SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------------
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________
Commission file number 333-55719
ECHELON CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 77-0203595
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
4015 Miranda Avenue
Palo Alto, CA 94304
(Address of principal executive office and zip code)
(650) 855-7400
(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 [_] NO [X*]
As of July 31, 1998, 32,500,339 shares of the Registrant's common stock were
outstanding.
*Registrant became subject to the filing requirements of the Securities Exchange
Act of 1934, as amended, on July 27, 1998, when its Registration Statement on
Form S-1 became effective.
ECHELON CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 1998
INDEX
Page
--------
Part I. FINANCIAL INFORMATION 2
Item 1. Financial statements
Condensed Consolidated Balance Sheets as of
June 30, 1998 and December 31, 1997 2
Condensed Consolidated Statements of Operations
for the three and six months ended June 30, 1998
and June 30, 1997 3
Condensed Consolidated Statements of Cash Flows
for the six months ended June 30, 1998 and
June 30, 1997 4
Notes to Condensed Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
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 25
Item 4. Submission of Matters to a Vote of Security Holders 25
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8-K 26
SIGNATURE 27
EXHIBIT 27.1 Financial Data Schedule
1
PART I FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
JUNE 30, December 31,
1998 1997
(UNAUDITED)
-------- --------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents......................................... $ 2,960 $ 4,872
Short-term investments............................................ -- 2,981
Accounts receivable, net.......................................... 4,978 3,810
Inventories....................................................... 3,469 2,444
Other current assets.............................................. 1,372 1,196
-------- --------
Total current assets.............................................. 12,779 15,303
PROPERTY AND EQUIPMENT, NET....................................... 1,607 1,513
-------- --------
$ 14,386 $ 16,816
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.................................................. $ 2,292 $ 2,081
Accrued payroll and related expenses.............................. 920 1,081
Accrued liabilities............................................... 1,248 907
Current portion of deferred revenues.............................. 2,286 2,351
-------- --------
Total current liabilities......................................... 6,746 6,420
-------- --------
LONG-TERM LIABILITIES:
Deferred rent, net of current portion............................. 161 246
Deferred revenues, net of current portion......................... 1,013 1,350
-------- --------
Total long-term liabilities....................................... 1,174 1,596
STOCKHOLDERS' EQUITY:
Convertible preferred stock....................................... 79 79
Common stock...................................................... 195 188
Additional paid-in capital........................................ 94,742 93,532
Deferred compensation............................................. (486) --
Cumulative translation adjustment................................. (505) (351)
Accumulated deficit............................................... (87,559) (84,648)
-------- --------
Total stockholders' equity........................................ 6,466 8,800
-------- --------
$ 14,386 $ 16,816
======== ========
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
2
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED SIX MONTHS ENDED
June 30, June 30,
-------------------- ------------------
1998 1997 1998 1997
-------- -------- -------- --------
REVENUES:
Product.................................. $ 7,673 $ 5,944 $14,861 $12,492
Service.................................. 873 1,036 1,644 1,962
------- ------- ------- -------
Total revenues........................... 8,546 6,980 16,505 14,454
------- ------- ------- -------
COST OF REVENUES:
Cost of product.......................... 3,356 2,840 6,605 5,951
Cost of service.......................... 434 445 977 900
------- ------- ------- -------
Total cost of revenues................... 3,790 3,285 7,582 6,851
------- ------- ------- -------
Gross profit............................. 4,756 3,695 8,923 7,603
------- ------- ------- -------
OPERATING EXPENSES:
Product development...................... 1,803 1,724 3,761 3,464
Sales and marketing...................... 3,064 3,140 6,095 6,154
General and administrative............... 1,052 981 1,987 2,079
------- ------- ------- -------
Total operating expenses................. 5,919 5,845 11,843 11,697
------- ------- ------- -------
Loss from operations..................... (1,163) (2,150) (2,920) (4,094)
------- ------- ------- -------
INTEREST AND OTHER INCOME, NET 34 122 109 214
------- ------- ------- -------
Loss before provision for income taxes... (1,129) (2,028) (2,811) (3,880)
Provision for income taxes............... 45 35 100 90
------- ------- ------- -------
Net loss................................. $(1,174) $(2,063) $(2,911) $(3,970)
======= ======= ======= =======
Basic net loss per share................. $ (0.06) $ (0.11) $ (0.15) $ (0.21)
======= ======= ======= =======
Shares used in computing
basic net loss per share................. 19,381 18,540 19,208 18,526
======= ======= ======= =======
Proforma basic net loss
per share................................ $ (0.04) $ (0.08) $ (0.11) $ (0.16)
======= ======= ======= =======
Shares used in computing
proforma basic net loss per share........
27,269 25,457 27,095 24,928
======= ======= ======= =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE SIX MONTHS ENDED JUNE 30,
--------------------------------
1998 1997
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................................................ $(2,911) $(3,970)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization........................................................... 433 356
Deferred compensation expense........................................................... 44 --
Loss on disposal of fixed assets........................................................ 2 --
Change in operating assets and liabilities:
Accounts receivable..................................................................... (1,168) 50
Inventories............................................................................. (1,025) (677)
Other current assets.................................................................... (176) 203
Accounts payable........................................................................ 211 (57)
Accrued liabilities..................................................................... 180 275
Deferred revenues....................................................................... (402) (1,222)
Deferred rent........................................................................... (85) (29)
------- -------
Net cash used in operating activities................................................... (4,897) (5,071)
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of held-to-maturity short-term investments..................................... -- (7,855)
Proceeds from maturities of held-to-maturity short-term investments..................... 2,981 --
Capital expenditures.................................................................... (529) (242)
Proceeds from sale of fixed assets...................................................... -- 28
------- -------
Net cash provided by (used in)
investing activities.................................................................... 2,452 (8,069)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of preferred and common stock.................................... 687 9,993
------- -------
EFFECT OF EXCHANGE RATES ON CASH........................................................ (154) (114)
------- -------
NET DECREASE IN CASH AND CASH EQUIVALENTS............................................... (1,912) (3,261)
CASH AND CASH EQUIVALENTS:
Beginning of period..................................................................... 4,872 8,051
------- -------
End of period........................................................................... $ 2,960 $ 4,790
======= =======
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes.............................................................. $ 64 $ 27
======= =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
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 operation 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,
1997 included in its Form S-1 declared effective on July 27, 1998.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles 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 and
technical support offered to its customers. Product revenues consist of revenues
from hardware sales and software licensing arrangements. Revenues from software
licensing arrangements have not been significant to date. Service revenues
consist of product support (including software post-contract support services)
and training.
Revenue from hardware sales is recognized upon shipment to the
customer. 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 sale. Revenue
from software sales, including sales to distributors, are recognized upon
shipment of the software if there are no significant post-delivery obligations
and if collection is probable. 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.
5
Cash and Cash Equivalents and Short-Term Investments
The Company considers bank deposits, money market investments and U.S.
government securities with an original maturity of three months or less as
cash and cash equivalents. At December 31, 1997, short-term investments consist
of U.S. government securities with original maturities of approximately five
months. These short-term investments are classified as held-to-maturity and
valued using the amortized cost method, which approximated the fair market
value.
Computation of Basic Net Loss Per Share and Pro Forma Basic Net Loss Per
Share
Historical net loss per share has been calculated under Statement of
Financial Accounting Standards (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 loss per share is calculated by
dividing net loss by the weighted average shares of common stock outstanding
during the period. No diluted loss per share information has been presented in
the accompanying consolidated statements of operations since potential common
shares from the conversion of preferred stock, stock options and warrants are
antidilutive. The Company evaluated the requirements of the Securities and
Exchange Commission Staff Accounting Bulletin No. 98 ("SAB 98"), and concluded
that there are no nominal issuances of common stock or potential common stock
which would be required to be shown as outstanding for all periods as outlined
in SAB 98.
Pro forma basic net loss per share has been calculated assuming the
conversion of the outstanding preferred stock into an equivalent number of
shares of common stock, as if the shares had been converted on the dates of
their issuance.
New Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, "Reporting Comprehensive Income", which establishes standards for reporting
and presentation of comprehensive income. SFAS No. 130, which was adopted by the
Company in the first quarter of 1998, requires companies to report a new
measurement of income. "Comprehensive Income (Loss)" is to include foreign
currency translation gains and losses and other unrealized gains and losses that
have historically been excluded from net income (loss) and reflected instead in
equity. The following table reconciles comprehensive net loss under the
provisions of SFAS No. 130 for the six months ended June 30, 1998 and 1997 (in
thousands):
JUN 30, JUN 30,
1998 1997
------- -------
Net loss............................................................... $(2,911) $(3,970)
Foreign currency translation adjustments............................... (154) (114)
------- -------
Comprehensive net loss................................................. $(3,065) $(4,084)
======= =======
6
In June 1997, the Financial Accounting Standards Board issued SFAS No.
131, "Disclosures About Segments of an Enterprise and Related Information",
which establishes standards for disclosure of segment information and which will
be adopted by the Company in the fourth quarter of 1998. The Company anticipates
that SFAS No. 131 will not have a material impact on its financial statements.
In December 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1,
"Software Revenue Recognition". SOP 97-2 is effective for transactions entered
into in the Company's fiscal year beginning January 1, 1998. Management has
assessed this new statement and the adoption in the first quarter of fiscal 1998
did not have a material effect on the Company's financial statements or on the
timing of the Company's revenue recognition, or cause changes to its revenue
recognition policies.
In April 1998, the AICPA issued SOP 98-5 "Reporting the Costs of Start-
up Activities". SOP 98-5 is effective for the Company's fiscal year beginning
January 1, 1999. SOP 98-5 provides guidance on the financial reporting of start-
up costs and organization costs and requires such costs to be expensed as
incurred. Management believes the adoption of SOP 98-5 will not have a material
effect on the Company's 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):
JUN 30, DEC 31,
1998 1997
------- -------
(Unaudited)
Purchased materials.................................................... $2,075 $1,791
Work-in-process........................................................ 406 130
Finished goods......................................................... 988 523
------- -------
$3,469 $2,444
======= =======
4. MAJOR CUSTOMER AND GEOGRAPHIC AREA
One customer, who is also a distributor of the Company's products,
accounted for 21.9% of total revenues for the second quarter of 1998 and 21.3%
of total revenues for the six months ended June 30, 1998, respectively. For the
second quarter of 1997 and the six months ended June 30, 1997, no single
customer accounted for 10% or more of total revenues.
Revenues from export sales (primarily to Europe) accounted for
approximately 48.4% and 47.6% of total revenues for the six months ended June
30, 1998 and June 30, 1997, respectively.
5. SUBSEQUENT EVENTS
On July 31, 1998, the Company consummated an initial public offering of
5,000,000 shares of its Common Stock at a price to the public of $7.00 per
share. The net proceeds to the Company from the offering were approximately
$31.9 million. Concurrent with the closing of the initial public offering,
7,887,381
7
shares of convertible preferred stock were converted into an equivalent number
of shares of common stock. The net proceeds received by the Company upon the
consummation of such offering were invested in short-term, investment-grade,
interest-bearing instruments. See "Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations Liquidity and Capital
Resources".
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and
Results of Operations includes a number of forward-looking statements which
reflect the Company's current views with respect to future events and financial
performance. These forward-looking statements are subject to certain risks and
uncertainties, including those discussed in the "Factors That May Affect Future
Results of Operations" and elsewhere in this Form 10-Q that could cause actual
results to differ materially from historical results or those anticipated. In
this report, the words "anticipates", "believes", "expects", "future",
"intends", and similar expressions identify forward-looking statements. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of the date hereof.
The following management's discussion and analysis of the financial
condition and results of operations should be read in conjunction with the
management's discussion and analysis of the financial condition and results of
operations included in the Company's Form S-1 declared effective on July 27,
1998.
Echelon, LonBuilder, LonMaker, LonPoint, LonTalk, LonUsers, LONWORKS,
Neuron, and NodeBuilder are trademarks, registered trademarks, service marks or
registered service marks of the Company.
OVERVIEW
Echelon Corporation develops, markets and supports a family of hardware
and software products and services that enables original equipment manufacturers
("OEMs") and systems integrators to design and implement open, interoperable,
distributed control networks. The Company offers its products and services to
OEMs and systems integrators in the building, industrial, transportation, home
and other automation markets. The Company provides a variety of technical
training courses related to its products and underlying technology as well as
customer support to its customers on a per incident or annual contract basis.
The Company markets its products and services in North America, Europe,
Japan and selected Asia-Pacific countries through a direct sales organization
augmented with the use of third-party distributors. International sales, which
include both export sales and sales by the Company's international
subsidiaries, accounted for 56.6% and 58.9% of total revenues for the second
quarters of 1998 and 1997, respectively, and 56.4% and 56.7% for the six months
ended June 30, 1998 and 1997, respectively. The Company believes that revenues
from Asian operations may grow more slowly than for other international markets
in part due to the current economic crisis in Asia. Revenues from Asian
operations for the year-to-date are generally consistent with the Company's
lowered expectations but are not expected to have a significant impact on the
Company's liquidity or results of operations. For the six months ended June 30,
1998, 9.4% of the Company's revenues were denominated in currencies other than
the U.S. dollar, principally the Japanese Yen. However, this percentage may
increase over time as the Company responds to market requirements to sell its
8
products and services in local currencies, such as the forthcoming Euro. As a
result, the Company's operations and the market price of its products may be
directly affected by economic and political conditions in the countries where
the Company does business. Additional risks inherent in the Company's
international business activities include currency fluctuations, unexpected
changes in regulatory requirements, tariffs and other trade barriers. The
Company expects that international sales will continue to constitute a
significant portion of total revenues.
The Company derives its revenues primarily from the sale and licensing
of its products and, to a lesser extent, from fees associated with training and
technical support offered to its customers. Product revenues consist of revenues
from sales of transceivers, control modules, routers, network interface devices
and development tools and from licenses for network services software products.
Revenues from software licensing arrangements have not been significant to date.
Service revenues consist of product support (including software post-contract
support services) and training. The Company recognizes revenue from product
sales at the time of shipment to the customer. 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, which have not
been material to the Company's financial results, are recorded at the time of
sale. Revenue from software sales is recognized upon shipment of the software if
there are no significant post-delivery obligations and if collection is
probable. The Company generally has not had any significant post-delivery
obligations associated with the sale of its products. Service revenues are
generally recognized as the services are performed.
The Company has experienced operating losses in all prior fiscal years
and for the six months ended June 30, 1998. During this period, the Company has
made significant investments in product development to implement open control
networks. Such development projects included development of transceivers,
control modules, routers, network interface devices, network management software
and the LonPoint System. Furthermore, because the Company's strategy is
significantly dependent upon achieving broad adoption of its LONWORKS technology
across many industries worldwide, the Company has incurred significant selling
and marketing expense promoting its products. The Company currently believes it
is unlikely that its future rate of growth of product development, sales and
marketing expenses will fall below historical levels. Additionally, the Company
believes that it has priced its products at competitive levels to ensure broad
adoption of LONWORKS technology. The Company continues to invest significantly
in product development, sales and marketing, and to the extent such expenditures
do not result in significant increases in revenues, the Company will continue to
incur operating losses for the foreseeable future and the Company's business,
operating results and financial condition will be materially and adversely
affected.
The Company has experienced, and expects to continue to experience,
significant variability in its quarterly and annual results due to a number of
factors, many of which are outside of the Company's control. The Company
believes that one of the factors in such variability is the fluctuation in the
rates at which OEMs purchase the Company's products and services, which is
impacted by OEMs' own business cycles. Another factor in such variability is
the timely introduction of new products. From time to time, the introduction of
new products by the Company has been delayed beyond the Company's projected
shipping date. In each instance, such delays have resulted in increased costs
and delayed revenues. Because future revenues are dependent on the timely
introduction of new product offerings, any such future delays could have a
material adverse effect on the Company's business, operating results and
9
financial condition. The Company's expense levels are based, in significant
part, on expectations of future revenues. Consequently, if revenue levels are
below expectations, expense levels could be disproportionately high as a
percentage of total revenues, and operating results would be immediately and
adversely affected. The Company has failed to meet its expectations of future
revenues in the past. In addition, the growth of the Company's revenues has been
adversely affected by declines in sales of existing products over time.
Revenues
Total revenues grew to $8.5 million in the second quarter of 1998 from
$7.0 million in the second quarter of 1997. Total revenues for the six months
ended June 30, 1998 grew to $16.5 million from $14.5 million in the same period
of 1997. One customer, EBV Elektronik GmbH ("EBV"), the sole distributor of the
Company's products in Europe since December 1997, accounted for 21.9% and 21.3%
of total revenues for the second quarter of 1998 and the six months ended June
30, 1998, respectively. For both the second quarter of 1997 and for the six
months ended June 30, 1997, no customer accounted for greater than 10% of total
revenues.
Product. Product revenues grew to $7.7 million in the second quarter of
1998 from $5.9 million in the second quarter of 1997. Product revenues for the
six months ended June 30, 1998 grew to $14.9 million from $12.5 million in the
same period of 1997. The 29.1% increase in product revenues between the two
quarters and the 19.0% increase in product revenues between the two six month
periods was primarily a result of increasing sales of control and connectivity
products partially offset by the decrease in sales for the network services and
development tools products.
Service. Service revenues decreased to $873,000 in the second quarter of
1998 from $1.0 million in the second quarter of 1997. Service revenues for the
six months ended June 30, 1998 decreased to $1.6 million from $2.0 million in
the same period of 1997. The 15.7% decrease in service revenues between the two
quarters and the 16.2% decrease in service revenues between the two six month
periods was primarily due to the timing and the number of technical training
courses offered by the Company.
Cost of Revenues
Cost of product. Cost of product revenues consist of costs associated
with the purchase of components and subassemblies, as well as allocated labor,
overhead and manufacturing variances associated with the packaging, preparation
and shipment of products. Cost of product revenues in the second quarter of 1998
increased to $3.4 million from $2.8 million in the same period of 1997 an
increase of 18.2%, representing product gross margins of 56.3% and 52.2%,
respectively. Cost of product revenues for the six months ended June 30, 1998
increased to $6.6 million from $6.0 million in the same period of 1997, an
increase of 11.0%, representing product gross margins of 55.6% and 52.4%,
respectively. The increase in product gross margins for both the quarter and six
month comparisons was primarily due to cost reductions for the Company's higher
volume control and connectivity products.
Cost of service. Cost of service revenues consist of employee-related
costs as well as direct costs incurred in providing training and customer
support services. Cost of service revenues for the second quarter of 1998
decreased slightly to $434,000 from $445,000 in the same period of 1997, a
decrease of 2.5%, representing service gross margins of 50.3% and 57.0%,
respectively. Cost
10
of service revenues for the six months ended June 30, 1998 increased to $977,000
from $900,000 in the same period of 1997, an increase of 8.6%, representing
service gross margins of 40.6% and 54.1%, respectively. The decrease in service
gross margins for both the quarter and six month comparison periods was due
primarily to the decline in service revenues.
Operating Expenses
Product development. Product development expenses consist primarily of
payroll and related expenses, expensed material and facility costs associated
with the development of new technologies and products. Product development
expenses for the second quarter of 1998 increased to $1.8 million
from $1.7 million in the same period of 1997, representing 21.1% and 24.7%,
respectively, of total revenues. Product development expenses for the six months
ended June 30, 1998 increased to $3.8 million from $3.5 million in the same
period of 1997, representing 22.8% and 24.0%, respectively, of total revenues.
The dollar amount increases for both the quarter and six month comparison
periods were primarily the result of increased salaries and other costs related
to the hiring of additional engineering personnel to support the development of
new and existing products.
Sales and marketing. Sales and marketing expenses consist primarily of
payroll and related expenses including commissions to sales personnel, travel
and entertainment, advertising and product promotion and facilities costs
associated with the Company's sales and support offices. Sales and marketing
expenses for the second quarter of 1998 remained flat at $3.1 million from the
same period of 1997, representing 35.9% and 45.0%, respectively, of total
revenues. Sales and marketing expenses for the six months ended June 30, 1998
slightly decreased to $6.1 million from $6.2 million from the same period of
1997, representing 36.9% and 42.6%, respectively, of total revenues. The
decrease in sales and marketing expense as a percentage of total revenues was
due primarily to the larger revenue base in 1998.
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 for the second quarter
of 1998 increased slightly to $1.1 from $1.0 million in the same period in 1997,
representing 12.3% and 14.1%, respectively, of total revenues. General and
administrative expenses for the six months ended June 30, 1998 decreased
slightly to $2.0 from $2.1 million in the same period in 1997, representing
12.0% and 14.4%, respectively, of total revenues.
Interest and other income, net. Interest and other income, net primarily
reflects interest earned by the Company on its cash and short-term investment
balances. Interest and other income, net for the second quarter of 1998
decreased to $34,000 from $122,000 for the comparable period in 1997. Interest
and other income, net for the six months ended June 30, 1998 decreased to
$109,000 from $214,000 for the comparable period in 1997. Both quarter and six
month comparison decreases were primarily due to the lower cash and short-term
investments balances, especially during the second quarter of 1998.
Provision for income taxes. Income taxes consist of income taxes related
to certain of the Company's foreign subsidiaries. Income taxes were $45,000 and
$35,000 for the second quarter of 1998 and 1997, respectively. Income taxes were
$100,000 and $90,000 for the six months ended June 30, 1998 and 1997,
respectively.
11
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations and met its
capital expenditure requirements primarily from the private sale of Preferred
Stock and Common Stock. From inception through June 30, 1998, the Company had
raised $95.0 million from the sale of Preferred Stock and Common Stock.
Net cash used in operating activities was $4.9 million and $5.1 million
for the six months ended June 30, 1998 and 1997. Net cash used in operations is
attributable primarily to the losses from operations in each of the periods. As
of June 30, 1998, inventories have grown $1.0 million since the end of the year
due to the combination of revenue growth, new product introductions, and product
and vendor transitions. Receivables have grown by $1.2 million as of June 30,
1998, primarily due to increased revenues.
Net cash used in investing activities was $8.1 million for the six
months ended June 30, 1997. This amount primarily reflected the purchases of
short-term investments of $7.9 million related to the placement of the equity
raised through the issuance of Preferred Stock in May 1997 and capital
expenditures of $242,000. Net cash provided by investing activities was $2.5
million for the six months ended June 30, 1998. The net cash provided by
investing activities reflected the maturities of short-term investments of $3.0
million partially offset by capital expenditures of $529,000.
Net cash provided by financing activities was $687,000 and $10.0 million
for the six months ended June 30, 1998 and 1997, respectively. Net cash provided
by financing activities consisted primarily of proceeds from private sales of
Preferred Stock and Common Stock and the exercise of employee stock options. At
June 30, 1998, the Company had cash and cash equivalents of $3.0 million. The
Company has a revolving line of credit agreement with a bank, whereby the
Company may borrow up to 85% of eligible accounts receivable, not to exceed $5.0
million. Advances under the credit agreement bear interest at the bank's
reference rate or, at the option of the Company, at a fixed rate of interest
equal to the London interbank offered rate plus 150 basis points. As of June 30,
1998, the amount available to be borrowed thereunder would have been $1.8
million. There was approximately $65,000 outstanding under this line of credit
in the form of a letter of credit. The credit agreement, which expires in May
1999, contains certain negative covenants restricting the Company's ability to
pay dividends or enter into certain financial transactions. The credit agreement
also contains a minimum tangible net worth requirement, determined on a
quarterly basis.
On July 31, 1998, the Company consummated an initial public offering of
5,000,000 shares of its Common Stock at a price to the public of $7.00 per
share. The net proceeds to the Company from the offering were approximately
$31.9 million. Concurrent with the closing of the initial public offering,
7,887,381 shares of convertible preferred stock were converted into an
equivalent number of shares of common stock. The net proceeds received by the
Company upon the consummation of such offering were invested in short-term,
investment-grade, interest-bearing instruments.
The Company believes that its existing available cash, credit facility
and the proceeds from its initial public offering, will satisfy the Company's
projected working capital and other cash requirements for at least the next 24
months. However, there can be no assurance that the Company will not require
additional
12
financing within this period or that any such financing will be available to the
Company in the amounts or at the times required by the Company, or on acceptable
terms, if at all. The failure of the Company to obtain additional financing
could have a material adverse effect on the Company's business, operating
results and financial condition.
New Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, "Reporting Comprehensive Income", which establishes standards for reporting
and presentation of comprehensive income. SFAS No. 130, which was adopted by the
Company in the first quarter of 1998, requires companies to report a new
measurement of income. "Comprehensive Income (Loss)" is to include foreign
currency translation gains and losses and other unrealized gains and losses
that have historically been excluded from net income (loss) and reflected
instead in equity. The following table reconciles comprehensive net loss under
the provisions of SFAS No. 130 for the six months ended June 30, 1998 and 1997
(in thousands):
JUN 30, JUN 30,
1998 1997
-------- --------
Net loss............................................................... $(2,911) $(3,970)
Foreign currency translation adjustments............................... (154) (114)
-------- --------
Comprehensive net loss................................................. $(3,065) $(4,084)
======== ========
In June 1997, the Financial Accounting Standards Board issued SFAS No.
131, "Disclosures About Segments of an Enterprise and Related Information",
which establishes standards for disclosure of segment information and which will
be adopted by the Company in the fourth quarter of 1998. The Company anticipates
that SFAS No. 131 will not have a material impact on its financial statements.
In December 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2 which superseded SOP 91-1,
"Software Revenue Recognition". SOP 97-2 is effective for transactions entered
into in the Company's fiscal year beginning January 1, 1998. Management has
assessed this new statement and the adoption in the first quarter of fiscal
1998 did not have a material effect on the Company's financial statements or
on the timing of the Company's revenue recognition, or cause changes to its
revenue recognition policies.
In April 1998, the AICPA issued SOP 98-5 "Reporting the Costs of Start-
up Activities". SOP 98-5 is effective for the Company's fiscal year beginning
January 1, 1999. SOP 98-5 provides guidance on the financial reporting of start-
up costs and organization costs and requires such costs to be expensed as
incurred. Management believes the adoption of SOP 98-5 will not have a material
effect on the Company's financial statements.
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
The Company's future results of operations are dependent upon a number
of factors, including those described below. For a complete description of such
factors, see the Company's Form S-1 declared effective on July 27, 1998.
13
HISTORY OF LOSSES; ACCUMULATED DEFICIT; ANTICIPATED CONTINUING LOSSES;
UNCERTAINTY OF FUTURE OPERATING RESULTS
The Company has incurred net losses each year since its inception. At
June 30, 1998, the Company had an accumulated deficit of $87.6 million. The
Company has invested and continues to invest significant financial resources in
product development, marketing and sales, and to the extent such expenditures do
not result in significant increases in revenues, the Company's business,
operating results and financial condition will be materially and adversely
affected. Due to the limited history and undetermined market acceptance of many
of the Company's products and technologies, the rapidly evolving nature of the
Company's business and markets, potential changes in voluntary product standards
that significantly influence many of the markets for the Company's products, the
high level of competition in the industries in which the Company operates and
the other factors described elsewhere in this document, there can be no
assurance that the Company's investment in these areas will result in increases
in revenues or that any revenue growth that is achieved can be sustained. Any
revenue growth that the Company has achieved or may achieve may not be
indicative of future operating results. In addition, the Company's history of
losses make future operating results difficult to predict. The Company and its
prospects must be considered in light of the risks, costs and difficulties
frequently encountered by emerging companies. As a result, there can be no
assurance that the Company will be profitable in any future period. Future
operating results will depend on many factors, including the growth of the
markets for the Company's products, the acceptance of the Company's products,
the level of competition, the ability of the Company to develop and market new
products, and general economic conditions. In view of the uncertainties
identified herein, the Company believes that period-to-period comparisons of
financial results are not necessarily meaningful and should not be relied upon
as an indication of future performance. As of December 31, 1997, the Company had
net operating loss carryforwards for Federal and state income tax reporting
purposes of approximately $76.0 million and $5.0 million, respectively, which
expire at various dates through 2012. In addition, as of December 31, 1997, the
Company had tax credit carryforwards of approximately $3.5 million, which expire
at various dates through 2012. 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. The Company had deferred tax assets,
including its net operating loss carryforwards and tax credits, totaling
approximately $33.6 million as of December 31, 1997. A valuation allowance has
been recorded for the entire deferred tax asset as a result of uncertainties
regarding the realization of the asset balance, the history of losses and the
variability of operating results.
FLUCTUATIONS IN OPERATING RESULTS
The Company has experienced, and expects to continue to experience,
significant variability in its quarterly and annual results, as a result of a
number of factors, many of which are outside of the Company's control. The
Company believes that such variability is primarily due to the fluctuations in
the rates at which OEMs purchase the Company's products and services, the OEMs'
own business cycles, the timely introduction of new products, any downturns in
any customer's or potential customer's business, the Company's ability to
anticipate and effectively adapt to developing markets and rapidly changing or
new technologies and distribution channels, increased competition, market
acceptance of the Company's products, product life cycles, order delays or
14
cancellations, changes in the mix of products and services sold by the Company,
shipment and payment schedules, changes in pricing policy by the Company or its
competitors, changes in product distribution, product ratings by industry
analysts and endorsement of competing products by industry groups. Declines in
general economic conditions could also precipitate significant reductions in
capital spending, which could, in turn, affect orders for the Company's
products. The Company's expense levels are based, in significant part, on
expectations of future revenues. Consequently, if revenue levels are below
expectations, expense levels could be disproportionately high as a percentage of
total revenues, and operating results would be immediately and adversely
affected. The Company has failed to meet its expectations of future revenues in
the past. As a result of these and other factors, the Company believes that its
revenues and operating results are difficult to predict and are subject to
fluctuations from period to period, and that period-to-period comparisons of its
results of operations are not meaningful and should not be relied upon as
indications of future performance. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations".
DEPENDENCE ON OEMS AND DISTRIBUTION CHANNELS
To date, substantially all of the Company's sales of its products have
been to OEMs. The rate at which the Company's products are used in control
networks is primarily subject to product and marketing decisions made by OEMs.
The Company believes that since OEMs in certain industries receive a large
portion of their revenues from sales of products and services to their installed
base, such OEMs have tended to moderate the rate at which they incorporate
LONWORKS technology into their products. The Company has attempted to motivate
OEMs, as well as systems integrators and owners of control systems, to effect a
more rapid transition to LONWORKS technology. Furthermore, OEMs that manufacture
and promote products and technologies that compete or may compete with the
Company may be particularly reluctant to employ the Company's products and
technologies to any significant extent, if at all. There can be no assurance
that the Company will be able to improve the current rate of acceptance or usage
of its products by OEMs and others, or that such usage will not decrease over
time. The failure to increase acceptance or usage of the Company's products, or
any decrease in usage of its products, would have a material adverse effect on
the business, operating results and financial condition of the Company.
Currently, a significant portion of the Company's revenues are derived
from sales by EBV, the sole independent distributor of the Company's products to
OEMs in Europe since December 1997. EBV accounted for 21.9% and 21.3% of the
Company's total revenues for the second quarter of 1998 and for the six months
ended June 30, 1998, respectively. The Company's agreement with EBV expires in
November 1998. In addition, as part of its distribution strategy, the Company
intends to develop distribution arrangements with systems integrators. In
particular, the Company expects that a significant portion of its future
revenues will be derived from sales by such systems integrators. Any failure by
EBV or any other existing or future distributor to dedicate sufficient resources
and efforts to the marketing and selling of the Company's products, or to
generate significant revenues for the Company, could have a material adverse
effect on the Company's business, operating results and financial condition.
Also, the failure of the Company to develop new distribution channels, to
maintain the EBV arrangement or any other distribution channels, or to renew the
EBV arrangement on a timely basis, would result in reduced or delayed revenues,
increased operating expenses and loss of customer goodwill, any of which could
have a material adverse effect on the business, operating results and financial
condition of the Company.
15
DEPENDENCE ON KEY MANUFACTURERS
The Neuron Chip is an important component used by the Company's
customers in control network nodes. In addition, the Neuron Chip is an important
device used in many of the Company's products. Neuron Chips are manufactured and
distributed by both Motorola, Inc. ("Motorola") and Toshiba Corporation
("Toshiba"). The Company has entered into licensing agreements with each of
Motorola and Toshiba. The agreements, among other things, grant Motorola and
Toshiba the worldwide right to manufacture and distribute Neuron Chips using
technology licensed from the Company and require the Company to provide support
and unspecified updates to the licensed technology over the terms of the
agreements. The Motorola and Toshiba agreements expire in December 1999 and
January 2000 respectively, unless renewed. However, both Motorola and Toshiba
have the right to terminate the agreements at any time. While the Company
developed the first version of the Neuron Chip, Motorola and Toshiba
subsequently developed improved, lower-cost versions of the Neuron Chip that are
presently utilized in products developed and sold by the Company and its
customers. The Company currently has no other source of supply for Neuron Chips
and has neither the resources nor the skills to replace either Motorola or
Toshiba as a designer, manufacturer or distributor of Neuron Chips. Motorola and
Toshiba have played, and are expected to continue to play, a key role in the
development and marketing of LONWORKS technology. The loss of either Motorola or
Toshiba as a supplier of the Neuron Chip would have a material adverse effect on
the business, operating results and financial condition of the Company, and in
such event there can be no assurance that the Company would be able to locate an
alternate source for the design, manufacture or distribution of Neuron Chips.
The Company's future success will also depend, in significant part, on
its ability to successfully manufacture its products cost-effectively and in
sufficient volumes. For certain key products, the Company utilizes outsourced
manufacturers including GET Manufacturing, Inc., Hi-Tech Manufacturing, Inc.,
muRata Electronics North America, Inc. and Quadrus Manufacturing Division of
Bell Microproducts, Inc. These outsourced manufacturers procure material and
assemble, test and inspect the final products to the Company's specifications.
Such a strategy involves certain risks, including the potential absence of
adequate capacity and reduced control over delivery schedules, product
availability, manufacturing yields, quality and costs. In addition, several key
components are currently purchased only from sole or limited sources. Any
interruption in the supply of these products or components, or the inability of
the Company to procure these products or components from alternate sources at
acceptable prices and within a reasonable time, could have a material adverse
effect upon the Company's business, operating results and financial condition.
COMPETITION
Competition in the Company's 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 its competitive position, the Company 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 its customers. The principal
competitive factors affecting the markets for the Company's control network
products are customer service and support, product reputation, quality,
performance, price and product features such as adaptability, scalability,
ability to integrate with other products, functionality and ease of use. The
Company believes it has in the past generally competed favorably with offerings
of its competitors on the basis of these factors. However,
16
there can be no assurance that the Company will continue to be able to compete
effectively based on these or any other competitive factors in the future.
In each of its markets, the Company competes with a wide array of
manufacturers, vendors, strategic alliances, systems developers and other
businesses. The Company's competitors include some of the largest companies in
the electronics industry, such as Siemens AG ("Siemens") in the building and
industrial automation industries and Allen-Bradley, a subsidiary of Rockwell
International ("Allen-Bradley"), and Groupe Schneider ("Schneider") in the
industrial automation industry. Many of the Company's competitors, alone or
together with their trade associations and partners, have longer operating
histories, significantly greater financial, technical, marketing, service and
other resources, significantly greater name recognition and broader product
offerings. As a result, such 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. Accordingly, there can be
no assurance that the Company will be able to compete successfully with existing
or new competitors, or that competition will not have a material adverse effect
on the business, operating results or financial condition of the Company.
Many of the Company's 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, those
of the Company. In some cases, companies have established associations or
cooperative relationships to enhance the competitiveness and popularity of their
products, or to promote such different or incompatible technologies, protocols
and standards. For example, in the building automation market, the Company faces
widespread reluctance by vendors of traditional closed or proprietary control
systems (who enjoy a captive market for servicing and replacing equipment) to
utilize the Company's interoperable technologies, as well as 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 the Company's LonTalk protocol
for use in the 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 the Company's LonTalk protocol.
There can be no assurance that the Company's technologies, protocols or
standards will be successful in any of its markets, or that the Company will be
able to compete with new or enhanced products or standards introduced by
existing or future competitors. Any increase in competition or failure by the
Company to effectively compete with new or enhanced products or standards could
result in fewer customer orders, price reductions, reduced order size, reduced
operating margins and loss of market share, any of which could have a material
adverse effect on the business, operating results or financial condition of the
Company.
LONWORKS technology is open, meaning that many of the Company's key
technology patents are broadly licensed without royalties or license fees. As a
result, the Company's customers are capable of developing products that compete
with some of the Company's products. Because some of the Company's customers are
OEMs that develop and market their own control systems, these
17
customers in particular could develop competing products based on the Company's
open technology. This could decrease the market for the Company's products,
increase competition, and have a material adverse effect on the Company's
business, operating results and financial condition.
DEPENDENCE ON KEY PERSONNEL
The Company's performance is substantially dependent on the performance
of its executive officers and key employees. The loss of the services of any of
the Company's executive officers or key employees could have a material adverse
effect on the business, operating results and financial condition of the
Company. The Company is particularly dependent upon its Chief Executive Officer,
as well as its technical personnel, due to the specialized technical nature of
the Company's business. The Company's future success will depend on its ability
to attract, integrate, motivate and retain qualified technical, sales,
operations and managerial personnel. There is intense competition for qualified
personnel in the areas of the Company's activities, and there can be no
assurance that the Company will be able to continue to attract and retain
qualified executive officers and key personnel necessary for the development and
success of its business. Currently, only Frederik Bruggink, the Company's Vice
President, Europe, Middle East and Africa, is bound by an employment agreement.
If the Company is unable to hire personnel on a timely basis in the future, the
Company's business, operating results and financial condition will be materially
and adversely affected. In addition, the departure or replacement of key
personnel could be disruptive, lead to additional departures and therefore have
a material adverse effect on the Company's business, operating results and
financial condition. The Company maintains and is the beneficiary of life
insurance policies in the amount of $2.5 million covering each of M. Kenneth
Oshman, its Chief Executive Officer, Beatrice Yormark, its Vice President of
Sales and Marketing, and Oliver R. Stanfield, its Chief Financial Officer. There
can be no assurance that such proceeds would be sufficient to compensate the
Company in the event of the death of Mr. Oshman, Ms. Yormark or Mr. Stanfield.
NEW PRODUCTS AND RAPID TECHNOLOGICAL CHANGE
Customer requirements for control network products can change as a
result of innovations or changes within the building, industrial,
transportation, home and other industries. For example, the adoption of new or
different standards within industry segments may give rise to new customer
requirements, which may or may not be compatible with the Company's current or
future product offerings. The Company's future success depends in large part on
its ability to continue to enhance existing products, lower product cost and
develop new products that maintain technological competitiveness. There can be
no assurance that the Company will be successful in modifying its products and
services to address these requirements and standards. For example, certain of
the Company's competitors may develop competing technologies based on Internet
protocols that may have advantages over the Company's products in remote
connection. If the Company is unable, for technological or other reasons, to
develop new products or enhancements of existing products in a timely manner to
respond to changing market conditions, competitive factors and customer
requirements, the Company's business, operating results and financial condition
would be materially adversely affected.
From time to time, the introduction of new products by the Company has
been delayed beyond the Company's projected shipping date for such products. In
each instance, such delays have resulted in increased costs and delayed
revenues. Because future revenues are dependent on the timely introduction of
18
new product offerings, any such future delays could have a material adverse
effect on the Company's business, operating results and financial condition.
MARKET ACCEPTANCE OF INTEROPERABILITY
The future operating success of the Company will depend, in significant
part, on the successful development of interoperable products by the Company
and OEMs, and the acceptance of interoperable products by systems integrators
and end-users. When products or subsystems from multiple vendors can be
integrated into a control system without the need to develop custom hardware
or software, they are "interoperable". The Company has expended considerable
resources to develop, market and sell interoperable products, and has made
such products a cornerstone of its sales and marketing strategy. The Company
has widely promoted interoperable products as offering benefits such as lower
life-cycle costs and improved flexibility to owners and users of control
networks. However, there can be no assurance that OEMs who manufacture and
market closed systems will accept, promote or employ interoperable products,
since doing so may expose such OEMs' businesses to increased competition. In
addition, there can be no assurance that OEMs will, in fact, successfully
develop interoperable products, or that OEMs' interoperable products will be
accepted by their customers. The failure of OEMs to develop interoperable
products, or the failure of interoperable products to achieve market
acceptance, would have a material adverse effect on the business, operating
results and financial condition of the Company.
INTERNATIONAL OPERATIONS; CURRENCY FLUCTUATIONS
The Company's sales and marketing operations are located in 10
countries. Revenues from international sales, which include both export sales
and sales by international subsidiaries, accounted for approximately 56.6% and
56.4% of the Company's total revenues during the second quarter of 1998 and for
the six months ended June 30, 1998, respectively. The Company's operations and
the market price of its products may be directly affected by economic and
political conditions in the countries where the Company does business. In
addition, there can be no assurance that the Company will be able to maintain or
increase the international demand for its products. Additional risks inherent in
the Company's international business activities generally include currency
fluctuations, unexpected changes in regulatory requirements, tariffs and other
trade barriers, costs of localizing products for foreign countries, 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 transacted by the Company in
other countries in any given quarter, the timing of the Company's revenues and
its ability to forecast its projected operating results for such quarter. For
the six months ended June 30, 1998, approximately 9.4% of the Company's revenues
were conducted in currencies other than the U.S. dollar, principally the
Japanese Yen. Fluctuations in the value of currencies in which the Company
conducts its business relative to the U.S. dollar could cause currency
translation adjustments. The Company has recently experienced and in the future
may experience an increase in currency translation adjustments relative to
currencies of Asia Pacific countries, as well as order delays, cancellations and
pricing pressure in those countries as a result of general economic conditions
in that region. The forthcoming introduction of the "Euro" as the standard
currency in participating European countries may also impact the ability of the
Company to
19
denominate sales transactions in U.S. dollars. To the extent that fewer of the
Company's sales in Europe are denominated in U.S. dollars, the Company may
experience an increase in currency translation adjustments, particularly as a
result of general economic conditions in Europe as a whole. The Company does not
currently engage in currency hedging transactions or otherwise cover its foreign
currency exposure. There can be no assurance that such factors will not have a
material adverse effect on international revenues and, consequently, the
Company's business, operating results and financial condition.
LENGTHY SALES CYCLE
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 the Company's products. Subsequent purchases of the Company's
products may be delayed by prolonged product development and introduction
periods for OEMs. Attendant delays in the Company's sales cycle can result from,
among other things, changes in customers' budgets or in the priority assigned to
control network development and to educating customers as to the potential
applications of and cost savings associated with the Company's products. The
Company generally has 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. As a result of the foregoing, the Company's ability to
forecast the timing and amount of specific sales is limited, and the delay or
failure to complete transactions could have a material adverse effect on the
Company's business, operating results and financial condition and cause the
Company's operating results to vary significantly from period to period.
LIMITED PROTECTION OF INTELLECTUAL PROPERTY RIGHTS
The Company's success depends significantly upon its intellectual
property rights. The Company relies on a combination of patent, copyright,
trademark and trade secret laws, non-disclosure agreements and other contractual
provisions to establish, maintain and protect its intellectual property rights,
all of which afford only limited protection. The Company has 65 issued U.S.
patents, 21 pending U.S. patent applications, and various foreign counterparts.
There can be no assurance that patents will issue from these pending
applications or from any future applications or that, if issued, any claims
allowed will be sufficiently broad to protect the Company's technology. Failure
of any patents to protect the Company's technology, may make it easier for the
Company's competitors to offer equivalent or superior technology. The Company
has registered or applied for registration for certain trademarks, and will
continue to evaluate the registration of additional trademarks as appropriate.
Any failure by the Company to properly register or maintain its trademarks or to
otherwise take all necessary steps to protect its trademarks may diminish the
value associated with the Company's trademarks. In addition, any failure by the
Company to take all necessary steps to protect its trade secrets or other
intellectual property rights may have a material adverse effect on the Company's
ability to compete in its markets. Despite the Company's efforts to protect its
proprietary rights, unauthorized parties may attempt to copy aspects of the
Company's products or services or to obtain and use information that the Company
regards as proprietary. There can be no assurance that any patents, trademarks,
copyrights or intellectual property rights that have been or may be issued or
granted will not be challenged, invalidated or circumvented, or that any rights
granted thereunder would provide protection for the Company's proprietary
rights. In addition, there can be no assurance that the Company has taken or
will take all necessary steps to protect its intellectual property rights. Third
parties may also independently develop similar technology without
20
breach of the Company's trade secrets or other proprietary rights. The Company
has licensed in the past and may license in the future its key technologies to
third parties. In addition, the laws of some foreign countries, including
several in which the Company operates or sells its products, do not protect
proprietary rights to as great an extent as do the laws of the United States.
Certain of the Company's 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 the
Company's proprietary rights. Such litigation could result in substantial
costs and diversion of management resources and could have a material adverse
effect on the Company's business, operating results and financial condition,
regardless of the final outcome. Despite the Company's efforts to safeguard
and maintain its proprietary rights both in the United States and abroad,
there can be no assurance that the Company will be successful in doing so or
that the steps taken by the Company in this regard will be adequate to deter
infringement, misuse, misappropriation or independent third-party development
of the Company's technology or intellectual property rights or to prevent an
unauthorized third party from copying or otherwise obtaining and using the
Company's products or technology. Any of such events could have a material
adverse effect on the Company's business, operating results and financial
condition.
RISKS OF PRODUCT DEFECTS OR MISUSE
Products developed, licensed and sold by the Company may contain errors
or failures or may be improperly installed or implemented. There can be no
assurance that errors or failures will not be found in the Company's products or
that, if discovered, the Company will be able to successfully correct such
errors or failures in a timely manner or at all. In addition, there can be no
assurance that the Company's products will be properly installed or implemented
by third parties. The occurrence of errors or failures in the Company's products
and applications, or improper installation or implementation of the Company's
products, could result in loss of or delay in market acceptance, increased
service and warranty costs or payment of compensatory or other damages. In
addition, such errors or failures may result in delays of revenue recognition by
the Company and diversion of the Company's engineering resources to correct such
defects. The Company maintains errors and omissions insurance to cover liability
associated with its operations but there can be no assurance that any such
insurance will be available or will be sufficient in amount to cover any
particular claim. Although the Company's agreements with its customers typically
contain provisions intended to limit the Company's exposure to potential claims
as well as any liabilities arising from such claims, and may in very limited
instances require that the Company be named as an additional insured under the
insurance policies carried by some of its customers, such contracts and
insurance may not effectively protect the Company against the liabilities and
expenses associated with product errors or failures. Accordingly, errors or
failures in the Company's products or applications or improper installation or
implementation of the Company's products by third parties could have a material
adverse effect on the Company's business, operating results and financial
condition. In addition, because of the low cost and interoperable nature of the
Company's products, LONWORKS technology could be used in a manner for which it
was not intended, which could lead to loss of goodwill or material financial
losses for the Company, or otherwise have a material adverse effect on the
Company's business, operating results and financial condition.
21
REGULATORY ACTIONS
Many of the Company's 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 the Company's products. For example, the power
line medium (the communications medium used by some of the Company's 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 the Company's competitors have
attempted to use regulatory actions to reduce the market opportunity for the
Company's products or to increase the market opportunity for the competitors'
products. For example, the Consumer Electronics Manufacturers Association
("CEMA"), a trade association that developed the CEBus protocol, an alternative
to the Company's LonTalk protocol for use in home automation applications, has
proposed that the Federal Communications Commission ("FCC") adopt a standard for
television-cable compatibility that encompasses CEBus. CEMA has also proposed
the use of such standard with respect to an FCC rulemaking relating to the
commercial availability of navigation devices, such as set-top boxes. The
Company has resisted these efforts and will continue to oppose competitors'
efforts to use regulation to impede competition in the markets for the Company's
products. There can be no assurance that existing or future regulations or
regulatory actions would not adversely affect the market for the Company's
products or require significant expenditures of management, technical or
financial resources, any of which could have a material adverse effect on the
Company's business, operating results and a financial condition.
VOLUNTARY STANDARDS
Standards bodies, which are formal and informal associations that
attempt to set voluntary, non-governmental product standards, are influential in
many of the Company's target markets. Some of the Company's competitors have
attempted to use voluntary standards to reduce the market opportunity for the
Company's 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 the Company's products. The Company participates in many
voluntary standards processes both to avoid adoption of exclusionary standards
and to promote voluntary standards for the Company's products. However, the
Company does not have the resources to participate in all voluntary standards
processes that may affect its markets. The adoption of voluntary standards that
are incompatible with the Company's products or technology could have a material
adverse effect on the Company's business, operating results and financial
condition.
YEAR 2000 COMPLIANCE
Computer programs that are written using two digits rather than four to
define the applicable year, may have date-sensitive software and, for instance,
may recognize a date using 00 as the year 1900 rather than the year 2000 ("Date
Code Dependency"). This could result in a system failure or miscalculations
causing disruptions of operations, including, among other things, a temporary
inability to process transactions, send invoices, or engage in normal business
activities. The Company's enterprise resource planning ("ERP") system does have
Date Code Dependencies. The Company is in the process of replacing its current
ERP system, and believes that this replacement will be completed by June 1999,
before any Date Code Dependencies within the Company's current ERP system have a
material adverse impact upon the Company's operations. The Company has not yet
estimated the cost of such replacement. The Company is currently evaluating the
dependency of its products on date codes and intends to announce a program for
addressing
22
the impact of the year 2000 on any such products in the near future. Failure of
the Company's ERP system or its products to operate properly with regard to the
Year 2000 and thereafter could require the Company to incur unanticipated
expenses to remedy any problems, which could have a material adverse effect on
the Company's business, operating results and financial condition. Date Code
Dependency issues may also arise with respect to any modifications made to the
Company's products by a party other than the Company or from the combination or
use of the Company's products with any other software programs or hardware
devices not provided by the Company, and therefore may result in unforeseen Year
2000 compliance problems for some of the Company's customers, which could result
in reduced customer orders or liability to the Company, and which could have a
material adverse effect on the Company's business, operating results and
financial condition. The Company faces risks to the extent that suppliers of
products, services and systems purchased by the Company have business systems or
products that have a Date Code Dependency. In the event any such third parties
cannot provide the Company with products, services or systems that meet year
2000 requirements in a timely manner, the Company's business operating results
and financial condition could be materially adversely affected. In addition,
some of the Company's customers or vendors could experience Date Code Dependency
problems that could result in disruptions of their internal operations, could
delay their purchases of the Company's products, and, in turn, could result in a
material adverse effect on the Company's business, operating results and
financial condition.
CONTROL BY EXISTING STOCKHOLDERS
As of July 31, 1998, the directors and executive officers of the
Company, together with certain entities affiliated with them, beneficially own
46.4% of the Company's outstanding Common Stock and Motorola, a principal
stockholder of the Company, owns 12.1% of the Company's outstanding Common
Stock. Further, pursuant to the terms of the stock purchase agreement under
which Motorola initially acquired its shares, Motorola and two other
stockholders which together own approximately 6.1% of the Company's outstanding
Common Stock have agreed to vote (i) all of their 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 the Company's
charter, liquidations, a sale of the Company or a merger of the Company into
another entity), as recommended by a majority of the Board of Directors. As a
result, these stockholders would be able to control substantially all matters
requiring approval by the stockholders of their Company, including the election
of all directors and approval of significant corporate transactions.
POSSIBLE VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock is likely to be highly
volatile and could be subject to wide fluctuations in response to quarterly
variations in operating results, announcements of technological innovations or
new products by the Company or its competitors, changes in financial estimates
by securities analysts, or other events or factors. In addition, there has been
significant volatility in the market price of securities of technology companies
(especially those in new or emerging industries, such as the Company), which
volatility is often unrelated to the operating performance of particular
companies. In the future, the Company's operating results could fall below
analysts' expectations, which would adversely affect the market price of the
Company's Common Stock. 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
23
companies. If brought against the Company, regardless of outcome, the costs and
diversion of management resources of defending such litigation could have a
material adverse effect on its business, operating results and financial
condition.
PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
CHANGES IN SECURITIES
The following information relates to all securities of the Company
sold by the Company within the past quarter which were not registered under the
securities laws at the time of grant, issuance and/or sale.
During the period from April 1, 1998 to June 30, 1998, the Company sold
an aggregate of 133,092 shares of unregistered Common Stock to 26 individuals
who were employees of the Company, for an aggregate offering price of $133,219.
These shares were sold pursuant to the exercise of options issued under the
Company's 1988 Stock Option Plan. As to each employee who was issued such
securities, the Company relied upon Rule 701 of the Securities Act. Each such
person purchased securities of the Company pursuant to a written contract
between such person and the Company; in addition, the Company met the conditions
imposed under Rule 701(b).
Appropriate legends were affixed to the share certificates issued in
the transactions described above. All recipients had adequate access, through
their relationships with the Company, to information about the Company.
In January 1998, the Company registered with the Commission pursuant to
a Regulation A Offering Statement options granted under the Company's 1997 Stock
Plan to purchase up to 3,571,428 of the Company's Common Stock and the Common
Stock issuable upon the exercise of such options. During the period from April
1, 1998 to June 30, 1998, the Company sold an aggregate of 100,375 shares of
unregistered Common Stock to 18 individuals who were officers, board members or
employees of the Company for an aggregate offering price of $170,525.
The Company's Registration Statement of Form S-1 (Registration No. 333-
55719) covering certain shares of its Common Stock was declared effective on
July 27, 1998. A total of 5,750,000 shares of Common Stock (including an over-
allotment option for the sale of 750,000 shares) were registered. The Company
consummated an initial public offering of 5,000,000 shares of Common Stock at a
price to the public of $7.00 per share on July 31, 1998. The lead underwriters
in the offering were NationsBanc Montgomery Securities LLC, BancAmerica
Robertson Stephens and Volpe Brown Whelan & Company, LLC. The proceeds received
by the Company, net of underwriting discounts and estimated expenses of the
offering, were approximately $31.9 million. The total underwriting discount was
$2,450,000. Other expenses in connection with the offering are estimated at
$700,000. None of such underwriting discounts and expenses will be paid,
directly or indirectly, to directors, officers or 10% stockholders of the
Company or their affiliates, except that legal fees will be paid to Wilson
Sonsini Goodrich & Rosati, counsel for the Company, of which Larry Sonsini, a
director of the Company, is a member, and a portion of the underwriting
discounts were paid to Volpe Brown Whelan & Company, LLC, in which Arthur Rock,
a director of the
24
Company, has an ownership interest. Concurrent with the closing of the initial
public offering, 7,887,381 shares of convertible preferred stock were converted
into an equivalent number of shares of common stock. The net proceeds of the
offering have been invested in short-term, investment-grade, interest-bearing
accounts. The Company has not utilized any of such net proceeds to date, and
currently has no specific plans for the use thereof, but the Company expects to
use such proceeds for general corporate purposes, including working capital and
capital expenditures.
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 April 16, 1998 (the
"Annual Meeting"). At such meeting, the following directors were elected:
Armas Clifford Markkula, Jr., Robert R. Maxfield, Richard M. Moley, M. Kenneth
Oshman, Arthur Rock and Larry W. Sonsini. In addition to the election of
directors, the following matters were submitted to stockholder vote at the
Annual Meeting:
(a) The amendment of the Company's 1997 Stock Plan (the "1997 Plan") to
increase the number of shares of Common Stock reserved for issuance thereunder
from 5,000,000 to 6,200,000.
Votes For: 21,553,737
Votes Against: 132,062
Votes Abstaining: 501,400
Broker Non-Votes: 0
(b) The ratification of the appointment of Arthur Andersen LLP as
independent public accountants of the Company for the fiscal year ending
December 31, 1998.
Votes For: 22,141,049
Votes Against: 0
Votes Abstaining: 46,150
Broker Non-Votes: 0
By written consent dated June 18, 1998, the following matters were
submitted to stockholder vote:
(a) The amendment and restatement of the Company's Certificate of
Incorporation to (i) increase the authorized number of shares of Common Stock
from 50,000,000 to 100,000,000 shares, (ii) increase the number of shares of
blank check Preferred Stock from 2,570,000 to 5,000,000 shares, (iii) eliminate
stockholder actions by written consent (effective upon the closing of the
Company's Initial Public Offering (the "IPO")) and (iv) eliminate the limit on
the number of directors (effective upon the closing of the IPO).
Votes For: 23,994,774
Votes Against: 0
Votes Abstaining: 0
Broker Non-Votes: 0
25
(b) The amendment and restatement of the Company's Certificate of
Incorporation following the closing of the IPO to reflect the conversion and
extinguishment of the Preferred Stock.
Votes For: 23,994,774
Votes Against: 0
Votes Abstaining: 0
Broker Non-Votes: 0
(c) The approval and adoption of the Company's 1998 Director Stock Option
Plan, effective as of the effective date of the IPO, under which 300,000 shares
of Common Stock are reserved for issuance to non-employee directors of the
Company, plus an annual increase to be added on the first day of the Company's
fiscal year (beginning in 1999) equal to the lesser of (i) 100,000 shares or
(ii) a lesser amount determined by the Board, and the form of Director's Option
Agreement.
Votes For: 23,994,774
Votes Against: 0
Votes Abstaining: 0
Broker Non-Votes: 0
(d) The amendment and restatement of the 1997 Plan to (1) provide for an
automatic annual increase in the number of shares reserved for issuance under
the 1997 Plan each year on the first day of the Company's fiscal year (beginning
in 1999) by a number of shares equal to the lesser of (i) 5,000,000 shares, (ii)
5% of the then outstanding Common Stock or (iii) a lesser amount determined by
the Board; (2) include certain changes related to Section 162(m) of the Internal
Revenue Code of 1986, as amended; (3) provide that not more than ten percent of
the aggregate number of shares which may be optioned and sold under the 1997
Plan may be granted as nonstatutory stock options at less than fair market value
on the date of grant; (4) provide for vesting acceleration in the event of
involuntary termination of employment (or termination of status as a director of
a successor corporation) within twelve months following the assumption or
substitution of options by a successor corporation; and (5) make such other
changes as are appropriate for a public company stock option plan.
Votes For: 23,994,774
Votes Against: 0
Votes Abstaining: 0
Broker Non-Votes: 0
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K
(a) Exhibit
Financial data schedule
(b) Reports on Form 8-K
None.
26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Echelon Corporation
Date: August 10, 1998 By /s/ Oliver R. Stanfield
-----------------------------
Oliver R. Stanfield,
Vice President Finance, and Chief
Financial Officer (Duly Authorized Officer and
Principal Financial and Accounting Officer)
27