ECHELON CORP - 10-Q Quarterly Report

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UNITED STATES 
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549 

______________ 

FORM 10-Q 

______________ 

(Mark one) 

[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the quarterly period ended March 31, 2004 

OR

[  ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the transition period from _______________ to _______________ 

000-29748
(Commission file number)

______________ 

ECHELON CORPORATION 

(Exact name of registrant as specified in its charter) 

______________ 

Delaware                      77-0203595
    (State or other jurisdiction of
           (IRS Employer 

incorporation or organization)          Identification Number)

550 Meridian Avenue
San Jose, CA 95126
(Address of principal executive office and zip code)

(408) 938-5200
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days. 

Yes x No o 

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). 

Yes x No o 

As of April 30, 2004, 40,672,923 shares of the Registrant’s common stock were outstanding. 

ECHELON CORPORATION
FORM 10-Q 
FOR THE QUARTER ENDED MARCH 31, 2004

INDEX 

 
Page 

Part I. 

FINANCIAL INFORMATION 

Item 1. 

Unaudited Condensed Consolidated Financial Statements 

Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003 

3 

Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and March 31, 2003 

4 

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and March 31, 2003 

5 

Notes to Condensed Consolidated Financial Statements 

6 

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations 

13 

Item 3. 

Quantitative and Qualitative Disclosures About Market Risk 

46 

Item 4. 

Controls and Procedures 

46 

Part II. 

OTHER INFORMATION 

Item 1. 

Legal Proceedings 

48 

Item 6. 

Exhibits and Reports on Form 8-K 

48 

SIGNATURE 

48 

EXHIBIT INDEX 

49

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 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including "Liquidity and Capital Resources," "New Accounting Standards" and "Factors That May Affect Future Results of Operations," and elsewhere in this report. These statements include statements concerning projected revenues, international revenues, expenses, gross profit, i
ncome, product development and market acceptance of our products. 

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 risk factors including, but not limited to, those set forth in the section entitled "Factors That May Affect Future Results of Operations" and elsewhere in this report. You should carefully consider these risks, in addition to the other information in this report and in our other filings with the SEC. All forward-looking statements and reasons why results may differ included in this report are made as of the date of this report, and we assume no obligation to update any such forward-
looking statement or reason why such results might differ. 

2

PART I. FINANCIAL INFORMATION 

ITEM 1.    UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 

ECHELON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

(Unaudited) 

	March 31, 2004		December 31, 2003

ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$ 19,435		$ 18,667
Short-term investments	131,430		126,256
Accounts receivable, net	17,614		20,110
Inventories	5,486		5,906
Other current assets	1,626		2,519

Total current assets	175,591		173,458

Property and equipment, net	18,857		19,098
Other long-term assets	21,596		21,572

	$ 216,044		$ 214,128


LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$ 6,340		$ 6,922
Accrued liabilities	4,484		4,793
Deferred revenues	1,225		998

Total current liabilities	12,049		12,713

LONG-TERM LIABILITIES:
Deferred rent	585		491

Total long-term liabilities	585		491

STOCKHOLDERS’ EQUITY:
Common stock	409		407
Additional paid-in capital	273,723		272,323
Treasury stock	(3,191	)	(3,191	)
Accumulated other comprehensive income	972		1,007
Accumulated deficit	(68,503	)	(69,622	)

Total stockholders’ equity	203,410		200,924

	$ 216,044		$ 214,128

See accompanying notes to condensed consolidated financial statements. 


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ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

	Three Months Ended March 31,

	2004	2003

REVENUES:
Product	$ 26,855	$ 32,393
Service	188	245

Total revenues	27,043	32,638

COST OF REVENUES:
Cost of product	11,261	15,408
Cost of service	503	686

Total cost of revenues	11,764	16,094

Gross profit	15,279	16,544

OPERATING EXPENSES:
Product development	6,215	5,095
Sales and marketing	5,058	4,670
General and administrative	3,330	2,936

Total operating expenses	14,603	12,701

Income from operations	676	3,843
Interest and other income, net	514	741

Income before provision for income taxes	1,190	4,584
Provision for income taxes	71	367

NET INCOME	$ 1,119	$ 4,217

Net income per share:
Basic	$ 0.03	$ 0.11

Diluted	$ 0.03	$ 0.10

Shares used in computing net income per share:
Basic	40,502	39,788

Diluted	40,857	40,396

See accompanying notes to condensed consolidated financial statements. 

4

ECHELON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS 
(In thousands)
(Unaudited)

	Three Months Ended March 31,

	2004		2003


CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
Net income	$ 1,119		$ 4,217
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization	1,393		1,050
Provision for doubtful accounts	2		11
Change in operating assets and liabilities:
Accounts receivable	2,494		(3,560	)
Inventories	420		1,474
Other current assets	893		866
Accounts payable	(582	)	1,707
Accrued liabilities	(309	)	(8	)
Deferred revenues	227		(1,348	)
Deferred rent	94		27

Net cash provided by operating activities	5,751		4,436


CASH FLOWS USED IN INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments	(46,165	)	(50,173	)
Proceeds from maturities and sales of available-for-sale short-term investments	40,976		36,494
Purchase of restricted investments	(242	)	(169	)
Change in other long-term assets	(112	)	825
Capital expenditures	(822	)	(1,001	)

Net cash used in investing activities	(6,365	)	(14,024	)


CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Proceeds from issuance of common stock	1,402		477
Net cash provided by financing activities	1,402		477


EFFECT OF EXCHANGE RATE CHANGES ON CASH	(20	)	(33	)


NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	768		(9,144	)

CASH AND CASH EQUIVALENTS:
Beginning of period	18,667		34,941

End of period	$ 19,435		$ 25,797


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$ 65		$ 299

See accompanying notes to condensed consolidated financial statements. 


	5

ECHELON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.    Basis of Presentation: 

The condensed consolidated financial statements include the accounts of Echelon Corporation (the "Company"), a Delaware corporation, and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. 

While the financial information furnished is unaudited, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2003 included in its Annual Report on Form 10-K. 

2.     Summary of Significant Accounting Policies: 

Use of Estimates in the Preparation of Financial Statements 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 

Revenue Recognition and Product Warranty

The Company’s revenues are derived from the sale and license of its products and to a lesser extent, from service revenues. Product revenues consist of revenues from hardware sales and software licensing arrangements. Revenues from software licensing arrangements accounted for approximately 4.6% of total revenues for the quarter ended March 31, 2004 and approximately 3.9% for the same period in 2003. Service revenues consist of product technical support (including software post-contract support services), training, and custom software development services. 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectibility is probable and there are no post-delivery obligations. For hardware sales, including sales to distributors and third party manufacturers, these criteria are generally met at the time of shipment. For software licenses, these criteria are generally met upon shipment to the final end-user. 

In accordance with Statement of Position 97-2, or SOP 97-2, Software Revenue Recognition, revenue earned on software arrangements involving multiple elements is allocated to each element based upon the relative fair values of the elements. The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date. In these instances, the amount of revenue deferred at the time of sale is based on vendor specific objective evidence ("VSOE") of the fair value for each undelivered element. If VSOE of fair value does not exist for
 each undelivered element, all revenue attributable to the multi-element arrangement is deferred until sufficient VSOE of fair value exists for each undelivered element or all elements have been delivered. 

The Company currently sells a limited number of products that are considered multiple element arrangements under SOP 97-2. Revenue for the software license element is recognized at the time of delivery of the applicable product to the end-user. The only undelivered element at the time of sale consists of post-contract customer support ("PCS"). The VSOE for this PCS is based on prices paid by the Company’s customers for stand-alone purchases of these PCS packages. Revenue for the PCS element is deferred and recognized ratably over the PCS service period. The costs of providing these PCS services are expensed when incurred. 


	6

The Company accounts for the rights of return, price protection, rebates, and other sales incentives offered to its distributors in accordance with Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists.

Service revenue is comprised of PCS, training, and custom software development services. PCS revenue is recognized ratably over the term of the support period. Training revenue is recognized when the training services are performed. In the case of custom software development services, revenue is recognized when the customer accepts the software.

Cash and Cash Equivalents

The Company considers bank deposits, money market investments and all debt and equity securities with an original maturity of three months or less as cash and cash equivalents. 

Short-Term Investments 

The Company classifies its investments in marketable debt securities as available-for-sale in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115,  Accounting for Certain Investments in Debt and Equity Securities. As of March 31, 2004, the Company’s available-for-sale short-term investment securities had contractual maturities from three to twenty-four months and an average maturity of eight months. The fair value of available-for-sale securities was determined based on quoted market prices at the reporting date for those instruments. As of March 31, 2004, the amortized cost basis, aggregate fair value, and gross unrealized holding gains by major security type were as follows (in thousands): 

	Amortized Cost	Aggregate Fair Value	Unrealized Holding Gains

U.S. corporate securities:
Commercial paper	$ 4,992	$ 4,992	$ --
Corporate notes and bonds	53,384	53,429	45

	58,376	58,421	45
U.S. government securities	72,937	73,009	72

Total investments in debt and equity securities	$ 131,313	$ 131,430	$ 117

Computation of Net Income Per Share 

Net income per share has been calculated under SFAS No. 128, Earnings per Share. SFAS No. 128 requires companies to compute earnings per share under two different methods (basic and diluted). Basic net income per share is calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted net income per share is calculated by adjusting the weighted average number of outstanding shares assuming conversion of all potentially dilutive stock options and warrants under the treasury stock method. 


	7

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the three months ended March 31, 2004 and 2003 (in thousands): 


	Three Months Ended March 31, 2004	Three Months Ended March 31, 2003

Net income (Numerator):
Net income, basic & diluted	$ 1,119	$ 4,217

Shares (Denominator):
Weighted average common shares outstanding	40,502	39,795
Weighted average common shares outstanding
subject to repurchase	--	(7	)

Shares used in basic computation	40,502	39,788
Weighted average common shares outstanding
subject to repurchase	--	7
Common shares issuable upon exercise of stock
options (treasury stock method)	355	601

Shares used in diluted computation	40,857	40,396

Net income per share:
Basic	$ 0.03	$ 0.11

Diluted	$ 0.03	$ 0.10

For the three months ended March 31, 2004 and 2003, stock options in the amount of 7,596,586 and 6,380,031, respectively, were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect of their inclusion would be anti-dilutive. 

    Stock-Based Employee Compensation Plans 

The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, or FASB 
123, Accounting for Stock-Based Compensation, to stock-based employee compensation. 

	Three Months Ended March 31,

		2004			2003

Net income as reported	$	1,119		$	4,217

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(4,958	)		(5,829	)

Pro forma net loss	$	(3,839	)	$	(1,612	)

Basic earnings/(loss) per share:
As reported	$	0.03		$	0.11

Pro forma	$	(0.09	)	$	(0.04	)

Diluted earnings/(loss) per share:
As reported	$	0.03		$	0.10

Pro forma	$	(0.09	)	$	(0.04	)


	8

The weighted-average grant date fair value of options granted during the three months ended March 31, 2004 and March 31, 2003 was $6.20 and $7.45, respectively. Under FASB 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: 

	Three Months Ended March 31,

	2004	2003

Expected dividend yield	0.0%	0.0%
Risk-free interest rate	2.4%	2.8%
Expected volatility	80.1%	107.1%
Expected life (in years)	3.7	4.5

Recently Issued Accounting Standards 

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. The Company is 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. The adoption of FIN 46R did not have a material impact on the Company’s 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 the Company’s financial position, results of operations, or cash flows. 

3.     Inventories: 

Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing overhead. Inventories consist of the following (in thousands): 

	March 31, 2004	December 31, 2003


Purchased materials	$ 1,122	$ 1,680
Work-in-process	14	8
Finished goods	4,350	4,218

	$ 5,486	$ 5,906


	9

4.   Accrued Liabilities: 

Accrued liabilities consist of the following (in thousands): 

	March 31, 2004		December 31, 2003

Accrued payroll and related costs	$	2,438	$	2,663
Accrued marketing costs		114		392
Other accrued liabilities		1,932		1,738

	$	4,484	$	4,793

5.    Segment Disclosure: 

In 1998, the Company adopted SFAS No. 131, or SFAS 131, Disclosures about Segments of an Enterprise and Related Information. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing business performance. The Company’s chief operating decision-making group is the Executive Staff, which is comprised of the Chief Executive Officer, the Chief Operating Officer, and their direct reports. SFAS 131 also requires disclo
sures about products and services, geographic areas and major customers. The adoption of SFAS 131 did not affect results of operations or the financial position of the Company but did affect the disclosure of segment information. 

The Company operates its business as one reportable segment: the design, manufacture and sale of products for the controls network industry, and markets its products primarily to the building automation, industrial automation, transportation, and utility/home automation markets. The Company’s products are marketed under the LONWORKS ® brand name, which provides the infrastructure and support required to implement and deploy open, interoperable, control network solutions. All of the Company’s products either incorporate or operate with the Neuron® Chip and/
or the LONWORKS protocol. The Company also provides services to customers that consist of technical support and training courses covering its LONWORKS network technology and products. The Company offers about 90 products and services that together constitute the LONWORKS system. Any given customer purchases a small subset of such products and services that are appropriate for that customer’s application. 

The Company manages its business primarily on a geographic basis. The Company’s geographic areas are comprised of three main groups: the Americas; Europe, Middle East and Africa ("EMEA"); and Asia Pacific/ Japan ("APJ"). Each geographic area provides products and services as further described in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company evaluates the performance of its geographic areas based on profit or loss from operations. Profit or loss for each geographic area includes sales and marketing expenses and other charges directly attributable to the geographic area and excludes certain expenses that are managed outside the geographic area. Costs excluded from geographic area profit or loss consist primarily of unallocate
d corporate expenses, which are comprised of product development costs, corporate marketing costs and other general and administrative expenses, which are separately managed. The Company’s long-lived assets include property and equipment, restricted investments, goodwill, loans to certain key employees, purchased technology, and deposits on its leased facilities. Long-lived assets are attributed to geographic areas based on the country where the assets are located. As of March 31, 2004 and December 31, 2003, long-lived assets of about $37.2 million and $37.2 million, respectively, were domiciled in the United States. Long-lived assets for all other locations are not material to the consolidated financial statements. Assets and the related depreciation and amortization are not reported by geography because that information is not reviewed by the Executive Staff when making decisions about resource allocation to the geographic areas based on their performance. 


	10

In North America, the Company sells its products through a direct sales organization. Outside North America, direct sales, applications engineering and customer support are conducted through the Company’s operations in EMEA and APJ. Revenues are attributed to geographic areas based on the country where the customer is domiciled. Summary information by geography for the quarters ended March 31, 2004 and 2003 is as follows (in thousands): 

	Three Months Ended March 31,

		2004			2003

Revenues from customers:
Americas	$	4,028		$	3,820
EMEA		21,200			22,330
APJ		1,815			6,409
Unallocated		--			79

Total	$	27,043		$	32,638

Gross profit:
Americas	$	2,600		$	2,407
EMEA		11,423			11,030
APJ		1,256			3,028
Unallocated		--			79

Total	$	15,279		$	16,544

Income/(Loss) from operations:
Americas	$	1,519		$	1,540
EMEA		9,925			10,041
APJ		218			2,188
Unallocated		(10,986	)		(9,926	)

Total	$	676		$	3,843

Products sold to Enel S.p.A., an Italian utility company ("Enel"), and its designated manufacturers accounted for $15.5 million, or 57.5% of total revenues for the quarter ended March 31, 2004 and $22.3 million, or 68.4% for the same period in 2003. During the quarter ended March 31, 2004, all of the revenues shipped under the Enel program were shipped to customers in EMEA. 80.0% of the revenues shipped under the Enel program during the first quarter of 2003 were shipped to customers in EMEA, and the remaining 20.0% to customers in APJ. 

EBV Electronik GmbH ("EBV"), the sole independent distributor of the Company’s products in Europe, accounted for 11.6% of total revenues for the quarter ended March 31, 2004 and 8.2% for the same period in 2003.

6.    Income Taxes:

The provision for income taxes for the quarters ended March 31, 2004 and 2003 includes a provision for Federal, state and foreign taxes based on the annual estimated effective tax rate applied to the Company and its subsidiaries for the year. The difference between the statutory rate and the Company’s effective tax rate is primarily due to the impact of foreign taxes and the utilization of net operating losses not previously benefited. 

7.    Related Party: 

In June 2000, the Company entered into a stock purchase agreement with Enel. At the same time, the Company also entered into a research and development agreement with an affiliate of Enel. Under the terms of the R&D agreement, the Company is cooperating with Enel to integrate LONWORKS technology into Enel’s remote metering management project in Italy. For the quarters ended March 31, 2004 and 2003, the Company recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $15.5 million and $22.3 million, respectively. Of these amounts, $12.2 million and $22.3 million is included in Accounts Receivable as of Mar
ch 31, 2004 and March 31, 2003, respectively. 

11

8.    Stock Repurchase Program: 

In March 2004, the Company’s board of directors approved a stock repurchase program. During the quarter ended March 31, 2004, no shares were repurchased under the program. As of March 31, 2004, 3,000,000 shares are available for repurchase. The stock repurchase program will expire in March 2005. 

9.    Warranty Reserves: 

When evaluating the reserve for warranty costs, management takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical return rates, historical costs of repair, and knowledge of new products introduced. Estimated reserves for warranty costs are recorded at the time of shipment. The reserve for warranty costs was $235,000 as of March 31, 2004 and $205,000 as of December 31, 2003.

10.    Subsequent Events: 

On May 3, 2004, the Company announced that its largest customer, Enel, filed a request for arbitration to resolve a dispute regarding the Company’s marketing and supply obligations under its research and development agreement (the "R&D Agreement") with Enel. The arbitration is to take place in London. Enel claims that the R&D Agreement obligates the Company to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel Echelon to sell to Enel an unspecified amount of additional products, to jointly market the
 Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. The Company believes it has fulfilled its obligations under the R&D Agreement, including any obligation with respect to the sale of products and with respect to joint marketing. The Company believes that Enel’s claims are without merit and intends to vigorously defend itself in the arbitration proceedings. 


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ITEM 2.         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 Quarterly Report. The following discussion contains forward-looking statements that involve risks and uncertainties including, without limitation, statements regarding our liquidity position, our expected overall growth, our revenues, our anticipated customer support sales, our anticipated gross margin, our anticipated operating expenses, and our exposure to foreign currency fluctuations. 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 Qua
rterly 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 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, utility/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 from sales 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 in the 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 rel
ated to our products and the underlying technology. Some of our customers also rely on us to provide customer support on a per-incident or term contract basis. 

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 11.6% of total net revenues for the quarter ended March 31, 2004, and 8.2% of total net revenues for the same period in 2003. Worldwide sales to distributors, including
 those to EBV, accounted for approximately 22.5% of total net revenues for the quarter ended March 31, 2004, and 9.8% of total net revenues for the same period in 2003. 


	13

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. Actual results could differ materially from these estimates. 
 

Other than standard warranty repair work, Enel and its designated contract meter manufacturers do not have rights to return products we ship to them. However, our agreement with Enel contains an "acceptance" provision, whereby Enel is entitled to inspect products we ship to them to ensure the products conform, in all material respects, to the product’s specifications. Once the product has been inspected and approved by Enel, or if the acceptance period lapses before Enel inspects, approves, or disapproves the products, the goods are considered accepted. Prior to shipping our products to Enel, we perform detailed reviews and tests to ensure the products have been manufactured in compliance with the specifications in our agreements with Enel and will meet all of Enel’s acceptance crite
ria. We do not ship products unless they have passed these reviews and tests. As a result, we record revenue for these products upon shipment to Enel. If Enel were to subsequently reject, in accordance with the terms of our agreements with them, 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 negative 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 our estimate of 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. Actual results could differ materially from these estimates. 
 

Our allowances for sales returns and other sales-related reserves were approximately $1.8 million as of March 31, 2004, and $1.4 million as of December 31, 2003. 

Allowance for Doubtful Accounts. We typically sell our products and services to customers with net 30-day payment terms. In certain instances, payment terms may extend to as much as net 90 days. For a customer whose credit worthiness does not meet our minimum criteria, we may require partial or full payment prior to shipment. Alternatively, customers may be required to provide us with an irrevocable letter of credit prior to shipment. 

We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer's inability to meet its financial obligations to us, we record a specific allowance against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. These determinations are made based on several sources of information, including, but not limited to, a specific customer’s payment history, recent discussions we have had with the customer, updated financial information for the customer, and publicly available news related to that customer. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business envir
onment, 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 March 31, 2004 and December 31, 2003. 


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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 $235,000 as of March 31, 2004 and $205,000 as of December 31, 2003. 

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. 

Valuation of Goodwill and Other Intangible Assets. We assess the impairment of goodwill and identifiable intangible assets on an annual basis and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following: 

significant underperformance relative to expected historical or projected future operating results;
significant changes in the manner or use of the acquired assets or the strategy for our overall business;
significant negative industry or economic trends; and
significant changes in the composition of the intangible assets acquired.

When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net goodwill and other intangible assets amounted to $8.4 million as of March 31, 2004. 

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. The net balance of goodwill as of March 31, 2004 was $8.1 million. We review goodwill for impairment annually during the quarter ending March 31. Our review during the quarter ended March 31, 2004 indicated no impairment. If, as a result of an annual or any other impairment review that we perform in the future, we determine that there has been an impairment of our goodwill or other intangible assets, we would be required to take an impairment charge. Such a charge could have a material adverse impact on our financial position and/or operating results. 


	15

Results of Operations 

The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the three months ended March 31, 2004 and March 31, 2003: 

	Three Months Ended March 31,

		2004		2003

Revenues:
Product		99.3	%	99.2	%
Service		0.7		0.8

Total revenues		100.0		100.0
Cost of revenues:
Cost of product		41.6		47.2
Cost of service		1.9		2.1

Total cost of revenues		43.5		49.3

Gross profit		56.5		50.7

Operating expenses:
Product development		23.0		15.6
Sales and marketing		18.7		14.3
General and administrative		12.3		9.0

Total operating expenses		54.0		38.9

Income from operations		2.5		11.8
Interest and other income, net		1.9		2.3

Income before provision for income taxes		4.4		14.1
Provision for income taxes		0.3		1.1

Net income		4.1	%	13.0	%

Revenues 

Total Revenues 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Total Revenues	$ 27,043	$ 32,638	$ (5,595	)	(17.1	%)

The $5.6 million decrease in total revenues for the quarter ended March 31, 2004 as compared to the same period in 2003 was primarily the result of a $6.8 million reduction in Enel Project related revenues partially offset by a $1.2 million increase in LONWORKS Infrastructure revenues. 

Product revenues

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Product Revenues	$ 26,855	$ 32,393	$ (5,538	)	(17.1	%)

The $5.5 million decrease in product revenues for the quarter ended March 31, 2004 as compared to the same period in 2003 was primarily the result of a $6.8 million reduction in Enel Project related revenues partially offset by a $1.3 million increase in LONWORKS Infrastructure product revenues. 

16

Enel Project revenues 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Enel Project Revenues	$ 15,540	$ 22,335	$ (6,795	)	(30.4	%)

Revenues from the Enel Project will typically fluctuate from quarter to quarter, and from year to year, for reasons such as those described in more detail later in this discussion in the section entitled "Factors That May Affect Future Results of Operations." The $6.8 million decrease in Enel Project revenues for the quarter ended March 31, 2004, as compared to the same period in 2003, was primarily attributable to decreased unit volumes for electricity meter components (also referred to as metering kit products) and data concentrator products. In addition, reduced average selling prices for metering kit products also contributed to the decline. Under the terms of our agreement with Enel, prices for the products we sell for the Enel Project are reduced based on the cumulative number of units s
hipped. 

We sell our products to Enel and its designated manufacturers in U. S. Dollars. Therefore, the associated revenues are not subject to foreign currency risks. 

If the Enel Project achieves its targeted volumes for 2004, we expect that total revenues attributable to the Enel 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 Project 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 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change	2004 over 2003 % Change

LONWORKS Infrastructure Revenues	$ 11,503	$ 10,303	$ 1,200	11.6	%

Our LONWORKS Infrastructure revenues are primarily comprised of sales of our hardware and software products, and to a lesser extent, revenues we generate from our customer support and training offerings. The $1.2 million increase in LONWORKS Infrastructure revenue for the quarter ended March 31, 2004 as compared to the same period in 2003 was driven by a combination of factors. Approximately $1.1 million of the increase was attributable to improved economic conditions in Europe and North America, partially offset by continued weakness i
n the Asian markets we serve. In addition, the impact of exchange rates on sales made in foreign currencies, principally the Japanese Yen, contributed approximately $70,000 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. 


	17

This expected improvement, however, will be subject to further fluctuations in the exchange rates between the U.S. Dollar and the Japanese Yen. If the U.S. Dollar were to strengthen against the Japanese Yen, our revenues would decrease. Conversely, if the U.S. Dollar were to weaken against the Japanese Yen, our revenues would increase. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of sales conducted in Japanese Yen (or other foreign currencies) and the magnitude of the exchange rate fluctuation from year to year. The portion of our revenues conducted in currencies other than the U.S. Dollar, principally the Japanese Yen, was about 2.8% for the quarter ended March 31, 2004 and 3.9% for the same period in 2003. We do not currently expect that, during
 the remainder of 2004, the portion of our revenues conducted in these foreign currencies will fluctuate significantly from that experienced in 2003. 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. 

EBV revenues 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change	2004 over 2003 % Change

EBV Revenues	$ 3,131	$ 2,662	$ 469	17.6	%

Sales to EBV, our largest distributor and the sole independent distributor of our products in Europe, accounted for 11.6% of our total revenues for the quarter ended March 31, 2004 and 8.2% of our total revenues for the same period in 2003. We believe the $469,000 increase between the two periods is primarily the result of improved economic conditions in Europe and other geographic areas where EBV serves its customers. Our contract with EBV, which has been in effect since 1997 and has been renewed annually thereafter, expires in December 2004. If our agreement with EBV is not renewed, or is renewed on terms that are less favorable to us, our revenues could decrease and our future financial position could be harmed. We currently sell our products to EBV in U. S. Dollars. Therefore, the associat
ed revenues are not subject to foreign currency exchange rate risks. However, EBV has the right, on notice to our company, to require that we sell our products to them in Euros. 

Service revenues 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Service Revenues	$ 188	$ 245	$ (57	)	(23.3	%)

The $57,000 decrease in LONWORKS Infrastructure service revenues during the quarter ended March 31, 2004 as compared to the same period in 2003 was the result of continued decreases in customer support and training revenues. We believe that the worldwide economic recession in 2002 and 2003 forced many of our customers to curtail spending for training and support. Although worldwide economic conditions began 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 of
ferings during 2004 in an effort to minimize their operating expenses. 


	18

Gross Profit and Gross Margin 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Gross Profit	$ 15,279	$ 16,544	$ (1,265	)	(7.6	%)
Gross Margin	56.5%	50.7%	--		5.8

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. Gross margin is equal to gross profit divided by revenues. 

The 5.8 percentage point improvement in gross margin during the first quarter of 2004 was due primarily to a change in the mix of Enel Project and LONWORKS Infrastructure revenues. During the quarter ended March 31, 2004, approximately 57.5% of our revenues were attributable to the Enel Project and the remaining 42.5% were attributable to sales of our LONWORKS Infrastructure products and services. For the quarter ended March 31, 2003, approximately 68.4% of our revenues were attributable to the Enel Project, while the remaining 31.6% re
sulted from sales of our LONWORKS Infrastructure products and services. In general, gross margins on Enel Project revenues tend to be lower than those generated from sales of our LONWORKS Infrastructure products and services. As a result, when Enel Project revenues are lower as a percentage of overall revenues, as they were during the quarter ended March 31, 2004, overall gross margins tend to be higher. Conversely, when Enel Project revenues comprise a higher percentage of overall revenues, as they were during the quarter ended March 31, 2003, overall gross margins tend to be lower. In addition to the mix of Enel Project and LONWORKS Infrastructure revenues, reductions in the price we pay our suppliers for some of the products we purchase from them for sale to our customers also contributed to the quarter over quarter gross margin improvement.

Partially offsetting these improvements was the impact of lower overall revenues on gross margins. As discussed above, a portion of our cost of goods sold relates to indirect costs. Some of these costs do not increase or decrease in conjunction with revenue levels, but rather remain relatively constant from quarter to quarter. As a result, when revenues decrease, as they did in the quarter ended March 31, 2004 as compared to the same period in 2003, gross margins are negatively impacted. 

We expect that, for full year 2004, overall gross margin will decline slightly from the 55.9% experienced in 2003. 

Operating Expenses 

Product Development 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change	2004 over 2003 % Change

Product Development	$ 6,215	$ 5,095	$ 1,120	22.0	%

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. 

Of the $1.1 million increase in product development expenses during the quarter ended March 31, 2004 as compared to the same period in 2003, approximately $587,000 was attributable to the asset acquisition transaction with Metering Technology Corporation, or MTC, that occurred during the second quarter of 2003. Of this $587,000, approximately $348,000 related to ongoing day-to-day operating expenses (primarily payroll, equipment and supplies, and other outside services), while the remaining $239,000 related to amortization expense for purchased technology. The remaining $533,000 increase between the two quarters was primarily the result of increased facilities costs associated with our new corporate headquarters building in San Jose and increased salaries and other compensation expenses.


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We expect that, for full year 2004, product development expenses will be reduced from 2003 levels due to the fact that the $9.8 million in-process research and development charge taken in the second quarter of 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. 

Sales and Marketing 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change	2004 over 2003 % Change

Sales and Marketing	$ 5,058	$ 4,670	$ 388	8.3	%

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. 

Approximately $194,000 of the $388,000 increase in sales and marketing expenses during the quarter ended March 31, 2004 as compared to the same period in 2003 was attributable to the impact of foreign currency exchange rate fluctuations between the U.S. Dollar and the local currencies in several of the foreign countries in which we operate, including the Euro, the Pound Sterling, and the Japanese Yen. The other primary factors contributing to the increase between the two quarters were increased salary, commission, and other compensation related expenses. 

We expect that, for full year 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 U.S. Dollar. If, however, the U.S. Dollar were to strengthen against the foreign currencies where we do business, our sales and marketing expenses could decrease slightly. Conversely, if the U.S. Dollar were to weaken further against these currencies, our expenses would rise. 

General and administrative

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change	2004 over 2003 % Change

General and Administrative	$ 3,330	$ 2,936	$ 394	13.4	%

General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, professional fees for legal and accounting services rendered to the company, facility costs, insurance, and other general corporate expenses. 

The $394,000 increase in general and administrative expenses during the quarter ended March 31, 2004 as compared to the same period in 2003 was primarily attributable to a $655,000 increase in rent, depreciation, and other expenses attributable to our second new building at our corporate headquarters facility in San Jose, the lease for which began in May 2003. This increase was partially offset by a $325,000 reduction in legal and other professional fees which were higher in the first quarter of 2003 due to work being performed in conjunction with our acquisition of certain assets of MTC, which transaction closed during the second quarter of 2003. We expect that, for full year 2004, general and administrative costs will remain at or slightly above the levels incurred in 2003. This higher level
 of spending will be due, in part, to additional administrative requirements imposed by the Sarbanes-Oxley Act of 2002. 


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Interest and Other Income, Net 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Interest and Other Income, Net	$ 514	$ 741	$ (227	)	(30.6	%)

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. 

Although the average amount of our invested cash increased during the quarter ended March 31, 2004 as compared to the same period in 2003, the impact of short-term interest rate reductions, which began in late 2001 and continued through 2003, have had a negative impact on our interest income. As short-term investments we purchased in 2002 and 2003 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 the quarter ended March 31, 2004, 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 U.S. Dollar and the currencies in which we maintain our short-term intercompany balances (principally the European Euro and the British Pound Sterling) will also affect our interest and other income, net. 

Provision for Income Taxes 

	Three Months Ended

(Dollars in thousands)	March 31, 2004	March 31, 2003	2004 over 2003 $ Change		2004 over 2003 % Change

Provision for Income Taxes	$ 71	$ 367	$ (296	)	(80.7	%)

The provision for income taxes for 2004 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 $71,000 for the quarter ended March 31, 2004, and $367,000 for the quarter ended March 31, 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. During 2003, our effective tax rate was negatively impacted primarily by
 the effect the $9.8 million in-process research and development charge, which was taken in the second quarter upon the completion of the MTC transaction, had on our pre-tax income. As we do not anticipate a similar charge in 2004, we expect that our full year 2004 pre-tax income will increase as compared to 2003. We believe this increase in pre-tax income will result in a decrease in our effective tax rate in 2004 as compared to 2003. 

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 our company 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. 


	21

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, and in some cases, up to one year. We also obtain individual components for our products from a wide variety of individual suppliers. We generally acquire these components through the issuance of purchase orders, which cover periods ranging from one to six months. 

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 $131,000 during the quarter ended March 31, 2004, and $143,000 for the same period in 2003. 

As of March 31, 2004, 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	$	38,622	$	4,932	$	9,045	$	8,962	$	15,683
Purchase commitments		10,158		10,158		--		--		--

Total	$	48,780	$	15,090	$	9,045	$	8,962	$	15,683

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. 


	22

In September 2000, we consummated a sale of 3.0 million shares of our common stock to Enel. The net proceeds of the sale were about $130.7 million. 

In September 2001, our Board of Directors approved a stock repurchase program which authorized us to repurchase up to 2.0 million shares of our common stock, in accordance with Rule 10b-18 and other applicable laws, rules and regulations. In September 2001, we repurchased 265,000 shares under the program at a cost of $3.2 million. No additional repurchases were made subsequent to September 2001. The stock repurchase program expired in September 2003. 

In March 2004, our Board of Directors approved a second stock repurchase program, which authorizes us to repurchase up to 3.0 million shares of our common stock, in accordance with Rule 10b-18 and other applicable laws, rules and regulations, and subject to prior approval by the Board of Directors. No repurchases have been made since the repurchase program was approved. The second stock repurchase program will expire in March 2005. 

The following table presents selected financial information as of March 31, 2004 and for each of the last three fiscal years (Dollars in thousands): 

	March 31, 2004		2003		2002		2001

Cash, cash equivalents, and short-term investments	$	150,865	$	144,923	$	134,489	$	111,653
Trade accounts receivable, net		17,614		20,110		22,930		29,113
Working capital		163,542		160,745		156,320		151,748
Stockholders’ equity		203,410		200,924		195,018		174,717

As of March 31, 2004, we had $150.9 million in cash, cash equivalents, and short-term investments, an increase of $5.9 million as compared to December 31, 2003. 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 purchas
es 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 $5.8 million for the quarter ended March 31, 2004, a $1.3 million increase over the same period in 2003. During the quarter ended March 31, 2004, net cash provided by operating activities was generated primarily from changes in our operating assets and liabilities of $3.2 million, net income of $1.1 million, and $1.4 million of dep
reciation and amortization. Cash provided by operating activities for the quarter ended March 31, 2003 was generated primarily from net income of $4.2 million and $1.1 million of depreciation and amortization, offset by a reduction in our operating assets and liabilities of $842,000. 

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 $6.4 million for the quarter ended March 31, 2004, a $7.7 million decrease from the same period in 2003. During the quarter ended March 31, 2004, net cash used for investing activities was primarily the result of purchases of $46.2 million of available-for-sale short-term investments, capital expenditures of $822,000, purchases of restricted investments of $242,000, and changes in our other long-term as
sets of $112,000, offset by proceeds from sales and maturities of available-for-sale short-term investments of $41.0 million. Net cash used in investing activities for the quarter ended March 31, 2003 of $14.0 million was principally due to the purchase of $50.2 million of available-for-sale investments, capital expenditures of $1.0 million, and purchases of restricted investments of $169,000, offset by the proceeds from sales and maturities of available-for-sale investments of $36.5 million and a reduction in our other long-term assets of $825,000.


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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 $1.4 million for the quarter ended March 31, 2004, a $925,000 increase over the same period in 2003. For both the quarter ended March 31, 2004 and the quarter ended March 31, 2003, net cash provided by financing activities was comprised of proceeds from the exercise of stock options by employees and directors. 

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): 


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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 was amortized over its estimated useful life of one year. For the three months ended March 31, 2004, amortization expense related to this purchased technology was approximately $239,000, which was recorded in product development expenses. As of March 31, 2004, the $957,000 purchased technology was fully amortized. 

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 quarter ended March 31, 2004, and 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 April 30, 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 April 30, 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 abstained 
from resolutions on any matter relating to Enel. 

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At the time we entered into the stock purchase agreement with Enel, we also entered into a research and development agreement (the "R&D Agreement") with an affiliate of Enel. Under the terms of the R&D 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 inc
luded 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 Project will decline as compared to the $75.8 million recognized in 2003. In addition, we expect that we will complete our Enel Project 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. 

On May 3, 2004, we announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. The arbitration is to take place in London. Enel claims that the R&D Agreement obligates us to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel Echelon to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. We believe our company has fulfilled its obligations under the R&D Agreement, including any obligation with respect to
 the sale of products and with respect to joint marketing. We believe that Enel’s claims are without merit and we intend to vigorously defend our company in the arbitration proceedings. 

Recently Issued Accounting Standards 

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 are 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. The adoption of FIN 46R did not have a material impact 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. 


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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: 

	Three Months Ended March 31,
	Three Months Ended March 31,			Year Ended December 31,
	2004			2003		2002			2001

Shares of common stock outstanding		40,624,123		40,409,956			39,725,550			38,753,360

Options granted		1,881,425		2,346,245			2,282,750			2,560,225
Options cancelled		(50,230	)	(743,344	)		(81,872	)		(244,314	)

Net options granted		1,831,195		1,602,901			2,200,878			2,315,911

Grant dilution *		4.5	%	4.0	%		5.5	%		6.0	%

Options exercised		214,167		793,633			631,917			971,107

Exercise dilution **		0.5	%	2.0	%		1.6	%		2.5	%

*      The percentage for grant dilution is computed based on options granted less options cancelled as a percentage of total outstanding shares of common stock. 

**    The percentage for exercise dilution is computed based on options exercised as a percentage of total outstanding shares of common stock. 


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The following table summarizes the options granted to our Named Executive Officers, whose names can be found under the section entitled "Executive Options" below. For the years ended December 31, the Named Executive Officers represent our Chief Executive Officer and the four other most highly paid executive officers whose salary and bonus for the respective fiscal year were in excess of $100,000. For the quarter ended March 31, 2004, our Named Executive Officers include the same group of individuals as was reported for the year ended December 31, 2003. 

	Three Months Ended March 31,
	Three Months Ended March 31,			Year Ended December 31,
	2004			2003		2002			2001

Options granted to the Named Executive Officers		400,000		380,000			540,000			450,000

Options granted to the Named Executive Officers as a % of net options granted		21.8	%	23.7	%		24.5	%		19.4	%

Options granted to the Named Executive Officers as a % of outstanding shares		1.0	%	0.9	%		1.4	%		1.2	%

Cumulative options held by Named Executive Officers as a % of total outstanding options		21.0	%	21.1	%		23.8	%		24.8	%

General Option Information 

The following table summarizes option activity under all plans since December 31, 2003 (prices are weighted average prices): 

				Options Outstanding

	Options Available for Grant			Number Outstanding			Weighted-Average Exercise Price Per Share

BALANCE AT DECEMBER 31, 2003		3,601,792			8,944,182		$	16.49
Granted		(1,881,425	)		1,881,425			10.88
Cancelled		50,230			(50,230	)		27.81
Exercised		---			(214,167	)		7.12
Additional shares reserved		2,120,498			---			---

BALANCE AT MARCH 31, 2004		3,891,095			10,561,210		$	15.63


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The following table summarizes the stock options outstanding as of March 31, 2004: 

	Exercisable						Unexercisable						Total

As of March 31, 2004		Shares (#	)		Weighted Average Exercise Price ($	)		Shares (#	)		Weighted Average Exercise Price ($	)		Shares (#	)		Weighted Average Exercise Price ($	)

In-the-Money		1,015,365		$	8.11			1,844,792		$	10.81			2,860,157		$	9.85
Out-of-the-Money *		4,501,566			20.17			3,199,487			14.40			7,701,053			17.77

Total Options Outstanding		5,516,931		$	17.95			5,044,279		$	13.09			10,561,210		$	15.63

* Out-of-the-Money options are those options with an exercise price equal to or above the closing price of $11.27 at March 31, 2004. 

Certain options issued under the 1997 Plan may be exercised at any time prior to their expiration, even if those options have not yet vested. Shares issued upon exercise of unvested options are considered unvested shares. Once issued, the unvested shares continue vesting in accordance with original option’s vesting schedule. If the option holder’s employment or service with our company terminates before the unvested shares become fully vested, we have the right, at our discretion, to repurchase from the option holder any unvested shares at the exercise price paid by the option holder. As of March 31, 2004, there were no exercised shares subject to repurchase by our company. Of the 5,516,931 options exercisable as of March 31, 2004, 4,948,915 were vested. 

Executive Options 

The following table sets forth certain information with respect to stock options granted to our Named Executive Officers during the three-month period ended March 31, 2004. All option grants were made under the 1997 Plan. 

	Individual Grants

	Number of Securities Underlying Options		% of Total Options Granted to Employees in Fiscal		Exercise Price Per			Expiration		Potential Realizable Value At Assumed Annual Rates of Stock Price Appreciation for Option Term ($) **
Name		Granted		Year *		Share ($	)		Date		5	%	10	%

M. Kenneth Oshman		120,000		6.4		10.89			3/17/2009		361,045		797,815
Beatrice Yormark		80,000		4.3		10.89			3/17/2009		240,697		531,876
Oliver R. Stanfield		80,000		4.3		10.89			3/17/2009		240,697		531,876
Frederik H. Bruggink		60,000		3.2		10.89			3/17/2009		180,522		398,907
Peter A. Mehring		60,000		3.2		10.89			3/17/2009		180,522		398,907

*      Based on a total of 1,881,425 options granted to all employees during the three months ended March 31, 2004. 

**    Potential gains are net of the exercise price but before taxes associated with the exercise. The 5% and 10% assumed annual rates of compounded stock appreciation based upon the deemed fair market value are for illustrative purposes only and do not represent our estimate or projection of the future common stock price. Actual gains, if any, on stock option exercises are dependent on several factors, including our future financial performance, overall market conditions, and the option holder’s continued employment with our Company. There can be no assurance that the amounts reflected in this table will be achieved. 


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The following table sets forth, for our Named Executive Officers, certain information concerning shares acquired upon the exercise of stock options during the three-month period ended March 31, 2004, as well as exercisable and unexercisable options held as of March 31, 2004. 

	Shares Acquired on			Value Realized		Number of Securities Underlying Unexercised Options at March 31, 2004 (#)			Value of Unexercised In-the-Money Options at March 31, 2004 ($) **
Name		Exercise (#	)		($) *		Exercisable	Unexercisable		Exercisable	Unexercisable

M. Kenneth Oshman		150,000			665,550		790,000	--		45,600	--
Beatrice Yormark		---			---		212,497	222,503		315,563	30,400
Oliver R. Stanfield		---			---		137,497	222,503		--	30,400
Frederik H. Bruggink		---			---		247,707	42,293		37,800	--
Peter A. Mehring		---			---		192,707	152,293		315,563	22,800

*     The value realized is based on the closing price of our common stock on the date of exercise, minus the per share exercise price, multiplied by the number of shares exercised. 

**    The value of underlying securities is based on the $11.27 per share closing price of our common stock on March 31, 2004, minus the aggregate exercise price. Only options that are in the money are included in this analysis. 

Equity Compensation Plan Information 

The following table summarizes our company’s stock option plans as of March 31, 2004. 

Plan Category	Number of Securities to be Issued Upon Exercise of Outstanding Options		Weighted-Average Exercise Price of Outstanding Options		Number of Securities Remaining Available for Issuance Under Stock Option Plans *

Equity compensation plans approved by stockholders		10,561,210	$	15.63		3,891,094

Equity compensation plans not approved by stockholders		---		---		---

Total		10,561,210	$	15.63		3,891,094

*    Both the 1997 Plan and the Director Option Plan provide for annual increases to the number of shares authorized for issuance under the plan. The amounts reflected in this table represent balances remaining available for future stock option issuance as of March 31, 2004. 

Accounting for Stock-Based Employee Compensation Plans 

We account for stock-based employee compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. 


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FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS 

Interested persons should carefully consider the risks described below in evaluating our company. Additional risks and uncertainties not presently known to us, or that we currently consider immaterial, may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our common stock could decline.        

Our future results would be significantly harmed if our project with Enel is terminated or is not successful. 

In September 2000, we entered into a research and development agreement with an affiliate of Enel S.p.A., an Italian utility company. Under the terms of the agreement, we agreed to work with Enel to integrate our LONWORKS technology into Enel’s Contatore Elettronico remote metering management project in Italy. During the quarter ended March 31, 2004, revenue attributable to the Contatore Elettronico project was approximately $15.5 million, or 57.5% of our total revenue. We expect the Contatore Elettronico project to account for the majority of our targeted revenue for 2004. 

We face a number of risks as we continue this project, including: 

we recently announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. Enel claims that the R&D Agreement obligates us to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel our company to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. Regardless of the outcome of the arbitration proceedings, the action will divert our management’s attention from other business and will cause us to incur legal and other costs to defend against Enel’s claims. It may also cause our customers or potential customers in the utility business to question whether the arbitration will affect our NES business. In addition, if Enel is successful in the arbitration, then we may have to pay as yet unspecified damages, and Enel may seek to terminate the R&D Agreement. These factors could have a material negative effect on our results of operations and our financial condition;
a dispute could develop between Enel and our company regarding scope of any of the other obligations of the parties with respect to the Contatore Elettronico, the research and development agreement or other agreements, or with respect to product suitability, quality, price, quantities, or other issues. Even if we should prevail in such a dispute, the costs incurred by Echelon and the diversion of time by key employees could adversely affect our company. If any dispute is not resolved in our favor or in a timely manner, the project, or revenue generated fro m 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. 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;
Enel could decide to no longer pursue the Contatore Elettronico project to the extent we currently contemplate, or Enel could replace the LONWORKS technology used by Enel in the Contatore Elettronico project with other technology;
once manufactured, electricity meters, data concentrators, or other products used in the Contatore Elettronico project may not be installed by Enel in accordance with Enel’s scheduled roll-out plan. Also, Enel could decide to reduce its inventories of electricity meters or data concentrators. As a result, excess inventories could develop for periods of time, which could result in the delay or cancellation of additional product shipments to Enel and the contract equipment manufacturers that Enel has selected to manufacture electricity meters for the project;
Enel may not successfully develop or maintain the management center software to monitor and control the electricity meters and other products used in the Contatore Elettronico project, or the management center software that Enel develops may not be scalable enough to support the estimated 27 million meters that Enel intends to install as part of the project. As a result, Enel might reduce purchases of electricity meters or other products, thereby reducing future shipments of our products;
under the Contatore Elettronico project, each order for electricity meters must be made by public tender. Any future public tenders for electricity meters may not be completed in a timely fashion, and this may delay production of electricity meters with an associated delay in shipments of products by us to Enel’s contract equipment manufacturers;

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the research and development agreement between Enel and our company might be terminated if, among other things, either party materially breaches its obligations under the agreement;
third parties may contest part or all of our agreement with Enel, or the Contatore Elettronico project in general. For example, the European Union and/or the Italian government could require a change in the system architecture or the sources of supply in order to satisfy rules regarding competition, thereby delaying or changing the scope of the project; or
our research and development activities under the Contatore Elettronico project might be unsuccessful, or the products we develop might not be commercially exploitable or yield economic returns.

Any of these factors would cause our revenues and income to suffer, which would significantly and adversely affect our financial condition and operating results. 

The performance of the contract equipment manufacturers that Enel has selected to manufacture electricity meters could affect our project with Enel. 

Enel has selected several contract equipment manufacturers, or meter manufacturers, to manufacture electricity meters for the Contatore Elettronico project. We sell a product called a metering kit to these meter manufacturers as part of this project. Our shipments of metering kits depend, to a large extent, on the production of electricity meters. In addition, the sales of our data concentrator products to Enel depend, in part, on the production of electricity meters. Our success under the Contatore Elettronico project could be affected by the meter manufacturers for many reasons, including: 

disputes may arise with us regarding product quality or responsibility for costs incurred by the meter manufacturers relating to metering kits;
if the meter manufacturers fail to meet their intended production or quality levels, fail to pay us in accordance with agreed-upon payment terms for products we ship to them, or breach any of their agreements with us, we could elect to cancel orders for products from meter manufacturers, delay shipment of products to meter manufacturers, or otherwise fail to achieve our revenue targets for the Contatore Elettronico project;
the meter manufacturers may not achieve their intended production levels;
we may be prohibited by government trade sanctions from selling metering kits to one or more meter manufacturers;
the meter manufacturers may not be able to maintain product quality at the levels required to successfully install electricity meters;
the meter manufacturers may not maintain sufficient net working capital to fund production of electricity meters or may fail to provide letters of credit that we mandate; and
the meter manufacturers may experience excess raw material and finished goods inventories if they fail to achieve intended production and/or quality levels and may therefore reduce future purchases of our products until their inventories return to acceptable levels.

Additionally, if any of Enel’s meter manufacturers were to experience cash flow problems resulting from one or more of the above listed failures, or any other factor, we could be forced to provide a bad debt reserve for some or all of the unpaid balances that meter manufacturer owed us for products we previously shipped to them. Given the volume of products that Enel’s meter manufacturers purchase from us, any bad debt provision we would be required to make would most likely be a material amount, and therefore, would have an adverse effect on our financial condition and operating results. 

Once the Enel project is completed, or if it is terminated, our overall revenue will decline significantly if we do not expand our customer base. 

If Enel continues to deploy its Contatore Elettronico project in accordance with its scheduled rollout plan, we expect that revenues from the Enel project will continue to account for a significant portion of our overall revenues through 2004. Once the delivery of our products for use in the project is completed, which we currently estimate will occur in early 2005, or if it is otherwise terminated, our revenues from Enel and its meter manufacturers will become negligible. Accordingly, we continue to seek new revenue opportunities with other utility companies around the world. 


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In May 2002, we formed a Service Provider Group tasked with selling our networked energy services, or NES, system to utility companies and value added resellers around the world. We believe that utility companies generally require a lengthier sales cycle than do most of our other customers. In most instances, one or more field trials of our products may be required before a final decision is made by the utility. For example, in July 2003, we entered into an agreement with Continuon Netbeheer, a utility grid operator located in the Netherlands, to perform a limited field trial of our NES system within their service territory. Even if the Continuon field trial or other field trials are successful, we may not be able to negotiate mutually agreeable terms with the utility. If the utility decides t
o move forward with a mass deployment, there is generally an extended development and integration effort required in order to incorporate the new technology into the utility’s existing infrastructure. Due to the extended sales cycle and the additional development and integration time required, we cannot assure you that we will be able to find a replacement for the Enel project before the Enel project is terminated or completed. If we are not able to replace the revenues generated by the Enel project, our revenues and results of operations will be harmed. 

Our utility market product offerings may not be accepted by our targeted customers, or may fail to meet our financial targets. If we incur penalties and/or damages with respect to sales of the NES system, such penalties and/or damages could have an adverse effect on our financial condition, revenues, and operating results. 

To be successful in our efforts to sell our NES system, we intend to continue investing significant resources in the development of the NES system. For example, in April 2003 we acquired certain assets of Metering Technology Corporation, or MTC, in exchange for $11.0 million in cash and the assumption of certain liabilities. Among the assets acquired was the right to use MTC’s developed electricity meter technology. However, as we have integrated their technology into our NES system, we have incurred and expect to continue to incur significant development costs. 

We cannot assure you that our NES system will be accepted in the utility market place. For example, in order to realize all of the benefits of the NES system, a utility must replace a significant portion of its metering infrastructure with a homogenous population of intelligent, networked meters. We also cannot assure you that, if accepted by the utilities, our NES system will generate economic returns that meet our financial targets. For example, revenues from our NES system offering may be lower than we anticipate. Additionally, the gross margins we receive from our NES system offering may not be as high as for our other products. 

Even if we are successful in penetrating the utility market with our NES system offering, we face competition from many companies. For example, Enel, our largest customer, 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. Enel recently announced an alliance with IBM to market and sell metering systems worldwide. While we are discussing with Enel and IBM what role, if any, our company may have in that alliance, it is possible that our company might not participate, or that if we do participate, our revenues may not be as high as for our other products. In addition, if we do participate, such participation could have a negative impact on 
our marketing efforts for the NES system. Other competitors, including our own customers such as Enermet, Horstmann Controls, Kamstrup, and Milab, could also develop and market their own multi-service metering systems that will compete with our NES offering. 

In addition, we presently plan to sell our NES products to utilities either directly or through resellers or other partners.  If we sell the NES system directly to a utility, the utility may require us to assume responsibility for installing the NES system in the utility's territory, integrating the NES system into the utility's operating and billing system, overseeing management of the combined system, and undertaking other activities.  These are services that we generally would not be responsible for if we sold our NES products through a reseller or other partner, or if we sold directly to a utility that managed those activities on its own. To date, we have only insignificant experience with those services. As a result, if we sold directly to a utility that required us to provide t
hose services, we may be required to contract with third parties to satisfy those obligations.  We cannot assure you that we would find appropriate third parties to provide those services on reasonable terms, or at all.  Assuming such responsibility for these or other services would add to the costs and risks associated with NES system installations, and could also negatively affect the timing of our revenues and cash flows related to these transactions.  

Lastly, sales of the NES system may also expose us to penalties and damages relating to late deliveries, late or improper installations or operations, failure to meet product specifications, failure to achieve performance specifications or otherwise. If we are unsuccessful in deploying the NES system, or otherwise fail to meet our financial targets for the NES system, our revenues and results of operations will be harmed. 


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We depend on a limited number of key manufacturers and use contract electronic manufacturers for most of our products requiring assembly. If any of these manufacturers terminates or decreases its relationships with us, we may not be able to supply our products and our revenues would suffer. 

The Neuron Chip is an important component that our customers use in control network devices. In addition, the Neuron Chip is an important device that we use in many of our products. Neuron Chips are currently manufactured and distributed by Toshiba and Cypress Semiconductor under license agreements we maintain with them. These agreements, among other things, grant Toshiba and Cypress the worldwide right to manufacture and distribute Neuron Chips using technology licensed from us, and require us to provide support, as well as unspecified updates to the licensed technology, over the terms of the agreements. The Cypress agreement expires in April 2009, and the Toshiba agreement expires in January 2010. However, we cannot be certain that these manufacturers will continue to supply Neuron Chips unt
il these contracts expire, and we currently have no other source of supply for Neuron Chips. If either Toshiba or Cypress were to cease designing, manufacturing, and distributing Neuron Chips, we could be forced to rely on a sole supplier for Neuron Chips. If both Toshiba and Cypress were to exit this business, we would attempt to find a replacement. This would be an expensive and time-consuming process, with no guarantee that we would be able to find an acceptable alternative source. 

We also maintain manufacturing agreements with other semiconductor manufacturers for the production of key products, including those used in the Enel Project and our NES system. For example, in 2003 we announced a new product family that we refer to as Power Line Smart Transceivers. A sole source supplier, STMicroelectronics, manufactures these products. Additionally, Cypress, ON Semiconductor and AMI Semiconductor are sole source suppliers of components we sell to Enel’s meter manufacturers. We currently have no other source of supply for Power Line Smart Transceivers or the components manufactured by Cypress, ON Semiconductor, and AMI Semiconductor. 

Our future success will also depend significantly on our ability to manufacture our products cost-effectively, in sufficient volumes and in accordance with quality standards. For most of our products requiring assembly, we use contract electronic manufacturers, including WKK Technology, Able Electronics, and TYCO TEPC/Transpower. These contract electronic manufacturers procure material and assemble, test, and inspect the final products to our specifications. This strategy involves certain risks. By using third parties to manufacture our products, we have reduced control over quality, costs, delivery schedules, product availability, and manufacturing yields. For instance, quality problems at a contract equipment manufacturer could result in missed shipments to our customers and unusable invento
ry, thereby reducing our revenues and increasing our costs associated with inventory reserves. In addition, contract electronic manufacturers can themselves experience turnover and instability, exposing us to additional risks as well as missed commitments to our customers. 

We will also face risks if and when we transition between contract electronic manufacturers. For example, we may have to move raw material and in-process inventory between locations in different parts of the world. Also, we would be required to re-establish acceptable manufacturing processes with a new work force. We could also be liable for excess or unused inventory held by contract manufacturers for use in our products. This inventory may become obsolete as a result of engineering changes that we make. In addition, we may no longer need this inventory because of factors such as changes in our production build plans, miscommunication between us and a contract manufacturer, or errors made by a contract manufacturer in ordering material for use in our products. Under our contracts with these c
ontract electronic manufacturers, we would become liable for all or some of these excess or obsolete inventories in the event our manufacturing agreement with them is cancelled and they are unable to return the material to their suppliers. 

The failure of any key manufacturer to produce products on time, at agreed quality levels, and fully compliant with our product, assembly and test specifications could adversely affect our revenues and gross profit, and could result in claims against us by our customers. 

Since we depend on sole or a limited number of suppliers, any price increases, shortages, or interruptions of supply would adversely affect our revenues and/or gross profits. 

As previously discussed, we currently purchase several key products and components only from sole or limited sources. For some of these suppliers, we do not maintain signed agreements that would obligate them to supply to us on negotiated terms. As a result, we may be vulnerable to price increases for products or components. In addition, in the past, we have occasionally experienced shortages or interruptions in supply for certain of these items, which caused us to delay shipments beyond targeted or announced dates. If we experience any shortage of products or components of acceptable quality, or any interruption in the supply of these products or components, or if we are not able to procure these products or components from alternate sources at acceptable prices and within a reasonable period
 of time, our revenues, gross profits or both could decrease. In addition, under the terms of some of our contracts with our customers, we may also be subject to penalties if we fail to deliver our products on time. 


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Although we have achieved profitability, we have a history of losses and cannot guarantee that profits will increase or continue in the future. 

We generated a profit of $1.1 million for the quarter ending March 31, 2004. As of March 31, 2004, we had an accumulated deficit of $68.5 million. We have invested and continue to invest significant financial resources in product development, marketing and sales. 

Our future operating results will depend on many factors, including: 

timely installation of Enel’s Contatore Elettronico project;
adoption of our NES solution and other products by service providers for use in utility and/or other home automation projects;
the affect of expensing stock option grants or other compensatory awards to our employees, if and when required under accounting pronouncements;
return of worldwide economic growth, particularly in certain industries such as semiconductor manufacturing equipment;
the ability of our contract electronic manufacturers to provide quality products on a timely basis, especially during periods where excess capacity in the contract electronic manufacturing market is reduced;
growth in acceptance of our products by OEMs, systems integrators, service providers and end-users;
the level of competition that we face;
our ability to attract new customers in light of increased competition;
our ability to develop and market, in a timely and cost-effective basis, new products that perform as designed;
costs associated with business acquisitions, including up-front in-process research and development charges and ongoing amortization expenses related to other identified intangible assets;
ongoing operational expenses associated with our acquisition of BeAtHome, our acquisition of certain assets of MTC, and any future business acquisitions;
results of impairment tests that we will perform from time to time in the future, in accordance with SFAS 142, with respect to goodwill and other identified intangible assets that we acquired in the past or that we may acquire in the future. If the results of these impairment tests indicate that an impairment event has taken place, we will be required to take an asset impairment charge that could have a material adverse effect on our operating results; and
general economic conditions.

As of December 31, 2003, we had net operating loss carry forwards for federal income tax reporting purposes of about $83.5 million and for state income tax reporting purposes of about $8.7 million, which expire at various dates through 2022. In addition, as of December 31, 2003, we had tax credit carry forwards of about $10.5 million, $6.0 million of which expire at various dates through 2022. The Internal Revenue Code of 1986, as amended, contains provisions that limit the use in future periods of net operating loss and credit carry forwards upon the occurrence of certain events, including significant changes in ownership interests. We have performed an analysis of our ownership changes and have reporte
d the net operating loss and credit carry forwards considering such limitations. We had deferred tax assets, including our net operating loss carry forwards and tax credits, totaling about $47.8 million as of December 31, 2003. We have recorded a valuation allowance for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance, our history of losses and the variability of our operating results. 

Fluctuations in our operating results may cause our stock price to decline. 

Our quarterly and annual results have varied significantly from period to period, and we have, on occasion, failed to meet securities analysts’ expectations. Our future results may fluctuate and may not meet analysts’ expectations in some future period. As a result, the price of our common stock could fluctuate or decline. Some factors that could cause this variability, many of which are outside of our control, include the following: 


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revenues from the Enel project may fail to meet analysts’ expectations or our revenue and earnings guidance;
we may fail to meet stockholder expectations relating to our NES system and additional utility customers and applications;
we may fail to meet stockholder expectation for revenue growth in our sales of LONWORKS Infrastructure products to OEMs and systems integrators;
the rates at which OEMs purchase our products and services may fluctuate;
our products may not be manufactured in accordance with specifications or our established quality standards, or may not perform as designed;
we may fail to introduce new products on a timely basis or before the end of an existing product’s life cycle;
downturns in any customer’s or potential customer’s business, or declines in general economic conditions, could cause significant reductions in capital spending, thereby reducing the levels of orders from our customers;
we may face increased competition in both our LONWORKS Infrastructure business and our NES business;
market acceptance of our products may decrease;
our customers may delay or cancel their orders;
the mix of products and services that we sell may change to a less profitable mix;
shipment and payment schedules may be delayed;
our pricing policies or those of our competitors may change;
costs associated with business acquisitions, including up-front in-process research and development charges and ongoing amortization expenses related to other identified intangible assets;
ongoing operational expenses associated with our acquisition of BeAtHome, our acquisition of certain assets of MTC, and any future business acquisitions;
the results of impairment tests that we will perform from time to time in the future, in accordance with SFAS 142, with respect to goodwill and other identified intangible assets that we acquired in the past or that we may acquire in the future. If the results of these impairment tests indicate that an impairment event has taken place, we will be required to take an asset impairment charge that could have a material adverse effect on our operating results;
our product distribution may change; and
product ratings by industry analysts and endorsements of competing products by industry groups could hurt the market acceptance of our products.

In addition, our expense levels are based, in significant part, on the future revenues that we expect. Consequently, if our revenues are less than we expect, our expense levels could be disproportionately high as a percentage of total revenues, which would negatively affect our profitability and cause our stock price to decline. 

If we are required to take a compensation expense for the value of stock options or other compensatory awards that we issue to our employees, our earnings would be harmed.

We believe that stock options are a key element in our ability to attract and retain employees in the markets in which we operate. On March 31, 2004, the Financial Accounting Standards Board issued an Exposure Draft, Share-Based Payment: an amendment of FASB Statements No. 123 and 95, which would require a company to recognize, as an expense, the fair value of stock option and other stock-based compensation to employees beginning in 2005. We currently use the intrinsic value method to measure compensation expense for stock-based awards to our employees. Under this standard, we generally do not c
onsider stock option grants issued under our employee stock option plans to be compensation when the exercise price of the stock option is equal to or greater than the fair market value on the date of grant. If the Exposure Draft is adopted in its current form, we would be required to take a compensation charge as stock options or other stock-based compensation awards are issued or as they vest, including the unvested portion of options that were granted prior to 2005. This compensation charge would be based on a calculated value of the option or other stock-based award using a methodology that has yet to be finalized, and which may not correlate to the current market price of our stock. In the event such a compensation charge was required, our reported results of operations would be adversely affected and the trading price of our stock could be negatively impacted. 
 
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Defects in or misuse of our products may delay our ability to generate revenues and may increase our liabilities and expenses. 

Our products may contain undetected errors or failures when first introduced, as new versions are released, or as a result of the manufacturing process. In addition, our customers or their installation partners may improperly install or implement our products. Furthermore, because of the low cost and interoperable nature of our products, LONWORKS technology could be used in a manner for which it was not intended.

If errors or failures are found in our products, we may not be able to successfully correct them in a timely manner, or at all. Such errors or failures could delay our product shipments and divert our engineering resources while we attempt to correct them. In addition, we could decide to extend the warranty period, or incur other costs outside of our normal warranty coverage, to help address any known errors or failures in our products and mitigate the impact on our customers. As a result, errors or failures in our products, or the improper installation or implementation of our products by third parties, could harm our reputation, reduce our revenues, increase our expenses, and negatively impact our operating results. 

To address these issues, the agreements we maintain with our customers typically contain provisions intended to limit our exposure to potential errors and omissions claims as well as any liabilities arising from them. In certain very limited instances, these agreements require that we be named as an additional insured on our customer’s insurance policies. However, our customer contracts and additional insured coverage may not effectively protect us against the liabilities and expenses associated with errors or failures attributable to our products. For example, utility customers purchasing our NES system may require that we agree to indemnities or penalties in excess of the provisions we typically employ with our LONWORKS Infrastructure business. Also, local law
s may impose liability for NES system or other product failures, including liability for harm to property or persons. Such failures could harm our reputation, expose our company to liability, and adversely affect our operating results.
 
To help reduce our exposure to these types of claims, we currently maintain errors and omissions insurance. However, it is possible that such insurance may not be available in the future or, if available, may be insufficient in amount to cover any particular claim. During 2000, the total limit for claims under these policies was $17.0 million. Since then, we have reduced the total limit for errors and omissions claims to $11.0 million because we believed the premiums our insurers requested were excessive. We believe that insurance premiums for errors and omissions coverage will continue to increase for the foreseeable future, which could result in increased costs or reduced limits. Consequently, if we elect to reduce our coverage, we may face increased exposure to these types of claims. If lia
bility for a claim exceeds our policy limits, our operating results and our financial position would be negatively affected. 
 

We face operational and financial risks associated with international operations. 

Our international sales and marketing operations are located in nine countries around the world. Revenues from international sales, which include both export sales and sales by international subsidiaries, accounted for about 85.1% of our total net revenues for the quarter ended March 31, 2004 and 88.3% of our total net revenues for the same period in 2003. We expect that international sales will continue to constitute a significant portion of our total net revenues. 

Our operations and the market price of our products may be directly affected by economic and political conditions in the countries where we do business. In addition, we may not be able to maintain or increase the international demand for our products. Additional risks inherent in our international business activities generally include the following: 

international terrorism and anti-American sentiment;
currency fluctuations;
unexpected changes in regulatory requirements, tariffs and other trade barriers;
costs of localizing products for foreign countries and lack of acceptance of non-local products in foreign countries;

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longer accounts receivable payment cycles;
difficulties in managing international operations;
labor actions generally affecting individual countries, regions, or any of our customers which could result in reduced demand for our products;
potentially adverse tax consequences, including restrictions on repatriation of earnings; and
the burdens of complying with a wide variety of foreign laws.

The outbreak of severe acute respiratory syndrome, or SARS, that began in China, Hong Kong, Singapore, and Vietnam in 2003 also had a negative impact on our business. Any future outbreak of SARS, or other widespread communicable diseases, could similarly impact our operations, including the inability for our sales and operations personnel located in affected regions to travel and conduct business freely, the impact any such disease may have on one or more of the distributors for our products in those regions, and increased supply chain costs. Additionally, any future SARS or other health-related disruptions at our third-party contract manufacturers or other key suppliers, many of whom are located in China and other parts of southeast Asia, could affect our ability to supply our customers with 
products in a timely manner. 

Differing vacation and holiday patterns in other countries, particularly in Europe, may also affect the amount of business that we transact in other countries in any given quarter, the timing of our revenues, and our ability to forecast projected operating results for such quarter. 

Fluctuations in the value of currencies in which we conduct our business relative to the U.S. Dollar could cause currency translation adjustments. The portion of our revenues conducted in currencies other than the U.S. Dollar, principally the Japanese Yen, was about 2.8% for the quarter ended March 31, 2004 and 3.9% for the same period in 2003. In addition, much of our sales and marketing expenses, as well as certain other costs, are incurred in currencies other than the U.S. Dollar. For example, if China revalues its currency, the Chinese Renminbi, against the U.S. Dollar, the costs of products and manufacturing and other services that we obtain from our suppliers and contractors in China could increase significantly. If the value of the U.S. Dollar declines as compared to the local currency 
where the expenses are incurred, our expenses, when translated back into U.S. Dollars, will increase. For example, using the currency rates in effect as of March 31, 2004, our 2003 costs and expenses, as reported in U.S. Dollars, would have increased by approximately $781,000. This would have resulted in a $0.02 reduction in earnings per share for 2003. 

The use of the Euro as the standard currency in participating European countries may also impact our ability to transact sales in U.S. Dollars. We have agreed with EBV, our European distributor, that upon notice from EBV, we will sell our products to EBV in European Euros rather than U.S. Dollars. We do not know when or if EBV will give such notice. If fewer of our sales in Europe are transacted in U.S. Dollars, we may experience an increase in currency translation adjustments, particularly as a result of general economic conditions in Europe as a whole. We do not currently engage in currency hedging transactions or otherwise cover our foreign currency exposure. 

Our business may suffer if it is alleged or found that we have infringed the intellectual property rights of others. 

Although we attempt to avoid infringing known proprietary rights of third parties in our product development efforts, from time to time we may receive notice that a third party believes that we may be infringing certain patents or other intellectual property rights of that third party. Responding to those claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. In that case, we may elect or be required to redesign our products so that they do not incorporate any intellectual property to which the third party has or claims rights. As a result, some of our product offerings could be delayed, or we could be required to cease distributing some of our products. In the alternati
ve, we could seek a license for the third party’s intellectual property, but it is possible that we would not be able to obtain such a license on reasonable terms, or at all. Any delays that we might then suffer or additional expenses that we might then incur could adversely affect our revenues, operating results and financial condition. 

Our customers may not pursue product opportunities based on their concerns regarding third party intellectual property rights, particularly patents and this could reduce the market opportunity for the sale of our products and services. 


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Our markets are highly competitive. Many of our competitors have longer operating histories and greater resources than we do. If we are unable to effectively compete in the industry, our operating results could be harmed. 

Competition in our markets is intense and involves rapidly changing technologies; evolving industry standards, frequent new product introductions and rapid changes in customer requirements. To maintain and improve our competitive position, we must continue to develop and introduce, on a timely and cost-effective basis, new products, features and services that keep pace with the evolving needs of our customers. The principal competitive factors that affect the markets for our control network products include the following: 

our customer service and support;
our ability to develop and introduce new products on a timely basis;
our product reputation, quality, and performance; and
the price and features of our products such as adaptability, scalability, functionality, ease of use, and the ability to integrate with other products.

In each of our markets, we compete with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses. For our LONWORKS Infrastructure business, 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 Groupe Schneider in the industrial automation industry. Many of our competitors, alone or together with their trade associations and partners, have significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition, and broader pro
duct offerings. As a result, these competitors may be able to devote greater resources to the development, marketing, and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, proprietary control systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. Products from other companies such as Digi International, emWare, Ipsil, JumpTec, Lantronix, Microsoft, and Wind River Systems, as well as certain micro-controller manufacturers including Motorola, Texas Instruments, Micro Chip, and Philips, all of which promote directly connecting devices to the Internet, could also compete with our products. In addition, in the utilities market, products from companies such as Actaris, Atos Origin, DCSI, Elster, Hexagram, Hunt Technologies, Itron, Iskraemeco, Nexus, and Ramar, each of which offers automatic meter reading pr
oducts 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. 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 competitors develop, support, and promote alternative control systems. If we are unable to promote and expand acceptance of our open, interoperable control system, our revenues and operating results may be harmed. 

Many of our current and prospective competitors are dedicated to promoting closed or proprietary systems, technologies, software and network protocols or product standards that differ from or are incompatible with ours. In some cases, companies have established associations or cooperative relationships to enhance the competitiveness and popularity of their products, or to promote these different or incompatible technologies, protocols and standards. For example, in the building automation market, we face widespread reluctance by vendors of traditional closed or proprietary control systems, who enjoy a captive market for servicing and replacing equipment, to use our interoperable technologies. We also face strong competition by large trade associations that promote alternative technologies and 
standards in their native countries, such as the Konnex Association in Belgium, and the European Installation Bus Association in Germany, each of which has over 100 members and licensees. Other examples include various industry groups who promote alternative open standards such as BACnet in the building market, DALI in the lighting controls market, Echonet in the home control market, and a group comprised of 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. 


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We promote an open technology platform that could increase our competition. 

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

Downturns in the control network technology market and related markets may decrease our revenues and margins. 

The market for our products depends on economic conditions affecting the broader control network technology and related markets. Downturns in these markets may cause our OEMs and system integrators to delay or cancel projects, reduce their production or reduce or cancel orders for our products. In this environment, customers may experience financial difficulty, cease operations or fail to budget for the purchase of our products. This, in turn, may lead to longer sales cycles, delays in payment and collection, and price pressures, causing us to realize lower revenues and margins. In particular, capital spending in the technology sector has decreased in past years, and many of our customers and potential customers have experienced declines in their revenues and operations. In addition, concerns 
with respect to terrorism and geopolitical issues in the Middle East and Asia have added more uncertainty to the current economic environment. We cannot predict the impact of these events, or of any related military action, on our customers or business. We believe that, in light of these events, some businesses may further curtail or may eliminate capital spending on control network technology altogether. If capital spending in our markets continues to decline, it may be necessary for us to gain significant market share from our competitors in order to achieve our financial goals and maintain profitability. 

The undetermined market acceptance of our products makes it difficult to evaluate our future prospects. 

We face a number of risks as an emerging company in a rapidly changing and developing new market, and you must consider our prospects in light of the associated risks. This is true of both our LONWORKS Infrastructure business and our new NES business. Our future operating results are difficult to predict due to many factors, including the following: 

our targeted markets have not yet accepted many of our products and technologies;
many of our customers do not fully support open, interoperable networks, and this reduces the market for our products;
we may not anticipate changes in customer requirements and, even if we do so, we may not be able to develop new or improved products that meet these requirements in a timely manner, or at all;
the markets in which we operate require rapid and continuous development of new products, and we have failed to meet some of our product development schedules in the past;
potential changes in voluntary product standards around the world can significantly influence the markets in which we operate; and
our industry is very competitive and many of our competitors have far greater resources and may be prepared to provide financial support from their other businesses in order to compete with us.

If our OEMs do not employ our products and technologies our revenues could decrease significantly.

To date, a substantial portion of our product sales has been to OEMs. The product and marketing decisions made by OEMs significantly affect the rate at which our products are used in control networks. We believe that because OEMs in certain industries receive a large portion of their revenues from sales of products and services to their installed base, these OEMs have tended to moderate the rate at which they incorporate LONWORKS technology into their products. They may believe that a more rapid transition to LONWORKS technology could harm their installed base business. Furthermore, OEMs that manufacture and promote products and technologies that compete or may compete with us may be particularly reluctant to employ our products and technologies to any significant extent, if at all. We may not be able to maintain or improve the current rate at which our products are accepted by OEMs and others, which could decrease our revenues. 


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If we do not maintain adequate distribution channels for our LONWORKS Infrastructure business, or establish adequate distribution channels for our NES system business, our revenues could be harmed significantly. 

Currently, significant portions of our revenues are derived from sales to distributors, including EBV, the sole independent distributor of our products to OEMs in Europe. Sales to EBV, our largest distributor, accounted for 11.6% of our total net revenues for the quarter ended March 31, 2004 and 8.2% of our total net revenues for the same period in 2003. Worldwide sales to distributors, including those to EBV, accounted for approximately 22.5% of our total net revenues for the quarter ended March 31, 2004, and 9.8% of our total net revenues for the same period in 2003. 

Our current agreement with EBV expires in December 2004. If EBV, or any other existing or future distributor, fails to dedicate sufficient resources and efforts to marketing and selling our products, our revenues could decrease. If EBV significantly reduces its inventory levels for our products, both our revenues and customer service levels would decrease. If we do not maintain our agreement with EBV, we would be required to locate another distributor or add our own pan-European distribution capability to meet the needs of our customers. In that event, our business could be harmed during the transition period as EBV’s inventory of our products was sold but not replaced. 

In our NES system business, we market directly, as well as through selected value added resellers, or VARs, and integration partners. However, we believe that a significant portion of our NES system sales, if any, will be made through our VARs and integration partners, rather than directly by our company, since to date, our VARs and integration partners have greater experience in overseeing projects for utilities. As a result, if our relationships with our VARs and integration partners are not successful, or if we are not able to create similar distribution channels for our NES system business with other companies, our NES business may not be successful, which could harm our revenues and operating results. 

If OEMs fail to develop interoperable products or if our targeted markets do not accept our interoperable products, we may be unable to generate sales of our products. 

Our future operating success will depend, in significant part, on the successful development of interoperable products by OEMs and us, and the acceptance of interoperable products by systems integrators and end-users. We have expended considerable resources to develop, market and sell interoperable products, and have made these products a cornerstone of our sales and marketing strategy. We have widely promoted interoperable products as offering benefits such as lower life-cycle costs and improved flexibility to owners and users of control networks. However, OEMs that manufacture and market closed systems may not accept, promote or employ interoperable products, since doing so may expose their businesses to increased competition. In addition, OEMs might not, in fact, successfully develop intero
perable products, or their customers might not accept their interoperable products. If OEMs fail to develop interoperable products, or our markets do not accept interoperable products, our revenues and operating results will suffer. 

Our executive officers and technical personnel are critical to our business, and if we lose or fail to attract key personnel, we may not be able to successfully operate our business. 

Our performance depends substantially on the performance of our executive officers and key employees. Due to the specialized technical nature of our business, we are particularly dependent on our Chief Executive Officer, our Chief Operating Officer, and our technical personnel. Our future success will depend on our ability to attract, integrate, motivate and retain qualified technical, sales, operations and managerial personnel. Competition for qualified personnel in our business areas is intense, and we may not be able to continue to attract and retain qualified executive officers and key personnel necessary to enable our business to succeed. Our product development and marketing functions are largely based in Silicon Valley, which is typically a highly competitive marketplace. It may be part
icularly difficult to recruit, relocate and retain qualified personnel in this geographic area. Moreover, the cost of living, including the cost of housing, in Silicon Valley is known to be high. Because we are prohibited from making loans to executive officers under recent legislation, we will not be able to assist potential key personnel as they acquire housing or incur other costs that might be associated with joining our company. In addition, if we lose the services of any of our key personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel may decide to leave, and we may incur increased operating expenses in finding and compensating their replacements. 


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The market for our products is new and rapidly evolving. If we are not able to develop or enhance products to respond to changing market conditions, our revenues will suffer. 

Customer requirements for control network products can change as a result of innovations or changes within the building, industrial, transportation, utility/home and other industries. For example, our NES system offering to utilities is new. Also, new or different standards within industry segments may be adopted, giving rise to new customer requirements. These customer requirements may or may not be compatible with our current or future product offerings. Our future success depends in large part on our ability to continually enhance our existing product offerings, lower the market price for our products, and develop new products that maintain technological competitiveness. We may not be successful in modifying our products and services to address these requirements and standards. For example,
 certain of our competitors may develop competing technologies based on Internet Protocols (IP) that could have, or could be perceived to have, advantages over our products in remote monitoring or other applications. As another example, many competitors promote media types, such as radio frequency (wireless) and fiber optics that, even if used with LONWORKS technology, could displace sales of certain of our transceiver products. If we are not able to develop or enhance our products to respond to these changing market conditions, our revenues and results of operations will suffer. 

In addition, due to the nature of development efforts in general, we often experience delays in the introduction of new or improved products beyond our original projected shipping date for such products. Historically, when these delays have occurred, we experienced an increase in our development costs and a delay in our ability to generate revenues from these new products. We believe that similar new product introduction delays in the future could also increase our costs and delay our revenues. 

The trading price of our stock has been volatile, and may fluctuate due to factors beyond our control. 

The trading price of our common stock is subject to significant fluctuations in response to numerous factors, including: 

significant stockholders may sell some or all of their holdings of our stock. For example, Enel presently owns 3,000,000 shares, or approximately 7.4% of our outstanding common stock. Enel is generally free to sell these shares at its discretion;
investors may be concerned about the success of our project with Enel, the success of our sales of our LONWORKS Infrastructure products and services to OEMs and systems integrators, or our ability to develop new customers for our NES business;
competitors may announce new products or technologies;
our quarterly operating results may vary widely;
we or our customers may announce technological innovations or new products;
securities analysts may change their estimates of our financial results; and
increases in market interest rates, which generally have a negative impact on stock prices.

In addition, the market price of securities of technology companies, especially those in rapidly evolving industries such as ours, has been very volatile in the past. This volatility in any given technology company’s stock price has often been unrelated or disproportionate to the operating performance of that particular company. 

In the future, we may be the target of securities class action lawsuits or other litigation, which could be costly and time consuming to defend. 

In the past, following a period of volatility in the market price of a company’s stock, securities class action lawsuits have often been instituted against such companies. In the future, we may become the target of similar litigation. If such a lawsuit were brought against us, regardless of its outcome, we would incur substantial costs and our management resources would be diverted in defending such litigation. 


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Voluntary standards that are established in our markets could limit our ability to sell our products and reduce our revenues. 

Standards bodies, which are formal and informal associations that attempt to set voluntary, non-governmental product standards, are influential in many of our target markets. Some of our competitors have attempted to use voluntary standards to reduce the market opportunity for our products, or to increase the market opportunity for their own products, by lobbying for the adoption of voluntary standards that would exclude or limit the use of products that incorporate our technology. We participate in many voluntary standards organizations around the world in order to both help prevent the adoption of exclusionary standards and to promote voluntary standards for our products. However, we do not have the resources to participate in all voluntary standards processes that may affect our markets. Th
e adoption of voluntary standards that are incompatible with our products or technology could limit the market opportunity for our products. If the markets we target were to adopt voluntary standards that are incompatible with our products or technology, either inadvertently or by design, our revenues, operating results, and financial condition would be adversely affected. 

As a result of our lengthy sales cycle, we have limited ability to forecast the amount and timing of specific sales. If we fail to complete or are delayed in completing transactions, our revenues could vary significantly from period to period. 

The sales cycle between initial customer contact and execution of a contract or license agreement with a customer can vary widely. For example, OEMs typically conduct extensive and lengthy product evaluations before making initial purchases of our products. They may further delay subsequent purchases of our products due to the OEMs’ own prolonged product development and product introduction periods. Delays in our sales cycle can also result from, among other things: 

changes in our customers’ budgets;
changes in the priority our customers assign to control network development;
the time it takes for us to educate our customers about the potential applications of and cost savings associated with our products;
the deployment schedule for projects undertaken by systems integrators;
the actions of utility regulators or management boards regarding investments in metering systems; and
delays in installing, operating, and evaluating the results of NES system field trials.

We generally have little or no control over these factors, which may cause a potential customer to favor a competitor’s products, or to delay or forgo purchases altogether. If any of these factors prevent or substantially delay our ability to complete a transaction, our revenues and results of operations could be harmed. 

We have limited ability to protect our intellectual property rights. 

Our success depends significantly upon our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect these intellectual property rights, all of which afford only limited protection. As of April 30, 2004, we have 91 issued U.S. patents, 6 pending U.S. patent applications, and various foreign counterparts. It is possible that patents will not issue from these pending applications or from any future applications or that, if issued, any claims allowed will not be sufficiently broad to protect our technology. In addition, we may not apply for or obtain patents in each country in which our technology may be used. If any of our patents fail to protect our t
echnology, or if we do not obtain patents in certain countries, our competitors may find it easier to offer equivalent or superior technology. We have registered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. If we fail to properly register or maintain our trademarks or to otherwise take all necessary steps to protect our trademarks, the value associated with the trademarks may diminish. In addition, if we fail to take all necessary steps to protect our trade secrets or other intellectual property rights, we may not be able to compete as effectively in our markets. 

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or services or to obtain and use information that we regard as proprietary. Any of the patents, trademarks, copyrights or intellectual property rights that have been or may be issued or granted to us could be challenged, invalidated or circumvented, and any of the rights granted may not provide protection for our proprietary rights. In addition, we cannot assure you that we have taken or will take all necessary steps to protect our intellectual property rights. Third parties may also independently develop similar technology without breach of our trade secrets or other proprietary rights. We have licensed in the past and may license in the future our key technologies to third 
parties. In addition, the laws of some foreign countries, including several in which we operate or sell our products, do not protect proprietary rights to as great an extent as do the laws of the United States and it may take longer to receive a remedy from a court outside of the United States. For example, certain of our products are licensed under shrink-wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions. 


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From time to time, litigation may be necessary to defend and enforce our proprietary rights. As a result of this litigation, we could incur substantial costs and divert management resources, which could harm our business, regardless of the final outcome. Despite our efforts to safeguard and maintain our proprietary rights both in the United States and abroad, we may be unsuccessful in doing so. Also, the steps that we take to safeguard and maintain our proprietary rights may be inadequate to deter third parties from infringing, misusing, misappropriating, or independently developing our technology or intellectual property rights; or to prevent an unauthorized third party from copying or otherwise obtaining and using our products or technology. 

Regulatory actions could limit our ability to market and sell our products. 

Many of our products and the industries in which they are used are subject to U.S. and foreign regulation. Government regulatory action could greatly reduce the market for our products. For example, the power line medium, which is the communications medium used by some of our products, is subject to special regulations in North America, Europe and Japan. In general, these regulations limit the ability of companies to use power lines as a communication medium. In addition, some of our competitors have attempted to use regulatory actions to reduce the market opportunity for our products or to increase the market opportunity for their own products. For example, the FCC is considering changes to Part 15 rules that would accommodate high-speed power data communication devices. The FCC has further i
ndicated that they intend to prohibit these new high-speed power line devices from interfering with other power line devices, such as those sold by our company, which operate in other portions of the frequency spectrum. If the FCC fails to implement and/or enforce measures intended to protect against interference by these new high-speed power line devices, the operation of our products could be adversely affected, which would consequently have a negative impact on the market for our products, or require us to expend significant management, technical, and financial resources to make our products resistant to such interference. 

Compliance with new rules and regulations concerning corporate governance may be costly and time-consuming, which could harm our operating results and business. 

The Sarbanes-Oxley Act, or the Act, which was signed into law in October 2002, mandates, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements. The Act also imposes increased civil and criminal penalties on a corporation, its chief executive and chief financial officers, and members of its Board of Directors, for securities law violations. In addition, the Nasdaq National Market, on which our common stock is traded, has adopted and is considering the adoption of additional comprehensive rules and regulations relating to corporate governance. These rules, laws, and regulations have increased the scope, complexity, and cost of our corporate governance, reporting, and disclosure practices. Because compliance with
 these new rules, laws, and regulations will be costly and time-consuming, our management’s attention could be diverted from managing our day-to-day business operations, and our operating expenses could increase. We also expect these developments will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer, and Chief Financial Officer face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficulty attracting and retaining qualified board members and executive officers, which could harm our business. 

We are subject to changes in financial accounting standards, which may affect our reported financial results or the way we conduct business.

Generally accepted accounting principles in the United States, including those affecting revenue recognition, have been the subject of frequent interpretations. As a result of the enactment of the Sarbanes-Oxley Act and the review of accounting policies by the Securities and Exchange Commission, as well as by national and international accounting standards bodies, the frequency of future accounting policy changes may accelerate. Such future changes in financial accounting standards, including pronouncements relating to revenue recognition, may have a significant effect on our reported results of operations, including results of transactions entered into before the effective date of the changes. For example, our results of operations will be negatively impacted if and when we are required to ex
pense stock options or other compensatory grants to our employees. 


	44

Our existing stockholders control a significant percentage of our stock, which will limit other stockholders’ ability to influence corporate matters. 

As of April 30, 2004, our directors and executive officers, together with certain entities affiliated with them (including, for this purpose, Enel, which has the right to nominate a director to our Board of Directors), beneficially owned 36.4 % of our outstanding stock. 

Under the stock purchase agreement with Enel, which transaction was completed September 11, 2000, Enel purchased 3.0 million newly issued shares of our common stock and was granted the right to nominate a director to our Board of Directors. As a condition to the closing of the stock purchase agreement, our directors and our Chief Financial Officer agreed to enter into a voting agreement with Enel in which each of them agreed to vote the shares of our company’s common stock that they beneficially owned or controlled in favor of Enel’s nominee to our Board of Directors. In addition, under the terms of the stock purchase agreement, Enel has agreed to (i) vote (and cause any of its affiliates that own shares of our common stock to vote) all of its shares in favor of the slate of director
 nominees recommended by the Board of Directors, and (ii) vote (and endeavor to cause any of its affiliates that own shares of our common stock to vote) a number of shares equal to at least that percentage of shares voted by all other stockholders for or against any specified matter, as recommended by the Board of Directors. The specified matters are the election of accountants, the approval of company option plans, and any proposal by any of our stockholders (unless the proposal could be prejudicial to Enel or the required voting would interfere with Enel’s fiduciary duties to its own shareholders). 

As a result, our directors and executive officers, together with certain entities affiliated with them, may be able to control substantially all matters requiring approval by our stockholders, including the election of all directors and approval of certain other corporate matters. 

Potential conflicts of interest could limit our ability to act on opportunities that are adverse to a significant stockholder or its affiliates. 

From time to time, we may enter into a material contract with a person or company that owns a significant amount of our company’s stock. As circumstances change, we may develop conflicting priorities or other conflicts of interest with the significant stockholder with regard to the contract, or the significant stockholder may exert or attempt to exert a significant degree of influence over our management and affairs. The significant stockholder might exert or attempt to exert this influence in its capacity as a significant stockholder or, if the significant stockholder has a representative on our board of directors, through that board member. 

For example, we have entered into the Contatore Elettronico project with an affiliate of Enel. Enel currently owns 3.0 million shares of our common stock, representing approximately 7.4% of our outstanding common stock. Enel also has the right to nominate a member of our board of directors as long as Enel owns at least 2.0 million shares of our common stock. As a consequence of the expiration of his mandate as Enel’s Chief Executive Officer, Mr. Francesco Tatò resigned as a board member in all of Enel’s subsidiaries and affiliates, including Echelon. Mr. Tatò served on our board of directors as a representative of Enel from September 2000 until September 2002. Enel has reserved its right to nominate a new member of our board of directors, who must be approved by us, to fill
 the vacancy created by the resignation of Enel’s former board representative to our board of directors. During the term of service of Enel’s former board representative from September 2000 to September 2002, Enel’s representative on our board abstained from resolutions on any matter relating to Enel. A member of our board of directors who is also an officer of or is otherwise affiliated with Enel may decline to take action in a manner that might be favorable to us but adverse to Enel. Conflicts that could arise might concern the Contatore Elettronico project with Enel and other matters where Enel’s interest may not always coincide with our interests or the interests of our other stockholders. Any of those conflicts could affect our ability to complete the Contatore Elettronico project on a timely basis, could increase our expenses or reduce our profits in connection with the project, could affect our ability to obtain approval for or complete other projects or plans that are in conflict 
with Enel’s goals, and could otherwise significantly and adversely affect our financial condition and results of operations. 


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Natural disasters or power outages could disrupt our business. 

We must protect our business and our network infrastructure against damage from earthquake, flood, hurricane and similar events, as well as from power outages. Many of our operations are subject to these risks, particularly our operations located in California. We have already experienced temporary power losses in our California facilities due to power shortages that have disrupted our operations, and we may in the future experience additional power losses that could disrupt our operations. While the impact to our business and operating results has not been material, it is possible that power losses will adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will increase significantly. Similarly, a natural disaster or other unanticipate
d problem could also adversely affect our business by, among other things, harming our primary data center or other internal operations, limiting our ability to communicate with our customers, and limiting our ability to sell our products. 

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS 

We have not experienced any material change in our exposure to interest rate and foreign currency risks since the date of our Annual Report on Form 10-K for the year ended December 31, 2003. 

Market Risk Disclosures. The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments to hedge these exposures. 

Interest Rate Sensitivity. We maintain a short-term investment portfolio consisting mainly of fixed income securities with a weighted average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market rates were to increase immediately and uniformly by 10 percent from levels at March 31, 2004 and March 31, 2003, the fair value of the portfolio would decline by an immaterial amount. We currently intend to hold our fixed income investments until maturity, and therefore we would not expect our operating results or cash flows to be affected to any significant degree by a sudden c
hange in market interest rates. If necessary, we may sell short-term investments prior to maturity to meet the liquidity needs of the company. 

Foreign Currency Exchange Risk. We have international subsidiaries and operations and are, therefore, subject to foreign currency rate exposure. To date, our exposure to exchange rate volatility has not been significant. If foreign exchange rates were to fluctuate by 10% from rates at March 31, 2004, and March 31, 2003, our financial position and results of operations would not be materially affected. However, we cannot assure you that there will not be a material impact in the future. 

ITEM 4.    CONTROLS AND PROCEDURES 

Limitations on the Effectiveness of Controls 

Our management, including our chief executive officer, or CEO, and our chief financial officer, or CFO, does not believe it is possible for our disclosure controls and procedures, or our internal controls over financial reporting, to prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have be
en detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. 


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Scope of the Controls Evaluation 

  The CEO/CFO evaluation of our disclosure controls and procedures and our internal controls over financial reporting included a review of the controls’ objectives and design, the controls’ implementation by Echelon, and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the controls evaluation, we sought to identify data errors, controls problems, or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-Q and Annual Report on Form 10-K. Our internal controls over financial reporting have been 
evaluated and will continue to be evaluated on a quarterly basis by our management and our internal audit personnel. In addition, consistent with our past practices, our internal controls over financial reporting are evaluated by personnel in our finance organization. The overall goals of these various evaluation activities are to monitor our disclosure controls and procedures and our internal controls over financial reporting and to make modifications as necessary. Our intent in this regard is that the disclosure controls and procedures and the internal controls over financial reporting will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant. 

  Among other matters, we sought in our evaluation to determine whether (i) there were any "significant deficiencies" or "material weaknesses" in the company’s internal controls over financial reporting, (ii) the company had identified any acts of fraud involving personnel who have a significant role in the company’s internal controls over financial reporting or (iii) whether there has been any change in our internal controls over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. This information was important both for the controls evaluation
 generally and because the Section 302 Certifications of the CEO and CFO require that the CEO and CFO disclose certain information to our Board’s Audit Committee and to our independent accountants and to report on related matters in this section of the Quarterly Report. 

  Our review of our internal controls over financial reporting was made within the context of the relevant professional auditing standards defining "internal controls over financial reporting," "reportable conditions," and "material weaknesses." As part of our evaluation of internal controls over financial reporting, we also address other, less significant control matters that we or our auditors identify, and we determine what revision or improvement to make, if any, in accordance with our on-going procedures. 

Conclusions Regarding Disclosure Controls and Procedures 

  Our CEO and our CFO, after evaluating our "disclosure controls and procedures" (as defined in the Securities Exchange Act of 1934, or the Exchange Act, Rules 13a-14(c) and 15-d-14(c)) as of a date (the "Evaluation Date") within 90 days before the filing of this Quarterly Report on Form 10-Q, have concluded that as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms. 

Conclusions Regarding Internal Controls Over Financial Reporting 

  Subsequent to the Evaluation Date, there were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures, nor were there any significant deficiencies or material weaknesses in our internal controls. As a result, no corrective actions were required or undertaken. 


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PART II. OTHER INFORMATION 

ITEM 1.    LEGAL PROCEEDINGS 

On May 3, 2004, we announced that Enel filed a request for arbitration to resolve a dispute regarding our marketing and supply obligations under the R&D Agreement. The arbitration is to take place in London under the rules of arbitration of the International Court of Arbitration of the International Chamber of Commerce, or ICC. Enel filed the request with the ICC in Paris, France on April 28, 2004. Enel claims that the R&D Agreement obligates us to supply Enel with additional concentrator and metering kit products for use outside of Italy and to cooperate with Enel to market Enel’s Contatore Elettronico system internationally. Enel is seeking to compel Echelon to sell to Enel an unspecified amount of additional products, to jointly market the Contatore Elettronico system with Enel outside of Italy, and to pay unspecified damages. We believe our company has fulfilled its obligations under the R&D Agreement, including any obligation with respect to the sale of products and with respect to joint marketing. We believe that Enel’s claims are without merit and we intend to vigorously defend our company in the arbitration proceedings. 

ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K 

(a) Exhibits 

Exhibit No.	Description of Document

31.1	Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.

(b) Reports on Form 8-K

We filed the following reports on Form 8-K during the quarter ended March 31, 2004:

On January 26, 2004, we filed a current report on Form 8-K dated January 21, 2004, under Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) and Item 9 (Regulation FD Disclosure), to reference and furnish as an exhibit a press release dated January 21, 2004, announcing our results of operations for the quarter ended December 31, 2003.

SIGNATURE 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. 

		ECHELON CORPORATION

Date: May 10, 2004	By:	/s/ Oliver R. Stanfield

		Oliver R. Stanfield, Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)


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EXHIBIT INDEX 

Exhibit No.	Description of Document

31.1	Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.


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		Page

Part I.	FINANCIAL INFORMATION
Item 1.	Unaudited Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and March 31, 2003	4
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and March 31, 2003	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.	Controls and Procedures	46

Part II.	OTHER INFORMATION
Item 1.	Legal Proceedings	48
Item 6.	Exhibits and Reports on Form 8-K	48