ECHELON CORP - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended June 30, 2002

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 incorporation or organization)		(IRS Employer Identification Number)

550 Meridian Avenue

San Jose, CA 95126

(Address of principal executive office and zip code)

(408) 938-5200

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days. Yes x No ¨

As of July 31, 2002, 39,677,441 shares of the Registrant’s common stock were outstanding.

ECHELON CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2002

INDEX

		Page
Part I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets as of June 30, 2002 (unaudited) and December 31, 2001	3

	Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2002 and June 30, 2001 (unaudited)	4

	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and June 30, 2001 (unaudited)	5

	Notes to Condensed Consolidated Financial Statements (unaudited)	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	22

Part II.	OTHER INFORMATION

Item 4.	Submission of Matters To A Vote of Security Holders	34

Item 6.	Exhibits and Reports on Form 8-K	34

SIGNATURE			34

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, income, 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.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ECHELON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

	June 30, 2002			December 31, 2001
	(unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	17,854		$	23,232
Short-term investments		92,668			88,421
Accounts receivable, net		26,705			29,113
Inventories		10,430			10,316
Other current assets		11,777			11,556

Total current assets		159,434			162,638

Property and equipment, net		16,681			16,480
Goodwill		7,639			1,637
Restricted investments		10,526			—
Other long-term assets		4,518			4,899

	$	198,798		$	185,654

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	9,047		$	7,409
Accrued liabilities		2,939			2,426
Deferred revenues		1,220			1,055

Total current liabilities		13,206			10,890

LONG-TERM LIABILITIES:
Deferred rent		110			47

Total long-term liabilities		110			47

STOCKHOLDERS’ EQUITY:
Common stock		399			390
Additional paid-in capital		268,497			265,787
Treasury stock		(3,191	)		(3,191	)
Accumulated other comprehensive income (loss)		265			38
Deferred compensation		—			(31	)
Accumulated deficit		(80,488	)		(88,276	)

Total stockholders’ equity		185,482			174,717

	$	198,798		$	185,654

See accompanying notes to condensed consolidated financial statements.

ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2002		2001			2002		2001
REVENUES:
Product	$	30,860	$	13,247		$	58,086	$	25,359
Service		458		670			817		1,146

Total revenues		31,318		13,917			58,903		26,505

COST OF REVENUES:
Cost of product		14,111		5,600			26,946		9,853
Cost of service		780		686			1,451		1,223

Total cost of revenues		14,891		6,286			28,397		11,076

Gross profit		16,427		7,631			30,506		15,429

OPERATING EXPENSES:
Product development		5,376		4,064			10,996		7,888
Sales and marketing		4,293		3,848			8,579		7,739
General and administrative		2,226		1,487			4,478		3,801

Total operating expenses		11,895		9,399			24,053		19,428

Income (loss) from operations		4,532		(1,768	)		6,453		(3,999	)
Interest and other income, net		1,011		1,807			2,011		4,061

Income before provision for income taxes		5,543		39			8,464		62
PROVISION FOR INCOME TAXES		443		1			677		2

Net income	$	5,100	$	38		$	7,787	$	60

Net income per share:
Basic	$	0.13	$	0.00		$	0.20	$	0.00

Diluted	$	0.12	$	0.00		$	0.19	$	0.00

Shares used in co mputing net income per share:
Basic		39,443		38,482			39,243		38,315

Diluted		40,818		41,458			40,812		41,154

See accompanying notes to condensed consolidated financial statements.

ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended June 30,
	2002			2001
CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:
Net income	$	7,787		$	60
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,964			942
In-process research and development		400			0
Provision for doubtful accounts		20			130
Deferred compensation expense		31			92
Change in operating assets and liabilities:
Accounts receivable		2,420			(1,076	)
Inventories		(114	)		(5,498	)
Other current assets		(205	)		(367	)
Accounts payable		871			1,288
Accrued liabilities		358			566
Deferred revenues		126			(510	)
Deferred rent		63			5

Net cash provided by (used in) operating activities		13,721			(4,368	)

CASH FLOWS USED IN INVESTING ACTIVITIES:
Purchase of available-for-sale short-term investments		(34,832	)		(38,715	)
Proceeds from maturities and sales of available-for-sale short-term investments		30,585			2,953
Unrealized gains (losses) on securities		(226	)		375
Purchase of BeAtHome.com, Inc.		(5,812	)		—
Purchase of restricted investments		(10,526	)		—
Change in other long-term assets		101			(5,104	)
Capital expenditures		(1,561	)		(2,775	)

Net cash used in investing activities		(22,271	)		(43,266	)

CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:
Proceeds from issuance of common stock		2,719			1,119

Net cash provided by financing activities		2,719			1,119

EFFECT OF EXCHANGE RATE CHANGES ON CASH		453			(440	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(5,378	)		(46,955	)
CASH AND CASH EQUIVALENTS:
Beginning of period		23,232			117,664

End of period	$	17,854		$	70,709

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	356		$	53

See accompanying notes to condensed consolidated financial statements.

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation:

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

While the financial information furnished is unaudited, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended December 31, 2001 included in its Form 10-K as filed with the Securities and Exchange Commission on March 29, 2002.

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 fees associated with training, technical support, and custom software design services offered to its customers. Product revenues consist of revenues from hardware sales and software licensing arrangements. Revenues from software licensing arrangements accounted for 6.8% of total revenues for the quarter ended June 30, 2002 and 9.2% for the same period in 2001; and 5.3% of total revenues for the six months ended June 30, 2002 and 10.3% for the same period in 2001. Service revenues consist of product 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 or reasonably assured and there are no post-delivery obligations. For hardware sales, including sales to distributors, 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. The Company provides limited post-contract customer support (PCS), consisting primarily of technical support and “bug” fixes. In accordance with Statement of Position (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. Revenue for the software license element is recognized at the time of delivery of the application product to the end-user. The Company uses the residual method to recognize software revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective evidence of the fair value of the undelivered element. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. Revenue for the PCS element, the total amount of which is determined from the stand-alone price of providing this service, is recognized over the service period. The costs of providing these services are expensed when incurred. Estimated reserves for warranty costs as well as reserves for sales returns and allowances related to anticipated return of products sold to distributors with limited rights of return, are recorded at the time of shipment. The Company generally has not had any significant post-delivery obligations associated with the sale of its products. Service revenue is recognized as the training services are performed, or ratably over the term of the support period. In the case of custom software development services, revenue is recognized when the customer accepts the software.

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Cash, Cash Equivalents and Short-Term Investments

The Company considers bank deposits, money market investments, and all debt and equity securities with an original maturity of three months or less as cash and cash equivalents. The Company classifies its investments in debt and equity securities as available-for-sale in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” As of June 30, 2002, the Company’s available-for-sale 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 June 30, 2002, 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 Gain
U.S. government securities	$	23,690	$	23,742	$	52
U.S. corporate securities:
Commercial paper		4,519		4,520		1
Corporate notes and bonds		63,977		64,406		429

Total investments in debt and equity securities	$	92,186	$	92,668	$	482

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.

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the three months and six months ended June 30, 2002 (in thousands):

	Three Months Ended June 30, 2002			Six Months Ended June 30, 2002
Net income (Numerator):
Net income, basic & diluted	$	5,100		$	7,787

Shares (Denominator):
Weighted average common shares outstanding		39,471			39,271
Weighted average common shares outstanding subject to repurchase		(28	)		(28	)

Shares used in basic computation		39,443			39,243
Weighted average common shares outstanding subject to repurchase		28			28
Common shares issuable upon exercise of stock (treasury stock method)		1,347			1,542
Common shares issuable upon exercise of warrants (treasury stock method)		0			0
Average unamortized deferred compensation		0			(1	)

Shares used in diluted computation		40,818			40,812

Net income per share:
Basic	$	0.13		$	0.20

Diluted	$	0.12		$	0.19

For the three months and six months ended June 30, 2002, stock options in the amount of 4,749,947 and 4,151,157, 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.

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

New Accounting Standards

In July 2001, the Financial Accounting Standards Board issued SFAS No. 141 (“SFAS 141”), “Business Combinations,” which supersedes Accounting Principles Board (“APB”) Opinion No. 16, “Business Combinations.” SFAS 141 eliminates the pooling-of-interests method of accounting for business combinations and modifies the application of the purchase accounting method. The elimination of the pooling-of-interest method is effective for transactions initiated after September 30, 2001. The remaining provisions of SFAS 141 will be effective for transactions accounted for using the purchase method that are completed after September 30, 2001. The adoption of this Statement did not have a material impact on our financial position, results of operations, or cash flows.

In July 2001, the FASB also issued SFAS No. 142 (“SFAS 142”), “Goodwill and Intangible Assets,” which supersedes APB Opinion No. 17, “Intangible Assets.” Under the SFAS 142, goodwill and intangible assets with indefinite lives acquired on or after June 29, 2001 are not amortized, but instead are tested for impairment annually, primarily using the fair value approach, when there is an impairment indicator. In addition, SFAS 142 provides that other intangible assets will continue to be valued and amortized over their estimated lives; in-process research and development will continue to be written off immediately; all acquired goodwill will be assigned to reporting units for purposes of impairment testing and segment reporting; and, effective January 1, 2002, goodwill and intangible assets with indefinite lives acquired before June 29, 2001 will no longer be subject to amortization, but will instead be subject to impairment tests in accordance with the new Statement.

We adopted SFAS 142 on January 1, 2002, and, as a result, ceased amortizing approximately $2.1 million of goodwill, which had a net unamortized balance of $1.7 million as of December 31, 2001. During 2001, we recorded amortization expenses totaling approximately $320,000 against this balance and would have charged approximately $360,000 of amortization in 2002. In lieu of amortization, SFAS 142 now requires that we perform an initial impairment review of our goodwill in 2002 and at least an annual impairment review thereafter. In accordance with these impairment review requirements, we have completed a transitional impairment test and determined that there was no impairment. However, if as a result of impairment reviews that we perform from time to time 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. An impairment charge could have a material adverse impact on our financial position and/or operating results.

The following table provides a reconciliation of reported net income to adjusted net income for the second quarter of 2001 had SFAS 142 been effective in the second quarter of 2001 (in thousands, except per share amounts):

	Quarter Ended June 30, 2001
	Amount		Basic EPS		Diluted EPS
Reported net income	$	38	$	0.00	$	0.00
Add back amortization expense (net of tax):
Goodwill and workplace in force		90		0.00		0.00

Adjusted net income	$	128	$	0.00	$	0.00

The following table provides a reconciliation of reported net income to adjusted net income for the six months ended June 30, 2001 had SFAS 142 been effective January 1, 2001 (in thousands, except per share amounts):

	Six-Months Ended June 30, 2001
	Amount		Basic EPS		Diluted EPS
Reported net income	$	60	$	0.00	$	0.00
Add back amortization expense (net of tax):
Goodwill and workplace in force		141		0.01		0.00

Adjusted net income	$	201	$	0.01	$	0.00

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The changes in the carrying amount of goodwill, net for the six months ended June 30, 2002 are as follows (in thousands):

	Amount
Balance as of December 31, 2001	$	1,637
Reclass of workplace in force		74
Unrealized foreign currency translation gain		183
Goodwill resulting from BeAtHome acquisition		5,745

Balance as of June 30, 2002	$	7,639

In August 2001, the FASB issued SFAS No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations,” which the Company is required to adopt no later than January 1, 2003. SFAS 143 addresses the financial accounting and reporting for obligations associated with the retirement of long-lived assets and the associated asset retirement costs. We have not yet determined the impact of adopting SFAS 143 on the Company’s financial position, results of operations, or cash flows.

In October 2001, the FASB issued SFAS No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” by requiring that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. We adopted SFAS 144 on January 1, 2002. The adoption of SFAS 144 did not have a material impact on our financial position, results of operations, or cash flows.

In April 2002, the FASB issued SFAS No. 145 (“SFAS 145”), “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS 145 updates, clarifies and simplifies existing accounting pronouncements including: rescinding SFAS 4, which required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect, and amending SFAS 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS 145 is effective for fiscal years beginning after May 15, 2002, with early adoption of the provisions related to the rescission of SFAS 4 encouraged. We do not expect the adoption of this Statement to have a material impact on our financial position, results of operations, or cash flows.

In June 2002, the FASB issued SFAS No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to an exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS 146 are effective for exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of SFAS 146 to have a material impact on our 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):

	June 30, 2002		December 31, 2001
Purchased materials	$	1,854	$	4,473
Work-in-process		29		57
Finished goods		8,547		5,786

	$	10,430	$	10,316

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4. Accrued Liabilities:

Accrued liabilities consist of the following (in thousands):

	June 30, 2002		December 31, 2001
Accrued payroll and related costs	$	1,847	$	1,778
Accrued marketing costs		462		390
Other accrued liabilities		630		258

	$	2,939	$	2,426

5. Segment Disclosure:

In 1998, the Company adopted SFAS No. 131 (“SFAS 131”), “Disclosures about Segments of an Enterprise and Related Information.” Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing business performance. The Company’s chief operating decision-making group is the Executive Staff, which is comprised of the Chief Executive Officer, the Chief Operating Officer, and their direct reports. SFAS 131 also requires disclosures about products and services, geographic areas, and major customers. The 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 which consist of technical support and training courses covering its LONWORKS network technology and products. The Company offers about 90 products and services that together constitute the LONWORKS system. In general, any given customer purchases a subset of such products and services that are appropriate for that customer’s application.

The Company manages its business primarily on a geographic basis. The Company’s geographic areas are comprised of three main 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 area and excludes certain expenses that are managed outside the geographic area. Costs excluded from area profit or loss primarily consist of unallocated corporate expenses, comprised of product development costs, corporate marketing costs and other general and administrative expenses, which are separately managed. The Company’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 June 30, 2002, and December 31, 2001, long-lived assets of about $36.4 million and $20.2 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.

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 products are shipped. Summary information by geography for the quarters and six months ended June 30, 2002 and 2001 is as follows (in thousands):

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
Revenues from customers:
Americas	$	3,519		$	4,599		$	7,156		$	8,696
EMEA		14,696			7,017			25,519			13,407
APJ		13,103			2,301			26,228			4,394
Unallocated		0			0			0			8

Total	$	31,318		$	13,917		$	58,903		$	26,505

Gross profit:
Americas	$	1,970		$	2,960		$	4,156		$	5,653
EMEA		7,861			3,168			14,036			6,912
APJ		6,596			1,503			12,314			2,856
Unallocated		0			0			0			8

Total	$	16,427		$	7,631		$	30,506		$	15,429

Income (loss) from operations:
Americas	$	1,045		$	2,008		$	2,261		$	3,729
EMEA		6,944			2,454			12,240			5,440
APJ		5,607			595			10,448			1,032
Unallocated		(9,064	)		(6,825	)		(18,496	)		(14,200	)

Total	$	4,532		$	(1,768	)	$	6,453		$	(3,999	)

Products sold to ENEL S.p.A., an Italian utility company (“ENEL”) and its designated manufacturers accounted for 65.5% of total revenues for the quarter ended June 30, 2002 and 18.8% for the same period in 2001; and 64.7% of total revenues for six months ended June 30, 2002 and 10.7% for the same period in 2001. For the quarter ended June 30, 2002, 50.6% of the revenues under the ENEL program were derived from products shipped to customers in EMEA and the remaining 49.4% were derived from products shipped to customers in APJ. For the six months ended June 30, 2002, 44.5% of the revenues derived from products shipped under the ENEL program were from customers in EMEA and the remaining 55.5% from customers in APJ.

EBV, the sole independent distributor of the Company’s products in Europe, accounted for 9.4% of total revenues for the quarter ended June 30, 2002 and 21.1% for the same period in 2001; and 10.1% of total revenues for the six months ended June 30, 2002 and 25.4% for the same period in 2001.

6. Income Taxes:

The provision for income taxes for the three months and six months ended June 30, 2002 and 2001 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 beneficial impact of deferred taxes resulting from the utilization of net operating losses.

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 quarter and six months ended June 30, 2002, the Company has recognized revenue from products and services sold to ENEL and its designated manufacturers of approximately $20.5 million and $38.1 million respectively, $19.6 million of which is included in Accounts Receivable at June 30, 2002. For the quarter and six months ended June 30, 2001, the Company has recognized revenue from products sold to ENEL and its designated manufacturers of approximately $2.6 million and $2.8 million respectively, $2.6 million of which is included in Accounts Receivable at June 30, 2001.

ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

8. Stock Repurchase Program:

In September 2001, the Company’s board of directors approved a stock repurchase program. During the quarter ended June 30, 2002, no shares were repurchased under the program. As of June 30, 2002, 1,735,000 shares are available to repurchase. Since inception of the repurchase plan, the Company has repurchased a total of 265,000 shares of its common stock at a cost of $3.2 million.

9. Acquisition:

On January 31, 2002, the Company acquired all of the outstanding capital stock of BeAtHome.com, Inc. (“BeAtHome^®”), a Fargo, North Dakota based developer of remote management system hardware and software. The results of BeAtHome’s operations, as well as a one-time charge of $400,000 related to in-process research and development (“IPR&D”), have been included in the consolidated condensed financial statements since that date. As a result of the acquisition, the Company expects to integrate certain components of BeAtHome’s technology into its current and future product offerings. The Company believes these enhancements will allow customers to more easily aggregate and process information from remote LONWORKS networks, thereby increasing overall network management capabilities. In exchange for all of the outstanding capital stock of BeAtHome, the Company 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 $372,000 of third party expenses.

The Company is in the process of finalizing its third-party valuations of certain intangible assets; thus, the allocation of the purchase price is subject to refinement. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands).


Current assets	$	129
Property and equipment		373
Other long-term assets		8
Intangible assets		600
Goodwill		5,745

Total assets acquired	$	6,855

Current liabilities		961

Total liabilities assumed	$	961

Net assets acquired	$	5,894

Of the $600,000 of acquired intangible assets, $400,000 was assigned to IPR&D and was expensed immediately upon the completion of the acquisition. The remaining $200,000 was assigned to purchased technology with a useful life of 2 years.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto, included elsewhere in this Quarterly Report, as well as management’s discussion and analysis of financial condition and results of operations included in our Form 10-K for the year ended December 31, 2001.

The following discussion contains forward-looking statements including, without limitation, statements regarding our liquidity position and our expected overall growth that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below in “Factors That May Affect Future Results Of Operations” and elsewhere in this Quarterly Report.

Overview

Based in San Jose, California, Echelon was incorporated in California in February 1988, and reincorporated in Delaware in January 1989. We develop, market and support a wide array of products and services based on our LONWORKS technology that enable OEMs and systems integrators to design and implement open, interoperable, distributed control networks. We offer these hardware and software products to OEMs and systems integrators in the building, industrial, transportation, utility/home and other automation markets. We also provide a variety of technical training courses related to our products and the underlying technology. Our customers also rely on us to provide customer support on a per-incident or annual contract basis.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these 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 investments, allowance for doubtful accounts, revenues, inventories, asset impairments, income taxes, commitments and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies relate to those policies that are most important to the presentation of our financial statements and require the most difficult, subjective and complex judgments.

Estimating Sales Returns and Allowances. We sell our products and services to OEM’s, 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 certain rights of return. Sales to EBV, our largest distributor, accounted for 9.4% of total net revenues for the quarter ended June 30, 2002 and 21.1% for the same period in 2001; and 10.1% of total net revenues for the six months ended June 30, 2002 and 25.4% for the same period in 2001. Worldwide sales to distributors, including those to EBV, accounted for approximately 18.3% of total net revenues for the quarter ended June 30, 2002 and 28.1% of total net revenues for the same period in 2001; and 17.1% of total net revenues for the six months ended June 30, 2002 and 37.0% of total net revenues for the same period in 2001.

Net revenue consists of product and service revenue reduced by estimated sales returns and allowances. Provisions for estimated sales returns and allowances, which are based on historical trends, contractual terms and other available information, are recorded at the time of sale. As part of our revenue recognition policy, management must make estimates of potential future product returns related to product revenue in the current period. Management analyzes historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances.

To estimate potential product returns from distributors other than EBV, management analyzes historical returns and the specific contractual return rights of each distributor. In the case of EBV, we further refine this analysis by reviewing month-end inventory levels at EBV, shipments in transit to EBV, EBV’s historical sales volume by

product, and forecasted sales volumes for some of EBV’s larger customers. Significant management judgments and estimates must be made and used in connection with establishing these distributor related sales returns and other allowances in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management revises its judgments or estimates.

Other material sales-related estimates include our allowance for sales discounts and rebates that we identify and reserve for at the time of sale. Our allowances for sales returns and other sales related reserves were approximately $1.7 million as of June 30, 2002 and $1.6 million as of December 31, 2001.

Allowance for Doubtful Accounts. 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. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, customer credit-worthiness, changes in our customers’ payment patterns and our historical experience. If the financial condition of our customers were to deteriorate or if economic conditions worsened, additional allowances may be required in the future. Our allowance for doubtful accounts was $549,000 as of June 30, 2002 and $510,000 as of December 31, 2001.

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 forecasted demand, generally one year or less, are not valued. In addition, we write off inventories that we consider obsolete. We adjust remaining inventory balances to approximate the lower of our standard manufacturing 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. Our reserve for excess and obsolete inventory was approximately $1.3 million as of June 30, 2002 and $1.2 million as of December 31, 2001.

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. If any of these factors changes materially in the future, we may be required to increase our warranty reserve. Our reserve for warranty costs was $212,000 as of June 30, 2002 and $119,000 as of December 31, 2001.

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 against 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, then we would reverse some or all of the previously provided valuation allowance. Our deferred tax asset valuation allowance was $46.5 million as of December 31, 2001.

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 $8.5 million as of June 30, 2002.

Results of Operations

Net Revenue

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
(dollars in thousands)
U.S. and unallocated	$	3,520	$	4,599	(23.5	)%	$	7,157	$	8,704	(17.8	)%
International		27,798		9,318	198.3	%		51,746		17,801	190.7	%

Total	$	31,318	$	13,917	125.0	%	$	58,903	$	26,505	122.2	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
(dollars in thousands)
ENEL related	$	20,508	$	2,613	684.8	%	$	38,083	$	2,831	1245.2	%
Non-ENEL related		10,810		11,304	(4.4	)%		20,820		23,674	(12.1	)%

Total	$	31,318	$	13,917	125.0	%	$	58,903	$	26,505	122.2	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
(dollars in thousands)
Product	$	30,860	$	13,247	133.0	%	$	58,086	$	25,359	129.1	%
Service		458		670	(31.6	)%		817		1,146	(28.7	)%

Total	$	31,318	$	13,917	125.0	%	$	58,903	$	26,505	122.2	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
% of Total Net Revenue
Product	98.5	%	95.2	%	3.3	%	98.6	%	95.7	%	2.9	%
Service	1.5	%	4.8	%	(3.3	)%	1.4	%	4.3	%	(2.9	)%

Total	100.0	%	100.0	%	0.0	%	100.0	%	100.0	%	0.0	%

Net revenue grew to $31.3 million in the second quarter of 2002 from $13.9 million in the same quarter of 2001. Net revenue grew to $58.9 million for the six months ended June 30, 2002 from $26.5 million in the same period of 2001. The 125.0% increase in total revenues between the two quarters and 122.2% increase in total revenues between the two six months periods was the result of an increase in product revenues, particularly products sold under the ENEL program. Products sold to ENEL and its designated manufacturers accounted for 65.5% of total revenues for the quarter ended June 30, 2002 and 18.8% for the same period in 2001; and 64.7% of total revenues for the six months ended June 30, 2002 and 10.7% for the same period in 2001. If the ENEL program achieves its targeted volumes for 2002, we expect that total revenues attributable to the project will account for more

than 60% of our total revenue for the year. If, after 2002, the program continues to move forward under ENEL’s current roll-out plan, we believe that revenue attributable to the project will continue to account for a material portion of our overall revenues during 2003 and 2004. Once the project is completed, or if it is cancelled prior to its completion, we would experience a significant drop in our overall revenue which would have a material negative impact on our financial position. Given our significant dependence on one customer at this time, we continue to seek opportunities to expand our customer base. We have formed a new sales and marketing organization which has been tasked with identifying other customers for our products over time, although we can give no assurance that their efforts will be successful.

EBV, the sole independent distributor of our products in Europe, accounted for 9.4% of total net revenues for the quarter ended June 30, 2002 and 21.1% for the same period in 2001; and 10.1% of total net revenues for the six months ended June 30, 2002 and 25.4% for the same period in 2001. Our contract with EBV expires in December 2002. While we expect that our agreement with EBV will be renewed at that time, if we were unsuccessful in that attempt, our revenues could decrease and our financial position could be harmed.

Product revenues grew to $30.9 million in the second quarter of 2002 from $13.2 million in the second quarter of 2001. Product revenues for the six months ended June 30, 2002 grew to $58.1 million from $25.4 million for the same period in 2001. The 133.0% increase in product revenues between the two quarters and 129.1% increase between the two six months periods was primarily the result of an increase in sales of products under the ENEL program. Offsetting these increases were sales decreases in all other product categories, with the exception of our i.LON^™ products, which experienced a slight increase in sales between the two periods, and our LonPoint^® products, which experienced a slight increase in sales during the six months ended June 30, 2002. We believe that, as long as the ongoing worldwide economic downturn continues, it will hinder our ability to generate material product revenue growth from our customers other than ENEL. In fact, a prolonged worldwide economic downturn could force some of our customers out of business permanently, which could have a material negative impact on our revenues and results of operations.

Service revenues declined to $458,000 in the second quarter of 2002 from $670,000 in the second quarter of 2001. Service revenues declined to $817,000 for the six months ended June 30, 2002 from $1.1 million in the same period of 2001. The 31.6% decrease in service revenues between the two quarters was primarily the result of a decrease in customer support and training revenues. The 28.7% decrease in service revenues between the two six month periods was the result of decreased customer software development, customer support, and training revenues. We believe that the ongoing worldwide economic downturn has forced many of our customers to curtail spending for training and support. We do not expect our service revenues to improve so long as these economic conditions continue. Slightly offsetting these service revenue decreases in both the quarter and six months ended June 30, 2002 were revenues generated from the monthly fees collected from customers for our BeAtHome remote monitoring services.

Cost of Revenues

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
Product	$	14,111	$	5,600	152.0	%	$	26,946	$	9,853	173.5	%
Service		780		686	13.7	%		1,451		1,223	18.6	%

Total	$	14,891	$	6,286	136.9	%	$	28,397	$	11,076	156.4	%

Gross Profit	$	16,427	$	7,631	115.3	%	$	30,506	$	15,429	97.7	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
As a % of Net Revenue
Product	45.0	%	40.2	%	4.8	%	45.7	%	37.2	%	8.5	%
Service	2.5	%	4.9	%	(2.4	)%	2.5	%	4.6	%	(2.1	)%

Total	47.5	%	45.1	%	2.4	%	48.2	%	41.8	%	6.4	%

Gross Profit	52.5	%	54.9	%	(2.4	)%	51.8	%	58.2	%	(6.4	)%

Cost of product. Cost of product revenues consists of costs associated with the purchase of components and subassemblies, as well as allocated labor, overhead and manufacturing variance costs associated with the packaging, preparation and shipment of products. Cost of product revenues in the second quarter of 2002 was $14.1 million compared to $5.6 million for the same period in 2001, representing product gross margins of 54.3% for the second quarter of 2002 and 57.7% for the same period in 2001. Cost of product revenues for the six months ended June 30, 2002 was $26.9 million compared to $9.9 million for the same period in 2001, representing product gross margins of 53.6% for the six months ended June 30, 2002 and 61.1% for the same period in 2001. The decline in product gross margin percentage for both the quarter and six months ended June 30, 2002 was primarily the result of shipping quantity volumes of product with lower margins under the ENEL program, and, to a lesser extent, changes in the mix of other products sold and fluctuations in overhead spending rates.

Cost of service. Cost of service revenues consists of employee-related costs as well as direct costs incurred in providing training and customer support services. Cost of service revenues increased to $780,000 for the second quarter of 2002 from $686,000 for the comparative period in 2001, an increase of 13.7%, representing service gross margins of (70.3)% for the second quarter of 2002 and (2.4)% for the same period in 2001. Cost of service revenues increased to $1.5 million for the six months ended June 30, 2002 from $1.2 million for the comparative period in 2001, an increase of 18.6%, representing service gross margins of (77.6)% for the six months ended June 30, 2002 and (6.7)% for the same period in 2001. The decline in service gross margins for both the quarter and six months was primarily due to reduced service revenues as well as increased facilities, payroll, and travel costs. In addition, customer service related expenses incurred by BeAtHome also contributed to the increased costs during the two periods.

Operating Expenses

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
(dollars in thousands)
Product Development	$	5,376	$	4,064	32.3	%	$	10,996	$	7,888	39.4	%
Sales and Marketing		4,293		3,848	11.6	%		8,579		7,739	10.9	%
General and Administrative		2,226		1,487	49.7	%		4,478		3,801	17.8	%

Total Operating Expenses	$	11,895	$	9,399	26.6	%	$	24,053	$	19,428	23.8	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
As a % of Net Revenue
Product Development	17.2	%	29.2	%	(12.0	)%	18.7	%	29.8	%	(11.1	)%
Sales and Marketing	13.7	%	27.6	%	(13.9	)%	14.6	%	29.2	%	(14.7	)%
General and Administrative	7.1	%	10.7	%	(3.6	)%	7.6	%	14.3	%	(6.7	)%

Total Operating Expenses	38.0	%	67.5	%	(29.5	)%	40.8	%	73.3	%	(32.5	)%

Product development. Product development expenses consist primarily of payroll and related expenses for development personnel, expensed material and facility costs associated with the development of new technologies and products. Product development expenses for the second quarter of 2002 grew to $5.4 million from $4.1 million in the same quarter of 2001, representing 17.2% of total revenues for the second quarter of 2002 and 29.2% of total revenues for the same period in 2001. Product development expenses for the six months ended June 30, 2002 grew to $11.0 million from $7.9 million in the same period of 2001, representing 18.7% of total revenues for the six months ended June 30, 2002 and 29.8% of total revenues for the same period in 2001. This increase in product development expenses for both the quarter and six months was primarily the result of costs attributable to operations at BeAtHome during February and March of 2002, including a one-time charge of $400,000 related to in-process research and development expensed in the first quarter of 2002, increased costs associated with our new corporate facilities in San Jose, and increased personnel costs.

Sales and marketing. Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales personnel, travel and entertainment, advertising and product promotion and facilities costs associated with our sales and support offices. Sales and marketing expenses for the second quarter of 2002 increased to $4.3 million from $3.8 million in the same quarter of 2001, representing 13.7% of total revenues for the second quarter of 2002 and 27.6% of total revenues for the same period in 2001. Sales and marketing expenses for the six months ended June 30, 2002 increased to $8.6 million from $7.7 million in the same period of 2001, representing 14.6% of total revenues for the six months ended June 30, 2002 and 29.2% of total revenues for the same period in 2001. The increase in sales and marketing expenses for the quarter was the result of increased costs associated with our new corporate facilities in San Jose, increased personnel costs, increased costs for consultants and other third party service providers, sales and marketing costs attributable to operations at BeAtHome, and increased travel costs. The increase in sales and marketing expenses for the six months was primarily the result of increased costs associated with our new corporate facilities in San Jose, increased personnel costs, increased costs for tradeshows and other marketing events, and sales and marketing costs attributable to operations at BeAtHome.

General and administrative. General and administrative expenses consist primarily of payroll and related expenses for executive, accounting and administrative personnel, insurance, professional fees and other general corporate expenses. General and administrative expenses in the second quarter of 2002 increased to $2.2 million from $1.5 million in the same quarter of 2001, representing 7.1% of total revenues for the second quarter of 2002 and 10.7% of total revenues for the same period in 2001. General and administrative expenses for the six months ended June 30, 2002 increased to $4.5 million from $3.8 million in the same period of 2001, representing 7.6% of total revenues for the six months ended June 30, 2002 and 14.3% of total revenues for the same period in 2001. This increase in general and administrative expenses for the both the quarter and six months was primarily the result of increased personnel costs, general and administrative costs attributable to operations at BeAtHome, and increased costs associated with our new corporate facilities in San Jose. Partially offsetting the six month year over year increase was the one-time $475,000 settlement charge related to the Calabrese patent infringement lawsuit that we paid in the first quarter of 2001.

Interest and other income, net

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
	(dollars in thousands)
Interest and other income, net	$	1,011	$	1,807	(44.1	)%	$	2,011	$	4,061	(50.5	)%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
	As a % of Net Revenue
Interest and other income, net	3.2	%	13.0	%	(9.8	)%	3.4	%	15.3	%	(11.9	)%

Interest and other income, net primarily reflects interest earned by our company on cash and short-term investment balances. Interest and other income, net for the second quarter of 2002 decreased to $1.0 million from $1.8 million for the comparable period in 2001. Interest and other income, net for the six months ended June 30,

2002 decreased to $2.0 million from $4.1 million for the comparable period in 2001. This decrease was primarily due to the lower average balance of invested cash during the comparative periods, as well as lower average rates of return on those invested balances.

Provision for income taxes

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
	(dollars in thousands)
Provision for income taxes	$	443	$	1	44,200	%	$	677	$	2	33,750	%

	Three Months Ended June 30,				2002 over 2001 % Change		Six Months Ended June 30,				2002 over 2001 % Change
	2002		2001		2002 over 2001 % Change		2002		2001		2002 over 2001 % Change
As a % of Net Revenue
Provision for income taxes	1.4	%	0.0	%	1.4	%	1.1	%	0.0	%	1.1	%

The provision for income taxes for the quarter and six months ended June 30, 2002 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 for the quarter and six months ended June 30, 2002 primarily consist of taxes related to profitable foreign subsidiaries and various state minimum taxes. Income taxes were $443,000 for the quarter ended June 30, 2002 and $1,000 for the same period in 2001. Income taxes were $677,000 for the six months ended June 30, 2002, and $2,000 for the same period in 2001.

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. From inception through June 30, 2002, we raised $268.9 million from the sale of preferred stock and common stock.

As of June 30, 2002, we had cash, cash equivalents and short-term investments of $110.5 million. Net cash provided by operating activities was $13.7 million for the six months ended June 30, 2002 compared to net cash used for operating activities of $4.4 million during the same period of 2001. Cash provided by operating activities in 2002 was principally the result of the net profit, a decrease in accounts receivable, and an increase in accounts payable and accrued liabilities. Cash used for operating activities in 2001 of $4.4 million was principally the result of a planned increase in inventories, increases in accounts receivable and other current assets, and a decrease in our deferred revenues, partially offset by increases in accounts payable and accrued liabilities.

Net cash used for investing activities for the six months ended June 30, 2002 of $22.3 million was principally due to the purchase of available-for-sale short-term investments, the purchase of restricted investments required by our bank to collateralize certain credit facilities issued to us, net cash paid of $5.8 million for BeAtHome, and capital expenditures of $1.6 million, partially offset by proceeds from sales and maturities of available-for-sale short-term investments. For the six months ended June 30, 2001, net cash used for investing activities of $43.3 million was principally due to the purchase of available-for-sale short-term investments, a $5.1 million increase in other long-term assets, and the incurrence of capital expenditures of $2.8 million, partially offset by proceeds from sales and maturities of available-for-sale short-term investments.

Net cash provided by financing activities of $2.7 million for the six months ended June 30, 2002 and $1.1 million for the same period in 2001 was principally due to the proceeds from the exercise of stock options by employees and, to a lesser extent, by the proceeds from the exercise of stock warrants by some of our warrant holders, which warrant holders are also directors of our company.

We believe that our existing available cash, cash equivalents and short-term investments will satisfy our projected working capital and other cash requirements for at least the next twelve months. However, in the unlikely event that we would require additional financing within this period, such financing may not be available to us in the

amounts or at the times that we require, or on acceptable terms. If we fail to obtain additional financing, when and if necessary, our business would be harmed.

Related Party Transactions

Larry W. Sonsini, a director of our company, serves as a member, Chairman and Chief Executive Officer of Wilson Sonsini Goodrich & Rosati, Professional Corporation (“WSGR”), our principal outside legal counsel. We believe payments made to WSGR for services performed during the quarters ended June 30, 2002 and 2001 were based upon hourly billing rates and other terms similar to those used by other unrelated law firms we engage from time to time.

In June 2000, we entered into a stock purchase agreement with ENEL. At the same time, we also entered into a research and development agreement with an affiliate of ENEL. 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 Tato as its representative to our Board of Directors in September 2000. As a consequence of the expiration of Mr. Tato’s mandate as ENEL’s Chief Executive Officer, Mr. Tato 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. Under the terms of the research and development agreement, we are cooperating with ENEL to integrate our LONWORKS technology into ENEL’s remote metering management project in Italy. For the quarter and six months ended June 30, 2002, the Company has recognized revenue from products and services sold to ENEL and its designated manufacturers of approximately $20.5 million and $38.1 million respectively, $19.6 million of which was included in Accounts Receivable at June 30, 2002. For the quarter and six months ended June 30, 2001, the Company recognized revenue from products sold to ENEL and its designated manufacturers of approximately $2.6 million and $2.8 million respectively, $2.6 million of which was included in Accounts Receivable at June 30, 2001. During the term of service of ENEL’s representative on our board of directors from September 2000 to June 2002, ENEL’s representative abstained from resolutions on any matter relating to ENEL.

New Accounting Standards

In July 2001, the FASB also issued SFAS No. 142 (“SFAS 142”), “Goodwill and Intangible Assets,” which supersedes APB Opinion No. 17, “Intangible Assets.” Under SFAS 142, goodwill and intangible assets with indefinite lives acquired on or after June 29, 2001 are not amortized, but instead are tested for impairment annually, primarily using the fair value approach, when there is an impairment indicator. In addition, SFAS 142 provides that other intangible assets will continue to be valued and amortized over their estimated lives; in-process research and development will continue to be written off immediately; all acquired goodwill will be assigned to reporting units for purposes of impairment testing and segment reporting; and, effective January 1, 2002, goodwill and intangible assets with indefinite lives acquired before June 29, 2001 will no longer be subject to amortization, but will instead be subject to impairment tests in accordance with the new Statement.

	Quarter Ended June 30, 2001
	Amount		Basic EPS		Diluted EPS
Reported net income	$	38	$	0.00	$	0.00
Add back amortization expense (net of tax):
Goodwill and workplace in force		90		0.00		0.00

Adjusted net income	$	128	$	0.00	$	0.00

	Six-Months Ended June 30, 2001
	Amount		Basic EPS		Diluted EPS
Reported net income	$	60	$	0.00	$	0.00
Add back amortization expense (net of tax):
Goodwill and workplace in force		141		0.01		0.00

Adjusted net income	$	201	$	0.01	$	0.00

The changes in the carrying amount of goodwill, net for the six months ended June 30, 2002 are as follows (in thousands):

	Amount
Balance as of December 31, 2001	$	1,637
Reclass of workplace in force		74
Unrealized foreign currency translation gain		183
Goodwill resulting from BeAtHome acquisition		5,745

Balance as of June 30, 2002	$	7,639

In August 2001, the FASB issued SFAS No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations,” which we will be required to adopt no later than January 1, 2003. SFAS 143 addresses the financial accounting and reporting for obligations associated with the retirement of long-lived assets and the associated asset retirement costs. We have not yet determined the impact of adopting SFAS 143 on our financial position, results of operations, or cash flows.

Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to an exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS 146 are effective for exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of SFAS 146 to have a material impact on our financial position, results of operations, or cash flows.

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 Form 10-K for the year ended December 31, 2001.

Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. All our investments are in high-quality issuances, and, by our company policy, are limited in the amount of credit exposure to any one issuer. We ensure the safety and preservation of the invested principal funds by investing only in marketable securities with active secondary or resale markets, which also helps to maintain portfolio liquidity. The table below presents principal amounts and related weighted average interest rates for our investment portfolio at June 30, 2002. According to our policy, all investments mature in two years or less.

	Carrying Amount		Average Interest Rate
	(in thousands)
Cash Equivalents:
U.S. corporate securities	$	11,199	1.81	%

Total cash equivalents	$	11,199	1.81	%

Short-term Investments:
U.S. corporate securities	$	71,773	3.66	%
U.S. government securities		23,742	2.87	%

Total short-term investments	$	95,515	3.46	%

Total investment securities	$	106,714	3.28	%

Foreign Currency Exchange Risk. We transact business in various foreign countries. Our primary foreign currency cash flows are in Japan. Currently, we do not employ a foreign currency hedge program utilizing foreign currency exchange contracts as the foreign currency transactions and risks to date have not been significant.

Factors That May Affect Future Results of Operations

Interested persons should carefully consider the risks described below in evaluating Echelon. 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 June 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 contract, we agreed to work with ENEL to integrate our LONWORKS technology into ENEL’s “Contatore Elettronico” remote metering management project in Italy. During the second quarter of 2002, revenue attributable to the Contatore Elettronico project was approximately $20.5 million, or 65.5% of our total revenue. If the Contatore Elettronico project achieves its targeted volumes during 2002, we expect this project to account for more than 60% of our total revenues for the year.

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

•

a dispute could develop between ENEL and our company regarding product suitability, quality, price, quantities or other issues. If any dispute is not resolved in a timely manner, the project could be delayed, could become less profitable to us, or either we or ENEL could seek to terminate the research and development agreement;

•

our research and development activities under this project might be unsuccessful, or might not be commercially exploitable;

•

the Contatore Elettronico project might not meet target dates;

•

once they have been manufactured, electricity meters or other products used in the Contatore Elettronico project may not be installed by ENEL in accordance with ENEL’s scheduled roll-out plan. 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;

•

the products we develop for the Contatore Elettronico project might not yield economic returns;

•

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; or

•

third parties may contest part or all of our agreement with ENEL.

In addition, ENEL has recently appointed a new chairman and chief executive officer, whom we understand will continue to review ENEL’s strategic plans and policies, including the Contatore Elettronico. If ENEL’s new management determines that ENEL no longer wishes to pursue the Contatore Elettronico to the extent we currently contemplate, or at all, then ENEL could seek to curtail or terminate the project.

If our efforts under our research and development agreement with ENEL or the related Contatore Elettronico project are not successful, our revenues and income could suffer and this could 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. We sell our products to these Meter Manufacturers as part of this project. Our success under the Contatore Elettronico could be affected by the Meter Manufacturers for many reasons, including:

•

the Meter Manufacturers may not achieve their intended production levels;

•

the Meter Manufacturers may not 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;

•

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;

•

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.

In addition, we understand that one of the Meter Manufacturers may be placed under sanction by the U.S. Department of State for alleged violations of the Iran-Iraq Arms Non-Proliferation Act of 1992 and the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991, which prohibit any company that helps either Iran or Iraq acquire certain weapons from doing business with U.S. companies and the U.S. government for a period of time. These laws also ban U.S. companies from exporting goods that require U.S. government license controls to the companies. We do not believe the Meter Manufacturer is currently under such sanctions. However, if these penalties are imposed on the Meter Manufacturer, and as a result, we cannot sell our products to the Meter Manufacturer, then until ENEL has found an alternate Meter Manufacturer to which we could provide products, our revenues and operating results could suffer materially.

We have a history of losses, and we may incur losses in the future.

We generated a profit of $5.1 million for the quarter ending June 30, 2002. Although this was our seventh consecutive profitable quarter, we have incurred net losses in all other periods since our inception. As of June 30, 2002, we had an accumulated deficit of $80.5 million. We have invested and continue to invest significant financial resources in product development, marketing and sales. If our revenues do not increase significantly as a result of these expenditures, we may not be able to sustain profitability. There is also no guarantee that our profitability will continue or increase on a quarterly or annual basis. Our future operating results will depend on many factors, including:

•

the timely installation of ENEL’s Contatore Elettronico remote metering management project;

•

the adoption of our products by service providers for use in utility and/or other home automation projects similar to ENEL’s Contatore Elettronico project;

•

the return of worldwide economic growth, particularly in certain countries such as Japan, and in certain industries such as semiconductor manufacturing equipment;

•

the 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 new products in a timely and cost-effective basis, or at all;

•

ongoing operational expenses associated with our acquisition of BeAtHome.com 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 intangible assets we acquired from BeAtHome and Arigo Software GmbH. 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, 2001, we had net operating loss carry forwards for Federal income tax reporting purposes of about $89.9 million and for state income tax reporting purposes of about $8.0 million, which expire at various dates through 2021. In addition, as of December 31, 2001, we had tax credit carry forwards of about $10.1 million, which expire at various dates through 2021. The Internal Revenue Code of 1986, as amended, contains provisions that limit the use in future periods of net operating loss and credit carry forwards upon the occurrence of certain events, including significant changes in ownership interests. We have performed an analysis of our ownership changes and have reported the net operating loss and credit carry forwards considering such limitations. We had deferred tax assets, including our net operating loss carry forwards and tax credits, totaling about $46.5 million as of December 31, 2001. 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, and we have, on occasion, failed to meet securities analysts’ expectations in the past. 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. The factors that could cause this variability, many of which are outside of our control, include the following:

•

the ENEL Project may fail to meet analysts’ expectations;

•

we may fail to meet our revenue and earnings guidance;

•

the rates at which OEMs purchase our products and services may fluctuate;

•

we may fail to introduce new products on a timely basis or before the end of an existing product’s life cycle;

•

downturns in any customer’s or potential customer’s business, or declines in general economic conditions, could cause significant reductions in capital spending, thereby reducing the levels of orders from our customers;

•

we may face increased competition;

•

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;

•

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.

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. 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 we believe 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 since OEMs in certain industries receive a large portion of their revenues from sales of products and services to their installed base, these OEMs have tended to moderate the rate at which they incorporate LONWORKS technology into their products. 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.

If we do not maintain and expand our distribution channels our revenues could decrease significantly.

Currently, significant portions of our revenues are derived from sales by EBV, the sole independent distributor of our products to OEMs in Europe. EBV accounted for 9.4% of our total revenues for the quarter ended June 30, 2002, and 21.1% of our total revenues for the same period in 2001; and 10.1% of our total revenues for the six months ended June 30, 2002, and 25.4% of our total revenues for the same period in 2001. Our current agreement with EBV expires in December 2002. In addition, as part of our distribution strategy, we intend to develop distribution arrangements with systems integrators. In particular, we expect that a significant portion of our future revenues will be derived from sales by such systems integrators. If EBV, or any other existing or future distributor, fails to dedicate sufficient resources and efforts to marketing and selling our products, our revenues could decrease. If EBV significantly reduces its inventory levels for our products, both our revenues and customer service levels would decrease. In that case, we might be required to add our own pan-European distribution capability to meet the needs of our customers. Our business will be harmed if any of the following occurs:

•

we fail to develop new distribution channels;

•

we fail to maintain the EBV arrangement or any other distribution channels;

•

EBV decides to reduce its stocking or other service levels; or

•

we do not renew the EBV arrangement on a timely basis.

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

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

The Neuron Chip is an important component that our customers use in control network nodes. In addition, the Neuron Chip is an important device that we use in many of our products. Neuron Chips are currently manufactured and distributed by Toshiba and Cypress Semiconductor. We have entered into licensing agreements with each of Toshiba and Cypress. The 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 and unspecified updates to the licensed technology over the terms of the agreements. The Cypress agreement expires in April 2009, and the Toshiba agreement expires in January 2010. We currently have no other source of supply for Neuron Chips and do not have resources or skills internally to replace Toshiba or Cypress as a manufacturer of Neuron Chips. Both Toshiba and Cypress are expected to play a key role in the development and marketing of LONWORKS technology. If we lose Toshiba or Cypress as a supplier, we may not be able to locate an alternate source for the design, manufacture or distribution of Neuron Chips.

Our future success will also depend significantly on our ability to manufacture our products cost-effectively and in sufficient volumes. 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 delivery schedules, product availability, manufacturing yields, quality and costs. In addition, contract electronic manufacturers can themselves experience turnover and instability, exposing us to additional risks as well as missed commitments to our customers. We will also face risks if and when we transition between contract electronic manufacturers. For example, we may have to move raw material and in process inventory between locations in different parts of the world. Also, we would be required to reestablish acceptable manufacturing processes with a

new work force. We could also be liable for excess or unused inventory held by contract manufacturers for use in our products. This inventory may become obsolete as a result of engineering changes that we make. In addition, we may no longer need this inventory because of factors such as changes in our production build plans, miscommunication between us and a contract manufacturer or errors made by a contract manufacturer in ordering material for use in our products. Under our contracts with these contract electronic manufacturers, we would become liable for all or some of these excess or obsolete inventories in the event our manufacturing agreement with them is cancelled and they are unable to return the material to their suppliers.

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

We currently purchase several key products and components only from sole or limited sources. 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.

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 product reputation, quality, and performance; and

•

the price and features of our products such as adaptability, scalability, the ability to integrate with other products, functionality, and ease of use.

In each of our markets, we compete with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses. Our competitors include some of the largest companies in the electronics industry, such as Siemens in the building and industrial automation industries, Allen-Bradley (a subsidiary of Rockwell) and Group Schneider in the industrial automation industry, and Microsoft. Many of our competitors, alone or together with their trade associations and partners, have significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition and broader product offerings. As a result, these competitors may be able to devote greater resources to the development, marketing and sale of their products, and may be able to respond more quickly to changes in customer requirements or product technology. In addition, those competitors that manufacture and promote closed, proprietary control systems may enjoy a captive customer base dependent on such competitors for service, maintenance, upgrades and enhancements. Most recently, Microsoft has announced a specification that it refers to as SCP (Simple Control Protocol) that is targeted at the networking of everyday devices. Microsoft has announced its intent to focus this capability on home networking applications. Products from other companies such as emWare, Ipsil, JumpTec, Lantronix, NetSilicon and Wind River Systems could also compete with our products, especially in the utility/home market.

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 BatiBus Club International in France, 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 the CEBus Industry Council, which is the proponent of an alternative protocol to our LONWORKS protocol for use in the utility/home automation industry, various industry groups who promote alternative open standards such as BACnet in the building market, and a group comprised of Asea Brown Boveri, ADtranz AB, Siemens, GEC Alstrom and other manufacturers that support an alternative rail transportation protocol to our LONWORKS protocol. Our technologies, protocols or standards may not be successful in any of our markets, and we may not be able to compete with new or enhanced products or standards introduced by existing or future competitors.

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 market for our products and increase the competition that we face.

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

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

•

investors may be concerned about the success of our project with ENEL;

•

Microsoft, or other 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

•

significant stockholders may sell some or all of their holdings of our stock.

In addition, the market price of securities of technology companies, especially those in rapidly evolving industries such as ours, has been very volatile in the past. This volatility has often been unrelated or disproportionate to the operating performance of particular companies. In addition, in the future, our operating results may fall below analysts’ expectations, which could adversely affect the market price of our stock.

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.

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 particularly difficult to recruit, relocate and retain qualified personnel in this geographic area. Moreover, the cost of living, including the cost of housing, in the 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 to

acquire housing or to alleviate other costs that might be associated with joining our company. In addition, if we lose the services of any of our key personnel and are not able to find replacements in a timely manner, our business could be disrupted, other key personnel may decide to leave, and we may incur increased operating expenses in finding and compensating their replacements.

The 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, 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 may have advantages over our products in remote connection. 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 frequently delay 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.

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

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

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; and

•

the deployment schedule for projects undertaken by systems integrators.

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.

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 over the past two years, and many of our customers and potential customers have experienced declines in their revenues and operations. In addition, the terrorist acts of September 11, 2001 and the possibility of subsequent terrorist activities have created an uncertain 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 curtail or eliminate capital spending on control network technology. If capital spending in our markets declines, it may be necessary for us to gain significant market share from our competitors in order to achieve our financial goals and maintain profitability.

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 or as new versions are released. In addition, our customers 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. 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 and 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.

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 our insurers requested premiums that 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.

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. We have 81 issued U.S. patents, 12 pending U.S. patent applications, and various foreign counterparts. It is possible that patents will not issue from these pending applications or from any future applications or that, if issued, any claims allowed will not be sufficiently broad to protect our technology. If any of our patents fail to protect our technology, our competitors may find it easier to offer equivalent or superior technology. We have registered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. If we fail to properly register or maintain our trademarks or to otherwise take all necessary steps to protect our trademarks, the value associated with the trademarks may diminish. In addition, if we fail to take all necessary steps to protect our trade secrets or other intellectual property rights, we may not be able to compete as effectively in our markets.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or services or to obtain and use information that we regard as proprietary. Any of the patents, trademarks, copyrights or intellectual property rights that have been or may be issued or granted to us could be challenged, invalidated or circumvented, and any of the rights granted may not provide protection for our proprietary rights. In addition, 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. For example, certain of our products are licensed under shrink-wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions.

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

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. These regulations limit the ability of companies in general to use power lines as a communication medium. In addition, some of our competitors have attempted to use regulatory actions to reduce the market opportunity for our products or to increase the market opportunity for their own products. For example, in the late 1990’s, we experienced efforts by CEMA, a trade association that developed a competing home automation protocol, to persuade the FCC to mandate use of its protocol in analog television and set-top box applications. We were a petitioner in litigation arising from a related FCC proceeding concerning commercial availability of these “navigation devices.” An appeal under this case was decided in favor of the government. We decided not to seek Supreme Court review. Although these specific FCC and judicial proceedings are not a significant threat to our digital and Internet-based products, changes in existing regulations or the issuance of new regulations in the future could adversely affect the market for our products or require us to expend significant management, technical and financial resources to make our products compliant with the new rules.

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 88.8% of our total revenues for the quarter ended June 30, 2002 and 66.9% of our total revenues for the same period in 2001; and 87.8% of our total revenues for the six months ended June 30, 2002 and 67.2% of our total revenues for the same period in 2001. We expect that international sales will continue to constitute a significant portion of total 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:

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currency fluctuations;

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unexpected changes in regulatory requirements, tariffs and other trade barriers;

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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;

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difficulties in managing international operations;

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potentially adverse tax consequences, including restrictions on repatriation of earnings; and

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the burdens of complying with a wide variety of foreign laws.

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

Fluctuations in the value of currencies in which we conduct our business relative to the U.S. dollar could cause currency translation adjustments. The portion of our revenues conducted in currencies other than the U.S. dollar, principally the Japanese yen, was about 5.9% for the quarter ended June 30, 2002 and 8.9% for the same period in 2001; and 5.2% for the six months ended June 30, 2002 and 7.9% for the same period in 2001.

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

As of July 31, 2002, 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 36.2% of our outstanding stock.

Under the stock purchase agreement with ENEL, which transaction was completed September 11, 2000, ENEL purchased 3 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 7.6% of our outstanding common stock. ENEL also has the right to nominate a member of our board of directors as long as ENEL owns at least 2.0 million shares of our common stock. As a consequence of the expiration of his mandate as ENEL’s Chief Executive Officer, Mr. Francesco Tato resigned as Board member in all of ENEL’s subsidiaries and affiliates, including Echelon in which he served as representative of ENEL on our board of directors from September 2000 until June 2002. ENEL has reserved its right to nominate a new member of our board of directors,

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 representative from September 2000 to June 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.

We rely on a continuous power supply to conduct our operations, and if California’s recent energy crisis reoccurs, our operations could be disrupted and our expenses could increase.

California recently experienced an energy crisis due to an acute power shortage, during which power reserves for the state of California fell below certain critical levels. As a result, California has on some occasions implemented rolling blackouts throughout the state. If an energy crisis reoccurs, we do not have backup generators or alternate sources of power in the event of an extended blackout, and our current insurance does not provide coverage for any damages we or our customers might suffer as a result of any interruption in our power supply. If extended blackouts interrupted our power supply, we would be temporarily unable to continue operations at our California facilities. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations.

PART II. OTHER INFORMATION

Item 4. Submission of Matters To A Vote of Security Holders

The Company held its annual meeting of stockholders on May 17, 2002 (the “Annual Meeting”). At such meeting, the following directors were elected: M. Kenneth Oshman and Larry W. Sonsini. Our incumbent directors, Robert J. Finocchio, Jr., Armas Clifford Markkula, Jr., Robert R. Maxfield, Richard M. Moley, and Arthur Rock will continue to serve on the Board. The only other matter submitted to stockholder vote at the Annual Meeting was the ratification of the appointment of KPMG LLP as independent public accountants of the Company for the fiscal year ending December 31, 2002. Voting results for the KPMG LLP appointment were as follows: For: 32,123,451; Against: 77,487; Abstain: 33,098; Broker Non-Votes: 0. Voting results for the election of the directors were as follows:

	Votes For:	Votes Withheld:
M. Kenneth Oshman	31,946,212	287,824
Larry W. Sonsini	32,147,618	86,418

Item 6. Exhibits and Reports on Form 8-K

Exhibit No.		Description of Document

99.1		Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURE

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

	ECHELON CORPORATION

Date: August 13, 2002	By:	/s/ Oliver R. Stanfield
		Oliver R. Stanfield Executive Vice President Finance and Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer)

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