<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 June 30, 2000
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)
415 Oakmead Parkway
Sunnyvale, CA 94086
(Address of principal executive office and zip code)
(408) 938-5200
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to filing requirements
for the past 90 days.
YES [X] NO [_]
As of July 31, 2000, 34,809,187 shares of the Registrant's common stock were
outstanding.
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ECHELON CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2000
INDEX
Page
----
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance
Sheets as of June 30, 2000 and December 31, 1999 3
Condensed Consolidated Statements of
Operations for the three months and six months
ended June 30, 2000 and June 30, 1999 4
Condensed Consolidated Statements of
Cash Flows for the six months ended June 30,
2000 and June 30, 1999 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk 14
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 25
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PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, December 31,
2000 1999
----------- ------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............... $ 16,825 $ 9,336
Short-term investments.................. 5,662 14,968
Accounts receivable, net................ 8,226 7,303
Inventories............................. 6,063 3,159
Other current assets.................... 3,487 2,297
------------ ------------
Total current assets.................... 40,263 37,063
Property and equipment, net............. 2,857 2,648
Other long-term assets.................. 765 0
------------ ------------
$ 43,885 $ 39,711
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable........................ $ 3,518 $ 2,586
Accrued liabilities..................... 3,129 2,540
Deferred revenues....................... 1,269 1,647
------------ ------------
Total current liabilities............... 7,916 6,773
------------ ------------
STOCKHOLDERS' EQUITY:
Common stock............................ 348 332
Additional paid-in capital.............. 131,738 127,613
Accumulated other comprehensive loss.... (245) (202)
Deferred compensation................... (307) (399)
Accumulated deficit..................... (95,565) (94,406)
------------ ------------
Total stockholders' equity.............. 35,969 32,938
------------ ------------
$ 43,885 $ 39,711
============ ============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------- -----------------------------
2000 1999 2000 1999
--------- -------- --------- --------
<S> <C> <C> <C> <C>
REVENUES:
Product............................. $12,100 $ 9,191 $23,040 $17,364
Service............................. 551 591 1,054 1,226
--------- --------- --------- ---------
Total revenues...................... 12,651 9,782 24,094 18,590
--------- --------- --------- ---------
COST OF REVENUES:
Cost of product..................... 4,371 3,588 8,655 6,913
Cost of service..................... 548 399 1,030 779
--------- --------- --------- ---------
Total cost of revenues.............. 4,919 3,987 9,685 7,692
--------- --------- --------- ---------
Gross profit........................ 7,732 5,795 14,409 10,898
--------- --------- --------- ---------
OPERATING EXPENSES:
Product development................. 2,912 2,187 5,275 4,627
Sales and marketing................. 4,162 3,593 8,240 7,093
General and administrative.......... 1,460 1,061 2,629 2,100
--------- --------- --------- ---------
Total operating expenses............ 8,534 6,841 16,144 13,820
--------- --------- --------- ---------
Loss from operations................ (802) (1,046) (1,735) (2,922)
--------- --------- --------- ---------
INTEREST AND OTHER INCOME, NET...... 330 331 652 693
--------- --------- --------- ---------
Loss before provision for income
taxes.............................. (472) (715) (1,083) (2,229)
Provision for income taxes.......... 36 29 76 88
---------- ---------- ---------- ----------
Net loss............................ $ (508) $ (744) $(1,159) $(2,317)
========== ========== ========== ==========
Basic net loss per share............ $ (0.01) $ (0.02) $ (0.03) $ (0.07)
========== ========== ========== ==========
Shares used in computing
basic net loss per share............ 34,507 32,826 34,079 32,733
========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended June 30,
--------------------------------
2000 1999
----------- ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss..................................................................... $(1,159) $ (2,317)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization................................................ 561 498
Deferred compensation expense................................................ 92 94
Change in operating assets and liabilities:
Accounts receivable.......................................................... (923) (1,598)
Inventories.................................................................. (2,904) 945
Other current assets......................................................... (1,190) 985
Other long-term assets....................................................... (765) --
Accounts payable............................................................. 932 79
Accrued liabilities.......................................................... 589 (281)
Deferred revenues............................................................ (378) (598)
Deferred rent................................................................ -- (76)
------------ ------------
Net cash used in operating activities........................................ (5,145) (2,269)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments........................ (509) (29,500)
Proceeds from maturities and sales of available-for-sale
short-term investments.................................................. 9,815 36,029
Unrealized gains (losses) on securities...................................... 7 (28)
Capital expenditures......................................................... (770) (374)
------------ ------------
Net cash provided by investing activities.................................... 8,543 6,127
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock....................................... 4,141 409
------------ ------------
EFFECT OF EXCHANGE RATES ON CASH............................................. (50) (210)
------------ ------------
NET INCREASE IN CASH AND CASH EQUIVALENTS.................................... 7,489 4,057
CASH AND CASH EQUIVALENTS:
Beginning of period.......................................................... 9,336 11,552
-------------- --------------
End of period................................................................ $16,825 $ 15,609
============== ==============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes................................................... $ 48 $ 61
============== ==============
</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,
1999 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 to
licensees 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
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investments in debt and equity securities as available-for-sale in accordance
with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for
Certain Investments in Debt and Equity Securities." As of June 30, 2000, the
Company's available-for-sale securities had contractual maturities from eight to
twenty-three months and an average maturity of three months. The fair value of
available-for-sale securities was determined based on quoted market prices at
the reporting date for those instruments. As of June 30, 2000, the amortized
cost basis, aggregate fair value and gross unrealized holding losses by major
security type were as follows (in thousands):
<TABLE>
<CAPTION>
Unrealized
Amortized Aggregate Holding
Cost Fair Value Losses
---- ---------- ------
<S> <C> <C> <C>
U.S. corporate securities:
Corporate notes and bonds........... $ 5,674 $ 5,662 $ (12)
========= ========== ==========
</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 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.
New Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Investments and Hedging Activities," which
establishes standards for the accounting for derivative transactions and the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for the Company's fiscal year beginning January 1, 2001. Management
believes that SFAS No. 133 will not have a material effect on the Company's
financial statements.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements." SAB 101 provides guidance on applying generally accepted accounting
principles to revenue recognition in financial statements. Under current SEC
guidance, we will be required to adopt SAB 101 in the fourth quarter of 2000.
Management has evaluated the effect of the adoption and has determined that
financial results will not be materially affected.
3. INVENTORIES:
Inventories are stated at the lower of cost (first-in, first-out) or market
and include material, labor and manufacturing overhead. Inventories consist of
the following (in thousands):
June 30, December 31,
2000 1999
--------- ------------
(Unaudited)
Purchased materials....................... $2,423 $1,674
Work-in-process........................... 28 51
Finished goods............................ 3,612 1,434
-------- -------
$6,063 $3,159
======== =======
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4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
June 30, December 31,
2000 1999
------------- ------------
(Unaudited)
<S> <C> <C>
Accrued payroll and related costs............ $2,306 $1,191
Accrued marketing costs...................... 294 372
Other accrued liabilities.................... 529 428
Accrued non-recurring charges................ -- 549
---------- -----------
$3,129 $2,540
========== ===========
</TABLE>
5. SEGMENT DISCLOSURE:
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information." Operating segments are defined as
components of an enterprise about which separate financial information is
available that is evaluated regularly by the chief operating decision maker in
deciding how to allocate resources and in assessing business performance. The
Company's chief operating decision-making group is the Executive Staff, which is
comprised of the Chief Executive Officer and the Vice Presidents. SFAS No. 131
also requires disclosures about products and services, geographic areas and
major customers. The adoption of SFAS No. 131 did not affect results of
operations or the financial position of the Company but did affect the
disclosure of segment information.
The Company operates in one principal industry segment: the design,
manufacture and sale of products for the controls network industry, and markets
its products primarily to the building automation, industrial automation,
transportation, and 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/or the LonWorks protocol. The Company also provides services to
customers which consist of technical support and training courses covering its
LonWorks network technology and products. The Company offers about 80 products
and services that together constitute the LonWorks system. Any given customer
purchases a small subset of such products and services that are appropriate for
that customer's application.
The Company manages its business primarily on a geographic basis. The
Company's geographic areas are comprised of the Americas, Europe, Middle East
and Africa ("EMEA") and Asia Pacific/ Japan ("APJ"). Each geographic area
provides products and services as further described in Note 1. The Company
evaluates the performance of its geographic areas based on profit or loss from
operations. Profit or loss for each geographic area includes sales and marketing
expenses and other charges directly attributable to the area and excludes
certain expenses that are managed outside the geographic area. Costs excluded
from area profit or loss primarily consist of unallocated corporate expenses,
comprised of product development costs, corporate marketing costs and other
general and administrative expenses, which are separately managed. The Company
has no long-lived assets, other than property and equipment and loans to certain
key employees. Long-lived assets are attributed to geographic areas based on the
country where the assets are located. As of June 30, 2000 and December 31, 1999
long-lived assets of about $3.3 million and $2.3 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
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geography because the information is not reviewed by the Executive Staff to make
decisions about resources to be allocated to the geographic areas based on their
performance.
In North America, the Company sells its products through a direct sales
organization. Outside the United States, direct sales, applications engineering
and customer support are conducted through the Company's operations in Europe,
Japan and China. Revenues are attributed to geographic areas based on the
country where the customer is domiciled. Summary information by geography for
the quarters and six months ended June 30, 2000 and 1999 is as follows (in
thousands):
<TABLE>
<CAPTION>
Three Months Ended Six months ended
June 30, June 30,
------------------ -----------------
2000 1999 2000 1999
--------- -------- ------- -------
<S> <C> <C> <C> <C>
Revenues from customers:
Americas........................ $ 3,776 $ 3,515 $ 7,875 $ 6,424
EMEA............................ 6,344 4,369 11,482 8,680
APJ............................. 2,324 1,689 4,324 3,064
Unallocated..................... 207 209 413 422
------- ------- ------- -------
Total...................... $12,651 $ 9,782 $24,094 $18,590
======= ======= ======= =======
Gross profit (loss):
Americas........................ $ 2,352 $ 2,376 $ 4,737 $ 4,283
EMEA............................ 3,711 2,476 6,633 4,970
APJ............................. 1,462 1,034 2,626 2,018
Unallocated..................... 207 (91) 413 (373)
------- ------- ------- -------
Total...................... $ 7,732 $ 5,795 $14,409 $10,898
======= ======= ======= =======
Income (loss) from operations:
Americas........................ $ 1,271 $ 1,423 $ 2,618 $ 2,448
EMEA............................ 2,880 1,618 4,877 3,324
APJ............................. 516 308 741 566
Unallocated..................... (5,470) (4,395) (9,972) (9,260)
------- ------- ------- -------
Total...................... $ (803) $(1,046) $(1,736) $(2,922)
======= ======= ======= =======
</TABLE>
One customer, the sole independent distributor of the Company's products in
Europe, accounted for 27.5% and 28.0% of total revenues for the quarter ended
June 30, 2000 and 1999, respectively and 27.4% and 26.7% of total revenues for
the six months ended June 30, 2000 and 1999, respectively.
6. INCOME TAXES:
Income taxes for the six-month periods ended June 30, 2000 and 1999 primarily
consist of taxes related to foreign subsidiaries.
7. SIGNIFICANT AGREEMENTS
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On June 30, 2000, the Company entered into a definitive binding common
stock purchase agreement with ENEL S.p.A., an Italian company. Under this
agreement, ENEL will purchase three million shares of newly issued common stock
for a purchase price to be based on the average trading price prior to the
closing (subject to a minimum price of $87.3 million and a maximum price of
$130.9 million). It is anticipated that the closing of this agreement will take
place during the third quarter of 2000. However, it is subject to a number of
conditions, including approval under U.S. antitrust legislation (Hart-Scott-
Rodino Act).
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 our
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 "believes," "future," 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 of this Form 10-Q.
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, 1999.
OVERVIEW
We develop, market and support a family of hardware and software products and
services that enables OEMs and systems integrators to design and implement open,
interoperable, distributed control networks. We offer our products and services
to OEMs and systems integrators in the building, industrial, transportation,
home and other automation markets. We provide a variety of technical training
courses related to our products and underlying technology. We also provide
customer support on a per-incident or annual contract basis.
We market our products and services in North America, Europe, Japan, South
America and selected Asia-Pacific countries through a direct sales organization
augmented with the use of third-party distributors and systems integrators.
International sales, which include both export sales and sales by international
subsidiaries, accounted for 68.5% and 61.9% of our total revenues for the second
quarter of 2000 and 1999, respectively and 65.6% and 63.2% of our total revenues
for the six months ended June 30, 2000 and 1999, respectively. The percentage of
our revenues denominated in currencies other than the U.S. dollar, principally
the Japanese Yen, was 10.1% and 8.5% for the second quarter of 2000 and 1999,
respectively and 10.2% and 9.6% for the six months ended June 30, 2000 and 1999,
respectively. However, this percentage may increase over time as we respond to
market requirements to sell our products and services in local currencies, such
as the Euro. As a result, our operations and the market price of our products
may be directly affected by economic and political conditions in the countries
where we do business. We expect that international sales will continue to
constitute a significant portion of total revenues.
We derive our revenues primarily from the sale and licensing of our products
and, to a lesser extent, from fees associated with training and technical
support offered to our customers. Our product revenues consist of revenues from
sales of transceivers, control modules, routers, network interface devices and
development tools and from licenses of network services software products. We
have not had significant revenues from software licensing arrangements to date.
Our service revenues consist of product support (including software post-
contract support services) and training. We recognize revenue from product sales
at the time we ship the products to the customer. We record estimated reserves
for warranty costs as well as for sales returns and
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allowances related to anticipated return of products sold to distributors with
limited rights of return, at the time we sell the products. We recognize revenue
from software sales when we ship the software if we have no significant post-
delivery obligations and if we determine that collection is probable. We
generally have not had any significant post-delivery obligations associated with
the sale of our products. We recognize service revenues as we perform the
services, or ratably over the term of the support period.
We have experienced operating losses in all prior years and for the first six
months of 2000. During this period, we have invested significantly in product
development to implement open control networks. Our development projects
included development of transceivers, control modules, routers, network
interface devices, network management software, LonPoint products and the i.LON
1000 Internet Server. Furthermore, because our strategy depends significantly on
achieving broad adoption of our LonWorks technology across many industries
worldwide, we have incurred significant selling and marketing expenses to
promote our products. We currently believe it is unlikely that our future rate
of growth of product development, sales and marketing expenses will fall below
their historical levels. In addition, we believe that our products are priced
competitively to ensure that our LonWorks technology is broadly adopted in many
industries. We plan to continue to invest significantly in product development,
sales and marketing, and to the extent such expenditures are accelerated to
exploit market opportunities, or do not result in significant increases in
revenues, we may continue to incur operating losses for the foreseeable future.
Our quarterly and annual results have varied significantly, and we expect our
results to continue to vary. Many of the factors that can cause our results to
vary are outside of our control. For example, the rates at which OEMs purchase
our products and services can fluctuate. These rates are affected by the OEMs'
own business cycles. Another factor is whether we can introduce new products in
a timely manner. From time to time, we have delayed introducing new products
beyond our projected shipping date. These delays have increased costs and
postponed revenues. Because our future revenues depend on our ability to timely
introduce new product offerings, any future delays could harm our business. Our
expense levels are based substantially on the levels of future revenues that we
expect to generate. Consequently, if our revenues are less than we expect, our
expense levels could be disproportionately high as a percentage of total
revenues, and our operating results could be harmed. In the past, we have
sometimes failed to meet our expected targets for revenues. In addition,
declines in sales of our existing products over time have hurt the growth of our
revenues.
Revenues
Total revenues grew to $12.7 million in the second quarter of 2000 from $9.8
million in the second quarter of 1999. Total revenues for the six months ended
June 30, 2000 grew to $24.1 million from $18.6 million in the same period in
1999. One customer, EBV, the sole independent distributor of our products in
Europe, accounted for 27.5% of total revenues for the second quarter of 2000 and
28.0% of total revenues for the same period in 1999. For the six months ended
June 30, 2000, EBV accounted for 27.4% of total revenues compared to 26.7% of
total revenues for the same period in 1999.
Product. Product revenues grew to $12.1 million in the second quarter of 2000
from $9.2 million in the second quarter of 1999. Product revenues for the six
months ended June 30, 2000 grew to $23.0 million from $17.4 million in the same
period of 1999. The 31.7% increase in product revenues between the two quarters
and 32.7% increase in product revenues between the two six-month periods was
primarily the result of an increase in sales of control and connectivity
products, network services products, and LonPoint products, as well as the
revenues generated from the sales of the new i.LON 1000 Internet Servers.
Service. Service revenues decreased to $551,000 in the second quarter of 2000
from $591,000 in the second quarter of 1999. Service revenues for the six months
ended June 30, 2000 decreased to $1.1 million from $1.2 million in the same
period of 1999. The 6.8% decrease in service revenues between the two
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quarters and 14.0% decrease between the two six-month periods was primarily due
to reduced customer support revenues partially offset by a slight increase in
training revenue.
Cost of Revenues
Cost of product. Cost of product revenues consists of costs associated with
the purchase of components and subassemblies, as well as allocated labor,
overhead and manufacturing variances associated with the packaging, preparation
and shipment of products. Cost of product revenues in the second quarter of 2000
was $4.4 million compared to $3.6 million in 1999, representing product gross
margins of 63.9% for the second quarter of 2000 and 61.0% for the same period in
1999. Cost of product revenues for the six months ended June 30, 2000 increased
to $8.7 million from $6.9 million in the same period of 1999 representing
product gross margin of 62.4% for the six months ended June 30, 2000 and 60.2%
for the same period in 1999. The increase in product gross margin percentage
for both the quarter and six-month was primarily due to improved overhead
spending rates.
Cost of service. Cost of service revenues consists of employee-related costs
as well as direct costs incurred in providing training and customer support
services. Cost of service revenues increased to $548,000 for the second quarter
of 2000 from $399,000 for the comparative period in 1999, an increase of 37.3%,
representing service gross margins of 0.5% for the second quarter of 2000 and
32.5% for the same period in 1999. Cost of service revenues for the six months
ended June 30, 2000 increased to $1.0 million from $779,000, an increase of
32.2%, representing service gross margins of 2.3% for the six months ended June
30, 2000 and 36.5% for the same period in 1999. The decline in service gross
margins for both the quarter and six-months was due to a decline in service
revenues along with an increase in the cost of providing those services due
primarily to increased personnel costs.
Operating Expenses
Product development. Product development expenses consist primarily of
payroll and related expenses, expensed material and facility costs associated
with the development of new technologies and products. Product development
expenses for the second quarter of 2000 grew to $2.9 million from $2.2 million
in the second quarter of 1999, representing 23.0% of total revenues for the
second quarter of 2000 and 22.4% of total revenues for the same period in 1999.
Product development expenses for the six months ended June 30, 2000 increased to
$5.3 million from $4.6 million in the same period of 1999, representing 21.9% of
total revenues for the six months ended June 30, 2000 and 24.9% of total
revenues for the same period in 1999.
Sales and marketing. Sales and marketing expenses consist primarily of
payroll and related expenses, including commissions to sales personnel, travel
and entertainment, advertising and product promotion and facilities costs
associated with the Company's sales and support offices. Sales and marketing
expenses for the second quarter of 2000 increased to $4.2 million from $3.6
million in the second quarter of 1999, representing 32.9% of total revenues for
the second quarter of 2000 and 36.7% of total revenues for the same period in
1999. Sales and marketing expenses for the six months ended June 30, 2000
increased to $8.2 million from $7.1 million in the same period of 1999,
representing 34.2% of total revenues for the six months ended June 30, 2000 and
38.2% of total revenues for the same period in 1999. The increase in sales and
marketing expenses for the comparison periods was primarily the result of
increased worldwide personnel expenses, including new employees in the sales and
marketing areas as well as increased commissions related to increased revenues.
General and administrative. General and administrative expenses consist
primarily of payroll and related expenses for executive, accounting and
administrative personnel, insurance, professional fees and other general
corporate expenses. General and administrative expenses in the second quarter of
2000 increased to $1.5 million from $1.1 million in the second quarter of 1999,
representing 11.5% of total revenues for the second quarter of 2000 and 10.8% of
total revenues for the same period in 1999. General and administrative
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expenses for the six months ended June 30, 2000 increased to $2.6 million from
$2.1 million in the same period in 1999, representing 10.9% of total revenues
for the six months ended June 30, 2000 and 11.3% of total revenues for the same
period in 1999. The increase in general and administrative expenses for the
comparison periods was primarily the result of one-time costs in the amount of
$337,000 associated with the negotiation of the R&D and stock purchase
agreements with ENEL S.p.A., an Italian company.
Interest and other income, net
Interest and other income, net primarily reflects interest earned by the
Company on its cash and short-term investment balances. Interest and other
income, net for the second quarter of 2000 decreased slightly to $330,000 from
$331,000 for the comparable period in 1999. Interest and other income, net for
the six months ended June 30, 2000 decreased to $652,000 from $693,000 of the
same period in 1999. The decrease for both quarter and six-month periods was
primarily due to a lower cash and short-term investments balance during the
second quarter of 2000 compared to the second quarter of 1999, partially offset
by a higher average yield on our short-term investment portfolio.
Provision for income taxes
Income taxes consist of taxes related to certain of the Company's foreign
subsidiaries. Income taxes were $36,000 for the second quarter of 2000 and
$29,000 for the same period in 1999. Income taxes were $76,000 for the six
months ended June 30, 2000 and $88,000 for the same period in 1999.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, we have financed our operations and met our capital
expenditure requirements primarily from the sale of preferred stock and common
stock. From inception through June 30, 2000, we had raised $132.1 million from
the sale of preferred stock and common stock.
As of June 30, 2000, we had cash, cash equivalents and short-term investments
of $22.5 million. Net cash used in operating activities was $5.1 million in the
six months ended June 30, 2000 compared to $2.3 million in the same period of
1999. Cash used in 2000 was principally the result of a planned increase in
inventories, an increase in other current assets, and the net loss. Cash used in
1999 was principally the result of increases in receivables and the net loss.
Net cash provided by investing activities of $8.5 million in the first half
of 2000 and $6.1 million in the first half of 1999 was principally due to the
net proceeds from maturities and sales of available-for-sale investments,
slightly offset by capital expenditures of $770,000 in the first half of 2000
and $374,000 in the first half of 1999.
Net cash provided by financing activities of $4.1 million in the first half
of 2000 and $409,000 in the first half of 1999 was principally due to the
proceeds from the exercise of stock options by employees.
We believe that our existing available cash, cash equivalents and short-term
investments will satisfy our projected working capital and other cash
requirements for at least the next twelve months. However, we may require
additional financing within this period, but such financing may not be available
to us in the amounts or at the times that we require, or on acceptable terms. If
we fail to obtain additional financing, when and if necessary, our business
would be harmed.
In addition, on June 30, 2000, we entered into a common stock purchase
agreement with ENEL S.p.A., an Italian company. Under this agreement, ENEL will
purchase three million shares of newly issued common stock for a purchase price
to be based on the average trading price prior to the closing (subject to a
minimum
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price of $87.3 million and a maximum price of $130.9 million). The closing of
this agreement is subject to a number of conditions, including approval under
U.S. antitrust legislation (Hart-Scott-Rodino Act).
Year 2000 Compliance
We did not experience any system problems relating to the Year 2000 issue. To
our knowledge, none of our material suppliers or vendors experienced any
material Year 2000 problems. We do not expect to incur any material expenditures
relating to Year 2000 systems remediation.
New Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Investments and Hedging Activities," which
establishes standards for the accounting for derivative transactions and the
derivative portion of certain other contracts. SFAS No. 133 will become
effective for our fiscal year beginning January 1, 2001. We believe that SFAS
No. 133 will not have a material effect on our financial statements.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements." SAB 101 provides guidance on applying generally accepted accounting
principles to revenue recognition in financial statements. Under current SEC
guidance, we will be required to adopt SAB 101 in the fourth quarter of 2000.
Management has evaluated the effect of the adoption and has determined that our
financial results will not be materially affected.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
There has not been any material change in our exposure to interest rate and
foreign currency risks since the date of the 1999 Form 10-K.
Interest Rate Risk. Our exposure to market risk for changes in interest rates
relates primarily to our investment portfolio. All investments are in high-
credit quality issuances, and, by our company policy, are limited in the amount
of credit exposure to any one issuer. We ensure the safety and preservation of
the invested principal funds by investing only in marketable securities with
active secondary or resale markets to maintain portfolio liquidity. The table
below presents principal amounts and related weighted average interest rates for
our investment portfolio at June 30, 2000. According to our policy, all
investments mature in two years or less.
<TABLE>
<CAPTION>
Average
Carrying Amount Interest Rate
------------------ ----------------
(in thousands)
<S> <C> <C>
Cash Equivalents:
U.S. corporate securities.................. $10,768 6.73%
------- ----
Total cash equivalents................ $10,768 6.73%
------- ----
Short-term Investments:
U.S. corporate securities.................. $ 5,662 6.18%
------- ----
Total short-term investments.......... $ 5,662 6.18%
------- ----
Total investment securities........... $16,430 6.54%
======= ====
</TABLE>
Foreign Currency Exchange Risk. We transact business in various foreign
countries. Our primary foreign currency cash flows are in Japan. Currently, we
do not employ a foreign currency hedge program utilizing foreign currency
exchange contracts as the foreign currency transactions and risks to date have
not been significant.
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FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
WE HAVE A HISTORY OF LOSSES, AND WE MAY INCUR LOSSES IN THE FUTURE.
We have incurred net losses each year since our inception. At June 30, 2000,
we had an accumulated deficit of $95.6 million. We have invested and continue to
invest significant financial resources in product development, marketing and
sales. If our revenues do not increase significantly as a result of these
expenditures, our financial results could decline. We may not achieve
profitability if our revenues increase more slowly than we expect or do not
increase at all. Even if we achieve profitability, we may not be able to
sustain or increase profitability on a quarterly or annual basis. Our future
operating results will depend on many factors, including:
. the growth of the markets for our products;
. the acceptance of our products;
. the level of competition that we face;
. our ability to develop and market new products; and
. general economic conditions.
As of December 31, 1999, we had net operating loss carryforwards for Federal
income tax reporting purposes of about $83.9 million and for state income tax
reporting purposes of about $4.9 million, which expire at various dates through
2019. In addition, as of December 31, 1999, we had tax credit carryforwards of
about $4.4 million, which expire at various dates through 2019. The Internal
Revenue Code of 1986, as amended, contains provisions that may limit the use in
any future period of net operating loss and credit carryforwards upon the
occurrence of certain events, including a significant change in ownership
interests. We had deferred tax assets, including our net operating loss
carryforwards and tax credits, totaling about $37.9 million as of December 31,
1999. A valuation allowance has been recorded for the entire deferred tax asset
as a result of uncertainties regarding the realization of the asset balance, our
history of losses and the variability of our operating results.
OUR LIMITED HISTORY AND THE UNDETERMINED MARKET ACCEPTANCE OF OUR PRODUCTS MAKE
IT DIFFICULT TO EVALUATE OUR FUTURE PROSPECTS.
We have only a limited operating history on which you can base your
evaluation of our business. We face a number of risks as an emerging company in
a new market, and you must consider our prospects in light of these risks. Our
future operating results are difficult to predict due to many factors, including
the following:
. our targeted markets have not yet accepted many of our products and
technologies;
. the nature of our business and markets require rapid progress;
. potential changes in voluntary product standards can significantly influence
many of the markets for our products; and
. our industry is very competitive.
OUR FUTURE RESULTS COULD BE SIGNIFICANTLY HARMED IF OUR PROJECT WITH ENEL S.P.A.
IS NOT SUCCESSFUL.
We have entered into a research and development agreement with an affiliate
of ENEL S.p.A., an Italian utility, under which we will cooperate with ENEL to
integrate our LonWorks system into ENEL's remote metering management project in
Italy. This project is called "Contratore Elettronico." We face a number of
risks as we undertake this project, including:
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. our research and development activities under this project might be
unsuccessful, or might not be commercially exploitable,
. the Contratore Elettronico project might not meet target dates,
. the products we develop for the Contratore Elettronico might not yield
economic returns, or
. the research and development agreement might be terminated if, among other
things, either party materially breaches its obligations under the
agreement.
If our efforts under this research and development agreement or the related
Contratore Elettronico project are not successful, our revenues and income could
suffer.
FLUCTUATIONS IN OUR OPERATING RESULTS MAY CAUSE OUR STOCK PRICE TO DECLINE.
Our quarterly and annual results have varied significantly, and we have
failed to meet securities analysts' expectations in the past. Our future results
may fluctuate and may not meet those expectations in some future period. As a
result, the price of our common stock could fluctuate or decline. The factors
that could cause this variability, many of which are outside of our control,
include the following:
. fluctuations in the rates at which OEMs purchase our products and services;
. OEMs' own business cycles;
. our ability to introduce new products on a timely basis;
. any downturns in any customer's or potential customer's business, or
declines in general economic conditions that cause significant reductions in
their capital spending;
. increased competition;
. market acceptance of our products;
. product life cycles;
. order delays or cancellations;
. changes in the mix of products and services that we sell;
. shipment and payment schedules;
. changes in our pricing policies or those of our competitors;
. changes in product distribution; and
. product ratings by industry analysts and endorsement of competing products
by industry groups.
In addition, our expense levels are based, in significant part, on the future
revenues that we expect. Consequently, if our revenues are less than we expect,
our expense levels could be disproportionately high as a percentage of total
revenues.
IF OUR OEMS DO NOT EMPLOY OUR PRODUCTS AND TECHNOLOGIES, OR IF WE DO NOT
MAINTAIN AND EXPAND OUR DISTRIBUTION CHANNELS, OUR REVENUES COULD DECREASE
SIGNIFICANTLY.
To date, substantially all of our product sales have been to OEMs. The
product and marketing decisions made by OEMs significantly affect the rate at
which our products are used in control networks. We believe that since OEMs in
certain industries receive a large portion of their revenues from sales of
products and services to their installed base, these OEMs have tended to
moderate the rate at which they incorporate LonWorks technology into their
products. We have attempted to motivate OEMs, as well as systems integrators and
owners of control systems, to transition more rapidly to LonWorks technology.
Furthermore, OEMs that manufacture and promote products and technologies that
compete or may compete with us may be particularly reluctant to employ our
products and technologies to any significant extent, if at all. We may not
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be able to maintain or improve the current rate at which our products are
accepted by OEMs and others, which could decrease our revenues.
Currently, significant portions of our revenues are derived from sales by EBV,
the sole independent distributor of our products to OEMs in Europe. EBV
accounted for 27.5% of total revenues for the quarter ended June 30, 2000 and
28.0% of total revenues for the same period in 1999, and 27.4% of total revenues
for the six months ended June 30, 2000 and 26.7% of total revenues for the same
period in 1999. Our current agreement with EBV expires in December 2000. In
addition, as part of our distribution strategy, we intend to develop
distribution arrangements with systems integrators. In particular, we expect
that a significant portion of our future revenues will be derived from sales by
such systems integrators. If EBV, or any other existing or future distributor,
fails to dedicate sufficient resources and efforts to marketing and selling our
products, our revenues could decrease. If EBV significantly reduces the stocking
levels for our products, both revenues and customer service levels would be
decreased. In that case, we might be required to add our own pan-European
distribution capability to meet the needs of our customers. Our business will be
harmed if we fail to do any of the following:
. develop new distribution channels;
. maintain the EBV arrangement or any other distribution channels; or
. renew the EBV arrangement on a timely basis.
WE DEPEND ON A LIMITED NUMBER OF KEY MANUFACTURERS FOR NEURON CHIPS AND USE
CONTRACT ELECTRONIC MANUFACTURERS FOR MOST OF OUR PRODUCTS REQUIRING ASSEMBLY.
IF ANY OF THESE MANUFACTURERS TERMINATES OR DECREASES ITS RELATIONSHIPS WITH US,
WE MAY NOT BE ABLE TO SUPPLY OUR PRODUCTS AND OUR REVENUES WOULD SUFFER.
The Neuron Chip is an important component that our customers use in control
network nodes. In addition, the Neuron Chip is an important device that we use
in many of our products. Neuron Chips are currently distributed by both Motorola
and Toshiba. We have entered into licensing agreements with each of Motorola,
Toshiba and Cypress. The agreements, among other things, grant Motorola, Toshiba
and Cypress the worldwide right to manufacture and distribute Neuron Chips using
technology licensed from us and require us to provide support and unspecified
updates to the licensed technology over the terms of the agreements. The
Motorola agreement expires in January 2001, the Cypress agreement expires in
April 2009, and the Toshiba agreement expires in January 2010. Motorola has
announced that it will discontinue distribution of Neuron Chips after January
31, 2001, although Motorola has the right to terminate the agreement at any
time. While we developed the first version of the Neuron Chip, Motorola and
Toshiba subsequently developed improved, lower-cost versions of the Neuron Chip
that are presently used in products that our customers and we develop and sell.
We currently have no other source of supply for Neuron Chips and have neither
the resources nor the skills to replace Toshiba or Cypress as a manufacturer of
Neuron Chips. Both Motorola and Toshiba have played, and Toshiba and Cypress are
expected to play, a key role in the development and marketing of LonWorks
technology. If we lose Toshiba or Cypress as a supplier, we may not be able to
locate an alternate source for the design, manufacture or distribution of Neuron
Chips.
Our future success will also depend significantly on our ability to
successfully manufacture our products cost-effectively and in sufficient
volumes. For most of our products requiring assembly, we use contract electronic
manufacturers, including Able Electronics, Jabil Circuits and muRata
Electronics. These contract electronic manufacturers procure material and
assemble, test and inspect the final products to our specifications. This
strategy involves certain risks. By using third parties to manufacture our
products, we have reduced control over delivery schedules, product availability,
manufacturing yields, quality and costs. In addition, contract electronic
manufacturers can themselves experience turnover and instability exposing us to
additional risks as well as missed commitments to our customers. We will also
face risks if and when we transition between contract electronic manufacturers.
For example, we may have to move raw material and in
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process inventory between locations in different parts of the world. Also, we
would be required to reestablish acceptable manufacturing processes with a new
work force. We currently purchase several key components only from sole or
limited sources. If we experience any shortage of products or components of
acceptable quality, or any interruption in the supply of these products or
components, or if we are not able to procure these products or components from
alternate sources at acceptable prices and within a reasonable period of time,
our revenues and/or gross profits could decrease. In the past, we have sometimes
experienced shortages or supply interruptions of products or components, which
caused us to delay shipments beyond targeted or announced dates.
MANY OF OUR CURRENT COMPETITORS HAVE LONGER OPERATING HISTORIES AND
SIGNIFICANTLY GREATER FINANCIAL, TECHNICAL, MARKETING AND OTHER RESOURCES THAN
WE DO, AND MAY BE MORE SUCCESSFUL AT SELLING THEIR PRODUCTS THAN WE ARE.
Competition in our markets is intense and involves rapidly changing
technologies, evolving industry standards, frequent new product introductions
and rapid changes in customer requirements. To maintain and improve our
competitive position, we must continue to develop and introduce, on a timely and
cost-effective basis, new products, features and services that keep pace with
the evolving needs of our customers. The principal competitive factors that
affect the markets for our control network products are the following:
. our customer service and support;
. our product reputation, quality, performance; and
. the price and features of our products such as adaptability, scalability, the
ability to integrate with other products, functionality, and ease of use.
In each of our markets, we compete with a wide array of manufacturers,
vendors, strategic alliances, systems developers and other businesses. Our
competitors include some of the largest companies in the electronics industry,
such as Siemens in the building and industrial automation industries and Allen-
Bradley, a subsidiary of Rockwell, and Group Schneider in the industrial
automation industry. Many of our competitors, alone or together with their trade
associations and partners, have significantly greater financial, technical,
marketing, service and other resources, significantly greater name recognition
and broader product offerings. As a result, these competitors may be able to
devote greater resources to the development, marketing and sale of their
products, and may be able to respond more quickly to changes in customer
requirements or product technology. In addition, those competitors that
manufacture and promote closed, proprietary control systems may enjoy a captive
customer base dependent on such competitors for service, maintenance, upgrades
and enhancements. Products from emerging companies such as emWare could also
compete with our products, especially in the home market. Even if we believe
that the products offered by some of these emerging companies do not provide the
robust and open networking solutions offered by LonWorks networks, we would be
required to educate our customers about what we believe are the potential long-
term cost and functionality problems inherent in such alternative solutions.
However, our customers may believe that these alternative products are
satisfactory for their needs.
Many of our current and prospective competitors are dedicated to promoting
closed or proprietary systems, technologies, software and network protocols or
product standards that differ from, or are incompatible with ours. In some
cases, companies have established associations or cooperative relationships to
enhance the competitiveness and popularity of their products, or to promote
these different or incompatible technologies, protocols and standards. For
example, in the building automation market, we face widespread reluctance by
vendors of traditional closed or proprietary control systems, who enjoy a
captive market for servicing and replacing equipment, to use our interoperable
technologies. We also face strong competition by large trade associations that
promote alternative technologies and standards in their native countries, such
as the BatiBus Club International in France and the European Installation Bus
Association in Germany, each of which has over 100 members and licensees. Other
examples include the CEBus Industry Council, which is the proponent
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of an alternative protocol to our LonWorks 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 our LonWorks protocol. Our technologies, protocols or
standards may not be successful in any of our markets, and we may not be able to
compete with new or enhanced products or standards introduced by existing or
future competitors.
LonWorks technology is open, meaning that many of our technology patents are
broadly licensed without royalties or license fees. As a result, our customers
are capable of developing products that compete with some of our products.
Because some of our customers are OEMs that develop and market their own control
systems, these customers in particular could develop competing products based on
our open technology. This could decrease the market for our products and
increase the competition that we face.
THE TRADING PRICE OF OUR STOCK HAS BEEN VOLATILE, AND MAY FLUCTUATE DUE TO
FACTORS BEYOND OUR CONTROL.
The trading price of our common stock is subject to significant fluctuations
in response to numerous factors, including:
. our quarterly operating results may vary widely;
. our customers or we may announce technological innovations or new products;
. securities analysts may change their estimates of our financial results; and
. significant stockholders may sell some or all of their holdings of our stock.
In addition, the market price of securities of technology companies,
especially those in new or emerging industries such as ours, has been very
volatile in the past. This volatility is often unrelated to the operating
performance of particular companies. In the future, our operating results may
fall below analysts' expectations, which could adversely affect the market price
of our stock. In the past, following a period of volatility in the market price
of a company's securities, securities class action lawsuits have often been
instituted against such companies. If such a lawsuit were brought against us,
regardless of its outcome, we would incur substantial costs and our management
resources would be diverted in defending such litigation.
OUR EXECUTIVE OFFICERS AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR BUSINESS, AND
WITHOUT THEM WE MAY NOT BE ABLE TO EXECUTE OUR BUSINESS STRATEGY.
Our performance depends substantially on the performance of our executive
officers and key employees. We are dependent in particular on our Chief
Executive Officer, as well as our technical personnel, due to the specialized
technical nature of our business. Our future success will depend on our ability
to attract, integrate, motivate and retain qualified technical, sales,
operations and managerial personnel. Competition for qualified personnel in our
business areas is intense, and we may not be able to continue to attract and
retain qualified executive officers and key personnel necessary to enable our
business to succeed. Our product development and marketing functions are largely
based in Silicon Valley, a highly competitive marketplace. It is particularly
difficult to recruit, relocate, and retain qualified personnel in this
geographic area. In addition, if we lose the services of any of our key
personnel and are not able to find replacements in a timely manner, business
could be disrupted, other key personnel may decide to leave, and we may incur
increased operating expenses in finding and compensating a replacement.
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THE MARKET FOR OUR PRODUCTS IS NEW AND RAPIDLY EVOLVING. IF WE ARE NOT ABLE TO
DEVELOP OR ENHANCE PRODUCTS TO RESPOND TO CHANGING MARKET CONDITIONS, OUR
REVENUES WILL SUFFER.
Customer requirements for control network products can change as a result of
innovations or changes within the building, industrial, transportation, home and
other industries. For example, new or different standards within industry
segments may be adopted, giving rise to new customer requirements. These
customer requirements may or may not be compatible with our current or future
product offerings. Our future success depends in large part on our ability to
continue to enhance existing products, lower product cost and develop new
products that maintain technological competitiveness. We may not be successful
in modifying our products and services to address these requirements and
standards. For example, certain of our competitors may develop competing
technologies based on Internet Protocols (IP) that may have advantages over our
products in remote connection. In addition, from time to time, we have delayed
introducing new products beyond our projected shipping date for such products.
In each instance, these delays increased our costs and delayed our revenues.
IF OUR INTEROPERABLE PRODUCTS ARE NOT ACCEPTED BY OUR TARGETED MARKETS, WE MAY
BE UNABLE TO GENERATE SALES OF OUR PRODUCTS.
Our future operating success will depend, in significant part, on the
successful development of interoperable products by us and OEMs, and the
acceptance of interoperable products by systems integrators and end-users. We
have expended considerable resources to develop, market and sell interoperable
products, and have made such products a cornerstone of our sales and marketing
strategy. We have widely promoted interoperable products as offering benefits
such as lower life-cycle costs and improved flexibility to owners and users of
control networks. However, OEMs that manufacture and market closed systems may
not accept, promote or employ interoperable products, since doing so may expose
their businesses to increased competition. In addition, OEMs might not, in fact,
successfully develop interoperable products, or their interoperable products
might not be accepted by their customers. If OEMs fail to develop interoperable
products, or interoperable products are not accepted by our markets, our
revenues will suffer.
WE FACE OPERATIONAL AND FINANCIAL RISKS ASSOCIATED WITH INTERNATIONAL
OPERATIONS.
Our sales and marketing operations are located in eight countries. Revenues
from international sales, which include both export sales and sales by
international subsidiaries, accounted for 68.5% of our total revenues for the
second quarter of 2000 and 61.9% of our total revenues for the same period in
1999, and 65.6% of our total revenues for the six months ended June 30, 2000 and
63.2% of our total revenues for the same period in 1999. Our operations and the
market price of our products may be directly affected by economic and political
conditions in the countries where we do business. In addition, we may not be
able to maintain or increase the international demand for our products.
Additional risks inherent in our international business activities generally
include the following:
. currency fluctuations;
. unexpected changes in regulatory requirements, tariffs and other trade
barriers;
. costs of localizing products for foreign countries and lack of acceptance of
non-local products in foreign countries;
. longer accounts receivable payment cycles;
. difficulties in managing international operations;
. potentially adverse tax consequences, including restrictions on repatriation
of earnings; and
. the burdens of complying with a wide variety of foreign laws.
Differing vacation and holiday patterns in other countries, particularly in
Europe, may also affect the
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amount of business that we transact in other countries in any quarter, the
timing of our revenues and our ability to forecast our projected operating
results for such quarter. The portion of our revenues that were conducted in
currencies other than the U.S. dollar, principally the Japanese Yen, was 10.1%
for the second quarter of 2000 and 8.5% for the same period in 1999, and 10.2%
for the six months ended June 30, 2000 and 9.6% for the same period in 1999.
Fluctuations in the value of currencies in which we conduct our 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 our ability to transact sales in U.S. dollars. We have
agreed with EBV, our European distributor, that upon notice from EBV, we will
sell our products to EBV in Euros rather than U.S. dollars. We do not know when
or if EBV will give such notice. If fewer of our sales in Europe are transacted
in U.S. dollars, we may experience an increase in currency translation
adjustments, particularly as a result of general economic conditions in Europe
as a whole. We do not currently engage in currency hedging transactions or
otherwise cover our foreign currency exposure.
AS A RESULT OF OUR LENGTHY SALES CYCLE, WE HAVE LIMITED ABILITY TO FORECAST THE
AMOUNT AND TIMING OF SPECIFIC SALES. IF WE FAIL TO COMPLETE OR ARE DELAYED IN
COMPLETING TRANSACTIONS, OUR REVENUES COULD VARY SIGNIFICANTLY FROM PERIOD TO
PERIOD.
The sales cycle between initial customer contact and execution of a contract
or license agreement with a customer can vary widely. OEMs typically conduct
extensive and lengthy product evaluations before making initial purchases of our
products. Subsequent purchases of our products may be delayed by prolonged
product development and introduction periods for OEMs. Attendant delays in our
sales cycle can result from, among other things, changes in customers' budgets
or in the priority assigned to control network development and the need to
educate customers about the potential applications of, and cost savings
associated with, our products. We generally have little or no control over these
factors, which may cause a potential customer to favor a competitor's products,
or to delay or forgo purchases altogether. Also, there can be long sales cycles
between the selection of our products for use by a systems integrator, and the
purchase of such products by the systems integrator.
WE HAVE LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS.
Our success depends significantly upon our intellectual property rights. We
rely on a combination of patent, copyright, trademark and trade secret laws,
non-disclosure agreements and other contractual provisions to establish,
maintain and protect our intellectual property rights, all of which afford only
limited protection. We have 78 issued U.S. patents, 13 pending U.S. patent
applications, and various foreign counterparts. It is possible that patents will
not issue from these pending applications or from any future applications or
that, if issued, any claims allowed will not be sufficiently broad to protect
our technology. If any of our patents fail to protect our technology, our
competitors may find it easier to offer equivalent or superior technology. We
have registered or applied for registration for certain trademarks, and will
continue to evaluate the registration of additional trademarks as appropriate.
If we fail to properly register or maintain our trademarks or to otherwise take
all necessary steps to protect our trademarks, the value associated with the
trademarks may diminish. In addition, if we fail to take all necessary steps to
protect our trade secrets or other intellectual property rights, we may not be
able to compete as effectively in our markets. Despite our efforts to protect
our proprietary rights, unauthorized parties may attempt to copy aspects of our
products or services or to obtain and use information that we regard as
proprietary. Any of the patents, trademarks, copyrights or intellectual property
rights that have been or may be issued or granted to us could be challenged,
invalidated or circumvented, and any of the rights granted may not provide
protection for our proprietary rights. In addition, there can be no assurance
that we have taken or will take all necessary steps to protect our intellectual
property rights. Third parties may also independently develop similar technology
without breach of our trade secrets or other proprietary rights. We have
licensed in the past and may license in the future our key technologies to third
parties. In addition, the laws of some foreign countries, including several in
which we operate or sell our products, do not protect proprietary rights to as
great an extent as do the laws of the United States. Certain of
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our products are licensed under shrink-wrap license agreements that are not
signed by licensees and therefore may not be binding under the laws of certain
jurisdictions.
From time to time, litigation may be necessary to defend and enforce our
proprietary rights. As a result of this litigation, we could incur substantial
costs and divert management resources, which could harm our business, regardless
of the final outcome. Despite our efforts to safeguard and maintain our
proprietary rights both in the United States and abroad, we may be unsuccessful
in doing so. Also, the steps that we take to safeguard and maintain our
proprietary rights may be inadequate to deter infringement, misuse,
misappropriation or independent third-party development of our technology or
intellectual property rights or to prevent an unauthorized third party from
copying or otherwise obtaining and using our products or technology.
DEFECTS IN OR MISUSE OF OUR PRODUCTS COULD RESULT IN A LOSS OF OR DELAY IN
MARKET ACCEPTANCE, INCREASED SERVICE AND WARRANTY COSTS, AND INCREASED LIABILITY
FOR COMPENSATORY OR OTHER DAMAGES.
The products that we develop, license and sell may contain errors or failures
or may be improperly installed or implemented. Errors or failures may be found
in our products, and we may not be able to successfully correct those errors or
failures in a timely manner or at all. In addition, our products may not be
properly installed or implemented by third parties. In addition, such errors or
failures may delay our revenue recognition and divert our engineering resources
to correct such defects. We maintain errors and omissions insurance to cover
liability associated with our operations but it is possible that such insurance
may not be available or may be insufficient in amount to cover any particular
claim. Although our agreements with our customers typically contain provisions
intended to limit our exposure to potential claims as well as any liabilities
arising from such claims, and may in very limited instances require that we be
named as an additional insured under the insurance policies carried by some of
our customers, such contracts and insurance may not effectively protect us
against the liabilities and expenses associated with product errors or failures.
Accordingly, errors or failures in our products or applications or improper
installation or implementation of our products by third parties could harm our
operating results. In addition, because of the low cost and interoperable nature
of our products, LonWorks technology could be used in a manner for which it was
not intended. As a result, our reputation could be harmed and we might suffer
material financial losses.
REGULATORY ACTIONS COULD AFFECT OUR ABILITY TO MARKET AND SELL OUR PRODUCTS.
Many of our products and the industries in which they are used are subject to
U.S. and foreign regulation. Government regulatory action could greatly reduce
the market for our products. For example, the power line medium, which is the
communications medium used by some of our products, is subject to special
regulations in North America, Europe and Japan. These regulations limit the
ability of companies in general to use power lines as a communication medium. In
addition, some of our competitors have attempted to use regulatory actions to
reduce the market opportunity for some of our products or to increase the market
opportunity for the competitors' products. In the late 1990's, we experienced
efforts by CEMA, a trade association that developed a competing home automation
protocol, to persuade the FCC to mandate use of its protocol in analog
television and set-top box applications. We were a petitioner in litigation
arising from a related FCC proceeding concerning commercial availability of
these "navigation devices." An appeal under this case was recently decided in
favor of the government. We have decided not to seek Supreme Court review.
Although these specific FCC and judicial proceedings are not a significant
threat to our digital and Internet-based products, existing or future
regulations or regulatory actions could adversely affect the market for our
products or require us to expend significant management, technical or financial
resources.
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VOLUNTARY STANDARDS THAT ARE ESTABLISHED IN OUR MARKETS COULD LIMIT OUR ABILITY
TO SELL OUR PRODUCTS AND REDUCE OUR REVENUES.
Standards bodies, which are formal and informal associations that attempt to
set voluntary, non-governmental product standards, are influential in many of
our target markets. Some of our competitors have attempted to use voluntary
standards to reduce the market opportunity for our products, or to increase the
market opportunity for the competitors' products, by lobbying for the adoption
of voluntary standards that would exclude or limit the use of our products. We
participate in many voluntary standards processes both to avoid adoption of
exclusionary standards and to promote voluntary standards for our products.
However, we do not have the resources to participate in all voluntary standards
processes that may affect our markets. The adoption of voluntary standards that
are incompatible with our products or technology could limit the market
opportunity for our products.
OUR EXISTING STOCKHOLDERS CONTROL A SIGNIFICANT PERCENTAGE OF OUR STOCK, WHICH
WILL LIMIT YOUR ABILITY TO INFLUENCE CORPORATE MATTERS.
As of July 31, 2000, our directors and executive officers, together with
certain entities affiliated with them, beneficially owned 32.2% of our
outstanding stock. In addition, if our stock purchase agreement with ENEL is
completed, ENEL will be entitled to nominate a director to our Board of
Directors, and the percentage of our outstanding stock that would be owned by
our directors and executive officers, together with certain entities affiliated
with them, would increase to 39.7%.
Under the stock purchase agreement with ENEL, ENEL would be required to (i)
vote (and cause any of its affiliates that own shares of our common stock to
vote) all of its shares in favor of the slate of director nominees recommended
by the Board of Directors, and (ii) vote (and endeavor to cause any of its
affiliates that own shares of our common stock to vote) a number of shares equal
to at least that percentage of shares voted by all other stockholders for or
against any specified matter, as recommended by the Board of Directors. The
specified matters are the election of accountants, the approval of company
options plans, and any proposal by any of our stockholders (unless the proposal
could be prejudicial to ENEL or the required voting would interfere with ENEL's
fiduciary duties to its own shareholders).
Under the terms of another stock purchase agreement, one other stockholder
that owns about 1% of our outstanding common stock has agreed to vote (i) all of
its shares in favor of the slate of director nominees recommended by the Board
of Directors, and (ii) a number of shares equal to at least that percentage of
shares voted by all other stockholders for or against any given matter, as
recommended by the Board of Directors (except certain matters relating to
certain changes to our charter, liquidations, a sale of our company or a merger
of our company into another entity), as recommended by a majority of our Board
of Directors.
As a result, our directors and executive officers, together with certain
entities affiliated with them, may be able to control substantially all matters
requiring approval by our stockholders, including the election of all directors
and approval of certain other corporate matters.
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PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
On July 19, 2000, our company was sued by an individual, Kathleen
Calabrese, for alleged direct and indirect infringement of a recently
expired patent claiming a data relay system. By her amended complaint,
Calabrese added Echelon as a defendant in the action previously
commenced against five other defendants in the Federal District Court
for the Eastern District of Illinois. Management believes that we do
not infringe the patent, and we intend to vigorously defend the
action.
ITEM 2. CHANGES IN SECURITIES
On June 30, 2000, our company entered into a common stock purchase
agreement with ENEL S.p.A., an Italian company. Under the stock
purchase agreement, ENEL has agreed to purchase, for cash, three
million newly issued shares of our common stock for a purchase price
to be based on the average trading price prior to the closing (subject
to a minimum price of $87.3 million and a maximum price of $130.9
million). The closing of this stock purchase is subject to a number of
conditions, including approval under U.S. antitrust legislation
(namely, the Hart-Scott-Rodino Act). The sale of the common stock will
be exempt from registration under U.S. securities laws pursuant to
Section 4(2) of the Securities Act of 1933.
The stock purchase agreement gives ENEL the right to nominate a
director to Echelon's Board of Directors as long as ENEL owns at least
two million shares of our common stock. As a condition to the closing
of the stock purchase agreement, our directors will agree to enter
into a voting agreement with ENEL in which each of them will agree to
vote the shares of our company's common stock that they beneficially
own or control in favor of ENEL's nominee to our Board of Directors.
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.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Echelon Corporation
Date: August 11, 2000 By /s/ Oliver R. Stanfield
------------------------
Oliver R. Stanfield,
Vice President Finance and Chief
Financial Officer (Duly
Authorized Officer and Principal
Financial and Accounting
Officer)
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