UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
DC 20549
FORM
10-Q
(Mark
one)
[X]
|
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF
1934
|
For
the quarterly period ended September 30, 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)
(Exact
name of registrant as specified in its
charter)
Delaware
(State
or other jurisdiction of
incorporation
or organization)
|
77-0203595
(IRS
Employer
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.
Yes
x
No
o
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 ¨
|
|
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).
Yes
o
No
x
As
of
October 31, 2006, 39,258,957 shares of the registrant’s common stock were
outstanding.
ECHELON
CORPORATION
FORM
10-Q
FOR
THE QUARTER ENDED SEPTEMBER 30, 2006
INDEX
|
|
|
Page
|
Part
I.
|
|
FINANCIAL
INFORMATION
|
|
Item
1.
|
|
|
|
|
|
|
3
|
|
|
|
4
|
|
|
|
5
|
|
|
|
6
|
Item
2.
|
|
|
27
|
Item
3.
|
|
|
64
|
Item
4.
|
|
|
64
|
|
|
|
|
Part
II.
|
|
OTHER
INFORMATION
|
|
Item
1.
|
|
|
66
|
Item
1A.
|
|
|
66
|
Item
2.
|
|
|
66
|
Item
6.
|
|
|
66
|
|
|
|
|
|
67
|
|
68
|
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 Securities and Exchange Commission (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)
|
|
September
30,
2006
|
|
December
31,
2005
|
|
ASSETS
|
|
|
|
|
|
|
|
|
|
|
|
CURRENT
ASSETS:
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
54,451
|
|
$
|
59,080
|
|
Short-term
investments
|
|
|
75,341
|
|
|
95,400
|
|
Accounts
receivable, net
|
|
|
17,086
|
|
|
11,006
|
|
Inventories
|
|
|
8,939
|
|
|
3,240
|
|
Other
current assets
|
|
|
15,557
|
|
|
2,289
|
|
Total
current assets
|
|
|
171,374
|
|
|
171,015
|
|
|
|
|
|
|
|
|
|
Property
and equipment, net
|
|
|
15,719
|
|
|
14,886
|
|
Goodwill
|
|
|
8,180
|
|
|
8,018
|
|
Other
long-term assets
|
|
|
1,963
|
|
|
2,019
|
|
|
|
|
|
|
|
|
|
TOTAL
ASSETS
|
|
$
|
197,236
|
|
$
|
195,938
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
CURRENT
LIABILITIES:
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
7,634
|
|
$
|
3,972
|
|
Accrued
liabilities
|
|
|
4,767
|
|
|
7,473
|
|
Deferred
revenues
|
|
|
20,833
|
|
|
2,096
|
|
Total
current liabilities
|
|
|
33,234
|
|
|
13,541
|
|
|
|
|
|
|
|
|
|
LONG-TERM
LIABILITIES:
|
|
|
|
|
|
|
|
Deferred
rent
|
|
|
1,240
|
|
|
1,089
|
|
Total
long-term liabilities
|
|
|
1,240
|
|
|
1,089
|
|
|
|
|
|
|
|
|
|
STOCKHOLDERS’
EQUITY:
|
|
|
|
|
|
|
|
Common
stock
|
|
|
416
|
|
|
415
|
|
Additional
paid-in capital
|
|
|
281,716
|
|
|
278,005
|
|
Treasury
stock
|
|
|
(18,027
|
)
|
|
(12,925
|
)
|
Accumulated
other comprehensive income (loss)
|
|
|
667
|
|
|
(118
|
)
|
Accumulated
deficit
|
|
|
(102,010
|
)
|
|
(84,069
|
)
|
Total
stockholders’ equity
|
|
|
162,762
|
|
|
181,308
|
|
|
|
|
|
|
|
|
|
TOTAL
LIABILITIES AND STOCKHOLDERS’ EQUITY
|
|
$
|
197,236
|
|
$
|
195,938
|
|
See
accompanying notes to condensed consolidated financial
statements.
ECHELON
CORPORATION
(In
thousands, except per share amounts)
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
REVENUES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
$
|
13,110
|
|
$
|
16,068
|
|
$
|
42,893
|
|
$
|
54,852
|
|
Service
|
|
|
181
|
|
|
183
|
|
|
517
|
|
|
562
|
|
Total
revenues
|
|
|
13,291
|
|
|
16,251
|
|
|
43,410
|
|
|
55,414
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
COST
OF REVENUES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost
of product (1)
|
|
|
4,936
|
|
|
7,085
|
|
|
16,802
|
|
|
23,107
|
|
Cost
of service (1)
|
|
|
509
|
|
|
525
|
|
|
1,406
|
|
|
1,629
|
|
Total
cost of revenues
|
|
|
5,445
|
|
|
7,610
|
|
|
18,208
|
|
|
24,736
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GROSS
PROFIT
|
|
|
7,846
|
|
|
8,641
|
|
|
25,202
|
|
|
30,678
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
OPERATING
EXPENSES:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
development (1)
|
|
|
6,875
|
|
|
6,170
|
|
|
21,029
|
|
|
18,747
|
|
Sales
and marketing (1)
|
|
|
5,076
|
|
|
5,164
|
|
|
15,312
|
|
|
15,585
|
|
General
and administrative (1)
|
|
|
3,746
|
|
|
8,550
|
|
|
10,946
|
|
|
16,597
|
|
Total
operating expenses
|
|
|
15,697
|
|
|
19,884
|
|
|
47,287
|
|
|
50,929
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LOSS
FROM OPERATIONS
|
|
|
(7,851
|
)
|
|
(11,243
|
)
|
|
(22,085
|
)
|
|
(20,251
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INTEREST
AND OTHER INCOME, NET
|
|
|
1,586
|
|
|
1,225
|
|
|
4,384
|
|
|
3,567
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LOSS
BEFORE PROVISION FOR INCOME TAXES
|
|
|
(6,265
|
)
|
|
(10,018
|
)
|
|
(17,701
|
)
|
|
(16,684
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INCOME
TAX EXPENSE
|
|
|
80
|
|
|
100
|
|
|
240
|
|
|
300
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
LOSS
|
|
$
|
(6,345
|
)
|
$
|
(10,118
|
)
|
$
|
(17,941
|
)
|
$
|
(16,984
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
NET
LOSS PER SHARE:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.16
|
)
|
$
|
(0.25
|
)
|
$
|
(0.45
|
)
|
$
|
(0.42
|
)
|
Diluted
|
|
$
|
(0.16
|
)
|
$
|
(0.25
|
)
|
$
|
(0.45
|
)
|
$
|
(0.42
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
SHARES
USED IN COMPUTING NET LOSS PER SHARE:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
39,354
|
|
|
40,074
|
|
|
39,577
|
|
|
40,538
|
|
Diluted
|
|
|
39,354
|
|
|
40,074
|
|
|
39,577
|
|
|
40,538
|
|
(1) |
Amounts
include stock-based compensation costs as follows:
|
|
Cost
of product
|
|
$
|
92
|
|
$
|
17
|
|
$
|
307
|
|
$
|
35
|
|
|
Cost
of service
|
|
|
10
|
|
|
1
|
|
|
36
|
|
|
1
|
|
|
Product
development
|
|
|
376
|
|
|
44
|
|
|
1,474
|
|
|
68
|
|
|
Sales
and marketing
|
|
|
249
|
|
|
33
|
|
|
911
|
|
|
57
|
|
|
General
and aministrative
|
|
|
275
|
|
|
75
|
|
|
989
|
|
|
195
|
|
See
accompanying notes to condensed consolidated financial
statements.
ECHELON
CORPORATION
(In
thousands)
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
CASH
FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(17,941
|
)
|
$
|
(16,984
|
)
|
Adjustments
to reconcile net loss to net cash provided by (used in) operating
activities:
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
3,270
|
|
|
3,115
|
|
Loss
on disposal of fixed assets
|
|
|
--
|
|
|
45
|
|
Recovery
of doubtful accounts
|
|
|
(32
|
)
|
|
(1
|
)
|
Stock-based
compensation
|
|
|
3,717
|
|
|
356
|
|
Change
in operating assets and liabilities:
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
(6,048
|
)
|
|
7,839
|
|
Inventories
|
|
|
(5,699
|
)
|
|
397
|
|
Other
current assets
|
|
|
(13,268
|
)
|
|
(701
|
)
|
Accounts
payable
|
|
|
3,662
|
|
|
137
|
|
Accrued
liabilities
|
|
|
(2,706
|
)
|
|
6,058
|
|
Deferred
revenues
|
|
|
18,737
|
|
|
(160
|
)
|
Deferred
rent
|
|
|
151
|
|
|
203
|
|
Net
cash provided by (used in) operating activities
|
|
|
(16,157
|
)
|
|
304
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS PROVIDED BY (USED FOR) INVESTING ACTIVITIES:
|
|
|
|
|
|
|
|
Purchase
of available-for-sale short-term investments
|
|
|
(47,761
|
)
|
|
(92,408
|
)
|
Proceeds
from maturities and sales of available-for-sale short-term
investments
|
|
|
68,140
|
|
|
89,794
|
|
Release
of restricted investments
|
|
|
--
|
|
|
11,106
|
|
Change
in other long-term assets
|
|
|
(106
|
)
|
|
250
|
|
Capital
expenditures
|
|
|
(4,103
|
)
|
|
(1,464
|
)
|
Net
cash provided by investing activities
|
|
|
16,170
|
|
|
7,278
|
|
|
|
|
|
|
|
|
|
CASH
FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
|
|
|
|
|
|
|
|
Repurchase
of common stock
|
|
|
(5,102
|
)
|
|
(7,869
|
)
|
Proceeds
from (costs associated with) issuance of common stock
|
|
|
(5
|
)
|
|
--
|
|
Net
cash used in financing activities
|
|
|
(5,107
|
)
|
|
(7,869
|
)
|
|
|
|
|
|
|
|
|
EFFECT
OF EXCHANGE RATE CHANGES ON CASH
|
|
|
465
|
|
|
(867
|
)
|
|
|
|
|
|
|
|
|
NET
DECREASE IN CASH AND CASH EQUIVALENTS
|
|
|
(4,629
|
)
|
|
(1,154
|
)
|
|
|
|
|
|
|
|
|
CASH
AND CASH EQUIVALENTS:
|
|
|
|
|
|
|
|
Beginning
of period
|
|
|
59,080
|
|
|
35,510
|
|
End
of period
|
|
$
|
54,451
|
|
$
|
34,356
|
|
|
|
|
|
|
|
|
|
SUPPLEMENTAL
DISCLOSURES OF CASH FLOW INFORMATION:
|
|
|
|
|
|
|
|
Net
cash paid for income taxes
|
|
$
|
183
|
|
$
|
298
|
|
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
custom 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 10.3%
of total revenues for the quarter ended September 30, 2006 and 8.0% for the
same
period in 2005; and 9.8% of total revenues for the nine months ended September
30, 2006 and 6.9% 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 made to the Company’s distributor
partners that do have rights to return certain excess inventory, these criteria
are generally met at the time the distributor 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 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 custom 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 did record 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 and nine months ended September 30, 2005 (in
thousands, except per share amounts).
|
|
Three
Months Ended
September
30, 2005
|
|
Nine
Months Ended
September
30, 2005
|
|
|
|
|
|
|
|
Net
loss as reported
|
|
$
|
(10,118
|
)
|
$
|
(16,984
|
)
|
Add:
Stock-based employee compensation expense included in reported net
income
(loss), net of related tax effects
|
|
|
170
|
|
|
356
|
|
Deduct:
Total stock-based employee compensation expense determined under
fair
value based method for all awards, net of related tax
effects
|
|
|
(2,322
|
)
|
|
(7,264
|
)
|
Pro
forma net loss
|
|
$
|
(12,270
|
)
|
$
|
(23,892
|
)
|
|
|
|
|
|
|
|
|
Basic
net loss per share:
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
(0.25
|
)
|
$
|
(0.42
|
)
|
Pro
forma
|
|
$
|
(0.31
|
)
|
$
|
(0.59
|
)
|
|
|
|
|
|
|
|
|
Diluted
net loss per share:
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
(0.25
|
)
|
$
|
(0.42
|
)
|
Pro
forma
|
|
$
|
(0.31
|
)
|
$
|
(0.59
|
)
|
The
weighted-average grant date fair value of options granted during the three
and
nine months ended September 30, 2005 was $3.77 and $3.63, respectively, and
was
determined using the following weighted average assumptions:
|
|
Three
Months Ended
September
30, 2005
|
|
Nine
Months Ended
September
30, 2005
|
|
|
|
|
|
|
|
|
|
Expected
dividend yield
|
|
|
0.0
|
%
|
|
0.0
|
%
|
Risk-free
interest rate
|
|
|
4.1
|
%
|
|
4.0
|
%
|
Expected
volatility
|
|
|
57.5
|
%
|
|
57.7
|
%
|
Expected
life (in years)
|
|
|
3.7
|
|
|
3.6
|
|
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.
Short-Term
Investments
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
September 30, 2006, the Company’s available-for-sale securities had contractual
maturities from six to twenty-four months and an average remaining term to
maturity of six 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 September 30, 2006, the amortized cost basis, aggregate
fair
value, and gross unrealized holding gains and losses by major security type
were
as follows (in thousands):
|
|
Amortized
Cost
|
|
Aggregate
Fair
Value
|
|
Unrealized
Holding
Gains/
(Losses)
|
|
U.S.
corporate securities:
|
|
|
|
|
|
|
|
|
|
|
Commercial
paper
|
|
$
|
13,650
|
|
$
|
13,654
|
|
$
|
4
|
|
Corporate
notes and bonds
|
|
|
29,622
|
|
|
29,573
|
|
|
(49
|
)
|
|
|
|
43,272
|
|
|
43,227
|
|
|
(45
|
)
|
Foreign
corporate notes and bonds
|
|
|
1,492
|
|
|
1,484
|
|
|
(8
|
)
|
U.S.
government securities
|
|
|
30,653
|
|
|
30,630
|
|
|
(23
|
)
|
Total
investments in debt and equity securities
|
|
$
|
75,417
|
|
$
|
75,341
|
|
$
|
(76
|
)
|
Computation
of Net Loss Per Share
Net
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 loss per share computations for the three months and nine months
ended September 30, 2006 and September 30, 2005 (in thousands, except per share
amounts):
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
Net
loss (Numerator):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(6,345
|
)
|
$
|
(10,118
|
)
|
$
|
(17,941
|
)
|
$
|
(16,984
|
)
|
Shares
(Denominator):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding
|
|
|
39,354
|
|
|
40,074
|
|
|
39,577
|
|
|
40,538
|
|
Shares
used in basic computation
|
|
|
39,354
|
|
|
40,074
|
|
|
39,577
|
|
|
40,538
|
|
Common
shares issuable upon exercise of stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
options
(treasury stock method)
|
|
|
--
|
|
|
--
|
|
|
--
|
|
|
--
|
|
Shares
used in diluted computation
|
|
|
39,354
|
|
|
40,074
|
|
|
39,577
|
|
|
40,538
|
|
Net
loss per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(0.16
|
)
|
$
|
(0.25
|
)
|
$
|
(0.45
|
)
|
$
|
(0.42
|
)
|
Diluted
|
|
$
|
(0.16
|
)
|
$
|
(0.25
|
)
|
$
|
(0.45
|
)
|
$
|
(0.42
|
)
|
In
accordance with SFAS 128, for the three and nine months ended September 30,
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 and nine months ended September
30,
2006 was 7,561,024. The number of stock options excluded from this calculation
for the three and nine months ended September 30, 2005 was 8,213,544.
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 three and
nine month periods ended September 30, 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.
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 September 30, 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
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
157 (“SFAS 157”), Fair Value Measurements. SFAS 157 defines fair value
as used in numerous accounting pronouncements, establishes a framework for
measuring fair value in generally accepted accounting principles (GAAP) and
expands disclosure related to the use of fair value measures in financial
statements. SFAS 157 does not expand the use of fair value measures in financial
statements, but standardizes its definition and guidance in GAAP. The Standard
emphasizes that fair value is a market-based measurement and not an
entity-specific measurement based on an exchange transaction in which the entity
sells an asset or transfers a liability (exit price). SFAS 157 establishes
a
fair value hierarchy from observable market data as the highest level to fair
value based on an entity’s own fair value assumptions as the lowest level. SFAS
157 is to be effective for the Company’s financial statements issued in 2008;
however, earlier application is encouraged. The Company believes that the
adoption of SFAS 157 will not have a material impact on its consolidated
financial statements.
In
September 2006, the Securities and Exchange Commission (SEC) released
Staff
Accounting Bulletin No. 108 (“SAB 108:”), Considering the Effects of Prior
Year Misstatements When Quantifying Misstatements in Current Year Financial
Statements. SAB 108 provides guidance on how the effects of the carryover
or reversal of prior year financial statement misstatements should
be considered
in quantifying a current year misstatement. Prior practice allowed
the
evaluation of materiality on the basis of (1) the error quantified
as the amount
by which the current year income statement was misstated (rollover
method) or
(2) the cumulative error quantified as the cumulative amount by which
the
current year balance sheet was misstated (iron curtain method). Reliance
on
either method in prior years could have resulted in misstatement of
the
financial statements. The guidance provided in SAB 108 requires both
methods to
be used in evaluating materiality. Immaterial prior year errors may
be corrected
with the first filing of prior year financial statements after adoption.
The
cumulative effect of the correction would be reflected in the opening
balance
sheet with appropriate disclosure of the nature and amount of each
individual
error corrected in the cumulative adjustment, as well as a disclosure
of the
cause of the error and that the error had been deemed to be immaterial
in the
past. The provisions of SAB 108 are effective as of the beginning of
our 2007
fiscal year. The Company believes that the adoption of SAB 108 will
not have a
material impact on its consolidated financial statements.
In
July
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes
- an Interpretation of FASB Statement No. 109, which clarifies the
accounting for uncertainty in tax positions. This Interpretation requires
that
the Company recognize in its financial statements the impact of a tax
position
if that position is more likely than not of being sustained on audit,
based on
the technical merits of the position. The provisions of FIN 48 are
effective as
of the beginning of our 2007 fiscal year, with the cumulative effect,
if any, of
the change in accounting principal recorded as an adjustment to opening
retained
earnings. The Company is currently evaluating the impact of adopting
FIN 48 on
its condensed consolidated financial statements.
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. The adoption of SFAS 154 did not have a material impact
on the
Company’s consolidated financial statements.
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 September 30, 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 September 30,
2006.
Common
Stock
As
of
September 30, 2006, the Company was authorized to issue 100,000,000 shares
of
$0.01 par value common stock, of which 39,257,966 were outstanding.
In
March
and August 2004 and March 2006, 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 September
30, 2006, the Company repurchased 322,612 shares under the program at a cost
of
approximately $2.6 million. During
the nine months ended September 30, 2006, the Company repurchased 642,067 shares
under the program at a cost of approximately $5.1 million. As of September
30,
2006, 949,934 shares were available for repurchase. The stock repurchase program
will expire in March 2007.
Comprehensive
Loss
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 loss for the three
and
nine months ended September 30, 2006 and 2005 is as follows (in
thousands):
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(6,345
|
)
|
$
|
(10,118
|
)
|
$
|
(17,941
|
)
|
$
|
(16,984
|
)
|
Other
comprehensive income/(loss), net of tax:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign
currency translation adjustment
|
|
|
(63
|
)
|
|
(89
|
)
|
|
465
|
|
|
(867
|
)
|
Unrealized
holding gain/(loss) on available-for-sale securities
|
|
|
270
|
|
|
(83
|
)
|
|
320
|
|
|
9
|
|
Comprehensive
loss
|
|
$
|
(6,138
|
)
|
$
|
(10,290
|
)
|
$
|
(17,156
|
)
|
$
|
(17,842
|
)
|
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 nine 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 two years from the new
option grant date. New options were subject to a one-year cliff-vesting
schedule, at which time the new option 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 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 compensation 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. As of September 30, 2006, 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 nine months. Each First Option and each Subsequent
Option have a term of five years and vest immediately upon grant.
The
following table summarizes stock award activity, including stock options and
performance shares, and related information for the three and nine month periods
ended September 30, 2006 and 2005:
|
|
|
|
Options
Outstanding
|
|
|
|
Shares
Available
for
Grant
|
|
Number
Outstanding
|
|
Weighted-Average
Exercise
Price Per Share
|
|
BALANCE
AT JUNE 30, 2005
|
|
|
7,995,704
|
|
|
7,346,802
|
|
$
|
11.66
|
|
Options
granted
|
|
|
(1,043,980
|
)
|
|
1,043,980
|
|
|
8.18
|
|
Performance
shares granted
|
|
|
(305,710
|
)
|
|
---
|
|
|
---
|
|
Options
exercised
|
|
|
---
|
|
|
---
|
|
|
---
|
|
Options
forfeited or expired
|
|
|
177,238
|
|
|
(177,238
|
)
|
|
9.38
|
|
BALANCE
AT SEPTEMBER 30, 2005
|
|
|
6,823,252
|
|
|
8,213,544
|
|
$
|
11.26
|
|
|
|
|
|
|
|
|
|
|
|
|
BALANCE
AT JUNE 30, 2006
|
|
|
8,930,789
|
|
|
7,608,798
|
|
$
|
11.23
|
|
Options
granted
|
|
|
(32,800
|
)
|
|
32,800
|
|
|
8.33
|
|
Performance
shares granted
|
|
|
(10,934
|
)
|
|
---
|
|
|
---
|
|
Options
exercised
|
|
|
---
|
|
|
(11,018
|
)
|
|
6.17
|
|
Options
forfeited or expired
|
|
|
69,556
|
|
|
(69,556
|
)
|
|
18.88
|
|
Performance
shares forfeited or expired
|
|
|
1,671
|
|
|
---
|
|
|
---
|
|
BALANCE
AT SEPTEMBER 30, 2006
|
|
|
8,958,279
|
|
|
7,561,024
|
|
$
|
11.15
|
|
|
|
|
|
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
|
|
|
(3,537,064
|
)
|
|
3,537,064
|
|
|
6.98
|
|
Performance
shares granted
|
|
|
(415,065
|
)
|
|
---
|
|
|
---
|
|
Options
exercised
|
|
|
---
|
|
|
---
|
|
|
---
|
|
Options
forfeited or expired
|
|
|
918,362
|
|
|
(918,362
|
)
|
|
16.98
|
|
Additional
shares reserved
|
|
|
1,747,463
|
|
|
---
|
|
|
---
|
|
BALANCE
AT SEPTEMBER 30, 2005
|
|
|
6,823,252
|
|
|
8,213,544
|
|
$
|
11.26
|
|
|
|
|
|
|
|
|
|
|
|
|
BALANCE
AT DECEMBER 31, 2005
|
|
|
6,949,420
|
|
|
8,089,473
|
|
$
|
11.24
|
|
Options
granted
|
|
|
(101,825
|
)
|
|
101,825
|
|
|
8.21
|
|
Performance
shares granted
|
|
|
(120,601
|
)
|
|
---
|
|
|
---
|
|
Options
exercised
|
|
|
---
|
|
|
(115,268
|
)
|
|
6.12
|
|
Options
forfeited or expired
|
|
|
515,006
|
|
|
(515,006
|
)
|
|
13.02
|
|
Performance
shares forfeited or expired
|
|
|
24,259
|
|
|
---
|
|
|
---
|
|
Additional
shares reserved
|
|
|
1,692,020
|
|
|
---
|
|
|
---
|
|
BALANCE
AT SEPTEMBER 30, 2006
|
|
|
8,958,279
|
|
|
7,561,024
|
|
$
|
11.15
|
|
The
following table provides additional information for significant ranges
of
outstanding and exercisable stock options as of September 30,
2006:
|
|
|
|
|
|
Weighted
Average
Remaining
Contractual
Life
(in
years)
|
|
|
Exercise
Price
per Share
|
|
|
Aggregate
Intrinsic
Value
|
|
$6.11
|
|
|
1,535,311
|
|
|
3.26
|
|
$ |
6.11
|
|
$
|
3,254,859
|
|
6.26-8.17
|
|
|
274,293
|
|
|
2.41
|
|
|
7.20
|
|
|
281,327
|
|
8.19
|
|
|
951,130
|
|
|
3.87
|
|
|
8.19
|
|
|
38,045
|
|
8.24-10.65
|
|
|
655,640
|
|
|
3.70
|
|
|
9.20
|
|
|
--
|
|
10.89
|
|
|
840,920
|
|
|
2.46
|
|
|
10.89
|
|
|
--
|
|
11.14-12.88
|
|
|
575,132
|
|
|
4.69
|
|
|
11.66
|
|
|
--
|
|
12.91
|
|
|
792,870
|
|
|
1.64
|
|
|
12.91
|
|
|
--
|
|
13.00-16.06
|
|
|
305,200
|
|
|
4.22
|
|
|
14.12
|
|
|
--
|
|
16.35
|
|
|
825,562
|
|
|
4.18
|
|
|
16.35
|
|
|
--
|
|
$16.36-$30.76
|
|
|
804,966
|
|
|
4.33
|
|
|
18.91
|
|
|
--
|
|
Outstanding
|
|
|
7,561,024
|
|
|
3.45
|
|
$ |
11.15
|
|
$
|
3,574,231
|
|
Vested
and expected to vest
|
|
|
7,489,270
|
|
|
3.44
|
|
$ |
11.18
|
|
$
|
3,547,844
|
|
Exercisable
|
|
|
6,497,776
|
|
|
3.43
|
|
$ |
11.73
|
|
$
|
2,921,352
|
|
The
aggregate intrinsic value in the preceding table represents the total pretax
intrinsic value, based on the Company’s closing stock price of $8.23 as of
September 30, 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 and nine month periods ended September 30, 2006 and
2005:
|
|
Number
Nonvested
and
Outstanding
|
|
Weighted-Average
Grant
Date Fair-Value
|
|
BALANCE
AT JUNE 30, 2005
|
|
|
109,355
|
|
$
|
6.77
|
|
Performance
shares granted
|
|
|
305,710
|
|
|
8.19
|
|
BALANCE
AT SEPTEMBER 30, 2005
|
|
|
415,065
|
|
$
|
7.82
|
|
|
|
|
|
|
|
|
|
BALANCE
AT JUNE 30, 2006
|
|
|
500,047
|
|
$
|
8.07
|
|
Performance
shares granted
|
|
|
10,934
|
|
|
8.33
|
|
Performance
shares vested and released
|
|
|
(71,222
|
)
|
|
8.19
|
|
Performance
shares forfeited
|
|
|
(1,671
|
)
|
|
8.19
|
|
BALANCE
AT SEPTEMBER 30, 2006
|
|
|
438,088
|
|
$
|
8.05
|
|
|
|
Number
Nonvested
and
Outstanding
|
|
Weighted-Average
Grant
Date Fair-Value
|
|
BALANCE
AT DECEMBER 31, 2004
|
|
|
---
|
|
$
|
---
|
|
Performance
shares granted
|
|
|
415,065
|
|
|
7.82
|
|
BALANCE
AT SEPTEMBER 30, 2005
|
|
|
415,065
|
|
$
|
7.82
|
|
|
|
|
|
|
|
|
|
BALANCE
AT DECEMBER 31, 2005
|
|
|
412,968
|
|
$
|
7.82
|
|
Performance
shares granted
|
|
|
120,601
|
|
|
8.94
|
|
Performance
shares vested and released
|
|
|
(71,222
|
)
|
|
8.19
|
|
Performance
shares forfeited
|
|
|
(24,259
|
)
|
|
8.04
|
|
BALANCE
AT SEPTEMBER 30, 2006
|
|
|
438,088
|
|
$
|
8.05
|
|
No
performance shares vested during the three or nine month periods ended September
30, 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 and nine months ended September 30, 2006 is summarized
in the following tables (in thousands, except per share amounts):
Three
months ended September 30, 2006
|
|
|
Intrinsic
Value Method
(A)
|
|
|
Fair
Value Method
(B)
|
|
|
Impact
of Adoption
(A)
- (B)
|
|
Loss
from continuing operations
|
|
$
|
(7,167
|
)
|
$
|
(7,851
|
)
|
$
|
(684
|
)
|
Loss
before provision for income taxes
|
|
$
|
(5,581
|
)
|
$
|
(6,265
|
)
|
$
|
(684
|
)
|
Net
loss
|
|
$
|
(5,661
|
)
|
$
|
(6,345
|
)
|
$
|
(684
|
)
|
Net
loss per share - basic
|
|
$
|
(0.14
|
)
|
$
|
(0.16
|
)
|
$
|
(0.02
|
)
|
Net
loss per share - diluted
|
|
$
|
(0.14
|
)
|
$
|
(0.16
|
)
|
$
|
(0.02
|
)
|
Cash
flows from operations
|
|
$
|
(7,888
|
)
|
$
|
(7,888
|
)
|
$
|
--
|
|
Cash
flows from financing activities
|
|
$
|
(2,753
|
)
|
$
|
(2,753
|
)
|
$
|
--
|
|
Nine
months ended September 30, 2006
|
|
|
Intrinsic
Value Method
(A)
|
|
|
Fair
Value Method
(B)
|
|
|
Impact
of Adoption
(A)
- (B)
|
|
Loss
from continuing operations
|
|
$
|
(19,281
|
)
|
$
|
(22,085
|
)
|
$
|
(2,804
|
)
|
Loss
before provision for income taxes
|
|
$
|
(14,897
|
)
|
$
|
(17,701
|
)
|
$
|
(2,804
|
)
|
Net
loss
|
|
$
|
(15,137
|
)
|
$
|
(17,941
|
)
|
$
|
(2,804
|
)
|
Net
loss per share - basic
|
|
$
|
(0.38
|
)
|
$
|
(0.45
|
)
|
$
|
(0.07
|
)
|
Net
loss per share - diluted
|
|
$
|
(0.38
|
)
|
$
|
(0.45
|
)
|
$
|
(0.07
|
)
|
Cash
flows from operations
|
|
$
|
(16,157
|
)
|
$
|
(16,157
|
)
|
$
|
--
|
|
Cash
flows from financing activities
|
|
$
|
(5,107
|
)
|
$
|
(5,107
|
)
|
$
|
--
|
|
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
and
nine months ended September 30, 2006, was $3.58 and $2.78, respectively, and
was
determined using the following weighted average assumptions:
|
|
Three
Months Ended
September
30, 2006
|
|
Nine
Months Ended
September
30, 2006
|
|
Expected
dividend yield
|
|
|
0.0
|
%
|
|
0.0
|
%
|
Risk-free
interest rate
|
|
|
4.8
|
%
|
|
4.8
|
%
|
Expected
volatility
|
|
|
51.2
|
%
|
|
48.8
|
%
|
Expected
life (in years)
|
|
|
3.8
|
|
|
2.6
|
|
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 and nine
months ended September 30, 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 September 30, 2006, total
compensation cost related to non-vested stock options and other equity based
awards not yet recognized was $5.4 million, which is expected to be recognized
over the next 18 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
and
nine months ended September 30, 2006 and 2005, which was allocated as follows
(in thousands):
|
|
Three
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
Cost
of sales - product
|
|
$
|
92
|
|
$
|
17
|
|
Cost
of sales - service
|
|
|
10
|
|
|
1
|
|
Stock-based
compensation expense included in cost of sales
|
|
|
102
|
|
|
18
|
|
Product
development
|
|
|
376
|
|
|
44
|
|
Sales
and marketing
|
|
|
249
|
|
|
33
|
|
General
and administrative
|
|
|
275
|
|
|
75
|
|
Stock-based
compensation expense included in operating expenses
|
|
|
900
|
|
|
152
|
|
Total
stock-based compensation expense related to stock options and performance
shares
|
|
|
1,002
|
|
|
170
|
|
Tax
benefit
|
|
|
--
|
|
|
--
|
|
Stock-based
compensation expense related to stock options and performance shares,
net
of tax
|
|
$
|
1,002
|
|
$
|
170
|
|
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
Cost
of sales - product
|
|
$
|
307
|
|
$
|
35
|
|
Cost
of sales - service
|
|
|
36
|
|
|
1
|
|
Stock-based
compensation expense included in cost of sales
|
|
|
343
|
|
|
36
|
|
Product
development
|
|
|
1,474
|
|
|
68
|
|
Sales
and marketing
|
|
|
911
|
|
|
57
|
|
General
and administrative
|
|
|
989
|
|
|
195
|
|
Stock-based
compensation expense included in operating expenses
|
|
|
3,374
|
|
|
320
|
|
Total
stock-based compensation expense related to stock options and performance
shares
|
|
|
3,717
|
|
|
356
|
|
Tax
benefit
|
|
|
--
|
|
|
--
|
|
Stock-based
compensation expense related to stock options and performance shares,
net
of tax
|
|
$
|
3,717
|
|
$
|
356
|
|
Of
the
$1.0 million of compensation expense recorded for the quarter ended September
30, 2006, approximately $126,000 related to equity compensation awards granted
during 2006, while the remaining $876,000 related to equity compensation awards
granted on or before December 31, 2005. Of the $3.7 million of compensation
expense recorded for the nine month period ended September 30, 2006,
approximately $411,000 related to equity compensation awards granted during
2006, while the remaining $3.3 million related to equity compensation awards
granted on or before December 31, 2005. Compensation expense of $170,000 and
$356,000 for the three and nine months ended September 30, 2005, respectively,
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 three and nine month periods ended September 30, 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 loss and diluted net loss per share for the three
and nine months ended September 30, 2006 compared with the pro forma information
for the three and nine months ended September 30, 2005 (in thousands, except
per
share amounts):
|
|
Three
Months Ended September
30,
|
|
|
|
2006
|
|
2005
|
|
Net
loss - as reported for the prior period (1)
|
|
|
N/A
|
|
$
|
(10,118
|
)
|
Stock-based
compensation expense related to employee stock options and performance
share awards (2)
|
|
$
|
1,002
|
|
$
|
2,152
|
|
Tax
benefit
|
|
|
--
|
|
|
--
|
|
Stock-based
compensation expense related to stock options and performance share
awards, net of tax (3)
|
|
$
|
1,002
|
|
$
|
2,152
|
|
|
|
|
|
|
|
|
|
Net
loss, including the effect of stock-based compensation expense
(4)
|
|
$
|
(6,345
|
)
|
$
|
(12,270
|
)
|
|
|
|
|
|
|
|
|
Diluted
net loss per share - as reported for the prior period (1)
|
|
|
N/A
|
|
$
|
(0.25
|
)
|
Diluted
net loss per share, including the effect of stock-based compensation
expense (4)
|
|
$
|
(0.16
|
)
|
$
|
(0.31
|
)
|
|
|
|
|
|
|
Nine
Months Ended September 30,
|
|
|
|
2006
|
|
2005
|
|
|
|
|
|
|
|
Net
loss - as reported for the prior period (1)
|
|
|
N/A
|
|
$
|
(16,984
|
)
|
Stock-based
compensation expense related to employee stock options and performance
share awards (2)
|
|
$
|
3,717
|
|
$
|
6,908
|
|
Tax
benefit
|
|
|
--
|
|
|
--
|
|
Stock-based
compensation expense related to stock options and performance share
awards, net of tax (3)
|
|
$
|
3,717
|
|
$
|
6,908
|
|
|
|
|
|
|
|
|
|
Net
loss, including the effect of stock-based compensation expense
(4)
|
|
$
|
(17,941
|
)
|
$
|
(23,892
|
)
|
|
|
|
|
|
|
|
|
Diluted
net loss per share - as reported for the prior period (1)
|
|
|
N/A
|
|
$
|
(0.42
|
)
|
Diluted
net loss per share, including the effect of stock-based compensation
expense (3)
|
|
$
|
(0.45
|
)
|
$
|
(0.59
|
)
|
(1) |
Net
loss and net loss 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.
Net loss and net loss per share prior to January 1, 2006 did include
stock-based compensation expense for performance share
awards.
|
(2) |
Stock-based
compensation expense related to employee stock options and performance
share awards for the three and nine months ended September 30, 2005
are
net of amounts already reflected in the net loss for the respective
periods.
|
(3) |
Stock-based
compensation expense prior to January 1, 2006 is calculated based
on the
pro forma application of SFAS 123.
|
(4) |
Net
loss and net loss 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 three and nine months ended September
30, 2006 and 2005, the percentage of the Company’s revenues attributable to
sales made to these two customers were as follows:
|
|
Three
Months Ended September 30,
|
|
Nine
Months Ended September 30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
Enel
|
|
|
0.40
|
%
|
|
27.00
|
%
|
|
16.40
|
%
|
|
37.10
|
%
|
EBV
|
|
|
32.00
|
%
|
|
22.70
|
%
|
|
25.30
|
%
|
|
20.50
|
%
|
Total
|
|
|
32.40
|
%
|
|
49.70
|
%
|
|
41.70
|
%
|
|
57.60
|
%
|
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.
The
Company’s original contract with Enel expired in June 2005, and shipments under
that contract were completed in 2005. During 2006, the Company has supplied
Enel
and its third party meter manufacturers with spare parts for Enel’s Contatore
Elettronico system. Recently, Enel and the Company entered into a new
development and supply agreement as well as a software enhancement agreement.
Under the development and supply agreement, Enel will purchase additional
metering kit and data concentrator products from the Company, assuming initial
acceptance tests are completed successfully. Under the software enhancement
agreement, the Company will provide software enhancements to Enel for use
in its
Contatore Elettronico system. The Company does not currently anticipate any
material revenues from either of these new agreements during 2006. Both the
new
development and supply agreement and the software enhancement agreement expire
on December 31, 2009, although delivery of products and services can extend
beyond that date and the agreements may be extended under certain
circumstances.
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, 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 three 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
U.S. 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
our consolidated statements of income, was approximately $142,000 during
the
quarter ended September 30, 2006, and $115,000 for the same period in
2005.
Royalty expense was approximately $352,000 for the nine months ended
September
30, 2006, and $363,000 for the same period in 2005.
The
Company will continue to be obligated for royalty payments in the future.
The
Company is currently unable to estimate the cumulative 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 or related to the officer’s or director’s tenure with the Company. 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 could 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 was
reflected in accrued liabilities. As of September 30, 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 September 30, 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):
|
|
September
30,
2006
|
|
December
31,
2005
|
|
Purchased
materials
|
|
$
|
2,322
|
|
$
|
1,064
|
|
Work-in-process
|
|
|
9
|
|
|
61
|
|
Finished
goods
|
|
|
6,608
|
|
|
2,115
|
|
|
|
$
|
8,939
|
|
$
|
3,240
|
|
8.
Accrued Liabilities
Accrued
liabilities consist of the following (in thousands):
|
|
September
30,
2006
|
|
December
31,
2005
|
|
Accrued
payroll and related costs
|
|
$
|
3,000
|
|
$
|
2,630
|
|
Accrued
taxes
|
|
|
1,187
|
|
|
1,128
|
|
Other
accrued liabilities
|
|
|
580
|
|
|
3,715
|
|
|
|
$
|
4,767
|
|
$
|
7,473
|
|
9. Segment
Disclosure
The
Company reports operating segment and other segment information in accordance
with SFAS No. 131 ("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 control network industry, and markets its
products
primarily to the building automation, industrial automation, transportation,
and
utility/home automation markets. The Company’s products are generally 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.
In general, any given customer purchases a 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 regions: 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 area and excludes certain expenses that are managed outside the geographic
area. Costs excluded from area profit or loss primarily consist of unallocated
corporate expenses, which are comprised of product development costs,
corporate
marketing costs and other general and administrative expenses, each of
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
September 30, 2006, and December 31, 2005, long-lived assets of about
$22.8
million and $22.0 million, respectively, were domiciled in the United
States.
Long-lived assets for all other locations are not material to the consolidated
financial statements. Assets and the related depreciation and amortization
are
not 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 supplemented by local distributors. Revenues are attributed
to
geographic areas based on the country where the products are shipped.
Summary
information by geography for the three and nine months ended September
30, 2006
and 2005 is as follows (in thousands):
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
Revenues
from customers:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
5,193
|
|
$
|
4,488
|
|
$
|
14,688
|
|
$
|
12,568
|
|
EMEA
|
|
|
5,949
|
|
|
9,341
|
|
|
23,528
|
|
|
36,817
|
|
APJ
|
|
|
2,149
|
|
|
2,422
|
|
|
5,194
|
|
|
6,029
|
|
Total
|
|
$
|
13,291
|
|
$
|
16,251
|
|
$
|
43,410
|
|
$
|
55,414
|
|
Gross
profit:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
3,134
|
|
$
|
2,599
|
|
$
|
8,875
|
|
$
|
7,565
|
|
EMEA
|
|
|
3,347
|
|
|
4,700
|
|
|
13,302
|
|
|
19,599
|
|
APJ
|
|
|
1,365
|
|
|
1,342
|
|
|
3,025
|
|
|
3,514
|
|
Total
|
|
$
|
7,846
|
|
$
|
8,641
|
|
$
|
25,202
|
|
$
|
30,678
|
|
Income
(loss) from operations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Americas
|
|
$
|
1,676
|
|
$
|
1,481
|
|
$
|
4,984
|
|
$
|
4,172
|
|
EMEA
|
|
|
2,007
|
|
|
3,352
|
|
|
9,094
|
|
|
15,239
|
|
APJ
|
|
|
298
|
|
|
191
|
|
|
(191
|
)
|
|
68
|
|
Unallocated
|
|
|
(11,832
|
)
|
|
(16,267
|
)
|
|
(35,972
|
)
|
|
(39,730
|
)
|
Total
|
|
$
|
(7,851
|
)
|
$
|
(11,243
|
)
|
$
|
(22,085
|
)
|
$
|
(20,251
|
)
|
Products
sold to Enel and its designated manufacturers accounted for approximately
$53,000, or 0.4% of total revenues for the quarter ended September 30, 2006,
and
$4.4 million, or 27.0% for the same period in 2005; and $7.1 million, or
16.4%
of total revenues for nine months ended September 30, 2006, and $20.6 million,
or 37.1% for the same period in 2005. For the quarter ended September 30,
2006,
100.0% of the revenues under the Enel program were derived from products
shipped
to customers in EMEA. For the nine months ended September 30, 2006, 97.2%
of the
revenues derived from products shipped under the Enel program were from
customers in EMEA and the remaining 2.8% from customers in
APJ.
EBV,
the
primary independent distributor of the Company’s LonWorks
infrastructure products
in Europe, accounted for 32.0% of total revenues for the quarter ended September
30, 2006 and 22.7% for the same period in 2005; and 25.3% of total revenues
for
the nine months ended September 30, 2006 and 20.5% for the same period in 2005.
10.
Income Taxes
The
provision for income taxes for the three months and nine months ended September
30, 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
During
the quarter and nine months ended September 30, 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.
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 quarter and nine months ended September 30, 2006, the Company
recognized revenue from products and services sold to Enel and its designated
manufacturers of approximately $53,000 and $7.1 million, respectively. For
the
quarter and nine months ended September 30, 2005, the Company recognized
revenue
from products and services sold to Enel and its designated manufacturers
of
approximately $4.4 million and $20.6 million, respectively. As of September
30,
2006 and September 30, 2005, $4.1 million and $5.3 million, respectively,
of the
Company’s total accounts receivable balance related to amounts owed by Enel and
its designated manufacturers.
In
October 2006, Enel and the Company entered into a new development and supply
agreement as well as a software enhancement agreement. Under the development
and
supply agreement, Enel will purchase additional metering kit and data
concentrator products from the Company, assuming initial acceptance tests
are
completed successfully. Under the software enhancement agreement, the Company
will provide software enhancements to Enel for use in its Contatore Elettronico
system. The Company does not currently anticipate any material revenues from
either of these new agreements during 2006. Both the new development and
supply
agreement and the software enhancement agreement expire on December 31, 2009,
although delivery of products and services can extend beyond that date and
the
agreements may be extended under certain
circumstances.
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 and predicted failure rates, 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 $239,000 as of
September 30, 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 $7.1 million in
2006
and our belief that we will not 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 slightly as compared to
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 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 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 Part II 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 original equipment manufacturers (“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
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
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 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 and nine months ended September
30,
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 expect that, during the remainder of 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. Partially offsetting this anticipated year-over-year
reduction are 2006 revenues associated with the shipment of spare parts to
Enel,
which have been completed as of September 30, 2006. In
October 2006, we entered into two additional agreements with Enel, a new
development and supply agreement and a software enhancement agreement. Under
the
new development and supply agreement, Enel will purchase additional metering
kit
and data concentrator products from us, assuming initial acceptance tests are
completed successfully. Under the software enhancement agreement, we will
provide software enhancements to Enel for use in its Contatore Elettronico
system. We do not currently anticipate any material revenues from either of
these new agreements during 2006. Both the new development and supply agreement
and the software enhancement agreement expire on December 31, 2009, although
delivery of products and services can extend beyond that date and the agreements
may be extended under certain circumstances.
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. For the nine months ended September 30, 2006, the adoption
of
this new accounting standard has resulted in an increase in equity compensation
expenses of approximately $3.4 million as compared to the same period in 2005.
During
the first and second quarters of 2006, we revised our revenue recognition
methodology for sales made to the distributors of our LONWORKS Infrastructure
products. Under the revised methodology, we now defer revenue, as well as cost
of goods sold, on items shipped to these distributors that remain in their
inventories at quarter-end. The revision significantly reduced our first and
second quarter 2006 revenues, but will not have an impact on cash flows from
operations or require any changes to our historical financial statements. A
more
thorough explanation of this revision can be found later in this report in
the
“LONWORKS Infrastructure revenues” and “EBV revenues” sections of our discussion
on Results of Operations.
CRITICAL
ACCOUNTING
ESTIMATES
Our
discussion and analysis of our financial condition and results of operations
is
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 32.0% of total net revenues for
the
quarter ended September 30, 2006, and 22.7% for the same period in 2005, and
25.3% of total revenues for the nine months ended September 30, 2006 and 20.5%
for the same period in 2005. Worldwide sales to distributors, including those
to
EBV, accounted for approximately 46.3% of total net revenues for the quarter
ended September 30, 2006, and 32.3% for the same period in 2005; and 34.4%
of
total net revenues for the nine months ended September 30, 2006 and 28.2% 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.
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.
Our
allowances for sales returns and other sales-related reserves were approximately
$694,000 as of September 30, 2006, 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 $250,000 as of September
30,
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 $239,000 as of September 30,
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.
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 $8.2
million as of September 30, 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.
RESULTS
OF
OPERATIONS
The
following table reflects the percentage of total revenues represented by each
item in our Consolidated Statements of Operations for the three and nine months
ended September 30, 2006 and September 30, 2005:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
2006
|
|
2005
|
|
2006
|
|
2005
|
|
Revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
|
|
|
98.7
|
%
|
|
98.9
|
%
|
|
98.8
|
%
|
|
99.0
|
%
|
Service
|
|
|
1.3
|
|
|
1.1
|
|
|
1.2
|
|
|
1.0
|
|
Total
revenues
|
|
|
100.0
|
|
|
100.0
|
|
|
100.0
|
|
|
100.0
|
|
Cost
of revenues:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost
of product
|
|
|
37.2
|
|
|
43.6
|
|
|
38.7
|
|
|
41.7
|
|
Cost
of service
|
|
|
3.8
|
|
|
3.2
|
|
|
3.3
|
|
|
2.9
|
|
Total
cost of
revenues
|
|
|
41.0
|
|
|
46.8
|
|
|
42.0
|
|
|
44.6
|
|
Gross
profit
|
|
|
59.0
|
|
|
53.2
|
|
|
58.0
|
|
|
55.4
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product
development
|
|
|
51.7
|
|
|
38.0
|
|
|
48.4
|
|
|
33.8
|
|
Sales
and marketing
|
|
|
38.2
|
|
|
31.8
|
|
|
35.3
|
|
|
28.1
|
|
General
and
administrative
|
|
|
28.2
|
|
|
52.6
|
|
|
25.2
|
|
|
30.0
|
|
Total
operating
expenses
|
|
|
118.1
|
|
|
122.4
|
|
|
108.9
|
|
|
91.9
|
|
Loss
from
operations
|
|
|
(59.1
|
)
|
|
(69.2
|
)
|
|
(50.9
|
)
|
|
(36.5
|
)
|
Interest
and other income,
net
|
|
|
12.0
|
|
|
7.5
|
|
|
10.1
|
|
|
6.4
|
|
Loss
before provision for income
taxes
|
|
|
(47.1
|
)
|
|
(61.7
|
)
|
|
(40.8
|
)
|
|
(30.1
|
)
|
Income
tax expense
|
|
|
0.6
|
|
|
0.6
|
|
|
0.5
|
|
|
0.5
|
|
Net
loss
|
|
|
(47.7
|
%)
|
|
(62.3
|
%)
|
|
(41.3
|
%)
|
|
(30.6
|
%)
|
Revenues
Total
Revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Total
Revenues
|
|
$
|
13,291
|
|
$
|
16,251
|
|
$
|
(2,960
|
)
|
|
(18.2
|
%)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
Months Ended
|
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Total
Revenues
|
|
$
|
43,410
|
|
$
|
55,414
|
|
$
|
(12,004
|
)
|
|
(21.7
|
%)
|
The
$3.0
million decrease in total revenues for the quarter ended September 30, 2006
as
compared to the same period in 2005 was primarily the result of a $4.3 million
decrease in Enel Project revenues, partially offset by a $1.3 million increase
in LonWorks
Infrastructure revenues. The $12.0 million decrease in total revenues for the
nine months ended September 30, 2006 as compared to the same period in 2005
was
primarily the result of a $13.5 million reduction in Enel Project revenues
partially offset by a $1.3 million increase in LonWorks
Infrastructure revenues, and a $150,000 increase in NES revenues.
LonWorks
Infrastructure revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
LonWorks
Infrastructure Revenues
|
|
$
|
13,040
|
|
$
|
11,702
|
|
$
|
1,338
|
|
|
11.4
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
LonWorks
Infrastructure Revenues
|
|
$
|
35,614
|
|
$
|
34,291
|
|
$
|
1,323
|
|
|
3.9
|
%
|
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 $1.3 million increase in
LonWorks
Infrastructure revenues for the quarter ended September 30, 2006 as compared
to
the same period in 2005 was evident in all of the geographic markets that we
serve, particularly in the Americas and EMEA, and to a lesser extent, in Asia.
Partially offsetting this increase was the unfavorable impact of exchange rates
on sales made in foreign currencies, which resulted in a $43,000 decrease
between the two quarters. We believe the overall $1.3 million increase is due,
at least in part, to our customer’s utilization of our products in new
applications, such as energy management and street lighting controls.
The
$1.3
million increase in LonWorks
Infrastructure revenue for the nine months ended September 30, 2006 as compared
to the same period in 2005 was negatively impacted by revisions that we made
earlier in 2006 to our revenue recognition methodology for sales made to our
distributor partners. During the first quarter of 2006, we modified our revenue
recognition method for sales made to our European distributor, EBV (see EBV
revenue discussion below). Under the revised method, revenue on sales made
to
EBV is deferred until EBV sells the products through to its end use customers.
During the second quarter of 2006, we completed a similar revision to our
revenue recognition methodology for sales made to our Asian distributor
partners. This revision was necessary as, during the quarter, we modified our
agreements with our Asian distributor partners. These contractual modifications,
which allow the distributors to return certain of their excess inventory, were
made to address changing business conditions in our Asian markets and to expand
our customer base there. The impact of these revenue recognition methodology
revisions made during the first and second quarters of 2006 was a one-time
reduction in
LonWorks
Infrastructure revenues of approximately $3.9 million.
Excluding
the impact of these revenue recognition revisions,
LonWorks
Infrastructure revenues for the nine months ended September 30, 2006 would
have
increased by approximately $5.2 million as compared to the same period in 2005.
This increase was spread across all of the geographic markets that we serve,
particularly EMEA and the Americas, and to a lesser extent, in Asia. Partially
offsetting this increase was the unfavorable impact of exchange rates made
in
foreign currencies, which resulted in a $141,000 decrease between the two
periods. As was the case for the quarter-over-quarter increase, we believe
these
overall increase is due, at least in part, to our customer’s utilization of our
products in new applications, as well as generally more favorable worldwide
economic conditions.
As
long
as current worldwide economic conditions do not deteriorate, we believe that
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. Through the first nine
months of 2006, the portion of our LonWorks Infrastructure revenues conducted
in
currencies other than the U.S. dollar, principally the Japanese Yen, was
about
6.4% as compared to 4.6% 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.
Enel
Project revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Enel
Project Revenues
|
|
$
|
53
|
|
$
|
4,388
|
|
$
|
(4,335
|
)
|
|
(98.8
|
%)
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Enel
Project Revenues
|
|
$
|
7,103
|
|
$
|
20,580
|
|
$
|
(13,477
|
)
|
|
(65.5
|
%)
|
The
$4.3
million decrease in Enel Project revenues for the quarter ended September 30,
2006, as compared to the same period in 2005, was primarily attributable to
a
reduction in the number of electricity metering components (also referred to
as
metering kit products) sold. The $13.5 million decrease in Enel Project revenues
for the nine months ended September 30, 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. Early in 2006, Enel asked us to provide them with spare parts
for
use in their system in Italy. We agreed to this request, and the $7.1 million
of
Enel project revenue recognized during the first nine months of 2006 represents
our shipments against this request. We do not currently expect any additional
revenue from the Enel project during 2006. However,
we recently signed agreements with Enel for the sale of additional products
and
the development of certain data concentrator software enhancements. We expect
revenues from these new agreements will commence in 2007, and will continue
through at least 2009, when the agreements are scheduled to
terminate.
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.
NES
revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
NES
revenues
|
|
$
|
199
|
|
$
|
162
|
|
$
|
37
|
|
|
22.8
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
NES
revenues
|
|
$
|
693
|
|
$
|
543
|
|
$
|
150
|
|
|
27.6
|
%
|
For
both
the three and nine-month periods ended September 30, 2006 and 2005, NES revenues
have primarily related to the completion of system trials and, to a lesser
extent, shipment of NES products.
During
2006, shipments of our NES products have increased significantly over 2005
levels, due primarily to the fact that in late 2005 and so far during 2006,
we
and our NES value-added reseller, or VAR, partners have won a number of
utility
tenders for intelligent metering systems in Sweden, the Netherlands, and
Australia, and have also entered into a variety trials of our NES system
in
other countries. While shipments have increased substantially during 2006,
we do
not expect that our 2006 NES revenues will grow at the same rate. This
is
because our ability to recognize revenue on shipments made in conjunction
with
these projects, 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 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.
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 the event of a contract award, we may hedge this additional
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.
EBV
revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
EBV
Revenues
|
|
$
|
4,255
|
|
$
|
3,686
|
|
$
|
569
|
|
|
15.4
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
EBV
Revenues
|
|
$
|
10,965
|
|
$
|
11,375
|
|
$
|
(410
|
)
|
|
(3.6
|
%)
|
Sales
to
EBV, our largest distributor and the sole independent distributor of our
LonWorks Infrastructure products in Europe, accounted for 32.0% of our total
revenues for the quarter ended September 30, 2006 and 22.7% of our total
revenues for the same period in 2005; and 25.3% of our total revenues for the
nine months ended September 30, 2006 and 20.5% for the same period in 2005.
We
believe the $569,000 increase between the two quarterly periods was due to
an
increase in demand for our LonWorks Infrastructure products by EBV’s customers,
due in part to EBV’s customers’ utilization of our products in new applications,
such as energy management and street lighting controls.
The
primary factor contributing to the $410,000 decrease between the two nine-month
periods 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 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 is then
recognized on these products, along with the corresponding gross margin, when
EBV sells them to its customers in future periods. This revision resulted in
a
one-time revenue decrease of approximately $2.9 million for the quarter ended
March 31, 2006. The revision did not have an impact on cash flows from
operations or require any changes to historical financial statements. Partially
offsetting the impact of the revenue recognition methodology revision was an
increase in EBV’s shipments to end-use customers for the reasons noted
above.
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.
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.
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Product
Revenues
|
|
$
|
13,110
|
|
$
|
16,068
|
|
$
|
(2,958
|
)
|
|
18.4
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Product
Revenues
|
|
$
|
42,893
|
|
$
|
54,852
|
|
$
|
(11,959
|
)
|
|
(21.8
|
%)
|
The
$3.0
million decrease in product revenues for the quarter ended September 30, 2006
as
compared to the same period in 2005 was primarily the result of a $4.3 million
decrease in Enel Project revenues, partially offset by a $1.3 million increase
in LonWorks
Infrastructure product revenues. The $12.0 million decrease in product revenues
for the nine months ended September 30, 2006 as compared to the same period
in
2005 was primarily the result of a $13.5 million reduction in Enel Project
revenues, partially offset by a $1.4 million increase in LonWorks
Infrastructure product revenues, and a $150,000 increase in NES product
revenues.
Service
revenues
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Service
Revenues
|
|
$
|
181
|
|
$
|
183
|
|
$
|
(2
|
)
|
|
(1.1
|
%)
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Service
Revenues
|
|
$
|
517
|
|
$
|
562
|
|
$
|
(45
|
)
|
|
(8.0
|
%)
|
The
$2,000 decrease in LonWorks
Infrastructure service revenues during the quarter ended September 30,
2006 as
compared to the same period in 2005, and the $45,000 decrease during the
nine
months ended September 30, 2006 as compared to the same period in 2005,
were the
result of a continued decrease in our customers’ use of our support and training
services. We believe that the worldwide economic recession, which began
in 2002
and continued through part of 2003, forced many of our customers to curtail
their spending for training and support. Although worldwide economic conditions
improved during the latter part of 2003, and currently remain reasonably
strong,
we do not expect our service revenues to increase over prior years’ levels. In
fact, we believe 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.
Gross
Profit and Gross Margin
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Gross
Profit
|
|
$
|
7,846
|
|
$
|
8,641
|
|
$
|
795
|
|
|
(9.2
|
%)
|
Gross
Margin
|
|
|
59.0
|
%
|
|
53.2
|
%
|
|
--
|
|
|
5.8
|
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Gross
Profit
|
|
$
|
25,202
|
|
$
|
30,678
|
|
$
|
(5,476
|
)
|
|
(17.8
|
%)
|
Gross
Margin
|
|
|
58.1
|
%
|
|
55.4
|
%
|
|
--
|
|
|
2.7
|
|
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
5.8
percentage point increase in gross margin during the third quarter of 2006
as
compared to the same period in 2005 was due to several factors, including the
mix of products sold as well as manufacturing and overhead absorption variances.
These overhead absorption variances were due primarily to increases in both
inventory and deferred cost of goods sold balances during the third quarter
of
2006. In accordance with U.S. generally accepted accounting principles, certain
indirect costs associated with the manufacture, procurement, and handling of
inventory are added, in the form of an overhead rate, to the stated cost of
the
inventory as of the balance sheet date. These indirect costs are subsequently
charged to cost of goods sold as the inventory is shipped and revenue is
recognized. If costs of goods sold are deferred in association with deferred
revenues, the corresponding indirect overhead costs are deferred as well.
Accordingly, when inventory and/or deferred cost of goods sold levels fluctuate
up or down, these capitalized indirect overhead costs also fluctuate and can
affect reported gross margins. For example, when inventory and/or deferred
cost
of goods sold levels increase, as they did during the third quarter of 2006,
a
portion of these indirect costs that would have otherwise been expensed during
the period are capitalized, thus having the effect of reducing current period
expenses and increasing gross margins. Conversely, when inventory and/or
deferred cost of goods sold levels decrease, previously capitalized indirect
costs are expensed, which increases period costs and reduces gross
margins.
Partially
offsetting these favorable impacts during the third quarter of 2006 was
the
impact of lower overall revenues. 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 September 30, 2006 as compared to the same period
in
2005, gross margins are unfavorably impacted. In addition, we also experienced
a
reduction in gross margin during the third quarter of 2006 resulting from
equity
compensation charges recorded in accordance with SFAS 123R. We adopted
SFAS 123R
in the first quarter of 2006 and began recording compensation expense associated
with stock options and other forms of equity compensation. This resulted
in a
$84,000 increase in our total cost of revenues during the third quarter
of 2006,
which had a corresponding effect of reducing our gross margin by 0.6 of
a
percentage point.
The
2.7
percentage point increase in gross margin during the first nine months
of 2006
as compared to the same period in 2005 was due primarily to the mix of
products
sold and favorable manufacturing and overhead absorption variances experienced
during the year-to-date period. Partially offsetting these favorable factors
were the impact of lower overall revenues on gross margins and SFAS 123R
equity
compensation charges. Equity compensation expense recorded under SFAS 123R
during the first half of 2006 increased our total cost of revenues by
approximately $307,000, which reduced our gross margin for the first nine
months
of 2006 by 0.7 of a percentage point.
We
expect
that, during the fourth quarter of 2006, our gross margins will decline
significantly from the 59.0% reported for the third quarter of 2006. This
anticipated decline is due in part to our expectation that, during the
fourth
quarter of 2006, we will recognize our first significant level of NES product
revenues, which generate lower overall gross margins than do our LonWorks
Infrastructure and Enel project revenues. To a lesser extent, we also believe
fourth quarter 2006 gross margins will decrease from third quarter reported
amounts as we do not currently expect the favorable manufacturing and overhead
absorption variances we have experienced so far this year to continue.
For the
full year 2006, we expect that overall gross margin will decrease slightly
from
the 55.6% experienced in 2005.
Operating
Expenses
Product
Development
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Product
Development
|
|
$
|
6,875
|
|
$
|
6,170
|
|
$
|
705
|
|
|
11.4
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Product
Development
|
|
$
|
21,029
|
|
$
|
18,747
|
|
$
|
2,282
|
|
|
12.2
|
%
|
Product
development expenses consist primarily of payroll and related expenses for
development personnel, facility costs, fees paid to third party consultants,
equipment and supplies, depreciation and amortization, and other costs
associated with the development of new technologies and products.
The
$705,000 and $2.3 million increases in product development expenses for the
quarter and nine month periods ended September 30, 2006 as compared to the
same
periods in 2005 were 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, increases in our product development
personnel headcount.
We
expect
that, during the fourth quarter of 2006, our product development expenses
will
increase over third quarter levels primarily due to increased development
efforts related to our NES system products. For full year 2006, we expect
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)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Sales
and Marketing
|
|
$
|
5,076
|
|
$
|
5,164
|
|
$
|
(88
|
)
|
|
(1.7
|
%)
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Sales
and Marketing
|
|
$
|
15,312
|
|
$
|
15,585
|
|
$
|
(273
|
)
|
|
(1.8
|
%)
|
Sales
and
marketing expenses consist primarily of payroll and related expenses
for sales
and marketing personnel, including commissions to sales personnel, advertising
and product promotion costs, travel and entertainment expenses, facilities
costs, and other costs associated with our sales and support
offices.
For
both
the quarter and nine months ended September 30, 2006, as compared to
the same
periods in 2005, the decrease in sales and marketing expenses was primarily
due
to reductions in salaries and wages paid to our sales and marketing staff,
travel and entertainment expenses, costs associated with tradeshows and
other
marketing communications expenses, and fees paid to third parties for
services
provided to our sales and marketing organization. Partially offsetting
these
reductions were increases in equity compensation expenses resulting from
our
adoption of SFAS 123R during the first quarter of 2006.
Also
contributing to the changes in sales and marketing expenses between the three
and nine month periods ended September 30, 2006 and 2005 was 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 Pound Sterling, and the Japanese Yen. These exchange
rate fluctuations increased our reported sales and marketing expenses during
the
three months ending September 30, 2006 by approximately $42,000, as, on average,
the U.S. dollar was weaker during the third quarter of 2006 as compared to
the
same period in 2005. However, for the nine months ending September 30 2006,
exchange rate fluctuations decreased our overall sales and marketing expenses
by
approximately $139,000, as, on average, the U.S. dollar was stronger against
these currencies than during same period in 2005.
We
expect
that, for full year 2006, our sales and marketing expenses will decrease over
2005 levels, as we believe the reduced sales and marketing spending trends
we
have experienced so far this year will continue for the remainder of 2006.
However, our sales and marketing expenses will continue to be affected by the
foreign currency exchange rates between the U.S. dollar and the local currencies
in which we operate. If the U.S. dollar were to weaken against these foreign
currencies, our future sales and marketing expenses would increase if local
currency spending remained steady. Conversely if the U.S. dollar were to
strengthen against these currencies, our future sales and marketing expenses
would decrease.
General
and Administrative
|
|
Three
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over2005
%
Change
|
|
General
and Administrative
|
|
$
|
3,746
|
|
$
|
8,550
|
|
$
|
(4,804
|
)
|
|
(56.2
|
%)
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
General
and Administrative
|
|
$
|
10,946
|
|
$
|
16,597
|
|
$
|
(5,651
|
)
|
|
(34.0
|
%)
|
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
$4.8
million decrease in general and administrative expenses during the quarter
ended
September 30, 2006 as compared to the same period in 2005 was primarily
attributable to the $5.1 million Enel arbitration award reflected in the
2005
results. Partially offsetting this was an increase in equity compensation
expenses between the two periods of approximately $200,000. The $5.6 million
decrease in general and administrative expenses during the nine-months
ended
September 30, 2006 as compared to the same period in 2005 was again primarily
due to the 2005 $5.1 million Enel arbitration award. To a lesser extent,
a $1.1
million reduction in legal and other administrative fees associated with
the
Enel arbitration, as well as reductions in other administrative costs such
as
travel and entertainment and bad debt expense, also contributed to the
decrease
between the two periods. Partially offsetting these decreases was a $794,000
increase in equity compensation expenses resulting from our 2006 adoption
of
SFAS 123R.
We
expect
that, for full year 2006, general and administrative costs will be slightly
lower than those incurred in 2005. Although we expect reduced spending
in 2006
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)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Interest
and Other Income, Net
|
|
$
|
1,586
|
|
$
|
1,225
|
|
$
|
361
|
|
|
29.5
|
%
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Interest
and Other Income, Net
|
|
$
|
4,384
|
|
$
|
3,567
|
|
$
|
817
|
|
|
22.9
|
%
|
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.
Of
the
$361,000 increase in interest and other income, net during the quarter ended
September 30, 2006 as compared to the same period in 2005, approximately
$401,000 was attributable to increased interest income. Similarly, of the
$817,000 increase in interest and other income, net during the nine months
ended
September 30, 2006 as compared to the same period in 2005, approximately $1.5
million was attributable to increased interest income. These increases are
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 these increases in interest income between
the two three and nine-month periods ending September 30, 2006 and 2005, 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)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Provision
for Income Taxes
|
|
$
|
80
|
|
$
|
100
|
|
$
|
(20
|
)
|
|
(20.0
|
%)
|
|
|
Nine
Months Ended
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
September
30,
2006
|
|
|
September
30,
2005
|
|
|
2006
over 2005
$
Change
|
|
|
2006
over 2005
%
Change
|
|
Provision
for Income Taxes
|
|
$
|
240
|
|
$
|
300
|
|
$
|
(60
|
)
|
|
(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. Income taxes of $80,000 and $100,000
for the
quarters ended September 30, 2006 and 2005, respectively, and $240,000 and
$300,000 for the nine months ended September 30, 2006 and 2005, respectively,
consist primarily 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 as well as
state
minimum taxes. 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 optional 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 nine 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 nine 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 $142,000 during the quarter ended September 30,
2006, and $115,000 for the same period in 2005. Royalty expense was
approximately $352,000 for the nine months ended September 30, 2006, and
$363,000 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 September 30, 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 September
30, 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
September 30, 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
|
|
$
|
27,828
|
|
$
|
5,050
|
|
$
|
9,385
|
|
$
|
9,440
|
|
$
|
3,953
|
|
Purchase
commitments
|
|
|
24,265
|
|
|
24,130
|
|
|
135
|
|
|
--
|
|
|
--
|
|
Total
|
|
$
|
52,093
|
|
$
|
29,180
|
|
$
|
9,520
|
|
$
|
9,440
|
|
$
|
3,953
|
|
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 September 30,
2006, we have raised $278.1 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 5.0 million 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 and March 2006, 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 2,050,066
shares under the program at a cost of $14.8 million. As of September 30,
2006,
949,934 shares are available for repurchase. The stock repurchase program
will
expire in March 2007.
The
following table presents selected financial information as of September 30,
2006
and for each of the last three fiscal years (dollars in thousands):
|
|
September
30,
2006
|
|
2005
|
|
2004
|
|
2003
|
|
Cash,
cash equivalents, and short-term investments
|
|
$
|
129,792
|
|
$
|
154,480
|
|
$
|
160,364
|
|
$
|
144,923
|
|
Trade
accounts receivable, net
|
|
|
17,086
|
|
|
11,006
|
|
|
17,261
|
|
|
20,110
|
|
Working
capital
|
|
|
138,140
|
|
|
157,474
|
|
|
173,391
|
|
|
160,745
|
|
Stockholders’
equity
|
|
|
162,762
|
|
|
181,308
|
|
|
211,062
|
|
|
200,924
|
|
As
of
September 30, 2006, we had $129.8 million in cash, cash equivalents, and
short-term investments, a decrease of $24.7 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 provided by (used in) operating activities.
Net cash
provided by (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 $16.2 million for the nine months
ended September 30, 2006, a $16.5 million increase from the same period in
2005.
During the nine months ended September 30, 2006, net cash used in operating
activities was primarily a result of our net loss of $17.9 million and changes
in our operating assets and liabilities of $5.2 million, partially offset by
stock-based compensation expenses of $3.7 million, depreciation and amortization
expense of $3.3 million, and a reduction in our bad debt reserve balance of
$32,000. During the nine months ended September 30, 2005, net cash provided
by
operating activities was primarily the result of changes in our operating assets
and liabilities of $13.8 million, depreciation and amortization expense of
$3.1
million, and stock-based compensation expenses of $356,000, partially offset
by
our net loss of $17.0 million.
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 $16.2 million for the nine months ended
September 30, 2006, an $8.9 million increase from the same period in 2005.
During the nine months ended September 30, 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 $68.1 million, partially offset
by
purchases of available-for-sale short-term investments of $47.8 million, capital
expenditures of $4.1 million, and changes in our other long-term assets of
$106,000. During
the nine months ended September 30, 2005, net cash provided by investing
activities was primarily the result of proceeds of $89.8 million from sales
and
maturities of available-for-sale short-term investments, an $11.1 million
reduction in our restricted investments, and changes in our other long-term
assets of $250,000, partially offset by purchases of $92.4 million of
available-for-sale short-term investments and capital expenditures of $1.5
million.
Net
cash provided by (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 $5.1
million for the nine months ended September 30, 2006, a $2.8 million decrease
over the same period in 2005. During both the nine month periods ended September
30, 2006 and 2005, net cash used in financing activities was primarily
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 and nine months ended September 30, 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 October 31, 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. 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. As of October 31, 2006, a
representative of Enel has not been appointed to our board.
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 and nine months ended September 30, 2006, we recognized revenue from
products and services sold to Enel and its designated manufacturers of
approximately $53,000 and $7.1 million, respectively. As of September 30,
2006,
$4.1 million of our total accounts receivable balance related to amounts
owed by
Enel and its designated manufacturers. For
the
quarter and nine months ended September 30, 2005, we recognized revenue from
products and services sold to Enel and its designated manufacturers of
approximately $4.4 million and $20.6 million, respectively. As of September
30,
2005, $5.3 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, and, as of September 30, 2006,
have also completed the $7.1 million worth of spare parts Enel ordered from
us
in early 2006.
RECENTLY
ISSUED
ACCOUNTING
STANDARDS
In
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
157 (“SFAS 157”), Fair
Value Measurements.
SFAS
157 defines fair value as used in numerous accounting pronouncements,
establishes a framework for measuring fair value in generally accepted
accounting principles (GAAP) and expands disclosure related to the use of fair
value measures in financial statements. SFAS 157 does not expand the use of
fair
value measures in financial statements, but standardizes its definition and
guidance in GAAP. The Standard emphasizes that fair value is a market-based
measurement and not an entity-specific measurement based on an exchange
transaction in which the entity sells an asset or transfers a liability (exit
price). SFAS 157 establishes a fair value hierarchy from observable market
data
as the highest level to fair value based on an entity’s own fair value
assumptions as the lowest level. SFAS 157 is to be effective for our financial
statements issued in 2008; however, earlier application is encouraged. We
believe that the adoption of SFAS 157 will not have a material impact on our
consolidated financial statements.
In
September 2006, the Securities and Exchange Commission (SEC) released Staff
Accounting Bulletin No. 108 (“SAB 108”), Considering
the Effects of Prior Year Misstatements When Quantifying Misstatements in
Current Year Financial Statements.
SAB 108
provides guidance on how the effects of the carryover or reversal of prior
year
financial statement misstatements should be considered in quantifying a current
year misstatement. Prior practice allowed the evaluation of materiality on
the
basis of (1) the error quantified as the amount by which the current year income
statement was misstated (rollover method) or (2) the cumulative error quantified
as the cumulative amount by which the current year balance sheet was misstated
(iron curtain method). Reliance on either method in prior years could have
resulted in misstatement of the financial statements. The guidance provided
in
SAB 108 requires both methods to be used in evaluating materiality. Immaterial
prior year errors may be corrected with the first filing of prior year financial
statements after adoption. The cumulative effect of the correction would be
reflected in the opening balance sheet with appropriate disclosure of the nature
and amount of each individual error corrected in the cumulative adjustment,
as
well as a disclosure of the cause of the error and that the error had been
deemed to be immaterial in the past. The provisions of SAB 108 are effective
as
of the beginning of our 2007 fiscal year. We believe that the adoption of SAB
108 will not have a material impact on our consolidated financial
statements.
In
July
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48 (“FIN 48”),
Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement
No. 109,
which
clarifies the accounting for uncertainty in tax positions. This Interpretation
requires that we recognize in our financial statements the impact of a tax
position if that position is more likely than not of being sustained on audit,
based on the technical merits of the position. The provisions of FIN 48 are
effective as of the beginning of our 2007 fiscal year, with the cumulative
effect, if any, of the change in accounting principal recorded as an adjustment
to opening retained earnings. We are currently evaluating the impact of adopting
FIN 48 on our condensed consolidated financial statements.
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 we have 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. The adoption of SFAS 154 did not have a material
impact on our consolidated financial statements.
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 $7.1 million in 2006, all of which was recognized during the
first
nine months of 2006. In October 2006, we entered into two additional agreements
with Enel, a new development and supply agreement and a software enhancement
agreement. Under the new development and supply agreement, Enel will purchase
additional metering kit and data concentrator products from us, assuming initial
acceptance tests are completed successfully. Under the software enhancement
agreement, we will provide software enhancements to Enel for use in its
Contatore Elettronico system. We do not currently anticipate any material
revenues from either of these new agreements during 2006. Accordingly, we
continue to seek new revenue opportunities with 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 a 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 occur in early 2007, we expect Nuon will
issue a public tender for an even larger deployment within their service
territory. However, there is no assurance 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 a 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 revenue
recognition, we do not believe we will be able to replace the expected
$19.8
million reduction in Enel revenues in 2006.
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 significantly 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, particularly
as we ramp up production of these 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.
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, or purchase of our products, 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
significantly harmed.
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 32.0% of our
total
net revenues for the quarter ended September 30, 2006, and 22.7% for the
same
period in 2005; and 25.3% of our total net revenues for the nine months ended
September 30, 2006, and 20.5% for the same period in 2005. Worldwide sales
to
distributors, including those to EBV, accounted for approximately 46.3% of
total
net revenues for the quarter ended September 30, 2006, and 32.3% of our total
net revenues for the same period in 2005; and 34.4% of total net revenues
for
the nine months ended September 30, 2006, and 28.2% 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, our 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. Any replacement distribution channel could prove
less
effective than EBV.
We
market
our NES system products directly, as well as through selected 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.
|
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 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
Flextronics. 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, and because our products
may
use components or materials that are subject to price fluctuations, 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. In addition, our products may incorporate components or
materials that are subject to price fluctuations. For example, we use copper
in
our NES meters and other products, and the price of copper has been very
volatile recently. As a result, we may be vulnerable to price increases for
products, components, or materials. 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.
During
the first nine months of 2006, we generated a loss of $17.9 million. As of
September 30, 2006, we had an accumulated deficit of $102.0 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;
|
· |
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, ongoing amortization
expenses
related to other identified intangible assets, and ongoing operational
expenses associated with the acquired
entity;
|
· |
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 60.9% of
our
total net revenues for the quarter ended September 30, 2006, and 72.4% of our
total net revenues for the same period in 2005; and 66.3% of our total revenues
for the nine months ended September 30, 2006, and 77.3% 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
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 6.7% for the quarter ended September 30, 2006, and
5.3%
for the same period in 2005; and 5.4% for the nine months ended September 30,
2006, and 4.6% 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 have not historically engaged in currency hedging transactions
or
otherwise covered our foreign currency exposures.
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 nine months of 2006 we generated additional losses
of $17.9 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, such as acceptance
criteria, are met in a future period;
|
· |
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;
|
· |
market
prices for components or materials that we use in our products
could
fluctuate;
|
· |
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, ongoing amortization
expenses related to other identified intangible assets, and
ongoing operational expenses associated with the acquired
entity;
|
· |
our
product distribution may change;
|
· |
product
ratings by industry analysts and endorsements of competing products
by
industry groups could hurt the market acceptance of our products;
and
|
· |
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.
|
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. In addition, 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, 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 October 31, 2006, we have 96 issued U.S. patents,
11 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;
|
· |
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
October 31, 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
36.1% 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. As of October 31, 2006, a representative of Enel has not been
appointed to our board.
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.
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 currently 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 September 30, 2006 and
September 30, 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 September 30, 2006, and September 30, 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.
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” (as defined in the
Securities Exchange Act of 1934, or the Exchange Act, Rules 13a-15(e) and
15d-15(e)) 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.
Conclusions
Regarding Disclosure Controls and Procedures and Internal Controls Over
Financial Reporting
Our
CEO
and our CFO have reviewed our disclosure controls and procedures and our
internal controls over financial reporting in order to both evaluate their
effectiveness and to ensure they have been designed to provide reasonable
assurance of achieving their objectives, which is to make sure 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. Based on this
evaluation, they have concluded that as of September 30, 2006, our disclosure
controls and procedures and our internal controls over financial reporting
are
effective at this reasonable assurance level.
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
September 30, 2006 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
PART
II. OTHER INFORMATION
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 “Factors That May Affect Future Results of Operations” in
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations,” contained in Item 2 of Part I of this report. This restated
description includes any material changes to and supersedes the description
of
the risk factors associated with our business previously disclosed in Part
I
Item 1A of our 2005 Annual Report on Form 10-K and in Part II Item 1A of our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2006, and is
incorporated herein by reference.
The
following table provides information about the
repurchase of our common stock during the quarter ended September 30,
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
|
|
July
1- July 31
|
|
|
111,090
|
(1)
|
$
|
7.82
|
|
|
1,838,544
|
(1)
|
|
1,161,456
|
|
August
1- August 31
|
|
|
211,522
|
|
$
|
7.98
|
|
|
2,050,066
|
|
|
949,934
|
|
September
1- September 30
|
|
|
---
|
|
|
---
|
|
|
2,050,066
|
|
|
949,934
|
|
Total
|
|
|
322,612
|
|
$
|
7.92
|
|
|
2,050,066
|
|
|
949,934
|
|
(1) |
Shares repurchased in open-market
transactions under the stock repurchase program approved by our board
of
directors in March and August 2004 and March 2006. 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 September 30, 2006, we repurchased 322,612 shares
under
the program at a cost of $2.6 million. Since
inception, we have repurchased a total of 2,050,066 shares under the
program at a cost of $14.8 million. The
stock repurchase program will expire in March
2007. |
Exhibit
No.
|
Description
of Document
|
31.1
|
|
31.2
|
|
32
|
|
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
|
|
|
ECHELON
CORPORATION
|
Date: November
9, 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
|
Certificate
of Echelon Corporation Chief Executive Officer pursuant to Section
302 of
the Sarbanes-Oxley Act of 2002.
|
31.2
|
Certificate
of Echelon Corporation Chief Financial Officer pursuant to Section
302 of
the Sarbanes-Oxley Act of 2002.
|
32
|
Certification
by the Chief Executive Officer and the Chief Financial Officer pursuant
to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, furnished
herewith.
|