<PAGE>
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 March 31, 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 April 30, 1999, 32,803,082 shares of the Registrant's common stock were
outstanding.
<PAGE>
ECHELON CORPORATION
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 1999
INDEX
Page
----
Part I.
FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
March 31, 1999 and December 31, 1998 3
Condensed Consolidated Statements of Operations
for the three months ended March 31, 1999 and
March 31, 1998 4
Condensed Consolidated Statements of Cash
Flows for the three months ended March 31, 1999
and March 31, 1998 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 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 25
2
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PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
-------------------- --------------------
<S> <C> <C>
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 12,498 $ 11,552
Short-term investments.................................... 15,067 17,501
Accounts receivable, net.................................. 5,603 4,559
Inventories............................................... 2,718 3,364
Other current assets...................................... 1,499 2,170
------------ ------------
Total current assets...................................... 37,385 39,146
Property and equipment, net 2,746 2,804
------------ ------------
$ 40,131 $ 41,950
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.......................................... $ 2,122 $ 1,787
Accrued liabilities....................................... 1,731 2,067
Current portion of deferred revenues...................... 1,396 1,559
------------ ------------
Total current liabilities................................. 5,249 5,413
------------ ------------
LONG-TERM LIABILITIES:
Deferred rent, net of current portion..................... 34 76
Deferred revenues, net of current portion................. 506 675
------------ ------------
Total long-term liabilities............................... 540 751
STOCKHOLDERS' EQUITY:
Common stock.............................................. 327 325
Additional paid-in capital................................ 127,015 126,844
Cumulative translation adjustment......................... (421) (314)
Deferred compensation..................................... (550) (597)
Unrealized holding gain on available-for-sale securities.. 43 27
Accumulated deficit....................................... (92,072) (90,499)
------------ ------------
Total stockholders' equity................................ 34,342 35,786
------------ ------------
$ 40,131 $ 41,950
============ ============
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended March 31,
--------------------------------
1999 1998
------------ ------------
<S> <C> <C>
REVENUES:
Product........................................... $ 8,173 $ 7,188
Service........................................... 635 771
------------ ------------
Total revenues.................................... 8,808 7,959
------------ ------------
COST OF REVENUES:
Cost of product................................... 3,325 3,249
Cost of service................................... 380 543
------------ ------------
Total cost of revenues............................ 3,705 3,792
------------ ------------
Gross profit...................................... 5,103 4,167
------------ ------------
OPERATING EXPENSES:
Product development............................... 2,440 1,958
Sales and marketing............................... 3,500 3,031
General and administrative 1,039 935
------------ ------------
Total operating expenses.......................... 6,979 5,924
------------ ------------
Loss from operations.............................. (1,876) (1,757)
------------ ------------
INTEREST AND OTHER INCOME, NET 362 75
------------ ------------
Loss before provision for income taxes............ (1,514) (1,682)
Provision for income taxes 59 55
------------ ------------
Net loss.......................................... $(1,573) $(1,737)
============ ============
Basic net loss per share.......................... $(0.05) $(0.09)
============ ============
Shares used in computing
basic net loss per share.......................... 32,639 19,029
============ ============
Proforma basic net loss
per share......................................... $(0.06)
============
Shares used in computing
proforma basic net loss per share................. 26,916
============
</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>
Three Months Ended March 31,
---------------------------------
1999 1998
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss..................................................................... $ (1,573) $(1,737)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization................................................ 245 194
Deferred compensation expense................................................ 47 11
Unrealized gain on securities................................................ 16 --
Change in operating assets and liabilities:
Accounts receivable.......................................................... (1,044) (676)
Inventories.................................................................. 646 (732)
Other current assets......................................................... 671 (186)
Accounts payable............................................................. 335 677
Accrued liabilities.......................................................... (336) (186)
Deferred revenues............................................................ (332) (264)
Deferred rent................................................................ (42) (30)
----------- -----------
Net cash used in operating activities........................................ (1,367) (2,929)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments........................ (24,691) --
Proceeds from maturities of held-to-maturity short-term investments.......... -- 2,981
Proceeds from maturities of available-for-sale short-term investments........ 27,125 --
Capital expenditures......................................................... (187) (167)
----------- -----------
Net cash provided by investing activities.................................... 2,247 2,814
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock....................................... 173 472
----------- -----------
EFFECT OF EXCHANGE RATES ON CASH............................................. (107) (64)
----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS.................................... 946 293
Beginning of period.......................................................... 11,552 4,872
----------- -----------
End of period................................................................ $ 12,498 $ 5,165
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes................................................... $ 37 $ 42
=========== ===========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
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 No. 115, "Accounting for Certain Investments in Debt and
Equity Securities". As of
6
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March 31, 1999, the Company's available-for-sale securities had contractual
maturities from four 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 March
31, 1999, the amortized cost basis, aggregate fair value and gross unrealized
holding gains by major security type were as follows (in thousands):
<TABLE>
<CAPTION>
Unrealized
Amortized Aggregate Holding
Cost Fair Value Gains
---- --------- -------------
<S> <C> <C> <C>
U.S. corporate securities:
Commercial paper $ 978 $ 996 $ 18
Certificates of deposit 2,044 2,044 --
Corporate notes and bonds 9,946 9,969 23
------- ------- ------
12,968 13,009 41
Foreign securities 2,056 2,058 2
------- ------- ------
Total investments in debt and
equity securities $15,024 $15,067 $ 43
======= ======= ======
</TABLE>
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 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 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 March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use". SOP 98-1 is effective
for the Company's fiscal year beginning January 1, 1999 and provides guidance on
the capitalization of software for internal use. The adoption of SOP 98-1 did
not have a material effect on the Company's financial statements.
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. The adoption of SOP 98-5 did 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 the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for the Company's fiscal year beginning January 1, 2000. Management
believes that SFAS No. 133 will not have a material effect on the Company's
financial statements.
7
<PAGE>
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):
<TABLE>
<CAPTION>
March 31,
1999 December 31,
(Unaudited) 1998
---------------- ---------------
<S> <C> <C>
Purchased materials........... $1,846 $1,671
Work-in-process............... 37 --
Finished goods................ 835 1,693
------ -------
$2,718 $3,364
====== =======
</TABLE>
4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
March 31,
1999 December 31,
(Unaudited) 1998
---------------- ---------------
<S> <C> <C>
Accrued payroll and related costs.. $ 883 $1,008
Accrued marketing costs............ 287 354
Other accrued liabilities.......... 561 705
------ ------
$1,731 $2,067
====== ======
</TABLE>
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.
8
<PAGE>
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 March 31, 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.
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 ended March 31, 1999, and 1998 is as follows (in thousands):
<TABLE>
<CAPTION>
Three Months Ended March 31,
-------------------------------
1999 1998
---- ----
<S> <C> <C>
Revenues from customers:
Americas.................... $ 2,909 $ 3,180
EMEA........................ 4,311 3,570
APJ......................... 1,375 906
Unallocated................. 213 303
------- -------
Total..................... $ 8,808 $ 7,959
======= =======
Gross profit (loss):
Americas.................... $ 1,907 $ 1,731
EMEA........................ 2,494 1,572
APJ......................... 984 540
Unallocated................. (282) 324
------- -------
Total..................... $ 5,103 $ 4,167
======= =======
Income (loss) from operations:
Americas.................... $ 1,025 $ 914
EMEA........................ 1,706 805
APJ......................... 258 28
Unallocated................. (4,865) (3,504)
------- -------
Total..................... $(1,876) $(1,757)
======= =======
</TABLE>
One customer, the sole independent distributor of the Company's products in
Europe since December 1997, accounted for 25.3% and 20.6% of total revenues for
the quarters ended March 31, 1999 and 1998, respectively.
9
<PAGE>
6. INCOME TAXES:
Income taxes for the three-month periods ended March 31, 1999 and 1998
primarily consists of taxes related to foreign subsidiaries.
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 64.6% and 57.0% of total revenues for the first quarters of 1999
and 1998, respectively. For the three months ended March 31, 1999 and 1998,
10.9% and 10.3%, 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
10
<PAGE>
(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, or ratably over the term of the support period.
The Company has experienced operating losses in all prior fiscal years and for
the three months ended March 31, 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 $8.8 million in the first quarter of 1999 from $8.0
million in the first quarter of 1998. One customer, EBV Elektronik GmbH ("EBV"),
the sole distributor of the Company's products in Europe since December 1997,
accounted for 25.3% and 20.6% of total revenues for the first quarters of 1999
and 1998, respectively.
Product. Product revenues grew to $8.2 million in the first quarter of 1999
from $7.2 million in the first quarter of 1998. The 13.7% increase in product
revenues in 1999 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 $635,000 in the first quarter of 1999
from $771,000 in the first quarter of 1998. The 17.6% decrease in service
revenues between the two quarters was primarily due to reduced customer support
revenues partially offset by an increase in training revenue.
11
<PAGE>
Cost of Revenues
Cost of product. Cost of product revenues consist of costs associated with the
purchase of components and subassemblies, as well as allocated labor, overhead
and manufacturing variances associated with the packaging, preparation and
shipment of products. Cost of product revenues in the first quarter of 1999 was
$3.3 million compared to $3.2 million in 1998, representing product gross
margins of 59.3% and 54.8%, respectively. The increase in product gross margin
percentages for the quarter 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 decreased to $380,000 for the first quarter
of 1999 from $543,000 for the comparative period in 1998, a decrease of 30.0%,
representing service gross margins of 40.2% and 29.6%, respectively. The
increase in the 1999 service gross margin compared to 1998 was primarily due to
a decline in personnel expenses related to the decline in service revenues. The
higher service spending in the first quarter of 1998 was also due to higher
equipment charges related to new training classes put in place during 1998.
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 first quarters of 1999 and 1998 were $2.4 million and $2.0 million,
respectively, representing 27.7% and 24.6%, respectively, of total revenues. The
increase in the first quarter of 1999 compared to 1998 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 first quarter of 1999 increased to $3.5 million from $3.0 million in the
first quarter of 1998, representing 39.7% and 38.1%, respectively, of total
revenues. The increase in sales and marketing expense in the first quarter of
1999 compared to 1998 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 first quarter of
1999 increased slightly to $1.0 million from $935,000 in the same period in
1998, representing 11.8% and 11.7% of total revenues, respectively.
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 first quarter of 1999 increased to $362,000 from $75,000 for
the comparable period in 1998. The increase for the first quarter of 1999
compared to 1998 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.
12
<PAGE>
Provision for income taxes
Income taxes consist of income taxes related to certain of the Company's
foreign subsidiaries. Income taxes were $59,000 and $55,000 for the first
quarters of 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 March 31, 1999, the Company had raised
$127.3 million from the sale of Preferred Stock and Common Stock.
Net cash used in operating activities was $1.4 million and $2.9 million for
the quarters ended March 31, 1999 and 1998, respectively. Net cash used in
operations is attributable primarily to the losses from operations in each of
the periods. As of March 31, 1999, receivables had grown by $1.0 million since
the end of the year, due to the combination of revenue growth and the later
timing of revenue in the first quarter of 1999.
Net cash provided by investing activities was $2.2 million and $2.8 million
for the quarters ended March 31, 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 $173,000 and $472,000 for the
quarters ended March 31, 1999 and 1998, respectively, and consists primarily of
proceeds from the exercise of employee stock options. At March 31, 1999, the
Company had cash, cash equivalents and short-term investments of $27.6 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.
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
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compliance of its products, internal systems, and key suppliers related to Date
Code Dependencies. The Y2K Team is in the process of documenting the results of
these evaluations and expects all such evaluations to be completed by June 1999
with any 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 is continuing to evaluate non-
key suppliers for Date Code Dependency issues.
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 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 March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use". SOP 98-1 is effective
for the Company's fiscal year beginning January 1, 1999 and provides guidance on
the capitalization of software for internal use. The adoption of SOP 98-1 did
not have a material effect on the Company's financial statements.
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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. The adoption of SOP 98-5 did 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 the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for the Company's fiscal year beginning January 1, 2000. Management
believes that SFAS No. 133 will not have a material effect on the Company's
financial statements.
Qualitative and Quantitative Disclosures About Market Risks
Interest Rate Risk. Echelon's exposure to market risk for changes in interest
rates relate 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. Echelon 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 Echelon's
investment portfolio at March 31, 1999. All investments mature, by Company
policy, in two years or less.
(in thousands, except average interest rates)
<TABLE>
<CAPTION>
Average Interest
Carrying Amount Rate
------------------- --------------------
<S> <C> <C>
Cash Equivalents:
U.S. corporate securities.................. $10,982 4.87 %
------- ------
Total cash equivalents................. $10,982 4.87 %
------- ------
Short-term Investments:
U.S. corporate securities.................. $13,009 5.43 %
Foreign securities......................... 2,058 4.93 %
------- ------
Total short-term investments........... $15,067 5.36 %
------- ------
Total investment securities............ $26,049 5.15 %
======= ======
</TABLE>
Foreign Currency Exchange Risk. Echelon 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.
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 March
31, 1999, the Company had an accumulated deficit of $92.1 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
result in significant increases in revenues, the Company's business, operating
results and financial condition
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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 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
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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 25.3% and 20.6% of the
Company's total revenues for the quarters ended March 31, 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 Motorola and
Toshiba agreements expire in January 2001 and January 2000 respectively, unless
renewed. 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 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.
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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 and muRata. 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
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
18
<PAGE>
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 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.
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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 64.6% and 57.0% of the
Company's total revenues during the quarters ended March 31, 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
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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 quarter ended
March 31, 1999 and 1998, approximately 10.9% and 10.3%, 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 71 issued U.S. patents, 19
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
21
<PAGE>
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.
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
22
<PAGE>
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 April 30, 1999, the directors and executive officers of the Company,
together with certain entities affiliated with them, beneficially owned 44.4% of
the Company's outstanding Common Stock and Motorola, a principal stockholder of
the Company, owned 11.9% 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
combined with Motorola own approximately 15.9% 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.
23
<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: May 11, 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
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