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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 SEPTEMBER 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
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 October 31, 1998, 32,503,466 shares of the Registrant's common stock were
outstanding.
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ECHELON CORPORATION
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1998
INDEX
Page
----
Part I.
FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 1998 and December 31, 1997 3
Condensed Consolidated Statements of Operations
for the three and nine months ended September 30,
1998 and September 30, 1997 4
Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 1998 and
September 30, 1997 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 9
Part II.
OTHER INFORMATION
Item 1. Legal Proceedings 25
Item 2. Changes in Securities 25
Item 3. Defaults upon Senior Securities 25
Item 4. Submission of Matters to a Vote of Security Holders 25
Item 5. Other Information 25
Item 6. Exhibits and Reports on Form 8-K 25
2
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PART I FINANCIAL INFORMATION
----------------------------
ITEM 1. FINANCIAL STATEMENTS
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
(UNAUDITED)
-------- --------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents......................................... $ 20,962 $ 4,872
Short-term investments............................................ 11,305 2,981
Accounts receivable, net.......................................... 3,326 3,810
Inventories....................................................... 4,254 2,444
Other current assets.............................................. 1,952 1,196
-------- --------
Total current assets.............................................. 41,799 15,303
Property and equipment, net....................................... 2,169 1,513
-------- --------
$ 43,968 $ 16,816
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.................................................. $ 2,180 $ 2,081
Accrued payroll and related expenses.............................. 762 1,081
Accrued liabilities............................................... 1,244 907
Current portion of deferred revenues.............................. 1,940 2,351
-------- --------
Total current liabilities......................................... 6,126 6,420
-------- --------
LONG-TERM LIABILITIES:
Deferred rent, net of current portion............................. 119 246
Deferred revenues, net of current portion......................... 843 1,350
-------- --------
Total long-term liabilities....................................... 962 1,596
-------- --------
STOCKHOLDERS' EQUITY:
Convertible preferred stock....................................... -- 79
Common stock...................................................... 325 188
Additional paid-in capital........................................ 126,811 93,532
Deferred compensation............................................. (644) --
Unrealized holding gain on available-for-sale securities.......... 35 --
Cumulative translation adjustment................................. (534) (351)
Accumulated deficit............................................... (89,113) (84,648)
-------- --------
Total stockholders' equity........................................ 36,880 8,800
-------- --------
$ 43,968 $ 16,816
======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
3
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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
September 30, September 30,
------------------ -----------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
REVENUES:
Product.................................. $ 6,406 $ 5,487 $21,267 $17,979
Service.................................. 717 862 2,361 2,824
------- ------- ------- -------
Total revenues........................... 7,123 6,349 23,628 20,803
------- ------- ------- -------
COST OF REVENUES:
Cost of product.......................... 2,701 2,724 9,305 8,675
Cost of service.......................... 424 408 1,402 1,308
------- ------- ------- -------
Total cost of revenues................... 3,125 3,132 10,707 9,983
------- ------- ------- -------
Gross profit............................. 3,998 3,217 12,921 10,820
------- ------- ------- -------
OPERATING EXPENSES:
Product development...................... 1,803 1,751 5,564 5,215
Sales and marketing...................... 3,010 2,890 9,105 9,044
General and administrative............... 1,105 983 3,092 3,062
------- ------- ------- -------
Total operating expenses................. 5,918 5,624 17,761 17,321
------- ------- ------- -------
Loss from operations..................... (1,920) (2,407) (4,840) (6,501)
------- ------- ------- -------
INTEREST AND OTHER INCOME, NET........... 403 161 512 375
------- ------- ------- -------
Loss before provision for income taxes... (1,517) (2,246) (4,328) (6,126)
Provision for income taxes............... 37 34 137 124
------- ------- ------- -------
Net loss................................. $(1,554) $(2,280) $(4,465) $(6,250)
======= ======= ======= =======
Basic net loss per share................. $ (0.05) $ (0.12) $ (0.20) $ (0.34)
======= ======= ======= =======
Shares used in computing
basic net loss per share................. 28,273 18,646 22,263 18,566
======= ======= ======= =======
Proforma basic net loss
per share................................ $ (0.05) $ (0.09) $ (0.16) $ (0.25)
======= ======= ======= =======
Shares used in computing
proforma basic net loss per share........
30,845 26,533 28,359 25,467
======= ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................................................ $ (4,465) $(6,250)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization........................................................... 691 518
Deferred compensation expense........................................................... 110 --
Loss on disposal of fixed assets........................................................ 4 --
Change in operating assets and liabilities:
Accounts receivable..................................................................... 484 528
Inventories............................................................................. (1,810) (658)
Other current assets.................................................................... (756) 60
Accounts payable........................................................................ 99 138
Accrued liabilities..................................................................... 18 250
Deferred revenues....................................................................... (918) (1,496)
Deferred rent........................................................................... (127) (43)
-------- --------
Net cash used in operating activities................................................... (6,670) (6,953)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of held-to-maturity short-term investments..................................... -- (9,759)
Purchase of available-for-sale short-term investments................................... (11,305) --
Proceeds from maturities of held-to-maturity short-term investments..................... 2,981 1,835
Capital expenditures.................................................................... (1,351) (426)
Proceeds from sale of fixed assets...................................................... -- 30
-------- --------
Net cash used in investing activities................................................... (9,675) (8,320)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of preferred and common stock.................................... 32,583 10,057
-------- --------
EFFECT OF EXCHANGE RATES ON CASH........................................................ (148) (185)
-------- --------
NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS.................................... 16,090 (5,401)
CASH AND CASH EQUIVALENTS:
Beginning of period..................................................................... 4,872 8,051
-------- --------
End of period........................................................................... $ 20,962 $ 2,650
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid for income taxes.............................................................. $ 155 $ 125
======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
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ECHELON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION:
The condensed consolidated financial statements include the accounts of
Echelon Corporation (the Company), a Delaware corporation, and its wholly owned
subsidiaries. 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,
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.
6
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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 September 30, 1998, short-term investments
consist of commercial paper, corporate notes and bonds, certificates of
deposit, and foreign government obligations with original maturities between
three and 21 months with an average maturity of approximately thirteen months.
At December 31, 1997, short-term investments consist of U.S. government
securities with original maturities of approximately five months.
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 nine months ended September 30, 1998 and 1997
(in thousands):
SEPT 30, SEPT 30,
1998 1997
-------- --------
Net loss.............................. $(4,465) $(6,250)
Unrealized holding gain on
available-for-sale securities......... 35 --
Foreign currency translation
adjustments........................... (534) (216)
------- -------
Comprehensive net loss................ $(4,964) $(6,466)
======= =======
7
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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.
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
derivative portions of certain other contracts. SFAS No. 133 will become
effective for the Company's year ending December 31, 2000. The Company believes
that SFAS No. 133 will not have a material impact 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):
SEPT 30, DEC 31,
1998 1997
------- -------
(Unaudited)
Purchased materials.......... $2,323 $1,791
Work-in-process.............. 373 130
Finished goods............... 1,558 523
------ ------
$4,254 $2,444
====== =======
4. MAJOR CUSTOMER AND GEOGRAPHIC AREA:
One customer, who is also a distributor of the Company's products,
accounted for 23.7% of total revenues for the third quarter of 1998 and 22.5% of
total revenues for the nine months ended September 30, 1998, respectively. For
the third quarter of 1997 and the nine months ended September 30, 1997, no
single customer accounted for 10% or more of total revenues.
Revenues from export sales (primarily to Europe) accounted for
approximately 47.5% and 46.6% of total revenues for the nine months ended
September 30, 1998 and September 30, 1997, respectively.
8
<PAGE>
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 52.6% and 53.3% of total revenues for the third quarters of 1998
and 1997, respectively, and 55.5% and 55.7% for the nine months ended September
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 nine months ended September 30, 1998, 8.8% 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 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
9
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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 nine months ended September 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
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
10
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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 $7.1 million in the third quarter of 1998 from $6.3
million in the third quarter of 1997. Total revenues for the nine months ended
September 30, 1998 grew to $23.6 million from $20.8 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 23.7% and 22.5%
of total revenues for the third quarter of 1998 and the nine months ended
September 30, 1998, respectively. For both the third quarter of 1997 and for the
nine months ended September 30, 1997, no customer accounted for greater than 10%
of total revenues.
Product. Product revenues grew to $6.4 million in the third quarter of 1998
from $5.5 million in the third quarter of 1997. Product revenues for the nine
months ended September 30, 1998 grew to $21.3 million from $18.0 million in the
same period of 1997. The 16.7% increase in product revenues between the two
quarters and the 18.3% increase in product revenues between the two nine-month
periods was primarily a result of increasing sales of control and connectivity
products partially offset by the decrease in sales for network services and
development tools products.
Service. Service revenues decreased to $717,000 in the third quarter of
1998 from $862,000 in the third quarter of 1997. Service revenues for the nine
months ended September 30, 1998 decreased to $2.4 million from $2.8 million in
the same period of 1997. The 16.8% decrease in service revenues between the two
quarters and the 16.4% decrease in service revenues between the two nine-month
periods was primarily due to fewer participants attending the 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 both the third quarter of
1998 and the third quarter of 1997 were $2.7 million, representing product gross
margins of 57.8% and 50.4%, respectively. Cost of product revenues for the nine
months ended September 30, 1998 increased to $9.3 million from $8.7 million in
the same period of 1997, an increase of 7.3%, representing product gross margins
of 56.2% and 51.7%, respectively. The increase in product gross margin
percentages for both the quarter and nine-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 consist of employee-related
costs as well as direct costs incurred in providing training and customer
support services. Cost of service revenues for the third quarter of 1998
increased slightly to $424,000 from $408,000 in the same period of 1997, an
increase of 3.9%, representing service gross margins of 40.9% and 52.7%,
respectively. Cost of service revenues for the nine months ended September 30,
1998 increased to $1.4 million from $1.3 million in the same period of 1997, an
increase of 7.2%, representing service gross margins of 40.6% and 53.7%,
respectively. The decrease in service gross margin percentages for both the
quarter and nine-month comparison periods was primarily due to the decline in
service revenues.
11
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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 both the third quarter of 1998 and the third quarter of 1997 were
$1.8 million, representing 25.3% and 27.6%,respectively, of total revenues.
Product development expenses for the nine months ended September 30, 1998
increased to $5.6 million from $5.2 million in the same period of 1997,
representing 23.5% and 25.1%, respectively, of total revenues. The dollar amount
increase for the nine-month comparison period 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 third quarter of 1998 increased to $3.0 million from $2.9
million in the third quarter of 1997, representing 42.3% and 45.5%,
respectively, of total revenues. Sales and marketing expenses for the nine
months ended September 30, 1998 increased slightly to $9.1 million from $9.0
million from the same period of 1997, representing 38.5% and 43.5%,
respectively, of total revenues. The decrease in sales and marketing expense as
a percentage of total revenues was primarily due 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 third quarter of
1998 increased slightly to $1.1 million from $983,000 in the same period in
1997, representing 15.5% of total revenues for both periods. General and
administrative expenses for the nine months ended September 30, 1998 stayed flat
at $3.1 million, representing 13.1% and 14.7%, 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 third quarter of 1998 increased
to $403,000 from $161,000 for the comparable period in 1997. Interest and other
income, net for the nine months ended September 30, 1998 increased to $512,000
from $375,000 for the comparable period in 1997. Both quarter and nine-month
comparison increases were 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 $31.9 million from its initial public offering.
Provision for income taxes. Income taxes consist of income taxes related to
certain of the Company's foreign subsidiaries. Income taxes were $37,000 and
$34,000 for the third quarter of 1998 and 1997, respectively. Income taxes were
$137,000 and $124,000 for the nine months ended September 30, 1998 and 1997,
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 September 30, 1998, the Company
had raised $127.1 million from the sale of Preferred Stock and Common Stock.
12
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Net cash used in operating activities was $6.7 million and $7.0 million for
the nine months ended September 30, 1998 and 1997, respectively. Net cash used
in operations is attributable primarily to the losses from operations in each of
the periods. As of September 30, 1998, inventories had grown by $1.8 million
since the end of the year, due to the combination of revenue growth, new product
introductions, and product and vendor transitions. Receivables decreased by
$484,000 as of September 30, 1998, primarily due to lower revenues in the third
quarter of 1998, compared to the fourth quarter of 1997.
Net cash used in investing activities was $9.7 million and $8.3 million for
the nine months ended September 30, 1998 and 1997, respectively. These amounts
primarily reflect the purchases of short-term investments related to the private
placement of the equity raised through the issuance of Preferred Stock in May
1997 and the placement of the equity raised in the Company's initial public
offering in July 1998. The increase in capital expenditures to $1.4 million for
the nine months ended September 30, 1998 compared to $426,000 for the nine
months ended September 30, 1997 is primarily due to the investment in a new
enterprise resource planning system during 1998.
Net cash provided by financing activities was $32.6 million and $10.1
million for the nine months ended September 30, 1998 and 1997, respectively. Net
cash provided by financing activities consists primarily of proceeds from sales
of Preferred Stock and Common Stock and the exercise of employee stock options.
At September 30, 1998, the Company had cash, cash equivalents and short-term
investments of $32.3 million.
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, cash equivalents and
short-term investments 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 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.
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
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the provisions of SFAS No. 130 for the nine months ended September 30, 1998 and
1997 (in thousands):
SEPT 30, SEPT 30,
1998 1997
-------- --------
Net loss........................... $(4,465) $(6,250)
Unrealized holding gain on
available-for-sale securities...... 35 --
Foreign currency translation
adjustments........................ (534) (216)
------- -------
Comprehensive net loss............. $(4,964) $(6,466)
======= =======
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.
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
derivative portions of certain other contracts. SFAS No. 133 will become
effective for the Company's year ending December 31, 2000. The Company believes
that SFAS No. 133 will not have a material impact 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.
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
September 30, 1998, the Company had an accumulated deficit of $89.1 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
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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
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
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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 23.7% and 22.5% of the
Company's total revenues for the third quarter of 1998 and for the nine months
ended September 30, 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 manufactured and
distributed by both Motorola, Inc. ("Motorola") and Toshiba Corporation
("Toshiba"). The Company has entered into licensing agreements with each of
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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. and muRata Electronics North
America, 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,
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
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<PAGE>
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
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.
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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
new product offerings, any such future delays could have a material adverse
effect on the Company's business, operating results and financial condition.
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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 52.6% and 55.5% of
the Company's total revenues during the third quarter of 1998 and for the nine
months ended September 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 nine months ended September 30, 1998, approximately 8.8% 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 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
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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 68 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 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
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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.
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)
22
<PAGE>
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 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 is funding
all costs related to Year 2000 compliance issues from its existing cash, cash
equivalents and short-term investment balances. The Company is continuing to
evaluate the dependency of its products on date codes and has announced a
program for addressing the impact of the year 2000 on any such products. 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
23
<PAGE>
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 October 31, 1998, the directors and executive officers of the
Company, together with certain entities affiliated with them, beneficially own
47.3% 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 6.4% 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 Company believes that 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 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.
24
<PAGE>
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
None.
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: November 13, 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)
25
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