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ELON > SEC Filings for ELON > Form 10-K on 10-Mar-2014All Recent SEC Filings

Show all filings for ECHELON CORP

Form 10-K for ECHELON CORP


10-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report. The following discussion contains 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 projections of Grid and IIoT 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 IIoT revenues will not fluctuate significantly due to a fluctuation in foreign currency sales; our forecasts regarding our sales and marketing expenses; and estimates of our interest income. 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 "Risk Factors" 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 seven foreign countries throughout Europe and Asia. Our products enable everyday devices - such as air conditioners, appliances, electricity meters, light switches, thermostats, and valves - to be made "smart" and inter-connected, part of an emerging market known as the Industrial Internet of Things (IIoT). Our products can be used to make the management of electricity over the smart grid cost effective, reliable, survivable and instantaneous.

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 products and services.

Prior to the fourth quarter of 2013, the Company operated in one operating segment. Effective in the fourth quarter of 2013, the Company changed the way it managed the business to focus the business on two operating segments based on homogeneity of products and technology. As a result of the change, a portion of the Company's personnel organization structure, as well as its products and services, were organized along the following two operating segments:

         IIoT: This division sells products and services aimed at Horizontal
          Embedded Control Platforms, such as LONWORKS and IzoT, which include
          components, control nodes and development software. These products are
          typically sold to Original Equipment Manufacturers (OEMs) to build into
          their industrial application solutions. Revenues from these products
          were previously categorized as Sub-systems revenues (including the
          majority of our revenues from the Enel project).



         Grid: This division focuses on Echelon's forward-integrated products
          such as smart meters, devices, and software that allow electric
          utilities to modernize their methods for collecting billing data and
          vital statistics on the health and performance of their smart grid.
          Previously, the majority of our revenues from our Grid solutions were
          categorized as Systems revenue, with a small portion categorized as
          Sub-system revenue.

Prior to the above-mentioned change, the Company was organized as a single sales organization, a single product development organization, a single manufacturing and support organization, and G&A organizations. The Company was not structured nor was it managed in a "product line" manner. The change into the two operating segments, effective in the fourth quarter of 2013, resulted in, among other things, a complex movement affecting a majority of the Company's employees, a significant modification to the Company's departmental organization structure, and a completely new way of presenting and reviewing operating performance for the new segments. As a result of this change from one operating segment to two operating segments in 2013, it is impracticable for us to restate and analyze the segment information for the earlier periods of 2012 and


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2011, except as it relates to the segment revenue information. For segment revenues, we will present comparative numbers and provide commentary on the variances. As relates to all the other line items from the Consolidated Statement of Operations generally commented upon, we shall continue to provide commentary at a Company- wide level, for reasons stated above.

Our total revenues decreased by 35.7% during 2013 as compared to 2012, driven principally by decreased sales of our Grid products. Gross margins increased by 8 percentage points during 2013 as compared to 2012, while overall operating expenses decreased by 12.4%. The net effect was a loss attributable to Echelon Corporation stockholders in 2013 that increased by $4.8 million as compared to 2012.

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

                                  Year ended 31 December
                                  2013              2012           $ Change         % Change
Net revenues                 $      86,160     $    134,017     $    (47,857 )         (35.7 )%
Gross margin                          50.1 %           42.1 %            ---           8 ppt
Operating expenses           $      59,327     $     67,695     $     (8,368 )         (12.4 )%
Net loss attributable to
Echelon Corporation
Stockholders                 $     (17,610 )   $    (12,818 )   $     (4,792 )          37.4  %
Cash, cash equivalents, and
short-term investments       $      57,635     $     61,855     $     (4,220 )          (6.8 )%

Net revenues: Our total revenues decreased by 35.7% during 2013 as compared to 2012. The decrease was driven primarily by a $44.9 million, or 53%, decrease in sales of our Grid products and services and a $2.9 million or 6% decrease in net revenues from our IIoT products. The decrease in our Grid revenues was primarily due to an overall decrease in the level of large-scale deployments in Finland and United States of our NES system products. With respect to our IIoT product line, the decrease in revenues during 2013 was primarily due to decrease in sales to our America and Asia Pacific IIoT customers, reflecting continued depressed economic activity in this segment and ongoing market share loss. Many of our IIoT customers produce products used in commercial or industrial buildings. The markets for these products were adversely affected by the recession that started in 2008. These markets have yet to recover to their pre-recession levels.

Gross margin: Our gross margin increased by 8 percentage points during 2013 as compared to 2012. The increase was primarily due to a change in mix of revenues in 2013 with the higher margin IIoT revenues comprising approximately 53% of total revenues for the year ended December 31, 2013, compared to only 36% in 2012. Also contributing to the increase was a one time software upgrade sale to a Grid customer in Sweden, combined with minor changes to the mix of our 2013 Grid sales being attributable to the higher margin customers and reductions in operations headcount and spending. In addition, the impact of reduced inventory levels which resulted in lower obsolescence reserves, reduced overhead costs due to restructuring actions, and charges in 2012 for some production equipment that we did not expect to have future use for, also contributed to the improvement. We do not expect any continued impact, similar to the one time software upgrade sale mentioned above, in the future and anticipate that the gross margins for future periods will return to more normal levels. However, fluctuations in the relative percentage of revenues from our Grid and IIoT divisions will continue to impact gross margins going forward.

Operating expenses: Our operating expenses decreased by 12.4% during 2013 as compared to 2012. The decrease, reflective of the reduced business activity for the year, was driven primarily by decreases in compensation costs (primarily due to reduced headcount and other employee related costs) as well as reduced equipment and supply costs. Along with the reasons noted above, also contributing to the decrease in operating expenses was the reversal of stock compensation expense previously recognized related to the performance grants to executives, as the achievement of the performance conditions was considered improbable at year end. These decreases were partially offset by the litigation charges of $3.5 million recorded for the Finmek settlement and higher restructuring related charges during 2013.

Net loss attributable to Echelon Corporation Stockholders: We generated a net loss of $17.6 million during 2013, which was an increase from the net loss of $12.8 million in 2012. Excluding the impact of non-cash stock-compensation charges, litigation charges and restructuring charges, our net loss increased by approximately $4.4 million in 2013 as compared to 2012.


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Cash, cash equivalents, and short-term investments: During 2013, our cash, cash equivalents, and short-term investment balance decreased by 6.8%, from $61.9 million at December 31, 2012 to $57.6 million at December 31, 2013. This decrease was primarily the result of cash used by financing activities of $2.5 million (principal payments of lease financing obligations of $2.1 million being the primary driver) and cash used by operations of $1.1 million due mainly to increased net losses in the year of $18.4 million, partly offset by a reduction in working capital (reduction in inventory balances of $5.3 million and increased A/R collections of $5.2 million being the primary drivers).

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. Note 1, "Significant Accounting Policies" of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K 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 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 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 and estimates relate to those policies that are most important to the presentation of our consolidated financial statements and require the most difficult, subjective, and complex judgments.

Revenue Recognition. Our revenues are derived from the sale and license of our products and to a lesser extent, from fees associated with training, technical support, and custom software design services offered to our customers. Product revenues consist of revenues from hardware sales and software licensing arrangements. Service revenues consist of product technical support (including software post-contract support services), training, and custom software development services.
We recognize revenue when persuasive evidence of an arrangement exists, delivery to the customer's carrier (and acceptance, as applicable) has occurred, the sales price is fixed or determinable, collectability is probable, and there are no post-delivery obligations. For non-distributor hardware sales, including sales to third party manufacturers, these criteria are generally met at the time of delivery to the customer's carrier. However, 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. Determining whether sufficient data exists to support recognition of revenue prior to customer acceptance or lapse of acceptance provisions involves significant judgment and changes in those judgments could have a material impact on the timing of revenue recognition. For example, in 2012 we began recognizing revenue on sales of certain variants of our meters at the time of delivery to the customer's carrier (and once all other revenue recognition criteria had been met) irrespective of the contractual acceptance rights stated in our agreements. This decision was based on the acceptance history for these products. We continue to measure acceptance history for other Grid products and intend to transition to revenue recognition at point of transfer of title for these products if and when the acceptance history supports this decision. For sales made to our distributor partners, revenue recognition criteria are generally met at the time the distributor sells the products through to its end-use customer. Service revenue is recognized as the training services are performed, or ratably over the term of the support period.

We account for the rights of return, price protection, rebates, and other sales incentives offered to distributors of our products as a reduction in revenue. With the exception of sales to distributors, the Company's customers are generally not entitled to return products for a refund. For sales to distributors, due to contractual rights of return and other factors that impact our ability to make a reasonable estimate of future returns and other sales incentives, revenues are not recognized until the distributor has shipped our products to the end customer.
Our multiple deliverable revenue arrangements are primarily related to sales of Grid products, which may include, within a single arrangement, electricity meters and data concentrators (collectively, the "Hardware"); NES system software; Element Manager software; post-contract customer support ("PCS") for the NES system and Element Manager software; extended warranties for the Hardware; and, occasionally, specified enhancements or upgrades to software used in the NES system. With the exception of the NES system software, each of these deliverables is considered a separate unit of accounting. The NES


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system software functions together with an electricity meter to deliver its essential functionality and any related software license fee is charged for on a per meter basis. Therefore, the NES system software and an electricity meter are combined and considered a single unit of accounting. The Element Manager software is not considered to be part of an electricity meter's essential functionality and, therefore, Element Manager software and any related PCS continues to be accounted for under industry specific software revenue recognition guidance. However, all other NES system deliverables are no longer within the scope of industry specific software revenue recognition guidance. We allocate revenue to each element in a multiple-element arrangement based upon the element's relative selling price. We determine the selling price for each deliverable using vendor-specific objective evidence ("VSOE") of selling price or third-party evidence ("TPE") of selling price, if it exists. If neither VSOE nor TPE of selling price exists for a deliverable, we use our best estimated selling price ("BESP") for that deliverable. Since the use of the residual method is eliminated under the accounting standards, any discounts we offer are allocated to each of the deliverables. Revenue allocated to each element is then recognized when the basic revenue recognition criteria is met for the respective element so long as such revenue is not contingent upon the delivery of other undelivered elements.
Consistent with our methodology under previous accounting guidance, if available, we determine VSOE of fair value for each element based on historical stand-alone sales to third parties or from the stated renewal rate for the elements contained in the initial contractual arrangement. We currently estimate the selling prices for our PCS and extended warranties based on VSOE of fair value.
In many instances, we are not currently able to obtain VSOE of fair value for all deliverables in an arrangement with multiple elements. This may be due to the fact that we infrequently sell each element separately or that we do not price products within a narrow range. When VSOE cannot be established, we attempt to estimate the selling price of each element based on TPE. TPE would consist of our competitor's prices for similar deliverables when sold separately. However, in general, our offerings contain significant differentiation from our competition such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine the stand-alone selling prices for similar products of our competitors. Therefore, we typically are not able to obtain TPE of selling price.

When we are unable to establish a selling price using VSOE or TPE, which is generally the case for the Hardware and certain specified enhancements or upgrades to our NES software, we use our BESP in determining the allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. BESP is generally used for offerings that are not typically sold on a stand-alone basis or for new or highly customized offerings. We establish pricing for our products and services by considering multiple factors including, but not limited to, geographies, market conditions, competitive landscape, internal costs, gross margin objectives, and industry pricing practices. The determination of pricing also includes consultation with and formal approval by our management, taking into consideration our go-to-market strategy. These pricing practices apply to both our Hardware and software products.
Based on our analysis of pricing stated in contractual arrangements for our Hardware products in historical multiple-element transactions and, to a lesser extent, historical standalone transactions, we have concluded that we typically price our Hardware within a narrow range of discounts when compared to the price listed on our standard pricing grid for similar deliverables (i.e., similar configuration, volume, geography, etc.). Therefore, we have determined that, for our current Hardware for which VSOE or TPE is not available, our BESP is generally comprised of prices based on a narrow range of discounts from pricing stated in our pricing grid.
When establishing BESP for our specified software enhancements or upgrades, we consider multiple factors including, but not limited to, the relative value of the features and functionality being delivered by the enhancement or upgrade as compared to the value of the software product to which the enhancement or upgrade relates, as well as our pricing practices for NES system PCS packages, which may include rights to the specified enhancements or upgrades.
We regularly review VSOE and have established a review process for TPE and BESP. We maintain internal controls over the establishment and updates of these estimates. There were no material impacts during the year ended December 31, 2013 resulting from changes in VSOE, TPE, or BESP, nor do we expect a material impact from such changes in the near term.


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Performance-Based Equity Compensation. Certain of the stock-based compensation awards we issue vest upon the achievement of specific financial-based performance requirements. We are required to estimate whether or not it is probable that these financial-based performance requirements will be met, and, in some cases, when they will be met. These estimates of future financial performance require significant management judgment and are based on the best information available at the time of grant, and each quarterly period thereafter until the awards are either earned or forfeited. Any changes we make to our estimates of future financial performance could have a material impact on the amount and timing of compensation expense associated with these awards. See Note 6 of Notes to Consolidated Financial Statements in Part IV, Item 15 of this report for further discussion of these awards with financial-based performance requirements.

Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. In general, the evaluation for excess quantities includes analyses of historical sales levels by product and projections of future demand. In general, inventories on hand in excess of one year's forecasted demand are deemed to be excess. However, in certain instances when the facts and circumstances for a particular item warrant an extended view, periods of longer than one year are used to determine excess supplies. In performing these analyses, management must make significant judgments in determining the appropriate time horizon over which to analyze for excess inventories.

In performing the excess inventory analysis, management considers factors that are unique to each of our Grid and IIoT product lines. For our Grid products, the analysis requires us to consider that Grid customers procure specific meter types that meet their requirements. In other words, any given customer may require a meter that is "custom" to its specifications. Accordingly, management must make significant judgments not only as to which customers will buy how many meters (and associated data concentrators), but also which meter type(s) each customer will buy. In making these judgments, management uses the best sales forecast information available at the time. However, because future sales volumes for any given customer opportunity have the potential to vary significantly, actual results could be materially different from original estimates. This could increase our exposure to excess inventory for which we would need to record a reserve, thereby resulting in a potentially material negative impact to our operating results.

For most of our IIoT products, our customers generally buy from a portfolio of "off-the-shelf" or standard products. In addition, whereas for our Grid customers our revenues are attributable to a relatively few customers buying substantial quantities of any given product, our IIoT revenues are composed of a larger volume of smaller dollar transactions. Accordingly, while any single IIoT customer's demand for a given product may fluctuate from quarter to quarter, the fact that there are so many IIoT customers buying a standard product tends to average out increases or decreases in any individual customer's demand. This has historically resulted in a relatively stable future demand forecast for our IIoT products, which, absent outside forces such as worsening general economic conditions, management evaluates in determining its requirement for an excess inventory reserve.

In addition to providing a reserve for excess inventories, we do not value inventories that we consider obsolete. We consider a product to be obsolete when one of several factors exists. These factors include, but are not limited to, our decision to discontinue selling an existing product, the product has been re-designed and we are unable to rework our existing inventory to update it to the new version, or our competitors introduce new products that make our products obsolete.

We adjust remaining inventory balances to approximate the lower of our cost or market value. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

Warranty Reserves. We evaluate our reserve for warranty costs based on a combination of factors. In circumstances where we are aware of a specific warranty related problem, for example a product recall, we reserve an estimate of the total out-of-pocket costs we expect to incur to resolve the problem, including, but not limited to, costs to replace or repair the defective items and shipping costs. When evaluating the need for any additional reserve for warranty costs, management takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical warranty-related return rates, historical costs of repair, and knowledge of new products introduced. If any of these factors were to change materially in the future, we may be required to increase our warranty reserve, which could have a material negative impact on our results of operations and our financial condition. Our reserve for warranty costs was $561,000 as of December 31, 2013, and $519,000 as of December 31, 2012.


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RESULTS OF OPERATIONS
The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the years ended December 31, 2013, 2012, and 2011:
                                                          Year ended 31 December
                                                    2013           2012           2011
Revenues:
Product                                              96.5  %        96.6  %        97.6  %
Service                                               3.5            3.4            2.4
Total revenues                                      100.0          100.0          100.0
Cost of revenues:
Cost of product                                      48.6           56.3           55.6
. . .
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