UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------------
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1999
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 000-29748
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)
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 [X] NO [_]
As of July 31, 1999, 33,031,979 shares of the Registrant's common stock were
outstanding.
ECHELON CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 1999
INDEX
Page
----
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
June 30, 1999 and December 31, 1998 3
Condensed Consolidated Statements of Operations
for the three and six months ended June 30, 1999
and June 30, 1998 4
Condensed Consolidated Statements of Cash Flows
for the six months ended June 30, 1999 and
June 30, 1998 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Item 3. Qualitative and Quantitative Disclosures About Market Risk 15
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities 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
Exhibit 27.1 Financial Data Schedule (SEC filing only) 25
2
PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, December 31,
1999 1998
-------------- ------------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents........................................ $ 15,609 $ 11,552
Short-term investments........................................... 10,972 17,501
Accounts receivable, net......................................... 6,157 4,559
Inventories...................................................... 2,419 3,364
Other current assets............................................. 1,185 2,170
-------- --------
Total current assets............................................. 36,342 39,146
Property and equipment, net 2,680 2,804
-------- --------
$ 39,022 $ 41,950
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable................................................. $ 1,866 $ 1,787
Accrued liabilities.............................................. 1,786 2,067
Current portion of deferred revenues............................. 1,298 1,559
-------- --------
Total current liabilities........................................ 4,950 5,413
-------- --------
LONG-TERM LIABILITIES:
Deferred rent, net of current portion............................ -- 76
Deferred revenues, net of current portion........................ 338 675
-------- --------
Total long-term liabilities...................................... 338 751
-------- --------
STOCKHOLDERS' EQUITY:
Common stock..................................................... 330 325
Additional paid-in capital....................................... 127,248 126,844
Cumulative translation adjustment................................ (524) (314)
Deferred compensation............................................ (503) (597)
Unrealized holding (loss) gain on available-for-sale securities.. (1) 27
Accumulated deficit.............................................. (92,816) (90,499)
-------- --------
Total stockholders' equity....................................... 33,734 35,786
-------- --------
$ 39,022 $ 41,950
======== ========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share amounts)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
1999 1998 1999 1998
-------- -------- ------- --------
REVENUES:
Product............................. $ 9,191 $ 7,673 $17,364 $14,861
Service............................. 591 873 1,226 1,644
------- ------- ------- -------
Total revenues...................... 9,782 8,546 18,590 16,505
------- ------- ------- -------
COST OF REVENUES:
Cost of product..................... 3,588 3,356 6,913 6,605
Cost of service..................... 399 434 779 977
------- ------- ------- -------
Total cost of revenues.............. 3,987 3,790 7,692 7,582
------- ------- ------- -------
Gross profit........................ 5,795 4,756 10,898 8,923
------- ------- ------- -------
OPERATING EXPENSES:
Product development................. 2,187 1,803 4,627 3,761
Sales and marketing................. 3,593 3,064 7,093 6,095
General and administrative.......... 1,061 1,052 2,100 1,987
------- ------- ------- -------
Total operating expenses............ 6,841 5,919 13,820 11,843
------- ------- ------- -------
Loss from operations................ (1,046) (1,163) (2,922) (2,920)
------- ------- ------- -------
INTEREST AND OTHER INCOME, NET...... 331 34 693 109
------- ------- ------- -------
Loss before provision for income
taxes.............................. (715) (1,129) (2,229) (2,811)
Provision for income taxes.......... 29 45 88 100
------- ------- ------- -------
Net loss............................ $ (744) $(1,174) $(2,317) $(2,911)
======= ======= ======= =======
Basic net loss per share............ $ (0.02) $ (0.06) $ (0.07) $ (0.15)
======= ======= ======= =======
Shares used in computing
basic net loss per share............ 32,826 19,381 32,733 19,208
======= ======= ======= =======
Proforma basic net loss
per share........................... $ (0.04) $ (0.11)
======= =======
Shares used in computing
proforma basic net loss per share... 27,269 27,095
======= =======
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
Six Months Ended June 30,
-------------------------------
1999 1998
---------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss..................................................................... $ (2,317) $(2,911)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization................................................ 498 433
Deferred compensation expense................................................ 94 44
Unrealized losses on securities.............................................. (28) --
Change in operating assets and liabilities:
Accounts receivable.......................................................... (1,598) (1,168)
Inventories.................................................................. 945 (1,025)
Other current assets......................................................... 985 (176)
Accounts payable............................................................. 79 211
Accrued liabilities.......................................................... (281) 180
Deferred revenues............................................................ (598) (402)
Deferred rent................................................................ (76) (85)
-------- -------
Net cash used in operating activities........................................ (2,297) (4,899)
-------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments........................ (29,500) --
Proceeds from maturities of held-to-maturity short-term investments.......... -- 2,981
Proceeds from maturities of available-for-sale short-term investments........ 36,029 --
Capital expenditures......................................................... (374) (527)
-------- -------
Net cash provided by investing activities.................................... 6,155 2,454
-------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock....................................... 409 687
-------- -------
EFFECT OF EXCHANGE RATES ON CASH............................................. (210) (154)
-------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........................ 4,057 (1,912)
Beginning of period.......................................................... 11,552 4,872
-------- -------
End of period................................................................ $ 15,609 $ 2,960
======== =======
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid for income taxes................................................... $ 61 $ 64
======== =======
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,
1998 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 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. Revenues 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 services are performed, or ratably over the term of the
support period.
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."
6
As of June 30, 1999, the Company's available-for-sale securities had contractual
maturities from nine to twenty-three months and an average maturity of ten
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, 1999, the amortized cost basis, aggregate fair value and gross unrealized
holding gains and losses by major security type were as follows (in thousands):
Unrealized
Holding
Amortized Aggregate Gains/
Cost Fair Value (Losses)
--------- ----------- -----------
U.S. corporate securities:
Certificates of deposit $ 1,009 $ 1,013 $ 4
Corporate notes and bonds 8,961 8,953 (8)
------- ------- ---
9,970 9,966 (4)
Foreign securities 1,003 1,006 3
------- ------- ---
Total investments in debt and
equity securities $10,973 $10,972 $(1)
======= ======= ===
Computation of Basic Net Loss Per Share and Pro Forma Basic Net Loss Per
Share
Historical net 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 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 stock options and warrants are antidilutive.
Pro forma basic net loss per share has been calculated assuming the
conversion of the then 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 Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Investments and Hedging Activities," which
establishes standards for the accounting for derivative transactions and the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for the Company's fiscal year beginning January 1, 2001. Management
believes that SFAS No. 133 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):
June 30,
1999 December 31,
(Unaudited) 1998
----------- ------------
Purchased materials...................................... $1,024 $1,671
Work-in-process.......................................... 156 --
Finished goods........................................... 1,239 1,693
------ ------
$2,419 $3,364
====== ======
7
4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
June 30,
1999 December 31,
(Unaudited) 1998
----------- ------------
Accrued payroll and related costs........................ $ 982 $1,008
Accrued marketing costs.................................. 126 354
Other accrued liabilities................................ 678 705
------ ------
$1,786 $2,067
====== ======
5. SEGMENT DISCLOSURE:
In 1998, the Company adopted SFAS 131, "Disclosures about Segments of an
Enterprise and Related Information." Operating segments are defined as
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision maker in
deciding how to allocate resources and in assessing business performance. The
Company's chief operating decision-making group is the Executive Staff, which is
comprised of the Chief Executive Officer and the Vice Presidents. SFAS 131 also
requires disclosures about products and services, geographic areas and major
customers. The adoption of SFAS 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 control network industry, and markets
its products primarily to the building automation, industrial automation,
transportation, and home automation markets. The Company's products are
marketed under the LonWorks brand name, which provides the infrastructure and
support required to implement and deploy open, interoperable, control network
solutions. All of the Company's products either incorporate or operate with the
Neuron Chip and the LonTalk 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 approximately 80
products and services that together constitute the LonWorks system. Any given
customer purchases a small subset of such products and services that are
appropriate for that customer's application.
The Company manages its business segments primarily on a geographic basis.
The Company's reportable segments are comprised of the Americas, Europe, Middle
East and Africa ("EMEA") and Asia Pacific/Japan ("APJ"). Each geographic
segment provides products and services as further described in Note 2. The
Company evaluates the performance of its geographic segments based on profit or
loss from operations. Profit or loss for each geographic segment includes sales
and marketing expenses and other charges directly attributable to the segment
and excludes certain expenses that are managed outside the reportable segments.
Costs excluded from segment profit or loss primarily consist of unallocated
corporate expenses, comprised of product development costs, corporate marketing
costs and other general and administrative expenses that are separately managed.
The Company has no long-lived assets, other than property and equipment. Long-
lived assets are attributed to geographic areas based on the country where the
assets are located. As of June 30, 1999 and December 31, 1998, long-lived
assets of approximately $2.3 million and $2.4 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 being reported by segment because the
information is not reviewed by the Executive Staff to make decisions about
resources to be allocated to the segments based on their performance.
8
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 segment for the
quarters and six months ended June 30, 1999, and 1998 is as follows (unaudited,
in thousands):
Three months ended Six months ended
June 30, June 30,
------------------ -----------------
1999 1998 1999 1998
-------- -------- -------- -------
Revenues from customers:
Americas .................... $ 3,515 $ 3,473 $ 6,424 $ 6,653
EMEA ........................ 4,369 3,756 8,680 7,326
APJ ......................... 1,689 1,080 3,064 1,986
Unallocated ................. 209 237 422 540
------- ------- ------- -------
Total .................. $ 9,782 $ 8,546 $18,590 $16,505
======= ======= ======= =======
Gross profit (loss):
Americas .................... $ 2,376 $ 2,064 $ 4,283 $ 3,795
EMEA ........................ 2,476 1,803 4,970 3,375
APJ ......................... 1,034 671 2,018 1,211
Unallocated ................. (91) 218 (373) 542
------- ------- ------- -------
Total .................. $ 5,795 $ 4,756 $10,898 $ 8,923
======= ======= ======= =======
Income (loss) from operations:
Americas .................... $ 1,423 $ 1,211 $ 2,448 $ 2,125
EMEA ........................ 1,618 1,072 3,324 1,877
APJ ......................... 308 172 566 200
Unallocated ................. (4,395) (3,618) (9,260) (7,122)
------- ------- ------- -------
Total .................. $(1,046) $(1,163) $(2,922) $(2,920)
======= ======= ======= =======
One customer, the sole independent distributor of the Company's products in
Europe since December 1997, accounted for 28.0% and 21.9% of total revenues for
the quarters ended June 30, 1999 and 1998, respectively, and 26.7% and 21.3% of
total revenues for the six months ended June 30, 1999 and 1998, respectively.
6. INCOME TAXES:
Income taxes for the six-month periods ended June 30, 1999 and 1998
primarily consists of taxes related to foreign subsidiaries.
9
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 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, 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 61.9% and 56.6% of total revenues for quarters ended June 30, 1999
and 1998, respectively and 63.2% and 56.4% of total revenues for the six months
ended June 30, 1999 and 1998, respectively. For the six months ended June 30,
1999 and 1998, 9.6% and 9.4%, respectively, 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 products and services in local currencies, such
as the 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-
10
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, or ratably over the term of the support period.
The Company has experienced operating losses in all prior fiscal years and
for the six months ended June 30, 1999. 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
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 materially 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 $9.8 million in the second quarter of 1999 from $8.5
million in the second quarter of 1998. Total revenues for the six months ended
June 30, 1999 grew to $18.6 million from $16.5 million in the same period in
1998. One customer, EBV Elektronik GmbH ("EBV"), the sole independent
distributor of the Company's products in Europe since December 1997, accounted
for 28.0% and 21.9% of total revenues for the quarters ended June 30, 1999 and
1998, respectively, and 26.7% and 21.3% of total revenues for the six months
ended June 30, 1999 and 1998, respectively.
Product. Product revenues grew to $9.2 million in the second quarter of 1999
from $7.7 million in the second quarter of 1998. Product revenues for the six
months ended June 30, 1999 grew to $17.4 million from $14.9 million in the same
period of 1998. The 19.8% increase in product revenues between the two quarters
and the 16.8% increase in product revenues between the two six-month periods was
primarily a result of an increase in sales of control and connectivity products
partially offset by the decrease in sales for development tools products.
Service. Service revenues decreased to $591,000 in the second quarter of
1999 from $873,000 in the second quarter of 1998. Service revenues for the six
months ended June 30, 1999 decreased to $1.2 million from $1.6 million in the
same period of 1998. The 32.3% decrease in service revenues between the two
quarters and the
11
25.4% decrease between the two six-month periods was primarily due to reduced
customer support revenues partially offset by an increase in training revenue.
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 variances associated with the packaging, preparation
and shipment of products. Cost of product revenues in the second quarter of 1999
was $3.6 million compared to $3.4 million in 1998, representing product gross
margins of 61.0% and 56.3%, respectively. Cost of product revenues for the six
months ended June 30, 1999 increased to $6.9 million from $6.6 million in the
same period in 1998 representing product gross margins of 60.2% and 55.6%,
respectively. The increase in product gross margin percentages for both the
quarter and six-month comparison periods was primarily due to cost reductions
for the Company's higher volume control and connectivity products.
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 decreased to $399,000 for the second
quarter of 1999 from $434,000 for the comparative period in 1998, a decrease of
8.1%, representing service gross margins of 32.5% and 50.3%, respectively. Cost
of service revenues for the six months ended June 30, 1999 decreased to $779,000
from $977,000, a decrease of 20.3%, representing service gross margins of 36.5%
and 40.6%, respectively. The decline in service gross margins for both the
quarter and six-month comparison periods was primarily due to a decline in
service revenues only partially offset by a matching decline in costs in
providing services.
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 1999 grew to $2.2 million compared to $1.8
million in the same quarter of 1998, representing 22.4% and 21.1%, respectively,
of total revenues. Product development expenses for the six months ended June
30, 1999 increased to $4.6 million from $3.8 million in the same period of 1998,
representing 24.9% and 22.8%, respectively, of total revenues. The increase in
product development expenses for both the quarter and six-month comparison
periods was 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 1999 increased to $3.6 million from $3.1
million in the second quarter of 1998, representing 36.7% and 35.9%,
respectively, of total revenues. Sales and marketing expenses for the six months
ended June 30, 1999 increased to $7.1 million from $6.1 million in the same
period of 1998, representing 38.2% and 36.9%, respectively, of total revenues.
The increase in sales and marketing expenses for both the quarter and six-month
comparison periods was primarily the result of increased selling expenses due to
the expansion of business in the Asia Pacific region.
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 1999 stayed flat at $1.1 million compared to the same period in 1998,
representing 10.8% and 12.3% of total revenues, respectively. General and
administrative expenses for the six months ended June 30, 1999 increased
slightly to $2.1 million from $2.0 million in the same period of 1998,
representing 11.3% and 12.0%, respectively, of total revenues.
12
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 1999 increased to $331,000 from $34,000
for the comparable period in 1998. Interest and other income, net for the six
months ended June 30, 1999 increased to $693,000 from $109,000 for the
comparable period in 1998. The increase for both the quarter and six-month
comparison periods was primarily due to the higher cash and short-term
investments balances generated in the third quarter of 1998, when the Company
received net proceeds of $31.7 million from its initial public offering.
Provision for income taxes
Income taxes consist of taxes related to certain of the Company's foreign
subsidiaries. Income taxes were $29,000 and $45,000 for the second quarters of
1999 and 1998, respectively. Income taxes were $88,000 and $100,000 for the six
months ended June 30, 1999 and 1998, respectively.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations and met its
capital expenditure requirements primarily from the sale of Preferred Stock and
Common Stock. From inception through June 30, 1999, the Company had raised
$127.6 million from the sale of Preferred Stock and Common Stock.
Net cash used in operating activities was $2.3 million and $4.9 million for
the six months ended June 30, 1999 and 1998, respectively. Net cash used in
operations is attributable primarily to the losses from operations in each of
the periods. As of June 30, 1999, receivables had grown by $1.6 million since
the end of the year, due to the combination of revenue growth and the later
timing of revenue in the second quarter of 1999.
Net cash provided by investing activities was $6.2 million and $2.5 million
for the six months ended June 30, 1999 and 1998, respectively. These amounts
primarily reflect the maturities of short-term investments offset by purchases
of short-term investments and capital expenditures.
Net cash provided by financing activities was $409,000 and $687,000 for the
six months ended June 30, 1999 and 1998, respectively, and consists primarily of
proceeds from the exercise of employee stock options. At June 30, 1999, the
Company had cash, cash equivalents and short-term investments of $26.6 million.
The Company believes that its existing available cash, cash equivalents and
short-term investments will satisfy the Company's projected working capital and
other cash requirements for at least the next 12 months. However, there can be
no assurance that the Company will not require additional 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 Company has terminated its revolving line of credit agreement with a
bank, which would have expired in May of 1999. The failure of the Company to
obtain additional financing, when and if necessary, could have a material
adverse effect on the Company's business, operating results and financial
condition.
Year 2000 Compliance
The information presented below related to Year 2000 compliance contains
forward-looking statements that are subject to risks and uncertainties. The
Company's actual results may differ significantly from the results discussed
below regarding Year 2000 compliance.
13
Year 2000
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"). Additional computer problems are possible related to leap
year calculations in the year 2000. Either problem 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.
State of Readiness
Echelon has formed a cross-functional team (the "Y2K Team") including
Information Services ("IS"), Operations, Product Marketing, Product Development
and Administration to evaluate and address the compliance of its products,
internal systems, and key suppliers related to Date Code Dependencies. The Y2K
Team has documented the results of the completed evaluations and expects the
required remediation to be completed by September 1999.
Echelon Products: All products that were available for sale beginning with
Echelon's January 1997 price list and all subsequent versions of the price list
are being analyzed and tested to verify conformity with the Company's selected
test for Date Code Dependencies. All Echelon product tests are being performed
according to the definition set forth in the British Standards Institution PD
2000-1 definition. In some instances, Echelon's compliance testing will depend
upon compliance certification provided by third party component vendors.
Internal Systems: IS is responsible for all corporate systems and servers
(including operating systems) and for desktop systems. The facilities located
at the Company's corporate headquarters in Palo Alto, California are being
evaluated according to the model of the California State Year 2000 Embedded
System Plan. There is increased risk with the Company's international sales and
marketing office locations due to the individual infrastructures and varying
rates of Year 2000 compliance in the hosting countries. Echelon is evaluating
each international location on a case-by-case basis. In January 1999, the
Company replaced its former enterprise resource planning system with a new
system, which does not have Date Code Dependencies.
Suppliers: All of the Company's key suppliers have indicated that they do
not anticipate Date Code Dependency problems. Echelon has also interviewed all
of its second-tier suppliers, and they do not anticipate Date Code Dependency
problems.
Customers: All of the Company's current customers are being mailed
quarterly letters updating them as to Date Code Dependencies with regard to
Echelon products. The Company's web site is also updated quarterly with this
information.
Costs and Risks Associated with Date Code Dependencies
With the exception of the new enterprise resource planning system, which
had capitalized costs of approximately $1.2 million, additional costs to test
and administer the Year 2000 compliance have been done internally without any
additional outside contracted services. To date, the Company has concluded that
additional costs to test, administer, and mitigate Year 2000 issues will not be
material. However, failures of the Company's products to operate properly with
regard to the Year 2000 and thereafter could require the Company to incur
unanticipated expenses to remedy any problems. 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
14
the Company. Moreover, the Company's insurance policies contain Year 2000
exclusion provisions. The Company also 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 addition, some of the
Company's customers or vendors could experience Date Code Dependency problems
that could result in disruptions of their internal operations that could delay
their purchases of the Company's products. Any of these factors could result in
a material adverse effect on the Company's business, operating results and
financial condition. Management expects to make contingency plans as necessary.
New Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Investments and Hedging Activities," which
establishes standards for the accounting for derivative transactions and the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for the Company's fiscal year beginning January 1, 2001. Management
believes that SFAS No. 133 will not have a material effect on the Company's
financial statements.
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISKS
There has not been a material change in the Company's exposure to interest rate
and foreign currency risks since the date of the 1998 Form 10-K.
Interest Rate Risk. The Company's exposure to market risk for changes in
interest rates relates primarily to its investment portfolio. All investments
are in high-credit quality issuances and, by policy, are limited in the amount
of credit exposure to any one issuer. The Company ensures the safety and
preservation of the invested principal funds by investing in safe and high-
credit quality securities which includes only marketable securities with active
secondary or resale markets to ensure portfolio liquidity. The table below
presents principal amounts and related weighted average interest rates for
the Company's investment portfolio at June 30, 1999. All investments mature, by
Company policy, in two years or less.
Average
Carrying Amount Interest Rate
--------------- ----------------
(in thousands)
Cash Equivalents:
U.S. corporate securities.................. $13,849 4.89%
------- ----
Total cash equivalents................ $13,849 4.89%
------- ----
Short-term Investments:
U.S. corporate securities.................. $ 9,966 5.75%
Foreign securities......................... 1,006 5.46%
------- ----
Total short-term investments.......... $10,972 5.72%
------- ----
Total investment securities........... $24,820 5.26%
======= ====
Foreign Currency Exchange Risk. The Company transacts business in various
foreign countries. Its primary foreign currency cash flows are in Japan and
Western Europe. Currently, the Company does 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.
15
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
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, 1999, the Company had an accumulated deficit of $92.8 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 makes 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, 1998, the Company had
net operating loss carryforwards for Federal and state income tax reporting
purposes of approximately $80.1 million and $5.0 million, respectively, which
expire at various dates through 2018. In addition, as of December 31, 1998, the
Company had tax credit carryforwards of approximately $4.1 million, which expire
at various dates through 2018. 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 $36.1 million as of December 31, 1998. 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
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
16
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.
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, significant portions 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 28.0% and 21.9% of total
revenues for the quarters ended June 30, 1999 and 1998, respectively, and 26.7%
and 21.3% of total revenues for the six months ended June 30, 1999 and 1998,
respectively. The Company's agreement with EBV will expire in December 1999. 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.
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 currently manufactured
and distributed by both Motorola, Inc. ("Motorola") and Toshiba Corporation
("Toshiba"). The Company has entered into licensing agreements with each of
Motorola, Toshiba and Cypress Semiconductor Corporation ("Cypress"). The
agreements, among other things, grant Motorola, Toshiba and Cypress 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 Cypress agreement expires in April 2009, unless renewed. The Toshiba
agreement expires in January 2001, unless renewed. The Motorola agreement
expires in January, 2001, and Motorola has announced that it will discontinue
distribution of Neuron Chips after January 31, 2001. 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
17
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 Motorola, Toshiba or Cypress as a
manufacturer of Neuron Chips. Both Motorola and Toshiba have played, and
Toshiba and Cypress are expected to play, a key role in the development and
marketing of LonWorks technology. The loss of Toshiba or Cypress as a supplier
of the Neuron Chip could have a material adverse effect on the business,
operating results and financial condition of the Company. In the event of the
loss of Toshiba or Cypress as a supplier, there could 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 outsource
manufacturers, including GET Manufacturing, Inc. and muRata Electronics North
America, Inc. These outsource 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, 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 Group 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
18
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 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.
VOLATILITY OF STOCK PRICE
The price of the Company's Common Stock has been, and from time to time may
be, volatile. The stock price is 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 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.
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. If the Company is unable to hire
19
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 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 nine countries.
Revenues from international sales, which include both export sales and sales by
international subsidiaries, accounted for approximately 61.9% and 56.6% of the
Company's total revenues for the quarters ended June 30, 1999 and 1998,
respectively,
20
and 63.2% and 56.4% of the Company's total revenues for the six months ended
June 30, 1999 and 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, 1999 and 1998, approximately 9.6% and 9.4%,
respectively, 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 introduction of the
Euro as the standard currency in participating European countries may also
impact the ability of the Company to 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. Also, there can be long sales cycles
between the selection of the Company's products for use by a systems integrator,
and the purchase of such products by the systems integrator. 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 72 issued U.S. patents, 18
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
21
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 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.
22
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, 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 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 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.
CONTROL BY EXISTING STOCKHOLDERS
As of July 31, 1999, the directors and executive officers of the Company,
together with certain entities affiliated with them, beneficially owned 34.2% of
the Company's outstanding Common Stock and Motorola, a principal stockholder of
the Company, owned 11.8% 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 one other stockholder which combined
with Motorola own approximately 14.3% 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. Mr. Bertrand
Cambou, formerly of Motorola, resigned from the Company's Board of Directors
in April 1999.
23
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 May 11, 1999
(the "Annual Meeting"). At such meeting, the following directors were
elected: M. Kenneth Oshman and Larry W. Sonsini. 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, 1999.
Votes For: 28,594,721
Votes Against: 6,570
Votes Abstaining: 12,557
Broker Non-Votes: 0
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K
(a) Exhibit
27.1 Financial data schedule
(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 12, 1999 By /s/ Oliver R. Stanfield
-----------------------
Oliver R. Stanfield,
Vice President Finance, and Chief
Financial Officer (Duly
Authorized Officer and Principal
Financial and Accounting Officer)
24