Back to GetFilings.com



 
UNITED STATES
 
SECURITIES AND EXCHANGE COMMISSION
 
WASHINGTON, D.C. 20549
 
FORM 10-K
(Mark One)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
r
TRANSITION REPORT PURSUANT TO SECTION 13 Or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________ to __________.
Commission file number: 000-29748
 
ECHELON CORPORATION
 
(Exact name of registrant as specified in its charter)
Delaware
77-0203595
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)
550 Meridian Avenue
San Jose, California 95126
(Address of principal executive office and zip code)
(408) 938-5200
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock $0.01 par value
Name of each exchange which registered: NASDAQ National Market
 
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 such filing requirements for the past 90 days. Yes x No r
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K. x
 
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No r
 
As of June 30, 2003 , the last business day of the Registrant’s most recently completed second fiscal quarter, there were 40,080,500 shares of the Registrant’s common stock outstanding, and the aggregate market value of such shares held by non-affiliates of the Registrant (based on the per share closing sale price of $13.93 of such shares on the Nasdaq National Market on June 30, 2003) was approximately $373.4 million. Shares of the Registrant’s common stock held by each executive officer and director and by each entity that owns 5% or more o f the Registrant’s outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of February 29, 2004, 40,467,998 shares of the registrant’s common stock, $.01 par value per share, were issued and outstanding.
 


  1  

ECHELON CORPORATION
FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2003

INDEX

 
 
 
Page
 
 
PART I
 
Item 1.
 
Business
3
Item 2.
 
Properties
16
Item 3.
 
Legal Proceedings
16
Item 4.
 
Submission of Matters to a Vote of Security Holders
16
 
 
PART II
 
Item 5.
 
Market for the Registrant’s Common Equity and Related Stockholder Matters
17
Item 6.
 
Selected Financial Data
18
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
19
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
49
Item 8.
 
Financial Statements and Supplementary Data
49
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
49
Item 9A.
 
Controls and Procedures
49
 
 
PART III
 
Item 10.
 
Directors and Executive Officers of the Registrant
51 
Item 11.
 
Executive Compensation
51 
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management
51 
Item 13.
 
Certain Relationships and Related Transactions
51 
Item 14.
 
Principal Accountant Fees and Services
51 
 
 
PART IV
 
Item 15.
 
Exhibits, Financial Statement Schedule, and Reports on Form 8-K
52 
 
 
 
 
SIGNATURES
79
EXHIBIT INDEX
80 
 
 



DOCUMENTS INCORPORATED BY REFERENCE
 
(1)   Certain sections of the Registrant’s proxy statement filed in connection with its annual meeting of stockholders, to be held on May 21, 2004, are incorporated by reference into Part III of this Form 10-K where indicated.
 
  2  
 

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 or strategies regarding the future that are forward-looking. These statements include those discussed in Item 1, Business, including "General," "Industry Background," "Our Solution," "Strategy," "Markets, Applications and Customers," "Products and Services" and "Product Development," in Item 2, "Properties," in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including "Critical Accounting Policies," "Results of Operations,"
"Off-Balance-Sheet Arrangements and Other Contractual Obligations," "Liquidity and Capital Resources," "Acquisitions," "Related Party Transactions," "Recently Issued Accounting Standards," "Equity Based Compensation," and "Factors That May Affect Future Results of Operations," and elsewhere in this report. In this report, the words "anticipate," "believe," "expect," "intend," "future," "moving toward" and 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 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. All f orward-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

ITEM 1.   BUSINESS

General

We develop, market and support hardware and software products and services that allow everyday devices — such as appliances, thermostats, air conditioners, electricity meters, and lighting systems — to communicate with one another and across the Internet. These everyday devices can be collected into systems, sometimes called control networks, in which the devices communicate with one another to perform a control or monitoring application. Control networks manage key functions in virtually all types of facilities that affect our daily lives — from heating, lighting, security, and elevators in buildings, to the electricity meters in homes and businesses, to the brakes in freight trains, to the equipment in waste water treatment plants, to the lights in your home. Our products and services can be used across many industries to network together everyday devices used by utilities, buildings, factories, transportation, homes and other systems.
 
Our products and services are based on our LONWORKS ® technology. Our LONWORKS technology is an open standard, meaning that many official standards-making bodies have published industry standards based on all or parts of our technology and that many of our technology patents are broadly licensed without royalties or license fees. LON WORKS technology also allows control networks to be interoperable, meaning that products or subsystems from multiple vendors can be integrated into a unified system without the need to develop custom hardware or software. As a result, our products allow original equipment manufacturers, or OEMs, and systems integrators, who are specialty contractors that combine products from multiple suppliers into integrated systems, to design and put into service open, interoperable control networks.

Traditionally, most commercial control systems have used closed, centrally-controlled architectures, in which the control is centralized or hard-wired. Open control networks based on LONWORKS technology are an alternative to the traditional approach of closed, centralized control. We believe that closed, centrally-controlled systems are more costly to install, less reliable, and more difficult to customize than open control networks based on our technology. Compared with traditional control systems, we believe that open control networks based on our technology can reduce life-cycle costs, are more flexible than cen tralized systems and permit control systems to be comprised of products and services from a variety of vendors. As a result, LONWORKS control networks can enable new applications while providing improved reliability, serviceability, and functionality.

 
 
  3  
 
 
 
Our LONWORKS control networking technology allows intelligence to be embedded into individual control devices, allowing the devices to make independent processing decisions based on values read from locally attached sensors or on feedback from local control actions. Each LONWORKS device is also inherently capable of communicating the information it knows with other devices in its control network and taking actions based on information that it receives from other devices. Communicat ions can be done across a variety of communications media, such as a twisted pair of wires or data cable, the existing power lines in a facility, radio frequency communication, or any Internet protocol-based network, such as corporate intranets or the Internet. By sensing and controlling their local environment, sharing this information with their peers, and taking actions based on information received from other devices, LONWORKS devices work together to perform the desired control functions. In effect, the network itself becomes the controller, enabling control to be distributed throughout the network, eliminating the need for central controllers, significantly reducing wiring costs, and enhancing the functionality and flexibility of the control system. In addition, by connecting to the Internet, LONWORKS networks allow devices that were once isolated by their physical location to be reached from anywhere in the world. Important data that previously could not be obtained can now be integrated into enterprise-wide information systems to lower costs and increase revenues. For example, a LONWORKS based occupancy sensor might detect motion within a room through local sensing hardware and publish this information onto the net work. Using the information from the occupancy sensor along with its own knowledge of the state of the building, a LONWORKS based security alarm could decide if the motion is authorized or not and if an alarm should be sounded. A LONWORKS based electronic ballast might receive this same information and turn on to illuminate the room. A LONWORKS based heating system might also use this same information to restore the room to the occupant’s preferred temperature. All of these actions might be transmitted over the Internet to the company’s headquarters to enable the company to better manage its facili ties and energy costs.

Our products and services provide the infrastructure and support required to build and implement multi-vendor, open, interoperable networks of everyday devices. Our wide-ranging product offerings include transceivers, concentrator products, control modules, routers, network interfaces, development tools, and software tools and toolkits. Through our project with Enel S.p.A., or Enel, the largest electric utility in Italy, we also provide products that enable electricity metering and other home networking functions to be networked across the utility’s service area. Our objective is to establish our LONWORKS technology and products as a leading solution for networking everyday devices for control applications.

We market our network infrastructure products and services to OEMs and systems integrators in the building, industrial, transportation, utility/home, and other automation markets. We sell primarily through a direct sales force in North America and other countries where we have marketing and sales operations. We also sell our products through distributors in Europe, Japan, South America, and various Asia Pacific countries. Representative customers include Enel (including its contract manufacturers for electricity meters: China National Machinery and Equipment Import and Export Corporation, Finmek Access S.p.A., Celestica Italy S.r.L., and Jabil Circuit Italia S.r.L.), Honeywell, TAC AB (a wholly owned subsidiary of Schneider Electric), Siemens, Inve nsys Intelligent Systems, Schindler Elevator, Johnson Controls, Fuji Electric, NTT Data, Samsung, and BOC Edwards.

In December 2003, we began shipments of our networked energy services, or NES, system, which we market directly and through selected value added resellers and integration partners, to electric utilities, primarily in Europe and Asia. The NES system is built upon our LONWORKS platform and consists of a set of intelligent, communicating digital electricity meters, data concentrators that supervise and manage meters, and server software based on our PanoramixTM enterprise software platform. By providing an open, bidirectional, and extensible infrastructure to enable a comprehensive range of utility applicat ions, we believe that the NES system brings cost savings in a wide range of utilities functions, from metering and customer services to distribution operations and value-added business. We believe that, in total, the benefits derived from our NES system deliver a more compelling return on investment than "traditional" automatic meter reading, or AMR, systems, which provide limited functionality, often over proprietary, one-way networks.
 
In the third quarter of 2000, we completed a transaction with Enel whereby Enel purchased three million newly issued shares of our common stock for a purchase price of $130.7 million in cash. In the second quarter of 2000, we entered into a research and development agreement with an affiliate of Enel, under which we have been cooperating with Enel to integrate our LONWORKS technology into Enel’s remote metering project in Italy. Through this project, which is called the Contatore Elettronico, Enel is replacing its existing stand-alone electricity meters with networked electricity meters to 27 million customers throughout Enel’s service territory. We sell a variety of electronic components and finished goods to Enel and its contract manufacturers for use in the Contatore Elettronico project. We began to ship products to Enel for use in the project in late 2000. During 2002 and 2003, we increased the volume of these shipments.

Although we had a net operating loss of $357,000 for full year 2001, we generated our first-ever operating profit in the fourth quarter of 2001 in the amount of $4.4 million. Our full year 2001 results included $534,000 of intangible amortization expense related to our acquisition of ARIGO Software, GmbH, or Arigo, in February 2001. In 2002, we generated an operating profit of $14.4 million. Included in our 2002 results were a $400,000 charge related to in-process research and development, or IPR&D, expensed in connection with our February 2002 acquisition of BeAtHome.com, Inc., or BeAtHome, as well as $344,000 of amortization expense related to intangible assets acquired from Arigo and BeAtHome. Although we remained profitable in 2003, our ope rating profit decreased to $278,000. Included in our 2003 results were a $9.8 million IPR&D charge related to our April 2003 acquisition of certain assets of Metering Technology Corporation, or MTC, as well as $1.1 million of amortization expense related to intangible assets acquired from Arigo, BeAtHome, and MTC.

 
 
  4  
 
 
 
Our total revenues for 2003 declined to $118.2 million from $122.8 million in 2002. Total revenues in 2001 were $76.6 million. Enel, our largest customer during 2003, 2002, and 2001, accounted for 64.2% of total revenues for 2003, 66.4% of total revenues for 2002, and 40.5% of total revenues for 2001. These revenues included sales of components to Enel’s contract manufacturers. Our second largest customer, EBV, the sole independent distributor of our products in Europe, accounted for 10.2% of total revenues for 2003, 9.2% of total revenues for 2002, and 16.9% of total revenues for 2001.

We were incorporated in California in 1988 and reincorporated in Delaware in 1989. Our corporate headquarters are located at 550 Meridian Avenue, San Jose, California 95126. In March 2003, we received ISO 9001 certification at this facility. Our telephone number is 408-938-5200. We maintain a Web site at www.echelon.com . Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC Web site at www.sec.gov.
 
Industry Background

Control systems manage key functions in a variety of facilities. For example, a common application of a control system is to allow a thermostat to communicate with other equipment in a building to automatically adjust temperature and airflow. In addition to interconnecting and monitoring heating, ventilation, and air conditioning, or HVAC, control systems are used in buildings to manage such functions as elevators, lighting, security, and access control. Electric utilities may use control systems to remotely turn power on or off to a customer, read usage information from a meter or detect a service outage. In industrial facilities, control systems are used to automate semiconductor manufacturing equipment, oil pumping stations, waste water treatmen t plants, textile dyeing machinery, and a myriad of other applications. In transportation systems, control systems are used to regulate such features as propulsion, braking and heating systems in trains, light rail cars, trucks, busses, and other vehicles. In homes, control systems have traditionally seen limited use in high-end residences for lighting control, security, and other automation applications and in simple hobbyist-level automation systems.

Control systems consist of an array of hardware devices and software used to collect data from the physical world and convert that data to electrical signals. These signals, in turn, provide information that can be used to effect responses based upon pre-programmed rules and logic. Traditionally, most control systems have incorporated closed, centrally controlled architectures. These systems share many of the same drawbacks of centralized computing architectures that rely upon mainframes and minicomputers to communicate to "dumb" terminals that lack independent processing capabilities.

Products for control systems are typically designed and manufactured by OEMs that focus on one or more vertical markets, such as HVAC systems for buildings, or braking control systems for trains. Control systems are typically installed and maintained by systems integrators, and in some instances, by the in-house installation and maintenance divisions of OEMs. We believe that closed, centralized control systems have a number of inherent disadvantages for OEMs, systems integrators, and end-users.

OEMs, as the designers of control systems, and in some instances, as developers of their own network protocols, can incur significant development and ongoing support expense to implement and maintain their closed systems. In addition, supporting such a closed infrastructure can take valuable resources away from developing competitive applications and can limit the OEM’s ability to support the product development efforts of third party companies that use open platforms. Finally, centralized systems also risk complete shutdown if the central controller fails.

For systems integrators, it is typically very costly and time-consuming to install closed, centralized control systems because of the physical task of installing large amounts of wire and conduit to connect each component to one or more central controllers. Once the physical infrastructure is installed, specially trained and highly skilled personnel must program, install, and "debug" detailed control logic software in the controllers in order to manage the various components. If a facility incorporates control systems from more than one OEM, systems integrators may also have to spend considerable time connecting systems that were not designed to operate together, such as HVAC and fire/life/safety systems. This complex process can also make it expen sive and time consuming to modify the systems. End-users ultimately must pay for these products and services. However, because it can be so costly to install and modify closed, centrally controlled systems, end-users often cannot always acquire new applications at an affordable cost. We believe that these factors have reduced the market opportunity for both OEMs and systems integrators to sell new products, functions, and applications to end-users.
 
 
 
  5  
 
 
We believe that OEMs, systems integrators, and end-users are trying to overcome the limitations of closed, centralized control systems. Just like the computer industry’s move away from centralized computing architectures, we believe that, across a broad range of control applications, the controls industry is moving away from custom, wiring-intensive and closed interconnection schemes among various system components. We believe that the controls industry is moving towards open, interoperable, distributed architectures in which the intelligence resides in the devices sensing and controlling the physical infrastructure itself, and in the communication between these devices, rather than in central controllers.

With respect to electric utilities, the automated metering systems they employ have historically been proprietary in nature and have generally offered only one-way communication. These systems have typically focused on providing a single service, such as AMR, direct load control, outage detection, pre-paid metering, or time of use metering. We believe that such systems are inflexible and costly for the utilities to install and maintain. In addition, we believe that, as regulators look for utilities to offer consumers so called "real time pricing" or "demand response" programs, and as markets deregulate and the utilities look to lower their operating costs and improve their operating efficiency, utilities will begin to look for more flexible, open s ystems that allow them to offer a multitude of services to their customers, such as our NES system.

Our Solution

We develop, market, and support a family of hardware and software products and services that allows OEMs and systems integrators to design and implement open, interoperable, distributed control networks. Our LONWORKS networking technology allows intelligence and communications capabilities to be embedded into individual control devices. The intelligent, networked control devices are then able to communicate with each other to perform the desired control functions. For example, a temperature sensor might detect a change in temperature and send a message over the network that is received and acted upon by other devic es that have been configured to accept the message. This eliminates the need for central controllers, significantly reduces wiring costs, increases system reliability, enables the creation of systems that can perform more functions, and makes it easier to adapt the systems to the user requirements — both at the time of initial installation and over the life of the system as the end-users’ needs change. In addition, we believe that our products and services create new market opportunities because they allow devices that were previously not part of control systems, such as home appliances, to be cost-effectively made into smart, networked devices that communicate with one another and across the Internet. Further, the information communicated between the control devices can be integrated into corporate data applications, such as systems for enterprise resource planning, or ERP, or customer resource management, or CRM, to improve operational efficiency, lower cost, and increase quality.

We offer a broad set of products and services that provide the foundation and support required to build and implement open, interoperable networks of everyday devices using products from multiple vendors for the building, industrial, transportation, utility/home and other automation markets. With a control network that incorporates our LONWORKS products, everyday devices become smart and can communicate with one another and across the Internet using our LonTalk® protocol. Each device in the network contains embedded intelligence that implements the protocol and performs local sensing and control functions. At the core of this embedded intelligence is typically a Neuron® Chip, an integrated circuit that we initially designed. Neuron Chips are currently manufactured and sold by Toshiba and Cypress Semiconductor. In addition, we offer:


Based on our past experience, we believe that our family of products and services provides the following customer benefits:
Strategy

Our objective is to be the leading supplier of products and services used in the growing market for open, interoperable control networks. Key elements of our strategy include:
Success in the execution of our marketing strategy will require a continued emphasis on our key technical competencies, including, but not limited to, networking hardware and software technology, custom communications integrated circuit design, and system level solutions for networks that provide device management, monitoring, and control.
 

 
  8  
 
 
 
Working Capital

As of December 31, 2003, we had working capital, defined as current assets less current liabilities, of $160.7 million, which was an increase of approximately $4.4 million compared to working capital of $156.3 million as of December 31, 2002.

As of December 31, 2003, we had cash, cash equivalents, and short-term investments of $144.9 million, which was an increase of approximately $10.4 million compared to a balance of $134.5 million as of December 31, 2002. Additionally, as of December 31, 2003, we had $10.9 million of restricted investments that secure a $10.0 million line of credit under which no amounts have been drawn.

Cash provided by operating activities in 2003 of $23.7 million was primarily the result of net income of $1.9 million, non-cash operating charges (including depreciation, amortization, and in-process research and development) of $15.5 million, a $2.8 million decrease in accounts receivable, a $2.1 million decrease in net inventories, and a $1.0 million increase in accrued liabilities.

Markets, Applications and Customers

We market our products and services primarily in Europe, Japan and selected Asia Pacific countries, and North and South America. Our target markets include:


Products and Services

We offer a wide-ranging set of over 90 products and services marketed under the LONWORKS brand name. These products and services provide the infrastructure and support required to implement and deploy open, interoperable, control network solutions. All of our products either incorporate or operate with the Neuron Chip and/or the LONWORKS protocol. While we recommend broad use of several of our products with other products that we offer, there is no inherent requirement for a custom er to do so given our open networking technology. For instance, a customer’s product could use a transceiver purchased from a third party that is installed with software that uses our network operating system. Similarly, a customer’s product could use a transceiver purchased from us that is installed with software from a third-party.

Components for Use in Enel’s Contatore Elettronico Project. We provide a number of products and components to Enel and its contract manufacturers. We sell Enel data concentrators that provide wide area connectivity to and supervision of digital electricity meters. We sell meter kits to Enel’s contract manufacturers, which include components that are incorporated into digital electricity meters for Enel and that allow these meters to communicate over the power-line using the LonTalk protocol.

Components for Making Everyday Devices Smart and Network Connected. We provide a set of hardware products at various levels of integration designed to allow OEMs to embed networking and intelligence into their products. Our products in this range include power line and free topology twisted pair transceivers, power line and free topology smart transceivers, twisted pair and free topology control modules, and associated development tools including our NodeBuilder® development tool, which is designed to make it easy for OEMs to develop and test individual LONWORKS nodes or small networks of LONWORKS devices. The NodeBuilder tool uses a familiar Windows based development environment with easy-to-use online help. Our FTT-10A free topology transceiver product, which permits communication over a twisted pair of wires, generated approximately 9.7% of our revenues during 2003 and 11.5% of our revenues during 2002.

Network Connectivity Products. This suite of hardware products, some with embedded firmware, serves as the physical interface between the control software that resides on the managed devices and the cabling and wiring that provide the physical communications path. These products include a variety of routers, adapters, and IP connectivity products. LONWORKS routers provide transparent support for multiple media, which makes it possible to signal between different types of media, such as twisted pair, power line, radio frequency, optical fiber, and infrared. Routers can also be used to control network traffic and partition sections of the network from traffic in another area, increasing the total throughput and speed of the network. Adapter products include network interfaces that can be used to connect computers to a LONWORKS network and LonPoint ® interface modules, which convert a variety of legacy digital and analog sensors and actuators into intelligent and interoperable LONWORKS devices. Our family of i .LON products provides a variety of options for providing cost-effective, secure Internet connectivity to the everyday devices in LonWorks networks.
 
Software Products. Our LNS® network operating system serves as the platform for installing, maintaining, monitoring, and interfacing with control networks. The LNS family of products adds the power of client-server architecture and component-based software design into control systems and allows tools from multiple vendors to work together. The most recent release of LNS is version 3.1.

The LonMaker ä Integration Tool, which is built on the LNS network operating system and the Microsoft Visio technical drawing package, gives users a graphical, "drag and drop" environment for designing their network’s control system. The graphical nature of the LonMaker tool provides an intuitive interface for designing, installing, and maintaining multi-vendor, open, interoperable LONWORKS control networks. LNS allows multiple users, each running their own copy of the LonMaker tool or other LNS based tools, to utilize the system in parallel, thereby streamlining the design and commissioning process, and facilitating future adds, moves and changes. Our current version, release 3.1, began shipping in October 2001.
 
 
 
  10  
 
 
 
In March 2003, we introduced the Panoramix platform, a scalable enterprise software product designed to enable businesses to collect and manage data from device networks across multiple facilities and turn it into actionable business intelligence. Our current version, release 1.11, began shipping in March 2004.

Training and Support. We conduct a variety of technical training courses covering our LONWORKS network technology and products. These courses are designed to provide hands-on, in-depth and practical experience that can be used immediately by OEMs and systems integrators using LONWORKS systems. In addition to conducting these classes ourselves, we license them to third-part ies in foreign markets who present them in the local language. We also offer technical support to our customers on an annual contract basis. We provide these support services to resolve customers’ technical problems on a timely basis, ensure that our products will be used properly, and to shorten the time required for our customers to develop products that use our technology. As of February 29, 2004, we had 11 employees in the United States, Japan, China and the United Kingdom engaged in training and support.

NES System. In December 2003, we began shipments of our networked energy services, or NES, system. We market our NES system directly to electric utilities, and indirectly through selected value added resellers and integration partners, all of whom are primarily located in Europe and Asia. The NES system is built upon our LONWORKS platform and consists of a set of intelligent, communicating digital electricity meters, data concentrators that supervise and manage meters, and server software based on our Pano ramix enterprise software platform.
 
Sales and Marketing

We market and sell our products and services to OEMs and systems integrators to promote the widespread use of our LONWORKS technology. In addition, we believe that awareness of the benefits of LONWORKS networks among end-users will increase the demand for our products. We currently market our NES system directly, and through selected value added resellers and integration partners, to electric utilities, primarily in Europe and Asia.

In North America, we sell our products through a direct sales organization. Outside the United States, direct sales, applications engineering, and customer support are conducted through our offices in China, France, Germany, Hong Kong, Italy, Japan, the Netherlands, South Korea, and the United Kingdom. Each of these offices is staffed primarily with local employees. We support our worldwide sales personnel with application engineers and technical and industry experts working in our headquarters. We also leverage our selling efforts through the use of an in-house telephone sales staff. Internationally, we support our direct sales with the use of distributors who tend to specialize in certain geographical markets. In Europe, we sell our products that do not relate to our project with Enel principally through EBV, our sole independent European distributor, and through our direct sales force. Under the Contatore Elettronico project with Enel, we sell products directly to Enel and also sell components directly to Enel’s contract manufacturers. We rely solely on distributors in certain markets in the Asia Pacific region, including Australia and Taiwan, and in Latin America, through our distributor in Argentina. International sales, which include both export sales and sales by international subsidiaries, accounted for 86.5% of our total revenues for 2003, 88.2% of our total revenues for 2002, and 78.1% of our total revenues for 2001.

We maintain an authorized network integrator program to increase the distribution of our products through systems integrators worldwide. These third-party systems integrators design, install, and service control systems using our LonMaker tool, our LonPoint products, and other manufacturers’ products that meet the certification guidelines of the LonMark® Interoperability Association, thereby reducing dependence on single-vendor products, eliminating the risks of centralized, closed controllers, and supporting less complex, peer-to-peer system architectures. We provide these systems integrators with the training, tools, and products required to cost-effectively install, commission, and maintain open, multi-vendor distributed control systems based on LONWORKS control networks.

The LonMark Interoperability Association and the LonWorldâ Conference and Exhibition assist our marketing efforts. We formed the LonMark Interoperability Association in May 1994 and as of February 29, 2004 it had about 300 members. This Association, which is in the process of becoming an independent corporation under the name LonMark International, makes technical recommendations for interoperable use of LONWORKS technology and promotes the use o f open control networks based on the LONWORKS standard. The purpose of the LonWorld Conference and Exhibition is to provide a forum in which parties can share recent information concerning LONWORKS technology and applications, build alliances, and support the LONWORKS standard for control networking. The most recent LonWorld Conference and Exhibition was held in October 2003 in Munich, Germany.
 
 
 
  11  
 
 
 
Strategic Alliances

Neuron Chips, which are important components used by our customers in control network devices, are currently manufactured and distributed by Toshiba and Cypress Semiconductor. Motorola also manufactured and distributed Neuron Chips until January 31, 2001. We presently have licensing agreements with both Cypress Semiconductor and Toshiba. Among other things, the agreements grant Cypress and Toshiba the worldwide right to manufacture and distribute Neuron Chips using technology licensed from us and require us to provide support and unspecified updates to the licensed technology over the terms of the agreements. The Cypress agreement expires in April 2009 and the Toshiba agreement expires in January 2010. We developed the first version of the Neuron C hip, although Motorola, Toshiba, and Cypress have subsequently developed improved, lower-cost versions of the Neuron Chip that are presently used in products developed and sold by us and our customers.

We entered into a Research and Development and Technological Cooperation Agreement with Enel Distribuzione S.p.A., a subsidiary of Enel, in June 2000. Under this agreement, we agreed to cooperate with Enel in the development of Enel’s Contatore Elettronico meter management project. The R&D Agreement expires, per its terms, in June 2005. The Contatore Elettronico project, which, among other things, will replace existing stand-alone electricity meters with networked electricity meters throughout Enel’s service territory in Italy, is intended to provide a variety of services, including the ability to:

The Contatore Elettronico project incorporates solid-state electricity meters designed by Enel and a third party. We have entered into supply agreements with various third party contract manufacturers who manufacture the meters for Enel. These contract manufacturers combine components purchased from us with other components to complete the manufacture of meters for sale to Enel. In addition, we sell a finished product, called a data concentrator, directly to Enel for use in the Contatore Elettronico project. We expect to complete the sale of our components and products for the Contatore Elettronico project during the first half of 2005.

In July 2001, we entered into an agreement with STMicroelectronics S.r.L. under which STMicroelectronics developed and produces our power line smart transceiver. The agreement expires in July 2011.

Product Development

Our future success depends in large part on our ability to enhance existing products, reduce product cost, and develop new products that maintain technological competitiveness. We have made and intend to continue to make substantial investments in product development. We obtain extensive product development input from customers and by monitoring end-user needs and changes in the marketplace. We continue to make significant engineering investments in bringing our software products, control and connectivity products, and development tools to market and extending our product offerings in the utility markets to customers beyond Enel. For example, we developed our NES system to provide a single, open infrastructure over which utilities can run a wide se t of functions to reduce costs and increase quality in a variety of functional areas, such as multi-tiered billing, pre-paid electricity, fault and outage detection, remote meter reading, and more accurate billing. Our NES system consists of intelligent, communicating electricity meters, IP connected data concentrators, and a software solution based on our Panoramix enterprise software platform.

Our total expenses for product development were $35.1 million for 2003, $21.5 million for 2002, and $17.0 million for 2001. Included in these amounts were acquisition related charges for in-process research and development and intangible amortization of $10.9 million in 2003, $744,000 in 2002, and $534,000 in 2001. We anticipate that we will continue to commit substantial resources to product development in the future and that product development expenses may increase in the future. To date, we have not recorded any capitalized software development costs from our development efforts.
 
 
 
  12  
 
 

As of February 29, 2004, we had 103 employees in our product development organization.
 
Competition
 
Competition in our markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions, and changes in customer requirements. To maintain and improve our competitive position, we must keep pace with the evolving needs of our customers and continue to develop and introduce new products, features and services in a timely and efficient manner. The principal competitive factors that affect the markets for our control network products include:
In each of our markets, we compete with a wide array of manufacturers, vendors, strategic alliances, systems developers, and other businesses. Our competitors include some of the largest companies in the electronics industry, such as Siemens in the building and industrial automation industries, and Allen-Bradley (a subsidiary of Rockwell) and Group Schneider in the industrial automation industry. Many of our competitors, alone or together with their trade associations and partners, have significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition and broader product offerings than us. 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 re spond 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 Motorola, Micro Chip, and Philips, all of which promote directly connecting devices to the Internet, could also compete with our products.
 
In the utility marketplace, products from companies such as Actaris, Atos Origin, DCSI, Elster, Hexagram, Hunt Technologies, Itron, Iskraemeco, Nexus, and Ramar, 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 Milab, could compete with our NES system in the utility marketplace. For example, Enel, our largest customer, could design a system that competes 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.
 
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, our products. 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 techno logies 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 that promote alternative open standards such as BACnet in the building market, DALI in the lighting controls market, and a group comprised of Asea Brown Boveri, 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.

LONWORKS technology is open, meaning that many of our technology patents are broadly licensed without royalties or license fees. For instance, all of the network management commands required to develop software that competes with our LNS software are published. As a result, our customers are capable of developing hardware and software solutions that compete with some of our products. Since some of our customers are OEMs who develop and market their own control systems, these customers in particular could develop competing products based on our open technology. This could decrease the market for our products and increase the competition that we face.    
 

 
  13  
 
 
 
Manufacturing

Our manufacturing strategy is to outsource production to third parties where it is more cost-effective and to limit our internal manufacturing to such tasks as quality inspection, system integration, testing, and order fulfillment. We maintain manufacturing agreements with Cypress and Toshiba, and until January 31, 2001 with Motorola, related to the Neuron Chip. We also maintain manufacturing agreements with STMicroelectronics for production of our power line transceiver, and with Cypress, On Semiconductor, and AMI Semiconductor for the production of certain components we sell to Enel and its designated contract manufacturers for use in Enel’s Contatore Elettronico project.
 
For most of our products requiring assembly, we use contract electronic manufacturers including WKK Technology, Able Electronics, and TYCO TEPC/Transpower. These contract electronic manufacturers procure material and assemble, test, and inspect the final products to our specifications.

Government Regulation

Many of our products and the industries in which they are used are subject to U.S. and foreign regulation as well as local, industry-specific codes and requirements. Government regulatory action could greatly reduce the market for our products. 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 our competitors’ products. We have resisted these efforts and will continue to oppose competitors’ efforts to use regulation to impede competition in the markets for our products.

Proprietary Rights

We own numerous patents, trademarks, and logos. As of February 29, 2004, we had received 91 United States patents, and had 6 patent applications pending. Some of these patents have also been granted in selected foreign countries. Many of the specific patents that are fundamental to LONWORKS technology have been licensed to our customers with no license fee or royalties. The principal value of the remaining patents relates to our specific implementation of our products and designs.

We hold several registered trademarks in the United States, including Echelon, LonBuilder, LonMark, LonTalk, LONWORKS, Neuron, LON, LonPoint, LonUsers, 3120, 3150, LNS, LonManager, Digital Home, and NodeBuilder. We have also registered some of our trademarks and logos in foreign countries.

Employees

As of February 29, 2004, we had 270 employees worldwide, of which 114 were in product development, 74 were in sales and marketing, 44 were in general and administrative, 27 were in operations, and 11 were in customer support and training. About 179 employees are located at our headquarters in California and 45 employees are located in other offices throughout the United States. Our remaining employees are located in nine countries worldwide, with the largest concentrations in Germany, Japan, the Netherlands, the United Kingdom, and Hong Kong. None of our employees is represented by a labor union. We have not experienced any work stoppages and we believe relations with our employees are good.

Where to Find More Information

We make our public filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all exhibits and amendments to these reports, available free of charge at our website, www.echelon.com , as soon as reasonably practicable after we file such material with the Securities and Exchange Commission. These materials are available in the "Investor Relations" portion of our website, under the link "SEC Filings." Information contained on our website is not incorporated by reference into our annual report on Form 10-K.

Executive Officers of the Registrant

M. Kenneth Oshman, age 63, has been our Chairman and Chief Executive Officer since December 1988. He also served as our President from 1988 to 2001. Mr. Oshman, with three associates, founded ROLM Corporation, a telecommunications equipment company, in 1969. He was Chief Executive Officer, President, and a director at ROLM from its founding until its merger with IBM in 1984. Following the merger, he became a Vice President of IBM and a member of the Corporate Management Board. He remained in that position until he left IBM in 1986. Prior to founding ROLM, Mr. Oshman was a member of the technical staff at Sylvania Electric Products from 196 3 to 1969. In addition to his responsibilities at our company, Mr. Oshman serves as a director of Sun Microsystems and Knight-Ridder. Mr. Oshman earned B.A. and B.S.E.E. degrees from Rice University and M.S. and Ph.D. degrees in Electrical Engineering at Stanford University.
 
 
 
  14  
 
 
 
Beatrice Yormark, age 59, has been our President and Chief Operating Officer since September 2001. She served as our Vice President of Marketing and Sales from January 1990 to August 2001. Ms. Yormark joined our company from Connect, Inc., an on-line information services company, where she was the Chief Operating Officer. Before joining Connect, Ms. Yormark held a variety of positions, including Executive Director of Systems Engineering for Telaction Corporation, Director in the role of Partner at Coopers & Lybrand, Vice President of Sales at INTERACTIVE Systems Corporation, and various staff positions at the Rand Corporation. In addition to her responsibilities at our company, Ms. Yormark serves as a director of ID Systems, (NASDAQ: IDSY). Ms. Yormark holds a B.S. degree in Mathematics from City College of New York and a M.S. degree in Computer Science from Purdue University.

Oliver R. Stanfield, age 54, has been our Executive Vice President & Chief Financial Officer since September 2001. He served as our Vice President and Chief Financial Officer from March 1989 to August 2001. Mr. Stanfield joined our company from ROLM, where he served in several positions since 1980, including Director of Pricing; Vice President, Plans and Controls; Vice President, Business Planning; Vice President, Financial Planning and Analysis; Treasurer; and Controller, Mil Spec Division. Prior to joining ROLM, Mr. Stanfield worked for ITEL Corporation, Computer Automation and Rockwell International. Mr. Stanfield began his business career with Ford Motor Company in 1969 in various accounting positions while completing a B.S. degree in Business Administration and an M.B.A. degree from the University of Southern California.

Anders B. Axelsson, age 44, has been our Senior Vice President of Sales & Marketing since June 2003. Prior to joining our company, he was Chief Executive Officer of PowerFile, Inc. From 1999 to 2001, he was President/General Manager of Snap Appliances, Inc. Between 1992 and 1999, he worked for Measurex, which was later acquired by Honeywell, and served in several positions, including Vice President of Engineering and Marketing and President/Managing Director for Europe. Mr. Axelsson started his career with ABB in 1981 where he worked for 11 years in various sales, marketing, and engineering management positions. He holds a B.S. in Elec trical Engineering from ED Technical Institute in Jonkpoing, Sweden and is a graduate of the Executive Program at the University of Michigan.

Kathleen Bloch, age 47, has been our Senior Vice President and General Counsel since February 2003. Prior to joining our company, Ms. Bloch was a partner in the law firm of Wilson Sonsini Goodrich & Rosati, P.C., where she practiced from 1996 to 2003. Prior to joining Wilson Sonsini Goodrich & Rosati, she was a partner with the San Francisco and Los Angeles offices of Sheppard Mullin Richter & Hampton. Ms. Bloch received a B.S. degree in Business Administration from the University of Southern California and her law degree from Stanford Law School.

Frederik Bruggink, age 48, has been our Senior Vice President and General Manager of our Service Provider Group since July 2002. He served as our Senior Vice President of Sales and Marketing from September 2001 to June 2002, and as our Vice President, Europe, Middle East and Africa, from April 1996 to August 2001. Mr. Bruggink joined our company in 1996 from Banyan Systems, where he was Vice President, Europe. From 1985 to 1993, Mr. Bruggink held several positions at Stratus Computer, including General Manager for Holland, Benelux, and Northern Europe. His last position at Stratus was Vice President, Northern Europe (including Germany). Prior to joining Stratus, he held sales positions at Burroughs Computers. Mr. Bruggink attended the University of Leiden.

Russell Harris, age 42, joined us in September 2001 as our Senior Vice President of Operations. Prior to joining our company, he served as the Vice President of Operations for NetDynamics from 1996 until its acquisition by Sun Microsystems in 1998. From 1991 to 1996, Mr. Harris was the Director of Operations at Silicon Graphics, Inc. From 1985 through 1991, he held various positions at Convergent Technologies and Unisys Corporation. His last position at Unisys was as Director of IT for Worldwide Operations. Mr. Harris earned B.S. and M.S. degrees in Industrial Engineering from Stanford University.

Peter A. Mehring, age 42, has been our Senior Vice President, Engineering since September 2001. He served as our Vice President, Engineering from March 1998 to August 2001. From January 1996 to March 1998, Mr. Mehring held a variety of positions at Umax Computer Corporation where he was a Founder, General Manager, and Vice President of Research and Development. Prior to joining Umax, Mr. Mehring held engineering management positions at Radius, Power Computing Corporation, Sun Microsystems, and Wang Laboratories. Mr. Mehring received a B.S. degree in Electrical Engineering from Tufts University, Massachusetts.

 
 
  15  
 
 
 
ITEM 2. PROPERTIES

We lease two buildings, each of which contains approximately 75,000 square feet of useable space, for our corporate headquarters in San Jose, California. We moved to this location in October 2001. The lease for the first building, which began in October 2001, requires minimum rental payments for ten years that total approximately $20.6 million. The lease for the second building, which began in May 2003, also requires minimum rental payments for ten years that total approximately $23.4 million.
 
In April 2003, in conjunction with our acquisition of certain assets of Metering Technology Corporation, or MTC, we entered into a sublease with MTC for a portion of their Scotts Valley, California facilities. This sublease expired on December 31, 2003.

We also lease office space for some of our sales and marketing employees in China, France, Germany, Hong Kong, Italy, Japan, the Netherlands, South Korea, and the United Kingdom and for some of our research and development employees in Livermore, California, Fargo, North Dakota, and Germany. The leases for these offices expire at various dates through 2008 and require minimum rental payments during that time that total approximately $1.1 million. The aggregate rental expense for this office space was approximately $1.2 million during 2003.

ITEM 3. LEGAL PROCEEDINGS
 
None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of our fiscal year ended December 31, 2003.
 
 
 
  16  
 
 
PART II


ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the Nasdaq National Market under the symbol "ELON." We began trading on Nasdaq on July 28, 1998, the date of our initial public offering. The following table sets forth, for the quarter indicated, the high and low sales price per share of our common stock as reported on the Nasdaq National Market.

 
 
Price Range
Year Ended December 31, 2003
 
High
Low
Fourth quarter
 
$15.33
10.15
Third quarter
 
18.73
11.89
Second quarter
 
15.00
10.35
First quarter
 
14.26
9.15
 
 
 
 
Year Ended December 31, 2002
 
High
Low
Fourth quarter
 
$15.75
8.41
Third quarter
 
16.00
8.36
Second quarter
 
20.84
11.10
First quarter
 
22.44
12.79

As of February 29, 2004, there were approximately 569 stockholders of record. Because brokers and other institutions hold many shares on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.

Dividend Policy

We have never paid dividends on our capital stock and do not expect to pay any dividends in the foreseeable future. We intend to retain future earnings, if any, for use in our business.

Equity Compensation Plan Summary Information

For information on our equity compensation plans, please refer to Note 6 to our accompanying consolidated financial statements, as well as Item 7, "Management’s Discussion and Analysis of Financial Condition and Results of Operations" under the section titled "Equity Based Compensation."
 
 
 
  17  
 
 
 
ITEM 6.   SELECTED FINANCIAL DATA

The following selected consolidated financial data has been derived from the audited consolidated financial statements. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, "Management’s Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and notes in Item 8 of this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below.

 
  
 
Year Ended December 31,
   
 
 
    
2003

 

 
2002

 

 
2001

 

 
2000

 

 
1999
 
   
 
 
 
 
 
Consolidated Statement of Operations Data:
 
(in thousands, except per share data) 
Net revenues:
   
 
    
 
    
 
    
 
    
 
  
Product    
 
$
117,153
 
$
121,454
 
$
74,777
 
$
47,261
 
$
37,546
 
Service    
   
1,000
   
1,380
   
1,812
   
2,038
   
2,220
 
   
 
 
 
 
 
Total revenues   
    
118,153
   
122,834
   
76,589
   
49,299
   
39,766
 
 
    
 
    
 
    
 
    
 
    
 
  
Cost of revenues:
   
 
    
 
    
 
    
 
    
 
  
Cost of product    
    
49,407
   
57,059
   
34,842
   
18,225
   
14,297
 
Cost of service    
   
2,650
   
2,880
   
2,347
   
2,017
   
1,529
 
   
 
 
 
 
 
Total cost of revenues 
   
52,057
   
59,939
   
37,189
   
20,242
   
15,826
 
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Gross profit    
    
66,096
   
62,895
   
39,400
   
29,057
   
23,940
 
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Operating expenses:
   
 
    
 
    
 
    
 
    
 
  
Product development   
   
35,113
   
21,456
   
17,028
   
11,159
   
9,214
 
Sales and marketing    
   
18,597
   
17,291
   
15,787
   
15,949
   
15,152
 
General and administrative    
   
12,108
   
9,711
   
6,942
   
5,787
   
4,101
 
Non-recurring charge/(benefit)    
   
--
   
--
   
--
   
(48
)
  
549
 
   
 
 
 
 
 
Total operating expenses   
    
65,818
   
48,458
   
39,757
   
32,847
   
29,016
 
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Operating income/(loss)
    
                278
   
14,437
   
(357
)
 
(3,790
)
 
(5,076
)
Interest and other income, net    
   
2,219
   
3,777
   
6,655
   
4,019
   
1,355
 
   
 
 
 
 
 
Income/(loss) before provision for income taxes    
    
2,497
   
18,214
   
6,298
   
229
   
(3,721
)
Provision for income taxes    
    
600
   
1,457
   
252
   
145
   
186
 
   
 
 
 
 
 
Net income/(loss)   
  
$
1,897
 
$
16,757
 
$
6,046
 
$
84
 
$
(3,907
)
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Income/(loss) per share (1):
   
 
    
 
    
 
    
 
    
 
  
Basic     
  
$
0.05
 
$
0.42
 
$
0.16
 
$
0.00
 
$
(0.12
)
   
 
 
 
 
 
Diluted   
  
$
0.05
 
$
0.41
 
$
0.15
 
$
0.00
 
$
(0.12
)
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Shares used in per share calculation (1):
   
 
    
 
    
 
    
 
    
 
  
Basic   
    
40,070
   
39,468
   
38,443
   
35,222
   
32,910
 
   
 
 
 
 
 
Diluted
   
40,792
   
40,726
   
41,141
   
39,734
   
32,910
 
   
 
 
 
 
 
 
    
 
    
 
    
 
    
 
    
 
  
Consolidated Balance Sheet Data:
   
 
    
 
    
 
    
 
    
 
  
Cash, cash equivalents and short-term investments   
  
$
144,923
 
$
134,489
 
$
111,653
 
$
150,793
 
$
24,304
 
Working capital    
    
160,745
   
156,319
   
151,748
   
164,377
   
30,290
 
Total assets    
    
214,128
   
207,492
   
185,654
   
175,676
   
39,711
 
Total stockholders’ equity    
    
200,924
   
195,018
   
174,717
   
168,761
   
32,938
 
                                 
 
(1)    See Note 2 of Notes to Consolidated Financial Statements for an explanation of shares used in computing basic net income/(loss) per share, and diluted net income/(loss) per share.
 
 
 
  18  
 
 
 
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto, included elsewhere in this Annual Report. The following discussion contains forward-looking statements including, without limitation, statements regarding our liquidity position and our expected overall growth that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below in "Factors That May Affect Future Results of Operations" and elsewhere in this Annual Report.
 
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 Southeast Asia. We develop, market and support a wide array of products and services based on our LonWorks technology that enable original equipment manufacturers, or 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, uti lity/home and other automation markets.

We sell certain of our products to Enel and certain suppliers of Enel for use in Enel’s electricity meter management project known as the Contatore Elettronico. We refer to Echelon’s revenue to Enel and Enel’s suppliers as Enel Project revenue. We refer to all other revenue as LONWORKS Infrastructure revenue. We have been investing in products for use by electricity utilities for use in management of electricity distribution. We believe that we will receive revenues from these investments beginning in 2004. We refer to this revenue as networked energy services, or NES, revenue. We also provide a variety of technical training courses related to o ur 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.
 
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 rea sonable 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 around the world. Sales to certain distributors are made under terms allowing limited rights of return. Sales to EBV, our largest distributor, accounted for 10.2% of total net revenues for 2003, 9.2% for 2002, and 16.9% for 2001. Worldwide sales to distributors, including those to EBV, accounted for approximately 14.6% of t otal net revenues for 2003, 14.2% for 2002, and 26.9% for 2001.

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 related to product revenues in the current period. In evaluating the adequacy of our sales returns and other allowances, management analyzes historical returns, current and historical economic trends, contractual terms, and changes in customer demand and acceptance of our products.

To estimate potential product returns from distributors other than EBV, management analyzes historical returns and the specific contractual return rights of each distributor. In the case of EBV, we further refine this analysis by reviewing month-end inventory levels at EBV, shipments in transit to EBV, EBV’s historical sales volume by product, and forecasted sales volumes for some of EBV’s larger customers. Significant management judgments and estimates must be made and used in connection with establishing these distributor-related sales returns and other allowances in any accounting period. Material differences may result in the amount and timing of our revenues for any period if management revises its judgments or estimates.
 
 
 
  19  
 
 

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 t hese products upon shipment to Enel. If Enel were to subsequently properly reject any material portion of a shipment for not meeting the agreed upon specifications, we would defer the revenue on that portion of the transaction until such time as Enel and we were able to resolve the discrepancy. Such a deferral could have a material impact on the amount and timing of our Enel related revenues.

We also provide for an allowance for sales discounts and rebates that we identify and reserve for at the time of sale. This reserve is primarily related to estimated future point of sale, or POS, credits to be issued to EBV. Under our arrangement with EBV, we have agreed to issue POS credits on sales they make to certain volume customers. We base this estimate on EBV’s historical and forecasted sales volumes to those customers. Significant management judgments and estimates must be made and used in connection with establishing these reserves for POS credits in any accounting period. Material differences may result in the amount and timing of our revenues for any period if management revises its judgments or estimates.

Our allowances for sales returns and other sales-related reserves were approximately $1.4 million as of December 31, 2003, and $2.1 million as of December 31, 2002.

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’ve 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 en vironment, 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 $500,000 as of December 31, 2003 and $570,000 as of December 31, 2002.

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 ne w 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 knowle dge 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 $205,000 as of December 31, 2003 and $229,000 as of December 31, 2002.

 
 
  20  
 
 
 
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 $47.8 million as of December 31, 2003 and $48.0 million as of December 31, 2002.

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:

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net goodwill and other intangible assets amounted to $8.8 million as of December 31, 2003.

We adopted SFAS 142 on January 1, 2002, and, as a result, ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. During 2002 and 2003, net goodwill increased by $6.5 million. For a reconciliation of this increase, please refer to Note 4 to our accompanying consolidated financial statements. The net balance of goodwill as of December 31, 2003 was $8.2 million. We review goodwill for impairment annually during the quarter ending March 31. 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.
 
 
 
  21  
 
 
 
Results of Operations
 
The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the twelve months ended December 31, 2003, 2002, and 2001:

 
  
Twelve Months Ended December 31,
   
 
   

2003 

 
2002 

 
2001 
  
   
 
 
 
Revenues:
   
 
    
 
    
 
  
Product    
    
99.2
%
 
98.9
%
 
97.6
%
Service    
    
0.8
   
1.1
   
2.4
 
   
 
 
 
Total revenues    
    
100.0
   
100.0
   
100.0
 
Cost of revenues:
   
 
    
 
    
 
  
Cost of product    
    
41.8
   
46.5
   
45.5
 
Cost of service    
    
2.3
   
2.3
   
3.1
 
   
 
 
 
Total cost of revenues    
    
44.1
   
48.8
   
48.6
 
   
 
 
 
Gross profit    
    
55.9
   
51.2
   
51.4
 
   
 
 
 
Operating expenses:
   
 
    
 
    
 
  
Product development    
    
29.7
   
17.5
   
22.2
 
Sales and marketing    
    
15.7
   
14.1
   
20.6
 
General and administrative    
    
10.3
 
7.9
   
9.1
 
   
 		  
     		  
 
Total operating expenses    
    
55.7
   
39.5
   
51.9
 
   
 
 
 
Income (loss) from operations    
    
                    0.2
   
11.7
   
(0.5
)
Interest and other income, net    
    
1.9
   
3.1
   
8.7
 
   
 
 
 
Income before provision for income taxes    
    
                   2.1
   
14.8
   
8.2
 
Provision for income taxes    
    
0.5
   
1.2
   
0.3
 
   
 
 
 
Net income    
    
1.6
%
 
13.6
%
 
7.9
%
   
 
 
 
 
Revenues
 
Total Revenues. Total revenues were $118.2 million for the year ended December 31, 2003, $122.8 million for the year ended December 31, 2002, and $76.6 million for the year ended December 31, 2001. The $4.6 million decrease in 2003 as compared to 2002 was primarily the result of a $5.7 million reduction in Enel Project related revenues partially offset by a $1.1 million increase in LONWORKS Infrastructure revenue. The $46.2 increase in revenues in 2002 as compared to 2001 was primarily the result of a $50.5 million increase in Enel Project revenues pa rtially offset by a $4.3 million decrease in LONWORKS Infrastructure revenue.
 
Product revenues. During 2003, product revenues decreased by $4.3 million, or 3.5%, to $117.2 million from $121.5 million in 2002. During 2002, product revenues increased by $46.7 million, or 62.4% from $74.8 million in 2001. The decrease in product revenues between 2003 and 2002 was attributable to the $5.7 million decrease in Enel program revenues partially offset by a $1.4 million increase in LONWORKS Infrastructure product revenues. The increase in product revenues between 2002 and 2001 was the result of the $50. 5 million increase in Enel Program revenues partially offset by a $3.8 million decrease in LONWORKS Infrastructure product revenues.
 
Enel Project revenues. Products sold to Enel and its designated contract manufacturers accounted for $75.8 million, or 64.2% of total revenues for the year ended December 31, 2003; $81.6 million, or 66.4% of total revenues for year ended December 31, 2002; and $31.0 million, or 40.5% of total revenues for the year ended December 31, 2001. Revenues from the Enel Project will typically fluctuate from quarter to quarter, and from year to year, for several reasons, many of which are described in more detail later in this discussion in the section entitled "Factors That May Affect Future Results of Operations." The $5.7 million decrease in Enel Project revenues in 2003 as compared to 2002 was primarily attributable to reduced average selling prices for electricity meter components (also referred to as metering kit products), partially offset by increased unit volumes of both metering kit and data concentrator products. Under the terms of our agreement with Enel, prices for the products we sell them are reduced based on the cumulative number of units shipped.
 
The $50.5 million, or 162.7% increase in Enel Project revenues in 2002 as compared to 2001 was primarily attributable to a significant increase in the number of metering kit and data concentrator products shipped. We began volume shipments of these products to Enel and its designated meter manufacturers during the second half of 2001 and continued shipping in volume throughout 2002.
 
 
 
  22  
 
 
 
We sell our products to Enel and its designated manufacturers in United States dollars. Therefore, the associated revenues are not subject to foreign currency risks.
 
If the Enel program achieves its targeted volumes for 2004, we expect that total revenues attributable to the project will decline from 2003 levels due primarily to lower average selling prices for metering kits. However, we still expect that revenues from the Enel program will continue to account for a majority of our revenues in 2004. Enel has stated that it intends to complete the installation of the Contatore Elettronico during 2005. Consequently, we believe that our revenue from the Enel Project will decline sharply in 2005 from our projected 2004 levels.
 
From time to time, we have interpreted the contracts between our companies differently from Enel, which has led to disagreements. For example, as a result of a dispute regarding the compensation owed to us for the transition from the second version of metering kit to the third generation of metering kit, which dispute has since been resolved, we deferred approximately $2.7 million of revenue from the second quarter to the third quarter of 2003. If any dispute is not resolved in our favor or in a timely manner, the project, or revenue generated from the project, could be delayed, could become less profitable to us, could result in damages or losses, or either we or Enel could seek to terminate the research and development agreement. Once the project is completed, or if it were cancelled prior t o its completion, we would experience a significant drop in our overall revenue, which would have a material negative impact on our financial position and results of operations.
 
Given our significant dependence on one customer at this time, we continue to seek opportunities to expand our customer base. In 2002, we formed a new sales and marketing organization that has 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.
 
LONWORKS Infrastructure revenues. 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. LONWORKS Infrastructure revenues accounted for $42.3 million, or 35.8% of total revenues for the year ended Decemb er 31, 2003; $41.3 million, or 33.6% of total revenues for the year ended December 31, 2002; and $45.5 million, or 59.5 % of total revenues for the year ended December 31, 2001. The $1.0 million, or 2.5% increase in LONWORKS Infrastructure revenue in 2003 as compared to 2002 was driven by a combination of factors. Approximately $600,000 of the increase was attributable to improved economic conditions in North America and Europe, partially offset by continued weakness in our Asian markets. We believe our LONWORKS Infrastructure revenues in Asia suffered during 2003 because of continued economic weakness, and in particular, the economic effects of Severe Acute Respiratory Syndrome, or SARS, during the first half of the year. In addition, the i mpact of exchange rates on sales made in foreign currencies, principally the Japanese Yen, contributed approximately $400,000 to the year-over-year increase. We believe that, as long as the current worldwide economic recovery continues to gain momentum, revenues from our LONWORKS Infrastructure business will continue to improve during 2004.
 
This expected improvement, however, will be subject to further fluctuations in the exchange rates between the United States dollar and the Japanese Yen. If the dollar were to strengthen against the Yen, our revenues would decrease. Conversely, if the dollar were to weaken against the Yen, our revenues would increase. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of sales conducted in Japanese Yen (or other foreign currencies) and the magnitude of the exchange rate fluctuation from year to year. The portion of our revenues conducted in currencies other than the United States dollar, principally the Japanese Yen, was about 3.8% in 2003, 4.8% in 2002, and 5.9% in 2001. We do not currently expect that, during 2004, the portion of our revenues conducted in these foreign currencies will fluctuate significantly from prior year levels. 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 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.
 
The $4.3 million, or 9.3% reduction in LONWORKS Infrastructure revenue in 2002 as compared to 2001 was primarily attributable to the worldwide economic slowdown, which began in late 2000 and continued through 2001 and 2002.
 
EBV revenues. Sales to EBV, our largest distributor and the sole independent distributor of our products in Europe, accounted for $12.1 million, or 10.2% of our total revenues in 2003; $11.3 million, or 9.2% of our total revenues in 2002; and $12.9 million, or 16.9% of our total revenues in 2001. Our contract with EBV expires in December 2004. If our agreement with EBV is not renewed, or is renewed on less favorable terms to us, our revenues could decrease and our future financial position could be harmed. We currently sell our products to EBV in United States dollars. Therefore, the associated revenues are not subject to foreign currency exchange rate risks.
 
 
 
  23  
 
 
 
Service revenues. During 2003, service revenues decreased by $380,000, or 27.5%, to $1.0 million from $1.4 million in 2002. During 2002, service revenues decreased by $432,000, or 23.8% from $1.8 million in 2001. The decrease in LONWORKS Infrastructure service revenues in both 2003 and 2002 was the result of continued decreases in customer support and training revenues. During this time, we believe that the worldwide economic recession forced many of our customers to curtail spending for training and support. Although worldwide economic conditions beg an to improve during late 2003, and continue to look promising for 2004, we do not expect our service revenues to increase over 2003 levels. In fact, we believe that many of our customers will continue to refrain from purchasing our customer support and training offerings during 2004 in an effort to minimize their operating expenses.

Gross Profit
 
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 costs incurred in providing training, customer support, and custom software development services.
 
During 2003, gross profit increased by $3.2 million, or 5.1% to $66.1 million from $62.9 million in 2002. As a percentage of revenues, gross profit in 2003 increased to 55.9% from 51.2% in 2002. Gross profit, as a percentage of revenues, improved during 2003 due primarily to the recognition of approximately $3.0 million of Enel program related revenue with no corresponding cost of goods sold. This $3.0 million is attributable to a surcharge Enel agreed to pay us for continuing to ship a former version of the metering kit to Enel’s meter manufacturers. Without this $3.0 million surcharge, 2003 gross profit, as a percentage of revenues, would have been 53.4%, a 2.2% improvement over 2002 levels. The primary factors contributing to this 2.2% improvement were: one-time reductions in the price we pay our contract manufacturers and other suppliers for products we purchase from them for sale to our customers, a change in the mix of products sold, favorable manufacturing variances, and reductions in certain cost-of-sales related charges (primarily provisions for excess and obsolete inventory). Offsetting these favorable factors was the previously discussed decrease in the average selling price for metering kit products sold under the Enel Program. We expect that, during 2004, gross profit as a percentage of revenues will be reduced slightly from 2003 levels. We expect this reduction to occur due to the fact that we do not currently expect to ship significant quantities of the former version of the metering kit to Enel’s meter manufacturers, which gave rise to the $3.0 million surcharge in 2003.
 
During 2002, gross profit increased by $23.5 million, or 59.6% to $62.9 million from $39.4 million in 2001. As a percentage of revenues, gross profit in 2002 decreased to 51.2% from 51.4% in 2001. The $23.5 million increase in gross profit during 2002 as compared to 2001 was primarily attributable to increased shipments under the Enel program.

Operating Expenses
 
Product development. Product development expenses consist primarily of payroll and related expenses for development personnel, facility costs, depreciation and amortization, expensed material, and other costs associated with the development of new technologies and products.
 
During 2003, product development expenses grew by $13.7 million, or 63.7%, to $35.1 million from $21.5 million in 2002, representing 29.7% of total revenues for 2003 and 17.5% of total revenues for 2002. The increase in product development expenses during 2003 was due to the asset acquisition transaction with Metering Technology Corporation, or MTC, that occurred during the second quarter of 2003. During 2003, total product development costs associated with the MTC transaction and ongoing operations amounted to $13.8 million, and consisted of a one-time $9.8 million charge related to in-process research and development taken in the second quarter of 2003, $3.3 million of ongoing day-to-day operating expenses (primarily payroll and facilities costs for the nineteen former MTC employees who join ed our company), and $718,000 of amortization expense for purchased technology. For additional information relating to this transaction, please refer to Note 3 in the Notes to Condensed Consolidated Financial Statements as well as to the "Acquisitions" section later in this Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
We expect that, during 2004, product development expenses will be reduced from 2003 levels due to the fact that the in-process research and development charge taken in 2003 was a one-time charge. However, we also expect that our product development expenses in 2004 will be somewhat higher than those incurred in 2002 and prior years, due primarily to the added costs associated with the employees who were formerly MTC personnel and the ongoing amortization of the purchased technology acquired from MTC.
 
 
 
  24  
 
 
 
During 2002, product development expenses grew by $4.4 million, or 26.0%, to $21.5 million from $17.0 million in 2001, representing 17.5% of total revenues for 2002 and 22.2% of total revenues for 2001. The primary components of the increase between the two years were costs associated with our new corporate facilities in San Jose and payroll and related costs associated with our engineering staff, including the addition of seven development personnel during the year. In addition, in January 2002 we acquired BeAtHome.com, Inc. of Fargo, North Dakota. Total product development costs incurred in our Fargo, North Dakota facility, including payroll, administrative, and operational costs associated with the 21 development personnel located there, a one-time charge of $400,000 related to in-proc ess research and development expensed in the first quarter of 2002, and amortization of purchased technology, contributed approximately $2.0 million of the $4.4 million increase in development spending during 2002. Slightly offsetting these increases were reductions in fees paid to consultants and other third parties who assist in our research and development activities.
 
Sales and marketing. Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales personnel, travel and entertainment, facilities costs, advertising and product promotion, and other costs associated with our sales and support offices.
 
During 2003, sales and marketing expenses increased by $1.3 million, or 7.6%, to $18.6 million from $17.3 million in 2002, representing 15.7% of total revenues for 2003 and 14.1% of total revenues for 2002. Approximately $845,000 of the increase during 2003 was due to the impact of foreign currency exchange rate fluctuations between the United States dollar and the local currency in several of the foreign countries in which we operate. Other factors contributing to the year-over-year increase were increased salary and other compensation related expenses, increased costs for third-party service providers, and recruiting expenses, offset by reductions in advertising and product promotion costs and travel and entertainment expenses.
 
We expect that, during 2004, our sales and marketing expenses will increase over 2003 levels. We believe that this increase will be attributable to increases in sales incentive compensation plans as well as the continued weakness of the United States dollar. If, however, the United States dollar were to strengthen against the foreign currencies where we do business, our sales and marketing expenses could decrease slightly. Conversely, if the dollar were to weaken further against these currencies, our expenses would rise.
 
During 2002, sales and marketing expenses increased by $1.5 million, or 9.5%, to $17.3 million from $15.8 million in 2001, representing 14.1% of total revenues for 2002 and 20.6% of total revenue for 2001. The primary components of the $1.5 million spending increase between the two years were costs associated with our new corporate facilities in San Jose, increased payroll and commission costs, including costs associated with the addition of seven sales and marketing personnel hired during the year, and increased advertising and product promotion costs.
 
General and administrative. 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.
 
During 2003, general and administrative expenses increased by $2.4 million, or 24.7%, to $12.1 million from $9.7 million in 2002, representing 10.3% of total revenues for 2003 and 7.9% of total revenues for 2002. Of the $2.4 million increase between the two years, $1.9 million was related to rent, depreciation, and other expenses attributable to our second new building at our corporate headquarters facility in San Jose. Excluding the costs associated with the new building, general and administrative expenses were approximately $508,000 higher in 2003 than in 2002. This $508,000 increase related primarily to increases in salaries and other compensation related costs, business insurance costs, director expenses, and professional fees paid to external service providers. We expect that, during 200 4, general and administrative costs will remain at or slightly above their current levels.
 
During 2002, general and administrative expenses increased by $2.8 million, or 39.9%, to $9.7 million from $6.9 million in 2001, representing 7.9% of total revenues for 2002 and 9.1% of total revenues for 2001. The primary components of the $2.8 million spending increase between the two years were payroll expenses associated with the full year effect of modifications made to our management structure during the fourth quarter of 2001, costs associated with our new corporate facilities in San Jose, insurance premiums, and travel and entertainment costs. In addition, in January 2002 we acquired BeAtHome of Fargo, North Dakota. Total general and administrative costs incurred in our Fargo, North Dakota facility, including payroll, administrative, and operational costs, contributed approximately $70 0,000 of the $2.8 million increase in general and administrative spending during 2002.
 
 
 
  25  
 
 
 
Interest and Other Income, Net
 
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.
 
During 2003, interest and other income, net decreased by $1.6 million, or 41.2%, to $2.2 million from $3.8 million in 2002. Although the average amount of our invested cash increased during 2003 as compared to 2002, the impact of short-term interest rate reductions, which began in late 2001 and have continued through 2003, have had a negative impact on our interest income. As short-term investments we purchased in 2001 and 2002 come to maturity, we have been forced to re-invest these funds in instruments with lower effective yields, thus reducing interest income. In addition, during 2003, the impact of foreign exchange translation losses on our short-term intercompany balances also contributed to the decline in interest and other income, net.
 
As long as interest rates remain low, we expect that our interest income will remain low as compared to historical levels. 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.
 
During 2002, interest and other income, net decreased by $2.9 million, or 43.2%, to $3.8 million from $6.7 million in 2001. As with 2003, this reduction was due to the impact of short-term interest rate reductions, which began in late 2001 and continued through 2002.
 
Provision for Income Taxes
 
The provision for income taxes for 2003 includes a provision for federal, state and foreign taxes based on our annual estimated effective tax rate for the year. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes and the beneficial impact of deferred taxes resulting from the utilization of net operating losses. Income taxes of $600,000 for 2003 primarily consist of taxes related to profitable foreign subsidiaries, federal alternative minimum taxes, and various state minimum and regular income taxes. We expect that, during 2004, our effective tax rate will drop as compared to 2003. This reduction will be driven primarily from an expected increase in 2004 pre-tax income.
 
The 2002 provision for income taxes of $1.5 million relates to various state and foreign taxes. We did not provide for any federal taxes in 2002 due to the utilization of our net operating loss carryforwards and the relief provided by the 2002 Tax Act on alternative minimum taxes.
 
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 headquarter facility in San Jose, California, under two non-cancelable operating leases. The first lease agreement expires in 2011 and the second lease agreement expires in 2013. Upon expiration, both lease agreements provide for extensions of up to ten years. As part of these lease transactions, we provided the lessor security deposits in the form of two standby letters of credit totaling $8.0 million. These letters of credit are secured with a cash deposit at the bank that issued the letters of credit. The cash on deposit is restricted as to withdrawal and is managed by a third party subject to certain limitations under our investment policy.
 
In addition to our corporate headquarter facility, we also lease facilities for our sales, marketing, and product development personnel located elsewhere within the United States and in nine foreign countries throughout Europe and Asia. These operating leases are of shorter duration, generally one to two years, and in some instances are cancelable with advance notice.
 
Purchase Commitments. We utilize several contract manufacturers who manufacture and test our products requiring assembly. These contract manufacturers acquire components and build product based on demand information supplied by us in the form of purchase orders and demand forecasts. These purchase orders and demand forecasts generally cover periods that range from one to six months, an 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, which cover periods ranging from one to six months.
 
 
 
  26  
 
 
 
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 limits our exposure and enables 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 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 $613,000 during 2003, $568,000 during 2002, and $578,000 during 2001.
 
As of December 31, 2003, 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
 
$
39,006
 
$
4,409
 
$
8,839
 
$
8,946
 
$
16,812
 
Purchase commitments
   
10,238
   
10,238
   
--
   
--
   
--
 
   
 
 
 
 
 
Total
 
$
49,244
 
$
14,647
 
$
8,839
 
$
8,946
 
$
16,812
 
   
 
 
 
 
 
 
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 recently we have also been able to finance our operations through operating cash flow. From inception through December 31, 2003, we raised $272.7 million from the sale of preferred stock and common stock.
 
In July 1998, we consummated an initial public offering of 5,000,000 shares of our common stock at a price to the public of $7.00 per share. The net proceeds from the offering were about $31.7 million. Concurrent with the closing of our initial public offering, 7,887,381 shares of convertible preferred stock were converted into an equivalent number of shares of common stock. The net proceeds received upon the consummation of such 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.
 
 
 
  27  
 
 
 
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.

The following table presents selected financial information for each of the last three fiscal years (dollars in thousands):

 
  
2003
2002
2001
   
 
 
 
Cash, cash equivalents, and short-term investments
 
$
144,923
 
$
134,489
 
$
111,653
 
Trade accounts receivable, net
   
20,110
   
22,930
   
29,113
 
Working capital
   
160,745
   
156,320
   
151,748
 
Stockholder’s equity
   
200,924
   
195,018
   
174,717
 

As of December 31, 2003, we had $144.9 million in cash, cash equivalents, and short-term investments, an increase of $10.4 million as compared to December 31, 2002. Historically, our primary source of cash 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 pur chases under our stock repurchase program.
 
Net cash provided by operating activities. Net cash provided by operating activities has historically been driven by net income levels, adjustments for non-cash charges such as depreciation, amortization, and in-process research and development charges, and fluctuations in operating asset and liability balances. Net cash provided by operating activities was $23.7 million for 2003, a $15.0 million decrease from 2002. During 2003, net cash provided by operating activities was generated primarily from the $9.8 million in-process research and development charge taken in relation to the MTC transaction in the second quarter; changes in our operating assets and liabilities of $6.3 million; $5.6 million of depreciation and amortization; and net income of $1.9 million. Cash provided by operating activities in 2002 of $38.7 million was primarily due to changes in our operating assets and liabilities of $17.4 million, net income for the year of $16.8 million, and $4.1 million of depreciation and amortization. Cash used in operating activities in 2001 of $17.8 million was primarily due to changes in our operating assets and liabilities of $26.7 million; offset by net income for the year of $6.0 million and $2.3 million of depreciation and amortization.
 
Net cash used for investing activities. Net cash 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 used for investing activities was $44.5 million for 2003, a $13.7 million increase from 2002. During 2003, net cash used for investing activities was primarily the result of purchases of available-for-sale short-term investments, our $11.0 million purchase of certain assets of MTC, and capital expenditures of $6.5 million, offset by proceeds from sales and maturities of available-for-sale short-term investments and a $576,000 reduction in long-term assets. Net cash used in investing activities in 2002 of $30.7 million was principally due to the purchase of available-for-sale investments, the purchase of restricted investments, the purchase of BeAtHome, and capital expenditures, offset by the proceeds from sales and maturities of available-for-sale investments. Net cash used in investing activities in 2001 of $75.6 million was principally due to the purchase of available-for-sale investments, capital expenditures related to our new corporate headquarters facility in San Jose, and an increase in other long-term assets, partially offset by the proceeds from sales and maturities of available-for-sale investments.
 
Net cash provided by financing activities. Net cash provided by financing activities has historically been driven by the proceeds from issuance of common and preferred stock offset by transactions under our stock repurchase program. Net cash provided by financing activities was $3.4 million for 2003, a $341,000 increase from 2002. During 2003, net cash provided by financing activities was comprised of proceeds from the exercise of stock options by employees. Net cash provided by financing activities in 2002 of $3.1 million was comprised of proceeds from the exercise of stock options by employees and, to a lesser extent, by the proceeds from the exercise of stock warrants by some of ou r warrant holders who are also directors of our company. Net cash used in financing activities in 2001 of $642,000 was comprised of $3.2 million attributable to open-market purchases of our common stock under our stock repurchase program, partially offset by $2.5 million of proceeds from the exercise of stock options by employees.
 
 
 
  28  
 
 
 
We use highly 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, money market funds. All investments are made according to guidelines and within compliance of policies approved by 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 may decline during 2004 in the event of a further weakening of the economy or changes in our planned cash outlay. However, based on our current business plan and revenue prospects, we believe that our existing balances, together with our anticipated cash flows from operations, 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.
 
Acquisitions
 
Purchase of Certain Assets of Metering Technology Corporation
 
On April 11, 2003, we acquired certain assets from privately held Metering Technology Corporation, or MTC, a Scotts Valley, California based developer of intelligent, communicating energy measuring devices and systems. In exchange for the assets acquired, we paid $11.0 million in cash to MTC. In conjunction with the asset purchase, we also entered into a sublease agreement with MTC for a portion of their Scotts Valley office space. The sublease expired in December 2003.
 
The assets we acquired from MTC included de minimus operating assets (e.g., fixed assets), certain intangible assets (e.g., in-process research and development, or IPR&D, and purchased technology), and the opportunity to hire certain of MTC’s employees. We did not assume any of MTC’s existing customer contracts, nor did we buy any of their existing finished goods inventory. Lastly, we did not assume any of MTC’s existing obligations or liabilities with the exception of a lease for a piece of office equipment and a term contract with an internet service provider. In evaluating the group of assets acquired, it was clear that several components necessary for the acquired set to continue operating normal operations were missing. As a result, we concluded that the assets acquired do not constitute a business as such term is defined in EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business, and SFAS No. 141, or FAS 141, Business Combinations. Accordingly, FAS 141 accounting does not apply to this transaction and no goodwill has been recorded.
 
We allocated the purchase price based upon the fair value of the assets acquired. The excess of the purchase price over the fair value of the assets acquired has been allocated to the identified intangible assets in accordance with the requirements of FAS 141 and SFAS No. 142, or FAS 142, Goodwill and Other Intangible Assets. The following is a final allocation of the purchase price (in thousands):

Property and equipment
 
$
235
 
Intangible assets and IPR&D
   
10,765
 
   
 
Total assets acquired
 
$
11,000
 
   
 
 
Of the acquired intangible assets of $10.8 million, $9.8 million was assigned to IPR&D and was charged to product development expenses on the date the assets were acquired. The remaining $957,000 was assigned to purchased technology and is being amortized over its estimated useful life of one year. For the twelve months ended December 31, 2003, amortization expense related to this purchased technology was approximately $718,000, which was recorded in product development expenses. The remaining unamortized balance of $239,000 will be charged to amortization expense during the first quarter of 2004.
 
 
 
  29  
 
 
 
Since the date of the asset purchase, we have focused the efforts of the employees who joined our company from MTC on the development of a new LONWORKS based electricity meter to be used in our Networked Energy Services, or NES, product offering. The foundation for this new electricity meter was a prototype design developed by MTC prior to the asset purchase transaction.
 
Acquisition of BeAtHome.com, Inc.
 
On January 31, 2002, we acquired all of the outstanding capital stock of BeAtHome, a Fargo, North Dakota based developer of remote management system hardware and software. In exchange for all of the outstanding capital stock of BeAtHome, we paid approximately $5.9 million, comprised of cash payments totaling approximately $2.0 million to BeAtHome’s shareholders, the forgiveness of approximately $3.5 million in operating loans made to BeAtHome, and approximately $371,000 of third party expenses. The transaction was accounted for as a purchase transaction under FAS 141.
 
We allocated the purchase price based upon the fair value of the assets acquired. Acquired in-process research and development assets of $400,000 were expensed at the date of acquisition. The results of BeAtHome’s operations have been included in the consolidated condensed financial statements since January 31, 2002.
 
Since the acquisition, we have been integrating certain components of BeAtHome’s technology into our current and future product offerings, such as our NES offering and the Panoramix platform. We believe these new products and product enhancements will make it easier for our customers to aggregate and process information from remote LONWORKS networks, thereby increasing overall network management capabilities.
 
Related Party Transactions
 
During the years ended December 31, 2003, 2002, and 2001, 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. These private air travel services are provided by certain entities controlled by Mr. Oshman or Armas Clifford Markkula, a director of our company. Our net cash outlay 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 9 to our accompanying 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 February 29, 2004, 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 as Board member in all of Enel’s subsidiaries and affiliates, including Echelon. His resignation from our board of directors was effective in June 2002. Enel has reserved its right to nominate a new member of our board of directors, although, as of February 29, 2004, they have not done so. During the term of service of Enel’s representative on our board of directors from September 2000 to September 2002, Enel’s representative abstain ed from resolutions on any matter relating to Enel.

At the time we entered into the stock purchase agreement with Enel, we also entered into a research and development agreement with an affiliate of Enel. Under the terms of the research and development agreement, we are cooperating with Enel to integrate our LONWORKS technology into Enel’s remote metering management project in Italy. During 2003, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $75.8 million, $15.3 million of which was included in accounts receivable at December 31, 2003. During 2002, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $81.6 million, $17.2 million of which was included in accounts receivable at December 31, 2002. During 2001, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $31.0 million. We expect that 2004 revenue relating to the Enel program will decline as compared to the $75.8 million recognized in 2003. In addition, we expect that we will complete our Enel program related deliveries during the first six months of 2005, after which revenue, if any, from Enel and its designated manufacturers will be reduced to an immaterial amount.
 
 
 
  30  
 
 
 
Recently Issued Accounting Standards
 
In November 2002, the FASB issued FASB Interpretation No. 45, or FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must discl ose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. We adopted FIN 45 on January 1, 2003. The adoption did not have a material impact on our financial position, results of operations, or cash flows.
 
In December 2002, the FASB issued SFAS No. 148, or SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123. SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We are required to follow the prescribed format and provide the additional disclosures required by SFAS 148 in our annual financial statements, beginning with the year ending December 31, 2002, and must also provide the disclosures in our quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ending March 31, 2003. The adoption of SFAS 148 did not have an effect on our financial position or results of operations as we did not adopt the fair value method of accounting for stock-based employee compensation.
 
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), or FIN 46R, Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. We will be required to apply FIN 46R to variable interests in variable interest entities, or VIEs, created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN 46R will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities, and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and noncontrolling interests of the VIE. We do not expect the adoption of FIN 46R to have a material impact on our financial position, results of operations, or ca sh flows.
 
In January 2003, the EITF published EITF No. 00-21, or EITF 00-21, Revenue Arrangements with Multiple Deliverables, which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. EITF 00-21 is effective for revenue arrang ements entered into in fiscal periods beginning after June 15, 2003. Additionally, in August 2003, the EITF reached consensus on EITF Issue No. 03-5, or EITF 03-5, Applicability of AICPA Statement of Position 97-2, "Software Revenue Recognition," to Non-Software Deliverables in an Arrangement Containing More-than-Incidental Software. EITF 03-5 provides guidance on determining whether non-software deliverables are included within the scope of SOP 97-2, and accordingly, whether multiple element arrangements are to be accounted for in accordance with EITF 00-21 or SOP 97-2. The application of EITF 00-21 and EITF 03-5 did not have a material impact on our financial position, results of operations, or cash flows.
 
In April 2003, the FASB issued SFAS No. 149, or SFAS 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. In particular, SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative. It also clarifies when a derivative contains a financing component that warrants special reporting in the statemen t of cash flows. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial position or results of operations as we do not currently hold any derivative instruments or engage in hedging activities.
 
 
 
  31  
 
 
 
In May 2003, the FASB issued SFAS No. 150, or SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. This statement is effective for interim periods beginning after June 15, 2003. As we have no instruments which management believes are subject to SFAS 150, the adoption of SFAS 150 did n ot have a material effect on our financial position, results of operations, or cash flows.

On December 17, 2003, the Staff of the Securities and Exchange Commission, or SEC, issued Staff Accounting Bulletin No. 104, or SAB 104, Revenue Recognition, which supersedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind the accounting guidance contained in SAB 101 related to multiple-element revenue arrangements that was superseded as a result of the issuance of EITF 00-21, Revenue Arrangements with Multiple Deliverables. Additionally, SAB 104 rescinds the SEC’s related Revenue Recognition in Financial Statements Frequently Asked Questions and Answers, which was issued with SAB 101 and was codified in SEC Topic 13, Revenue Recognition. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The adoption of SAB 104 did not have a material effect on our financial position, results of operations, or cash flows.
 
Equity Based Compensation
 
We have two plans under which we grant options: the 1997 Stock Plan, or the "1997 Plan," and the 1998 Director Option Plan, or the "Director Option Plan." A more detailed description of each plan can be found in Note 6 to our accompanying consolidated financial statements.
 
Stock option grants are designed to reward employees, officers, and directors for their long-term contribution to our company and to provide incentives for them to remain with our company. The number and frequency of stock option grants is based on competitive practices, our operating results, and government regulations. Since the inception of the 1997 Plan, we have granted options to all of our employees.
 
Distribution and Dilutive Effect of Options

The following table illustrates the grant dilution and exercise dilution:

 
  
Year Ended December 31,
   
 
    
2003

 

 
2002

 

 
2001
 
   
 
 
 
Shares of common stock outstanding    
    
40,409,956
   
39,725,550
   
38,753,360
 
   
 
 
 
 
    
 
    
 
    
 
  
Options granted    
    
2,346,245
   
2,282,750
   
2,560,225
 
Options cancelled    
    
(743,344
)