Echelon Corporation 10Q For the Period Ended March 31, 2006
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, 2006
OR
|
[
]
|
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF
1934
|
For
the transition period from _______________ to
_______________
000-29748
(Commission
file number)
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)
|
550
Meridian Avenue
San
Jose, CA 95126
(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.
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
|
|
Large
accelerated filer o
|
|
Accelerated
filer x
|
|
Non-accelerated
filer ¨
|
|
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
As
of
April 30, 2006, 39,711,002 shares of the registrant’s common stock were
outstanding.
ECHELON
CORPORATION
FORM
10-Q
FOR
THE QUARTER ENDED MARCH 31, 2006
INDEX
| |
|
|
Page
|
|
Part
I.
|
|
FINANCIAL
INFORMATION
|
|
|
Item
1.
|
|
|
|
| |
|
|
3
|
| |
|
|
4
|
| |
|
|
5
|
| |
|
|
6
|
|
Item
2.
|
|
|
23
|
|
Item
3.
|
|
|
57
|
|
Item
4.
|
|
|
57
|
| |
|
|
|
|
Part
II.
|
|
|
|
|
Item
1.
|
|
|
59
|
|
Item
1A.
|
|
|
59
|
|
Item
2.
|
|
|
59
|
|
Item
6.
|
|
|
59
|
| |
|
|
|
FORWARD-LOOKING
INFORMATION
This
report
contains forward-looking statements within the meaning of the U.S. federal
securities laws that involve risks and uncertainties. Certain statements
contained in this report are not purely historical including, without
limitation, statements regarding our expectations, beliefs, intentions,
anticipations, commitments or strategies regarding the future that are
forward-looking. These statements include those discussed in Item 2,
Management’s Discussion and Analysis of Financial Condition and Results of
Operations, including “Liquidity and Capital Resources,” “Recently Issued
Accounting Standards” and “Factors That May Affect Future Results of
Operations,” and elsewhere in this report. These statements include statements
concerning projected revenues, international revenues, expenses, gross profit,
income, product development and market acceptance of our
products.
In
this
report, the words “may,” “could,” “would,” “might,” “will,” “should,” “plan,”
forecast,” “anticipate,” “believe,” “expect,” “intend,” “estimate,” “predict,”
“potential,” “continue,” “future,” “moving toward” or the negative of these
terms or other similar expressions also identify forward-looking statements.
Our
actual results could differ materially from those forward-looking statements
contained in this report as a result of a number of risk factors including,
but
not limited to, those set forth in the section entitled “Factors That May Affect
Future Results of Operations” and elsewhere in this report. You should carefully
consider these risks, in addition to the other information in this report and
in
our other filings with the SEC. All forward-looking statements and reasons
why
results may differ included in this report are made as of the date of this
report, and we assume no obligation to update any such forward-looking statement
or reason why such results might differ.
PART
I. FINANCIAL INFORMATION
ECHELON
CORPORATION
(In
thousands)
(Unaudited)
| |
|
March
31,
2006
|
|
December
31,
2005
|
|
|
ASSETS
|
|
|
|
|
|
|
|
|
CURRENT
ASSETS:
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
65,437
|
|
$
|
59,080
|
|
|
Short-term
investments
|
|
|
86,085
|
|
|
95,400
|
|
|
Accounts
receivable, net
|
|
|
6,155
|
|
|
11,006
|
|
|
Inventories
|
|
|
3,444
|
|
|
3,240
|
|
|
Other
current assets
|
|
|
4,016
|
|
|
2,289
|
|
|
Total
current assets
|
|
|
165,137
|
|
|
171,015
|
|
| |
|
|
|
|
|
|
|
|
Property
and equipment, net
|
|
|
14,885
|
|
|
14,886
|
|
|
Goodwill
|
|
|
8,075
|
|
|
8,018
|
|
|
Other
long-term assets
|
|
|
2,002
|
|
|
2,019
|
|
|
Total
Assets
|
|
$
|
190,099
|
|
$
|
195,938
|
|
| |
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
CURRENT
LIABILITIES:
|
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
4,333
|
|
$
|
3,972
|
|
|
Accrued
liabilities
|
|
|
4,601
|
|
|
7,473
|
|
|
Deferred
revenues
|
|
|
6,591
|
|
|
2,096
|
|
|
Total
current liabilities
|
|
|
15,525
|
|
|
13,541
|
|
| |
|
|
|
|
|
|
|
|
LONG-TERM
LIABILITIES:
|
|
|
|
|
|
|
|
|
Deferred
rent, net of current portion
|
|
|
1,150
|
|
|
1,089
|
|
|
Total
long-term liabilities
|
|
|
1,150
|
|
|
1,089
|
|
| |
|
|
|
|
|
|
|
|
STOCKHOLDERS’
EQUITY:
|
|
|
|
|
|
|
|
|
Common
stock
|
|
|
415
|
|
|
415
|
|
|
Additional
paid-in capital
|
|
|
279,404
|
|
|
278,005
|
|
|
Treasury
stock
|
|
|
(13,895
|
)
|
|
(12,925
|
)
|
|
Accumulated
other comprehensive income (loss)
|
|
|
58
|
|
|
(118
|
)
|
|
Accumulated
deficit
|
|
|
(92,558
|
)
|
|
(84,069
|
)
|
|
Total
Stockholders’ Equity
|
|
|
173,424
|
|
|
181,308
|
|
|
Total
Liabilities and Stockholders’ Equity
|
|
$
|
190,099
|
|
$
|
195,938
|
|
See
accompanying notes to condensed consolidated financial
statements.
(In
thousands, except per share amounts)
(Unaudited)
| |
|
Three
Months Ended
March
31,
|
|
| |
|
2006
|
|
2005
|
|
|
REVENUES:
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
10,574
|
|
$
|
21,516
|
|
|
Service
|
|
|
171
|
|
|
167
|
|
|
Total
revenues
|
|
|
10,745
|
|
|
21,683
|
|
| |
|
|
|
|
|
|
|
|
COST
OF REVENUES:
|
|
|
|
|
|
|
|
|
Cost
of product (1)
|
|
|
4,563
|
|
|
8,707
|
|
|
Cost
of service (1)
|
|
|
445
|
|
|
506
|
|
|
Total
cost of revenues
|
|
|
5,008
|
|
|
9,213
|
|
|
Gross
profit
|
|
|
5,737
|
|
|
12,470
|
|
| |
|
|
|
|
|
|
|
|
OPERATING
EXPENSES:
|
|
|
|
|
|
|
|
|
Product
development (1)
|
|
|
6,991
|
|
|
6,217
|
|
|
Sales
and marketing (1)
|
|
|
5,147
|
|
|
5,025
|
|
|
General
and administrative (1)
|
|
|
3,402
|
|
|
4,451
|
|
|
Total
operating expenses
|
|
|
15,540
|
|
|
15,693
|
|
|
Loss
from operations
|
|
|
(9,803
|
)
|
|
(3,223
|
)
|
|
Interest
and other income, net
|
|
|
1,394
|
|
|
1,061
|
|
|
Loss
before provision for income taxes
|
|
|
(8,409
|
)
|
|
(2,162
|
)
|
|
Provision
for income taxes
|
|
|
80
|
|
|
100
|
|
|
NET
LOSS
|
|
$
|
(8,489
|
)
|
$
|
(2,262
|
)
|
| |
|
|
|
|
|
|
|
|
Net
loss per share:
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.21
|
)
|
$
|
(0.06
|
)
|
|
Diluted
|
|
$
|
(0.21
|
)
|
$
|
(0.06
|
)
|
|
Shares
used in computing net loss per share:
|
|
|
|
|
|
|
|
|
Basic
|
|
|
39,767
|
|
|
41,023
|
|
|
Diluted
|
|
|
39,767
|
|
|
41,023
|
|
| (1) |
Amounts
include stock-based compensation costs as
follows:
|
|
Cost
of product
|
|
$
|
112
|
|
$
|
9
|
|
|
Cost
of service
|
|
|
14
|
|
|
--
|
|
|
Product
development
|
|
|
614
|
|
|
12
|
|
|
Sales
and marketing
|
|
|
360
|
|
|
12
|
|
|
General
and administrative
|
|
|
306
|
|
|
60
|
|
See
accompanying notes to condensed consolidated financial
statements.
ECHELON
CORPORATION
(In
thousands)
(Unaudited)
| |
|
Three
Months Ended
March
31,
|
|
|
|
|
2006
|
|
2005
|
|
|
CASH
FLOWS USED IN OPERATING ACTIVITIES:
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(8,489
|
)
|
$
|
(2,262
|
)
|
|
Adjustments
to reconcile net loss to net cash used in operating
activities:
|
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
1,032
|
|
|
1,089
|
|
|
Loss
on disposal of fixed assets
|
|
|
--
|
|
|
18
|
|
|
Provision
for (recovery of) doubtful accounts
|
|
|
(94
|
)
|
|
--
|
|
|
Stock-based
compensation
|
|
|
1,406
|
|
|
93
|
|
|
Change
in operating assets and liabilities:
|
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
4,945
|
|
|
(56
|
)
|
|
Inventories
|
|
|
(204
|
)
|
|
67
|
|
|
Other
current assets
|
|
|
(1,727
|
)
|
|
(683
|
)
|
|
Accounts
payable
|
|
|
361
|
|
|
(75
|
)
|
|
Accrued
liabilities
|
|
|
(2,872
|
)
|
|
192
|
|
|
Deferred
revenues
|
|
|
4,495
|
|
|
442
|
|
|
Deferred
rent
|
|
|
61
|
|
|
79
|
|
|
Net
cash used in operating activities
|
|
|
(1,086
|
)
|
|
(1,096
|
)
|
| |
|
|
|
|
|
|
|
|
CASH
FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
|
|
|
|
|
|
|
|
|
Purchases
of available-for-sale short-term investments
|
|
|
(12,842
|
)
|
|
(36,487
|
)
|
|
Proceeds
from maturities and sales of available-for-sale short-term
investments
|
|
|
22,192
|
|
|
23,764
|
|
|
Purchase
of restricted investments
|
|
|
--
|
|
|
(1
|
)
|
|
Change
in other long-term assets
|
|
|
(40
|
)
|
|
(57
|
)
|
|
Capital
expenditures
|
|
|
(1,031
|
)
|
|
(556
|
)
|
|
Net
cash provided by (used in) investing activities
|
|
|
8,279
|
|
|
(13,337
|
)
|
| |
|
|
|
|
|
|
|
|
CASH
FLOWS USED IN FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
|
Repurchase
of common stock
|
|
|
(977
|
)
|
|
(2,099
|
)
|
|
Net
cash used in financing activities
|
|
|
(977
|
)
|
|
(2,099
|
)
|
| |
|
|
|
|
|
|
|
|
EFFECT
OF EXCHANGE RATE CHANGES ON CASH
|
|
|
141
|
|
|
(304
|
)
|
| |
|
|
|
|
|
|
|
|
NET
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
|
|
|
6,357
|
|
|
(16,836
|
)
|
| |
|
|
|
|
|
|
|
|
CASH
AND CASH EQUIVALENTS:
|
|
|
|
|
|
|
|
|
Beginning
of period
|
|
|
59,080
|
|
|
35,510
|
|
|
End
of period
|
|
$
|
65,437
|
|
$
|
18,674
|
|
| |
|
|
|
|
|
|
|
|
SUPPLEMENTAL
DISCLOSURES OF CASH FLOW INFORMATION:
|
|
|
|
|
|
|
|
|
Cash
paid for income taxes
|
|
$
|
81
|
|
$
|
154
|
|
See
accompanying notes to condensed consolidated financial
statements
ECHELON
CORPORATION
(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. All 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 Company’s consolidated financial
statements for the year ended December 31, 2005 included in its Annual Report
on
Form 10-K.
2.
Summary
of Significant Accounting Policies:
Principles
of Consolidation
The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. All intercompany accounts and transactions have
been
eliminated.
Foreign
Currency Translation
For
foreign subsidiaries using the local currency as their functional currency,
assets and liabilities are translated at exchange rates in effect at the balance
sheet date and income and expenses are translated at average exchange rates.
The
effects of these translation adjustments are reported as a separate component
of
stockholders’ equity. Remeasurement adjustments for non-functional currency
monetary assets and liabilities are included in other income (expense) in the
accompanying condensed consolidated statements of operations.
Use
of Estimates in the Preparation of Financial Statements
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America 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
The
Company’s revenues are derived from the sale and license of its products and to
a lesser extent, from fees associated with training, technical support, and
customer software design services offered to its customers. Product revenues
consist of revenues from hardware sales and software licensing arrangements.
Revenues from software licensing arrangements accounted for approximately 12.3%
of total revenues for the quarter ended March 31, 2006 and approximately 5.9%
for the same period in 2005. Service revenues consist of product technical
support (including software post-contract support services), training, and
custom software development services.
The
Company recognizes revenue when persuasive evidence of an arrangement exists,
delivery has occurred, the sales price is fixed or determinable, collectibility
is probable and there are no post-delivery obligations. For hardware sales,
including sales to third party manufacturers and certain of the Company’s
distributors for which no rights of return exist, these criteria are generally
met at the time of shipment. For sales to the Company’s European distributor,
EBV Elektronik (“EBV”), these criteria are generally met at the time EBV sells
the products through to its end-use customer. For sales of shrink-wrapped
software, these criteria are generally met upon shipment to the final end-user.
In
accordance with Statement of Position 97-2, or SOP 97-2, Software
Revenue Recognition,
revenue
earned on software arrangements involving multiple elements is allocated to
each
element based upon the relative fair values of the elements. The Company uses
the residual method to recognize revenue when a license agreement includes
one
or more elements to be delivered at a future date. In these instances, the
amount of revenue deferred at the time of sale is based on vendor specific
objective evidence (“VSOE”) of the fair value for each undelivered element. If
VSOE of fair value does not exist for each undelivered element, all revenue
attributable to the multi-element arrangement is deferred until sufficient
VSOE
of fair value exists for each undelivered element or all elements have been
delivered.
The
Company currently sells a limited number of products that are considered
multiple element arrangements under SOP 97-2. Revenue for the software license
element is recognized at the time of delivery of the applicable product to
the
end-user. The only undelivered element at the time of sale consists of
post-contract customer support (“PCS”). The VSOE for this PCS is based on prices
paid by the Company’s customers for stand-alone purchases of these PCS packages.
Revenue for the PCS element is deferred and recognized ratably over the PCS
service period. The costs of providing these PCS services are expensed when
incurred.
The
Company accounts for the rights of return, price protection, rebates, and other
sales incentives offered to its distributors in accordance with Statement of
Financial Accounting Standards (“SFAS”) No. 48, Revenue
Recognition When Right of Return Exists.
Service
revenue is recognized as the training services are performed, or ratably over
the term of the support period. In the case of customer software development
services, revenue is recognized when the customer accepts the
software.
Stock-Based
Compensation
Effective
January 1, 2006, the Company began recording compensation expense associated
with stock options and other forms of equity compensation in accordance with
SFAS No. 123R (“SFAS 123R”), Share-Based
Payment,
and
Securities and Exchange Commission Staff Accounting Bulletin No. 107 (“SAB
107”). SFAS 123R eliminates the ability to account for stock-based compensation
transactions using the intrinsic value method under Accounting Principles Board
Opinion No. 25 (“APB 25”), Accounting
for Stock Issued to Employees,
and
instead generally requires that such transactions be accounted for using a
fair-value-based method.
The
Company has elected to adopt SFAS 123R using the modified prospective method.
Consequently, there have been no retroactive adjustments made to prior period
financial statements reflecting the impact of the adoption. Under the modified
prospective method, beginning January 1, 2006, stock-based compensation expense
is recorded for all new and unvested stock options and performance shares as
the
requisite service is rendered. Stock-based compensation expense for awards
granted prior to January 1, 2006 is based on the grant date fair-value as
determined under the pro forma provisions of SFAS No. 123, Accounting
for Stock-Based Compensation.
As
permitted under SFAS 123R, the Company uses the Black-Scholes-Merton (“BSM”)
option-pricing model to determine the fair-value of stock-based awards. The
BSM
model is consistent with the option-pricing model the Company used to value
stock-based awards granted prior to January 1, 2006 for pro-forma disclosure
purposes under SFAS 123.
Prior
to
January 1, 2006, the Company accounted for equity compensation according to
the
provisions of APB 25, and applied the disclosure provisions of SFAS 123 as
amended by SFAS No. 148, Accounting
for Stock-Based Compensation - Transition and Disclosure,
as if
the fair-value-based method had been applied in measuring compensation expense.
Under APB 25, no compensation expense was recorded in the Company’s statement of
operations for stock options where the exercise price was equal to or greater
than the fair market value of the underlying stock on the date of grant.
However, during 2005, the Company has recorded compensation expense for
performance share awards issued during 2005. The following table illustrates
the
effect on net income and earnings per share as if the Company had applied the
fair value recognition provisions of SFAS 123 to stock-based employee
compensation for the three months ended March 31, 2005 (in thousands, except
per
share amounts).
| |
|
Three
Months Ended March 31, 2005
|
|
| |
|
|
|
|
Net
loss as reported
|
|
$
|
(2,262
|
)
|
|
Add:
Stock-based employee compensation expense included in reported net
loss,
net of related tax effects
|
|
|
93
|
|
|
Deduct:
Total stock-based employee compensation expense determined under
fair
value based method for all awards, net of related tax effects
|
|
|
(2,499
|
)
|
|
Pro
forma net loss
|
|
$
|
(4,668
|
)
|
| |
|
|
|
|
|
Basic
loss per share:
|
|
|
|
|
|
As
reported
|
|
$
|
(0.06
|
)
|
|
Pro
forma
|
|
$
|
(0.11
|
)
|
| |
|
|
|
|
|
Diluted
loss per share:
|
|
|
|
|
|
As
reported
|
|
$
|
(0.06
|
)
|
|
Pro
forma
|
|
$
|
(0.11
|
)
|
The
weighted-average grant date fair value of options granted during the three
months ended March 31, 2005 was $3.64 and was determined using the following
weighted average assumptions:
| |
|
Three
Months Ended March 31, 2005
|
|
| |
|
|
|
|
Expected
dividend yield
|
|
|
0.0
|
%
|
|
Risk-free
interest rate
|
|
|
3.5
|
%
|
|
Expected
volatility
|
|
|
65.7
|
%
|
|
Expected
life (in years)
|
|
|
3.7
|
|
Further
information regarding stock-based compensation can be found in Note 4 of these
Notes to Condensed Consolidated Financial Statements.
Cash
and Cash Equivalents
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 marketable debt securities as
available-for-sale in accordance with SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities.
As of
March 31, 2006, the Company’s available-for-sale short-term investment
securities had contractual maturities from four to twenty-four months and an
average remaining term to maturity of eight 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, 2006, the amortized
cost basis, aggregate fair value, and gross unrealized holding losses by major
security type were as follows (in thousands):
| |
|
Amortized
Cost
|
|
Aggregate
Fair
Value
|
|
Unrealized
Holding
Losses
|
|
|
U.S.
corporate securities:
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
paper
|
|
$
|
3,935
|
|
$
|
3,935
|
|
$
|
--
|
|
|
Certificates
of deposit
|
|
|
1,508
|
|
|
1,508
|
|
|
--
|
|
|
Corporate
notes and bonds
|
|
|
45,642
|
|
|
45,482
|
|
|
160
|
|
| |
|
|
51,085
|
|
|
50,925
|
|
|
160
|
|
|
Foreign
corporate notes and bonds
|
|
|
3,022
|
|
|
3,006
|
|
|
16
|
|
|
U.S.
government securities
|
|
|
32,342
|
|
|
32,154
|
|
|
188
|
|
|
Total
investments in debt and equity securities
|
|
$
|
86,449
|
|
$
|
86,085
|
|
$
|
364
|
|
Computation
of Net Income (Loss) Per Share
Net
income (loss) per share has been calculated under SFAS No. 128 (“SFAS 128”),
Earnings
per Share.
SFAS
128 requires companies to compute earnings per share under two different methods
(basic and diluted). Basic net income per share is calculated by dividing net
income by the weighted average shares of common stock outstanding during the
period. Diluted net income per share is calculated by adjusting the weighted
average number of outstanding shares assuming conversion of all potentially
dilutive stock options and warrants under the treasury stock
method.
The
following is a reconciliation of the numerators and denominators of the basic
and diluted net income (loss) per share computations for the three months ended
March 31, 2006 and 2005 (in thousands, except per share amounts):
| |
|
|
|
| |
|
Three
Months Ended March 31, 2006
|
|
Three
Months Ended March 31, 2005
|
|
|
Net
income (Numerator):
|
|
|
|
|
|
|
|
|
Net
loss, basic & diluted
|
|
$
|
(8,489
|
)
|
$
|
(2,262
|
)
|
|
Shares
(Denominator):
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding
|
|
|
39,767
|
|
|
41,023
|
|
|
Shares
used in basic computation
|
|
|
39,767
|
|
|
41,023
|
|
|
Common
shares issuable upon exercise of stock
|
|
|
|
|
|
|
|
|
options
(treasury stock method)
|
|
|
--
|
|
|
--
|
|
|
Shares
used in diluted computation
|
|
|
39,767
|
|
|
41,023
|
|
|
Net
income (loss) per share:
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.21
|
)
|
$
|
(0.06
|
)
|
|
Diluted
|
|
$
|
(0.21
|
)
|
$
|
(0.06
|
)
|
In
accordance with SFAS 128, for the three months ended March 31, 2006 and 2005,
the diluted net loss per share calculation is equivalent to the basic net
loss
per share calculation as there were no potentially dilutive stock options
due to
the Company’s net loss position. The number of stock options excluded from this
calculation for the three months ended March 31, 2006 and 2005 was 8,005,244
and
5,488,435, respectively.
Impairment
of Long-Lived Assets Including Goodwill
The
Company reviews property, plant, and equipment and certain identifiable
intangibles, excluding goodwill, for impairment whenever events or changes
in
circumstances indicate the carrying amount of an asset may not be recoverable.
Recoverability is measured by comparing the asset’s carrying value to the future
undiscounted cash flows the asset is expected to generate. If property, plant,
and equipment and certain identifiable intangibles are considered to be
impaired, the impairment to be recognized equals the amount by which the
carrying value of the asset exceeds its fair market value. For the quarters
ended March 31, 2006 and 2005, the Company has made no material adjustments
to
its long-lived assets.
Costs
in
excess of the fair value of tangible and other intangible assets acquired and
liabilities assumed in a purchase business combination are recorded as goodwill.
SFAS No. 142 (“SFAS 142”), Goodwill
and Other Intangible Assets, requires
that companies no longer amortize goodwill, but instead test for impairment
at
least annually using a two-step approach. The Company evaluates goodwill, at
a
minimum, on an annual basis during the first quarter and whenever events and
changes in circumstances suggest that the carrying amount may not be
recoverable. Impairment of goodwill is tested at the reporting unit level by
comparing the reporting unit’s carrying amount, including goodwill, to the fair
value of the reporting unit. If the carrying amount of the reporting unit
exceeds its fair value, goodwill is considered impaired and a second step is
performed to measure the amount of impairment loss, if any. To date, the Company
has recorded no impairment of goodwill as a result of its required tests.
SFAS
142
also requires that intangible assets with definite lives be amortized over
their
estimated useful lives and reviewed for impairment in accordance with SFAS
No.
144, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of.
As of
March 31, 2006, the Company’s acquired intangible assets with a definite life,
which consisted of purchased technology, have been fully amortized.
Recently
Issued Accounting Standards
In
February 2006, the FASB issued SFAS No. 155 (“SFAS 155”), Accounting
for Certain Hybrid Financial Instruments,
which
amends SFAS No. 133 (“SFAS 133”), Accounting
for Derivative Instruments and Hedging Activities
and SFAS
No. 140 (“SFAS 140”), Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities.
SFAS
155 simplifies the accounting for certain derivatives embedded in other
financial instruments by allowing them to be accounted for as a whole if the
holder elects to account for the whole instrument on a fair value basis. SFAS
155 also clarifies and amends certain other provisions of SFAS 133 and SFAS
140.
SFAS 155 is effective for all financial instruments acquired, issued, or subject
to a remeasurement event occurring in fiscal years beginning after September
15,
2006. Earlier adoption is permitted, provided the Company has not yet issued
financial statements, including for interim periods, for that fiscal year.
As
the Company does not currently engage in hedging activities, it does not
currently expect the adoption of SFAS 155 will have a material impact on its
consolidated financial position, results of operations, or cash flows.
In
June
2005, the FASB issued SFAS No. 154 (“SFAS 154”), Accounting
Changes and Error Corrections, a replacement of APB Opinion No. 20,
Accounting Changes, and Statement No. 3, Reporting Accounting Changes in
Interim Financial Statements.
SFAS 154 changes the requirements for how an entity accounts for, and
reports, a change in accounting principle. Previously, most voluntary changes
in
accounting principles were implemented by reflecting a cumulative effect
adjustment within net income during the period of the change. SFAS 154
requires retrospective application to prior periods’ financial statements,
unless it is impracticable to determine either the period-specific effects
or
the cumulative effect of the change. SFAS 154 is effective for accounting
changes made in fiscal years beginning after December 15, 2005; however,
SFAS 154 does not change the transition provisions of any existing accounting
pronouncements.
3.
Stockholders’ Equity and Employee Stock Option Plans
Preferred
Stock
With
the
closing of the Company’s initial public offering (“IPO”) in July 1998, all of
the then outstanding preferred stock automatically converted into 7,887,381
shares of common stock. Upon conversion of the outstanding preferred stock
to
common stock, such preferred stock was retired. As of March 31, 2006, the
Company was authorized to issue 5,000,000 shares of new $0.01 par value
preferred stock, of which none was outstanding as of March 31,
2006.
Common
Stock
As
of
March 31, 2006, the Company was authorized to issue 100,000,000 shares of $0.01
par value common stock, of which 39,678,006 were outstanding.
In
March
and August 2004, the Company’s board of directors approved a stock repurchase
program, which authorizes the Company to repurchase up to 3.0 million shares
of
the Company’s common stock. During
the quarter ended March 31, 2006, the Company repurchased 121,712 shares under
the program at a cost of approximately $969,000. As of March 31, 2006, 1,470,289
shares were available for repurchase. The stock repurchase program will expire
in March 2007.
Comprehensive
Income
Comprehensive
income for the Company consists of net income plus the effect of unrealized
holding gains or losses on investments classified as available-for-sale and
foreign currency translation adjustments. Comprehensive income for the three
months ended March 31, 2006 and 2005 is as follows (in thousands):
| |
Three
Months Ended
March
31,
|
| |
2006
|
|
2005
|
|
| |
|
|
|
|
|
Net
loss
|
$
(8,489
|
)
|
$
(2,262
|
)
|
|
Other
comprehensive income/(loss), net of tax:
|
|
|
|
|
|
Foreign
currency translation adjustment
|
140
|
|
(304
|
)
|
|
Unrealized
holding gain/(loss) on available-for-sale securities
|
35
|
|
(113
|
)
|
|
Comprehensive
loss
|
$
(8,314
|
)
|
$
(2,679
|
)
|
Employee
Stock Option Exchange Program
On
September 21, 2004, the Company announced a voluntary employee stock option
exchange program (the “Exchange Program”) whereby eligible employees were given
an opportunity to exchange some or all of their outstanding options for a
predetermined number of new stock options. Under the Exchange Program,
participating eligible employees would receive one new stock option for each
exchanged option with an exercise price less than $12.00 per share. For
exchanged options with an exercise price equal to or greater than $12.00 per
share, participants would receive between 0.2 and 0.67 new options for each
option exchanged, depending on the exercise price of the exchanged option.
The
Company’s Chief Executive Officer, President and Chief Operating Officer, and
Executive Vice President and Chief Financial Officer, along with members of
the
board of directors, were not eligible to participate in the Exchange
Program.
On
October 21, 2004, in accordance with the Exchange Program, the Company accepted
and cancelled options to purchase 3,816,812 shares of its common stock. On
April
22, 2005, which was the first business day that was six months and one day
after
cancellation of the exchanged options, the Company granted new stock options
totaling 2,148,725 shares. With the exception of new options granted to
participating executive officers, the new options were granted at an exercise
price of $6.11, the closing price of the Company’s stock on April 22, 2005. In
accordance with the terms of the Exchange Program, the exercise price for
new
options granted to participating executive officers was $8.52, which was
the
greater of the fair market value of the Company’s stock on the date of grant, or
115% of the closing price of the Company’s stock on the date the exchanged
options were cancelled. For certain foreign employees, local laws restricted
the
Company from issuing the new options on April 22, 2005. For those employees,
7,268 new options were issued on May 25, 2005 at an exercise price of $6.35,
the
closing price of the Company’s stock on that date.
New
options granted under the Exchange Program have a term equal to the greater
of
the remaining term of the exchanged options or 2 years from the new option
grant
date. New options are subject to a one-year cliff-vesting schedule, at which
time the new option will be vested to the same percentage as the exchanged
option would have been on that date. After one year from the date of grant,
the
new options will continue to vest and become exercisable as to 1/48th of
the
shares subject to the new option on each monthly anniversary of the new option
grant date. All vesting of the new options is subject to the participating
employee’s continued employment with the Company on each relevant vesting
date.
The
Exchange Program had no impact on the Company’s financial position, results of
operations, or cash flows during 2005 or 2004.
Option
Vesting Acceleration
On
September 17, 2004, the Company’s board of directors approved the acceleration
of vesting for 668,340 outstanding options previously issued to the Company’s
Chief Executive Officer, President and Chief Operating Officer, and Executive
Vice President and Chief Financial Officer. The accelerated options had exercise
prices ranging from $10.89 to $16.69. The fair market value of the Company’s
stock on September 17, 2004 was $8.27. The acceleration of the vesting of these
options did not result in a charge, as there was no intrinsic value in the
options as of the acceleration date. For pro forma disclosure requirements
under
SFAS 123, the unamortized stock-based compensation related to these options
prior to the vesting acceleration was approximately $3.2 million, all of which
was recognized in 2004. The Company’s board of directors approved the vesting
acceleration for the three executive officers, as they were not eligible to
participate in the previously discussed Exchange Program, and because doing
so
reduced the future stock compensation expense required to be included in the
Company’s results from operations under SFAS 123R.
On
November 18, 2005, the Company’s board of directors approved the acceleration of
vesting for 1,201,550 outstanding options previously awarded to employees and
officers. The accelerated options had exercise prices ranging from $8.34 per
share to $20.34 per share. The fair market value of the Company’s stock on
November 18, 2005 was $8.06. The acceleration of the vesting of these options
did not result in a charge, as there was no intrinsic value in the options
as of
the acceleration date. For pro forma disclosure requirements under SFAS 123,
the
unamortized stock-based compensation related to these options prior to the
vesting acceleration was approximately $3.5 million, all of which was recognized
in 2005. The Company’s board of directors approved the vesting acceleration for
these options in order to reduce the future stock compensation expense required
to be reflected in the Company’s statement of operations under SFAS
123R.
Stock
Option Program Description
The
Company has two plans under which it grants options: the 1997 Stock Plan
(the
“1997 Plan”) and the 1998 Director Option Plan (the “Director Option Plan”). A
more detailed description of each plan can be found below and in the Company’s
Annual Report on Form 10-K.
Stock
option and other equity compensation grants are designed to reward employees,
officers, and directors for their long-term contribution to the Company,
to
align their interest with those of the Company’s stockholders in creating
stockholder value, and to provide incentives for them to remain with the
Company. The number and frequency of equity compensation grants is based
on
competitive practices, operating results of the Company, and accounting
regulations. Since the inception of the 1997 Plan, the Company has granted
options to all of its employees.
Historically,
the Company has issued new shares upon the exercise of stock options. However,
treasury shares are also available for issuance, although the Company does
not
currently intend to use treasury shares for this purpose.
1997
Stock Plan
The
1997
Stock Plan (the “1997 Plan”) is a stockholder approved plan that provides for
broad-based grants to employees, including executive officers. Based on the
terms of individual option grants, options granted under the 1997 Plan generally
expire five years after the date of grant, although options granted from June
15, 2000 through May 5, 2003, generally have a term of ten years. Options
granted under the 1997 Plan generally vest at a rate of 25% per year over four
years. In addition to incentive and nonstatutory stock options, the 1997 Plan
also permits the granting of stock purchase rights, stock appreciation rights,
performance units, and performance shares. To date, other than stock options,
the Company has only granted performance shares under the 1997 Plan. Certain
of
these performance shares vest 100% on the two-year anniversary of the grant
date, while the remaining performance shares vest 25% per year over four
years.
1998
Directors Option Plan
Non-employee
directors are entitled to participate in the stockholder approved 1998 Director
Option Plan (the “Director Plan”). The Director Plan provides for the automatic
grant of 25,000 shares of common stock (the “First Option”) to each non-employee
director on the date he or she first becomes a director. Each non-employee
director is also automatically granted an option to purchase 10,000 shares
(a
“Subsequent Option”) on the date of the Company’s Annual Stockholder Meeting
provided that he or she is re-elected to the Board or otherwise remains on
the
Board, and provided that on such date, he or she shall have served on the Board
for at least the preceding six months. Each First Option and each Subsequent
Option have a term of five years and vest immediately upon grant.
Stock
Award Activity
The
following table summarizes stock award activity, including stock options and
performance shares, and related information for the three-month periods ended
March 31, 2006 and 2005:
| |
|
|
Options
Outstanding
|
|
|
Shares
Available for Grant
|
|
Number
Outstanding
|
|
|
Weighted-Average
Exercise Price Per Share
|
|
BALANCE
AT DECEMBER 31, 2004
|
8,109,556
|
|
5,594,842
|
|
$
|
14.91
|
|
Options
granted
|
(50,000
|
)
|
50,000
|
|
|
7.25
|
|
Performance
shares granted
|
(109,355
|
)
|
---
|
|
|
---
|
|
Options
exercised
|
---
|
|
---
|
|
|
---
|
|
Options
forfeited or expired
|
156,407
|
|
(156,407
|
)
|
|
15.58
|
|
Additional
shares reserved
|
1,747,463
|
|
---
|
|
|
---
|
|
BALANCE
AT MARCH 31, 2005
|
9,854,071
|
|
5,488,435
|
|
$
|
14.82
|
| |
|
|
Options
Outstanding
|
| |
Shares
Available for Grant
|
|
Number
Outstanding
|
|
$ |
Weighted-Average
Exercise Price Per Share
|
|
BALANCE
AT DECEMBER 31, 2005
|
6,949,420
|
|
8,089,473
|
|
$
|
11.24
|
|
Options
granted
|
(8,075
|
)
|
8,075
|
|
|
8.16
|
|
Performance
shares granted
|
(106,017
|
)
|
---
|
|
|
---
|
|
Options
exercised
|
---
|
|
---
|
|
|
---
|
|
Options
forfeited or expired
|
92,304
|
|
(92,304
|
)
|
|
7.50
|
|
Performance
shares forfeited or expired
|
4,867
|
|
---
|
|
|
---
|
|
Additional
shares reserved
|
1,692,020
|
|
---
|
|
|
---
|
|
BALANCE
AT MARCH 31, 2006
|
8,624,519
|
|
8,005,244
|
|
$
|
11.28
|
The
following table provides additional information for significant ranges of
outstanding and exercisable stock options as of March 31, 2006:
| |
|
Exercise
Price
Range
|
|
Number
Outstanding
|
|
Weighted
Average
Remaining
Contractual
Life
(in
years)
|
|
Weighted
Average Exercise Price per Share
|
|
Aggregate
Intrinsic Value
|
| |
|
$6.11
|
|
1,664,031
|
|
3.72
|
|
$
|
6.11
|
|
$
|
5,541,223
|
| |
|
6.26-8.12
|
|
237,293
|
|
3.00
|
|
|
7.00
|
|
|
579,036
|
| |
|
8.19
|
|
985,330
|
|
4.38
|
|
|
8.19
|
|
|
1,231,663
|
| |
|
8.24-10.75
|
|
678,890
|
|
4.04
|
|
|
9.36
|
|
|
322,373
|
| |
|
10.89
|
|
882,420
|
|
2.96
|
|
|
10.89
|
|
|
--
|
| |
|
11.12-12.88
|
|
638,132
|
|
5.25
|
|
|
11.65
|
|
|
--
|
| |
|
12.91
|
|
826,670
|
|
2.14
|
|
|
12.91
|
|
|
--
|
| |
|
13.00-16.06
|
|
340,200
|
|
4.42
|
|
|
14.10
|
|
|
--
|
| |
|
16.35
|
|
869,812
|
|
4.75
|
|
|
16.35
|
|
|
--
|
| |
|
$16.36-$38.81
|
|
882,466
|
|
4.56
|
|
|
19.57
|
|
|
--
|
|
Outstanding
|
|
8,005,244
|
|
3.92
|
|
$
|
11.27
|
|
$
|
7,674,295
|
|
Vested
and expected to vest
|
|
7,908,370
|
|
3.92
|
|
$
|
11.32
|
|
$
|
7,505,475
|
|
Exercisable
|
|
5,258,148
|
|
3.89
|
|
$
|
13.58
|
|
$
|
610,758
|
The
aggregate intrinsic value in the preceding table represents the total pretax
intrinsic value, based on the Company’s closing stock price of $9.44 as of March
31, 2006, which would have been received by the option holders had all option
holders exercised their options as of that date.
The
following table provides additional information regarding performance share
activity for the three-month periods ended March 31, 2006 and 2005:
|
|
Number
Nonvested and Outstanding
|
|
|
Weighted-Average
Grant Date Fair-Value
|
|
BALANCE
AT DECEMBER 31, 2004
|
---
|
|
$
|
---
|
|
Performance
shares granted
|
109,355
|
|
|
6.77
|
|
BALANCE
AT MARCH 31, 2005
|
109,355
|
|
$
|
6.77
|
| |
|
|
|
|
|
BALANCE
AT DECEMBER 31, 2005
|
412,968
|
|
$
|
7.82
|
|
Performance
shares granted
|
106,017
|
|
|
9.00
|
|
Performance
shares forfeited
|
(4,867
|
)
|
|
8.19
|
|
BALANCE
AT MARCH 31, 2006
|
514,118
|
|
$
|
8.06
|
No
performance shares vested during the three-month periods ended March 31, 2006
and 2005.
4.
Stock-Based Compensation:
Impact
of Adopting SFAS 123R
The
Company adopted SFAS 123R on January 1, 2006, using
the
modified prospective method. The impact of adopting SFAS 123R on the Company’s
loss from continuing operations, pre-tax loss, net loss, basic and diluted
net
loss per share, cash flows from operations, and cash flows from financing
activities for the three months ended March 31, 2006 is summarized in the
following table (in thousands, except per share amounts):
|
|
|
Intrinsic
Value Method (A)
|
|
Fair
Value Method
(B)
|
|
Impact
of Adoption
(A)
- (B)
|
|
|
|
|
|
|
|
|
|
|
|
Loss
from continuing operations
|
|
$
|
(8,654
|
)
|
$
|
(9,803
|
)
|
$
|
(1,149
|
)
|
|
Loss
before provision for income taxes
|
|
$
|
(7,260
|
)
|
$
|
(8,409
|
)
|
$
|
(1,149
|
)
|
|
Net
loss
|
|
$
|
(7,340
|
)
|
$
|
(8,489
|
)
|
$
|
(1,149
|
)
|
|
Net
loss per share - basic
|
|
$
|
(0.18
|
)
|
$
|
(0.21
|
)
|
$
|
(0.03
|
)
|
|
Net
loss per share - diluted
|
|
$
|
(0.18
|
)
|
$
|
(0.21
|
)
|
$
|
(0.03
|
)
|
|
Cash
flows from operations
|
|
$
|
(1,086
|
)
|
$
|
(1,086
|
)
|
$
|
--
|
|
|
Cash
flows from financing activities
|
|
$
|
(977
|
)
|
$
|
(977
|
)
|
$
|
--
|
|
Valuation
of Options Granted
SFAS
123R
requires the use of a valuation model to calculate the fair-value of stock-based
awards. The Company has elected to use the BSM option-pricing model, which
incorporates various assumptions including volatility, expected term of the
option from the date of grant to the time of exercise, risk-free interest rates,
and dividend yields. The BSM option-pricing model was developed for use in
estimating the fair-value of traded options having no vesting or hedging
restrictions and that are fully transferable. As the Company’s employee stock
options have certain characteristics that differ significantly from traded
options, and because changes in the subjective assumptions used in the BSM
option-pricing model can materially affect the estimated fair-value, in
management’s opinion, the Company’s estimate of fair-value for its options based
on the BSM option-pricing model may not provide an accurate measure of the
fair-value an independent third-party would assign in an arms-length
transaction.
The
weighted average calculated fair value of options granted during the three
months ended March 31, 2006, was $3.61 and was determined using the following
weighted average assumptions:
| |
Three
Months Ended March 31, 2006
|
|
Expected
dividend yield
|
0.0%
|
|
Risk-free
interest rate
|
4.4%
|
|
Expected
volatility
|
53.7%
|
|
Expected
life (in years)
|
3.8
|
The
expected dividend yield reflects the fact that the Company has not paid any
dividends in the past and does not currently intend to pay dividends in the
foreseeable future. The risk-free interest rate assumption is based on U.S.
Treasury yields in effect at the time of grant for the expected life of the
option. The expected volatility is based on the historical volatility of the
Company’s common stock over the most recent period commensurate with the
expected life of the option, and does not include any implied volatility as
there currently are no market traded options on the Company’s stock that meet
the criteria required for reliance on implied volatility in accordance with
SAB
107. The expected life of the option has been calculated using the simplified
method as permitted under SAB 107. Under
the
simplified method, the expected term is calculated by taking the average of
the
vesting term and the contractual term of the option. The
simplified method was chosen due to the fact that there has been only limited
exercise activity for options granted over the last several years, and thus,
management has concluded that such exercise data does not provide a reasonable
basis upon which to estimate expected term.
Expense
Allocation
Compensation
expense for all share-based payment awards, including those granted prior to
January 1, 2006, has been recognized in accordance with SFAS 123R using the
accelerated multiple-option approach. As stock-based compensation expense
recognized in the Consolidated Statement of Operations for the three months
ended March 31, 2006 is based on awards ultimately expected to vest, it has
been
reduced for estimated forfeitures. SFAS 123R requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. Forfeitures have been
estimated based on historical experience. In the Company’s pro forma information
required under SFAS 123 for periods prior to January 1, 2006, the Company
accounted for forfeitures as they occurred. As of March 31, 2006, total
compensation cost related to non-vested stock options and other equity based
awards not yet recognized was $7.4 million, which is expected to be recognized
over the next 11 months on a weighted-average basis.
The
following table summarizes the stock-based compensation expense related to
employee stock options and performance shares under SFAS 123R for the three
months ended March 31, 2006, which was allocated as follows (in
thousands):
| |
|
Three
Months Ended March 31,
|
| |
|
2006
|
|
2005
|
|
Cost
of sales - product
|
|
$
112
|
|
$
9
|
|
Cost
of sales - service
|
|
14
|
|
--
|
|
Stock-based
compensation expense included in cost of sales
|
|
126
|
|
9
|
|
Product
development
|
|
614
|
|
12
|
|
Sales
and marketing
|
|
360
|
|
12
|
|
General
and administrative
|
|
306
|
|
60
|
|
Stock-based
compensation expense included in operating expenses
|
|
1,280
|
|
84
|
|
Stock-based
compensation expense related to stock options and performance
shares
|
|
1,406
|
|
93
|
|
Tax
benefit
|
|
--
|
|
--
|
|
Stock-based
compensation expense related to stock options and performance shares,
net
of tax
|
|
$
1,406
|
|
$
93
|
Of
the
$1.4 million of compensation expense recorded for the quarter ended March
31,
2006, approximately $74,000 related to equity compensation awards granted
during
2006, while the remaining $1.3 million related to equity compensation awards
granted on or before December 31, 2005. Compensation expense of $93,000 for
the
quarter ended March 31, 2005 related solely to performance share awards,
and did
not reflect any compensation expense for stock options as the Company accounted
for those equity compensation awards in accordance with APB 25. Under
APB
25, no compensation expense was recorded in the Company’s statement of
operations for stock options where the exercise price was equal to or greater
than the fair market value of the underlying stock on the date of grant.
During
the quarters ended March 31, 2006 and 2005, no stock-based compensation expense
was capitalized as part of the cost of an asset.
Comparative
Results
The
following table reflects net income and diluted net income per share for the
three months ended March 31, 2006 compared with the pro forma information for
the three months ended March 31, 2005 (in thousands, except per share
amounts):
| |
Three
Months Ended March 31,
|
| |
2006
|
|
2005
|
|
| |
|
|
|
|
|
Net
loss - as reported for the prior period (1)
|
N/A
|
|
$
(2,262
|
)
|
|
Stock-based
compensation expense related to employee stock options
|
$
1,406
|
|
$
2,406
|
|
|
Tax
benefit
|
--
|
|
--
|
|
|
Stock-based
compensation expense related to stock options, net of tax
(2)
|
$
1,406
|
|
$
2,406
|
|
| |
|
|
|
|
|
Net
loss, including the effect of stock-based compensation expense
(3)
|
$
(8,489
|
)
|
$
(4,668
|
)
|
| |
|
|
|
|
|
Diluted
net loss per share - as reported for the prior period (1)
|
N/A
|
|
$
(0.06
|
)
|
|
Diluted
net loss per share, including the effect of stock-based compensation
expense (3)
|
$
(0.21
|
)
|
$
(0.11
|
)
|
| (1) |
Net
income and net income per share prior to January 1, 2006 did not
include
stock-based compensation expense for employee stock options under
SFAS 123
because the Company did not adopt the recognition provisions of SFAS
123.
|
| (2) |
Stock-based
compensation expense prior to January 1, 2006 is calculated based
on the
pro forma application of SFAS 123.
|
| (3) |
Net
income and net income per share prior to January 1, 2006 represents
pro
forma information based on SFAS
123.
|
5. Significant
Customers:
The
Company markets its products and services throughout the world to original
equipment manufacturers (OEMs) and systems integrators in the building,
industrial, transportation, utility/home, and other automation markets. For
the
last several years, the Company has had two customers that represent a majority
of the Company’s revenues: Enel S.p.A. (“Enel”), an Italian utility company
(including Enel’s third party meter manufacturers) and EBV Electronik GmbH
(“EBV”), the Company’s primary distributor of its LonWorks®
Infrastructure products in Europe. For the quarters ended March 31, 2006 and
2005, the percentage of the Company’s revenues attributable to sales made to
these two customers were as follows:
| |
|
Three
Months Ended March 31,
|
|
| |
|
2006
|
|
2005
|
|
|
Enel
|
|
|
1.9
|
%
|
|
48.1
|
%
|
|
EBV
|
|
|
22.7
|
%
|
|
17.8
|
%
|
| |
|
|
|
|
|
|
|
|
Total
|
|
|
24.6
|
%
|
|
65.9
|
%
|
The
Company’s contract with Enel expired in June 2005, and shipments under that
contract were completed in 2005. The Company currently expects to supply Enel
and its third party meter manufacturers with spare parts for Enel’s Contatore
Elettronico system during 2006. The Company’s contract with EBV, which has been
in effect since 1997 and to date has been renewed annually thereafter, expires
in December 2006.
6.
Commitments and Contingencies:
Lease
Commitments
The
Company leases its facilities under operating leases that expire on various
dates through 2013. In December 1999, the Company entered into a lease agreement
with a real estate developer for its existing corporate headquarters in San
Jose, California. This agreement requires minimum rental payments for ten years
totaling approximately $20.6 million and also required that the Company provide
a $3.0 million security deposit, which requirement has since been reduced to
$1.5 million. The Company satisfied the security deposit requirement by causing
to have issued a standby letter of credit (“LOC”) in July 2000. The LOC is
subject to annual renewals and is currently secured by a line of credit at
the
bank that issued the LOC. At the end of the current ten-year lease term, the
Company has the right, pursuant to the lease agreement, to extend the lease
for
two sequential five-year terms.
In
October 2000, the Company entered into another lease agreement with the same
real estate developer for an additional building at its headquarters site.
Construction on the second building was completed in May 2003, at which time
monthly rental payments commenced. This second lease agreement also requires
minimum rental payments for ten years totaling approximately $23.4 million.
In
addition, this second lease agreement also required a security deposit of $5.0
million. The Company satisfied this security deposit requirement by causing
to
have issued another LOC in October 2001. This LOC is also subject to annual
renewals and is currently secured by a line of credit at the bank that issued
it. At the end of the current ten-year lease term, the Company has the right,
pursuant to the lease agreement, to extend the lease for two sequential
five-year terms.
In
addition to its corporate headquarters facility, the Company also leases
facilities for its sales, marketing, and product development personnel located
elsewhere within the United States and in nine foreign countries throughout
Europe and Asia. These operating leases are of shorter duration, generally
one
to two years, and in some instances are cancelable with advance notice.
Royalties
The
Company has certain royalty commitments associated with the shipment and
licensing of certain of its products. Royalty expense is generally based on
a
dollar amount per unit shipped or a percentage of the underlying revenue.
Royalty expense, which is recorded as a component of cost of product revenues
in
the Company’s consolidated statements of income, was approximately $108,000 and
$132,000 for the quarters ended March 31, 2006 and 2005, respectively.
The
Company will continue to be obligated for royalty payments in the future
associated with the shipment and licensing of certain of its products. The
Company is currently unable to estimate the maximum amount of these future
royalties. However, such amounts will continue to be dependent on the number
of
units shipped or the amount of revenue generated from these products.
Guarantees
In
the
normal course of business, the Company provides indemnifications of varying
scope to its customers against claims of intellectual property infringement
made
by third parties arising from the use of its products. Historically, costs
related to these indemnification provisions have not been significant. However,
the Company is unable to estimate the maximum potential impact of these
indemnification provisions on its future results of operations.
As
permitted under Delaware law, the Company has entered into agreements whereby
it
indemnifies its officers and directors for certain events or occurrences while
the officer or director is, or was serving, at the Company’s request in such
capacity. The indemnification period covers all pertinent events and occurrences
during the officer’s or director’s lifetime. The maximum potential amount of
future payments the Company could be required to make under these
indemnification agreements is unlimited. However, the Company has directors
and
officers insurance coverage that would enable it to recover a portion of any
future amounts paid. The Company believes the estimated fair value of these
indemnification agreements in excess of the applicable insurance coverage is
minimal.
Legal
Actions
On
May 3,
2004, the Company announced that Enel filed a request for arbitration to resolve
a dispute regarding the Company’s marketing and supply obligations under the
Research and Development and Technological Cooperation Agreement dated June
28,
2000. The arbitration took place in London in early March 2005 under the rules
of arbitration of the International Court of Arbitration of the International
Chamber of Commerce, or ICC. The Company received the arbitration panel’s
decision on September 29, 2005. The arbitration tribunal awarded Enel €4,019,750
in damages plus interest from December 15, 2004 and the sums of $52,000 and
€150,000 in arbitration and legal related costs, respectively. These amounts,
which total approximately $5.2 million, were included in the Company’s results
of operations for the year ended December 31, 2005. As of December 31, 2005,
approximately $3.0 million of the $5.2 million award was unpaid and is reflected
in accrued liabilities. As of March 31, 2006, all amounts due Enel under the
arbitration ruling have been paid. The arbitration tribunal refused Enel’s
request to extend the supply or marketing obligations of Echelon.
In
addition to the matter described above, from time to time, in the ordinary
course of business, the Company is also subject to legal proceedings, claims,
investigations, and other proceedings, including claims of alleged infringement
of third-party patents and other intellectual property rights, and commercial,
employment, and other matters. In accordance with generally accepted accounting
principles, the Company makes a provision for a liability when it is both
probable that a liability has been incurred and the amount of the loss can
be
reasonably estimated. These provisions are reviewed at least quarterly and
adjusted to reflect the impacts of negotiations, settlements, rulings, advice
of
legal counsel, and other information and events pertaining to a particular
case.
While the Company believes it has adequately provided for such contingencies
as
of March 31, 2006, the amounts of which were immaterial, it is possible that
the
Company’s results of operations, cash flows, and financial position could be
harmed by the resolution of any such outstanding claims.
7.
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):
|
|
|
March
31,
2006
|
|
December
31,
2005
|
|
|
Purchased
materials
|
|
$
|
1,247
|
|
$
|
1,064
|
|
|
Work-in-process
|
|
|
9
|
|
|
61
|
|
|
Finished
goods
|
|
|
2,188
|
|
|
2,115
|
|
| |
|
$
|
3,444
|
|
$
|
3,240
|
|
Accrued
liabilities consist of the following (in thousands):
| |
|
March
31,
2006
|
|
December
31,
2005
|
|
|
Accrued
payroll and related costs
|
|
$
|
2,867
|
|
$
|
2,630
|
|
|
Accrued
taxes
|
|
|
1,140
|
|
|
1,128
|
|
|
Other
accrued liabilities
|
|
|
594
|
|
|
3,715
|
|
| |
|
$
|
4,601
|
|
$
|
7,473
|
|
9. Segment
Disclosure:
In
1998,
the Company adopted SFAS No. 131, or 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,
the Chief Operating Officer, and their direct reports. SFAS 131 also requires
disclosures about products and services, geographic areas and major customers.
The
Company operates its business as one reportable 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
utility/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 that consist of
technical support and training courses covering its LonWorks
network
technology and products. The Company offers about 90 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 three main groups: the Americas; Europe,
Middle East and Africa (“EMEA”); and Asia Pacific/ Japan (“APJ”). Each
geographic area provides products and services as further described in Item
2,
Management’s Discussion and Analysis of Financial Condition and Results of
Operations. 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 geographic area and excludes certain expenses that are managed outside
the
geographic area. Costs excluded from geographic area profit or loss consist
primarily of unallocated corporate expenses, which are comprised of product
development costs, corporate marketing costs and other general and
administrative expenses, which are separately managed. The Company’s long-lived
assets include property and equipment, goodwill, loans to certain key employees,
purchased technology, and deposits on its leased facilities. Long-lived assets
are attributed to geographic areas based on the country where the assets are
located. As of March 31, 2006 and December 31, 2005, long-lived assets of about
$22.0 million 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 reported by
geography because that information is not reviewed by the executive staff when
making decisions about resource allocation to the geographic areas based on
their performance.
In
North
America, the Company sells its products through a direct sales organization
and
select third-party electronics representatives. Outside North America, the
Company sells its products through direct sales organizations in EMEA and APJ,
whose efforts are supported by local distributors. Revenues are attributed
to
geographic areas based on the country where the products are shipped. Summary
information by geography for the quarters ended March 31, 2006 and 2005 is
as
follows (in thousands):
| |
|
Three
Months Ended
March
31,
|
|
| |
|
2006
|
|
2005
|
|
|
Revenues
from customers:
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
4,800
|
|
$
|
3,946
|
|
|
EMEA
|
|
|
3,984
|
|
|
16,291
|
|
|
APJ
|
|
|
1,961
|
|
|
1,446
|
|
|
Unallocated
|
|
|
--
|
|
|
--
|
|
|
Total
|
|
$
|
10,745
|
|
$
|
21,683
|
|
|
Gross
profit:
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
2,649
|
|
$
|
2,472
|
|
|
EMEA
|
|
|
2,184
|
|
|
9,141
|
|
|
APJ
|
|
|
904
|
|
|
857
|
|
|
Unallocated
|
|
|
--
|
|
|
--
|
|
|
Total
|
|
$
|
5,737
|
|
$
|
12,470
|
|
|
Income/(Loss)
from operations:
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
1,400
|
|
$
|
1,332
|
|
|
EMEA
|
|
|
728
|
|
|
7,613
|
|
|
APJ
|
|
|
(223
|
)
|
|
(150
|
)
|
|
Unallocated
|
|
|
(11,708
|
)
|
|
(12,018
|
)
|
|
Total
|
|
$
|
(9,803
|
)
|
$
|
(3,223
|
)
|
Products
sold to Enel and its designated manufacturers accounted for $200,000, or 1.9%
of
total revenues for the quarter ended March 31, 2006 and $10.4 million, or 48.1%
for the same period in 2005. During the quarter ended March 31, 2006, 100.0%
of
the revenues shipped under the Enel program were shipped to customers in APJ.
During the quarter ended March 31, 2005, 99.9% of the revenues shipped under
the
Enel program were shipped to customers in EMEA, while the remaining 0.1% was
shipped to customers in APJ.
EBV,
the
primary independent distributor of the Company’s LonWorks
infrastructure products in Europe, accounted for 22.7% of total revenues for
the
quarter ended March 31, 2006 and 17.8% for the same period in 2005.
10.
Income Taxes:
The
provision for income taxes for the quarters ended March 31, 2006 and 2005
includes a provision for Federal, state and foreign taxes based on the annual
estimated effective tax rate applied to the Company and its subsidiaries for
the
year. The difference between the statutory rate and the Company’s effective tax
rate is primarily due to the impact of foreign taxes.
11.
Related Party:
In
June
2000, the Company entered into a stock purchase agreement with Enel. At the
same
time, the Company also entered into a Research and Development and Technological
Cooperation Agreement with an affiliate of Enel (the “R&D Agreement”). Under
the terms of the R&D Agreement, the Company cooperated with Enel to
integrate LonWorks
technology into Enel’s remote metering management project in Italy. For the
quarters ended March 31, 2006 and 2005, the Company recognized revenue from
products and services sold to Enel and its designated manufacturers of
approximately $200,000 and $10.4 million, respectively. As of March 31, 2006,
there were no amounts owed the Company by Enel or its designated manufacturers.
As of March 31, 2005, $12.9 million of the Company’s total accounts receivable
balance related to amounts owed by Enel and its designated manufacturers.
On
May 3,
2004, the Company announced that Enel filed a request for arbitration to resolve
a dispute regarding the Company’s marketing and supply obligations under the
R&D Agreement. An arbitration award was issued on September 29, 2005. For
additional information regarding the arbitration, please refer to the “Legal
Actions” section of Note 6, Commitments and Contingencies.
12.
Warranty Reserves:
When
evaluating the reserve for warranty costs, management takes into consideration
the term of the warranty coverage, the quantity of product in the field that
is
currently under warranty, historical return rates, and historical costs of
repair. In addition, certain other applicable factors, such as technical
complexity, may also be taken into consideration when historical information
is
not yet available for recently introduced products. Estimated reserves for
warranty costs are recorded at the time of shipment. In addition, additional
warranty reserves may be established when the Company becomes aware of a
specific warranty related problem, such as a product recall. Such additional
warranty reserves are based on the Company’s current estimate of the total
out-of-pocket costs expected to be incurred to resolve the problem, including,
but not limited to, costs to replace or repair the defective items and shipping
costs. The reserve for warranty costs was $409,000 as of March 31, 2006 and
$469,000 as of December 31, 2005.
The
following discussion should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this Quarterly
Report. The following discussion contains predictions, estimates, and other
forward-looking statements that involve a number of risks and uncertainties
about our business, including but not limited to: our belief that control
networks based on our products can reduce life-cycle costs, save energy, are
more flexible than centralized systems and permit control systems to be
comprised of products and services from a variety of vendors; our belief that
the NES system brings cost savings in a wide range of a utility’s functions,
from metering and customer services to distribution operations and value-added
services; our belief that new products and product enhancements, such as our
NES
offering and Panoramix platform, will make it easier for our customers to
aggregate and process information from remote LonWorks networks, thereby
increasing overall network management capabilities; our belief that the benefits
derived from our NES system deliver a more compelling return on investment
than
“traditional” AMR systems; our expectation that Enel will purchase spare parts
from us with a value of approximately $7.0 million in 2006 and our belief that
we will be able to find one or more replacements for the Enel project revenue
reduction; our expectation that shipments of our NES products will increase
significantly; our belief that, in general, as long as the current worldwide
economic recovery continues to gain momentum, overall revenues from our LonWorks
Infrastructure business will continue to improve during 2006 as compared to
2005; our belief that market conditions in Asia, particularly Japan, will
continue to be challenging in 2006; our belief that, during 2006, our gross
margin will decrease from 2005 levels; our belief that, during 2006, our sales
and marketing and product development expenses will increase over 2005 levels;
our belief that many of our customers will continue to refrain from purchasing
our customer support and training offerings during 2006 in an effort to minimize
their operating expenses; our belief that our existing cash and short-term
investment balances will be sufficient to meet our projected working capital
and
other cash requirements for at least the next twelve months; our belief that
we
will incur a substantial loss in 2006; our expectation that the impact of our
modified revenue recognition methodology with respect to LonWorks Infrastructure
revenues in 2006 will be less than $1.0 million; our belief that the amount
of
our LonWorks Infrastructure revenues earned in foreign currencies will not
fluctuate significantly between 2005 and 2006; our expectation that our initial
NES system roll-out to Nuon will be completed in late 2006 or early 2007 and
that Nuon will then issue a public tender for an even larger deployment; and
our
belief that the estimates and judgments made regarding future events in
connection with the preparation of our financial statements are reasonable.
These statements may be identified by the use of words such as “we believe,”
“expect,” “anticipate,” “intend,” “plan,” and similar expressions. In addition,
forward-looking statements include, but are not limited to, statements about
our
beliefs, estimates, or plans about our ability to maintain low manufacturing
and
operating costs and costs per unit, our ability to estimate revenues, pricing
pressures, returns, reserves, demand for our products, selling, general, and
administrative expenses, taxes, research, development, and engineering expenses,
spending on property, plant, and equipment, expected sales of our products
and
the market for our products generally and certain customers specifically, and
our beliefs regarding our liquidity needs.
Forward-looking
statements are estimates reflecting the best judgment of our senior management,
and they involve a number of risks and uncertainties that could cause actual
results to differ materially from those suggested by the forward-looking
statements. Our business is subject to a number of risks and uncertainties.
While this discussion represents our current judgment on the future direction
of
our business, these risks and uncertainties could cause actual results to differ
materially from any future performance suggested herein. Some of the important
factors that may influence possible differences are continued competitive
factors, technological developments, pricing pressures, changes in customer
demand, and general economic conditions, as well as those discussed above in
“Factors That May Affect Future Results of Operations.” We undertake no
obligation to update forward-looking statements to reflect events or
circumstances occurring after the date of such statements. Readers should review
the Risk Factors in Item 1A in this report, as well as other documents filed
from time to time by us with the SEC.
OVERVIEW
Echelon
Corporation was incorporated in California in February 1988 and reincorporated
in Delaware in January 1989. We are based in San Jose, California, and maintain
offices in nine foreign countries throughout Europe and Asia. We develop, market
and support a wide array of products and services based on our LONWORKS
technology that enable OEMs and systems integrators to design and implement
open, interoperable, distributed control networks. We offer these hardware
and
software products to OEMs and systems integrators in the building, industrial,
transportation, utility/home, and other automation markets.
We
sell
certain of our products to Enel and certain suppliers of Enel for use in Enel’s
Contatore Elettronico electricity meter management project in Italy. We refer
to
Echelon’s revenue derived from sales to Enel and Enel’s designated manufacturers
as Enel Project revenue. We have been investing in products for use by
electricity utilities for use in management of electricity distribution. We
began to receive modest amounts of revenue resulting from these investments
in
2004, which increased to approximately $883,000 in 2005. We refer to this
revenue as networked energy services, or NES, revenue. We refer to all other
revenue as LONWORKS Infrastructure revenue. We also provide a variety of
technical training courses related to our products and the underlying
technology. Some of our customers also rely on us to provide customer support
on
a per-incident or term contract basis.
We
have a
history of losses and, although we achieved profitability in past fiscal
periods, we incurred a loss for the quarter ended March 31, 2006 and expect
to
incur substantial operating losses for the remainder of 2006. This expectation
is due primarily to two factors. First, we have already experienced, and
we anticipate that, during 2006, we will experience a further
reduction in the amount of Enel Project revenue as compared to 2005. This
expected reduction is the result of the completion of our Enel Project shipments
in 2005. Enel
recently asked us to provide them with spare parts for use in their system
in
Italy. We have agreed to this request, and currently expect shipments of these
spare parts to be completed during the second quarter of 2006. The second factor
contributing to our expectation for losses in 2006 relates to the fact that,
effective January 1, 2006, we began recording compensation expense associated
with stock options and other forms of equity compensation as required under
SFAS
123R.
During
the first quarter of 2006, we revised our revenue recognition methodology for
sales made to EBV. Under the revised methodology, we will now defer revenue,
as
well as cost of goods sold, on items shipped to EBV that remain in EBV’s
inventories at quarter-end. The revision significantly reduced our first quarter
2006 revenues, but will not have an impact on cash flows from operations or
require any changes to historical financial statements. A more thorough
explanation of this revision can be found later in this report in the “EBV
revenues” section of our discussion on Results of Operations.
CRITICAL
ACCOUNTING ESTIMATES
Our
discussion and analysis of our financial condition and results of operations
are
based upon our consolidated financial statements, which have been prepared
in
accordance with accounting principles generally accepted in the United States
of
America. The preparation of these consolidated financial statements requires
us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates, including
those related to our revenues, allowance for doubtful accounts, inventories,
commitments and contingencies, income taxes, and asset impairments. We base
our
estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form
the
basis for making judgments about the carrying values of assets and liabilities.
Actual results may differ from these estimates under different assumptions
or
conditions.
We
believe the following critical accounting estimates relate to those policies
that are most important to the presentation of our consolidated financial
statements and require the most difficult, subjective and complex
judgments.
Sales
Returns and Allowances.
We sell
our products and services to OEMs, systems integrators, and our other customers
directly through our sales force and indirectly through distributors located
in
the geographic markets that we serve. Sales to certain distributors are made
under terms allowing limited rights of return. Sales
to
EBV, our largest distributor accounted for 22.7% of total net revenues for
the
quarter ended March 31, 2006, and 17.8% for the same period in 2005. Worldwide
sales to distributors, including those to EBV, accounted for approximately
36.1%
of total net revenues for the quarter ended March 31, 2006, and 23.1% for the
same period in 2005.
Net
revenues consist of product and service revenues reduced by estimated sales
returns and allowances. Provisions for estimated sales returns and allowances
are recorded at the time of sale, and are based on management’s estimates of
potential future product returns and allowances related to product revenues
in
the current period. In evaluating the adequacy of our sales returns and other
allowances, management analyzes historical returns, current and historical
economic trends, contractual terms, and changes in customer demand and
acceptance of our products.
To
estimate potential product returns from distributors other than EBV, management
analyzes historical returns and the specific contractual return rights of each
distributor. Significant management judgments and estimates must be made and
used in connection with establishing these distributor-related sales returns
and
other allowances in any accounting period. Material differences may result
in
the amount and timing of our revenues for any period if management revises
its
judgments or estimates.
Other
than standard warranty repair work, Enel and its designated contract meter
manufacturers do not have rights to return products we ship to them. However,
our agreement with Enel contains an “acceptance” provision, whereby Enel is
entitled to inspect products we ship to them to ensure the products conform,
in
all material respects, to the product’s specifications. Once the product has
been inspected and approved by Enel, or if the acceptance period lapses before
Enel inspects or approves the products, the goods are considered accepted.
Prior
to shipping our products to Enel, we perform detailed reviews and tests to
ensure the products will meet Enel’s acceptance criteria. We do not ship
products unless they have passed these reviews and tests. As a result, we record
revenue for these products upon shipment to Enel. If Enel were to subsequently
properly reject any material portion of a shipment for not meeting the agreed
upon specifications, we would defer the revenue on that portion of the
transaction until such time as Enel and we were able to resolve the discrepancy.
Such a deferral could have a material impact on the amount and timing of our
Enel related revenues.
We
also
provide for an allowance for sales discounts and rebates that we identify and
reserve for at the time of sale. This reserve is primarily related to estimated
future point of sale, or POS, credits to be issued to certain of our
distributors. Under our arrangements with these distributors, we have agreed
to
issue POS credits on sales they make to certain volume customers. We base these
estimates on the respective distributor’s historical and forecasted sales
volumes to those customers. Significant management judgments and estimates
must
be made and used in connection with establishing these reserves for POS credits
in any accounting period. Material differences may result in the amount and
timing of our revenues for any period if management revises its judgments or
estimates.
Our
allowances for sales returns and other sales-related reserves were approximately
$876,000 as of March 31, 2005, and $1.2 million as of December 31,
2005.
Stock-Based
Compensation.
Effective January 1, 2006, we adopted the provisions of and account for
stock-based compensation in accordance with SFAS 123R. We elected the
modified-prospective method, under which prior periods are not revised for
comparative purposes. Under the fair value recognition provisions of this
statement, stock-based compensation cost is measured at the grant date based
on
the calculated fair value of the award and is recognized as expense ratably
over
the requisite service period, which is the vesting period.
We
currently use the Black-Scholes-Merton (“BSM”) option-pricing model to determine
the calculated fair value of stock options. The determination of the calculated
fair value of stock-based payment awards on the date of grant using the BSM
option-pricing model is affected by our stock price on the date of grant, as
well as a number of highly complex and subjective variables. These variables
include the expected volatility of our stock price over the expected term of
the
option, actual and projected employee stock option exercise behaviors, risk-free
interest rates, and expected dividends.
We
estimate the expected term of options granted using the simplified method as
illustrated in SEC Staff Accounting Bulletin No. 107 (“SAB 107”). Under the
simplified method, the expected term is calculated by taking the average of
the
vesting term and the contractual term of the option. The
expected volatility is based on the historical volatility of our common stock
over the most recent period commensurate with the expected life of the option,
and does not include any implied volatility as there are currently no market
traded options on our stock that meet the criteria required for reliance on
implied volatility in accordance with SAB 107. We base the risk-free interest
rate that we use in the BSM option-pricing model on U.S. Treasury issues in
effect at the time of option grant that have remaining terms similar to the
expected term of the option. We have never paid cash dividends on our common
stock, and do not anticipate paying cash dividends in the foreseeable future.
Therefore, we use an expected dividend yield of zero in the BSM option-pricing
model.
SFAS
123R
also requires us to record compensation expense for stock-based compensation
net
of estimated forfeitures, and to revise those estimates in subsequent periods
if
actual forfeitures differ from those estimates. We use historical data to
estimate pre-vesting option forfeitures and record stock-based compensation
expense only for those awards that are expected to vest. All share-based payment
awards are amortized using the multiple option method over their requisite
service period, which is generally the vesting period.
If
factors change and we employ different assumptions for estimated stock-based
compensation expense in future periods, or if we decide to use a different
option-pricing model, stock-based compensation expense in those future periods
may differ significantly from what we have recorded in the current period and
could materially affect our operating results and earnings per
share.
The
BSM
option-pricing model was developed for use in estimating the calculated fair
value of traded options that have no vesting or hedging restrictions and that
are fully transferable, characteristics that are not present in our option
grants. Existing valuation models, including the BSM and lattice binomial
models, may not provide reliable measures of fair values of our stock-based
compensation. Consequently, there is a risk that our estimates of the calculated
fair values of our stock-based compensation awards on the grant dates may be
significantly different from the actual values realized, if any, upon the
exercise, expiration, early termination, or forfeiture of those stock-based
payments in the future. For example, our employee stock options may expire
worthless or otherwise result in zero intrinsic value as compared to the
calculated fair values originally estimated on the grant date and reported
in
our financial statements. Alternatively, value may be realized from these
instruments that is significantly higher than the calculated fair values
originally estimated on the grant date and reported in our financial statements.
There currently is no market-based mechanism or other practical application
to
verify the reliability and accuracy of the estimated fair values resulting
from
these valuation models, nor is there a means to compare and adjust the estimates
to actual values.
The
guidance of SFAS 123R and SAB 107 is relatively new. The application of these
principles may be subject to further interpretation and refinement over time.
There are significant differences among valuation models, and there is a
possibility that we will adopt different valuation models in the future. This
may result in a lack of consistency in future periods and materially affect
the
calculated fair value estimate of stock-based payments. It may also result
in a
lack of comparability with other companies that use different models, methods,
and assumptions.
Further
information regarding stock-based compensation can be found in Note 4 of our
Notes to Condensed Consolidated Financial Statements contained in this
report.
Allowance
for Doubtful Accounts.
We
typically sell our products and services to customers with net 30-day payment
terms. In certain instances, payment terms may extend to as much as net 90
days.
For a customer whose credit worthiness does not meet our minimum criteria,
we
may require partial or full payment prior to shipment. Alternatively, customers
may be required to provide us with an irrevocable letter of credit prior to
shipment.
We
evaluate the collectibility of our accounts receivable based on a combination
of
factors. In circumstances where we are aware of a specific customer's inability
to meet its financial obligations to us, we record a specific allowance against
amounts due to reduce the net recognized receivable to the amount we reasonably
believe will be collected. These determinations are made based on several
sources of information, including, but not limited to, a specific customer’s
payment history, recent discussions we have had with the customer, updated
financial information for the customer, and publicly available news related
to
that customer. For all other customers, we recognize allowances for doubtful
accounts based on the length of time the receivables are past due, the current
business environment, the credit-worthiness of our overall customer base,
changes in our customers’ payment patterns, and our historical experience. If
the financial condition of our customers were to deteriorate, or if general
economic conditions worsened, additional allowances may be required in the
future, which could materially impact our results of operations and financial
condition. Our allowance for doubtful accounts was $200,000 as of March 31,
2006, and $300,000 as of December 31, 2005.
Inventory
Valuation.
At each
balance sheet date, we evaluate our ending inventories for excess quantities
and
obsolescence. This evaluation includes analyses of sales levels by product
and
projections of future demand. Inventories on hand, in excess of one year’s
forecasted demand, are not valued. In addition, we write off inventories that
we
consider obsolete. We consider a product to be obsolete when one of several
factors exists. These factors include, but are not limited to, our decision
to
discontinue selling an existing product, the product has been re-designed and
we
are unable to rework our existing inventory to update it to the new version,
or
our competitors introduce new products that make our products obsolete. We
adjust remaining inventory balances to approximate the lower of our cost or
market value. If future demand or market conditions are less favorable than
our
projections, additional inventory write-downs may be required and would be
reflected in cost of sales in the period the revision is made.
Warranty
Reserves.
We
evaluate our reserve for warranty costs based on a combination of factors.
In
circumstances where we are aware of a specific warranty related problem, for
example a product recall, we reserve an estimate of the total out-of-pocket
costs we expect to incur to resolve the problem, including, but not limited
to,
costs to replace or repair the defective items and shipping costs. When
evaluating the need for any additional reserve for warranty costs, management
takes into consideration the term of the warranty coverage, the quantity of
product in the field that is currently under warranty, historical
warranty-related return rates, historical costs of repair, and knowledge of
new
products introduced. If any of these factors were to change materially in the
future, we may be required to increase our warranty reserve, which could have
a
material negative impact on our results of operations and our financial
condition. Our reserve for warranty costs was $409,000 as of March 31, 2006,
and
$469,000 as of December 31, 2005.
Deferred
Income Taxes.
We
record a valuation allowance to reduce our deferred tax assets to the amount
that is more likely than not to be realized. Based on our historical net
operating losses, and the uncertainty of our future operating results, we have
recorded a valuation allowance that fully reserves our deferred tax assets.
If
we later determine that, more likely than not, some or all of the net deferred
tax assets will be realized, we would then need to reverse some or all of the
previously provided valuation allowance. Our deferred tax asset valuation
allowance was $52.2 million as of December 31, 2005.
Valuation
of Goodwill and Other Intangible Assets.
We
assess the impairment of goodwill and identifiable intangible assets on an
annual basis and whenever events or changes in circumstances indicate that
the
carrying value may not be recoverable. Factors we consider important which
could
trigger an impairment review include the following:
· significant
underperformance relative to expected historical or projected future operating
results;
· significant
changes in the manner or use of the acquired assets or the strategy for our
overall business;
· significant
negative industry or economic trends; and
· significant
changes in the composition of the intangible assets acquired.
When
we
determine that the carrying value of goodwill and other intangible assets may
not be recoverable based upon the existence of one or more of the above
indicators, we measure any impairment based on a projected discounted cash
flow
method using a discount rate determined by our management to be commensurate
with the risk inherent in our current business model. Net goodwill and other
intangible assets amounted to $8.0 million as of December 31, 2005.
When
we
adopted SFAS 142,
Goodwill and Other Intangible Assets,
in 2002,
we ceased amortizing goodwill, which had a net unamortized balance of $1.7
million as of December 31, 2001. Since then, primarily as a result of
acquisitions in 2002 and 2003, the net balance of goodwill has grown to $8.1
million as of March 31, 2006. We review goodwill for impairment annually during
the quarter ending March 31. Our review during the quarter ended March 31,
2006
indicated no impairment. If, as a result of an annual or any other impairment
review that we perform in the future, we determine that there has been an
impairment of our goodwill or other intangible assets, we would be required
to
take an impairment charge. Such a charge could have a material adverse impact
on
our financial position and/or operating results.
The
following table reflects the percentage of total revenues represented by each
item in our Consolidated Statements of Operations for the three months ended
March 31, 2006 and March 31, 2005:
| |
|
Three
Months Ended March 31,
|
|
| |
|
2006
|
|
2005
|
|
|
Revenues:
|
|
|
|
|
|
|
|
|
Product
|
|
|
98.4
|
%
|
|
99.2
|
%
|
|
Service
|
|
|
1.6
|
|
|
0.8
|
|
|
Total
revenues
|
|
|
100.0
|
|
|
100.0
|
|
|
Cost
of revenues:
|
|
|
|
|
|
|
|
|
Cost
of product
|
|
|
42.5
|
|
|
40.2
|
|
|
Cost
of service
|
|
|
4.1
|
|
|
2.3
|
|
|
Total
cost of revenues
|
|
|
46.6
|
|
|
42.5
|
|
|
Gross
profit
|
|
|
53.4
|
|
|
57.5
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
Product
development
|
|
|
65.0
|
|
|
28.7
|
|
|
Sales
and marketing
|
|
|
47.9
|
|
|
23.2
|
|
|
General
and administrative
|
|
|
31.7
|
|
|
20.5
|
|
|
Total
operating expenses
|
|
|
144.6
|
|
|
72.4
|
|
|
Loss
from operations
|
|
|
(91.2
|
)
|
|
(14.9
|
)
|
|
Interest
and other income, net
|
|
|
12.9
|
|
|
4.9
|
|
|
Loss
before provision for income taxes
|
|
|
(78.3
|
)
|
|
(10.0
|
)
|
|
Provision
for income taxes
|
|
|
0.7
|
|
|
0.4
|
|
|
Net
loss
|
|
|
(79.0
|
%)
|
|
(10.4
|
%)
|
Revenues
Total
revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
revenues
|
|
$
|
10,745
|
|
$
|
21,683
|
|
$
|
(10,938
|
)
|
|
(50.4
|
%)
|
The
$10.9
million decrease in total revenues for the quarter ended March 31, 2006 as
compared to the same period in 2005 was primarily the result of a $10.2 million
reduction in Enel Project related revenues (see discussion below), a $530,000
reduction in LonWorks
Infrastructure revenues (see discussion below), and a $187,000 reduction in
NES
revenues (see discussion below).
LonWorks
Infrastructure revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LonWorks
Infrastructure revenues
|
|
$
|
10,379
|
|
$
|
10,909
|
|
$
|
(530
|
)
|
|
(4.9
|
%)
|
Our
LonWorks
Infrastructure revenues are primarily comprised of sales of our hardware and
software products, and to a lesser extent, revenues we generate from our
customer support and training offerings. The $530,000 decrease in LonWorks
Infrastructure revenue for the quarter ended March 31, 2006 as compared to
the
same period in 2005 was primarily the result of a revision we made to our
revenue recognition methodology for sales made to our European distributor,
EBV
(see discussion below). The revision resulted in a decrease in our LonWorks
Infrastructure revenues during the first quarter of 2006 of approximately $2.9
million. In addition, the impact of sales made in foreign currencies,
principally the Japanese Yen, contributed approximately $54,000 to the
quarter-over-quarter decline. Offsetting these decreases were increases in
LonWorks
Infrastructure revenues in all the geographic markets we serve. We believe
these
increases are due, at least in part, to our customer’s utilization of our
products in new applications, such as energy management and street lighting
controls.
We
sell
our
LonWorks
Infrastructure products through our direct sales force, distributors, and select
third-party electronics representatives. Worldwide sales to distributors,
including those to EBV, accounted for approximately 36.1% of total net revenues
for the quarter ended March 31, 2006, and 23.1% for the same period in 2005.
With the exception of EBV, none of our distributor partners are entitled to
return excess products. In order to address changing business conditions with
these distributors other than EBV, we are currently considering modifying our
contracts with them to allow for limited rights of return, which will likely
require us to defer revenue recognition on sales made to them until such time
as
the products are sold through to their end customers. We currently expect these
contractual modifications, if completed, will occur before the end of 2006.
We
expect the impact of these contractual changes with our distributor partners
other than EBV will be to reduce our full year 2006 LonWorks
Infrastructure revenues by less than $1.0 million.
Although
we experienced a modest decrease in our LonWorks
Infrastructure revenues during the first quarter of 2006 as compared to the
same
period in 2005, we continue to believe that, as long as current worldwide
economic conditions do not deteriorate, full year 2006 revenues from our
LonWorks
Infrastructure business will improve from the $46.6 million recorded in 2005.
This expected improvement, however, will be subject to further fluctuations
in
the exchange rates between the U.S. dollar and the Japanese Yen. If the U.S.
dollar were to strengthen against the Japanese Yen, our revenues would decrease.
Conversely, if the U.S. dollar were to weaken against the Japanese Yen, our
revenues would increase. The extent of this exchange rate fluctuation increase
or decrease will depend on the amount of sales conducted in Japanese Yen (or
other foreign currencies) and the magnitude of the exchange rate fluctuation
from year to year. The portion of our revenues conducted in currencies other
than the U.S. dollar, principally the Japanese Yen, was about 6.2% for the
quarter ended March 31, 2006 and 3.1% for the same period in 2005. We do not
currently expect that, during the remainder of 2006, the amount of our
LonWorks
Infrastructure revenues conducted in these or other foreign currencies will
fluctuate significantly from that experienced in 2005. Given the historical
and
expected future level of sales made in foreign currencies, we do not currently
plan to hedge against these currency rate fluctuations. However, if the portion
of our LonWorks
Infrastructure revenues conducted in foreign currencies were to grow
significantly, we would re-evaluate these exposures and, if necessary, enter
into hedging arrangements to help minimize these risks.
NES
revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NES
revenues
|
|
$
|
166
|
|
$
|
353
|
|
$
|
(187
|
)
|
|
(53.0
|
%)
|
NES
revenues generated during the quarters ended March 31, 2006 and 2005 were
primarily related to the completion of system trials and, to a lesser extent,
for the first quarter of 2006, shipment of NES products.
We
expect
that, during 2006, shipments of our NES products will increase significantly
over 2005 levels, due primarily to the fact that in late 2005, we and one of
our
NES value-added resellers, or VAR, partners won a utility tender for an
intelligent metering system with Vattenfall AB, a Swedish utility company.
In
addition, in early 2006 we won a small utility tender in the Netherlands with
the Dutch utility Nuon. Our ability to recognize revenue on these shipments,
as
well as shipments for other NES projects that we may win in the future, will
depend on several factors, including, but not limited to, modification of the
existing shipment schedules included in the contracts that have been awarded
to
us thus far, and certain contractual provisions, such as customer acceptance.
In
addition, the complex revenue recognition rules relating to products such our
NES system could also require us to defer some or all of the revenue associated
with NES product shipments until certain conditions are met in a future period.
In some instances, the reasons for these deferrals may not be fully under our
control, which could result in the actual timing of revenue being significantly
different than we currently anticipate.
We
also
expect that many foreign utilities will require us to price our NES system
in
the respective utility’s local currency, which will expose us to foreign
currency risk. In most cases, in the event of a contract award, we intend to
hedge this foreign currency risk so long as we can secure forward currency
contracts that are reasonably priced and that are consistent with the scheduled
deliveries for that project. In addition, we will face foreign currency
exposures from the time we submit our foreign currency denominated bid until
the
award of a contract by the utility (the “bid to award” term). This bid to award
term can often exceed several months. If a utility awards us a contract that
gives the utility the right to exercise options for additional supply in the
future, we would also be exposed to foreign currency risk until such time as
these options, if any, were exercised. We may decide that it is too expensive
to
hedge the foreign currency risks during the bid to award term or for any
unexercised options. Any resulting adverse foreign currency fluctuations could
significantly harm our revenues, results of operations, and financial condition.
Enel
project revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006over
2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Enel
project revenues
|
|
$
|
200
|
|
$
|
10,422
|
|
$
|
(10,222
|
)
|
|
(98.1
|
%)
|
The
$10.2
million decrease in Enel Project revenues for the quarter ended March 31, 2006,
as compared to the same period in 2005, was primarily attributable to the
completion of our sales of components and products for the deployment phase
of
Enel’s Contatore Elettronico project during 2005. Enel has asked us to provide
them with spare parts for use in their system in Italy. We have agreed to this
request, and the $200,000 of Enel project revenue recognized in the first
quarter of 2006 represents our initial shipments against this request. We
currently expect shipments of these spare parts will total approximately $7.0
million during 2006, and expect to complete our deliveries during the second
quarter of 2006.
We
sell
our products to Enel and its designated manufacturers in U.S. dollars.
Therefore, the associated revenues are not subject to foreign currency
risks.
Given
our
historical dependence on one customer, we continue to seek opportunities to
expand our customer base. In 2002, we formed a sales and marketing organization
that has since been tasked with identifying other customers for our NES system
products. However, we can give no assurance that our efforts in the networked
energy services area will be successful.
EBV
revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
EBV
revenues
|
|
$
|
2,444
|
|
$
|
3,853
|
|
$
|
(1,409
|
)
|
|
(36.6
|
%)
|
Sales
to
EBV, our largest distributor and the primary independent distributor of our
products in Europe, accounted for 22.7% of our total revenues for the quarter
ended March 31, 2006 and 17.8% of our total revenues for the same period in
2005. The primary factor contributing to the $1.4 million decrease between
the
two quarters was the fact that, during the first quarter of 2006, we revised
our
revenue recognition methodology for sales made to EBV. Under the revised
methodology, we will now defer revenue, as well as cost of goods sold, on items
shipped to EBV that remain in EBV’s inventories at quarter-end. Revenue will be
recognized on these products, along with the corresponding gross margin, when
EBV sells them to its customers in future periods. As noted above, this revision
resulted in a revenue decrease of approximately $2.9 million for the quarter
ended March 31, 2006. The revision will not have an impact on cash flows from
operations or require any changes to historical financial statements.
Prior
to
2006, we recognized revenue on sales made to EBV upon shipment, less estimated
reserves for future sales discounts and returns as required under Statement
of
Financial Accounting Standards No. 48 (“SFAS 48”), Revenue
Recognition When Right of Return Exists.
This
methodology required us to monitor EBV’s quarter-end inventory balances, as well
as forecasted future sales activity, and to defer revenue and cost of goods
sold
on those items in EBV’s inventory that we considered to be excess to EBV’s
requirements, and thus subject to return under EBV’s contractual stock rotation
rights. In addition, at each quarter-end, a separate reserve was established
to
provide for estimated future sales discounts in the form of point-of-sale
(“POS”) credits. These POS credits would in turn be issued to EBV once EBV sold
qualifying products to certain of its customers.
The
revision made to our method of revenue recognition for sales made to EBV was
done for a number of reasons, including, but not limited to, changes in both
the
demand for our products and the types of applications for which our products
are
being used by EBV’s end-customers, as well as an increase in the breadth and mix
of products sold to EBV for high volume applications. These changes caused
our
management to conclude that they could no longer reasonably and reliably
estimate and reserve for both EBV’s future returns of excess inventory and
allowances for future POS credits, each of which is a required adjustment under
SFAS 48 when revenue is recognized at the time of shipment.
Excluding
the impact of the accounting method revision, EBV shipments were quite strong
during the first quarter of 2006 as compared to the same period in 2005. We
believe this was due to an increase in demand for our products by EBV’s
customers, as well as changes in EBV’s purchasing activity resulting from the
new Restriction of Hazardous Substances, or RoHS, regulations. Under these
new
rules, which become effective in the European Union (and elsewhere) in mid-2006,
manufacturers such as Echelon will be required to eliminate certain hazardous
substances (e.g., lead, cadmium, mercury, etc.) from the products they sell
into
the region. We believe that, in an effort to minimize any excess inventories
of
non-RoHS compliant products, EBV and EBV’s customers have been tightly managing
their inventory balances, which, in late 2005, resulted in reduced shipments
to
EBV until the RoHS compliant products became available. We began shipping the
RoHS compliant versions of some of our products in volume quantities in late
2005, and expect to complete the transition for our remaining products during
2006.
We
currently sell our products to EBV in U.S. dollars.
Therefore, the associated revenues are not subject to foreign currency exchange
rate risks. However, EBV has the right, on notice to our company, to require
that we sell our products to them in Euros.
Our
contract with EBV, which has been in effect since 1997 and to date has been
renewed annually thereafter, expires in December 2006. If our agreement with
EBV
is not renewed, or is renewed on terms that are less favorable to us, our
revenues could decrease and our future financial position could be harmed.
Product
revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
revenues
|
|
$
|
10,574
|
|
$
|
21,516
|
|
$
|
(10,942
|
)
|
|
(50.9
|
%)
|
The
$10.9
million decrease in product revenues for the quarter ended March 31, 2006 as
compared to the same period in 2005 was primarily the result of a $10.2 million
reduction in Enel Project related revenues, as well as reductions in both our
LonWorks
Infrastructure and NES revenues.
Service
revenues
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Service
revenues
|
|
$
|
171
|
|
$
|
167
|
|
$
|
4
|
|
|
2.4
|
%
|
The
$4,000 increase in service revenues during the quarter ended March 31, 2006
as
compared to the same period in 2005 was primarily due to the timing of our
customer support and training revenues. We do not currently believe that our
service revenues will change substantially from prior year levels.
Gross
Profit and Gross Margin
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
Profit
|
|
$
|
5,737
|
|
$
|
12,470
|
|
$
|
(6,733
|
)
|
|
(54.0
|
%)
|
|
Gross
Margin
|
|
|
53.4
|
%
|
|
57.5
|
%
|
|
--
|
|
|
(4.1
|
)
|
Gross
profit is equal to revenues less cost of goods sold. Cost of goods sold for
product revenues includes direct costs associated with the purchase of
components, subassemblies, and finished goods, as well as indirect costs such
as
allocated labor and overhead; costs associated with the packaging, preparation,
and shipment of products; and charges related to warranty and excess and
obsolete inventory reserves. Cost of goods sold for service revenues consists
of
employee-related costs such as salaries and fringe benefits as well as other
direct and indirect costs incurred in providing training, customer support,
and
custom software development services. Gross margin is equal to gross profit
divided by revenues.
The
4.1
percentage point decrease in gross margin during the first quarter of 2006
was
due primarily to the impact of lower overall revenues on gross margins. As
discussed above, a portion of our cost of goods sold relates to indirect costs.
Some of these costs do not increase or decrease in conjunction with revenue
levels, but rather remain relatively constant from quarter to quarter. As a
result, when revenues decrease, as they did in the quarter ended March 31,
2006
as compared to the same period in 2005, gross margins are negatively impacted.
In addition, during the first quarter of 2006, we adopted SFAS 123R and began
recording compensation expense associated with stock options and other forms
of
equity compensation. This resulted in a $117,000 increase in our total cost
of
revenues, which had a corresponding effect of reducing our gross margin by
1.1
percentage points.
Offsetting
these negative impacts was a favorable increase in our gross margin related
to a
change in the mix of Enel Project and LonWorks
Infrastructure revenues. During the quarter ended March 31, 2006, approximately
1.9% of our revenues were attributable to the Enel Project and 96.6% were
attributable to sales of our LonWorks
Infrastructure products and services. For the quarter ended March 31, 2005,
approximately 48.1% of our revenues were attributable to the Enel Project,
while
50.3% resulted from sales of our LonWorks
Infrastructure products and services. The percentage of revenues generated
from
sales of our NES system products was relatively unchanged between the two
periods, at 1.5% for the quarter ended March 31, 2006 and 1.6% for the same
period in 2005. In general, gross margins on Enel Project revenues tend to
be
lower than those generated from sales of our LonWorks
Infrastructure products and services. As a result, when Enel Project revenues
are lower as a percentage of overall revenues, as they were during the quarter
ended March 31, 2006, overall gross margins tend to be higher. Conversely,
when
Enel Project revenues comprise a higher percentage of overall revenues, as
they
were during the quarter ended March 31, 2005, overall gross margins tend to
be
lower.
We
expect
that, for full year 2006, overall gross margin will decrease from the 55.6%
experienced in 2005 due to lower overall expected revenues, the impact of SFAS
123R, and the mix of our revenues.
Operating
Expenses
Product
Development
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
Development
|
|
$
|
6,991
|
|
$
|
6,217
|
|
$
|
774
|
|
|
12.4
|
%
|
Product
development expenses consist primarily of payroll and related expenses for
development personnel, facility costs, expensed material, fees paid to third
party service providers, depreciation and amortization, and other costs
associated with the development of new technologies and products.
The
$774,000 increase in product development expenses for the quarter ended March
31, 2006 as compared to the same period in 2005 was primarily due to an increase
in compensation expenses for our product development personnel, which was
comprised of stock-based compensation expenses resulting from our adoption
of
SFAS 123R during the first quarter of 2006 and, to a lesser extent, an increases
in our product development personnel headcount. Partially offsetting these
increases was a decrease in fees paid to third party service
providers.
We
expect
that, for full year 2006, product development expenses will increase over 2005
levels due primarily to the impact of SFAS 123R and, to a lesser extent,
increases in our product development personnel headcount.
Sales
and Marketing
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Sales
and Marketing
|
|
$
|
5,147
|
|
$
|
5,025
|
|
$
|
122
|
|
|
2.4
|
%
|
Sales
and
marketing expenses consist primarily of payroll and related expenses for sales
and marketing personnel, including commissions to sales personnel, facilities
costs, travel and entertainment, advertising and product promotion, and other
costs associated with our sales and support offices.
The
$122,000 increase in sales and marketing expenses for the quarter ended March
31, 2006 as compared to the same period in 2005 was primarily due to an increase
in stock-based compensation expenses resulting from our adoption of SFAS 123R
effective January 1, 2006. Partially offsetting this increase was a $156,000
decrease resulting from the impact of foreign currency exchange rate
fluctuations between the U.S. dollar and the local currencies in several of
the
foreign countries in which we operate, including the Euro, the British Pound
Sterling, and the Japanese Yen.
We
expect
that, for full year 2006, our sales and marketing expenses will increase over
2005 levels. We believe that this increase will be primarily attributable to
increases in compensation expenses due to the impact of SFAS 123R as well as
sales incentive compensation plans. If foreign exchange rates remain at March
31, 2006 levels, a portion of these increases may be offset by favorable
exchange rate fluctuations. If the U.S. dollar were to strengthen further
against the foreign currencies where we do business, our sales and marketing
expenses could decrease further as compared to amounts incurred in 2005.
Conversely, if the dollar were to weaken against these currencies, our expenses
would rise.
General
and Administrative
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
General
and Administrative
|
|
$
|
3,402
|
|
$
|
4,451
|
|
$
|
(1,049
|
)
|
|
(23.6
|
%)
|
General
and administrative expenses consist primarily of payroll and related expenses
for executive, accounting, and administrative personnel, professional fees
for
legal and accounting services rendered to the company, facility costs,
insurance, and other general corporate expenses.
The
$1.0
million decrease in general and administrative expenses during the quarter
ended
March 31, 2006 as compared to the same period in 2005 was primarily attributable
to a $1.1 million decrease in professional fees paid for legal and accounting
services rendered to the company. During the first quarter of 2005, these costs
were unusually high due to our arbitration with Enel, and to a lesser extent,
additional fees paid to our external auditors resulting from increased
Sarbanes-Oxley compliance requirements. While we did experience an increase
of
approximately $246,000 in our compensation costs for general and administrative
personnel during the first quarter of 2006 as compared to the same period in
2005 resulting from our adoption of SFAS 123R, these increased expenses were
offset by reductions in other costs such as bad debt expense and travel and
entertainment expenses, among others.
We
expect
that, for full year 2006, general and administrative costs will be slightly
lower than those incurred in 2005. Although we expect reduced 2006 spending
for
legal and other costs as a result of the conclusion of our Enel arbitration
in
2005, we expect these savings will be partially offset by increases in
stock-based compensation costs resulting from our adoption of SFAS 123R.
Interest
and Other Income, Net
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
and Other Income, Net
|
|
$
|
1,394
|
|
$
|
1,061
|
|
$
|
333
|
|
|
31.4
|
%
|
Interest
and other income, net primarily reflects interest earned by our company on
cash
and short-term investment balances. In addition, foreign exchange translation
gains and losses related to short-term intercompany balances are also reflected
in this amount.
Interest
income increased by approximately $587,000 during the quarter ended March
31,
2006 as compared to the same period in 2005. This increase is primarily
attributable to an overall improvement in the average yield on our investment
portfolio. Yields have been increasing since June 2004 as a result of the
Federal Reserve’s interest rate increases. As short-term investments we
purchased in 2004 and 2005 have come to maturity, the proceeds have been
re-invested in instruments with higher effective yields, thus increasing
interest income. Partially offsetting the $587,000 increase in interest income
between the two quarters was the impact of foreign exchange translation losses
on our short-term intercompany balances.
Although
interest rates have been increasing steadily since June 2004, we expect that
our
anticipated operating losses for 2006 will require us to use a portion of
our
existing cash and short-term investment portfolio to fund ongoing business
operations. In addition, we may decide to continue repurchasing our common
stock
in accordance with our board of directors approved stock repurchase program,
which expires in March 2007. As a result, we expect that the average amount
of
our invested cash will decrease during 2006, which could result in reduced
interest income. In addition, future fluctuations in the exchange rates between
the United States dollar and the currencies in which we maintain our short-term
intercompany balances (principally the European Euro and the British Pound
Sterling) will also affect our interest and other income, net.
Provision
for Income Taxes
| |
|
Three
Months Ended
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
March
31,
2006
|
|
|
March
31,
2005
|
|
|
2006
over 2005 $ Change
|
|
|
2006
over 2005 % Change
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision
for Income Taxes
|
|
$
|
80
|
|
$
|
100
|
|
$
|
(20
|
)
|
|
(20.0
|
%)
|
The
provision for income taxes for 2006 includes a provision for federal, state
and
foreign taxes based on our annual estimated effective tax rate for the year.
The
difference between the statutory rate and our effective tax rate is primarily
due to the impact of foreign taxes and the beneficial impact of deferred taxes
resulting from the utilization of net operating losses. Income taxes of $80,000
for the quarter ended March 31, 2006, and $100,000 for the quarter ended March
31, 2005, primarily consist of taxes related to profitable foreign subsidiaries
and various state minimum taxes.
Although
we expect to generate a loss before provision for income taxes in 2006, we
will
be required to book income tax expense to cover, at a minimum, the foreign
taxes
owed on income generated by our profitable foreign subsidiaries. We currently
expect our 2006 provision for income taxes will be slightly higher than the
amounts provided for in 2005.
OFF-BALANCE
SHEET
ARRANGEMENTS
AND OTHER
CONTRACTUAL
OBLIGATIONS
Off-Balance-Sheet
Arrangements.
We have
not entered into any transactions with unconsolidated entities whereby we have
financial guarantees, subordinated retained interests, derivative instruments,
or other contingent arrangements that expose Echelon to material continuing
risks, contingent liabilities, or any other obligation under a variable interest
in an unconsolidated entity that provides financing, liquidity, market risk,
or
credit risk support to us.
Operating
Lease Commitments.
We lease
our present corporate headquarters facility in San Jose, California, under
two
non-cancelable operating leases. The first lease agreement expires in 2011
and
the second lease agreement expires in 2013. Upon expiration, both lease
agreements provide for extensions of up to ten years. As part of these lease
transactions, we provided the lessor security deposits in the form of two
standby letters of credit totaling $6.5 million.
In
addition to our corporate headquarters facility, we also lease facilities for
our sales, marketing, distribution, and product development personnel located
elsewhere within the United States and in nine foreign countries throughout
Europe and Asia. These operating leases are of shorter duration, generally
one
to two years, and in some instances are cancelable with advance
notice.
Purchase
Commitments.
We
utilize several contract manufacturers who manufacture and test our products
requiring assembly. These contract manufacturers acquire components and build
product based on demand information supplied by us in the form of purchase
orders and demand forecasts. These purchase orders and demand forecasts
generally cover periods that range from one to six months, and in some cases,
up
to one year. We also obtain individual components for our products from a wide
variety of individual suppliers. We generally acquire these components through
the issuance of purchase orders, and in some cases through demand forecasts,
both of which cover periods ranging from one to six months.
We
also
utilize purchase orders when procuring capital equipment, supplies, and services
necessary for our day-to-day operations. These purchase orders generally cover
periods ranging up to twelve months, but in some instances cover a longer
duration.
Indemnifications.
In the
normal course of business, we provide indemnifications of varying scope to
customers against claims of intellectual property infringement made by third
parties arising from the use of our products. Historically, costs related to
these indemnification provisions have not been significant. However, we are
unable to estimate the maximum potential impact of these indemnification
provisions on our future results of operations.
As
permitted under Delaware law, we have agreements whereby we indemnify our
officers and directors for certain events or occurrences while the officer
or
director is, or was serving, at our request in such capacity. The
indemnification period covers all pertinent events and occurrences during the
officer’s or director’s lifetime. The maximum potential amount of future
payments we could be required to make under these indemnification agreements
is
unlimited; however, we have director and officer insurance coverage that could
enable us to recover a portion of any future amounts paid. We believe the
estimated fair value of these indemnification agreements in excess of the
applicable insurance coverage is minimal.
Royalties.
We have
certain royalty commitments associated with the shipment and licensing of
certain products. Royalty expense is generally based on a U.S. dollar amount
per
unit shipped or a percentage of the underlying revenue. Royalty expense, which
was recorded under our cost of products revenue on our consolidated statements
of income, was approximately $108,000 during the quarter ended March 31, 2006,
and $132,000 for the same period in 2005.
We
will
continue to be obligated for royalty payments in the future associated with
the
shipment and licensing of certain of our products. While we are currently unable
to estimate the maximum amount of these future royalties, such amounts will
continue to be dependent on the number of units shipped or the amount of revenue
generated from these products.
Legal
Actions. On
May 3,
2004, we announced that Enel filed a request for arbitration to resolve a
dispute regarding our marketing and supply obligations under the Research and
Development and Technological Cooperation Agreement dated June 28, 2000. The
arbitration took place in London in early March 2005 under the rules of
arbitration of the International Court of Arbitration of the International
Chamber of Commerce. We received the arbitration panel’s decision on September
29, 2005. The arbitration tribunal awarded Enel €4,019,750 in damages plus
interest from December 15, 2004 and the sums of $52,000 and €150,000 in
arbitration and legal related costs, respectively. These amounts, which total
approximately $5.2 million, were included in our results of operations for
the
year ended December 31, 2005. As of December 31, 2005, approximately $3.0
million of the $5.2 million award was unpaid and is reflected in accrued
liabilities. As of March 31, 2006, all amounts due Enel under the arbitration
ruling have been paid. The arbitration tribunal refused Enel’s request to extend
the supply or marketing obligations of Echelon.
In
addition to the matter described above, from time to time, in the ordinary
course of business, we are also subject to legal proceedings, claims,
investigations, and other proceedings, including claims of alleged infringement
of third-party patents and other intellectual property rights, and commercial,
employment, and other matters. In accordance with generally accepted accounting
principles, we make a provision for a liability when it is both probable that
a
liability has been incurred and the amount of the loss can be reasonably
estimated. These provisions are reviewed at least quarterly and adjusted to
reflect the impacts of negotiations, settlements, rulings, advice of legal
counsel, and other information and events pertaining to a particular case.
While
we believe we have adequately provided for such contingencies as of March 31,
2006, it is possible that our results of operations, cash flows, and financial
position could be harmed by the resolution of any such outstanding
claims.
As
of
March 31, 2006, our contractual obligations were as follows (in
thousands):
| |
|
Payments
due by period
|
|
| |
|
Total
|
|
Less
than 1 year
|
|
1-3
years
|
|
3-5
years
|
|
More
than 5 years
|
|
|
Operating
leases
|
|
$
|
30,075
|
|
$
|
4,999
|
|
$
|
9,380
|
|
$
|
9,395
|
|
$
|
6,301
|
|
|
Purchase
commitments
|
|
|
20,360
|
|
|
20,198
|
|
|
162
|
|
|
--
|
|
|
--
|
|
|
Total
|
|
$
|
50,453
|
|
$
|
25,197
|
|
$
|
9,542
|
|
$
|
9,395
|
|
$
|
6,301
|
|
LIQUIDITY
AND
CAPITAL
RESOURCES
Since
our inception, we have financed our operations and met our capital expenditure
requirements primarily from the sale of preferred stock and common stock,
although during the years 2002 through 2004, we were also able to finance our
operations through operating cash flow. From inception through March 31, 2006,
we raised $277.9 million from the sale of preferred stock and common stock,
including the exercise of stock options and warrants from our employees and
directors.
In
July
1998, we consummated an initial public offering of 5,000,000 shares of our
common stock at a price to the public of $7.00 per share. The net proceeds
from
the offering were about $31.7 million. Concurrent with the closing of our
initial public offering, 7,887,381 shares of convertible preferred stock were
converted into an equivalent number of shares of common stock. The net proceeds
received upon the consummation of the offering were invested in short-term,
investment-grade, interest-bearing instruments.
In
September 2000, we consummated a sale of 3.0 million shares of our common stock
to Enel. The net proceeds of the sale were about $130.7 million.
In
September 2001, our board of directors approved a stock repurchase program
which
authorized us to repurchase up to 2.0 million shares of our common stock, in
accordance with Rule 10b-18 and other applicable laws, rules and regulations.
In
September 2001, we repurchased 265,000 shares under the program at a cost of
$3.2 million. No additional repurchases were made subsequent to September 2001.
The stock repurchase program expired in September 2003.
In
March
and August 2004, our board of directors approved a second stock repurchase
program, which authorizes us to repurchase up to 3.0 million shares of our
common stock, in accordance with Rule 10b-18 and other applicable laws, rules
and regulations. Since inception, we have repurchased a total of 1,529,711
shares under the program at a cost of $10.7 million. As of March 31, 2006,
1,470,289 shares are available for repurchase. The stock repurchase program
will
expire in March 2007.
The
following table presents selected financial information as of March 31, 2006
and
for each of the last three fiscal years (dollars in thousands):
| |
|
March
31, 2006
|
|
2005
|
|
2004
|
|
2003
|
|
|
Cash,
cash equivalents, and short-term investments
|
|
$
|
151,522
|
|
$
|
154,480
|
|
$
|
160,364
|
|
$
|
144,923
|
|
|
Trade
accounts receivable, net
|
|
|
6,155
|
|
|
11,006
|
|
|
17,261
|
|
|
20,110
|
|
|
Working
capital
|
|
|
149,612
|
|
|
157,474
|
|
|
173,391
|
|
|
160,745
|
|
|
Stockholders’
equity
|
|
|
173,424
|
|
|
181,308
|
|
|
211,062
|
|
|
200,924
|
|
As
of
March 31, 2006, we had $151.5 million in cash, cash equivalents, and short-term
investments, a decrease of $3.0 million as compared to December 31, 2005.
Historically, our primary source of cash, other than stock sales, has been
receipts from revenue, and to a lesser extent, proceeds from the exercise of
stock options and warrants by our employees and directors. Our primary uses
of
cash have been cost of product revenue, payroll (salaries, commissions, bonuses,
and benefits), general operating expenses (costs associated with our offices
such as rent, utilities, and maintenance; fees paid to third party service
providers such as consultants, accountants, and attorneys; travel and
entertainment; equipment and supplies; advertising; and other miscellaneous
expenses), acquisitions, capital expenditures, and purchases under our stock
repurchase program.
Net
cash used in operating activities.
Net cash
used in operating activities has historically been driven by net income (loss)
levels, adjustments for non-cash charges such as depreciation, amortization,
in-process research and development charges, and stock-based compensation,
as
well as fluctuations in operating asset and liability balances. Net cash used
in
operating activities was $1.1 million for the quarter ended March 31, 2006,
roughly equivalent to the same period in 2005. During the quarter ended March
31, 2006, net cash used in operating activities was primarily a result of our
net loss of $8.5 million, offset by stock-based compensation expenses of $1.4
million, depreciation and amortization expense of $1.0 million, a reduction
in
our bad debt reserve balance of $94,000, and changes in our operating assets
and
liabilities of $5.1 million. During the quarter ended March 31, 2005, net cash
used in operating activities was primarily a result of our net loss of $2.3
million, offset by depreciation and amortization expense of $1.1 million,
stock-based compensation expenses of $93,000, and changes in our operating
assets and liabilities of $34,000.
Net
cash provided by (used for) investing activities.
Net cash
provided by (used for) investing activities has historically been driven by
transactions involving our short-term investment portfolio, capital
expenditures, changes in our long-term assets, and acquisitions. Net cash
provided by investing activities was $8.3 million for the quarter ended March
31, 2006, a $21.6 million increase from the same period in 2005. During the
quarter ended March 31, 2006, net cash provided by investing activities was
primarily the result of proceeds from maturities and sales of available-for-sale
short-term investments of $22.2 million, offset by purchases of
available-for-sale short-term investments of $12.8 million and capital
expenditures of $1.0 million. Net cash used in investing activities for the
quarter ended March 31, 2005 of $13.3 million was principally due to purchases
of $36.5 million of available-for-sale short-term investments, capital
expenditures of $556,000, and changes in our other long-term assets of $57,000,
offset by proceeds from sales and maturities of available-for-sale short-term
investments of $23.8 million.
Net
cash used in financing activities.
Net cash
provided by (used in) financing activities has historically been driven by
the
proceeds from issuance of common and preferred stock offset by transactions
under our stock repurchase programs. Net cash used in financing activities
was
$977,000 million for the quarter ended March 31, 2006, a $1.1 million decrease
over the same period in 2005. During the quarters ended March 31, 2006 and
2005,
net cash used in financing activities was attributable to open-market purchases
of our common stock under our stock repurchase program.
We
use
well-regarded investment management firms to manage our invested cash. Our
portfolio of investments managed by these investment managers is primarily
composed of highly rated United States corporate obligations, United States
government securities, and to a lesser extent, foreign corporate obligations,
certificates of deposit, and money market funds. All investments are made
according to guidelines and within compliance of policies approved by the Audit
Committee of our board of directors.
We
expect
that cash requirements for our payroll and other operating costs will continue
at or slightly above existing levels. We also expect that we will continue
to
acquire capital assets such as computer systems and related software, office
and
manufacturing equipment, furniture and fixtures, and leasehold improvements,
as
the need for these items arises. Furthermore, our cash reserves may be used
to
strategically acquire other companies, products, or technologies that are
complementary to our business.
Our
existing cash, cash equivalents, and investment balances will likely decline
during 2006 as a result of our anticipated operating losses. In addition, any
weakening of current economic conditions, or changes in our planned cash outlay,
could also negatively affect our existing cash, cash equivalents, and investment
balances. However, based on our current business plan and revenue prospects,
we
believe that our existing cash and short-term investment balances will be
sufficient to meet our projected working capital and other cash requirements
for
at least the next twelve months. Cash from operations could be affected by
various risks and uncertainties, including, but not limited to, the risks
detailed later in this discussion in the section titled “Factors
That May Affect Future Results of Operations.”
In the
unlikely event that we would require additional financing within this period,
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.
RELATED
PARTY
TRANSACTIONS
During
the quarter ended March 31, 2006, and the years ended December 31, 2005, 2004,
and 2003, the law firm of Wilson Sonsini Goodrich & Rosati, P.C. acted as
principal outside counsel to our company. Mr. Sonsini, a director of our
company, is a member of Wilson Sonsini Goodrich & Rosati, P.C.
From
time
to time, M. Kenneth Oshman, our Chairman of the Board and Chief Executive
Officer, uses private air travel services for business trips for himself and
for
any employees accompanying him. Prior to January 1, 2005, a company controlled
by Armas Clifford Markkula, a director of our company, provided these private
air travel services. Our net expense with respect to such private air travel
services is no greater than comparable first class commercial air travel
services. Such net outlays to date have not been material.
In
September 2000, we entered into a stock purchase agreement with Enel pursuant
to
which Enel purchased 3.0 million newly issued shares of our common stock for
$130.7 million (see Note 11 to our accompanying condensed consolidated financial
statements for additional information on our transactions with Enel). The
closing of this stock purchase occurred on September 11, 2000. At the closing,
Enel had agreed that it would not, except under limited circumstances, sell
or
otherwise transfer any of those shares for a specified time period. That time
period expired September 11, 2003. As of April 30, 2006, to our knowledge Enel
had not disposed of any of its 3.0 million shares.
Under
the
terms of the stock purchase agreement, Enel has the right to nominate a member
of our board of directors. Enel appointed Mr. Francesco Tatò as its
representative to our board of directors in September 2000. As a consequence
of
the expiration of Mr. Tatò’s mandate as Enel’s Chief Executive Officer, Mr. Tatò
resigned his board memberships in all of Enel’s subsidiaries and affiliates,
including Echelon. His resignation from our board of directors was effective
in
June 2002. Enel has reserved its right to nominate a new member of our board
of
directors, although, as of April 30, 2006, it has not done so. During the term
of service of Enel’s representative on our board of directors from September
2000 to June 2002, Enel’s representative abstained from resolutions on any
matter relating to Enel.
At
the
time we entered into the stock purchase agreement with Enel, we also entered
into a research and development agreement with an affiliate of Enel. Under
the
terms of the research and development agreement, we cooperated with Enel to
integrate our LonWorks
technology into Enel’s remote metering management project in Italy. For the
quarter ended March 31, 2006, we recognized revenue from products and services
sold to Enel and its designated manufacturers of approximately $200,000, none
of
which was included in our accounts receivable balance as of March 31, 2006.
For
the quarter ended March 31, 2005, we recognized revenue from products and
services sold to Enel and its designated manufacturers of approximately $10.4
million. As of March 31, 2005, $12.9 million of our total accounts receivable
balance related to amounts owed by Enel and its designated manufacturers. We
completed the sale of our components and products for the deployment phase
of
the Contatore Elettronico project during 2005. We currently expect that, during
2006, Enel will purchase approximately $7.0 million worth of spare parts from
us
for use in the Contatore Elettronico.
RECENTLY
ISSUED
ACCOUNTING
STANDARDS
In
February 2006, the FASB issued SFAS No. 155 (“SFAS 155”), Accounting
for Certain Hybrid Financial Instruments,
which
amends SFAS No. 133 (“SFAS 133”), Accounting
for Derivative Instruments and Hedging Activities
and SFAS
No. 140 (“SFAS 140”), Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities.
SFAS
155 simplifies the accounting for certain derivatives embedded in other
financial instruments by allowing them to be accounted for as a whole if the
holder elects to account for the whole instrument on a fair value basis. SFAS
155 also clarifies and amends certain other provisions of SFAS 133 and SFAS
140.
SFAS 155 is effective for all financial instruments acquired, issued, or subject
to a remeasurement event occurring in fiscal years beginning after September
15,
2006. Earlier adoption is permitted, provided the Company has not yet issued
financial statements, including for interim periods, for that fiscal year.
As we
do not currently engage in hedging activities, we do not currently expect the
adoption of SFAS 155 will have a material impact on our consolidated financial
position, results of operations, or cash flows.
In
June
2005, the FASB issued SFAS No. 154 (“SFAS 154”), Accounting
Changes and Error Corrections, a replacement of APB Opinion No. 20,
Accounting Changes, and Statement No. 3, Reporting Accounting Changes in
Interim Financial Statements.
SFAS 154 changes the requirements for how an entity accounts for, and
reports, a change in accounting principle. Previously, most voluntary changes
in
accounting principles were implemented by reflecting a cumulative effect
adjustment within net income during the period of the change. SFAS 154
requires retrospective application to prior periods’ financial statements,
unless it is impracticable to determine either the period-specific effects
or
the cumulative effect of the change. SFAS 154 is effective for accounting
changes made in fiscal years beginning after December 15, 2005; however,
the Statement does not change the transition provisions of any existing
accounting pronouncements.
FACTORS
THAT
MAY AFFECT
FUTURE
RESULTS
OF
OPERATIONS
Interested
persons should carefully consider the risks described below in evaluating our
company. Additional risks and uncertainties not presently known to us, or that
we currently consider immaterial, may also impair our business operations.
If
any of the following risks actually occur, our business, financial condition
or
results of operations could be materially adversely affected. In that case,
the
trading price of our common stock could decline.
Now
that the deployment phase of the Enel project has been completed, our overall
revenue has declined. Due to the lengthy sales cycle and timing of revenues
for
our NES business, our revenues may decline further.
We
completed our deliveries under the deployment phase of the Enel project during
2005. We currently expect that our revenues from Enel and its meter
manufacturers will decline significantly, from $26.9 million in 2005 to
approximately $7.0 million in 2006. We do not currently anticipate any material
revenues from Enel thereafter. Accordingly, we continue to seek new revenue
opportunities with other utility companies around the world.
We
believe that utility companies generally require a lengthier sales cycle than
do
most of our other customers. For example, in December 2005 we announced the
Swedish utility, Vattenfall AB, had selected our NES system for deployment
in
part of its service territory. Prior to this award, our VAR partner, Telvent,
and we had been discussing the benefits of the NES system with Vattenfall for
about three years. In addition, in many instances, one or more field trials
of
our NES system products may be required before a final decision is made by
the
utility. For example, a subsidiary of Nuon, a utility grid operator located
in
the Netherlands, completed a limited field trial of our NES system within its
service territory in early 2005. In early 2006, Nuon selected our NES system
for
a small deployment in part of its service territory. Once that effort is
completed, which we believe will happen in late 2006 or early 2007, we expect
Nuon will issue a public tender for an even larger deployment within their
service territory. However, there is no guarantee that we will win that tender,
if and when Nuon decides to issue it. In addition, there is generally an
extended development and integration effort required in order to incorporate
the
new technology into the utility’s existing infrastructure.
Once
a
utility decides to move forward with a large-scale deployment of our NES system,
the timing of, and our ability to recognize revenue on, our NES system product
shipments will depend on several factors, including, but not limited to, the
shipment schedules included in the contracts and certain contractual provisions,
such as acceptance of all or any part of the system by the utility. For example,
under the terms of our current arrangement with Nuon, there are significant
customer acceptance provisions that will require us to defer revenue recognition
until Nuon accepts the system, which we currently expect will happen in early
2007. In addition, the complex revenue recognition rules relating to products
such as our NES system could also require us to defer some or all of the revenue
associated with NES product shipments until certain conditions are met in a
future period. In some instances, the reasons for these deferrals may not be
fully under our control, which could result in the actual timing of revenue
being significantly different than we currently anticipate.
Due
to
the extended sales cycle and the additional development and integration time
required, as well as the uncertainty of the timing of our NES revenues, we
do
not currently believe we will be able to completely replace the expected $19.9
million reduction in Enel revenues in 2006. As a result, our 2006 revenues,
results of operations, and financial condition will be harmed.
Although
we have invested substantial amounts of time and money into our NES system,
our
utility market product offerings may fail to meet customers’ expectations, or
may fail to meet our financial targets. If we incur penalties and/or damages
with respect to sales of the NES system, such penalties and/or damages could
have an adverse effect on our financial condition, revenues, and operating
results.
To
be
successful in our efforts to sell our NES system, we have invested and intend
to
continue investing significant resources in its development. For example, in
April 2003 we acquired certain assets of Metering Technology Corporation, or
MTC, for $11.0 million in cash and the assumption of certain liabilities. Among
the assets acquired was the right to use MTC’s developed electricity meter
technology. As we have integrated their technology into our NES system, we
have
incurred and expect to continue to incur significant development
costs.
We
cannot
assure you that our NES system will be accepted in the utility market place
to
the extent required for us to realize a reasonable return on our investments
in
developing the system. For example, in order to realize all of the benefits
of
the NES system, a utility must replace a significant portion of its metering
infrastructure with a homogenous population of intelligent, networked meters.
In
addition, even if the NES system meets a utility’s technical specifications, we
may not be able to meet all of the utility’s contractual requirements. We also
cannot assure you that, if accepted by the utilities, our NES system will
generate economic returns that meet our financial targets. For example, revenues
from our NES system offering may be lower than we currently anticipate, as
was
the case for actual versus targeted NES system revenues for both 2004 and 2005.
The timing of these revenues could also fluctuate from our business plan for
a
variety of reasons, including changes in shipping schedules, contractual
provisions such as customer acceptance, and complex revenue recognition rules
related to sales of products consisting of multiple elements such as our NES
system. Additionally, when we do recognize revenue on sales of our NES system
products, we expect the gross margins generated from such sales will be lower
than those generated by most of our other products.
Even
if
we are successful in penetrating the utility market with our NES system
offering, we face competition from many companies. For example, Enel, our
largest customer for the last several years, has designed a system that it
may
use to compete with our NES system using third party products instead of our
products. Enel has significantly greater experience and financial, technical,
and other resources than we have. Enel previously announced an alliance with
IBM
to market and sell metering systems worldwide. We do not currently believe
that
our company will contribute to that alliance. Other competitors, including
Actaris, DCSI, Elster, Hunt Technologies, Itron, Iskraemeco, and Landis and
Gyr,
as well as our own customers such as Enermet, Horstmann Controls, Kamstrup,
and
Metrima, have also developed and are marketing their own multi-service metering
systems that compete with our NES system offering. We believe that our NES
system will compete with other offerings both in terms of technical capabilities
as well as price, warranties, indemnities, penalties, and other contractual
provisions.
In
addition, we presently plan to sell our NES products to utilities either
directly or through resellers or other partners. If we sell the NES system
directly to a utility, the utility may require us to assume responsibility
for
installing the NES system in the utility's territory, integrating the NES system
into the utility's operating and billing system, overseeing management of the
combined system, and undertaking other activities. These are services that
we generally would not be responsible for if we sold our NES products through
a
reseller or other partner, or if we sold directly to a utility that managed
those activities on its own. To date, we do not have any significant experience
with those services. As a result, if we sold directly to a utility that required
us to provide those services, we may be required to contract with third parties
to satisfy those obligations. We cannot assure you that we would find
appropriate third parties to provide those services on reasonable terms, or
at
all. Assuming responsibility for these or other services would add to the
costs and risks associated with NES system installations, and could also
negatively affect the timing of our revenues and cash flows related to these
transactions.
Lastly,
sales of the NES system will expose us to penalties, damages and other
liabilities relating to late deliveries, late or improper installations or
operations, failure to meet product specifications, failure to achieve
performance specifications, indemnities or otherwise. If we are unsuccessful
in
deploying the NES system, or otherwise fail to meet our financial targets for
the NES system, our revenues, results of operations, and financial position
will
be harmed.
Compliance
with new rules and regulations concerning hazardous materials is costly and
time-consuming, and may result in increased costs and a reduction in, or changes
in the timing of, our expected revenues.
We
are in
the process of implementing programs to comply with newly enacted Restrictions
on Hazardous Substances, or RoHS, regulations that require certain
manufacturers, such as Echelon, to eliminate hazardous substances (e.g., lead,
cadmium, mercury, etc.) from the commercial products that are sold to customers
in the European Union and Japan. These new rules become effective in
mid-2006. Transitioning our products from non-compliant to RoHS-compliant
is a complex, costly, and time-consuming process. During the transition, we
face
several risks, including, but not limited to, risks that we will be unable
to
successfully develop RoHS compliant alternatives for our existing non-RoHS
compliant products, that we will be unable to complete the transition in a
timely manner, that our contract electronic manufacturers will not be able
to
produce our RoHS compliant products in a timely and cost effective manner,
and
that the costs associated with this development effort will be higher than
originally anticipated. In addition, as all other suppliers in the market
affected by the RoHS regulations attempt to make this transition, availability
of RoHS compliant materials and expertise in RoHS compliant certifications
is in
great demand. Delays in availability of RoHS compliant materials and the
certifications necessary to support their use may have a negative impact on
our
revenues for the balance of 2006 or until such time as our transition is
complete.
In
addition, we face the risk that, in order to minimize any exposure to excess
non-RoHS compliant inventories, our customers, including our distributors such
as EBV, may reduce their inventory levels significantly from historical levels.
While we expect that, once the transition is complete, our customers would
restore their inventories back to historical levels, such action by our
customers and/or distributors could result in a reduction in revenue during
the
second quarter of 2006 due to the timing of these inventory level adjustments.
Lastly, we also face the risk that, in transitioning our products to comply
with
these new regulations, we could ourselves be left with excess quantities of
non-RoHS compliant inventory for which an excess and obsolete inventory reserve
would be required. If any of these risks materialize, our revenues, results
of
operations, and financial position could be harmed.
Effective
January 1, 2006, we began recording compensation expense for the calculated
fair
value of stock options and other compensatory equity-based awards that we issue
to our employees, which has harmed our results of
operations.
We
believe that stock options are a key element in our ability to attract and
retain employees in the markets in which we operate. In December 2004, the
Financial Accounting Standards Board issued SFAS 123R, Share-Based
Payment: an amendment of FASB Statements No. 123 and 95.
SFAS
123R requires a company to recognize, as an expense, the calculated fair value
of stock options and other stock-based compensation granted to employees and
other service providers. We adopted these new rules effective January 1, 2006.
Prior
to
2006, we used the intrinsic value method to measure compensation expense for
stock-based awards to our employees. Under this standard, we generally did
not
consider stock option grants issued under our employee stock option plans to
be
compensation when the exercise price of the stock option was equal to or greater
than the fair market value on the date of grant. Effective January 1, 2006,
we
began recording a compensation charge as stock options or other stock-based
compensation awards are issued or as they vest, including the unvested portion
of options that were granted on or before December 31, 2005. This compensation
charge is based on a calculated fair value of the option or other stock-based
award using a complex methodology, and which may not correlate to the current
market price of our stock. In addition, this calculation requires management
to
use several estimates, any one of which could have a significant impact on
the
option’s calculated fair value. If any of these estimates prove to be different
from actual results, the calculated fair value of the option could be
significantly under or over stated. The additional compensation expense we
are
required to record under SFAS 123R has resulted in a reduction in our reported
gross margins as compared to prior years as well as a material increase in
our
operating expenses from historical levels. This has, in turn, had, and will
continue to have, a significant negative impact on our results of
operations.
Our
markets are highly competitive. Many of our competitors have longer operating
histories and greater resources than we do. If we are unable to effectively
compete in the industry, our operating results would be
harmed.
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, in a timely and cost-effective manner, 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 include the following:
| · |
our
ability to develop and introduce new products on a timely
basis;
|
| · |
our
product reputation, quality, and performance;
|
| · |
the
price and features of our products such as adaptability, scalability,
functionality, ease of use, and the ability to integrate with other
products;
|
| · |
our
customer service and support; and
|
| · |
warranties,
indemnities, and other contractual
terms.
|
In
each
of our markets, we compete with a wide array of manufacturers, vendors,
strategic alliances, systems developers and other businesses. For our LONWORKS
Infrastructure products, 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 Automation)
and Groupe 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
other companies such as Digi International, emWare, Ipsil, JumpTec, Lantronix,
Microsoft, and Wind River Systems, as well as certain micro-controller
manufacturers including Freescale (formerly Motorola), Texas Instruments, Micro
Chip, and Philips, all of which promote directly connecting devices to the
Internet, could also compete with our products. In addition, in the utilities
market, products from companies such as Actaris, DCSI, Elster, Hunt
Technologies, Itron, Iskraemeco, and Landis and Gyr, each of which offers
automatic meter reading products for the utility industry, as well as metering
systems from our customers such as Enel, Enermet, Horstmann Controls, Kamstrup,
and Metrima, could compete with our NES system. For example, Enel, working
with
IBM, competes with our NES system using third party products instead of our
products. Enel and IBM, as well as several other named competitors, have
significantly greater experience and financial, technical, and other resources
than we have. If we are unable to compete effectively in any of the markets
we
serve, our revenues, results of operations, and financial position could be
harmed.
As
a result of our lengthy sales cycle, we have limited ability to forecast the
amount and timing of revenue related to 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. For example, OEMs, as well as
utilities that may be interested in our NES system, typically conduct extensive
and lengthy product evaluations before making initial purchases of our products.
They may further delay subsequent purchases of our products due to their own
prolonged product development, system integration, and product introduction
periods. Delays in our sales cycle can also result from, among other
things:
| · |
changes
in our customers’ budgets;
|
| · |
changes
in the priority our customers assign to control network
development;
|
| · |
the
time it takes for us to educate our customers about the potential
applications of and cost savings associated with our products;
|
| · |
the
deployment schedule for projects undertaken by our utility or systems
integrator customers;
|
| · |
the
actions of utility regulators or management boards regarding investments
in metering systems;
|
| · |
delays
in installing, operating, and evaluating the results of NES system
field
trials; and
|
| · |
the
time it takes for utilities to evaluate multiple competing bids,
negotiate
terms, and award contracts for large scale metering system
deployments.
|
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. If any of these factors prevent or substantially delay
our
ability to complete a transaction, our revenues and results of operations could
be harmed.
If
we do not maintain adequate distribution channels for our LONWORKS
Infrastructure products or our NES system products, our revenues will be harmed
significantly.
Currently,
significant portions of our revenues are derived from sales to distributors,
including EBV, the primary independent distributor of our products to OEMs
in
Europe. Sales to EBV, our largest distributor, accounted for 22.7% of our total
net revenues for the quarter ended March 31, 2006, and 17.8% for the same period
in 2005. Worldwide sales to distributors, including those to EBV, accounted
for
approximately 36.1% of total net revenues during the first quarter of 2006,
and
23.1% of our total net revenues for the same period in 2005.
Our
current agreement with EBV, which has been in effect since 1997, expires in
December 2006. 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 its inventory levels
for our products, both our revenues and customer service levels would decrease.
If we do not maintain our agreement with EBV, we would be required to locate
another distributor or add our own pan-European distribution capability to
meet
the needs of our customers. In that event, our business could be harmed during
the transition period as EBV’s inventory of our products was sold but not
replaced. Moreover, any replacement distribution channel could prove less
effective than EBV.
In
addition, in order to address changing business conditions in other parts of
the
world that are not served by EBV, we are currently considering modifying the
contractual return rights, or otherwise changing the terms of our agreements
with our distributors that operate in those locations. If such changes are
made,
we could be required to defer the revenue on sales made to these distributors
until such time as the distributors sold the products to their end-user
customers. Such a change in our revenue recognition for these sales could result
in a material reduction in our revenues in the period when we modify the
distributor agreement(s).
We
market
our NES system products directly, as well as through selected value added
resellers, or VARs, and integration partners. We believe that a significant
portion of our NES system sales will be made through our VARs and integration
partners, rather than directly by our company. To date, our VARs and integration
partners have greater experience in overseeing projects for utilities. As a
result, if our relationships with our VARs and integration partners are not
successful, or if we are not able to create similar distribution channels for
our NES system business with other companies, our NES system business may not
be
successful or may otherwise not meet our financial targets, which will harm
our
revenues and operating results.
The
undetermined market acceptance of our products makes it difficult to evaluate
our future prospects.
We
face a
number of risks as a company in a rapidly changing and developing market, and
you must consider our prospects in light of the associated risks. This is true
of both our LONWORKS Infrastructure products and our NES system products. Our
future operating results are difficult to predict due to many factors, including
the following:
| · |
some
of our targeted markets have not yet accepted many of our products
and
technologies;
|
| · |
many
of our customers do not fully support open, interoperable networks,
and
this reduces the market for our
products;
|
| · |
we
may not anticipate changes in customer requirements and, even if
we do so,
we may not be able to develop new or improved products that meet
these
requirements in a timely manner, or at
all;
|
| · |
the
markets in which we operate require rapid and continuous development
of
new products, and we have failed to meet some of our product development
schedules in the past;
|
| · |
potential
changes in voluntary product standards around the world can significantly
influence the markets in which we operate;
and
|
| · |
our
industry is very competitive and many of our competitors have far
greater
resources and may be prepared to provide financial support from their
other businesses in order to compete with
us.
|
Compliance
with new rules and regulations concerning corporate governance is costly,
time-consuming, and difficult to achieve, which could harm our operating results
and business.
The
Sarbanes-Oxley Act, or the Act, which was signed into law in 2002, mandates,
among other things, that companies adopt new corporate governance measures
and
imposes comprehensive reporting and disclosure requirements. The Act also
imposes increased civil and criminal penalties on a corporation, its chief
executive and chief financial officers, and members of its board of directors,
for securities law violations. In addition, the Nasdaq National Market, on
which
our common stock is traded, has adopted and is considering the adoption of
additional comprehensive rules and regulations relating to corporate governance.
These rules, laws, and regulations have increased the scope, complexity, and
cost of our corporate governance, reporting, and disclosure practices. Because
compliance with these new rules, laws, and regulations is costly and
time-consuming, our management’s attention could be diverted from managing our
day-to-day business operations, and our operating expenses could increase.
In
addition, because of the inherent limitations in all financial control
systems,
it is possible that a material weakness may be found in our internal controls
over financial reporting, which could affect our ability to insure proper
financial reporting. For example, as described more fully in our Quarterly
Report on Form 10-Q for the quarter ended September 30, 2005, in October
2005 we
identified a material weakness in our internal controls over revenue recognition
at our Japanese subsidiary, although that weakness was remediated prior
to the
end of 2005.
In
the
future, these developments could make it more difficult and more expensive
for
us to obtain director and officer liability insurance, and we may be required
to
accept reduced coverage or incur substantially higher costs to obtain coverage.
Further, our board members, Chief Executive Officer, and Chief Financial
Officer
face an increased risk of personal liability in connection with the performance
of their duties. As a result, we may have difficulty attracting and retaining
qualified board members and executive officers, which could harm our
business.
We
depend on a limited number of key manufacturers 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
devices. In addition, the Neuron Chip is an important device that we use in
many
of our products. Neuron Chips are currently manufactured and distributed by
Toshiba and Cypress Semiconductor under license agreements we maintain with
them. These agreements, among other things, grant Toshiba and Cypress the
worldwide right to manufacture and distribute Neuron Chips using technology
licensed from us, and require us to provide support, as well as unspecified
updates to the licensed technology, over the terms of the agreements. The
Cypress agreement expires in April 2009 and the Toshiba agreement expires in
January 2010. However, we cannot be certain that these manufacturers will
continue to supply Neuron Chips until these contracts expire, and we currently
have no other source of supply for Neuron Chips. If either Toshiba or Cypress
were to cease designing, manufacturing, and distributing Neuron Chips, we could
be forced to rely on a sole supplier for Neuron Chips. If both Toshiba and
Cypress were to exit this business, we would attempt to find a replacement.
This
would be an expensive and time-consuming process, with no guarantee that we
would be able to find an acceptable alternative source.
We
also
maintain manufacturing agreements with other semiconductor manufacturers for
the
production of key products, including those used in the Enel Project and our
NES
system. For example, in 2003 we announced a new product family that we refer
to
as Power Line Smart Transceivers. A sole source supplier, ST Microelectronics,
manufactures these products. We currently have no other source of supply for
Power Line Smart Transceivers or the components manufactured by Cypress and
AMI
Semiconductor.
Our
future success will also depend significantly on our ability to manufacture
our
products cost-effectively, in sufficient volumes and in accordance with quality
standards. For most of our products requiring assembly, we use contract
electronic manufacturers, including WKK Technology, TYCO TEPC/Transpower, and
World Fair International. 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 quality, costs, delivery
schedules, product availability, and manufacturing yields. For instance, quality
problems at a contract equipment manufacturer could result in missed shipments
to our customers and unusable inventory. Such delays could, among other things,
reduce our revenues, increase our costs by increasing our inventory reserves,
and cause us to incur penalties. 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. When we transition, we may have to move raw material and
in-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 could also be liable for excess or unused inventory held by
contract manufacturers for use in our products. This inventory may become
obsolete as a result of engineering changes that we make. In addition, we may
no
longer need this inventory because of factors such as changes in our production
build plans, miscommunication between us and a contract manufacturer, or errors
made by a contract manufacturer in ordering material for use in our products.
Under our contracts with these contract electronic manufacturers, we would
become liable for all or some of these excess or obsolete
inventories.
The
failure of any key manufacturer to produce products on time, at agreed quality
levels, and fully compliant with our product, assembly and test specifications
could adversely affect our revenues and gross profit, and could result in claims
against us by our customers.
Because
we depend on sole or a limited number of suppliers, any price increases,
shortages, or interruptions of supply would adversely affect our revenues
and/or
gross profits.
As
previously discussed, we currently purchase several key products and components
only from sole or limited sources. For some of these suppliers, we do not
maintain signed agreements that would obligate them to supply to us on
negotiated terms. As a result, we may be vulnerable to price increases for
products or components. In addition, in the past, we have occasionally
experienced shortages or interruptions in supply for certain of these items,
which caused us to delay shipments beyond targeted or announced dates. In some
cases, these shortages were caused by the normal fluctuations in component
lead
times. Any future lengthening of component lead times may make it more difficult
for us to meet our scheduled delivery dates and could adversely affect our
revenues.
To
help
address these issues, we may decide to purchase quantities of these items that
are in excess of our estimated requirements. As a result, we could be forced
to
increase our excess and obsolete inventory reserves to provide for these excess
quantities, which could harm our operating results. 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, gross profits or both could
decrease. In addition, under the terms of some of our contracts with our
customers, we may also be subject to penalties if we fail to deliver our
products on time.
Our
business may suffer if it is alleged or found that our products infringe the
intellectual property rights of others or if our customers are concerned about
the potential for such infringement.
Although
we attempt to avoid infringing known proprietary rights of third parties in
our
product development efforts, from time to time we may receive notice that a
third party believes that our products may be infringing certain patents or
other intellectual property rights of that third party. We may also be
contractually obligated to indemnify our customers or other third parties that
use our products in the event they are alleged to infringe a third party’s
intellectual property rights. Responding to those claims, regardless of their
merit, can be time consuming, result in costly litigation, divert management’s
attention and resources and cause us to incur significant expenses. Thus, even
if our products do not infringe, we may elect to take a license or settle to
avoid incurring such costs.
In
the
event our products are infringing upon the intellectual property rights of
others, we may elect or be required to redesign our products so that they do
not
incorporate any intellectual property to which the third party has or claims
rights. As a result, some of our product offerings could be delayed, or we
could
be required to cease distributing some of our products. In the alternative,
we
could seek a license for the third party’s intellectual property, but it is
possible that we would not be able to obtain such a license on reasonable terms,
or at all. Any delays that we might then suffer or additional expenses that
we
might then incur could adversely affect our revenues, operating results and
financial condition.
In
addition, our customers may not pursue product opportunities based on their
concerns regarding third party intellectual property rights, particularly
patents, and this could reduce the market opportunity for the sale of our
products and services.
We
have a history of losses and, although we achieved profitability in prior years,
we expect to incur substantial losses again in 2006.
For
the
quarter ended March 31, 2006, we generated a loss of $8.5 million. As of March
31, 2006, we had an accumulated deficit of $92.6 million. We have invested
and
expect to continue investing significant financial resources in product
development, marketing and sales. We believe we will incur a substantial loss
in
2006. Consequently, we currently expect our cash and short-term investment
balances to decline as a result of such losses.
Our
future operating results will depend on many factors, including:
| · |
adoption
of our NES solution and other products by service providers for use
in
utility and/or other home automation
projects;
|
| · |
the
timing of revenue recognition related to sales of our NES system
products;
|
| · |
the
timing of revenue recognition related to sales of our NES system
products;
|
| · |
revenue
growth of our LONWORKS Infrastructure
products;
|
| · |
continuation
of worldwide economic growth, particularly in certain industries
such as
semiconductor manufacturing
equipment;
|
| · |
the
ability of our contract electronic manufacturers to provide quality
products on a timely basis, especially during periods where excess
capacity in the contract electronic manufacturing market is
reduced;
|
| · |
growth
in acceptance of our products by OEMs, systems integrators, service
providers and end-users;
|
| · |
the
effect of expensing stock option grants or other compensatory awards
to
our employees;
|
| · |
our
ability to attract new customers in light of increased
competition;
|
| · |
our
ability to develop and market, in a timely and cost-effective way,
new
products that perform as designed;
|
| · |
costs
associated with any future business acquisitions, including up-front
in-process research and development charges and ongoing amortization
expenses related to other identified intangible
assets;
|
| · |
ongoing
operational expenses associated with any future business acquisitions;
|
| · |
results
of impairment tests that we will perform from time to time in the
future,
in accordance with SFAS 142, with respect to goodwill and other identified
intangible assets that we acquired in the past or that we may acquire
in
the future. If the results of these impairment tests indicate that
an
impairment event has taken place, we will be required to take an
asset
impairment charge that could have a material adverse effect on our
operating results; and
|
| · |
general
economic conditions.
|
As
of
December 31, 2005, we had net operating loss carry forwards for federal income
tax reporting purposes of approximately $81.0 million and for state income
tax
reporting purposes of approximately $16.5 million, which will expire at various
dates through 2025. In addition, as of December 31, 2005, we had tax credit
carry forwards of approximately $12.4 million, $6.7 million of which will expire
at various dates through 2025. The Internal Revenue Code of 1986, as amended,
contains provisions that limit the use in future periods of net operating loss
and credit carry forwards upon the occurrence of certain events, including
significant changes in ownership interests. We have performed an analysis of
our
ownership changes and have reported the net operating loss and credit carry
forwards considering such limitations. As of December 31, 2005, our deferred
tax
assets, including our net operating loss carry forwards and tax credits, totaled
approximately $52.2 million. The Internal Revenue Code of 1986 also contains
provisions requiring companies to fully utilize net operating losses before
utilizing tax credits. As a result, depending on our future taxable income
in
any given year, some or all of the Federal increased research tax credits,
as
well as portions of our federal and state net operating loss carryforwards,
may
expire before being utilized. Consequently, we have recorded a valuation
allowance 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.
We
face operational and financial risks associated with international
operations.
Our
international sales and marketing operations are located in nine countries
around the world. Revenues from international sales, which include both export
sales and sales by international subsidiaries, accounted for about 55.7% of
our
total net revenues for the quarter ended March 31, 2006, and 81.8% of our total
net revenues for the same period in 2005. We expect that international sales
will continue to constitute a significant portion of our total net
revenues.
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:
| · |
international
terrorism and anti-American
sentiment;
|
| · |
unexpected
changes in regulatory requirements, tariffs and other trade
barriers;
|
| · |
costs
associated with compliance with local environmental regulations,
such as
the RoHS initiative in Europe, Japan, and
elsewhere;
|
| · |
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;
|
| · |
labor
actions generally affecting individual countries, regions, or any
of our
customers which could result in reduced demand for our
products;
|
| · |
potentially
adverse tax consequences, including restrictions on repatriation
of
earnings; and
|
| · |
the
burdens of complying with a wide variety of foreign laws.
|
Differing
vacation and holiday patterns in other countries, particularly in Europe, may
also affect the amount of business that we transact in other countries in any
given quarter, the timing of our revenues, and our ability to forecast projected
operating results for such quarter.
Fluctuations
in the value of currencies in which we conduct our business relative to the
U.S.
dollar could cause currency translation adjustments. The portion of our revenues
conducted in currencies other than the United States dollar, principally the
Japanese Yen, was about 6.2% for the quarter ended March 31, 2006, and 3.1%
for
the same period in 2005. In addition, much of our sales and marketing expenses,
as well as certain other costs, are incurred in currencies other than the U.S.
dollar. For example, in 2005 China revalued its currency, the Chinese Renminbi,
against the U.S. dollar. Although the adjustment has not resulted in a material
change to the costs for goods and services we obtain from our suppliers and
contractors in China, any future revaluations of the Chinese currency against
the U.S. dollar could result in significant cost increases. If the value of
the
U.S. dollar declines as compared to the local currency where the expenses are
incurred, our expenses, when translated back into U.S. dollars, will
increase.
The
use
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 European 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.
In
addition, we expect that many foreign utilities will require us to price our
NES
system in the respective utility’s local currency, which will expose us to
foreign currency risk. In most cases, in the event of a contract award, we
intend to hedge this foreign currency risk so long as we can secure forward
currency contracts that are reasonably priced and that are consistent with
the
scheduled deliveries for that project. In addition, we will face foreign
currency exposures from the time we submit our foreign currency denominated
bid
until the award of a contract by the utility (the “bid to award” term). This bid
to award term can often exceed several months. If a utility awards us a contract
that gives the utility the right to exercise options for additional supply
in
the future, we would also be exposed to foreign currency risk until such time
as
these options, if any, were exercised. We may decide that it is too expensive
to
hedge the foreign currency risks during the bid to award term or for any
unexercised options. Any resulting adverse foreign currency fluctuations could
significantly harm our revenues, results of operations, and financial condition.
Fluctuations
in our operating results may cause our stock price to
decline.
Our
quarterly and annual results have varied significantly from period to period,
and we have sometimes failed to meet securities analysts’ expectations. For
example, although we generated net income ranging from $84,000 to $16.8 million
during the years from 2000 to 2004, in 2005 we generated a net loss of $19.7
million, and during the first quarter of 2006 we generated additional losses
of
$8.5 million. We expect to incur a substantial loss again for the full year
2006, and our future results may continue to fluctuate and may not meet
analysts’ expectations in some future period. As a result, the price of our
common stock could fluctuate or decline. Some factors that could cause this
variability, many of which are outside of our control, include the
following:
| · |
the
complex revenue recognition rules relating to products such our NES
system
could require us to defer some or all of the revenue associated with
NES
product shipments until certain conditions are met in a future period;
|
| · |
revenue
recognition for sales of our NES system products may be dependent
on
acceptance criteria determined by our NES system
customers;
|
| · |
our
products may not be manufactured in accordance with specifications
or our
established quality standards, or may not perform as
designed;
|
| · |
our
future operating results will continue to be materially adversely
effected
by the expense required to be recorded under SFAS 123R, Share-Based
Payment,
which became effective in 2006;
|
| · |
we
may fail to meet analysts’ expectations relating to our NES system and
additional utility customers and
applications;
|
| · |
we
may fail to meet analysts’ expectations for revenue growth in our sales of
LONWORKS Infrastructure products to OEMs, systems integrators, and
other
customers;
|
| · |
transitioning
from non-RoHS compliant to RoHS compliant products could cause our
customers to reduce their historical inventory levels, which could
reduce
our revenues;
|
| · |
the
rates at which OEMs purchase our products and services may
fluctuate;
|
| · |
we
may fail to introduce new products on a timely basis or before the
end of
an existing product’s life cycle;
|
| · |
downturns
in any customer’s or potential customer’s business, or declines in general
economic conditions, could cause significant reductions in capital
spending, thereby reducing the levels of orders from our
customers;
|
| · |
we
may face increased competition for both our LONWORKS Infrastructure
products and our NES products;
|
| · |
market
acceptance of our products may decrease;
|
| · |
our
customers may delay or cancel their orders;
|
| · |
the
mix of products and services that we sell may change to a less profitable
mix;
|
| · |
shipment
and payment schedules may be delayed;
|
| · |
our
pricing policies or those of our competitors may change;
|
| · |
we
could incur costs associated with future business acquisitions, including
up-front in-process research and development charges and ongoing
amortization expenses related to other identified intangible
assets;
|
| · |
we
could incur ongoing operational expenses associated with future business
acquisitions;
|
| · |
the
results of impairment tests that we will perform from time to time
in the
future, in accordance with SFAS 142, with respect to goodwill and
other
identified intangible assets that we acquired in the past or that
we may
acquire in the future may indicate that an impairment event has taken
place. If so, we will be required to take an asset impairment charge
that
could have a material adverse effect on our operating results;
|
| · |
our
product distribution may change;
and
|
| · |
product
ratings by industry analysts and endorsements of competing products
by
industry groups could hurt the market acceptance of our
products.
|
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, which would negatively affect our profitability and cause our stock
price to decline.
Many
of our competitors develop, support, and promote alternative control systems.
If
we are unable to promote and expand acceptance of our open, interoperable
control systems, our revenues and operating results may be harmed.
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
Konnex Association in Belgium, and the European Installation Bus Association
in
Germany, each of which has over 100 members and licensees. Other examples
include various industry groups who promote alternative open standards such
as
BACnet in the building market, DALI in the lighting controls market, Echonet
in
the home control market, and a group comprised of ABB, Adtranz/Bombardier,
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.
Defects
in or misuse of our products or other liabilities not covered by insurance
may
delay our ability to generate revenues and may increase our liabilities
and
expenses.
Our
products may contain undetected errors or failures when first introduced, as
new
versions are released, or as a result of the manufacturing process. For example,
many of the products we have sold to Enel remain under warranty, and Enel may
claim that some of them are defective. Also, in NES trials, undetected errors
may hinder our ability to win a subsequent tender. In addition, our customers
or
their installation partners may improperly install or implement our products.
Furthermore, 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.
If
errors
or failures are found in our products, we may not be able to successfully
correct them in a timely manner, or at all. Such errors or failures could delay
our product shipments and divert our engineering resources while we attempt
to
correct them. In addition, we could decide to extend the warranty period, or
incur other costs outside of our normal warranty coverage, to help address
any
known errors or failures in our products and mitigate the impact on our
customers. As a result, errors or failures in our products, or the improper
installation or implementation of our products by third parties, could harm
our
reputation, reduce our revenues, increase our expenses, and negatively impact
our operating results and financial condition.
To
address these issues, the agreements we maintain with our customers typically
contain provisions intended to limit our exposure to potential errors and
omissions claims as well as any liabilities arising from them. In certain very
limited instances, these agreements require that we be named as an additional
insured on our customers’ insurance policies. However, our customer contracts
and additional insured coverage may not effectively protect us against the
liabilities and expenses associated with errors or failures attributable to
our
products. For example, utility customers purchasing our NES system may require
that we agree to indemnities or penalties in excess of the provisions we
typically employ with our LONWORKS Infrastructure products, or that are not
limited at all. Also, local laws may impose liability for NES system or other
product failures, including liability for harm to property or persons. Such
failures could harm our reputation, expose our company to liability, and
adversely affect our operating results and financial position.
We
may
also experience losses or potential losses in the event of property damage,
liability for harm to a third party’s property or person, claims against our
directors or officers, and the like. To help reduce our exposure to these types
of claims, we currently maintain property, general commercial liability, errors
and omissions, directors and officers, and other lines of insurance. However,
it
is possible that such insurance may not be available in the future or, if
available, may be insufficient in amount to cover any particular claim, or
we
might not carry insurance that covers a specific claim. For example, during
2000, the total limit for claims under our errors and omissions insurance policy
was $17.0 million. Since then, we have reduced the total limit for this line
of
coverage to $10.0 million because we believed the premiums our insurers
requested were excessive. We believe that the premiums for the types of
insurance we carry will continue to fluctuate from period to period. In times
of
significant cost increases, this could result in increased costs or reduced
limits. Consequently, if we elect to reduce our coverage further, or if we
do
not carry insurance for a particular type of claim, we will face increased
exposure to these types of claims. If liability for a claim exceeds our policy
limits, our operating results and our financial position would be negatively
affected.
We
promote an open technology platform that could increase our
competition.
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 hardware and software solutions 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. For instance, all of the network
management commands required to develop software that competes with our LNS
software are published. This could decrease the demand for our products and
increase the competition that we face.
Downturns
in the control network technology market and related markets may decrease
our
revenues and margins.
The
market for our products depends on economic conditions affecting the broader
control network technology and related markets. Downturns in these markets
may
cause our OEMs and system integrators to delay or cancel projects, reduce their
production or reduce or cancel orders for our products. In this environment,
customers may experience financial difficulty, cease operations or fail to
budget for the purchase of our products. This, in turn, may lead to longer
sales
cycles, delays in payment and collection, and price pressures, causing us to
realize lower revenues and margins. In particular, capital spending in the
technology sector has decreased in past years, and many of our customers and
potential customers have experienced declines in their revenues and operations.
In addition, concerns with respect to terrorism and geopolitical issues in
the
Middle East and Asia have added more uncertainty to the current economic
environment. We cannot predict the impact of these events, or of any related
military action, on our customers or business. We believe that, in light of
these events, some businesses may further curtail or may eliminate capital
spending on control network technology altogether. If capital spending in our
markets declines, or does not increase, it may be necessary for us to gain
significant market share from our competitors in order to achieve our financial
goals and return to profitability.
If
our OEMs do not employ our products and technologies our revenues could decrease
significantly.
To
date,
a substantial portion of our product sales has 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 because 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. They may believe
that a more rapid transition to LONWORKS technology could harm their installed
base business. 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 be able to maintain or improve the current rate at which our products
are accepted by OEMs and others, which could decrease our revenues.
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 these intellectual property rights, all of which afford
only limited protection. As of April 30, 2006, we have 95 issued U.S. patents,
12 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. In addition, we may not apply
for
or obtain patents in each country in which our technology may be used. If any
of
our patents fail to protect our technology, or if we do not obtain patents
in
certain countries, 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, we cannot
assure you 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
and
it may take longer to receive a remedy from a court outside of the United
States. For example, certain of 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 third parties from infringing, misusing,
misappropriating, or independently developing our technology or intellectual
property rights; or to prevent an unauthorized third party from copying or
otherwise obtaining and using our products or technology.
If
OEMs fail to develop interoperable products or if our targeted markets do not
accept our interoperable products, 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 OEMs and us, 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 these 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 customers might not accept
their interoperable products. If OEMs fail to develop interoperable products,
or
our markets do not accept interoperable products, our revenues and operating
results will suffer.
Our
executive officers and technical personnel are critical to our business, and
if
we lose or fail to attract key personnel, we may not be able to successfully
operate our business.
Our
performance depends substantially on the performance of our executive officers
and key employees. Due to the specialized technical nature of our business,
we
are particularly dependent on our Chief Executive Officer, our President and
Chief Operating Officer, and our technical personnel. 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, which is typically a highly
competitive marketplace. It may be particularly difficult to recruit, relocate
and retain qualified personnel in this geographic area. Moreover, the cost
of
living, including the cost of housing, in Silicon Valley is known to be high.
Because we are legally prohibited from making loans to executive officers,
we
will not be able to assist potential key personnel as they acquire housing
or
incur other costs that might be associated with joining our company. In
addition, if we lose the services of any of our key personnel and are not able
to find replacements in a timely manner, our business could be disrupted, other
key personnel may decide to leave, and we may incur increased operating expenses
in finding and compensating their replacements.
The
markets for our products are 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, utility/home
and
other industries. For example, our NES system offering to utilities is new.
Also, 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 continually enhance our existing
product
offerings, lower the market price for our products, 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 could have, or could be perceived to have,
advantages over our products in remote monitoring or other applications.
As
another example, many competitors promote media types, such as radio frequency
(wireless) and fiber optics that, even if used with LONWORKS technology,
could
displace sales of certain of our transceiver products. If we are not able
to
develop or enhance our products to respond to these changing market conditions,
our revenues and results of operations will suffer.
In
addition, due to the nature of development efforts in general, we often
experience delays in the introduction of new or improved products beyond our
original projected shipping date for such products. Historically, when these
delays have occurred, we experienced an increase in our development costs and
a
delay in our ability to generate revenues from these new products. We believe
that similar new product introduction delays in the future could also increase
our costs and delay our revenues.
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:
| · |
significant
stockholders may sell some or all of their holdings of our stock.
For
example, Enel presently owns 3,000,000 shares, or approximately 7.6%
of
our outstanding common stock. Enel is generally free to sell these
shares
at its discretion. In the event Enel, or any other significant
stockholder, elects to sell all or a portion of their holdings in
our
shares, such sale or sales could depress the market price of our
stock
during the period in which such sales are
made;
|
| · |
investors
may be concerned about our ability to develop additional customers
for our
NES system products and the success we have selling our LONWORKS
Infrastructure products and services to OEMs, systems integrators,
and
other customers;
|
| · |
investors
may be concerned about the expense that we will be required to record
for
stock options and other stock-based incentives provided to our
employees;
|
| · |
transitioning
from non-RoHS compliant to RoHS compliant products could cause our
customers to reduce their historical inventory levels, which could
reduce
our revenues;
|
| · |
competitors
may announce new products or
technologies;
|
| · |
our
quarterly operating results may vary widely;
|
| · |
we
or our customers may announce technological innovations or new products;
|
| · |
securities
analysts may change their estimates of our financial results;
and
|
| · |
increases
in market interest rates, which generally have a negative impact
on stock
prices.
|
In
addition, the market price of securities of technology companies, especially
those in rapidly evolving industries such as ours, has been very volatile in
the
past. This volatility in any given technology company’s stock price has often
been unrelated or disproportionate to the operating performance of that
particular company.
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 their own products, by lobbying for the adoption of
voluntary standards that would exclude or limit the use of products that
incorporate our technology. We participate in many voluntary standards
organizations around the world in order to both help prevent the 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. If the markets we target were to adopt voluntary
standards that are incompatible with our products or technology, either
inadvertently or by design, our revenues, operating results, and financial
condition would be adversely affected.
Regulatory
actions could limit 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. In general, these regulations
limit the ability of companies 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 our products or to increase the market
opportunity for their own products.
Our
existing stockholders control a significant percentage of our stock, which
will
limit other stockholders’ ability to influence corporate
matters.
As
of
April 30, 2006, our directors and executive officers, together with certain
entities affiliated with them (including, for this purpose, Enel, which has
the
right to nominate a director to our board of directors), beneficially owned
35.7% of our outstanding stock.
Under
the
stock purchase agreement with Enel, which transaction was completed September
11, 2000, Enel purchased 3.0 million newly issued shares of our common stock
and
was granted the right to nominate a director to our board of directors. As
a
condition to the closing of the stock purchase agreement, our directors and
our
Chief Financial Officer agreed to enter into a voting agreement with Enel in
which each of them agreed to vote the shares of our company’s common stock that
they beneficially owned or controlled in favor of Enel’s nominee to our board of
directors. In addition, under the terms of the stock purchase agreement, Enel
has agreed 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 option 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).
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.
Potential
conflicts of interest could limit our ability to act on opportunities that
are
adverse to a significant stockholder or its affiliates.
From
time
to time, we may enter into a material contract with a person or company that
owns a significant amount of our company’s stock. As circumstances change, we
may develop conflicting priorities or other conflicts of interest with the
significant stockholder with regard to the contract, or the significant
stockholder may exert or attempt to exert a significant degree of influence
over
our management and affairs. The significant stockholder might exert or attempt
to exert this influence in its capacity as a significant stockholder or, if
the
significant stockholder has a representative on our board of directors, through
that Board member.
For
example, we entered into the Contatore Elettronico project with an affiliate
of
Enel. Enel currently owns 3.0 million shares of our common stock, representing
approximately 7.6% of our outstanding common stock. Enel also has the right
to
nominate a member of our board of directors as long as Enel owns at least 2.0
million shares of our common stock. As a consequence of the expiration of his
mandate as Enel’s Chief Executive Officer, Mr. Francesco Tatò resigned his board
membership in all of Enel’s subsidiaries and affiliates, including Echelon. Mr.
Tatò served on our board of directors as a representative of Enel from September
2000 until September 2002. Enel has reserved its right to nominate a new member
of our board of directors, who must be approved by us, to fill the vacancy
created by the resignation of Enel’s former board representative to our board of
directors. During the term of service of Enel’s former board representative from
September 2000 to September 2002, Enel’s representative on our Board abstained
from resolutions on any matter relating to Enel. A member of our board of
directors who is also an officer of or is otherwise affiliated with Enel may
decline to take action in a manner that might be favorable to us but adverse
to
Enel. Conflicts that could arise might concern the Contatore Elettronico project
with Enel and other matters where Enel’s interest may not always coincide with
our interests or the interests of our other stockholders. Any of those conflicts
could lead to litigation and could otherwise significantly and adversely affect
our financial condition and results of operations.
Natural
disasters, power outages, and other factors outside of our control such as
widespread pandemics could disrupt our business.
We
must
protect our business and our network infrastructure against damage from
earthquake, flood, hurricane and similar events, as well as from power outages.
Many of our operations are subject to these risks, particularly our operations
located in California. In past years, we experienced temporary power losses
in
our California facilities due to power shortages that have disrupted our
operations, and we may in the future experience additional power losses that
could disrupt our operations. While the impact to our business and operating
results has not been material, it is possible that power losses will adversely
affect our business in the future, or that the cost of acquiring sufficient
power to run our business will increase significantly. Similarly, a natural
disaster or other unanticipated problem could also adversely affect our business
by, among other things, harming our primary data center or other internal
operations, limiting our ability to communicate with our customers, and limiting
our ability to sell our products. We do not insure against several natural
disasters, including earthquakes.
The
outbreak of severe acute respiratory syndrome, or SARS, that began in China,
Hong Kong, Singapore, and Vietnam in 2003 also had a negative impact on our
business. Any future outbreak of SARS, or other widespread communicable disease
pandemics such as avian influenza, more commonly know as bird flu, could
similarly impact our operations. Such impact could include, among other things,
the inability for our sales and operations personnel located in affected regions
to travel and conduct business freely, the impact any such disease may have
on
one or more of the distributors for our products in those regions, and increased
supply chain costs. Additionally, any future SARS or other health-related
disruptions at our third-party contract manufacturers or other key suppliers,
many of whom are located in China and other parts of southeast Asia, could
affect our ability to supply our customers with products in a timely manner,
which would harm our results of operations.
| ITEM
3. |
QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET
RISKS |
We
have
not experienced any material change in our exposure to interest rate and foreign
currency risks since the date of our Annual Report on Form 10-K for the year
ended December 31, 2005.
Market
Risk Disclosures.
The
following discussion about our market risk disclosures involves forward-looking
statements. Actual results could differ materially from those projected in
the
forward-looking statements. We are exposed to market risk related to changes
in
interest rates and foreign currency exchange rates. We do not use derivative
financial instruments to hedge these exposures.
Interest
Rate Sensitivity.
We
maintain a short-term investment portfolio consisting mainly of fixed income
securities with a weighted average maturity of less than one year. These
available-for-sale securities are subject to interest rate risk and will fall
in
value if market interest rates increase. If market rates were to increase
immediately and uniformly by 10 percent from levels at March 31, 2006 and March
31, 2005, the fair value of the portfolio would decline by an immaterial amount.
We currently intend to hold our fixed income investments until maturity, and
therefore we would not expect our operating results or cash flows to be affected
to any significant degree by a sudden change in market interest rates. If
necessary, we may sell short-term investments prior to maturity to meet the
liquidity needs of the company.
Foreign
Currency Exchange Risk.
We have
international subsidiaries and operations and are, therefore, subject to foreign
currency rate exposure. To date, our exposure to exchange rate volatility has
not been significant. If foreign exchange rates were to fluctuate by 10% from
rates at March 31, 2006, and March 31, 2005, our financial position and results
of operations would not be materially affected. However, we could experience
a
material impact in the future.
Our
review of our internal controls over financial reporting was made within the
context of the relevant professional auditing standards defining “internal
controls over financial reporting,” “reportable conditions,” and “material
weaknesses.” As part of our evaluation of internal controls over financial
reporting, we also address other, less significant control matters that we
or
our auditors identify, and we determine what revision or improvement to make,
if
any, in accordance with our on-going procedures.
Conclusions
Regarding Disclosure Controls and Procedures
Our
CEO
and our CFO, after evaluating our “disclosure controls and procedures” (as
defined in the Securities Exchange Act of 1934, or the Exchange Act, Rules
13a-14(c) and 15-d-14(c)) as of March 31, 2006, have concluded that as of such
date, our disclosure controls and procedures are effective to ensure that
information we are required to disclose in reports that we file or submit under
the Exchange Act is recorded, processed, summarized, and reported within the
time periods specified in Securities and Exchange Commission rules and
forms.
Changes
in Internal Controls Over Financial Reporting
There
were no changes in our internal controls over financial reporting (as defined
in
Rule 13a-15(e) of the Exchange Act) that occurred during the quarter ended
March
31, 2006 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.
Limitations
on the Effectiveness of Controls
Since
we
began reviewing our internal controls over financial reporting, we have
identified a number of procedures where an opportunity to improve our internal
controls existed. As part of our ongoing effort to maximize our internal
controls over financial reporting, each of these control improvement
opportunities has been, or is in the process of being, remediated by
management.
Our
management, including our Chief Executive Officer and Chief Financial Officer,
does not expect that our disclosure controls and procedures or our internal
controls over financial reporting will prevent all error and all fraud. A
control system, no matter how well conceived and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in
all
control systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, within the company have
been
detected.
For
a
discussion regarding our legal proceedings and matters, please refer to the
“Legal Actions” section of Note 6, Commitments and Contingencies, to our
condensed consolidated financial statements included under Item 1 of Part
I,
Financial Information, which information is incorporated herein by
reference.
A
restated description of the risk factors associated with our business is
included under “Risk Factors” in “Management’s Discussion and Analysis of
Financial Condition and Results of Operations,” contained in Item 2 of Part 1 of
this report. This description includes any material changes to and supersedes
the description of the risk factors associated with our business previously
disclosed in Item 1A of our 2005 Annual Report on Form 10-K and is incorporated
herein by reference.
| ITEM
2. |
UNREGISTERED
SALES OF
EQUITY SECURITIES AND USE OF
PROCEEDS |
The
following table provides information about the repurchase of our common
stock
during the quarter ended March 31, 2006:
|
Period
|
|
|
Total
Number of Shares Purchased
|
|
|
Average
Price Paid per Share
|
|
|
Total
Number of Shares Purchased as Part of Publicly Announced Plans
or
Programs
|
|
|
Maximum
Number of Shares that May Yet Be Purchased Under the Plans or
Programs
|
|
|
January
1-January 31
|
|
|
--
|
(1)
|
|
--
|
|
|
1,407,999
|
(1)
|
|
1,592,001
|
|
|
February
1-February 28
|
|
|
2,300
|
|
$
|
8.01
|
|
|
1,410,299
|
|
|
1,589,701
|
|
|
March
1-March 31
|
|
|
119,412
|
|
$
|
7.96
|
|
|
1,529,711
|
|
|
1,470,289
|
|
|
Total
|
|
|
121,712
|
|
$
|
7.97
|
|
|
1,529,711
|
|
|
1,470,289
|
|
|
(1)
|
Shares repurchased in open-market
transactions under the stock repurchase program approved by our
board of
directors in March 2004 and August 2004. The program authorizes
us to repurchase up to 3.0 million shares of our common stock,
in
accordance with Rule 10b-18 and other applicable laws, rules and
regulations. During
the quarter ended March 31, 2006, we repurchased 121,712 shares
under the
program at a cost of $969,000. Since
inception, we have repurchased a total of 1,529,711 shares under
the
program at a cost of $10.7 million. The
stock repurchase program will expire in March
2007 |
|
Exhibit
No.
|
Description
of Document
|
|
31.1
|
|
|
31.2
|
|
|
32
|
|
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
10, 2006
|
|
By:
|
/s/
Oliver R. Stanfield
|
| |
|
|
Oliver
R. Stanfield,
Executive
Vice President and Chief Financial Officer (Duly Authorized Officer
and
Principal Financial and Accounting
Officer)
|
|
Exhibit
No.
|
Description
of Document
|
|
31.1
|
|
|
31.2
|
|
|
32
|
|