costs of repair, and knowledge of new products int roduced. If any of these factors were to change materially in the future, we may be required to increase our warranty reserve, which could have a material negative impact on our results of operations and our financial condition. Our reserve for warranty costs was $249,000 as of September 30, 2004 and $205,000 as of December 31, 2003.

Deferred Income Taxes. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Based on our historical net operating losses, and the uncertainty of our future operating results, we have recorded a valuation allowance that fully reserves our deferred tax assets. If we later determine that, more likely than not, some or all of the net deferred tax assets will be realized, we would then need to reverse some or all of the previously provided valuation allowance. Our deferred tax asset valuation allowance was $47.8 million as of December 31, 2003.

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

·	significant underperformance relative to expected historical or projected future operating results;

·	significant changes in the manner or use of the acquired assets or the strategy for our overall business;

·	significant negative industry or economic trends; and

·	significant changes in the composition of the intangible assets acquired.

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net goodwill and other intangible assets amounted to $8.2 million as of September 30, 2004.

We adopted SFAS 142 on January 1, 2002, and, as a result, ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. The net balance of goodwill as of September 30, 2004 was $8.2 million. We review goodwill for impairment annually during the quarter ending March 31. Our review during the quarter ended March 31, 2004 indicated no impairment. If, as a result of an annual or any other impairment review that we perform in the future, we determine that there has been an impairment of our goodwill or other intangible assets, we would be required to take an impairment charge. Such a charge could have a material adverse impact on our financial position and/or operating results.


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Results of Operations

The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and September 30, 2003:

	Three Months Ended September 30,					Nine Months Ended September 30,
		2004		2003			2004		2003
Revenues:
Product		99.2	%	99.1	%		99.2	%	99.1	%
Service		0.8		0.9			0.8		0.9
Total revenues		100.0		100.0			100.0		100.0
Cost of revenues:
Cost of product		41.4		33.1			41.9		41.9
Cost of service		2.0		2.0			1.9		2.0
Total cost of revenues		43.4		35.1			43.8		43.9
Gross profit		56.6		64.9			56.2		56.1
Operating expenses:
Product development		27.4		22.0			23.9		29.6
Sales and marketing		20.1		15.1			18.8		14.8
General and administrative		13.7		10.1			12.6		9.7
Total operating expenses		61.2		47.2			55.3		54.1
Income (loss) from operations		(4.6	)	17.7			0.9		2.0
Interest and other income, net		2.7		1.8			2.2		1.9
Income (loss) before provision for income taxes		(1.9	)	19.5			3.1		3.9
Income tax expense (benefit)		0.2		4.9			0.3		1.4
Net income (loss)		(1.7)	%	14.6	%		2.8	%	2.5	%

Revenues

Total revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Total revenues	$	22,741	$	30,732	$	(7,991	)		(26.0	%)
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Total revenues	$	78,065	$	94,626	$	(16,561	)		(17.5	%)

The $8.0 million decrease in total revenues for the quarter ended September 30, 2004 as compared to the same period in 2003 was primarily the result of a $8.1 million reduction in Enel Project revenues partially offset by a $139,000 increase in LONWORKS Infrastructure revenues. The $16.6 million decrease in total revenues for the nine months ended September 30, 2004 as compared to the same period in 2003 was primarily the result of a $19.7 million reduction in Enel Project revenues partially offset by a $3.1 million increase in LONWORKS Infrastructure revenues.


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Product revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Product revenues	$	22,556	$	30,447	$	(7,891	)		(25.9	%)
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Product revenues	$	77,467	$	93,819	$	(16,352	)		(17.4	%)

The $7.9 million decrease in product revenues for the quarter ended September 30, 2004 as compared to the same period in 2003 was primarily the result of a $8.1 million reduction in Enel Project revenues partially offset by a $139,000 increase in LONWORKS Infrastructure revenues, which are primarily comprised of product sales. The $16.4 million decrease in total revenues for the nine months ended September 30, 2004 as compared to the same period in 2003 was primarily the result of a $19.7 million reduction in Enel Project revenues partially offset by a $3.1 mill ion increase in LONWORKS Infrastructure revenues.

Enel Project revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Enel Project revenues	$	11,605	$	19,742	$	(8,137	)		(41.2	%)
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Enel Project revenues	$	43,796	$	63,476	$	(19,680	)		(31.0	%)

Revenues from the Enel Project will typically fluctuate from quarter to quarter, and from year to year, for reasons such as those described in more detail in the section entitled “Factors That May Affect Future Results of Operations.” The $8.1 million decrease in Enel Project revenues for the quarter ended September 30, 2004, as compared to the same period in 2003, was attributable to several factors. The primary reason for this decline was the fact that, late in the third quarter of 2004, we agreed to modify the data concentrator products we shipped to Enel during the third quarter of 2004. As a result, we postponed the recognition of revenue on these units until the modification work is completed, which we currently expect will be substantially completed in the fourth quarter of 2004. This resulted in a year-over-year decline in data concentrator revenues of approximately $6.5 million. In addition, during the third quarter of 2003, we recognized approximately $3.0 million of revenue related to one-time surcharges Enel agreed to pay Echelon for agreeing to ship to Enel’s meter manufacturers an older version of the metering kit. There was no corresponding revenue during the third quarter of 2004. Offsetting these reductions was an increase in metering kit revenue of approximately $1.4 million. This increase was due to an increase in the number of metering kits shipped during the third quarter of 2004, offset by a reduction in the average selling price for these products. Under the terms of our agreement with Enel, prices for the products we sell for the Enel Project are reduced based on the cumulative number of units shipped.

The $19.7 million decrease in Enel Project revenues for the nine months ended September 30, 2004 as compared to the same period in 2003 was also attributable to several factors. The primary reason for the decline was a reduction in data concentrator product revenues of approximately $10.8 million, which was the result of fewer units shipped during the nine months ended September 30, 2004 as compared to the same period in 2003, as well as our decision to postpone the recognition of revenue on units shipped during the third quarter of 2004 as discussed above. Additionally, metering kit revenues were down by approximately $6.0 million due primarily to a reduction in the average selling price of these products, offset by an increase in the number of units shipped during 2004. Lastly, the $3.0 million of revenue relate d to the one-time surcharge in the third quarter of 2003 also contributed to the year-over-year decline.


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We sell our products to Enel and its designated manufacturers in U.S. Dollars. Therefore, the associated revenues are not subject to foreign currency risks.

If the Enel Project achieves its targeted volumes for 2004, we expect that total Enel Project revenues will decline from 2003 levels due primarily to lower average selling prices for metering kits. We still expect that Enel Project revenues will continue to account for the majority of our revenues in 2004. Enel has stated that it intends to complete the installation of the Contatore Elettronico during 2005. Consequently, we believe that our Enel Project revenue will decline sharply in 2005 from our projected 2004 levels.

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. More recently, in May 2004, we announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. Under the arbitration request, Enel is seeking to compel our company to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outs ide of Italy, and to pay unspecified damages. If any current or future dispute is not resolved in our favor, or in a timely manner, the Enel Project, or Enel Project revenue, 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 R&D Agreement. Once the project is completed, or if it were cancelled prior to its completion, we would experience a significant drop in our overall revenue, which would have a material negative impact on our financial position and results of operations.

Given our significant dependence on one customer at this time, we continue to seek opportunities to expand our customer base. In 2002, we formed a new sales and marketing organization that has been tasked with identifying other customers for our NES system products. However, we can give no assurance that our efforts in the networked energy services area will be successful. To date, revenues generated from sales of our NES system products have been immaterial.

LONWORKS Infrastructure revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

LONWORKS Infrastructure Revenues	$	11,129	$	10,990	$	139	1.3	%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

LONWORKS Infrastructure Revenues	$	34,238	$	31,150	$	3,088	9.9	%

Our LONWORKS Infrastructure revenues are primarily comprised of sales of our hardware and software products, and to a lesser extent, revenues we generate from our customer support and training offerings. The $139,000 increase in LONWORKS Infrastructure revenues for the quarter ended September 30, 2004 as compa red to the same period in 2003 was primarily attributable to improved economic conditions in Europe and North America. Also contributing to the increase was the impact of exchange rates on sales made in foreign currencies, principally the Japanese Yen, which contributed approximately $44,000 to the year-over-year increase. Offsetting these increases was a decrease in sales made to customers in the Asian markets we serve, primarily Japan. The $3.1 million increase in LONWORKS Infrastructure revenue for the nine months ended September 30, 2004 as compared to the same period in 2003 was also primarily attributable to improved economic conditions in our European and North American markets. Of the $3.1 million increase, approximately $163,000 was attributable t o the impact of exchange rates on sales made in foreign currencies, principally the Japanese Yen. Offsetting this $3.l million year-over-year improvement was a slight reduction in sales made to our customers in Asia, with Japan again being the primary contributor to this decrease.


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We believe that, in general, as long as the current worldwide economic recovery continues to gain momentum, revenues from our LONWORKS Infrastructure business will continue to improve during 2004 as compared to 2003. This expected improvement, however, will be subject to further fluctuations in the exchange rates between the U.S. Dollar and the Japanese Yen. If the U.S. Dollar were to strengthen against the Japanese Yen, our revenues would decrease. Conversely, if the U.S. Dollar were to weaken against the Japanese Yen, our revenues would increase. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of sales conducted in Japanese Yen (or other foreign currencies) and the magnitude of the exchange rate fluctuation from year to year. The portion of our revenues conducted in currencies other than the U.S. Dollar, principally the Japanese Yen, was about 3.9% for the quarter ended September 30, 2004 and 4.0% for the same period in 2003. We do not currently expect that, during the remainder of 2004, the portion of our revenues conducted in these foreign currencies will fluctuate significantly from that experienced in 2003. Given the historical and expected future level of sales made in foreign currencies, we do not currently plan to hedge against these currency rate fluctuations. However, if the portion of our revenues conducted in foreign currencies were to grow significantly, we would re-evaluate these exposures and, if necessary, enter int o hedging arrangements to help minimize these risks.

EBV revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

EBV Revenues	$	3,743	$	3,305	$	438	13.3	%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

EBV Revenues	$	11,849	$	8,469	$	3,380	39.9	%

Sales to EBV, our largest distributor and the sole independent distributor of our products in Europe, accounted for 16.5% of our total revenues for the quarter ended September 30, 2004 and 10.8% of our total revenues for the same period in 2003; and 15.2% of our total revenues for the nine months ended September 30, 2004 and 8.9% for the same period in 2003. We believe the $438,000 increase between the two quarterly periods, and the $3.4 million increase between the two nine month periods, is primarily the result of improved economic conditions in Europe and other geographic areas where EBV serves its customers. Our contract with EBV, which has been in effect since 1997 and has been renewed annually thereafter, expires in December 2005. If our agreement with EBV is not renewed, or is renewed on terms that are less favorable to us, our revenues could decrease and our future financial position could be harmed. We currently sell our products to EBV in U.S. Dollars. Therefore, the associated revenues are not subject to foreign currency exchange rate risks. However, EBV has the right, on notice to our company, to require that we sell our products to them in Euros.

Service revenues

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Service Revenues	$	185	$	285	$	(100	)		(35.1	%)

	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Service Revenues	$	598	$	807	$	(209	)		(25.9	%)


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The $100,000 decrease in LONWORKS Infrastructure service revenues during the quarter ended September 30, 2004 as compared to the same period in 2003, and the $209,000 decrease during the nine months ended September 30, 2004 as compared to the same period in 2003, were the result of a continued decrease in our customers’ use of our support and training services. We believe that the worldwide economic recession in 2002 and 2003 forced many of our customers to curtail spending for training and support. Although worldwide economic conditions began to improve du ring late 2003, and have continued to improve during 2004, we do not expect our service revenues to increase over 2003 levels. In fact, we believe that many of our customers will continue to refrain from purchasing our customer support and training offerings during 2004 in an effort to minimize their operating expenses.

Gross Profit and Gross Margin

	Three Months Ended
(Dollars in thousands)		September 30, 2004			September 30, 2003			2004 over 2003 $ Change		2004 over 2003 % Change

Gross Profit	$	12,878		$	19,956		$	(7,078	)		(35.5		%)
Gross Margin		56.6	%		64.9	%		--			(8.3	)
	Nine Months Ended
(Dollars in thousands)		September 30, 2004			September 30, 2003			2004 over 2003 $ Change		2004 over 2003 % Change

Gross Profit	$	43,843		$	53,066		$	(9,223	)		(17.4		%)
Gross Margin		56.2	%		56.1	%		--			0.1

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

The 8.3 percentage point reduction in gross margin during the third quarter of 2004 as compared to the same period in 2003 was the result of several factors. As discussed above, during the third quarter of 2003, we recognized approximately $3.0 million of revenue related to one-time surcharges Enel agreed to pay Echelon for agreeing to ship to Enel’s meter manufacturers an older version of the metering kit. This $3.0 million had no corresponding cost of goods sold, and thus increased gross profit during the third quarter of 2003 by $3.0 million. Excluding the impact of this $3.0 million, gross margin during the third quarter of 2003 would have been 61.1%, 4.5 percentage points better than what was achieved during the third quarter of 2004. This 4.5 percentage point reduction was primarily attributable to the fact that we did not recognize any revenue associated with data concentrator product shipments during the third quarter of 2004 due to pending modification work. In the mix of products sold to Enel and its meter manufacturers, the data concentrator products generally have a higher gross margin percentage than do the metering kits. As a result, when the ratio of data concentrator product revenue as a percentage of overall Enel project revenue increases, gross margin improves. Conversely, when the revenue ratio decreases, as it did during the third quarter of 2004, overall gross margins will decline. Offsetting the negative impact the reduction in data concentrator product revenue had on overall gross margins was an improvement in the gross margin achieved on our LONWORKS Infrastructure revenues. As discussed above, a portion of our cost of goods sold relates to certain indirect costs. Some of these costs do not increase or decrease in conjunction with revenue levels, but rather remain relatively constant from quarter to quarter. As a result, when revenue levels increase, as they did with our LONWORKS Infrastructure revenues during the third quarter of 2004 as compared to the same period in 2003, gross margins improve.


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We expect that, for full year 2004, our overall gross margin will slightly exceed the 55.9% experienced in 2003.

Operating Expenses

Product Development

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Product Development	$	6,227	$	6,753	$	(526	)		(7.8	)%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Product Development	$	18,623	$	28,034	$	(9,411	)		(33.6	)%

Product development expenses consist primarily of payroll and related expenses for development personnel, facility and other allocated costs, fees paid to third party consultants, depreciation and amortization, expensed material, and other costs associated with the development of new technologies and products.

One of the primary factors contributing to the $526,000 decrease in product development expenses during the quarter ended September 30, 2004 as compared to the same period in 2003 was the amortization of acquired intangibles in 2003. During the third quarter of 2003, we incurred amortization expense of approximately $264,000 related to purchased technology assets acquired in 2002 and 2003. Those assets became fully amortized in the first and second quarters of 2004. As a result, there was no corresponding amortization expense recorded in the third quarter of 2004. In addition to this decrease, we also experienced decreases in product development expenses totaling approximately $591,000 related to compensation costs and prototype and other expensed material. Compensation related costs, which decreased by approximat ely $416,000 between the two periods, were reduced primarily as a result of a reduction in the number of personnel in our product development group, as well as a reduction in the management bonus incentive plan for certain members of our development staff. Offsetting these decreases were increases in fees paid to third party consultants and facility and other allocated costs, which totaled approximately $320,000.

The primary factor contributing to the $9.4 million decrease in product development expenses during the nine months ended September 30, 2004 as compared to the same period in 2003 was costs incurred in 2003 attributable to the asset acquisition transaction with Metering Technology Corporation, or MTC. For additional information regarding this transaction, please refer to the “Acquisitions” section later in this Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations. In conjunction with the MTC transaction, we expensed approximately $9.8 million related to in-process researc h and development and an additional $478,000 related to amortization of purchased technology during the nine month period ending September 30, 2003. For the nine months ended September 30, 2004, the amortization expense related to these acquired MTC intangibles totaled $239,000. Excluding the $10.0 million impact of the MTC transaction, product development expenses during the nine months ended September 30, 2004 increased by approximately $636,000 as compared to the same period in 2003. This increase between the two nine month periods was primarily the result of increased facilities and other allocated costs associated with our new corporate headquarters building in San Jose and increased fees paid to third party consultants, offset by a decrease in compensation related costs.

We expect that, for full year 2004, product development expenses will be reduced from 2003 levels due primarily to the fact that the $9.8 million in-process research and development charge taken in the second quarter of 2003 was a one-time charge. However, we also expect that our product development expenses in 2004 will be somewhat higher than those incurred in 2002 and prior years, due primarily to the added costs associated with the employees we have added to support the development of our NES products.


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Sales and Marketing

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Sales and Marketing	$	4,572	$	4,662	$	(90	)		(2.0	)%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Sales and Marketing	$	14,660	$	13,965	$	695			5.0	%

Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales personnel, travel and entertainment, facilities costs, advertising and product promotion, and other costs associated with our sales and support offices.

The $90,000 decrease in sales and marketing expenses during the quarter ended September 30, 2004 as compared to the same period in 2003 was primarily attributable to reductions in compensation and other employee related expenses of approximately $183,000 and facilities and other allocated expenses of approximately $126,000. The reduction in compensation and other employee related expenses was primarily due to a reduction in expenses associated with our management incentive bonus plan for certain members of our sales and marketing staff. Offsetting these reductions were increases in advertising and other marketing costs of approximately $101,000, travel and entertainment expenses of approximately $51,000, and supplies and equipment rental of approximately $49,000.

The $695,000 increase in sales and marketing expenses during the nine months ended September 30, 2004 as compared to the same period in 2003 was primarily attributable to increases in salary, commission, and other employee related expenses of approximately $441,000, travel and entertainment expenses of approximately $200,000, advertising and other marketing costs of approximately $200,000, fees paid to third party service providers of approximately $150,000, and supplies and equipment rental expenses of approximately $136,000, offset by reductions in facilities and other allocated expenses of approximately $293,000 and other miscellaneous sales and marketing related expenses of approximately $131,000.

In evaluating the changes in sales and marketing expenses between the two quarterly and nine month periods, the impact of foreign currency exchange rate fluctuations between the U.S. dollar and the local currencies in several of the foreign countries in which we operate, including the Euro, the Pound Sterling, and the Japanese Yen, must also be taken into consideration. While expenses between the two quarterly periods decreased in total by $90,000, the impact of exchange rate fluctuations increased these costs by approximately $113,000 in the third quarter of 2004. For the nine month period ending September 30, 2004, sales and marketing expenses increased by approximately $430,000 due to exchange rate fluctuations. Excluding the impact of these foreign currency exchange rate fluctuations, sales and marketing expen ses would have decreased between the two quarterly periods by approximately $203,000 versus $90,000, and would have increased between the two nine month periods by approximately $265,000 versus $695,000.

We expect that, for full year 2004, our sales and marketing expenses will increase over 2003 levels. We believe that this increase will be attributable to increases in sales incentive compensation plans as well as the continued weakness of the U.S. Dollar. If, however, the U.S. Dollar were to strengthen against the foreign currencies where we do business, our sales and marketing expenses could decrease slightly. Conversely, if the U.S. Dollar were to weaken further against these currencies, our expenses would rise.


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General and Administrative

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

General and Administrative	$	3,123	$	3,093	$	30	1.0	%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change	2004 over 2003 % Change

General and Administrative	$	9,855	$	9,154	$	701	7.7	%

General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, professional fees for legal and accounting services rendered to the company, facility costs, insurance, and other general corporate expenses.

The $30,000 increase in general and administrative expenses during the quarter ended September 30, 2004 as compared to the same period in 2003 was primarily attributable increases in legal and accounting fees of approximately $308,000, premiums for certain insurance policies and other general expenses of approximately $70,000, and increased travel and entertainment costs of approximately $58,000, offset by decreases in compensation related costs of $319,000 and facilities and other allocated expenses of $143,000. The reduction in compensation related expense was primarily related to a reduction in costs associated with our management incentive bonus plan for certain members of our general and administrative staff.

The $701,000 increase in general and administrative expenses during the nine months ended September 30, 2004 as compared to the same period in 2003 was primarily attributable to increases in costs associated with our second new building at our corporate headquarters facility in San Jose of approximately $692,000, legal, accounting, and other third party service provider fees of approximately $251,000, and insurance and other general corporate expenses of approximately $88,000, offset by decreases in compensation related costs of approximately $330,000.

We expect that, for full year 2004, general and administrative costs will increase over 2003 levels. This higher level of spending will be due, in part, to additional administrative requirements imposed by the Sarbanes-Oxley Act of 2002, as well as legal costs associated with our arbitration with Enel.

Interest and Other Income, Net

	Three Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Interest and Other Income, Net	$	609	$	537	$	72			13.4	%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004		September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Interest and Other Income, Net	$	1,755	$	1,820	$	(65	)		(3.6	%)

Interest and other income, net primarily reflects interest earned by our company on cash and short-term investment balances. In addition, foreign exchange translation gains and losses related to short-term intercompany balances are also reflected in this amount.

The $72,000 increase in interest and other income, net during the quarter ended September 30, 2004 as compared to the same period in 2003 is primarily attributable to an increase in interest income between the two periods. This increase is primarily the result of an increase in the average amount of invested cash during the third quarter of 2004. The $65,000 decrease in interest and other income, net during the nine months ended September 30, 2004 as compared to the same period in 2003 was primarily attributable to lower average yield on our investment portfolio. Although the average amount of our invested cash increased during the nine months ended September 30, 2004 as compared to the same period in 2003, the impact of short-term interest rate reductions, which began in late 2001 and continued through 2003, has had an overall negative impact on our interest income. As short-term investments we purchased in 2002 and 2003 come to maturity, we have been forced to re-invest these funds in instruments with lower effective yields, thus reducing interest income.


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In addition to interest income, fluctuations in exchange rates between the U.S. dollar and the local currencies in several of the foreign countries in which we operate, including the Euro and the Pound Sterling, also have an impact on interest and other income, net. In accordance with SFAS No. 52, Foreign Currency Translation, we account for foreign currency translation gains and losses associated with our short-term intercompany balances by reflecting these amounts as either other income or loss in our consolidated statements of operations. During periods when the U.S. dollar strengthens in value against these foreign currenc ies, the associated translation gains favorably impact other income. Conversely, when the U.S. dollar weakens, the resulting translation losses negatively impact other income. During the quarter and nine months ended September 30, 2004, we recognized translation losses associated with these short-term intercompany balances of approximately $41,000 and $42,000, respectively. For the quarter and nine month periods ended September 30, 2003, we recognized translation losses of approximately $26,000 and $129,000, respectively.

Although interest rates have increased modestly over the last several months, they remain at historically low levels. As long as rates remain relatively low, we expect that our interest income will remain low as compared to prior years. In addition, future fluctuations in the exchange rates between the U.S. Dollar and the currencies in which we maintain our short-term intercompany balances (principally the Euro and the British Pound) will also affect our interest and other income, net.

Provision for Income Taxes

	Three Months Ended
(Dollars in thousands)		September 30, 2004			September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Provision for Income Taxes	$	(35	)	$	1,496	$	(1,531	)		(102.3	)%
	Nine Months Ended
(Dollars in thousands)		September 30, 2004			September 30, 2003		2004 over 2003 $ Change		2004 over 2003 % Change

Provision for Income Taxes	$	197		$	1,316	$	(1, 119	)		(85.0	)%

The provision for income taxes for 2004 includes a provision for federal, state and foreign taxes based on our annual estimated effective tax rate for the year. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes and the beneficial impact of deferred taxes resulting from the utilization of net operating losses. Income taxes for the quarter and nine months ended September 30, 2004, primarily consist of taxes related to profitable foreign subsidiaries, federal alternative minimum taxes, and various state minimum and regular income taxes. Income taxes were a benefit of $35,000 for the quarter ended September 30, 2004 and an expense of $1.5 million for the same period in 2003. Income tax expense was $197,000 for the nine months ended September 30, 2004, and $1.3 million for the same period in 2003.

We expect that, during 2004, our effective tax rate will drop as compared to 2003. During 2003, our effective tax rate was negatively impacted primarily by the effect the $9.8 million in-process research and development charge, which was taken in the second quarter upon the completion of the MTC transaction, had on our pre-tax income. As we do not anticipate a similar charge in 2004, we expect that our full year 2004 pre-tax income will increase as compared to 2003. We believe this increase in pre-tax income will result in a decrease in our effective tax rate in 2004 as compared to 2003.


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Off-Balance-Sheet Arrangements and Other Contractual Obligations

Off-Balance-Sheet Arrangements. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose our company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us.

Operating Lease Commitments. We lease our present corporate headquarter facility in San Jose, California, under two non-cancelable operating leases. The first lease agreement expires in 2011 and the second lease agreement expires in 2013. Upon expiration, both lease agreements provide for extensions of up to ten years. As part of these lease transactions, we provided the lessor security deposits in the form of two standby letters of credit totaling $8.0 million. These letters of credit are secured with a cash deposit at the bank that issued the letters of credit. The cash on deposit is restricted as to withdrawal and is managed by a third party subject to certain limitations under our investment policy.

In addition to our corporate headquarters buildings in San Jose, California, we also lease facilities for our sales, marketing, and product development personnel located elsewhere within the United States and in nine foreign countries throughout Europe and Asia. These operating leases are of shorter duration, generally one to two years, and in some instances are cancelable with advance notice.

Purchase Commitments. We utilize several contract manufacturers who manufacture and test our products requiring assembly. These contract manufacturers acquire components and build product based on demand information supplied by us in the form of purchase orders and demand forecasts. These purchase orders and demand forecasts generally cover periods that range from one to nine months, and in some cases, up to one year. We also obtain individual components for our products from a wide variety of individual suppliers. We generally acquire these components through the issuance of purchase orders, which cover periods ranging from one to nine months. Lastly, we routinely issue purchase orders to various vendors and servic e providers from whom we procure goods and services necessary to run our day-to-day business operations. These purchase orders generally cover periods ranging from one to 12 months. In certain cases, where long-term agreements have been entered into, these purchase orders may exceed 12 months.

Indemnifications. In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant. However, we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that is intended to limit our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of the applicable insurance coverage is minimal.

Royalties. We have certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a U.S. Dollar amount per unit shipped or a percentage of the underlying revenue. Royalty expense, which was recorded under our cost of products revenue on our consolidated statements of income, was approximately $125,000 during the quarter ended September 30, 2004, and $130,000 for the same period in 2003. Royalty expense was approximately $355,000 for the nine months ended September 30, 2004, and $427,000 for the same period in 2003.


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As of September 30, 2004, our contractual obligations were as follows (in thousands):

	Payments due by period
	Total	Less than 1 year	1-3 years	3-5 years	More than 5 years
Operating leases	$ 36,372	$ 4,845	$ 9,099	$ 9,041	$ 13,387
Purchase commitments	10,877	10,783	94	--	--
Total	$42,249	$15,628	$ 9,193	$ 9,041	$13,387

Liquidity and Capital Resources

Since our inception, we have financed our operations and met our capital expenditure requirements primarily from the sale of preferred stock and common stock, although since 2002 we have also been able to finance our operations through operating cash flow. From inception through September 30, 2004, we raised $277.8 million from the sale of preferred stock and common stock.

In July 1998, we consummated an initial public offering of 5,000,000 shares of our common stock at a price to the public of $7.00 per share. The net proceeds from the offering were about $31.7 million. Concurrent with the closing of our initial public offering, 7,887,381 shares of convertible preferred stock were converted into an equivalent number of shares of common stock. The net proceeds received upon the consummation of such offering were invested in short-term, investment-grade, interest-bearing instruments.

In September 2000, we consummated a sale of 3.0 million shares of our common stock to Enel. The net proceeds of the sale were about $130.7 million.

In September 2001, our Board of Directors approved a stock repurchase program which authorized us to repurchase up to 2.0 million shares of our common stock, in accordance with Rule 10b-18 and other applicable laws, rules and regulations. In September 2001, we repurchased 265,000 shares under the program at a cost of $3.2 million. No additional repurchases were made subsequent to September 2001. The stock repurchase program expired in September 2003.

In March and August 2004, our Board of Directors approved a second stock repurchase program, which authorizes us to repurchase up to 3.0 million shares of our common stock, in accordance with Rule 10b-18 and other applicable laws, rules and regulations, and subject to prior approval by the Board of Directors. No repurchases have been made since the repurchase program was approved. The second stock repurchase program will expire in March 2005.

The following table presents selected financial information as of September 30, 2004 and for each of the last three fiscal years (Dollars in thousands):

		September 30, 2004		2003		2002		2001
Cash, cash equivalents, and short-term investments	$	161,250	$	144,923	$	134,489	$	111,653
Trade accounts receivable, net		12,599		20,110		22,930		29,113
Working capital		169,617		160,745		156,320		151,748
Stockholders’ equity		207,758		200,924		195,018		174,717

As of September 30, 2004, we had $161.3 million in cash, cash equivalents, and short-term investments, an increase of $16.3 million as compared to December 31, 2003. Historically, our primary source of cash has been receipts from revenue, and to a lesser extent, proceeds from the exercise of stock options and warrants by our employees and directors. Our primary uses of cash have been cost of product revenue, payroll (salaries, commissions, bonuses, and benefits), general operating expenses (costs associated with our offices such as rent, utilities, and maintenance; fees paid to third party service providers such as consultants, accountants, and attorneys; travel and entertainment; equipment and supplies; advertising; and other miscellaneous expenses), acquisitions, capital expenditures, and purchases under our sto ck repurchase program.


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Net cash provided by operating activities. Net cash provided by operating activities has historically been driven by net income levels, adjustments for non-cash charges such as depreciation, amortization, and in-process research and development charges, and fluctuations in operating asset and liability balances. Net cash provided by operating activities was $13.7 million for the nine months ended September 30, 2004, a $11.2 million decrease over the same period in 2003. During the nine months ended September 30, 2004, net cash provided by operating activities was generated primarily from changes in our operating assets and liabilities of $7.7 million, net income of $2.3 million, and $3.7 million of depreciation and amortization. Cash provided by operating activities for the nine months ended September 30, 2003 was generated primarily from in-process research and development of $9.8 million and $3.9 million of depreciation and amortization, net income of $2.4 million, and changes in our operating assets and liabilities of $8.8 million.

Net cash used for investing activities. Net cash used for investing activities has historically been driven by transactions involving our short-term investment portfolio, capital expenditures, changes in our long-term assets, and acquisitions. Net cash used for investing activities was $2.4 million for the nine months ended September 30, 2004, a $26.0 million decrease from the same period in 2003. During the nine months ended September 30, 2004, net cash used for investing activities was primarily the result of purchases of $111.6 million of available-for-sale short-term investments, capital expenditures of $1.6 million, purchases of restricted investments of $238,000, and changes in our other long-term assets of $1 46,000, offset by proceeds from sales and maturities of available-for-sale short-term investments of $111.1 million. Net cash used in investing activities for the nine months ended September 30, 2003 of $28.4 million was impacted primarily by transactions involving our available for sale short-term investments, the $11.0 million purchase of certain assets of MTC, and capital expenditures of $4.6 million.

Net cash provided by financing activities. Net cash provided by financing activities has historically been driven by the proceeds from issuance of common and preferred stock offset by transactions under our stock repurchase program. Net cash provided by financing activities was $5.1 million for the nine months ended September 30, 2004, a $2.5 million increase over the same period in 2003. For both the nine months ended September 30, 2004 and the nine months ended September 30, 2003, net cash provided by financing activities was comprised of proceeds from the exercise of stock options by employees and directors.

We use highly regarded investment management firms to manage our invested cash. Our portfolio of investments managed by these investment managers is primarily composed of highly rated United States corporate obligations, United States government securities, and to a lesser extent, money market funds. All investments are made according to guidelines and within compliance of policies approved by the Audit Committee of our Board of Directors.

We expect that cash requirements for our payroll and other operating costs will continue at or slightly above existing levels. We also expect that we will continue to acquire capital assets such as computer systems and related software, office and manufacturing equipment, furniture and fixtures, and leasehold improvements, as the need for these items arises. Furthermore, our cash reserves may be used to strategically acquire other companies, products, or technologies that are complementary to our business.

Our existing cash, cash equivalents, and investment balances may decline in the event of a weakening of the economy or changes in our planned cash outlay. However, based on our current business plan and revenue prospects, we believe that our existing balances, together with our anticipated cash flows from operations, will be sufficient to meet our projected working capital and other cash requirements for at least the next twelve months. Cash from operations could be affected by various risks and uncertainties, including, but not limited to, the risks detailed later in this discussion in the section titled “Factors That May Affect Future Results of Operations.” In the unlikely event that we would require additional financing within this period, such financing may not be available to us in the amounts or at the times that we require, or on acceptable terms. If we fail to obtain additional financing, when and if necessary, our business would be harmed.


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Acquisitions

Purchase of Certain Assets of Metering Technology Corporation

On April 11, 2003, we acquired certain assets from privately held Metering Technology Corporation, or MTC, a Scotts Valley, California based developer of intelligent, communicating energy measuring devices and systems. In exchange for the assets acquired, we paid $11.0 million in cash to MTC. In conjunction with the asset purchase, we also entered into a sublease agreement with MTC for a portion of their Scotts Valley office space. The sublease expired in December 2003.

The assets we acquired from MTC included de minimus operating assets (e.g., fixed assets), certain intangible assets (e.g., in-process research and development, or IPR&D, and purchased technology), and the opportunity to hire certain of MTC’s employees. We did not assume any of MTC’s existing customer contracts, nor did we buy any of their existing finished goods inventory. Lastly, we did not assume any of MTC’s existing obligations or liabilities with the exception of a lease for a piece of office equipment and a term contract with an internet service provider. In evaluating the group of assets acquired, it was clear that several components necessary for the acquired set to continue normal operations were missing. As a result, we concluded that the assets acquired do not constitute a business a s such term is defined in EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business, and SFAS No. 141, or FAS 141, Business Combinations. Accordingly, FAS 141 accounting does not apply to this transaction and no goodwill has been recorded.

We 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 FAS 141 and SFAS No. 142, or FAS 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 $10.8 million, $9.8 million was assigned to IPR&D and was charged to product development expenses on the date the assets were acquired. The remaining $957,000 was assigned to purchased technology and was amortized over its estimated useful life of one year. During the quarter ended March 31, 2004, amortization expense of approximately $239,000 related to this purchased technology was recorded in product development expenses. As of March 31, 2004, the $957,000 purchased technology was fully amortized. As such, there has been no additional amortization of this purchased technology reflected in our operating results since the first quarter of 2004.

Since the date of the asset purchase, we have focused the efforts of the employees who joined our company from MTC on the development of a new LONWORKS based electricity meter to be used in our Networked Energy Services, or NES, product offering. The foundation for this new electricity meter was a prototype design developed by MTC prior to the asset purchase transaction.

Related Party Transactions

During the quarter and nine months ended September 30, 2004, and during the years ended December 31, 2003, 2002, and 2001, the law firm of Wilson Sonsini Goodrich & Rosati, P.C. acted as principal outside counsel to our company. Mr. Sonsini, a director of our company, is a member of Wilson Sonsini Goodrich & Rosati, P.C.

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


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In September 2000, we entered into a stock purchase agreement with Enel pursuant to which Enel purchased 3.0 million newly issued shares of our common stock for $130.7 million (see Note 7 to our accompanying consolidated financial statements for additional information on our transactions with Enel). The closing of this stock purchase occurred on September 11, 2000. At the closing, Enel had agreed that it would not, except under limited circumstances, sell or otherwise transfer any of those shares for a specified time period. That time period expired September 11, 2003. As of October 31, 2004, Enel had not disposed of any of its 3.0 million shares. In the event Enel elects to sell all or a portion of its holdings in our shares, such sale or sales could depress the market price of our stock during the period in whic h such sales are made.

Under the terms of the stock purchase agreement, Enel has the right to nominate a member of our board of directors. Enel appointed Mr. Francesco Tatò as its representative to our board of directors in September 2000. As a consequence of the expiration of Mr. Tatò’s mandate as Enel’s Chief Executive Officer, Mr. Tatò resigned as Board member in all of Enel’s subsidiaries and affiliates, including Echelon. His resignation from our board of directors was effective in September 2002. Enel has reserved its right to nominate a new member of our board of directors, although, as of October 31, 2004, they have not done so. During the term of service of Enel’s representative on our board of directors from September 2000 to September 2002, Enel’s representative abstained from resolutio ns on any matter relating to Enel.

At the time we entered into the stock purchase agreement with Enel, we also entered into a research and development agreement (the “R&D Agreement”) with an affiliate of Enel. Under the terms of the R&D Agreement, we are cooperating with Enel to integrate our LONWORKS technology into Enel’s remote metering management project in Italy. For the quarter and nine months ended September 30, 2004, we recognized revenue from products and services sold to Ene l and its designated manufacturers of approximately $11.6 million and $43.8 million, respectively, $8.8 million of which was included in accounts receivable at September 30, 2004. For the quarter and nine months ended September 30, 2003, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $19.7 million and $63.5 million, respectively, $13.7 million of which was included in accounts receivable at September 30, 2003. We expect that full year 2004 revenue relating to the Enel Project will decline as compared to the $75.8 million recognized in 2003. In addition, we expect that we will complete our Enel Project related deliveries during 2005, after which revenue, if any, from Enel and its designated manufacturers will be reduced to an immaterial amount.

On May 3, 2004, we announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. The arbitration is to take place in London. Enel claims that the R&D Agreement obligates us to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel Echelon to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. We believe our company has fulfilled its obligations under the R&D Agreement, including any obligation with respect to the sale of products and with respect to joint marketing. We believe that Enel’s claims are without merit and we intend to vigorously defend our company in the arbitration proceedings.

Recently Issued Accounting Standards

In March 2004, the FASB issued EITF Issue No. 03-1, or EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. We do not currently expect the adoption of EITF 03-1 will have a material impact on our fin ancial position, results of operations, or cash flows.

In June 2004, the FASB issued EITF Issue No. 02-14, or EITF 02-14, Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock. EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means. EITF 02-14 states that the investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influe nce over the operating and financial policies of the investee. The accounting provisions of EITF 02-14 are effective for reporting periods beginning after September 15, 2004. We do not currently expect the adoption of EITF 02-14 will have a material impact on our financial position, results of operations, or cash flows.


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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 June 2000, we entered into an R&D Agreement with an affiliate of Enel S.p.A., an Italian utility company. Under the terms of the Agreement, we agreed to work with Enel to integrate our LonWorks technology into Enel’s Contatore Elettronico remote metering management project in Italy. During the quarter ended September 30, 2004, revenue attributable to the Contatore Elettronico project was approximately $11.6 million, or 51.0% of our total revenue. For the nine months ended September 30, 2004, revenue attributable to the Contatore Elettronico project was approximately $43.8 million, or 56.1% of our total revenue. We expect th e 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:

in May 2004, we announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. Enel claims that the R&D Agreement obligates us to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel our company to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. Regardless of the outcome of the arbitration proceedings, the action will divert our management’s attention from other business and will cause us to incur legal and other costs to defend against Enel’s claims. It may also cause our customers or potential customers in the utility business to ques tion whether the arbitration will affect our NES business. In addition, if Enel is successful in the arbitration, then we may have to pay as yet unspecified damages, and Enel may seek to terminate the R&D Agreement. These factors could have a material negative effect on our results of operations and our financial condition;

a dispute could develop between Enel and our company regarding the scope of any of the other obligations of the parties with respect to the Contatore Elettronico project, the R&D Agreement or other agreements, or with respect to product suitability, quality, price, specifications, quantities, 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 R&D 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 compensa tion 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;

·	Enel could decide to no longer pursue the Contatore Elettronico project to the extent we currently contemplate, 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 R&D 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 sources of supply in order to satisfy rules regarding competition, thereby delaying or changing the scope of the project; or

our research and development or support activities under the Contatore Elettronico project might be unsuccessful.


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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 effect on our financial condition and operating results.


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Once the Enel project is completed, or if it is 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 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, Continuon Netbeheer, a utility grid operator located in the Netherlands, has completed a limited field trial of our NES system within its service territory. We do not know if Continuon will decide to move forward with a mass deployment, and even if Continuon decides to proceed, we may not be able to negotiate mutually agreeable terms for such a deployment. In addition, there is generally an ex tended 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 do not currently believe that we will be able to find one or more replacements 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.

Although we have invested substantial amounts of time and money into our NES system, our 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 efforts to sell our NES system, we have invested and intend to continue to invest 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. 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. In addition, even if the NES system meets a utility’s technical specifications, we may not be able to meet all of the utility’s contractual requirements. 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, as was the case for actual versus targeted NES system revenues for the second and third quarters of 2004. The timing of these revenues cou ld also fluctuate from our business plan for a variety of reasons, including the contractual acceptance provisions we agree to when negotiating our NES system sales agreements. Additionally, the gross margins we receive from our NES system offering will not be as high as for many of our other products.

Even if we are successful in penetrating the utility market with our NES system offering, we face competition from many companies. For example, we believe that Enel, our largest customer, has designed a system that it intends to use to compete 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. Enel recently announced an alliance with IBM to market and sell metering systems worldwide. While we continue to discuss with Enel and IBM what role, if any, our company may have in supporting that alliance, it is possible that our company might not contribute, or that if we do contribute, our revenues may not be as high as for our other products. In addition, if we do contribute, such contribution could have a negative impact on our marketing efforts for the NES system. Other competitors, including Actaris, Atos Origin, DCSI, Elster, Hexagram, Hunt Technologies, Itron, Iskraemeco, Nexus, and Ramar, as well as our own customers such as Enermet, Horstmann Controls, Kamstrup, and Milab, could also develop and market their own multi-service metering systems that will compete with our NES system offering. Our NES system will compete with other offerings both in terms of technical capabilities as well as in terms of warranties, indemnities, penalties, and other contractual provisions.


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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 do not have any significant 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 reasonable 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 the NES system, or otherwise fail to meet our financial targets for the NES system, our revenues and results of operations will be harmed.

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 until these contracts ex pire, 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 Project 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 inventory. Such delays could , among other things, reduce our revenues, increase our costs associated with inventory reserves, and cause us to incur penalties. In addition, contract electronic manufacturers can themselves experience turnover and instability, exposing us to additional risks as well as missed commitments to our customers.


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We will also face risks if and when we transition between contract electronic manufacturers. For example, we may have to move raw material and in-process inventory between locations in different parts of the world. Also, we would be required to re-establish acceptable manufacturing processes with a new work force. We could also be liable for excess or unused inventory held by contract manufacturers for use in our products. This inventory may become obsolete as a result of engineering changes that we make. In addition, we may no longer need this inventory because of factors such as changes in our production build plans, miscommunication between us and a contract manufacturer, or errors made by a contract manufacturer in ordering material for use in our products. Under our contracts with these contract electronic ma nufacturers, we would become liable for all or some of these excess or obsolete inventories.

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 price increases, shortages, 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. As a result, we may be vulnerable to price increases for products or components. In addition, 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. To help address these issues, we may decide to purchase quantities of these items that are in excess of our estimated requirements. As a result, we could be forced to increase our excess and obsolete inventory reserves to provide for these excess quantities. 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.

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

For the nine months ended September 30, 2004, we generated a profit of $2.3 million. As of September 30, 2004, we had an accumulated deficit of $67.4 million. We have invested and expect to continue investing 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;

·	the affect of expensing stock option grants or other compensatory awards to our employees, if and when such requirements become effective;

continuation 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 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.


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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 an alysis of our ownership changes and have reported 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. For example, in the first and second quarters of 2004, we generated net income totaling $2.7 million, whereas in the third quarter, we generated a net loss of $400,000. Our future results may continue to 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;

·	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;

·	we could incur costs associated with business acquisitions, including up-front in-process research and development charges and ongoing amortization expenses related to other identified intangible assets;

·	we could incur ongoing operational expenses associated with 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.


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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.

If we are required to take a compensation expense for the value of stock options or other compensatory awards 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. On March 31, 2004, the Financial Accounting Standards Board issued an Exposure Draft, Share-Based Payment: an amendment of FASB Statements No. 123 and 95, which would require a company to recognize, as an expense, the fair value of stock option and other stock-based compensation to employees beginning in 2005. 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 issu ed 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 grant. If the Exposure Draft is adopted in its current form, we would be required to take a compensation charge as stock options or other stock-based compensation awards are issued or as they vest, including the unvested portion of options that were granted prior to 2005. This compensation charge would be based on a calculated value of the option or other stock-based award using a methodology that has yet to be finalized, 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.

Defects in or misuse of our products or other liabilities not covered by insurance 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 and financial condition.

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, or that are not limited at all. Also, local laws may impose liability for NES system or other product failures, including liability for harm to property or persons. Such failures could harm our reputation, expose our company to liability, and adversely affect our operating results and financial position.

We may also experience losses or potential losses in the event of property damage, liability for harm to a third party’s property or person, claims against our directors or officers, and the like. To help reduce our exposure to these types of claims, we currently maintain property, general commercial liability, errors and omissions, directors and officers, and other lines of 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, or we might not carry insurance that covers a specific claim. For example, during 2000, the total limit for claims under our errors and omissions insurance policy was $17.0 million. Since then, we have reduced the total limit for this line of coverage to $11.0 million beca use we believed the premiums our insurers requested were excessive. We believe that the premiums for the types of insurance we carry will continue to fluctuate from period to period. In times of significant cost increases, this could result in increased costs or reduced limits. Consequently, if we elect to reduce our coverage, or if we do not carry insurance for a particular type of claim, 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 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 81.7% of our total net revenues for the quarter ended September 30, 2004 and 86.7% of our total net revenues for the same period in 2003; and 84.1% of our total revenues for the nine months ended September 30, 2004 and 87.5% for the same period in 2003. 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.

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 3.9% for the quarter ended September 30, 2004 and 4.0% for the same period in 2003; and 3.2% for the nine months ended September 30, 2004 and 3.3% for the same period in 2003. 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. For example, if China revalues its currency, the Chinese Renminbi, against the U.S. Dollar, the costs of products and manufacturing and other services that we obtain from our suppliers and contractors in China could increase significantly. 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 September 30, 2004, our 2003 costs and expenses, as reported in U.S. Dollars, would have increased by approximately $723,000. This would have resulted in a $0.02 reduction in earnings per share for 2003.


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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 European 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 our products infringe 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 our products may be infringing certain patents or other intellectual property rights of that third party. We may also be contractually obligated to indemnify our customers or other third parties that use our products in the event they are alleged to infringe a third party’s intellectual property rights. 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 the event our products are infringing upon the intellectual property rights of others, we may elect or be required to red esign 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 alternative, 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 ability to develop and introduce new products on a timely basis;

our product reputation, quality, and performance;

the price and features of our products such as adaptability, scalability, functionality, ease of use, and the ability to integrate with other products;

·	our customer service and support; and

·	warranties, indemnities, and other contractual terms.

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, t echnical, marketing, service and other resources, significantly greater name recognition, and broader product offerings. As a result, these competitors may be able to devote greater resources to the development, marketing, and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, proprietary control systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. 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 Freescale (formerly 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, D CSI, Elster, Hexagram, Hunt Technologies, Itron, Iskraemeco, Nexus, and Ramar, each of which offers automatic meter reading 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, we believe that Enel, our largest customer, will compete 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 na tive 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 .


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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 terro rism 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 declines, or does not increase, 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 a company in a rapidly changing and developing 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 m ay 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 16.5% of our total net revenues for the quarter ended September 30, 2004 and 10.8% of our total net revenues for the same period in 2003; and 15.2% of our total net revenues for the nine months ended September 30, 2004 and 8.9% for the same period in 2003. Worldwide sales to distributors, including those to EBV, accounted for approximately 17.0% of total net revenues for the quarter ended September 30, 2004 and 15.8% of total net revenues for the same period in 2003; and 21.4% of total net revenues for the nine months ended September 30, 2004 and 12.8% for the same period in 2003.

Our current agreement with EBV expires in December 2005. 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 interoperable 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 particularly 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 markets for our products are 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 compe titors 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 7.3% of our outstanding common stock. Enel is generally free to sell these shares at its discretion. In the event Enel, or any other significant stockholder, elects to sell all or a portion of their holdings in our shares, such sale or sales could depress the market price of our stock during the period in which such sales are made;

· investors may be concerned about our ability to develop new customers for our NES business, the success of our project with Enel, and the success we have selling our LONWORKS Infrastructure products and services to OEMs and systems integrators;

· 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;

· securities analysts may change their estimates of our financial results; and

· increases in market interest rates, which generally have a negative impact on stock prices.

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.


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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. The adoption of volunta ry 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.

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, as well as utilities that may be interested in our NES system, 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 their own prolonged product development, system integration, 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 our utility or systems integrator customers;

·	the actions of utility regulators or management boards regarding investments in metering systems;

·	delays in installing, operating, and evaluating the results of NES system field trials; and

·	the time it takes for utilities to evaluate multiple competing bids, negotiate terms, and award contracts for large scale metering system deployments.

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 October 31, 2004, we have 92 issued U.S. patents, 8 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. In addition, we may not apply for or obtain patents in each country in which our technology may be used. If any of our patents fail to protect our technology, or if we do not obtain patents in certain countries, our competitors may find it easier to offer equivalent or superior technology. We have registered 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.


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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.

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 indicated that they in tend 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, time-consuming, and difficult to achieve, 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, law s, 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. In addition, because of the inherent limitations in all financial control systems, it is possible that a material weakness may be found in our internal controls over financial reporting, which could affect our ability to insure proper financial reporting.


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We also expect these developments could 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. For example, our reported results of operations will be negatively impacted if and when we are required to expense stock options or other compensatory grants to our employees.

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

As of October 31, 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 36.5% of our outstanding stock.

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

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

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

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


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For example, we have entered into the Contatore Elettronico project with an affiliate of Enel. Enel currently owns 3.0 million shares of our common stock, representing approximately 7.3% 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 unanticipated 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.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

We have not experienced any material change in our exposure to interest rate and foreign currency risks since the date of our Annual Report on Form 10-K for the year ended December 31, 2003.

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

Interest Rate Sensitivity. We maintain a short-term investment portfolio consisting mainly of fixed income securities with a weighted average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market rates were to increase immediately and uniformly by 10 percent from levels at September 30, 2004 and September 30, 2003, the fair value of the portfolio would decline by an immaterial amount. We currently intend to hold our fixed income investments until maturity, and therefore we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. If necessary, we may sell short-term investments prior to maturity to meet the liquidity needs of the company.

Foreign Currency Exchange Risk. We have international subsidiaries and operations and are, therefore, subject to foreign currency rate exposure. To date, our exposure to exchange rate volatility has not been significant. If foreign exchange rates were to fluctuate by 10% from rates at September 30, 2004, and September 30, 2003, our financial position and results of operations would not be materially affected. However, we could experience a material impact in the future.


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ITEM 4. 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 al l control issues and instances of fraud, if any, within our 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 undetected errors or fraud may occur.

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 our company, and the effect of the controls on the information generated for use in this Quarterly 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 is 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 F orm 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) our company had identified any acts of fraud involving personnel who have a significant role in our 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 gen erally and because the Section 302 Certifications of the CEO and CFO require that the CEO and CFO 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 Quarterly 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 the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that as of such 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.


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Changes in Internal Controls Over Financial Reporting

There were no changes in our internal controls over financial reporting (as defined in Rule 13a-15(e) of the Exchange Act) that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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PART II. OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits

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

(b)	Reports on Form 8-K

We filed the following report on Form 8-K during the quarter ended September 30, 2004:

On July 19, 2004, we filed a current report on Form 8-K dated July 15, 2004, under Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 12 (Results of Operations and Financial Condition), to reference and furnish as an exhibit a press release dated July 15, 2004, announcing our results of operations for the quarter ended June 3, 2004.

SIGNATURE

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

		ECHELON CORPORATION

Date: November 9, 2004	By:	/s/ Oliver R. Stanfield
		Oliver R. Stanfield, Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)


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EXHIBIT INDEX

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


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