SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

Commission File Number: 000-50798

Color Kinetics Incorporated

10 Milk Street, Suite 1100

(617) 423-9999

Indicate by check mark whether 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 such 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 o  No x

As of November 1, 2004, Color Kinetics Incorporated had 17,886,535 shares of common stock, par value $0.001 per share, outstanding.

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COLOR KINETICS INCORPORATED

FORM 10-Q

INDEX

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PART I. FINANCIAL INFORMATION

Item 1.  Unaudited Condensed Consolidated Financial Statements

Color Kinetics Incorporated
Condensed Consolidated Balance Sheets
(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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Color Kinetics Incorporated
Condensed Consolidated Statements of Operations
(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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Color Kinetics Incorporated
Condensed Consolidated Statements of Cash Flows
(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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Color Kinetics Incorporated
Notes to Unaudited Condensed Consolidated Financial Statements

1. Nature of Business and Basis of Presentation

Nature of Business – Color Kinetics Incorporated, incorporated on September 15, 1997, is a pioneer in the design, marketing and licensing of intelligent solid-state lighting systems. We sell our products through our direct sales force and network of manufacturer’s representatives and distributors.

Basis of Presentation –The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted in accordance with such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the annual audited consolidated financial statements and notes thereto as of and for the year ended December 31, 2003 included in our Registration Statement on Form S-1 (File No. 333-114386) (the “Registration Statement on Form S-1”) filed with the Securities and Exchange Commission.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for their fair presentation in conformity with GAAP. Our operating results for interim periods presented are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004 or future periods.

2. Initial Public Offering

On June 22, 2004, we completed the initial public offering of 4,000,000 shares of our common stock at a price to the public of $10.00 per share. We received net proceeds from the offering of $35,227,311, after deducting the underwriting discount of $2,800,000 and other direct costs of $1,972,689. We have invested the net proceeds in cash equivalents and short-term investments. In connection with the initial public offering, all 20,381,610 shares of our preferred stock then issued and outstanding were converted into 11,069,031 shares of common stock. Included in the conversion of preferred stock to common stock were 3,484,849 shares of Series F Preferred Stock issued in January and February 2004 for net proceeds of $13,002,687.

In addition, we:

	•		Completed a 1-for-2 reverse stock split of our common stock in May 2004. All share and per share information presented herein has been adjusted to reflect this split;
	•		Increased the number of authorized shares of our common stock from 41,000,000 to 100,000,000 shares in May 2004; and
	•		Adopted in April 2004 the 2004 employee stock purchase plan and 2004 employee stock incentive plan under which we are authorized to issue up to a maximum of 400,000 and 1,750,000 shares, respectively, of common stock.

3.  Revenue Recognition

We recognize revenues in connection with sales of our lighting systems and OEM products when all of the following conditions have been met: (1) evidence exists of an arrangement with the customer, typically consisting of a purchase order or contract; (2) our products have been delivered and risk of loss has passed to the customer, which typically occurs when a product is shipped under our customary terms, generally FOB shipping point; (3) the amount of revenue to which we are entitled is fixed or determinable; and (4) we believe it is probable that we will be able to collect the amount due to us from our customer. To the extent that one or more of these conditions is not present, we delay recognition of revenue until all the conditions are present. We classify the amount of freight that is invoiced to our customers as revenue, with the corresponding cost classified as cost of revenues.

We offer our lighting systems customers limited rights of return, which typically provide that within 30 days of shipment products in unopened and saleable condition may, at our discretion, be returned to us for refund, net of a 15% restocking fee. We also provide certain distributors with limited stock rotation rights. Based on historical experience, we provide for potential returns from customers through a sales return reserve. The reserve is evaluated and adjusted as conditions warrant. An allowance for doubtful accounts is provided to reserve for credit losses as a result of customers’ inability to pay.

4. Stock-Based Compensation

We apply the intrinsic value method of accounting for stock options granted to employees and apply the fair value method for stock options and awards granted to non-employees.

In accordance with the intrinsic value method, we determine the compensation associated with stock awards to employees as the difference, if any, between the fair value of the underlying common stock on the date compensation is measured and the price an employee must pay to exercise the award. The measurement date for employee awards is generally the date of grant. Under the fair value method, we determine the compensation associated with stock awards to non-employees based on the estimated fair value of the award, measured using either current market data or an established option pricing model. The measurement date for non-employee awards is generally the date the performance of services is complete.

Had we used the fair value method to measure compensation related to stock awards to employees, pro forma net income and pro forma earnings per share would have been as follows (in thousands, except per share data):

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The fair value of options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

The weighted average fair value of options granted during the three months ended September 30, 2004 and 2003 was $4.39 and $0.50, respectively. The weighted average fair value of options granted during the nine months ended September 30, 2004 and 2003 was $1.24 and $0.40, respectively.

Stock-based compensation charges in the nine months ended September 30, 2004 included $147,000 resulting primarily from acceleration in June 2004 of the remaining unvested portion of stock options granted to advisory board members and other non-employee consultants.

5. Short-Term Investments

Short-term investments consist of a certificate of deposit from a bank purchased with a seven month maturity.

6. Inventory

Inventory is stated at the lower of cost (first-in, first-out method) or market and consists of the following (in thousands):

7. Warranty Reserve

Our products are generally warranted against defects for 12 months following purchase. Reserves for potential warranty claims are provided at the time of revenue recognition based on historical claims experience, repair costs and current sales levels. Activity within the reserve was as follows in the nine months ended September 30, 2004 and 2003 (in thousands):

8. Earnings per Share

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Basic earnings per share is calculated using the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options, stock warrants, and preferred stock using the treasury stock method. Due to our net loss in the nine months ended September 30, 2003, the effect of these items would be antidilutive in this period and, accordingly, are excluded from the computation. When such shares would be dilutive to the periods presented, preferred shares converted to common shares in connection with our initial public offering on June 22, 2004 (Note 2) were included in the weighted average computations of diluted earnings per share until the date of actual conversion on an if-converted basis and in the weighted average computations of basic earnings per share from the date of such conversion.

For the three months ended September 30, 2003 and nine months ended September 30, 2004 and 2003, outstanding stock options to purchase approximately, 616,000, 29,000 and 629,000 shares of common stock, respectively, were excluded from the calculation of diluted earnings per share, because these options were anti-dilutive. For the three months ended September 30, 2004, all stock options were considered dilutive and, hence, included in the calculation of diluted earnings per share. A reconciliation of shares used in the computation of basic earnings (loss) per share and diluted earnings (loss) per share is as follows (in thousands):

On a pro forma basis, earnings (loss) per basic share for the three and nine months periods ended September 30, 2004 and 2003 would have been $0.04, $0.09, $0.00 and ($0.32) per share, respectively, if the conversion of preferred stock to common stock in connection with our initial public offering had occurred at the beginning of all periods in which such preferred shares were outstanding.

9. Segment Information

We operate in two distinct segments. These segments are identified by reference to the manner in which the chief operating decision maker views the business, which is generally by the type of customer each segment serves. The first segment is “Lighting Systems,” which consists primarily of completed products that we have developed and sourced. The second segment is “OEM and Licensing,” which consists primarily of subassemblies and completed products sold to original equipment manufacturers for combination with their own developed products and licenses to utilize our technology sold to the same class of customer.

Direct contribution margin includes direct costs normally associated with costs of goods sold determined using GAAP and additional direct costs, such as direct selling expenses, included in other expense categories contained in the accompanying statements of operations. We do not generate information regarding indirect costs by segment or assets or cash flows by segment, and hence, such information is not provided below. The information set forth below is prepared in accordance with the accounting principles referred to in Note 1, with the exception that direct costs includes some expenses normally allocated to different expense categories on our consolidated statement of operations. There are no inter-segment transactions.

The following tables set forth revenue and contribution margin from our reportable segments on an interim basis (in thousands):

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10. Comprehensive Income (Loss)

Comprehensive income (loss) includes foreign currency translation gains and losses and other items of comprehensive income (loss) that have been excluded from net income (loss) and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive income (loss) on an interim basis (in thousands):

11. Contingencies

In March 2002, Super Vision International, Inc., or Super Vision, filed a lawsuit in the United States District Court for the Middle District of Florida seeking a declaratory judgment that certain of our patents are invalid, that Super Vision’s products do not infringe the patents in question, and that the patents are unenforceable. Super Vision subsequently amended the complaint to add claims for interference with prospective business relationships, unfair competition, trade disparagement and defamation.

In June 2002, we filed a lawsuit against Super Vision in the United States District Court for the District of Massachusetts. In this litigation, we alleged that certain products of Super Vision, including solid-state architectural lighting fixtures, pool lights and spa lights, infringes four of the patents at issue in Super Vision’s declaratory judgment action; this complaint has been amended to assert infringement of a fifth patent.

Super Vision’s lawsuit in Florida was transferred by the court to the United States District Court for the District of Massachusetts. The cases are in the discovery phase, with discovery closing in January, dispositive motions due in February, and trial expected in the second quarter of 2005. We believe that Super Vision’s claims of invalidity, unenforceability and non-infringement of the patents at issue in our infringement suit against Super Vision, and its claims against us of interference with prospective business relationships, unfair competition, trade disparagement and defamation, are without merit.

On March 4, 2004, Super Vision announced that it had acquired from High End Systems a patent relating to variable color lighting systems. On March 5, 2004, Super Vision filed a lawsuit in the United States District Court for the Middle District of Florida alleging that we have infringed the High End patent and seeking damages of $10.5 million. We had previously investigated the High End patent and concluded that our products and technology do not infringe any valid claim of the patent. Accordingly, we believe that Super Vision’s High End patent lawsuit is without merit and intend to defend against it vigorously. We are now seeking to transfer Super Vision’s High End patent lawsuit to federal court in Massachusetts.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statements

The Private Securities Litigation Reform Act of 1995 contains certain safe harbor provisions regarding forward-looking statements. This Form 10-Q contains, and other information provided by Color Kinetics Incorporated or statements made by our directors, officers or employees from time to time may contain, forward-looking statements and information, which involve risks and uncertainties. Actual future results may differ materially. Forward-looking statements include statements concerning plans, objectives, goals, strategies, expectations, intentions, projections, developments, future events, performance or products, underlying assumptions and other statements which are other than statements of historical facts. In some

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cases, forward-looking statements are identified by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” “believes,” “contemplates,” “predicts,” “projects,” “continue” and other similar terminology or the negative of these terms. All such forward-looking statements, whether written or oral, are expressly qualified by the cautionary statements contained in this Form 10-Q, including those set forth below under the heading “Factors That May Affect Future Results,” and any other cautionary statements which may accompany the forward-looking statements. Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face. We undertake no obligation to update any forward-looking statements we make.

Overview

We design, market and license intelligent solid-state lighting systems. We outsource the manufacture of our systems to contract manufacturers, primarily in Asia. We operate in two lines of business:

	•		Lighting systems: we offer intelligent solid-state lighting systems under the Color Kinetics brand for installation in lighting projects where their use has typically been specified by a designer or architect.
	•		OEM and licensing: we offer a standard line of intelligent solid-state lighting modules that are incorporated by manufacturers in products sold under their own brands. We also license our technology on a royalty-bearing basis.

We sell our lighting systems and OEM products through our direct sales force and through distributors and manufacturer’s representatives in North America, Asia, Europe, Latin America and the Middle East. Licensing arrangements are handled through our direct sales force, often with the involvement of our senior management.

In a typical lighting systems sale, our direct sales force, in cooperation with a distributor or manufacturer’s representative (or, outside North America, a dealer/ distributor or VAR), works with a lighting designer, architect or other specifier to have our system “designed in” to a particular new construction or renovation project. Typically, this is followed by a bid process in which pricing and other terms are negotiated with the project owner or owner’s representative. When construction on the project has reached the appropriate stage, our product is shipped, typically to an electrical equipment or lighting equipment distributor, which purchases the system from us and, in turn, sells it to the project owner or its electrical contractor for installation.

We sell our OEM products primarily through our direct sales force and, in certain cases, manufacturer’s representatives with strong industry relationships and expertise in a particular vertical market. In a typical OEM sales cycle, our direct sales personnel first work with a manufacturer to qualify our systems for incorporation into one or more of its products. Initially, the manufacturer may purchase only small quantities of our system. Once a product incorporating our system is introduced and successfully marketed by our OEM customer, purchases of our OEM products in larger volumes may occur.

Our products are distributed in Japan by Color Kinetics Japan, a joint venture in which we hold a 50% equity interest. An unrelated third party holds the other 50% interest. The terms of our distribution agreement with Color Kinetics Japan are substantially similar to those that we employ with unaffiliated distributors. We account for our investment in Color Kinetics Japan using the equity method of accounting, whereby we record our proportionate share of the income or loss earned by the joint venture. We record revenue from sales to Color Kinetics Japan as revenue from a related party. We eliminate our profit associated with inventory we have sold to Color Kinetics Japan that is held by it at the end of the period. Because Color Kinetics Japan uses the Japanese yen as its functional currency, we translate the results of operations of Color Kinetics Japan into United States dollars using the average rates of exchange during the reporting periods. We also record on our balance sheet translation adjustments reflecting the changes in Color Kinetics Japan’s equity measured in dollars resulting from changes in exchange rates.

     Description of Our Revenues, Costs and Expenses

Our lighting systems revenues include amounts from the sale of our intelligent solid-state lighting systems as well as any fees from our customers for applications engineering, integration or technical support services we provide to assist them in specifying, designing, installing and operating our systems.

Our OEM and licensing revenues include amounts from the sale of our OEM products, license fees and related fees attributable to the licensing of our proprietary technology, and fees for any engineering support services that are requested by our OEM and licensing customers.

Our cost of lighting systems revenues and cost of OEM and license revenues consist primarily of the cost of the lighting products sold, including amounts paid to our contract manufacturers, the costs of any components that we provide, other direct and indirect manufacturing support costs, shipping and handling, tooling and provisions for product warranty, scrap and inventory obsolescence, as well as overhead cost allocated to these activities. It may also include an allocation of salaries and related benefits of engineering personnel when they provide engineering support services for which we charge fees.

Our selling and marketing expenses consist primarily of salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities, commissions paid to our manufacturers’ representatives, costs of marketing programs and promotional materials, trade show expenses and overhead cost related to these activities.

Our research and development expenses consist primarily of salaries, bonuses and related benefits of personnel engaged in research and development and product quality activities, out-of-pocket product development costs, travel expenses and overhead cost related to these activities. Research and development expenses are expensed as incurred.

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Our general and administrative expenses consist primarily of salaries, bonuses and related benefits of personnel engaged in corporate administration, finance, human resources, information systems and legal functions, outside legal expenses related to patent prosecution, patent litigation, trademarks and general corporate matters, other professional fees, bad debt expense, other general corporate expenditures, and overhead cost related to these activities.

Critical Accounting Estimates

We make estimates and assumptions in the preparation of our consolidated financial statements that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. However, actual results may differ from these estimates.

We have identified the following critical accounting policies that require the use of significant judgments and estimates in the preparation of our consolidated financial statements. This listing is not a comprehensive list of all of our accounting policies. For further information regarding the application of these and other accounting policies, see Note 1 in the Notes to Consolidated Financial Statements for the year ended December 31, 2003 included in our Registration Statement on Form S-1 filed with the Securities and Exchange Commission.

Revenue Recognition. We recognize revenues in connection with sales of our lighting systems and OEM products when all of the following conditions have been met:

	•		evidence exists of an arrangement with the customer, typically consisting of a purchase order;
	•		our products have been delivered and risk of loss has passed to the customer, which typically occurs when a product is shipped under our customary terms, generally FOB shipping point;
	•		the amount of revenue to which we are entitled is fixed or determinable; and
	•		we believe it is probable that we will be able to collect the amount due us from our customer.

To the extent that one or more of these conditions is not present, we delay recognition of revenue until all the conditions are present. We classify the amount of freight invoiced to the customer as revenue, with the corresponding cost classified as cost of revenues.

We offer our lighting systems customers limited rights of return, which typically provide that within 30 days of shipment products in unopened and saleable condition may, at our discretion, be returned to us for refund, net of a 15% restocking fee. We also provide certain distributors with limited stock rotation rights. Based on historical experience, we provide for potential returns from customers through a sales return reserve. The reserve is evaluated and adjusted as conditions warrant.

Allowance for Doubtful Accounts. We estimate the uncollectibility of our accounts receivable and we maintain allowances for estimated losses. This allowance is established using estimates that management makes based on factors such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different estimates, or if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.

Product Warranty. We generally warrant our products against defects in materials and workmanship for one year after sale and provide for estimated future warranty costs at the time revenues are recognized. Warranty expense is based on historical claims experience, repair costs, and current sales levels, as well as various other assumptions that we believe to be reasonable under the circumstances. Should actual product failure rates differ from our estimates, revisions to the estimated warranty liability would be required.

Inventory Reserves. We state our inventories at the lower of cost or market, computed on a standard cost basis, which approximates actual cost on a first-in, first-out basis, with market being determined as the lower of replacement cost or net realizable value. We provide reserves equal to the difference between the cost of the inventory and the estimated market value of our inventory using estimates of their net realizable value that are based upon our assumptions about future demand and market conditions. If actual market conditions are less favorable than those expected by management, additional inventory reserves may be required.

Accounting for Income Taxes. We account for income taxes using a liability approach. Our deferred tax assets consist primarily of net operating loss and credit carryforwards, for which we have provided a full valuation allowance, due to our limited operating history and the unlikelihood that we would realize those assets based on that history. To the extent that we begin to generate significant taxable income, such that it becomes more likely than not that these assets will be recoverable, we will reverse those valuation allowances through income. To the extent that we are unable to operate profitably, our tax assets could expire unutilized. The occurrence of certain events, such as significant changes in ownership interests in Color Kinetics, could result in limitations on the amount of those assets that could be utilized in any given year.

Stock-Based Compensation. We use the intrinsic value method to account for stock-based compensation provided to employees and the fair value method to account for stock-based compensation to non-employees, such as consultants and members of our advisory board. Under the intrinsic value method, compensation associated with awards of stock or stock options is measured as the difference between the price the employee must pay to exercise the award and the fair value of our common stock on the date compensation is measured, which is generally the date of the award. To date, most awards to employees have had exercise prices equal to the fair value of the common stock on the date of award, and as a result no material compensation charges have been recorded for awards to employees. Under the fair value method, compensation is measured using the estimated fair value of an award, established either through the estimated value of the share of stock or, in the case of options, through the use of an option pricing

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model, such as the Black-Scholes option pricing model. We disclose the difference between the two methods in our notes to our consolidated financial statements, and those differences have been significant. In addition, use of an option pricing model invariably involves assumptions about future events, such as the volatility of the underlying stock and the estimated life of an award. These assumptions are difficult to predict and could generally result in changing levels of compensation expense for these awards in our financial statements. We do not currently have any intentions to change our accounting for employee awards from the intrinsic value method to the fair value method. However, the Financial Accounting Standards Board has approved for public comment an exposure draft on stock-based compensation which, if adopted, would have the effect of requiring us to adopt the fair value method in the future.

Results of Operations

The following table sets forth certain income and expense items as a percentage of total revenues (or, in the case of our cost of lighting systems revenues and cost of OEM and licensing revenues, as a percentage of the related revenues), and the percentage change in dollar amounts of such items compared with the corresponding periods in the previous fiscal year:

Revenues. Total revenues increased 42%, from $7.8 million in the third quarter of 2003 to $11.1 million in the third quarter of 2004 and increased 39%, from $21.2 million in the first nine months of 2003 to $29.4 million in the first nine months of 2004.

Lighting systems revenues increased 31%, from $7.1 million in the third quarter of 2003 to $9.3 million in the third quarter of 2004 and increased 27%, from $19.5 million in the first nine months of 2003 to $24.8 million in the first nine months of 2004. Lighting systems revenues in North America increased 46%, from $4.2 million in the third quarter of 2003 to $6.1 million in the third quarter of 2004 and increased 40%, from $11.6 million in the first nine months of 2003 to $16.2 million in the first nine months of 2004. Lighting systems revenues in markets outside North America increased 9%, from $2.9 million in the third quarter of 2003 to $3.1 million in the third quarter of 2004 and increased 8%, from $7.9 million in the first nine months of 2003 to $8.5 million in the first nine months of 2004.

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The increases in lighting systems revenues for the third quarter and first nine months of 2004 were primarily attributable to increased worldwide market acceptance of our intelligent solid-state lighting systems and the addition of new products to our product line in prior periods. Growth in sales in North America was also attributable to our ongoing efforts to expand and support our North American manufacturer’s representative network. These factors more than offset declines in sales in the Japanese market to our joint venture partner, Color Kinetics Japan, of $232,000 and $893,000 during the third quarter and first nine months of 2004, respectively, compared to the same periods in the prior year. In addition, sales of branded consumer products declined to zero in the third quarter of 2004, representing a decline of $332,000 and $752,000 in revenues compared to the third quarter and first nine months of 2003, respectively, resulting from our decision in 2003 to discontinue selling these as branded Color Kinetics products and to distribute them instead through our OEM and licensing program.

Our OEM and licensing revenues increased 155%, from $700,000 in the third quarter of 2003 to $1.8 million in the third quarter of 2004 and increased 185%, from $1.6 million in the first nine months of 2003 to $4.7 million in the nine months of 2004. The increases in the three and nine month periods were primarily attributable to increases of $1.0 million and $1.7 million, respectively, in sales of our OEM pool products. At September 30, 2004, we had agreements with 31 OEM and licensing customers compared with 17 such customers at December 31, 2003.

Revenues derived from sales of lighting systems and OEM products to Color Kinetics Japan, the joint venture that distributes our products in Japan, decreased from 16% and 18% of total revenues to 9% and 10% of total revenues in both the third quarter and first nine months of September 30, 2003 and 2004, respectively.

Revenues derived from sales of lighting systems products to Color Kinetics Distribution, Inc., or CKDI, a distributor unaffiliated with us that fulfills smaller orders (generally those having a value less than $10,000), as well as all orders for specifically defined regions of the Canadian marketplace, were less than 10% of total revenues in 2003 and amounted to 11% and 12% of total revenues during the third quarter and first nine months of 2004, respectively.

Gross Profit. Total gross profit increased from $3.7 million in the third quarter of 2003 to $5.6 million in the third quarter of 2004 and from $10.4 million in the first nine months of 2003 to $14.9 million in the first nine months of 2004. The dollar increase was attributable primarily to increased sales, to improved profit margins on certain of our lighting systems products and to increased licensing revenues that more than offset lower margins on our OEM pool lights and sales to CKDI. Gross profit as a percentage of revenues, or gross margin, increased from 48% in the third quarter of 2003 to 50% in the third quarter of 2004 and amounted to 49% and 51% in the first nine months of 2003 and 2004, respectively. Gross margin may vary from period to period depending on relative product mix.

Gross margin from lighting systems increased from 47% in the third quarter of 2003 to 53% in the third quarter of 2004 and increased from 49% in the first nine months of 2003 to 51% in the first nine months of 2004. The increases in the third quarter and first nine months of 2004 compared to the same periods in 2003 are primarily attributable to reduced raw materials and product costs and to an overall more favorable product mix, in part reflecting our decision to discontinue direct distribution of our lower-margin consumer products. Gross margin from lighting systems may vary from period to period depending on relative product mix.

Gross margin from our OEM and licensing business decreased from 53% in the third quarter of 2003 to 39% in the third quarter of 2004 and decreased from 48% in the first nine months of 2003 to 46% in the first nine months of 2004. The decrease in the third quarter of 2004 was primarily attributable to increased sales of lower-margin OEM pool products compared to the third quarter of 2003. The decrease in the first nine months of 2004 compared to the first nine months of 2003 was primarily attributable to lower margin associated with increased sales of our OEM pool products partially offset by an increased percentage of licensing revenues in the first half of 2004. Gross margin for our OEM and licensing business may vary in future periods depending on the mix of higher and lower-margin OEM product revenues and the relative percentage of higher-margin licensing revenues.

Selling and Marketing Expenses. Selling and marketing expenses increased 30% from $1.8 million in the third quarter of 2003 to $2.3 million in the third quarter of 2004 and increased 7%, from $5.8 million in the first nine months of 2003 to $6.2 million in the first nine months of 2004. The increase in dollar amount for the third quarter of 2004 compared to the same period in the prior year was primarily attributed to an increase in commissions to our manufacturer’s representatives as a result of our revenue growth. The decrease in dollar amount for the first nine months of 2004 compared to the same period in 2003 was primarily attributable to unfilled vacancies for sales positions in early 2004 and elimination of direct sales costs associated with our branded consumer products business, offset partially by an increase in commissions to our manufacturer’s representatives as a result of our revenue growth and increased marketing spending on trade shows and other related marketing programs. Certain vacant sales positions were filled in the second quarter of 2004. As a percentage of total revenues, sales and marketing expenses decreased from 23% in the third quarter of 2003 to 21% in the third quarter of 2004 and from 27% in the first nine months of 2003 to 21% in the first nine months of 2004. The declines in selling and marketing expense as a percentage of revenues were attributable primarily to our revenue growth. We plan to further expand our sales force with the hiring of additional sales personnel during the remainder of 2004 and into 2005. As a result, we expect our selling and marketing expenses to increase in dollar amount in subsequent periods.

Research and Development Expenses. Research and development expenses increased 49%, from $594,000 in the third quarter of 2003 to $886,000 in the third quarter of 2004 and 35%, from $1.8 million in the first nine months of 2003 to $2.5 million in the first nine months of 2004. These increases were primarily attributable to increases in our research and development headcount based both in our Boston and China offices, as well as to increased spending on materials and equipment for new product development and testing. As a percentage of total revenues, research and development expenses remained constant at 8% for each of the third quarter periods presented and decreased from 9% in the first nine months of 2003 to 8% in the first nine months of 2004. The decreases in research and development expenses as a percentage of revenues were attributable primarily to our revenue growth. We expect our research and development expenses to increase in dollar amount in subsequent periods, as we devote additional resources to developing new products and technologies and supporting scheduled new product introductions during the remainder of 2004 and into 2005.

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General and Administrative Expenses. General and administrative expenses increased 48%, from $1.2 million in the third quarter of 2003 to $1.8 million in the third quarter of 2004 and increased 43% from $3.4 million in the first nine months of 2003 to $4.9 million in the first nine months of 2004. Outside legal expenses increased by $309,000 and $557,000 in the third quarter and first nine months of 2004, respectively, compared to the same periods in the prior year, primarily as a result of increased patent application activity and litigation matters. Stock-based compensation charges increased by $8,000 and $339,000 in the third quarter and first nine months of 2004, respectively, compared to the same periods in the prior year, primarily as a result of options granted to advisory board members, including the impact of acceleration of the remaining unvested portion of such options in June 2004. The remaining increases in general and administrative expenses for the three and nine periods are primarily the result of increased personnel-related costs to support overall growth in the business. We expect our general and administrative expenses to increase in future periods to support our expanding operations, the additional reporting and other obligations associated with our being a public company, and protection of our intellectual property.

Restructuring Expenses. No restructuring expenses were recorded in 2004. The $161,000 of restructuring expenses in 2003 was attributable to an adjustment made to the restructuring reserve established in 2001, to reflect a change in estimate related to the amount of income we expect to receive from the sublease of our vacated space.

Interest Income (Expense), Net. Interest income increased from $5,000 in the third quarter of 2003 to $181,000 in the third quarter of 2004 and from $41,000 in the first nine months of 2003 to $258,000 in the first nine months of 2004, due to higher average cash and cash equivalent balances in 2004. We incurred $3,000 of interest expense in the first half of 2003 and none in 2004, as a result of our repayment of all bank debt in 2003.

Equity in Earnings (Loss) of Joint Venture. Equity in earnings of joint venture increased from a $140,000 loss in the third quarter of 2003 to a $69,000 gain in the third quarter of 2004 and increased from $45,000 in the first nine months of 2003 to $221,000 in the first nine months of 2004. The loss in the third quarter of 2003 was primarily attributed to unrealized losses during that period on open foreign exchange forward contracts that were purchased by Color Kinetics Japan in order to hedge anticipated dollar-denominated purchases. Differences period to period in equity in earnings of Color Kinetics Japan was also attributed to fluctuation in net earnings of Color Kinetics Japan.

Provision for Income Taxes. We recorded no provision for income tax in either 2003 or 2004 due to our net loss carryforward position. At December 31, 2003, we had net loss carryforwards available to offset future taxable income of $31.2 million and federal research and development tax credit carryforwards available to reduce future taxes payable of $526,000. Should it become more likely than not that these assets will be recovered, we would remove the allowances provided, which would have the effect of reducing or eliminating our provision for income tax and possibly creating a tax benefit to earnings.

Liquidity and Capital Resources

At September 30, 2004, we had $40.0 million in cash and equivalents, as well as $15.0 million in short-term investments, representing an increase of $34.3 million compared to our $5.7 million balance of cash and equivalents at December 31, 2003, as well as a $15 million increase in short-term investments over the same time period.

During the first nine months of 2004, we generated $1.6 million of cash from operating activities. The increase in cash flows from operating activities during the first nine months of 2004 as compared to the same period in the prior year was primarily due to higher net income and changes in operating assets and liabilities. Net operating assets increased year over year primarily as a result of increased sales.

Net cash used in investing activities was $15.5 million during the first nine months of 2004, reflecting $15 million used for purchase of short-term investments, with the remaining $500,000 reflecting purchases of property and equipment, primarily computers, a trade show booth for marketing purposes, and tooling and test equipment related to our product development efforts. Short-term investments are composed of a certificate of deposit from a bank purchased with a seven month maturity.

Net cash provided by financing activities was $48.3 million for the first nine months of 2004, primarily attributable to $13.0 million from issuance of preferred stock in January and February of 2004 and $35.2 million of proceeds from our initial public offering of 4,000,000 million shares of common stock in June 2004. In connection with the initial public offering, all 20.4 million shares of then outstanding preferred stock with a carrying value of $61.1 million were converted into 11.1 million shares of common stock. Our previous bank line of credit expired unused in September 2004. We presently have no plans to obtain additional bank financing.

We anticipate that our cash and equivalents and short-term investments at September 30, 2004 will be sufficient to fund our foreseeable cash requirements for at least the next twelve months.

Factors That May Affect Future Results

We have experienced, and may in the future experience, significant quarter-to-quarter fluctuations in our revenue, gross profit and operating results. Because our sales cycles are long and our customers generally do not enter into long-term purchase commitments, forecasting our revenues is difficult. Even after our lighting systems have been specified for a particular project or installation, the timing of our receipt of revenue may be difficult to predict, as shipment of our systems can be postponed or cancelled due to construction delays, design changes or cost overruns. Similarly, receipt of substantial revenues from an OEM or licensing customer depends on the success of the OEM or licensing customer in developing, introducing and marketing a product including our OEM product or technology, a process that is beyond our control. As is the case for many technology companies, a substantial portion of our revenue in each quarter is attributable to purchase orders issued and shipments made near the end of the quarter. A delay in shipment near the end of the quarter, due, for example, to an unanticipated construction delay or project cancellation, may cause our revenues to fall significantly below our expectations. Because a substantial portion of our expenses is relatively fixed and cannot rapidly be reduced, a shortfall in quarterly revenue may materially adversely affect our operating results for the quarter. Other factors that may contribute to fluctuations in our quarterly operating results include:

•

changes in product mix;

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	•		changes in our distribution and sales channels;
	•		seasonal patterns in purchases of our products;
	•		changes in gross margin associated with inventory and supply chain management issues;
	•		increases or decreases in legal expenses associated with intellectual property litigation initiated by or against us;
	•		changes in the results of operations of Color Kinetics Japan, our joint venture in Japan;
	•		introduction by us and our competitors of new products; and
	•		competitive factors, including pricing and availability of, and demand for, products that compete with ours.

In addition, we face a number of risks and challenges, many of which we describe under the heading “Risk Factors” in our Registration Statement on Form S-1. Among the challenges which we think are most significant, and which have in the past, and will in the future affect our financial performance, are the following:

	•		Market acceptance of intelligent solid-state lighting: The success of our business depends on growing acceptance of intelligent solid-state lighting, both as a replacement for traditional lighting solutions and in new applications. Our senior management team spends a significant amount of time, and we expend significant resources, on efforts to promote the adoption of solid-state lighting in general, and our intelligent solid-state lighting systems in particular.
	•		Ability to meet demand and maintain quality: The success of our business also depends on our ability to supply our products in quantities adequate to meet demand, and to maintain the high standards of quality that our customers require. Our senior management spends a significant amount of its time, and we devote substantial resources, to efforts to ensure our sources of supply and to improve our supply chain management and quality control processes.
	•		Need for continued product and technology innovation: Our competitive position depends on our ability to innovate, and to anticipate the rapid changes in lighting technology, changing customer requirements and evolving standards which characterize our industry. Driving and supporting this process of continuous innovation is a key priority of our senior management team and will require continuing expenditures by us.
	•		Defending our intellectual property: We believe that our proprietary intellectual property is an important source of competitive advantage and is critical to our growing OEM and licensing business. We will continue to devote substantial resources to extending our intellectual property portfolio and, where necessary, we will take appropriate steps to defend it. This could involve substantial expenditures on our part.
	•		Management of growth: We recognize that if our business plans are successful, we may be required to manage a larger and rapidly growing enterprise. We will also be required to meet the reporting, regulatory and other obligations of a public company. This will impose new burdens on management and involve additional costs that we have not historically borne.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

Market risk to which we are subject consists of the risk of loss arising from adverse changes in market rates and foreign exchange rates.

Our joint venture, Color Kinetics Japan, has entered into forward currency contracts to hedge anticipated dollar denominated purchases of product from us. These contracts consist solely of forward contracts to acquire dollars at a fixed yen rate. These contracts are reflected on the balance sheet of Color Kinetics Japan at current fair value and cover a notional amount of $7.2 million, settling at various dates through 2010. Our exposure to these contracts is limited to the impact on our proportional share of the income or loss of Color Kinetics Japan. We have provided no guarantees with respect to Color Kinetics Japan, and as a result the maximum loss we would record with respect to our investment would be the carrying value of that investment at any point in time. At September 30, 2004, our investment in Color Kinetics Japan was carried at $536,000.

Item 4. Controls and Procedures

(a)  Evaluation of disclosure controls and procedures.

Our management, including our Chief Executive Officer and our Chief Financial Officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures as of the end the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide a reasonable level of assurance that the information required to be disclosed in the reports filed or submitted by us under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the requisite time periods.

(b)  Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Super Vision International, Inc.

In March 2002, Super Vision International, Inc., or Super Vision, filed a lawsuit in the United States District Court for the Middle District of Florida seeking a declaratory judgment that certain of our patents are invalid, that Super Vision’s products do not infringe the patents in question, and that the patents are unenforceable. Super Vision subsequently amended the complaint to add claims for interference with prospective business relationships, unfair competition, trade disparagement and defamation.

In June 2002, we filed a lawsuit against Super Vision in the United States District Court for the District of Massachusetts. In this litigation, we alleged that certain products of Super Vision, including solid-state architectural lighting fixtures, pool lights and spa lights, infringes four of the patents at issue in Super Vision’s declaratory judgment action; this complaint has been amended to assert infringement of a fifth patent.

Super Vision’s lawsuit in Florida was transferred by the court to the United States District Court for the District of Massachusetts. The cases are in the discovery phase, with discovery closing in January, dispositive motions due in February, and trial expected in the second quarter of 2005. We believe that Super Vision’s claims of invalidity, unenforceability and non-infringement of the patents at issue in our infringement suit against Super Vision, and its claims against us of interference with prospective business relationships, unfair competition, trade disparagement and defamation, are without merit.

On March 4, 2004, Super Vision announced that it had acquired from High End Systems a patent relating to variable color lighting systems. On March 5, 2004, Super Vision filed a lawsuit in the United States District Court for the Middle District of Florida alleging that we have infringed the High End patent and seeking damages of $10.5 million. We had previously investigated the High End patent and concluded that our products and technology do not infringe any valid claim of the patent. Accordingly, we believe that Super Vision’s High End patent lawsuit is without merit and intend to defend against it vigorously. We are now seeking to transfer Super Vision’s High End patent lawsuit to federal court in Massachusetts.

TIR Systems, Ltd.

In December 2003, we filed a lawsuit against TIR Systems Ltd, a Canadian corporation, in the United States District Court for the District of Massachusetts. In this litigation, we alleged that certain products of TIR infringe three patents of Color Kinetics. The Complaint has been amended to add a fourth patent. TIR has filed counterclaims seeking declarations that it does not infringe and that the patents are invalid. We believe that these claims by TIR are without merit. The present scheduling order specifies that all discovery is to be completed by February 2006 and dispositive motions filed by April 2006.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

No change.

Items 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

     (a)  Exhibits

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    (b)   Reports on Form 8-K

We filed a report on Form 8-K on August 5, 2004, furnishing, under Item 7, a copy of a press release related to our second quarter financial results, and identifying such press release as required by Item 12.

SIGNATURES

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

Date: November 15, 2004	COLOR KINETICS INCORPORATED (Registrant)
	By:	/s/ George G. Mueller
		George G. Mueller
		Chief Executive Officer
	By:	/s/ David K. Johnson
		David K. Johnson
		Chief Financial Officer

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