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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
--------------
FORM 10-Q
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(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________
000-29748
(Commission file number)
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ECHELON CORPORATION
(Exact name of registrant as specified in its charter)
--------------
Delaware 77-0203595
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
415 Oakmead Parkway
Sunnyvale, CA 94086
(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 |_|
As of July 31, 2001, 38,732,542 shares of the Registrant's common stock
were outstanding.
================================================================================
ECHELON CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2001
INDEX
Page
---------
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2001 and
December 31, 2000....................................................................... 3
Condensed Consolidated Statements of Operations for the three months and six months
ended June 30, 2001 and June 30, 2000................................................... 4
Condensed Consolidated Statements of Cash Flows for the six months ended
June 30, 2001 and June 30, 2000......................................................... 5
Notes to Condensed Consolidated Financial Statements...................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations.............................................................................. 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................ 14
Part II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................................... 24
Item 2. Changes in Securities and Use of Proceeds................................................. 24
Item 3. Defaults upon Senior Securities........................................................... 24
Item 4. Submission of Matters to a Vote of Security Holders....................................... 24
Item 5. Other Information......................................................................... 24
Item 6. Exhibits and Reports on Form 8-K.......................................................... 24
SIGNATURE.................................................................................................. 24
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 1, Business, including "General," "Industry
Background," "Our Solution," "Strategy," "Markets, Applications and Customers,"
"Products and Services" and "Product Development," in Item 2, "Properties," in
Item 7, 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.
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
June 30, December 31,
2001 2000
------------ -------------
(unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents..................................................... $ 70,709 $ 117,664
Short-term investments........................................................ 68,891 33,129
Accounts receivable, net...................................................... 10,494 9,548
Inventories................................................................... 11,243 5,745
Other current assets.......................................................... 5,570 5,203
------------ ------------
Total current assets...................................................... 166,907 171,289
------------ ------------
Property and equipment, net................................................... 5,151 3,085
Other long-term assets........................................................ 6,172 1,302
------------ ------------
$ 178,230 $ 175,676
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.............................................................. $ 5,488 $ 4,200
Accrued liabilities........................................................... 2,172 1,606
Deferred revenues............................................................. 596 1,106
------------ ------------
Total current liabilities................................................. 8,256 6,912
------------ ------------
LONG-TERM LIABILITIES:
Deferred rent ................................................................ 8 3
------------ ------------
Total long-term liabilities .............................................. 8 3
------------ ------------
STOCKHOLDERS' EQUITY:
Common stock.................................................................. 386 380
Additional paid-in capital.................................................... 264,361 263,248
Accumulated other comprehensive loss.......................................... (396) (330)
Deferred compensation......................................................... (123) (215)
Accumulated deficit........................................................... (94,262) (94,322)
------------ ------------
Total stockholders' equity................................................ 169,966 168,761
------------ ------------
$ 178,230 $ 175,676
============ ============
The accompanying notes are an integral part of these
condensed consolidated financial statements.
3
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
2001 2000 2001 2000
---------- ---------- ---------- ----------
REVENUES:
Product................................................... $ 13,247 $ 12,100 $ 25,359 $ 23,040
Service................................................... 670 551 1,146 1,054
---------- ---------- ---------- ----------
Total revenues........................................ 13,917 12,651 26,505 24,094
---------- ---------- ---------- ----------
COST OF REVENUES:
Cost of product........................................... 5,600 4,371 9,853 8,655
Cost of service........................................... 686 548 1,223 1,030
---------- ---------- ---------- ----------
Total cost of revenues................................ 6,286 4,919 11,076 9,685
---------- ---------- ---------- ----------
Gross profit.......................................... 7,631 7,732 15,429 14,409
---------- ---------- ---------- ----------
OPERATING EXPENSES:
Product development....................................... 4,064 2,912 7,888 5,275
Sales and marketing....................................... 3,848 4,162 7,739 8,240
General and administrative................................ 1,487 1,460 3,801 2,629
---------- ---------- ---------- ----------
Total operating expenses.............................. 9,399 8,534 19,428 16,144
---------- ---------- ---------- ----------
Loss from operations.................................. (1,768) (802) (3,999) (1,735)
Interest and other income, net............................ 1,807 330 4,061 652
---------- ---------- ---------- ----------
Income/(loss) before provision for income taxes....... 39 (472) 62 (1,083)
PROVISION FOR INCOME TAXES.................................... 1 36 2 76
---------- ---------- ---------- ----------
Net income/(loss)......................................... $ 38 $ (508) $ 60 $ (1,159)
========== ========== ========== ==========
Net income/(loss) per share:
Basic................................................. $ 0.00 $ (0.01) $ 0.00 $ (0.03)
========== ========== ========== ==========
Diluted............................................... $ 0.00 $ (0.01) $ 0.00 $ (0.03)
========== ========== ========== ==========
Shares used in computing net income/(loss) per share:
Basic................................................. 38,482 34,507 38,315 34,079
========== ========== ========== ==========
Diluted............................................... 41,458 34,507 41,154 34,079
========== ========== ========== ==========
The accompanying notes are an integral part of these
condensed consolidated financial statements.
4
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Six Months Ended
June 30,
----------------------
2001 2000
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income/(loss).................................................................. $ 60 $ (1,159)
Adjustments to reconcile net income/(loss) to net cash used in operating activities:
Depreciation and amortization................................................... 942 561
Provision for doubtful accounts................................................. 130 ---
Deferred compensation expense................................................... 92 92
Change in operating assets and liabilities:
Accounts receivable........................................................... (1,076) (923)
Inventories................................................................... (5,498) (2,904)
Other current assets.......................................................... (367) (1,190)
Accounts payable.............................................................. 1,288 932
Accrued liabilities........................................................... 566 589
Deferred revenues............................................................. (510) (378)
Deferred rent................................................................. 5 ---
---------- ----------
Net cash used in operating activities...................................... (4,368) (4,380)
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments.............................. (38,715) (509)
Proceeds from maturities and sales of available-for-sale short-term investments.... 2,953 9,815
Unrealized gains on securities..................................................... 375 7
Change in other long-term assets................................................... (5,104) (765)
Capital expenditures............................................................... (2,775) (770)
---------- ----------
Net cash provided by (used in) investing activities........................ (43,266) 7,778
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock............................................. 1,119 4,141
EFFECT OF EXCHANGE RATE CHANGES ON CASH................................................ (440) (50)
---------- ----------
NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS................................... (46,955) 7,489
CASH AND CASH EQUIVALENTS:
Beginning of period................................................................ 117,664 9,336
---------- ----------
End of period...................................................................... $ 70,709 $ 16,825
========== ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes......................................................... $ 53 $ 48
========== ==========
The accompanying notes are an integral part of these
condensed consolidated financial statements.
5
ECHELON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation:
The condensed consolidated financial statements include the accounts of
Echelon Corporation (the "Company"), a Delaware corporation, and its wholly
owned subsidiaries. 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 Echelon
Corporation consolidated financial statements for the year ended December 31,
2000 included in its 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 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 9.2%
of total revenues for the quarter ended June 30, 2001 and 12.2% for the same
period in 2000, and 10.3% of total revenues for the six months ended June 30,
2001 and 10.3% for the same period in 2000. 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, 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. The Company
provides limited post-contract customer support (PCS), consisting primarily of
technical support and "bug" fixes. 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. Revenue for the software license
element is recognized at the time of delivery of the application product to the
end-user. 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
if evidence of the fair value of all undelivered elements exists. If an
undelivered element of the arrangement exists under the license arrangement,
revenue is deferred based on vendor-specific objective evidence of the fair
value of the undelivered element. If vendor-specific objective evidence of fair
value does not exist for all undelivered elements, all revenue is deferred until
sufficient evidence exists or all elements have been delivered. Revenue for the
PCS element, the total amount of which is determined from the stand-alone price
of providing this service, is recognized over the service period. The costs of
providing these services are expensed when incurred. Estimated reserves for
warranty costs as well as reserves for sales returns and allowances related to
anticipated return of products sold to distributors with limited rights of
return, which are not material to the consolidated financial statements, are
recorded at the time of shipment. The Company generally has not had any
significant post-delivery obligations associated with the sale of its products.
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 software has been accepted by the
customer.
6
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 June 30, 2001, the Company's
available-for-sale securities had contractual maturities from three to
twenty-four months and an average maturity of nine months. The fair value of
available-for-sale securities was determined based on quoted market prices at
the reporting date for those instruments. As of June 30, 2001, the amortized
cost basis, aggregate fair value and gross unrealized holding losses by major
security type were as follows (in thousands):
Unrealized
Amortized Aggregate Holding
Cost Fair Value Gains
---------- ---------- ----------
U.S. government securities..................................... $ 7,121 $ 7,126 $ 5
U.S. corporate securities:
Corporate notes and bonds................................... 61,375 61,765 390
---------- ---------- ----------
Total investments in debt and equity securities................ $ 68,496 $ 68,891 $ 395
========== ========== ==========
Computation of Net Income/(Loss) Per Share
Net income/(loss) 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/(loss)
per share is calculated by dividing net income/(loss) by the weighted average
shares of common stock outstanding during the period. Diluted net income/(loss)
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 and six
months ended June 30, 2001 (in thousands):
Three Six
Months Months
Ended Ended
June 30, June 30,
2001 2001
----------- ----------
Net income/(loss) (Numerator):
Net income/(loss), basic & diluted........................ $ 38 $ 60
========== =========
Shares (Denominator):
Weighted average common shares outstanding................ 38,539 38,372
Weighted average common shares outstanding
subject to repurchase................................. (57) (57)
---------- ---------
Shares used in basic computation.......................... 38,482 38,315
Weighted average common shares outstanding
subject to repurchase................................. 57 57
Common shares issuable upon exercise of stock
options (treasury stock method)....................... 2,668 2,536
Common shares issuable upon exercise of
warrants (treasury stock method)...................... 258 255
Average unamortized deferred compensation................. (7) (9)
---------- ---------
Shares used in diluted computation........................ 41,458 41,154
========== =========
Net income/(loss) per share:
Basic..................................................... $ 0.00 $ 0.00
========== =========
Diluted................................................... $ 0.00 $ 0.00
========== =========
For the three months and six months ended June 30, 2001, stock options in
the amount of 1,998,882 and 1,945,277, respectively, were not included in the
computation of diluted earnings per share because the options' exercise price
was greater than the average market price of the common shares and therefore,
the effect would be anti-dilutive.
7
For the three months and six months ended June 30, 2000, no diluted net
loss per share calculation was performed as the inclusion of potentially
dilutive stock options and warrants of 4,554,526 and 4,842,434, respectively,
would be anti-dilutive.
New Accounting Standards
In July 2001, the Financial Accounting Standards Board issued Statement No.
141 (SFAS 141), "Business Combinations", and Statement No. 142 (SFAS 142),
"Goodwill and Other Intangible Assets". SFAS 141 and 142 will change the
accounting for business combinations and goodwill. SFAS 141 requires that the
purchase method of accounting be used for all business combinations initiated
after June 30, 2001. Use of the pooling-of-interest method will be prohibited.
SFAS 142 changes the accounting for goodwill from an amortization method to an
impairment-only approach, which will be adopted by the Company effective January
1, 2002. The Company is currently reviewing and assessing the impact SFAS 141
and 142 will have on its financial statements.
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):
June 30, December 31,
2001 2000
------------- -------------
(unaudited)
Purchased materials.................................................. $ 4,235 $ 3,599
Work-in-process...................................................... 10 10
Finished goods....................................................... 6,998 2,136
------------- -------------
$ 11,243 $ 5,745
============= =============
4. Accrued Liabilities:
Accrued liabilities consist of the following (in thousands):
June 30, December 31,
2001 2000
------------- -------------
(unaudited)
Accrued payroll and related costs.................................... $ 1,433 $ 1,171
Accrued marketing costs.............................................. 386 367
Other accrued liabilities............................................ 353 68
------------- -------------
$ 2,172 $ 1,606
============= =============
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 and the Vice Presidents. 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 in one principal industry segment: the design,
manufacture and sale of products for the controls network industry, and markets
its products primarily to the building automation, industrial automation,
transportation, and utility/home automation markets. The Company's products are
marketed under the LONWORKS(R) 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(R) 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.
8
The Company manages its business primarily on a geographic basis. The
Company's geographic areas are comprised of the Americas, Europe, Middle East
and Africa ("EMEA") and Asia Pacific/ Japan ("APJ"). Each geographic area
provides products and services as further described in Note 1. The Company
evaluates the performance of its geographic areas based on profit or loss from
operations. Profit or loss for each geographic area includes sales and marketing
expenses and other charges directly attributable to the area and excludes
certain expenses that are managed outside the geographic area. Costs excluded
from area profit or loss primarily consist of unallocated corporate expenses,
comprised of product development costs, corporate marketing costs and other
general and administrative expenses, which are separately managed. The Company
has no long-lived assets, other than property and equipment, goodwill, and loans
to certain key employees. Long-lived assets are attributed to geographic areas
based on the country where the assets are located. As of June 30, 2001 and
December 31, 2000, long-lived assets of about $8.3 million and $4.1 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 the information is not reviewed by the Executive Staff to make
decisions about resources to be allocated to the geographic areas based on their
performance.
In North America, the Company sells its products through a direct sales
organization. Outside the United States, direct sales, applications engineering
and customer support are conducted through the Company's operations in Europe,
Japan and China. Revenues are attributed to geographic areas based on the
country where the customer is domiciled. Summary information by geography for
the quarters and six months ended June 30, 2001 and 2000 is as follows (in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
2001 2000 2001 2000
----------- ---------- ---------- ----------
Revenues from customers:
Americas................................. $ 4,599 $ 3,776 $ 8,696 $ 7,875
EMEA..................................... 7,017 6,344 13,407 11,482
APJ...................................... 2,301 2,324 4,394 4,324
Unallocated.............................. 0 207 8 413
--------- --------- --------- ---------
Total................................ $ 13,917 $ 12,651 $ 26,505 $ 24,094
========= ========= ========= =========
Gross profit:
Americas................................. $ 2,960 $ 2,352 $ 5,653 $ 4,737
EMEA..................................... 3,168 3,711 6,912 6,633
APJ...................................... 1,503 1,462 2,856 2,626
Unallocated.............................. 0 207 8 413
--------- --------- --------- ---------
Total................................ $ 7,631 $ 7,732 $ 15,429 $ 14,409
========= ========= ========= =========
Loss from operations:
Americas................................. $ 2,008 $ 1,271 $ 3,729 $ 2,618
EMEA..................................... 2,454 2,880 5,440 4,877
APJ...................................... 595 516 1,032 741
Unallocated.............................. (6,825) (5,469) (14,200) (9,971)
--------- --------- --------- ---------
Total................................ $ (1,768) $ (802) $ (3,999) $ (1,735)
========= ========= ========= =========
One customer, the sole independent distributor of the Company's products
in Europe, accounted for 21.1% of total revenues for the quarter ended June 30,
2001 and 27.5% for the same period in 2000, and 25.4% of total revenues for the
six months ended June 30, 2001 and 27.4% for the same period in 2000.
6. Income Taxes:
The provision for income taxes for the three months and six months ended
June 30, 2001 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 beneficial impact of deferred taxes resulting from the utilization of net
operating losses. Income taxes for the three months and six months ended June
30, 2000 primarily consist of taxes related to profitable foreign subsidiaries
and various state minimum taxes.
9
7. Related Party:
In June 2000, the Company entered into a stock purchase agreement with ENEL
S.p.A., an Italian utility company ("ENEL"). At the same time, the Company also
entered into a research and development agreement with an affiliate of ENEL.
Under the terms of the R&D agreement, the Company will cooperate with ENEL to
integrate LONWORKS technology into ENEL's remote metering management project in
Italy. For the quarter and six months ended June 30, 2001, the Company has
recognized approximately $2.6 million and $2.8 million respectively, of revenue
related to the R&D agreement, $2.6 million of which is included in Accounts
Receivable at June 30, 2001.
8. Acquisition:
On February 7, 2001, the Company acquired all of the outstanding capital
stock of ARIGO Software GmbH ("ARIGO"), a Beckum, Germany based developer of
LONWORKS hardware and software products. The Company paid cash for the
acquisition and has accounted for it using the purchase method of accounting.
Accordingly, results of operations for ARIGO have been included with those of
the Company since the date of acquisition.
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following management's discussion and analysis of financial condition
and results of operations should be read in conjunction with management's
discussion and analysis of financial condition and results of operations
included in our Form 10-K for the year ended December 31, 2000.
Overview
We develop, market and support a family of hardware and software products
and services that enables original equipment manufacturers, or OEMs, and systems
integrators to design and implement open, interoperable, distributed control
networks. We offer our products and services to OEMs and systems integrators in
the building, industrial, transportation, utility/home and other automation
markets. We provide a variety of technical training courses related to our
products and underlying technology. To assist customers in trouble-shooting
application issues, we provide customer support on a per-incident or annual
contract basis. We also provide custom software development services to our
customers.
We market our products and services in North America, Europe, Japan, South
America and selected Asia-Pacific countries through a direct sales organization
augmented with the use of third-party distributors and systems integrators.
International sales, which include both export sales and sales by international
subsidiaries, accounted for 66.9% of our total revenues for the second quarter
of 2001 and 68.5% for the same period in 2000, and 67.2% of total revenues for
the six months ended June 30, 2001 and 65.6% for the same period in 2000. The
percentage of our revenues denominated in currencies other than the U.S. dollar,
principally the Japanese yen, was 8.9% for the second quarter of 2001 and 10.1%
for the same period in 2000, and 7.9% of total revenues for the six months ended
June 30, 2001 and 10.2% for the same period in 2000. However, this percentage
may increase over time as we respond to market requirements to sell our
products and services in local currencies, such as the Euro. As a result, our
operations and the market price of our products may be directly affected by
economic and political conditions in the countries where we do business. We
expect that international sales will continue to constitute a significant
portion of total revenues.
We derive our revenues primarily from the sale and licensing of our
products and, to a lesser extent, from fees associated with training and
technical support offered to our customers. Our product revenues consist of
revenues from sales of transceivers, control modules, routers, network interface
devices and development tools and from licenses of network services software
products. Revenues from software licensing arrangements accounted for 9.2% of
total revenues for the quarter ended June 30, 2001 and 12.2% for the same period
in 2000, and 10.3% of total revenues for the six months ended June 30, 2001 and
10.3% for the same period in 2000. Our service revenues consist of product
support (including software post-contract support services), training, and
custom software development services. We recognize 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, these criteria
are generally met at the time of shipment to the customer. For software sales,
these criteria are generally met upon shipment to the final end-user. 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 if evidence of
the fair value of all undelivered elements exists. If an undelivered element of
the arrangement exists under the license arrangement, revenue is deferred based
on vendor-specific objective evidence of the fair value of the undelivered
element. If vendor-specific objective evidence of fair value does not exist for
all undelivered elements, all revenue is deferred until sufficient evidence
exists or all elements have been delivered. We record estimated reserves for
warranty costs as well as for sales returns and allowances related to
anticipated return of products sold to distributors with limited rights of
return, at the time we sell the products. We generally have not had any
significant post-delivery obligations associated with the sale of our products.
We recognize service revenues as we perform the services, or ratably over the
term of the support period. In the case of custom software development services,
revenue is recognized when the software has been accepted by the customer.
Although we generated a profit of $38,000 in the second quarter of 2001,
and for the fourth consecutive quarter, we have incurred net losses in all other
periods since our inception. We may not be able to sustain this profitability on
a quarterly or annual basis. We plan to continue to invest heavily in product
development to implement open control networks. Our development projects include
the development of hardware and software products to support ENEL's program,
development of transceivers, control modules, routers, network interface
devices, network management software, development tools, and the i.LON(TM) 1000
Internet Server. Furthermore,
11
because our strategy depends significantly on achieving broad adoption of our
LONWORKS technology across many industries worldwide, we plan to continue to
invest heavily in selling and marketing to promote our products. We currently
believe it is unlikely that our future rate of growth of product development,
sales and marketing expenses will fall below their historical levels. As a
result, we will need to significantly increase revenues over historical levels
to sustain profitability in the future. Although our revenues have grown
sequentially year over year, we cannot be certain that this growth will continue
at the same rate, or that our revenues will not decline on a year over year
basis.
Our quarterly and annual results have varied significantly, and we expect
our results to continue to vary. Many of the factors that can cause our results
to vary are outside of our control. For example, our project with ENEL may not
meet target dates, or could be cancelled altogether. In addition, the rates at
which OEMs purchase our products and services can fluctuate. These rates are
affected by the OEMs' own business cycles. Another factor is whether we can
introduce new products in a timely manner. From time to time, we have delayed
introducing new products beyond our projected shipping date. These delays have
increased costs and postponed revenues. Because our future revenues depend on
our ability to timely introduce new product offerings, any future delays could
harm our business. Our expense levels are based substantially on the levels of
future revenues that we expect to generate. Consequently, if our revenues are
less than we expect, our expense levels could be disproportionately high as a
percentage of total revenues, and our operating results could be harmed. In the
past, we have sometimes failed to meet our expected targets for revenues. In
addition, declines in sales of our existing products over time have hurt the
growth of our revenues.
Results of Operations
Revenues
Total. Total revenues grew to $13.9 million in the second quarter of 2001
from $12.7 million in the second quarter of 2000. Total revenues for the six
months ended June 30, 2001 grew to $26.5 million from $24.1 million in the same
period in 2000. The 10.0% increase in total revenues between the two quarters
and 10.0% increase between the two six months periods was primarily the result
of an increase in product revenues. One customer, EBV, the sole independent
distributor of our products in Europe, accounted for 21.1% of total revenues for
the second quarter of 2001 and 27.5% of total revenues for the same period in
2000, and 25.4% of total revenues for the six months ended June 30, 2001 and
27.4% of total revenues for the same period in 2000.
Product. Product revenues grew to $13.2 million in the second quarter of
2001 from $12.1 million in the second quarter of 2000. Product revenues for the
six months ended June 30, 2001 grew to $25.4 million from $23.0 million for the
same period in 2000. The 9.5% increase in product revenues between the two
quarters was primarily the result of an increase in sales of control and
connectivity products and i.LON products, partially offset by slight decreases
in LonPoint(R) products, development tools, and network services products. The
10.1% increase in product revenues between the two six month periods was
primarily the result of an increase in sales of control and connectivity
products, partially offset by slight decreases in LonPoint and network
services products.
Service. Service revenues grew to $670,000 in the second quarter of 2001
from $551,000 in the second quarter of 2000. Service revenues grew slightly to
$1.2 million for the six months ended June 30, 2001 from $1.1 million in the
second quarter of 2000. The 21.6% increase in service revenues between the two
quarters was primarily the result of an increase in custom software development
revenues, partially offset by a slight decrease in training revenues. The 8.7%
increase in service revenues between the two six month periods was primarily the
result of increases in custom software development and customer support revenues
offset by a reduction in training revenues.
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 second
quarter of 2001 was $5.6 million compared to $4.4 million for the same period in
2000, representing product gross margins of 57.7% for the second quarter of 2001
and 63.9% for the same period in 2000. Cost of product revenues for the six
months ended June 30, 2001 increased to $9.9 million from $8.7 million in the
same period of 2000 representing product gross margin of 61.1% for the six
months ended June 30, 2001 and 62.4% for the same period in 2000. The decline in
product gross margin percentage for the two quarters was primarily the result of
shipping our first quantity volumes of product
12
under the ENEL program, and, to a lesser extent, changes in the mix of other
products sold and fluctuations in overhead spending rates. The change in product
gross margin percentage for the two six month periods was primarily due to
fluctuations in overhead spending rates as well as the mix of products sold
during the two periods, particularly those products shipped under the terms of
our agreement with ENEL.
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 second
quarter of 2001 from $548,000 for the comparative period in 2000, an increase of
25.2%, representing service gross margins of (2.4%) for the second quarter of
2001 and 0.5% for the same period in 2000. Cost of service revenues for the six
months ended June 30, 2001 increased to $1.2 million from $1.0 million, an
increase of 18.7%, representing service gross margins of (6.7)% for the six
months ended June 30, 2001 and 2.3% for the same period in 2000. The decline in
service gross margins for both the quarter and six months was primarily due to
increased personnel costs.
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 second quarter of 2001 grew to $4.1 million
from $2.9 million in the second quarter of 2000, representing 29.2% of total
revenues for the second quarter of 2001 and 23.0% of total revenues for the same
period in 2000. Product development expenses for the six months ended June 30,
2001 increased to $7.9 million from $5.3 million in the same period of 2000,
representing 29.8% of total revenues for the six months ended June 30, 2001 and
21.9% of total revenues for the same period in 2000. This increase in product
development expenses for both the quarter and six months was primarily the
result of increased personnel and consultant costs, increased expensed material
and depreciation costs, and expenses related to the operation of Arigo Software
GmbH which we acquired in February 2001.
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 second quarter of 2001 decreased
to $3.8 million from $4.2 million in the second quarter of 2000, representing
27.6% of total revenues for the second quarter of 2001 and 32.9% of total
revenues for the same period in 2000. Sales and marketing expenses for the six
months ended June 30, 2001 decreased to $7.7 million from $8.2 million in the
same period of 2000, representing 29.2% of total revenues for the six months
ended June 30, 2001 and 34.2% of total revenues for the same period in 2000.
This decrease in sales and marketing expenses for both the quarter and six
months was the result of decreased worldwide personnel and advertising costs
partially offset by increased travel expenses.
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 second quarter of
2001 increased to $1.49 million from $1.46 million in the second quarter of
2000, representing 10.7% of total revenues for the second quarter of 2001 and
11.5% of total revenues for the same period in 2000. General and administrative
expenses for the six months ended June 30, 2001 increased to $3.8 million from
$2.6 million in the same period in 2000, representing 14.3% of total revenues
for the six months ended June 30, 2001 and 10.9% of total revenues for the same
period in 2000. This increase in general and administrative expenses for the six
months was primarily the result of legal fees and the $475,000 settlement charge
related to the Calabrese patent infringement lawsuit, and to a lesser extent, an
increase in our provision for bad debts.
Interest and other income, net
Interest and other income, net primarily reflects interest earned by our
company on cash and short-term investment balances. Interest and other income,
net for the second quarter of 2001 increased to $1.8 million from $330,000 for
the comparable period in 2000. Interest and other income, net for the six months
ended June 30, 2001 increased to $4.1 million from $652,000 for the same period
in 2000. This increase was primarily due to the higher average balance of
invested cash during the comparative periods in 2001.
13
Provision for income taxes
The provision for income taxes for the quarter and six months ended June
30, 2001 includes a provision for Federal, state and foreign taxes based on our
annual estimated effective tax rate for the year. The difference between the
statutory rate and our effective tax rate is primarily due to the impact of
foreign taxes and the beneficial impact of deferred taxes resulting from the
utilization of net operating losses. Income taxes for the quarter and six months
ended June 30, 2000 primarily consist of taxes related to profitable foreign
subsidiaries and various state minimum taxes. Income taxes were $1,000 for the
second quarter of 2001 and $36,000 for the same period in 2000. Income taxes
were $2,000 for the six months ended June 30, 2001 and $76,000 for the same
period in 2000.
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 June 30, 2001, we raised $264.7 million from the
sale of preferred stock and common stock.
As of June 30, 2001, we had cash, cash equivalents and short-term
investments of $139.6 million. Net cash used in operating activities was $4.4
million for the six months ended June 30, 2001 compared to $4.4 million during
the same period of 2000. Cash used in 2001 was principally the result of a
planned increase in inventories, increases in accounts receivable and other
current assets, and a decrease in our deferred revenues, partially offset by
increases in accounts payable and accrued liabilities. Cash used in 2000 was
principally the result of a planned increase in inventories, increases in other
current assets and accounts receivable, and the net loss.
Net cash used for investing activities for the six months ended June 30,
2001 of $43.3 million was principally due to the purchase of available-for-sale
short-term investments, a $5.1 million increase in other long-term assets, and
by capital expenditures of $2.8 million. For the six months ended June 30, 2000,
net cash provided by investing activities of $7.8 million was principally due to
the net proceeds from maturities and sales of available-for-sale investments,
slightly offset by capital expenditures of $770,000 and an increase in other
long-term assets of $765,000.
Net cash provided by financing activities of $1.1 million for the six
months ended June 30, 2001 and $4.1 million for the six months ended June 30,
2000 was principally due to the proceeds received 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.
New Accounting Standards
In July 2001, the Financial Accounting Standards Board issued Statement
No. 141 (SFAS 141), "Business Combinations", and Statement No. 142 (SFAS 142),
"Goodwill and Other Intangible Assets". SFAS 141 and 142 will change the
accounting for business combinations and goodwill. SFAS 141 requires that the
purchase method of accounting be used for all business combinations initiated
after June 30, 2001. Use of the pooling-of-interest method will be prohibited.
SFAS 142 changes the accounting for goodwill from an amortization method to an
impairment-only approach, which will be adopted by the Company effective January
1, 2002. The Company is currently reviewing and assessing the impact SFAS 141
and 142 will have on its financial statements.
Item 3. Quantitative and Qualitative Disclosures about Market Risks
There has not been any material change in our exposure to interest rate
and foreign currency risks since the date of our Form 10-K for the year ended
December 31, 2000.
Interest Rate Risk. Our exposure to market risk for changes in interest
rates relates primarily to our investment portfolio. All our investments are in
high-credit quality issuances, and, by our company policy, are limited in the
14
amount of credit exposure to any one issuer. We ensure the safety and
preservation of the invested principal funds by investing only in marketable
securities with active secondary or resale markets to maintain portfolio
liquidity. The table below presents principal amounts and related weighted
average interest rates for our investment portfolio at June 30, 2001. According
to our policy, all investments mature in two years or less.
Carrying Average
Amount Interest Rate
------------- -------------
(in thousands)
Cash Equivalents:
U.S. corporate securities....................................... $ 68,918 3.89%
------------- -------------
Total cash equivalents...................................... $ 68,918 3.89%
------------- -------------
Short-term Investments:
U.S. corporate securities....................................... $ 61,765 5.44%
U.S. government securities...................................... 7,126 4.16%
------------- -------------
Total short-term investments................................ $ 68,891 5.33%
------------- -------------
Total investment securities................................. $ 137,809 4.61%
============= =============
Foreign Currency Exchange Risk. We transact business in various foreign
countries. Our primary foreign currency cash flows are in Japan. Currently, we
do not employ a foreign currency hedge program utilizing foreign currency
exchange contracts as the foreign currency transactions and risks to date have
not been significant.
Factors That May Affect Future Results of Operations
Interested persons should carefully consider the risks described below in
evaluating Echelon. Additional risks and uncertainties not presently known to us
or that we currently consider immaterial may also impair our business
operations. If any of the following risks actually occur, our business,
financial condition or results of operations could be materially adversely
affected. In that case, the trading price of our common stock could decline.
Our future results could be significantly harmed if our project with ENEL is not
successful.
We have entered into a research and development agreement with an
affiliate of ENEL S.p.A., an Italian utility company, under which we will
cooperate with ENEL to integrate our LONWORKS system into ENEL's remote metering
management project in Italy. This project is called "Contratore Elettronico." We
face a number of risks as we undertake this project, including:
. our research and development activities under this project might be
unsuccessful, or might not be commercially exploitable;
. the Contratore Elettronico project might not meet target dates;
. the products we develop for the Contratore Elettronico project might
not yield economic returns; or
. the research and development agreement might be terminated if, among
other things, either party materially breaches its obligations under
the agreement; or
. third parties may contest part or all of the agreement.
If our efforts under this research and development agreement or the
related Contratore Elettronico project are not successful, our revenues and
income could suffer.
We have a history of losses, and we may incur losses in the future.
Although we generated a profit of $38,000 in the second quarter of 2001,
and for the fourth consecutive quarter, we have incurred net losses in all other
periods since our inception. As of June 30, 2001, we had an accumulated deficit
of $94.3 million. We have invested and continue to invest significant financial
resources in product development, marketing and sales. If our revenues do not
increase significantly as a result of these expenditures, we may not be able to
sustain profitability. There is also no guarantee that our profitability will
continue or increase on a quarterly or annual basis. Our future operating
results will depend on many factors, including:
. the growth of the markets for our products, especially utility/home
automation products;
. the acceptance of our products;
. the level of competition that we face;
15
. our ability to develop and market new products; and
. general economic conditions.
As of December 31, 2000, we had net operating loss carryforwards for
Federal income tax reporting purposes of about $101.1 million and for state
income tax reporting purposes of about $11.1 million, which expire at various
dates through 2020. In addition, as of December 31, 2000, we had tax credit
carryforwards of about $5.6 million, which expire at various dates through 2020.
The Internal Revenue Code of 1986, as amended, contains provisions that may
limit the use in any future period of net operating loss and credit
carryforwards upon the occurrence of certain events, including a significant
change in ownership interests. We have performed an analysis of our ownership
changes and have reported the net operating loss and credit carryforwards
considering such limitations. We had deferred tax assets, including our net
operating loss carryforwards and tax credits, totaling about $44.2 million as of
December 31, 2000. A valuation allowance has been recorded for the entire
deferred tax asset as a result of uncertainties regarding the realization of the
asset balance, our history of losses and the variability of our operating
results.
Our limited history and the undetermined market acceptance of our products make
it difficult to evaluate our future prospects.
We have only a limited operating history on which you can base your
evaluation of our business. We face a number of risks as an emerging company in
a new market, and you must consider our prospects in light of these risks. Our
future operating results are difficult to predict due to many factors, including
the following:
. our targeted markets have not yet accepted many of our products and
technologies;
. the nature of our business and markets requires rapid progress;
. potential changes in voluntary product standards can significantly
influence many of the markets for our products; and
. our industry is very competitive.
Fluctuations in our operating results may cause our stock price to decline.
Our quarterly and annual results have varied significantly, and we have
failed to meet securities analysts' expectations in the past. Our future results
may fluctuate and may not meet those expectations in some future period. As a
result, the price of our common stock could fluctuate or decline. The factors
that could cause this variability, many of which are outside of our control,
include the following:
. fluctuations in the rates at which OEMs purchase our products and
services;
. OEMs' own business cycles;
. our ability to introduce new products on a timely basis;
. any downturns in any customer's or potential customer's business, or
declines in general economic conditions that cause significant
reductions in their capital spending;
. increased competition;
. market acceptance of our products;
. product life cycles;
. order delays or cancellations;
. changes in the mix of products and services that we sell;
. shipment and payment schedules;
. changes in our pricing policies or those of our competitors;
. changes in product distribution; and
. product ratings by industry analysts and endorsement of competing
products by industry groups.
In addition, our expense levels are based, in significant part, on the
future revenues that we expect. Consequently, if our revenues are less than we
expect, our expense levels could be disproportionately high as a percentage of
total revenues.
16
If our OEMs do not employ our products and technologies, or if we do not
maintain and expand our distribution channels, our revenues could decrease
significantly.
To date, substantially all of our product sales have been to OEMs. The
product and marketing decisions made by OEMs significantly affect the rate at
which our products are used in control networks. We believe that since OEMs in
certain industries receive a large portion of their revenues from sales of
products and services to their installed base, these OEMs have tended to
moderate the rate at which they incorporate LONWORKS technology into their
products. We have attempted to motivate OEMs, as well as systems integrators and
owners of control systems, to transition more rapidly to LONWORKS technology.
Furthermore, OEMs that manufacture and promote products and technologies that
compete or may compete with us may be particularly reluctant to employ our
products and technologies to any significant extent, if at all. We may not be
able to maintain or improve the current rate at which our products are accepted
by OEMs and others, which could decrease our revenues.
Currently, significant portions of our revenues are derived from sales by
EBV, the sole independent distributor of our products to OEMs in Europe. EBV
accounted for 21.1% of total revenues for the quarter ended June 30, 2001 and
27.5% of total revenues for the same period in 2000. EBV accounted for 25.4% of
total revenues for the six months ended June 30, 2001 and 27.4% of total
revenues for the same period in 2000. Our current agreement with EBV expires in
December 2001. In addition, as part of our distribution strategy, we intend to
develop distribution arrangements with systems integrators. In particular, we
expect that a significant portion of our future revenues will be derived from
sales by such systems integrators. If EBV, or any other existing or future
distributor, fails to dedicate sufficient resources and efforts to marketing and
selling our products, our revenues could decrease. If EBV significantly reduces
the stocking levels for our products, both our revenues and customer service
levels would decrease. In that case, we might be required to add our own
pan-European distribution capability to meet the needs of our customers. Our
business will be harmed if we fail to do any of the following:
. develop new distribution channels;
. maintain the EBV arrangement or any other distribution channels; or
. renew the EBV arrangement on a timely basis.
If OEMs fail to develop interoperable products or if our interoperable products
are not accepted by our targeted markets, we may be unable to generate sales of
our products.
Our future operating success will depend, in significant part, on the
successful development of interoperable products by us and OEMs, and the
acceptance of interoperable products by systems integrators and end-users. We
have expended considerable resources to develop, market and sell interoperable
products, and have made such products a cornerstone of our sales and marketing
strategy. We have widely promoted interoperable products as offering benefits
such as lower life-cycle costs and improved flexibility to owners and users of
control networks. However, OEMs that manufacture and market closed systems may
not accept, promote or employ interoperable products, since doing so may expose
their businesses to increased competition. In addition, OEMs might not, in fact,
successfully develop interoperable products, or their interoperable products
might not be accepted by their customers. If OEMs fail to develop interoperable
products, or interoperable products are not accepted by our markets, our
revenues will suffer.
We depend on a limited number of key manufacturers for Neuron Chips and use
contract electronic manufacturers for most of our products requiring assembly.
If any of these manufacturers terminates or decreases its relationships with us,
we may not be able to supply our products and our revenues would suffer.
The Neuron Chip is an important component that our customers use in control
network nodes. In addition, the Neuron Chip is an important device that we use
in many of our products. Neuron Chips are currently manufactured and distributed
by Toshiba, and will be in the future by Cypress Semiconductor. We have entered
into licensing agreements with each of Toshiba and Cypress. The agreements,
among other things, grant Toshiba and Cypress the worldwide right to manufacture
and distribute Neuron Chips using technology licensed from us and require us to
provide support and unspecified updates to the licensed technology over the
terms of the agreements. The Cypress agreement expires in April 2009, and the
Toshiba agreement expires in January 2010. While we developed the first version
of the Neuron Chip, Toshiba subsequently developed improved, lower-cost versions
of the Neuron Chip that are presently used in products that our customers and we
develop and sell. We currently have no other source of supply for Neuron Chips
and have neither the resources nor the skills to replace Toshiba or Cypress as a
manufacturer of Neuron Chips. Both Toshiba and Cypress are expected to play a
key role in the development and
17
marketing of LONWORKS technology. If we lose Toshiba or Cypress as a supplier,
we may not be able to locate an alternate source for the design, manufacture or
distribution of Neuron Chips.
Our future success will also depend significantly on our ability to
successfully manufacture our products cost-effectively and in sufficient
volumes. For most of our products requiring assembly, we use contract electronic
manufacturers, including Able Electronics, Transpower Technologies, Escatec
Electronics, WKK Technology and muRata Electronics. These contract electronic
manufacturers procure material and assemble, test and inspect the final products
to our specifications. This strategy involves certain risks. By using third
parties to manufacture our products, we have reduced control over delivery
schedules, product availability, manufacturing yields, quality and costs. In
addition, contract electronic manufacturers can themselves experience turnover
and instability, exposing us to additional risks as well as missed commitments
to our customers. We will also face risks if and when we transition between
contract electronic manufacturers. For example, we may have to move raw material
and in process inventory between locations in different parts of the world.
Also, we would be required to reestablish acceptable manufacturing processes
with a new work force.
Because we depend on sole or a limited number of suppliers, any shortage or
interruptions of supply would adversely affect our revenues and/or gross
profits.
We currently purchase several key components only from sole or limited
sources. If we experience any shortage of products or components of acceptable
quality, or any interruption in the supply of these products or components, or
if we are not able to procure these products or components from alternate
sources at acceptable prices and within a reasonable period of time, our
revenues and/or gross profits could decrease. In the past, we have sometimes
experienced shortages or supply interruptions of products or components, which
caused us to delay shipments beyond targeted or announced dates.
Our markets are highly competitive. Many of our competitors have longer
operating histories and greater resources than we do. If we are unable to
effectively compete in the industry, our operating results could be harmed.
Competition in our markets is intense and involves rapidly changing
technologies, evolving industry standards, frequent new product introductions
and rapid changes in customer requirements. To maintain and improve our
competitive position, we must continue to develop and introduce, on a timely and
cost-effective basis, new products, features and services that keep pace with
the evolving needs of our customers. The principal competitive factors that
affect the markets for our control network products include the following:
. our customer service and support;
. our product reputation, quality, performance; and
. the price and features of our products such as adaptability,
scalability, the ability to integrate with other products,
functionality, and ease of use.
In each of our markets, we compete with a wide array of manufacturers,
vendors, strategic alliances, systems developers and other businesses. Our
competitors include some of the largest companies in the electronics industry,
such as Siemens in the building and industrial automation industries,
Allen-Bradley (a subsidiary of Rockwell) and Group Schneider in the industrial
automation industry, and Microsoft. Many of our competitors, alone or together
with their trade associations and partners, have significantly greater
financial, technical, marketing, service and other resources, significantly
greater name recognition and broader product offerings. As a result, these
competitors may be able to devote greater resources to the development,
marketing and sale of their products, and may be able to respond more quickly to
changes in customer requirements or product technology. In addition, those
competitors that manufacture and promote closed, proprietary control systems may
enjoy a captive customer base dependent on such competitors for service,
maintenance, upgrades and enhancements. Most recently, Microsoft has announced a
specification that it refers to as SCP (Simple Control Protocol) which is
targeted at the networking of everyday devices. Microsoft has announced its
intention to focus this capability on home networking applications. Products
from emerging companies such as emWare could also compete with our products,
especially in the utility/home market. Even if we believe that the products
offered by some of these companies do not provide the robust and open networking
solutions offered by LONWORKS networks, we would be required to educate our
customers about what we believe are the potential long-term cost and
functionality problems inherent in such alternative solutions. However, our
customers may believe that these alternative products are satisfactory for their
needs.
18
Many of our competitors develop, support and promote closed or proprietary
control systems. If we are unable to promote and expand acceptance of open,
interoperable control systems, our revenues and operating results may be harmed.
Many of our current and prospective competitors are dedicated to promoting
closed or proprietary systems, technologies, software and network protocols or
product standards that differ from, or are incompatible with ours. In some
cases, companies have established associations or cooperative relationships to
enhance the competitiveness and popularity of their products, or to promote
these different or incompatible technologies, protocols and standards. For
example, in the building automation market, we face widespread reluctance by
vendors of traditional closed or proprietary control systems, who enjoy a
captive market for servicing and replacing equipment, to use our interoperable
technologies. We also face strong competition by large trade associations that
promote alternative technologies and standards in their native countries, such
as the BatiBus Club International in France and the European Installation Bus
Association in Germany, each of which has over 100 members and licensees. Other
examples include the CEBus Industry Council, which is the proponent of an
alternative protocol to our LONWORKS protocol for use in the utility/home
automation industry, and a group comprised of Asea Brown Boveri, ADtranz AB,
Siemens, GEC Alstrom and other manufacturers that support an alternative rail
transportation protocol to our LONWORKS protocol. Our technologies, protocols or
standards may not be successful in any of our markets, and we may not be able to
compete with new or enhanced products or standards introduced by existing or
future competitors.
We promote an open technology platform that could increase our competition.
LONWORKS technology is open, meaning that many of our technology patents
are broadly licensed without royalties or license fees. As a result, our
customers are capable of developing products that compete with some of our
products. Because some of our customers are OEMs that develop and market their
own control systems, these customers in particular could develop competing
products based on our open technology. This could decrease the market for our
products and increase the competition that we face.
The trading price of our stock has been volatile, and may fluctuate due to
factors beyond our control.
The trading price of our common stock is subject to significant
fluctuations in response to numerous factors, including:
. our quarterly operating results may vary widely;
. our customers or we may announce technological innovations or new
products;
. securities analysts may change their estimates of our financial results;
and
. significant stockholders may sell some or all of their holdings of our
stock.
In addition, the market price of securities of technology companies,
especially those in new or emerging industries such as ours, has been very
volatile in the past. This volatility has often been unrelated or
disproportionate to the operating performance of particular companies. In the
future, our operating results may fall below analysts' expectations, which could
adversely affect the market price of our stock.
In the future, we may be the target of securities class action lawsuits or other
litigation, which could be costly and time consuming to defend.
In the past, following a period of volatility in the market price of a
company's securities, securities class action lawsuits have often been
instituted against such companies. We may in the future be the target of similar
litigation. If such a lawsuit were brought against us, regardless of its
outcome, we would incur substantial costs and our management resources would be
diverted in defending such litigation.
Our executive officers and technical personnel are critical to our business, and
if we lose or fail to attract our key personnel, we may not be able to
successfully operate our business.
Our performance depends substantially on the performance of our executive
officers and key employees. We are dependent in particular on our Chief
Executive Officer, as well as our technical personnel, due to the specialized
technical nature of our business. Our future success will depend on our ability
to attract, integrate, motivate and retain qualified technical, sales,
operations and managerial personnel. Competition for qualified personnel in our
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business areas is intense, and we may not be able to continue to attract and
retain qualified executive officers and key personnel necessary to enable our
business to succeed. Our product development and marketing functions are largely
based in Silicon Valley, a highly competitive marketplace. It is particularly
difficult to recruit, relocate and retain qualified personnel in this geographic
area. In addition, if we lose the services of any of our key personnel and are
not able to find replacements in a timely manner, our business could be
disrupted, other key personnel may decide to leave, and we may incur increased
operating expenses in finding and compensating a replacement.
The market for our products is new and rapidly evolving. If we are not able to
develop or enhance products to respond to changing market conditions, our
revenues will suffer.
Customer requirements for control network products can change as a result
of innovations or changes within the building, industrial, transportation,
utility/home and other industries. For example, new or different standards
within industry segments may be adopted, giving rise to new customer
requirements. These customer requirements may or may not be compatible with our
current or future product offerings. Our future success depends in large part on
our ability to continue to enhance existing products, lower product cost and
develop new products that maintain technological competitiveness. We may not be
successful in modifying our products and services to address these requirements
and standards. For example, certain of our competitors may develop competing
technologies based on Internet Protocols (IP) that may have advantages over our
products in remote connection. In addition, from time to time, we have delayed
introducing new products beyond our projected shipping date for such products.
In each instance, these delays increased our costs and delayed our revenues.
Voluntary standards that are established in our markets could limit our ability
to sell our products and reduce our revenues.
Standards bodies, which are formal and informal associations that attempt
to set voluntary, non-governmental product standards, are influential in many of
our target markets. Some of our competitors have attempted to use voluntary
standards to reduce the market opportunity for our products, or to increase the
market opportunity for the competitors' products, by lobbying for the adoption
of voluntary standards that would exclude or limit the use of our products. We
participate in many voluntary standards processes both to avoid adoption of
exclusionary standards and to promote voluntary standards for our products.
However, we do not have the resources to participate in all voluntary standards
processes that may affect our markets. The adoption of voluntary standards that
are incompatible with our products or technology could limit the market
opportunity for our products.
As a result of our lengthy sales cycle, we have limited ability to forecast the
amount and timing of specific sales. If we fail to complete or are delayed in
completing transactions, our revenues could vary significantly from period to
period.
The sales cycle between initial customer contact and execution of a
contract or license agreement with a customer can vary widely. OEMs typically
conduct extensive and lengthy product evaluations before making initial
purchases of our products. Subsequent purchases of our products may be delayed
by prolonged product development and introduction periods for OEMs. Attendant
delays in our sales cycle can result from, among other things, changes in
customers' budgets or in the priority assigned to control network development
and the need to educate customers about the potential applications of and cost
savings associated with our products. We generally have little or no control
over these factors, which may cause a potential customer to favor a competitor's
products, or to delay or forgo purchases altogether. Also, there can be long
sales cycles between the selection of our products for use by a systems
integrator, and the purchase of such products by the systems integrator.
Defects in or misuse of our products may delay our ability to generate revenues
and may increase our liabilities and expenses.
The products that we develop, license and sell may contain errors or
failures or may be improperly installed or implemented. Errors or failures may
be found in our products, and we may not be able to successfully correct those
errors or failures in a timely manner or at all. In addition, our products may
not be properly installed or implemented by third parties. In addition, such
errors or failures may delay our revenue recognition and divert our engineering
resources to correct such defects. We maintain errors and omissions insurance to
cover liability associated with our operations but it is possible that such
insurance may not be available or may be insufficient in amount to cover any
particular claim. During 2000, the total limit for claims under these policies
was $17.0 million. We have since then reduced the total limit for errors and
omissions claims to $2.0 million because our insurers requested premiums that
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we believed were excessive. We may face increased exposure to these types of
claims as a result of the decrease in our coverage. Although our agreements with
our customers typically contain provisions intended to limit our exposure to
potential claims as well as any liabilities arising from such claims, and may in
very limited instances require that we be named as an additional insured under
the insurance policies carried by some of our customers, such contracts and
insurance may not effectively protect us against the liabilities and expenses
associated with product errors or failures. Accordingly, errors or failures in
our products or applications or improper installation or implementation of our
products by third parties could harm our operating results. In addition, because
of the low cost and interoperable nature of our products, LONWORKS technology
could be used in a manner for which it was not intended. As a result, our
reputation could be harmed and we might suffer material financial losses.
We have limited ability to protect our intellectual property rights.
Our success depends significantly upon our intellectual property rights. We
rely on a combination of patent, copyright, trademark and trade secret laws,
non-disclosure agreements and other contractual provisions to establish,
maintain and protect our intellectual property rights, all of which afford only
limited protection. We have 77 issued U.S. patents, 15 pending U.S. patent
applications, and various foreign counterparts. It is possible that patents will
not issue from these pending applications or from any future applications or
that, if issued, any claims allowed will not be sufficiently broad to protect
our technology. If any of our patents fail to protect our technology, our
competitors may find it easier to offer equivalent or superior technology. We
have registered or applied for registration for certain trademarks, and will
continue to evaluate the registration of additional trademarks as appropriate.
If we fail to properly register or maintain our trademarks or to otherwise take
all necessary steps to protect our trademarks, the value associated with the
trademarks may diminish. In addition, if we fail to take all necessary steps to
protect our trade secrets or other intellectual property rights, we may not be
able to compete as effectively in our markets.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our products or services or to obtain and use
information that we regard as proprietary. Any of the patents, trademarks,
copyrights or intellectual property rights that have been or may be issued or
granted to us could be challenged, invalidated or circumvented, and any of the
rights granted may not provide protection for our proprietary rights. In
addition, there can be no assurance that we have taken or will take all
necessary steps to protect our intellectual property rights. Third parties may
also independently develop similar technology without breach of our trade
secrets or other proprietary rights. We have licensed in the past and may
license in the future our key technologies to third parties. In addition, the
laws of some foreign countries, including several in which we operate or sell
our products, do not protect proprietary rights to as great an extent as do the
laws of the United States. Certain of our products are licensed under
shrink-wrap license agreements that are not signed by licensees and therefore
may not be binding under the laws of certain jurisdictions.
From time to time, litigation may be necessary to defend and enforce our
proprietary rights. As a result of this litigation, we could incur substantial
costs and divert management resources, which could harm our business, regardless
of the final outcome. Despite our efforts to safeguard and maintain our
proprietary rights both in the United States and abroad, we may be unsuccessful
in doing so. Also, the steps that we take to safeguard and maintain our
proprietary rights may be inadequate to deter infringement, misuse,
misappropriation or independent third-party development of our technology or
intellectual property rights or to prevent an unauthorized third party from
copying or otherwise obtaining and using our products or technology.
Regulatory actions could limit our ability to market and sell our products.
Many of our products and the industries in which they are used are subject
to U.S. and foreign regulation. Government regulatory action could greatly
reduce the market for our products. For example, the power line medium, which is
the communications medium used by some of our products, is subject to special
regulations in North America, Europe and Japan. These regulations limit the
ability of companies in general to use power lines as a communication medium. In
addition, some of our competitors have attempted to use regulatory actions to
reduce the market opportunity for some of our products or to increase the market
opportunity for the competitors' products. In the late 1990's, we experienced
efforts by CEMA, a trade association that developed a competing home automation
protocol, to persuade the FCC to mandate use of its protocol in analog
television and set-top box applications. We were a petitioner in litigation
arising from a related FCC proceeding concerning commercial availability of
these "navigation devices." An appeal under this case was decided in favor of
the government. We decided not to seek Supreme Court review. Although these
specific FCC and judicial proceedings are not a significant threat to our
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digital and Internet-based products, existing or future regulations or
regulatory actions could adversely affect the market for our products or require
us to expend significant management, technical or financial resources.
We face operational and financial risks associated with international
operations.
Our sales and marketing operations are located in nine countries. Revenues
from international sales, which include both export sales and sales by
international subsidiaries, accounted for about 66.9% of our total revenues for
the second quarter of 2001 and 68.5% of our total revenues for the same period
in 2000, and 67.2% of our total revenues for the six months ended June 30,
2001 and 65.6% of our total revenues for the same period in 2000. Our operations
and the market price of our products may be directly affected by economic and
political conditions in the countries where we do business. In addition, we may
not be able to maintain or increase the international demand for our products.
Additional risks inherent in our international business activities generally
include the following:
. currency fluctuations;
. unexpected changes in regulatory requirements, tariffs and other trade
barriers;
. costs of localizing products for foreign countries and lack of
acceptance of non-local products in foreign countries;
. longer accounts receivable payment cycles;
. difficulties in managing international operations;
. potentially adverse tax consequences, including restrictions on
repatriation of earnings; and
. the burdens of complying with a wide variety of foreign laws.
Differing vacation and holiday patterns in other countries, particularly in
Europe, may also affect the amount of business that we transact in other
countries in any quarter, the timing of our revenues and our ability to forecast
our projected operating results for such quarter. The portion of our revenues
that were conducted in currencies other than the U.S. dollar, principally the
Japanese yen, was about 8.9% for the second quarter of 2001 and 10.1% for the
same period in 2000, and 7.9% for the six months ended June 30, 2001 and 10.2%
for the same period in 2000. Fluctuations in the value of currencies in which we
conduct our business relative to the U.S. dollar could cause currency
translation adjustments. The use of the Euro as the standard currency in
participating European countries may also impact our ability to transact sales
in U.S. dollars. We have agreed with EBV, our European distributor, that upon
notice from EBV, we will sell our products to EBV in Euros rather than U.S.
dollars. We do not know when or if EBV will give such notice. If fewer of our
sales in Europe are transacted in U.S. dollars, we may experience an increase in
currency translation adjustments, particularly as a result of general economic
conditions in Europe as a whole. We do not currently engage in currency hedging
transactions or otherwise cover our foreign currency exposure.
We rely on a continuous power supply to conduct our operations, and California's
current energy crisis could disrupt our operations and increase our expenses.
California is in the midst of an energy crisis that could disrupt our
operations and increase our expenses. In the event of an acute power shortage,
that is, when power reserves for the state of California fall below certain
critical levels, California has on some occasions implemented, and may in the
future continue to implement, rolling blackouts throughout the state. We
currently do not have backup generators or alternate sources of power in the
event of a blackout, and our current insurance does not provide coverage for any
damages we or our customers may suffer as a result of any interruption in our
power supply. If blackouts interrupt our power supply, we would be temporarily
unable to continue operations at our California facilities. Any such
interruption in our ability to continue operations at our facilities could
damage our reputation, harm our ability to retain existing customers and to
obtain new customers, and could result in lost revenue, any of which could
substantially harm our business and results of operations.
Furthermore, the deregulation of the energy industry instituted in 1996 by
the California government has caused power prices to increase. Under
deregulation, utilities were encouraged to sell their plants, which
traditionally had produced most of California's power, to independent energy
companies that were expected to compete aggressively on price. Instead, due in
part to a shortage of supply, wholesale prices have skyrocketed over the past
year. If wholesale prices continue to increase, the operating expenses
associated with our facilities located in California will likely increase which
would harm our results of operations.
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Our existing stockholders control a significant percentage of our stock, which
will limit other stockholders' ability to influence corporate matters.
As of July 31, 2001, our directors and executive officers, together with
certain entities affiliated with them, beneficially owned 36.7% of our
outstanding stock.
Under the stock purchase agreement with ENEL, which transaction was
completed September 11, 2000, ENEL purchased 3 million newly issued shares of
our common stock and was granted the right to nominate a director to our Board
of Directors. As a condition to the closing of the stock purchase agreement, our
directors and our chief financial officer agreed to enter into a voting
agreement with ENEL in which each of them agreed to vote the shares of our
company's common stock that they beneficially owned or controlled in favor of
ENEL's nominee to our Board of Directors. In addition, under the terms of the
stock purchase agreement, ENEL has agreed to (i) vote (and cause any of its
affiliates that own shares of our common stock to vote) all of its shares in
favor of the slate of director nominees recommended by the Board of Directors,
and (ii) vote (and endeavor to cause any of its affiliates that own shares of
our common stock to vote) a number of shares equal to at least that percentage
of shares voted by all other stockholders for or against any specified matter,
as recommended by the Board of Directors. The specified matters are the election
of accountants, the approval of company options plans, and any proposal by any
of our stockholders (unless the proposal could be prejudicial to ENEL or the
required voting would interfere with ENEL's fiduciary duties to its own
shareholders).
Under the terms of another stock purchase agreement, one other stockholder
that owns less than 0.5% of our outstanding common stock has agreed to vote (i)
all of its shares in favor of the slate of director nominees recommended by the
Board of Directors, and (ii) a number of shares equal to at least that
percentage of shares voted by all other stockholders for or against any given
matter, as recommended by the Board of Directors (except certain matters
relating to certain changes to our charter, liquidations, a sale of our company
or a merger of our company into another entity), as recommended by a majority of
our Board of Directors.
As a result, our directors and executive officers, together with certain
entities affiliated with them, may be able to control substantially all matters
requiring approval by our stockholders, including the election of all directors
and approval of certain other corporate matters.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 2. Changes In Securities
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission Of Matters To A Vote Of Security Holders
The Company held its annual meeting of stockholders on June 11, 2001 (the
"Annual Meeting"). At such meeting, the following directors were elected:
Richard M. Moley, Arthur Rock and M. Francesco Tato. Our incumbent directors, M.
Kenneth Oshman, Robert J. Finocchio, Robert R. Maxfield, Armas Clifford
Markkula, Jr. and Larry W. Sonsini will continue to serve on the Board. The only
other matter submitted to stockholder vote at the Annual Meeting was the
ratification of the appointment of Arthur Andersen LLP as independent public
accountants of the Company for the fiscal year ending December 31, 2001. Voting
results for the Arthur Andersen LLP appointment were as follows: For:
35,654,218; Against: 20,216; Abstain: 13,147; Broker Non-Votes: 0. Voting
results for the election of the directors were as follows:
Votes For: Votes Withheld:
---------- ---------------
Richard M. Moley.................... 35,613,346 74,235
Arthur Rock......................... 35,612,547 75,034
M. Francesco Tato................... 35,041,801 645,780
Item 5. Other Information
None.
Item 6. Exhibits and Reports On Form 8-K
(a) Exhibits
None.
(b) Reports on Form 8-K
None.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ECHELON CORPORATION
Date: August 14, 2001 By:/s/ Oliver R. Stanfield
-------------------------------------------------
Oliver R. Stanfield,
Vice President Finance and Chief Financial
Officer (Duly Authorized Officer and Principal
Financial and Accounting Officer)
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