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ELON > SEC Filings for ELON > Form 10-Q on 3-May-2013All Recent SEC Filings

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Form 10-Q for ECHELON CORP


3-May-2013

Quarterly Report


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. The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business. These statements may be identified by the use of words such as "we believe," "expect," "anticipate," "intend," "plan," "goal," "continues," "may" and similar expressions. Forward-looking statements include statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances. In particular, these statements include statements such as: our predictions about the smart energy market, increased pricing pressures and worldwide macro-economic conditions; our projections of Systems and Sub-systems revenues; estimates of our future gross margins; statements regarding reinvesting a portion of our earnings from foreign operations; plans to use our cash reserves to strategically acquire other companies, products, or technologies; our projections of our combined cash, cash equivalent and short term investment balance; the sufficiency of our cash reserves to meet cash requirements; our expectations that our Sub-systems revenues will not fluctuate significantly from foreign currency sales; our forecasts regarding the allocation of our future product development spend; estimates of our interest income and expense; our expectations about finalizing the settlement with Finmek and the amounts of timing of the related payments; our expectations about the amount and timing of paying out restructuring charges; and out belief that we have made adequate provisions for tax exposure and legal matters. Such statements are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing and particularly in the "Factors That May Affect Future Results of Operations" section. Therefore, our actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to review or update publicly any forward-looking statements for any reason.

EXECUTIVE OVERVIEW
Echelon Corporation was incorporated in California in February 1988 and reincorporated in Delaware in January 1989. We are based in San Jose, California, and maintain offices in eleven foreign countries throughout Europe and Asia. We develop, market, and sell energy control networking solutions, a critical element of incorporating action-oriented intelligence into the utility grid, buildings, streetlights, and other energy devices - all components of the evolving smart grid, which encompasses everything from the power plant to the plug. Echelon's products can be used to make the management of electricity over the smart grid cost effective, reliable, survivable and instantaneous. Our products enable everyday devices - such as air conditioners, appliances, electricity meters, light switches, thermostats, and valves - to be made "smart" and inter-connected.

Our proven, open standard, multi-application energy control networking platform powers energy-savings applications for smart grid, smart cities and smart buildings that help customers save on their energy usage, reduce outage duration or prevent them from happening entirely, reduce carbon footprint and more. Today, we offer, directly and through our partners worldwide, a wide range of innovative, fully integrated products and services. We classify these products and services into two primary categories: Systems, such as our smart metering solutions, which are targeted for use by utilities; and Sub-systems that include our components, control nodes and development software, which are sold typically to OEMs who build them into their smart grid, smart cities and smart buildings solutions.

Our total revenues decreased by 37.6% during the first quarter of 2013 as compared to the same period in 2012, driven principally by decreased sales of our Systems products. Gross margins increased by 3.9 percentage points between the two periods, while overall operating expenses increased by 9.3%. The net effect was a first quarter loss attributable to Echelon Corporation stockholders in 2013, that increased by $6.7 million as compared to the first quarter of 2012.

The following tables provide an overview of key financial metrics for the three months ended March 31, 2013 and 2012 that our management team focuses on in evaluating our financial condition and operating performance (in thousands, except percentages).


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                                    Three Months Ended
                                         March 31,
                                  2013              2012            $ Change         % Change
Net revenues                 $      25,182     $      40,333     $    (15,151 )         (37.6 )%
Gross margin                          46.8 %            42.9 %            ---         3.9 ppt
Operating expenses           $      21,097     $      19,304     $      1,793             9.3  %
Net income (loss)
attributable to Echelon
Corporation Stockholders     $      (9,247 )   $      (2,568 )   $     (6,679 )         260.1  %
                                       Balance as of
                                March 31,       December 31,
                                  2013              2012            $ Change         % Change
Cash, cash equivalents, and
short-term investments       $      59,069     $      61,855     $     (2,786 )          (4.5 )%

Net revenues: Our total revenues decreased by 37.6% during the first quarter of 2013 as compared to the same period in 2012, driven primarily by a $15.4 million, or 54%, decrease in sales of our Systems products and services, partly offset by a $270,000 or 2% increase in net revenues from our Sub-systems products. The decrease in our Systems revenues was primarily due to an overall decrease in the level of large-scale deployments in the United States and Finland of our NES system products. With respect to our Sub-systems product line, the increase in revenues during the first quarter of 2012 was due to an increase in sales made to Enel and in the Americas and APJ regions, partly offset by reductions in sales to EMEA region. These markets have yet to recover to their pre-recession levels. During 2013, we plan to reinvest in our foundational technology to broaden the applicability of our control networking platform (part of our Sub-system business) into new markets.

Gross margin: Our gross margin increased by 3.9 percentage points for the three months ended March 31, 2013 as compared to the same period in 2012. The increase was primarily due to improved margins earned on sales of our Systems products, as well as the impact of efforts to reduce overhead costs over the past year.

Operating expenses: Our operating expenses increased by 9.3% during the three month period ended March 31, 2013, as compared to the same period in 2012. The increase was primarily driven by Q1' 2013 organizational restructuring as well as a non recurring litigation charge for the potential settlement of the Finmek case. This increase was partially offset by the decreases in compensation costs (salaries and other employee related costs, including equity compensation) due to restructurings that took place in May 2012 and February 2013, as well as reduced travel costs.

Net loss attributable to Echelon Corporation Stockholders: We generated a net loss of $9.2 million during the first quarter of 2013 compared to $2.6 million during the same period in 2012. This increase in net loss was directly attributable to the $15.2 million quarter-over-quarter decrease in net revenues as well as the increase in operating expenses. Excluding the impact of non-cash stock-compensation charges, restructuring charges and litigation charges, our net loss increased by approximately $2.1 million in the first quarter of 2013 as compared to the same period in 2012.

Cash, cash equivalents, and short-term investments: During the first three months of 2013, our cash, cash equivalents, and short-term investment balance decreased by 4.5%, from $61.9 million at December 31, 2012 to $59.1 million at March 31, 2013. This decrease was primarily the result of cash used in operations of $1.7 million due mainly to our net loss including non controlling interest of $9.4 million, partly offset by the reduction in working capital (increased accrued liabilities of $5.2 million being the primary driver), as well as cash used for principal payments on our lease financing obligations.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. Note 1, "Significant Accounting Policies" of Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2012, which we filed with the Securities and Exchange Commission in March 2013, describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our revenues, stock-based compensation, allowance for doubtful accounts, inventories, and commitments and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for


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making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

During the three months ended March 31, 2013, there were no material changes to our critical accounting policies or in the matters for which we make critical accounting estimates in the preparation of our condensed consolidated financial statements as compared to those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012.

                             RESULTS OF OPERATIONS
The following table reflects the percentage of total revenues represented by
each item in our Condensed Consolidated Statements of Operations for the three
months ended March 31, 2013 and 2012:
                                                                Three Months Ended
                                                                     March 31,
                                                               2013             2012
Revenues:
Product                                                         96.3  %          97.9  %
Service                                                          3.7              2.1
Total revenues                                                 100.0            100.0
Cost of revenues:
Cost of product                                                 51.9             55.7
Cost of service                                                  1.3              1.4
Total cost of revenues                                          53.2             57.1
Gross profit                                                    46.8             42.9
Operating expenses:
Product development                                             26.8             21.8
Sales and marketing                                             17.8             15.3
General and administrative                                      15.5             10.8
Litigation charges                                              13.7                -
Restructuring charges                                           10.0                -
Total operating expenses                                        83.8             47.9
Income (loss) from operations                                  (37.0 )           (5.0 )
Interest and other income (expense), net                         1.1             (0.6 )
Interest expense on lease financing obligations                 (1.3 )           (0.9 )
Income (loss) before provision for income taxes                (37.2 )           (6.5 )
Income tax expense                                               0.1             (0.1 )
Net income (loss)                                              (37.3 )%          (6.4 )%
Net loss attributable to non controlling interest                0.6  %             -  %
Net income (loss) attributable to Echelon Corporation
stockholders                                                   (36.7 )%          (6.4 )%



Revenues
Total revenues
                                                  Three Months Ended
                                              March 31,       March 31,     2013 over 2012    2013 over 2012 %
(Dollars in thousands)                           2013           2012           $ Change            Change

Total revenues                               $   25,182     $    40,333     $   (15,151 )        (37.6 )%


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The $15.2 million decrease in total revenues for the quarter ended March 31, 2013 as compared to the same period in 2012 was primarily due to a $15.4 million, or 53.7%, decrease in sales of our Systems products and services and a $270,000, or 2.3%, increase in net revenues from our Sub-systems products, including sales to Enel.

As we look forward to the remainder of 2013, the smart energy market remains relatively stagnant, with no particular large growth drivers being noted. Macro-economic conditions remain tentative in Europe, and competition for the existing business is heightened. New tender activity for smart-metering deployments, while slightly improved from 2012, continues to be slow, especially in Europe, and pricing pressures are increasing. In this challenging environment, we expect our revenues in the second quarter of 2013 will be consistent with Q1'2013 revenues.

Systems revenues
                                                  Three Months Ended
                                              March 31,       March 31,     2013 over 2012    2013 over 2012 %
(Dollars in thousands)                           2013           2012           $ Change            Change

Systems revenues                             $   13,271     $    28,692     $   (15,421 )        (53.7 )%

During the three months ended March 31, 2013 and 2012, our Systems revenues were derived primarily from a relatively small number of customers who have undertaken large-scale deployments of our NES System products. These deployments generally come to fruition after an extended and complex sales process, and each is relatively substantial in terms of its revenue potential. They vary significantly from one another in terms of, among other things, the overall size of the deployment, the duration of time over which the products will be sold, the mix of products being sold, the timing of delivery of those products, and the ability to modify the timing or size of those projects. This relative uniqueness among each deployment results in significant variability and unpredictability in our Systems revenues.
Systems revenues decreased during the quarter ended March 31, 2013 as compared to the same period in 2012. This was primarily due to an overall decrease in the level of large-scale deployments in Finland and the United States of our NES system products, partly offset by an increase in sales to our customers in Austria.
Our ability to recognize revenue for our Systems products depends on several factors, including, but not limited to, the impact on delivery dates of any modifications to existing shipment schedules included in the contracts that have been awarded to us thus far, and in some cases, certain contractual provisions, such as customer acceptance. For arrangements that contain contractual acceptance provisions, revenue recognition may be delayed until acceptance by the customer or the acceptance provisions lapse unless we can objectively demonstrate that the contractual acceptance criteria have been satisfied, which is generally accomplished by establishing a history of acceptance for the same or similar products.

Our Systems revenues have historically been concentrated with a relatively few customers. During the years ended December 31, 2012, 2011 and 2010 approximately 86.3%, 94.2% and 85.4%, respectively, of our Systems revenues were attributable to four customers. While our Systems customers will change over time, given the nature of the Systems market, we expect our future Systems revenues will continue to be concentrated among a limited number of customers.

Sub-systems revenues
                                                       Three Months Ended
                                                                                      2013 over 2012    2013 over 2012
(Dollars in thousands)                         March 31, 2013      March 31, 2012        $ Change          % Change

Sub-systems revenues                         $         11,911     $        11,641     $         270          2.3 %

Our Sub-systems revenues are primarily comprised of sales of our hardware products, and to a lesser extent, revenues we generate from sales of our software products and from our customer support and training offerings. Included in these totals are products and services sold to Enel.


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Excluding sales of products and services to Enel, which are discussed more fully below, our Sub-systems revenues decreased by $1.4 million, or 12.2% during the three months ended March 31, 2013, as compared to the same period in 2012. For the three month period, this decrease was primarily due to a decrease in revenues in EMEA and ongoing market share loss, partially offset by increases in Americas and APJ. Within the Sub-systems family of products, the decrease was driven primarily from decreased sales of our SmartServer and control and connectivity products.

Our future Sub-systems revenues will also be subject to further fluctuations in the exchange rates between the United States dollar and the foreign currencies in which we sell these products and services. In general, if the dollar were to weaken against these currencies, our revenues from those foreign currency sales, when translated into United States dollars, would increase. Conversely, if the dollar were to strengthen against these currencies, our revenues from those foreign currency sales, when translated into United States dollars, would decrease. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of sales conducted in these currencies and the magnitude of the exchange rate fluctuation from year to year. The portion of our Sub-systems revenues conducted in currencies other than the United States dollar, principally the Japanese Yen, was about 6.3% for the three months ended March 31, 2013 and 7.7% for the same period in 2012. To date, we have not hedged any of these foreign currency risks. We do not currently expect that, during 2013, the amount of our Sub-systems revenues conducted in these foreign currencies will fluctuate significantly from prior year levels. Given the historical and expected future level of sales made in foreign currencies, we do not currently plan to hedge against these currency rate fluctuations. However, if the portion of our revenues conducted in foreign currencies were to grow significantly, we would re-evaluate these exposures and, if necessary, enter into hedging arrangements to help minimize these risks. Enel project revenues (included in Sub-systems) Three Months Ended March 31, 2013 over 2013 over (Dollars in thousands) March 31, 2013 2012 2012 $ Change 2012 % Change

Enel project revenues $ 1,890 $ 227 $ 1,663 732.6 %

In October 2006, we entered into two agreements with Enel, a development and supply agreement and a software enhancement agreement. Under the development and supply agreement, Enel is purchasing additional metering kit and data concentrator products from us. Under the software enhancement agreement, we are providing software enhancements to Enel for use in its Contatore Elettronico system. Enel Project revenues recognized during the three months ended March 31, 2013 and 2012, related primarily to shipments under the development and supply agreement. The software enhancement agreement expired in December 2012 and the development and supply agreement expires in December 2015, although delivery of products and services can extend beyond those dates and the agreements may be extended under certain circumstances.

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

Gross Profit and Gross Margin
                                              Three Months Ended
                                              March     March 31,   2013 over 2012   2013 over 2012 %
(Dollars in thousands)                       31, 2013     2012         $ Change           Change

Gross Profit                                 $11,776     $17,298    $   (5,522 )        (31.9 )%
Gross Margin                                  46.8%       42.9%            N/A            3.9

Gross profit is equal to revenues less cost of goods sold. Cost of goods sold for product revenues includes direct costs associated with the purchase of components, subassemblies, and finished goods, as well as indirect costs such as allocated labor and overhead; costs associated with the packaging, preparation, and shipment of products; and charges related to warranty and excess and obsolete inventory reserves. Cost of goods sold for service revenues consists of employee-related costs such as


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salaries and fringe benefits as well as other direct and indirect costs incurred in providing training, customer support, and custom software development services. Gross margin is equal to gross profit divided by revenues. Gross margin increased by 3.9 percentage points for the first quarter ended March 31, 2013 as compared to the same period in 2012. Our gross margins for the first quarter ended March 31, 2013 were higher primarily due to improved pricing for products sold in North America as well as marginal improvement of pricing in Finland, combined with lower overhead spend and an improved mix of products sold. This was partially offset by some increases in costs for our Sub-system products.
Our future gross margins will continue to be affected by several factors, including, but not limited to: overall revenue levels, changes in the mix of products sold, periodic charges related to excess and obsolete inventories, warranty expenses, introductions of cost reduced versions of our Systems and Sub-systems products, changes in the average selling prices of the products we sell, purchase price variances, and fluctuations in the level of indirect overhead spending that is capitalized in inventory. In addition, the impact of foreign exchange rate fluctuations and labor rates may affect our gross margins in the future. We currently outsource the manufacturing of most of our products requiring assembly to CEMs located primarily in China. To the extent labor rates were to rise further, or to the extent the U.S. dollar were to weaken against the Chinese currency, or other currencies used by our CEMs, our costs for the products they manufacture could rise, which would negatively affect our gross margins. Lastly, many of our products, particularly our Systems products, contain significant amounts of certain commodities, such as silver, copper, and cobalt. Prices for these commodities have been volatile, which in turn have caused fluctuations in the prices we pay for the products in which they are incorporated.

Operating Expenses
Product Development
                                                    Three Months Ended
                                                                  March 31,     2013 over 2012   2013 over 2012 %
(Dollars in thousands)                        March 31, 2013        2012           $ Change           Change

Product Development                          $    6,744         $     8,801     $   (2,057 )        (23.4 )%

Product development expenses consist primarily of payroll and related expenses for development personnel, facility costs, expensed material, fees paid to third party service providers, depreciation and amortization, and other costs associated with the development of new technologies and products. Our product development expenses decreased by $2.1 million during the first quarter ended March 31, 2013 as compared to the same period in 2012. These decreases were primarily due to reduced compensation costs, including share based compensation expenses (as mentioned in the executive overview above), which were down primarily due to lower headcount in our product development organization in 2012 and 2013. During 2013, we plan to focus our product development spend in our foundational technology to broaden the applicability of our control networking platform into new markets.

Sales and Marketing
                                                    Three Months Ended
                                                                  March 31,     2013 over 2012   2013 over 2012 %
(Dollars in thousands)                        March 31, 2013        2012           $ Change           Change

Sales and Marketing                          $    4,493         $     6,157     $   (1,664 )        (27.0 )%

Sales and marketing expenses consist primarily of payroll, commissions, and related expenses for sales and marketing personnel, travel and entertainment, facilities costs, advertising and product promotion, and other costs associated with our sales and marketing activities.
The decrease in sales and marketing expenses during the first quarter ended March 31, 2013 as compared to the same period in 2012 was driven primarily by lower compensation costs (lower wage costs, bonus expense and stock compensation


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expense, offset by slightly higher commission expenses), lower travel and entertainment expenses and reduced fees paid to consultants and other third party service providers.

General and Administrative
                                                    Three Months Ended
                                                                  March 31,     2013 over 2012 $   2013 over 2012 %
(Dollars in thousands)                        March 31, 2013        2012             Change             Change

General and Administrative                   $    3,886         $     4,346     $      (460 )         (10.6 )%

. . .

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