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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2003

OR

For the transition period from ____________ to ____________

000-29748

(Commission file number)

ECHELON CORPORATION

(Exact name of registrant as specified in its charter)

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  ¨

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

Yes  x  No  ¨

As of April 30, 2003, 39,865,536 shares of the Registrant’s common stock were outstanding.

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ECHELON CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2003

INDEX

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 obligation to update any such forward-looking statement or reason why such results might differ.

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PART I.    FINANCIAL INFORMATION

Item 1.    Unaudited Condensed Consolidated Financial Statements

ECHELON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    Basis of Presentation:

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

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

2.    Summary of Significant Accounting Policies:

Use of Estimates in the Preparation of Financial Statements

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

Revenue Recognition and Product Warranty

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 3.9% of total revenues for the quarter ended March 31, 2003 and 3.7% for the same period in 2002. Service revenues consist of product support (including software post-contract support services), training, and custom software development services.

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

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

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 SFAS 48. Estimated reserves for warranty costs, which are not material to the consolidated financial statements, are recorded at the time of shipment.

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, Cash Equivalents and Short-Term Investments

The Company considers bank deposits, money market investments and all debt and equity securities with an original maturity of three months or less as cash and cash equivalents. The Company classifies its investments in debt and equity securities as available-for-sale in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. As of March 31, 2003, the Company’s available-for-sale securities had contractual maturities from three to twenty-two months and an average maturity of six months. The fair value of available-for-sale securities was determined based on quoted market prices at the reporting date for those instruments.

Computation of Net Income Per Share

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

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the three months ended March 31, 2003 and 2002 (in thousands):

For the three months ended March 31, 2003 and 2002, stock options in the amount of 6,380,031 and 2,306,065, respectively, were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect of their inclusion would be anti-dilutive.

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Stock-Based Employee Compensation Plans

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

Recently Issued Accounting Standards

In April 2002, the FASB issued SFAS No. 145, or SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS 145 updates, clarifies and simplifies existing accounting pronouncements including: rescinding SFAS 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect, and amending SFAS 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS 145 is effective for fiscal years beginning after May 15, 2002, with early adoption of the provisions related to the rescission of SFAS 4 encouraged. SFAS 145 is effective beginning in 2003, and the effect of adoption did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In June 2002, the FASB issued SFAS No. 146, or SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force, or EITF, Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to an exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS 146 are effective for exit or disposal activities initiated after December 31, 2002. The Company adopted SFAS 146 on January 1, 2003. The adoption did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In November 2002, the FASB issued FASB Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45

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elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company adopted FIN 45 on January 1, 2003. The adoption did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In December 2002, the FASB issued SFAS No. 148, or SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123. SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company is required to follow the prescribed format and provide the additional disclosures required by SFAS No. 148 in its annual financial statements for the year ending December 31, 2002 and must also provide the disclosures in its quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ending March 31, 2003. The adoption of SFAS No. 148 will not have an effect on the Company’s financial position or results of operations as the Company does not currently intend to adopt the fair value method of accounting for stock-based employee compensation.

In January 2003, the FASB issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of FIN 46 did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In January 2003, the EITF published EITF No. 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF No. 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. EITF No. 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating the impact the adoption of EITF No. 00-21 will have on its financial position, results of operations, and 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):

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4.    Accrued Liabilities:

Accrued liabilities consist of the following (in thousands):

5.    Segment Disclosure:

In 1998, the Company adopted SFAS No. 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 No. 131 also requires disclosures about products and services, geographic areas and major customers. The adoption of SFAS No. 131 did not affect results of operations or the financial position of the Company but did affect the disclosure of segment information.

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

The Company manages its business primarily on a geographic basis. The Company’s geographic areas are comprised of three main groups: the Americas; Europe, Middle East and Africa (“EMEA”); and Asia Pacific/ Japan (“APJ”). Each geographic area provides products and services as further described in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company evaluates the performance of its geographic areas based on profit or loss from operations. Profit or loss for each geographic area includes sales and marketing expenses and other charges directly attributable to the area and excludes certain expenses that are managed outside the geographic area. Costs excluded from area profit or loss primarily consist of unallocated corporate expenses, comprised of product development costs, corporate marketing costs and other general and administrative expenses, which are separately managed. The Company’s long-lived assets include property and equipment, restricted investments, goodwill, loans to certain key employees, purchased technology, and deposits on its leased facilities. Long-lived assets are attributed to geographic areas based on the country where the assets are located. As of March 31, 2003 and December 31, 2002, long-lived assets of about $35.2 million and $35.9 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.

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In North America, the Company sells its products through a direct sales organization. Outside North America, direct sales, applications engineering and customer support are conducted through the Company’s operations in EMEA and APJ. Revenues are attributed to geographic areas based on the country where the customer is domiciled. Summary information by geography for the quarters ended March 31, 2003 and 2002 is as follows (in thousands):

Products sold to Enel S.p.A., an Italian utility company (“Enel”), and its designated manufacturers accounted for $22.3 million, or 68.4% of total revenues for the quarter ended March 31, 2003 and $17.6 million, or 63.7% for the same period in 2002. During the quarter ended March 31, 2003, 80.0% of the revenues shipped under the Enel program were shipped to customers in EMEA and the remaining 20.0% to customers in APJ. 37.5% of the revenues shipped under the Enel program during the first quarter of 2002 were shipped to customers in EMEA, and the remaining 62.5% to customers in APJ.

EBV Electronik GmbH (“EBV”), the sole independent distributor of the Company’s products in Europe, accounted for 8.2% of total revenues for the quarter ended March 31, 2003 and 10.9% for the same period in 2002.

6.    Income Taxes:

The provision for income taxes for the quarters ended March 31, 2003 and 2002 includes a provision for Federal, state and foreign taxes based on the annual estimated effective tax rate applied to the Company and its subsidiaries for the year. The difference between the statutory rate and the Company’s effective tax rate is primarily due to the impact of foreign taxes and the utilization of net operating losses not previously benefited.

7.    Related Party:

In June 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 quarters ended March 31, 2003 and 2002, the Company recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $22.3 million and $17.6 million, respectively, all of which is included in Accounts Receivable at the respective balance sheet dates.

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8.    Stock Repurchase Program:

In September 2001, the Company’s board of directors approved a stock repurchase program. During the quarter ended March 31, 2003, no shares were repurchased under the program. As of March 31, 2003, 1,735,000 shares are available to repurchase. Since inception of the repurchase plan, the Company has repurchased a total of 265,000 shares of its common stock at a cost of $3.2 million.

9.    Subsequent Events:

On April 11, 2003, the Company acquired certain assets from privately held Metering Technology Corporation (“MTC”) of Scotts Valley, California. The purchase price of $11.0 million will be allocated to the acquired assets, predominately in-process research and development (“IPR&D”) and other intangible assets based on the relative fair value of the assets acquired. The assets acquired do not constitute a business as defined in SFAS No. 141, Business Combinations. As such, no goodwill will result from this transaction. The following is a preliminary allocation of the purchase price (in thousands):

Of the acquired intangible assets of $10,765,000, approximately $9,808,000 will be assigned to IPR&D and will be expensed immediately upon the completion of the acquisition. The remaining $957,000 will be assigned to purchased technology and will be amortized over its estimated useful life of 1 year.

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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 unaudited condensed consolidated financial statements and notes thereto, included elsewhere in this Quarterly Report, as well as management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2002.

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

Based in San Jose, California, Echelon was incorporated in California in February 1988, and reincorporated in Delaware in January 1989. We develop, market and support a wide array of products and services based on our LONWORKS technology that enable OEMs and systems integrators to design and implement open, interoperable, distributed control networks. We offer these hardware and software products to OEMs and systems integrators in the building, industrial, transportation, utility/home and other automation markets. We also provide a variety of technical training courses related to our products and the underlying technology. Our customers also rely on us to provide customer support on a per-incident or annual contract basis.

Critical Accounting Policies

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

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

Estimating Sales Returns and Allowances.    We sell our products and services to OEM’s, 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 certain rights of return. Sales to EBV, our largest distributor, accounted for 8.2% of total net revenues for the quarter ended March 31, 2003, and 10.9% of total net revenues for the same period in 2002. Worldwide sales to distributors, including those to EBV, accounted for approximately 9.8% of total net revenues for the quarter ended March 31, 2003, and 15.8% of total net revenues for the same period in 2002.

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

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

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product, and forecasted sales volumes for some of EBV’s larger customers. Significant management judgments and estimates must be made and used in connection with establishing these distributor related sales returns and other allowances in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates.

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

Allowance for Doubtful Accounts.    We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us, we record a specific allowance against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, customer credit-worthiness, changes in our customers’ payment patterns and our historical experience. If the financial condition of our customers were to deteriorate or if economic conditions worsened, additional allowances may be required in the future. Our allowance for doubtful accounts was $585,000 as of March 31, 2003 and $570,000 as of December 31, 2002.

Inventory Valuation.    At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analyses of sales levels by product and projections of future demand. Inventories on hand, in excess of forecasted demand, generally one year or less, are not valued. In addition, we write off inventories that are considered obsolete. Remaining inventory balances are adjusted to approximate the lower of our standard manufacturing cost or market value. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made. Our reserve for excess and obsolete inventory was approximately $1.7 million as of March 31, 2003 and $1.6 million as of December 31, 2002.

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

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

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

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 $8.5 million as of March 31, 2003.

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We adopted SFAS 142 on January 1, 2002, and, as a result, ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. The balance of goodwill as of March 31, 2003 was $7.9 million. We review goodwill for impairment annually during the quarter ending March 31. If, as a result of our annual or other impairment reviews that we perform from time to time 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, which could have a material adverse impact on our financial position and/or operating results.

Results of Operations

Net Revenues

        Net revenues grew to $32.6 million in the first quarter of 2003 from $27.6 million in the same quarter of 2002. The $5.1 million, or 18.3% increase in total revenues between the two quarters was primarily the result of an increase in product revenues, particularly products sold under the Enel program. Products sold to Enel and its designated manufacturers accounted for 68.4% of total revenues for the quarter ended March 31, 2003 and 63.7% for the same period in 2002. If the Enel program achieves its targeted volumes for 2003, we expect that total revenues attributable to the project will account for more than 60% of our total revenue for the year. If, after 2003, the program continues to move forward under Enel’s current roll-out plan, we believe that revenue attributable to the project will continue to account for a material portion of our overall revenues during 2004. Once the Enel project is completed, or if it is cancelled prior to its completion, we could experience a significant drop in our overall revenues, which would have a material negative impact on our financial position. Given our significant dependence on one customer at this time, we continue to seek opportunities to expand our customer base. During 2002, we formed a new sales and marketing organization that has been tasked with identifying other utility customers for our products. However, we can give no assurance that their efforts will be successful.

EBV, the sole independent distributor of our products in Europe, accounted for 8.2% of total revenues for the quarter ended March 31, 2003, and 10.9% for the same period in 2002. Our contract with EBV expires in December

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2003. If we are unable to renew our agreement with EBV at that time, or do not otherwise establish an alternative for the distribution of our products in Europe, our revenues could decrease and our financial position and results of operations could be harmed.

Product revenues grew to $32.4 million in the first quarter of 2003 from $27.2 million in the first quarter of 2002. The $5.2 million, or 19.0% increase in product revenues between the two quarters was primarily the result of a $4.8 million increase in sales of products under the Enel program. The remaining $400,000 increase in product sales between the two quarters was attributable to increased sales of our i.LON^™ and network services products, offset by decreases in all other product categories. Although we are optimistic that new products we released in late 2002 and early 2003 will provide new revenue opportunities for us during 2003 and beyond, we cannot assure you that these new opportunities will be sufficient to overcome the effects that the continuing worldwide economic slowdown and the current geopolitical concerns in the Middle East and Asia are having on our product sales. In fact, if these conditions continue for a prolonged period of time, some of our customers could be forced out of business permanently, which could have a material negative impact on our revenues and results of operations.

Service revenues decreased to $245,000 in the first quarter of 2003 from $359,000 in the same quarter of 2002. The $114,000, or 31.8% decrease in service revenues between the two quarters was primarily the result of a decrease in customer support and training revenues. We believe that the ongoing worldwide economic downturn has forced many of our customers to curtail spending for training and support. We do not expect our service revenues to improve so long as these economic conditions continue.

Cost of Revenues

Cost of product.    Cost of product revenues consists of costs associated with the purchase of components and subassemblies, as well as allocated labor, overhead and manufacturing variance costs associated with the packaging, preparation and shipment of products. Cost of product revenues in the first quarter of 2003 was $15.4 million compared to $12.8 million for the same period in 2002, representing product gross margins of 52.4% for the first quarter of 2003 and 52.9% for the same period in 2002. The $2.6 million increase in cost of product revenues between the two quarters was primarily the result of increased shipments under the Enel program, and to a lesser extent, changes in the mix of other products sold and overhead spending rates.

Cost of service.    Cost of service revenues consists of employee-related costs as well as direct costs incurred in providing training and customer support services. Cost of service revenues increased to $686,000 for the first quarter of 2003 from $671,000 for the comparative period in 2002, an increase of 2.2%, representing service gross margins of (180.0)% for the first quarter of 2003 and (86.9)% for the same period in 2002. The decline in service gross margins between the two quarters was primarily due to reduced service revenues.

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Operating Expenses

Product development.    Product development expenses consist primarily of payroll and related expenses for development personnel, expensed material, and facility costs associated with the development of new technologies and products. Product development expenses for the first quarter of 2003 decreased to $5.1 million from $5.6 million in the same quarter of 2002, representing 15.6% of total revenues for the first quarter of 2003 and 20.4% of total revenues for the same period in 2002. The $525,000 reduction in product development expenses between the two quarters was primarily the result of a one-time charge of $400,000 related to in-process research and development related to the acquisition of BeAtHome.com, Inc., which we expensed during the quarter ended March 31, 2002.

Sales and marketing.    Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales personnel, travel and entertainment, advertising and product promotion and facilities costs associated with our sales and support offices. Sales and marketing expenses for the first quarter of 2003 increased to $4.7 million from $4.3 million in the same quarter of 2002, representing 14.3% of total revenues for the first quarter of 2003 and 15.5% of total revenues for the same period in 2002. This increase in sales and marketing expenses between the two quarters was primarily the result of increased personnel costs, increased commissions, and increased legal and other third party costs incurred in connection with our sales and marketing activities.

General and administrative.    General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, insurance, professional fees and other general corporate expenses. General and administrative expenses in the first quarter of 2003 increased to $2.9 million from $2.3 million in the same quarter of 2002, representing 9.0% of total revenues for the first quarter of 2003 and 8.2% of total revenues for the same period in 2002. The $684,000 increase in general and administrative expenses between the two quarters was primarily the result of increases in legal and accounting fees, payroll related expenses, general business insurance, and the provision for bad debts.

Interest and other income, net

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Interest and other income, net primarily reflects interest we earned on our cash and short-term investment balances. Interest and other income, net for the first quarter of 2003 decreased to $741,000 from $1.0 million for the comparable period in 2002. This decrease was primarily due to the lower average rates of return on our invested cash balances.

Provision for income taxes

The provision for income taxes for the quarter ended March 31, 2003 includes a provision for Federal, state and foreign taxes based on our annual estimated effective tax rate for the year. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes and the beneficial impact of deferred taxes resulting from the utilization of net operating losses. Income taxes for the quarter ended March 31, 2003 primarily consist of taxes related to profitable foreign subsidiaries and federal and state minimum taxes. Income taxes were $367,000 for the first quarter of 2003 and $234,000 for the same period in 2002.

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. From inception through March 31, 2003, we raised $269.8 million from the sale of preferred stock and common stock.

As of March 31, 2003, we had cash, cash equivalents and short-term investments of $139.0 million. Net cash provided by operating activities was $4.4 million for the quarter ended March 31, 2003 compared to $20,000 during the same period of 2002. Cash provided by operating activities in the first quarter of 2003 was principally the result of the net profit, decreases in inventories and other current assets, and an increase in accounts payable, partially offset by an increase in accounts receivable and a decrease in deferred revenues. Cash used for operating activities in 2002 was principally the result of the net profit, partially offset by increases in accounts receivable, other current assets, and inventories, and a decrease in accounts payable.

Net cash used in investing activities for the quarter ended March 31, 2003 of $14.0 million was principally due to the purchase of available-for-sale short-term investments and capital expenditures, partially offset by proceeds from sales and maturities of available for sale short-term investments and a reduction in other long-term assets. For the three months ended March 31, 2002, net cash used for investing activities of $452,000 was principally due to the purchase of available-for-sale short-term investments, the net cash paid of $5.8 million for BeAtHome, and capital expenditures of $478,000, partially offset by proceeds from sales and maturities of available for sale short-term investments.

Net cash provided by financing activities of $477,000 during the first quarter of 2003 and $830,000 for the same period in 2002 was principally due to the proceeds from the exercise of stock options by employees.

We believe that our existing available cash, cash equivalents and short-term investments will satisfy our projected working capital and other cash requirements for at least the next twelve months. However, in the unlikely event that we would require additional financing within this period, such financing may not be available to us in the amounts or at the times that we require, or on acceptable terms. If we fail to obtain additional financing, when and if necessary, our business would be harmed.

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Equity Based Compensation

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

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

Distribution and Dilutive Effect of Options

The following table illustrates the grant dilution and exercise dilution: