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ECHELON CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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 32-------------------------------------------------------------------------------- Table of Contents 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. 33-------------------------------------------------------------------------------- Table of Contents • 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 34-------------------------------------------------------------------------------- Table of Contents 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. 35-------------------------------------------------------------------------------- Table of Contents 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. 36-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONSThe 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 Cost of service 1.3 1.6 1.5 Total cost of revenues 49.9 57.9 57.1 Gross profit 50.1 42.1 42.9 Operating expenses: Product development 26.0 22.4 22.2 Sales and marketing 19.0 16.0 16.4 General and administrative 17.0 11.2 11.5 Litigation charges 4.0 - - Restructuring charges 2.9 0.9 - Total operating expenses 68.9 50.5 50.1 Loss from operations (18.8 ) (8.4 ) (7.2 ) Interest and other income (expense), net (0.8 ) (0.3 ) - Interest expense on lease financing obligations (1.4 ) (1.0 ) (0.9 ) Loss before provision for income taxes (21.0 ) (9.7 ) (8.1 ) Income tax expense 0.4 0.2 0.2 Net loss (21.4 ) (9.9 ) (8.3 ) Net loss attributable to non controlling interest 1.0 0.3 - Net loss attributable to Echelon Corporation stockholders (20.4 )% (9.6 )% (8.3 )% Revenues Total revenues Year ended 31 December 2013 over 2012 over 2012 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Total revenues $ 86,160 $ 134,017 $ 156,487 (47,857 ) (22,470 ) (35.7 )% (14.4 )% Our total revenues decreased by 35.7% during 2013 as compared to 2012. The $47.9 million decrease in total revenues for the year ended December 31, 2013 as compared to 2012, was primarily due to an $44.9 million, or 52.7%, decrease in sales of our Grid products and services and a $2.9 million, or 6.0%, decrease in net revenues from our IIoT products, which reflected the slowdown in the market in general. The $22.5 million decrease in total revenues for the year ended December 31, 2012 as compared to 2011 was primarily the result of an $8.3 million decrease in IIoT revenues and a $14.2 million decrease in Grid revenues. 37-------------------------------------------------------------------------------- Table of Contents Grid revenues Year ended 31 December 2013 over 2012 over 2012 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Grid revenues $ 40,303 $ 85,241 $ 99,428 (44,938 ) (14,187 ) (52.7 )% (14.3 )% During the years ended December 31, 2013, 2012 and 2011, our Grid revenues were derived primarily from a relatively small number of customers who have undertaken large-scale deployments of our NES System products, and to a lesser extent, from sales of certain products to Enel. 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 Grid revenues. Excluding sales of certain products and services to Enel, which are discussed more fully below, Grid revenues decreased during the year ended December 31, 2013 as compared to 2012. This was primarily due to a decrease in the level of large-scale deployments of our NES System products in the Finland, United States and Denmark, partly offset by increased sales to customers in Austria and a one time software upgrade sale to a customer in Sweden. Grid revenues also decreased during the year ended December 31, 2012 as compared to 2011. This was primarily due to an overall decrease in the level of large-scale deployments of our NES System products in the United States, Denmark, and Russia, partly offset by an increase in the products shipped to our customer in Finland. Our ability to recognize revenue for our Grid 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. In the future, we will continue to evaluate historical acceptance rates for our Grid products and, when the data supports it, will recognize revenue at the point of delivery to the customer's carrier for those particular products (once all other revenue recognition criteria have been met), which could increase our Grid revenue in the period in which this determination is made. In addition, the revenue recognition rules relating to products such as our NES System may require us to defer some or all of the revenue associated with NES product shipments until certain conditions are met in a future period. Our Grid revenues have historically been concentrated with a relatively few customers. During the years ended December 31, 2013, 2012, and 2011, approximately 75.1%, 86.3%, and 94.2%, respectively, of our Grid revenues were attributable to four customers. While our Grid customers will change over time, given the nature of the Grid market, we expect our future Grid revenues will continue to be concentrated among a limited number of customers. IIoT revenues Year ended 31 December 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change IIoT revenues $ 45,857 $ 48,776 $ 57,059 (2,919 ) (8,283 ) (6.0 )% (14.5 )% Our IIoT 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 certain products and services sold to Enel. Excluding sales of products and services to Enel, which are discussed more fully below, our IIoT revenues decreased by $3.8 million, or 9.0% during the year ended December 31, 2013 as compared to 2012. This decrease was primarily due to a 38-------------------------------------------------------------------------------- Table of Contents decrease in revenues in the America and Asia Pacific regions we serve and ongoing market share loss. Within the IIoT family of products, the year-over-year decrease was driven primarily from decreased sales of our control and connectivity products as well as our SmartServer products. We have seen a loss in market share primarily due to reduced investment in research and development and marketing over several years, especially the LONWORKS portfolio, which has caused a decrease in our IIoT revenues. Excluding sales of products and services to Enel, our IIoT revenues decreased by $7.6 million, or 15.3% in 2012 as compared to 2011. This decrease was primarily due to a decrease in revenues in all the regions we serve and ongoing market share loss. Within the IIoT family of products, the year-over-year decrease was driven primarily from decreased sales of our control and connectivity products as well as our SmartServer products. We have seen a loss in market share primarily due to reduced investment in research and development, especially the LONWORKS portfolio, which combined with the overall macro economic slowdown has caused a decrease in our IIoT revenues. Our future IIoT revenues will also be subject to 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 IIoT revenues conducted in currencies other than the United States dollar, principally the Japanese Yen, was about 5.6% for the year ended December 31, 2013, 8.2% in 2012 and 7.4% in 2011. To date, we have not hedged any of these foreign currency risks. We do not currently expect that, during 2014, the amount of our IIoT 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 Grid and IIoT) Year ended 31 December 2013 over 2012 over 2012 2012 over 2011 2013 over 2012 2011 % (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change Change Enel Grid revenues 4,400 $ - $ - 4,400 - 100.0 % - % Enel IIoT revenues 7,363 6,458 7,119 905 (661 ) 14.0 % (9.3 )% Total Enel revenues $ 11,763 $ 6,458 $ 7,119 $ 5,305 $ (661 ) 82.1 % (9.3 )% 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 years ended December 31, 2013, 2012, and 2011, respectively, related primarily to shipments under the development and supply agreement. Further, in 2013, we shipped data concentrators, which contributed to an increase in Grid revenues during 2013 as compared to 2012. The software enhancement agreement expired in December 2012 and the development and supply agreement expires in December 2015. 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. 39-------------------------------------------------------------------------------- Table of Contents Gross Profit and Gross Margin Year ended 31 December 2013 over 2012 over 2012 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Gross Profit $ 43,157 $ 56,455 $ 67,162 (13,298 ) (10,707 ) (23.6 )% (15.9 )% Gross Margin 50.1 % 42.1 % 42.9 % - - 8.0 (0.8 ) Gross profit is equal to revenues less cost of revenues. Cost of revenues for product revenues includes direct costs associated with the purchase of components, sub-assemblies, 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 revenues for service revenues consists of employee-related costs such as 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 8.0 percentage points for the year ended December 31, 2013 as compared to 2012. The increase was primarily due to the change in mix of revenues in 2013 . The higher margin IIoT revenues comprise approximately 53% of total revenues for the year ended December 31, 2013, compared to only 36% in 2012. Gross margins were also favorably impacted by a one time software upgrade sale to a Swedish Grid customer, which had the impact of improving gross margins by 1.5 percentage points for the year ended December 31, 2013 (we do not currently expect any continued impact, similar to this one time software upgrade sale in the future). 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; partly offset by a one time price increase for products sold in the first half of 2012 to one of our customers, also contributed to the improvement year over year. Gross margin decreased by approximately 0.8 percentage points during the year ended December 31, 2012 as compared to 2011. The decrease was primarily due to an increased percentage of lower margin deals in our Grid business and the change in mix of IIoT products sold, with increased revenues from our smart server products. This decline in gross margins was partially offset by the increase in margins from service revenues comprising a higher percentage of total revenues. Our gross margins for the year ended December 31, 2012 were impacted by non routine items such as charges for excess inventory and some production equipment that we don't expect to use, which were the result of lower volume expectations, offset by a one time price increase for products sold in the first half of 2012 to one of our customers. On balance these items did not impact our gross margins in 2012. In June 2011, Jabil, one of our primary CEMs, notified us that they intended to increase the prices they charge us for manufacturing our Grid products. The new pricing became effective July 1, 2011, and was based on increased fees for Jabil's overhead and profit, cost increases for commodities contained in our products, and higher labor rates for Jabil's production personnel. The impact of these cost increases began to phase in during the third quarter of 2011 and became fully effective at the beginning of the fourth quarter. In an effort to mitigate the effects of these price increases and thus improve our gross margins within the foreseeable future, we worked on certain design modifications for these products intended to reduce their cost to manufacture. We continue to work closely with Jabil to identify other opportunities to reduce their manufacturing costs associated with our products. Also contributing to the reduction in gross margins during 2011 was the accounting treatment effect for a software deliverable we had committed to a customer but that was not yet delivered as of December 31, 2011. In this case, we had committed to provide a particular customer with firmware for certain hardware that we began delivering to them during the third quarter of 2011 and continued for the remainder of the year. This firmware enabled the hardware, which was included in some of the meters we shipped to this customer, to become fully functional. Because this incremental hardware was not separable from the meters, we were expensing its cost once the customer accepted the corresponding meter. However, we were deferring the associated revenue for this additional hardware functionality until such time as we delivered the promised firmware in the first quarter of 2012. Partially offsetting the negative 2011 gross margin trends described above was the impact of higher overall revenues. 40-------------------------------------------------------------------------------- Table of Contents In addition to the impact of cost increases from our suppliers, 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 Grid and IIoT 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 Grid 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 Year ended 31 December 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Product Development $ 22,361 $ 30,009 $ 34,755 (7,648 ) (4,746 ) (25.5 )% (13.7 )% 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 during 2013 as compared to 2012, driven primarily by reductions in compensation (including equity compensation) due to the restructuring actions of 2012 and 2013 and the consequential impact on the allocated costs to the product development organization, lower facilities costs and reduced fees paid to third party service providers. During 2011, our product development expenses were impacted by a contractual arrangement whereby a third party was making payments to us in connection with certain design and development activities we were performing. During 2011, we completed efforts worth $1.5 million. These amounts were used to offset our product development expenses in these periods. Excluding the impact of these offsetting payments, our product development expenses decreased by $6.2 million during 2012 as compared to 2011. These decreases were primarily due to reduced compensation costs, including share based compensation expenses, which were down primarily due to lower headcount in our product development organization in 2012. These compensation cost reductions were partially offset by increased outside services and contractor costs. Sales and Marketing Year ended 31 December 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Sales and Marketing $ 16,348 $ 21,460 $ 25,719 (5,112 ) (4,259 ) (23.8 )% (16.6 )% 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. Our sales and marketing expenses decreased during 2013 as compared to 2012, driven primarily by lower compensation costs (including equity compensation) due to the 2012 and 2013 restructurings, reduced equipment costs, reduced marketing communications costs, lower travel and entertainment expenses and reduced fees paid to consultants and other third party service providers. 41-------------------------------------------------------------------------------- Table of Contents Our sales and marketing expenses decreased in 2012 during as compared to 2011, driven primarily by lower compensation (including commission expenses and bonus expenses), lower travel and entertainment expenses and reduced fees paid to consultants and other third party service providers. General and Administrative Year ended 31 December (Dollars in 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 thousands) 2013 2012 2011 $ Change $ Change % Change % Change General and Administrative $ 14,644 $ 15,050 $ 17,897 (406 ) (2,847 ) (2.7 )% (15.9 )% General and administrative expenses consist primarily of payroll and related expenses for executive, finance, and administrative personnel, professional fees for legal and accounting services rendered to the company, facility costs, insurance, and other general corporate expenses. General and administrative expenses marginally decreased in 2013 as compared to the same period in 2012, primarily due to lower compensation (including stock based compensation, partly offset by increased bonus expenses), partly offset by the higher allocation of fixed costs related to facilities following the restructuring actions of 2012 and 2013. General and administrative expenses decreased in 2012 as compared to the same period in 2011, primarily due to lower compensation (including bonus expenses and stock based compensation), lower outside service fees and lower professional fees. Litigation Charges Year ended 31 December 2013 over 2012 over 2012 2011 2013 over 2012 2012 over 2011 % (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change Change Litigation charges $ 3,452 $ - $ - 3,452 - 100.0 % - % To avoid any possibility of an adverse ruling against us in relation to the Finmek litigation, as well as to limit administrative inconvenience and curtail litigation costs, we reached an agreement with respect to a tentative financial settlement of $3.5 million and recognized a charge for this amount in the first quarter of 2013. This settlement was formalized and became effective in the fourth quarter of 2013, to be paid in two substantially equal installments, one in the fourth quarter of 2013 and the other in the fourth quarter of 2014. Restructuring Charges Year ended 31 December 2013 over 2012 over 2012 over 2012 2011 2013 over 2012 2011 % (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change Change Restructuring Charges $ 2,522 $ 1,176 $ - 1,346 1,176 114.5 % 100.0 % On February 12, 2013, the company undertook restructuring actions affecting 43 employees to be terminated between February 2013 and December 31, 2013, as part of an overall plan to reshape the company for the future. In connection with this restructuring, the company recorded restructuring charges of $2.5 million related to termination benefits for these personnel during the year ended December 31, 2013. We do not anticipate any further charges related to this restructuring action in the future. This workforce reduction plan was designed to enable us to rebalance our operating expense structure to optimally support the revenues at current and future expected levels. We believe the reduction to our ongoing costs and expenses that resulted from this action, which took place in Q1'2013, has been fully realized in our quarterly operating results for Q4'2013. 42-------------------------------------------------------------------------------- Table of Contents The charges in 2012 represent the impact of the May 2012 restructuring. With the exception of $49,000, which represents amount payable for May 2012 restructuring action that is reflected in accrued liabilities on our Consolidated Balance Sheets as of December 31, 2013, restructuring charges totaling $2.6 million were paid out during 2013. We expect to pay the remaining $49,000 of accrued termination benefits through 2014. Interest and Other Income (Expense), Net Year ended 31 December (Dollars in 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 thousands) 2013 2012 2011 $ Change $ Change % Change % Change Interest and Other Income (Expense), Net $ (702 ) $ (362 ) $ 6 (340 ) (368 ) 93.9 % (6133.3 )% Interest and other income (expense), net primarily reflects interest earned by our company on cash and short-term investment balances as well as foreign exchange translation gains and losses related to short-term intercompany balances. Interest and other expense, net increased during 2013 as compared to the same period in 2012. This increase was primarily attributable to the increase of $410,000 in foreign currency translation losses during 2013 as compared to 2012. Interest and other expense, net increased during 2012 as compared to 2011. This increase was primarily attributable to the increase of $466,000 in foreign currency translation losses during 2012 as compared to 2011. These foreign currency fluctuations are attributable to our foreign currency denominated short-term intercompany balances. We account for translation gains and losses associated with these balances by reflecting these amounts as either other income or loss in our consolidated statements of operations. During periods when the U.S. dollar weakens in value against these foreign currencies, the associated translation losses negatively impact other income. Conversely, when the U.S. dollar strengthens, the resulting translation gains favorably impact other income. We do not currently anticipate interest income on our investment portfolio will improve during 2014 as we expect interest rates to remain historically low. Future gains or losses associated with translating our foreign currency denominated short-term intercompany balances will depend on exchange rates in effect at the time of translation. Interest Expense on Lease Financing Obligations Year ended 31 December 2012 over (Dollars in 2013 over 2012 2012 over 2011 2013 over 2012 2011 % thousands) 2013 2012 2011 $ Change $ Change % Change Change Interest Expense on Lease Financing Obligations (1,235 ) (1,360 ) (1,468 ) (125 ) (108 ) (9.2 )% (7.4 )% The monthly rent payments we make to our lessor under the lease agreements for our San Jose headquarters site are recorded in our financial statements partially as land lease expense, with the remainder being allocated to principal and interest on the financing liability. "Interest expense on lease financing obligations" reflects the portion of our monthly lease payments that is allocated to interest expense. Interest expense on lease financing obligations decreased during 2013 as compared to 2012, and during 2012 as compared to 2011 as well, which were a result of the nature of this expense. As with any amortizing fixed rate loan, payments made earlier in the term of the loan are comprised primarily of interest expense with little being allocated to principal repayment. Payments made later in the term of the loan, however, have an increasing proportion of principal repayment, with less being attributable to interest expense. Accordingly, as we continue to make payments in accordance with our lease obligation, we expect a higher proportion of the payments we make in the future will be allocated to principal repayment and less will be allocated to interest expense. 43-------------------------------------------------------------------------------- Table of Contents Income Tax Expense Year ended 31 December 2013 over 2012 2012 over 2011 2013 over 2012 2012 over 2011 (Dollars in thousands) 2013 2012 2011 $ Change $ Change % Change % Change Income Tax Expense $ 311 $ 219 $ 329 92 (110 ) 42.0 % (33.4 )% The income tax expense for years ended 2013, 2012 and 2011 was $311,000, $219,000 and $329,000, respectively. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes, changes in the valuation allowance on deferred tax assets, and changes in the accruals related to unrecognized tax benefits. OFF-BALANCE-SHEET ARRANGEMENTS AND OTHER CONTRACTUAL OBLIGATIONS Off-Balance-Sheet Arrangements. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose our company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us. Lease Commitments. In December 1999, we entered into a lease agreement with a real estate developer for our existing corporate headquarters in San Jose, California. In October 2000, we entered into a third lease agreement with the same real estate developer for an additional building at our headquarters site. These leases were scheduled to expire in 2011 and 2013, respectively. Effective June 2008, the building leases were amended resulting in an extension of the lease term for both buildings through March 2020. The extended leases require minimum lease payments through March 2020 totaling approximately $48.9 million. Both leases permit us to exercise an option to extend the respective lease for two sequential five-year terms. In addition, we lease facilities under operating leases for our sales, marketing, and product development personnel located elsewhere within the United States and in seven foreign countries throughout Europe and Asia, including a land lease for accounting purposes associated with our corporate headquarters facilities. These operating leases expire on various dates through 2020, and in some instances are cancelable with advance notice. Lastly, we also lease certain equipment and, for some of our sales personnel, automobiles. These operating leases are generally less than five years in duration. Purchase Commitments. We utilize several contract manufacturers who manufacture and test our products requiring assembly. These contract manufacturers acquire components and build product based on demand information supplied by us in the form of purchase orders and demand forecasts. These purchase orders and demand forecasts generally cover periods up to twelve months, and in rare cases, up to eighteen months. We also obtain individual components for our products from a wide variety of individual suppliers. We generally acquire these components through the issuance of purchase orders, and in some cases through demand forecasts, both of which cover periods up to twelve months. The products covered by these purchase orders are not included in our reported inventory until such time as we receive them. To the extent our sales forecasts are not achieved, and we are unable to cancel or modify our outstanding purchase orders for quantities exceeding our revised requirements, our reported inventories may increase or we may be required to provide a reserve against excess inventories. We also utilize purchase orders when procuring capital equipment, supplies, and services necessary for our day-to-day operations. These purchase orders generally cover periods ranging up to twelve months, but in some instances cover a longer duration. In March 2012, we announced the formation of a joint venture in Hangzhou, China with Holley Metering, a Chinese company with which we have been developing smart energy products for the Chinese and rest-of-world markets. The joint venture required us to provide capital contributions of $2.0 million, which we contributed during 2012. Indemnifications. In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant. However, we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations. 44-------------------------------------------------------------------------------- Table of Contents As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer's or director's lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that would enable us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of the applicable insurance coverage is minimal. Royalties. We have certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a U.S. dollar amount per unit shipped or a percentage of the underlying revenue. Royalty expense, which was recorded as cost of products revenue in our consolidated statements of income, was approximately $470,000 during the year ended December 31, 2013, $508,000 in 2012, and $532,000 in 2011. We will continue to be obligated for royalty payments in the future associated with the shipment and licensing of certain of our products. While we are currently unable to estimate the maximum amount of these future royalties, such amounts will continue to be dependent on the number of units shipped or the amount of revenue generated from these products. Taxes. We conduct our operations in many tax jurisdictions throughout the world. In many of these jurisdictions, non-income based taxes such as property taxes, sales and use taxes, and value-added taxes are assessed on Echelon's operations in that particular location. While we strive to ensure compliance with these various non-income based tax filing requirements, there have been instances where potential non-compliance exposures have been identified. In accordance with generally accepted accounting principles, we make a provision for these exposures when it is both probable that a liability has been incurred and the amount of the exposure can be reasonably estimated. To date, such provisions have been immaterial, and we believe that, as of December 31, 2013, we have adequately provided for such contingencies. However, it is possible that our results of operations, cash flows, and financial position could be harmed if one or more non-compliance tax exposures are asserted by any of the jurisdictions where we conduct our operations. Legal Actions. In April 2009, the company received notice that the receiver for two companies that filed for the Italian law equivalent of bankruptcy protection in May 2004, Finmek Manufacturing SpA and Finmek Access SpA (collectively, the "Finmek Companies"), had filed a lawsuit under an Italian "claw back" law in Padua, Italy against Echelon, seeking the return of approximately $16.7 million in payments received by Echelon in the ordinary course of business for components we sold to the Finmek Companies prior to the bankruptcy filing. The Finmek Companies were among Enel's third party meters manufacturers, and from time to time through January 2004, we sold components to the Finmek Companies that were incorporated into the electricity meters that were manufactured by the Finmek Companies and sold to Enel SpA for the Enel Project. The company believed that the Italian claw back law was not applicable to its transactions with the Finmek Companies, and the claims of the Finmek Companies' receiver were without merit. However, it was recently brought to the company's attention that a substantial percentage of claw back cases reviewed by the local courts, which are located in the jurisdiction in which the Finmek Companies were headquartered, were being decided in favor of the Finmek Companies. To avoid any possibility of an adverse ruling against the company, as well as to limit administrative inconvenience and curtail litigation costs, in April 2013, with the consent of its Board of Directors, the company decided to settle this matter. The company reached an agreement with respect to a tentative financial settlement of $3.5 million and recognized a charge for this amount in the first quarter of 2013. This settlement was formalized and became effective in the fourth quarter of 2013, to be paid in two substantially equal installments, one in the fourth quarter of 2013 and the other in the fourth quarter of 2014. The company did not admit that the Italian claw back law applied to its circumstances as part of this settlement. From time to time, in the ordinary course of business, we are subject to legal proceedings, claims, investigations, and other proceedings, including claims of alleged infringement of third-party patents and other intellectual property rights, and commercial, employment, and other matters. In accordance with generally accepted accounting principles, we make a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case. While we believe we have adequately provided for such contingencies as of December 31, 2013, it is possible that our results of operations, cash flows, and financial position could be harmed by the resolution of any such outstanding claims. 45-------------------------------------------------------------------------------- Table of Contents As of December 31, 2013, our contractual obligations were as follows (in thousands): Payments due by period Less than 1 More than 5 Total year 2-3 years 4-5 years yearsLease financing obligations $ 22,124 $ 3,328 $ 6,903 $ 7,361 $ 4,532 Operating leases 5,852 1,355 1,863 1,729 905 Purchase commitments 8,380 8,380 - - - Total $ 36,356 $ 13,063 $ 8,766 $ 9,090 $ 5,437 The amounts in the table above exclude $709,000 of income tax liabilities and related interest and penalties related to uncertain tax positions as we are unable to reasonably estimate the timing of settlement. See Note 10, "Income Taxes" of Notes to Consolidated Financial Statements for further discussion. LIQUIDITY AND CAPITAL RESOURCES Since our inception, we have financed our operations and met our capital expenditure requirements primarily from the sale of preferred stock and common stock, although during 2012 and certain earlier years, we were also able to finance our operations through operating cash flow. From inception through December 31, 2013, we raised $295.0 million from the sale of preferred stock and common stock, including the exercise of stock options and warrants from our employees and directors. The following table presents selected financial information as of December 31, 2013, and for each of the last two fiscal years (dollars in thousands): December 31, 2013 2012 2011 Cash, cash equivalents, and short-term investments $ 57,635 $ 61,855 $ 58,656 Trade accounts receivable, net 10,522 15,725 35,215 Working capital 57,090 72,661 74,922 Stockholders' equity $ 67,977 $ 83,795 $ 89,108 As of December 31, 2013, we had $57.6 million in cash, cash equivalents, and short-term investments, a decrease of $4.3 million as compared to December 31, 2012. Historically, our primary source of cash, other than stock sales, has been receipts from revenue, and to a lesser extent, proceeds from the exercise of stock options and warrants by our employees and directors. Our primary uses of cash have been cost of product revenue, payroll (salaries, commissions, bonuses, and benefits), general operating expenses (costs associated with our offices such as rent, utilities, and maintenance; fees paid to third party service providers such as consultants, accountants, and attorneys; travel and entertainment; equipment and supplies; advertising; and other miscellaneous expenses), acquisitions, capital expenditures, payment of taxes associated with certain equity compensation awards and purchases under our stock repurchase programs. Cash flows from operating activities. Cash flows from operating activities have historically been driven by net income (loss) levels; adjustments for non-cash charges such as stock-based compensation; depreciation and amortization; changes in accrued investment income; and fluctuations in operating asset and liability balances. Net cash used in operating activities was $1.1 million for the year ended December 31, 2013, a decrease in cash inflows of approximately $6.5 million as compared to 2012. During the year ended December 31, 2013, net cash used in operating activities was primarily the result of a net loss of $18.4 million, partly offset by changes in operating assets and liabilities of $10.7 million, non-cash charges for depreciation and amortization expense of $4.0 million and stock-based compensation expenses of $2.5 million. The primary components of the $10.7 million net change in our operating assets and liabilities were a $5.3 million decrease in inventories, a $5.2 million decrease in accounts receivable, a $2.6 million increase in accrued liabilities, a $1.0 million increase in deferred revenues and a $0.5 million decrease in other current assets, partially offset by a $2.9 million decrease in accounts payable and a $0.8 million increase in deferred cost of goods sold. Inventories decreased in line with the Company's actions to consciously reduce inventory held, in response to slowing demand situation. Accounts receivable decreased primarily as a result of the timing of collections and the fact that our revenues were down in the fourth quarter of 2013 as compared to the same period in 2012. 46-------------------------------------------------------------------------------- Table of Contents Accrued liabilities increased primarily due to accrual for the Finmek litigation, as well as the bonuses that were accrued as of December 31, 2013 in accordance with our 2013 compensation arrangements. Deferred revenues increased due primarily to increased inventory sold to our distributors (especially in Europe), as well as product revenues deferred due to certain acceptance criteria for some arrangements not being met as of year end. Accounts payable decreased due to an overall reduction in the level of purchasing activity and timing of expenditures during 2013. Deferred cost of goods sold increased in conjunction with an increase in deferred revenues. Net cash provided by operating activities was $5.4 million for the year ended December 31, 2012, an increase in cash inflows of approximately $5.6 million as compared to 2011. During the year ended December 31, 2012, net cash provided by operating activities was primarily the result of changes in operating assets and liabilities of $5.0 million. While we generated a net loss of $13.2 million, that amount was more than offset by non-cash charges for stock-based compensation expenses of $7.0 million and depreciation and amortization expense of $6.6 million. The primary components of the $5.0 million net change in our operating assets and liabilities were a $19.4 million decrease in accounts receivable, a $5.7 million decrease in deferred cost of goods sold and a $1.4 million decrease in other current assets, partially offset by a $9.7 million decrease in accounts payable, a $7.9 million decrease in deferred revenues, a $3.3 million decrease in accrued liabilities and a $642,000 increase in inventories. Accounts receivable decreased primarily as a result of the timing of collections and the fact that our revenues were down in the fourth quarter of 2012 as compared to the same period in 2011. Also contributing to the decrease in accounts receivable was a general improvement in the days sales outstanding for our Grid related receivables. Deferred cost of goods sold decreased in conjunction with a decrease in deferred revenues. Inventories increased primarily due to inventory positions carried over from the first half of the year in to year end, as well as a general increase in the cost of manufacturing, that had a full impact in 2012 as against only half a year of impact in 2011. Accounts payable decreased due to an overall reduction in the level of purchasing activity and timing of expenditures during 2012. Deferred revenues decreased due primarily to our ability to objectively demonstrate that the contractual acceptance criteria for much of the Grid products we shipped during the year was satisfied at the time of delivery, as against prior year where revenues were deferred until customer acceptance was received. Accrued liabilities decreased primarily due to the payment of bonuses and commissions during the first quarter of 2012 that were accrued as of December 31, 2011 in accordance with our 2011 compensation arrangements. Net cash used in operating activities was $225,000 in 2011, a $9.0 million decrease from 2010. During 2011, net cash used in operating activities was primarily the result of our net loss of $13.0 million and a net change in our operating assets and liabilities of $3.0 million, which was partially offset by non-cash charges for stock-based compensation expenses of $9.6 million and depreciation and amortization expenses of $5.9 million. The primary components of the $3.0 million net change in our operating assets and liabilities were a $10.1 million increase in accounts receivable, a $3.9 million increase in deferred cost of goods sold, and a $2.1 million increase in inventories, all of which were partially offset by an $8.0 million increase in accounts payable, a $3.8 million increase in deferred revenues, and a $1.2 million increase in accrued liabilities. Accounts receivable increased due primarily to higher days sales outstanding as of December 31, 2011 as compared to December 31, 2010, and to a lesser extent by an overall increase in revenues in the fourth quarter of 2011 as compared to the same period in 2010. Deferred cost of goods sold increased in conjunction with an increase in deferred revenues. Inventories increased primarily due to the timing of customer shipments during the latter part of the fourth quarter that had not yet reached their destination. During the fourth quarter of 2011, the amount of product shipped in the latter part of the quarter for which customer acceptance had not yet been received was higher than what was observed in the fourth quarter of 2010. Accounts payable increased due to the timing of expenditures during the fourth quarter of 2011. Deferred revenues increased due primarily to the timing of products shipped during the fourth quarter of 2011. Accrued liabilities increased primarily due to amounts accrued for our 2011 management bonus program, which were partially offset by the payment of termination benefits that were accrued as part of our restructuring program in the fourth quarter of 2010. Cash flows from investing activities. Cash flows from investing activities have historically been driven by transactions involving our short-term investment portfolio, capital expenditures, changes in our long-term assets, and acquisitions. Net cash used in investing activities was $1.0 million for the year ended December 31, 2013, a decrease of $2.1 million in cash outflows compared to 2012. During the year ended December 31, 2013, net cash used in investing activities was primarily the result of the purchases of available-for-sale short-term investments of $46.9 million and capital expenditures of $1.0 million, partially offset by proceeds from maturities and sales of available-for-sale short-term investments of $46.9 million. Net cash used in investing activities was $3.1 million for the year ended December 31, 2012, an increase of $16.6 million in cash outflows compared to 2011. During the year ended December 31, 2012, net cash used in investing activities was primarily the result of the purchases of available-for-sale short-term investments of $83.9 million and capital expenditures of $1.1 million, partially offset by proceeds from maturities and sales of available-for-sale short-term investments of $82.0 million. 47-------------------------------------------------------------------------------- Table of Contents Net cash provided by investing activities in 2011 was primarily the result of net redemptions of available-for-sale short-term investments of $15.9 million, partially offset by capital expenditures of $2.3 million. Cash flows from financing activities. Cash flows from financing activities have historically been driven by the proceeds from issuance of common and preferred stock offset by transactions under our stock repurchase programs and principal payments on our lease financing obligations. Net cash used in financing activities was $2.5 million for the year ended December 31, 2013, an increase in outflows of $1.2 million as compared to the same period in 2012. During the year ended December 31, 2013, net cash used in financing activities was primarily the result of $2.1 million in principal payments on our building lease financing obligations and $0.5 million worth of shares repurchased from employees for payment of employee taxes on vesting of restricted stock units and upon exercise of stock options. Net cash used in financing activities was $1.3 million for the year ended December 31, 2012, a decrease of $1.7 million as compared to the same period in 2011. During the year ended December 31, 2012, net cash used in financing activities was primarily the result of $1.3 million worth of shares repurchased from employees for payment of employee taxes on vesting of restricted stock units and upon exercise of stock options and $2.0 million in principal payments on our building lease financing obligations, partly offset by cash received for the capital infusion of $2.0 million by Holley Metering in our joint venture in China. Net cash used in financing activities in 2011 was primarily attributable to $2.3 million of repurchases of common stock from our employees for payment of income and other payroll taxes they owed upon the vesting of restricted stock units and upon the exercise of options and $1.7 million of principal payments on our lease financing obligations; partially offset by proceeds of $945,000 resulting from issuance of common stock upon exercise of options by our employees. As noted above, our cash and investments totaled $57.6 million as of December 31, 2013. Of this amount, approximately 5% was held by our foreign subsidiaries. Our intent is to permanently reinvest a significant portion of our earnings from foreign operations, and current plans do not anticipate that we will need funds generated from foreign operations to fund our domestic operations. In the event funds from foreign operations are needed to fund operations in the United States and if U.S. tax has not already been previously provided, we would provide for and pay any additional U.S. taxes due in connection with repatriating these funds. We use well-regarded investment managers to manage our invested cash. Our portfolio of investments managed by these investment managers is primarily composed of highly rated U.S. government securities, and to a lesser extent, money market funds. All investments are made according to guidelines and within compliance of policies approved by the Audit Committee of our Board of Directors. We maintain a $5.0 million line of credit with our primary bank, which expires on July 1, 2014. The letter of credit contains certain financial covenants requiring us to maintain an overall minimum tangible net worth level and to maintain a minimum level of liquid assets. As of December 31, 2013, we were in compliance with these covenants. As of December 31, 2013, our primary bank has issued, against the line of credit, one standby letter of credit totaling $113,000. Other than issuing standby letters of credit, we have never drawn against the line of credit, nor have amounts ever been drawn against the standby letters of credit issued by the bank. In the future, our cash reserves may be used to strategically acquire other companies, products, or technologies that are complementary to our business or for settlements of customer disputes or litigation. In addition, our combined cash, cash equivalents, and short-term investments balances could be negatively affected by various risks and uncertainties, including, but not limited to, the risks detailed in this Annual Report in Part I, Item 1A - Risk Factors. For example, any continued weakening of economic conditions or changes in our planned cash outlay could negatively affect our existing cash reserves. Based on our current business plan and revenue prospects, we believe that our existing cash reserves will be sufficient to meet our projected working capital and other cash requirements for at least the next twelve months. However, we currently expect that our combined cash, cash equivalent, and short-term investment balance will decline during 2014. In the event that we require additional financing, 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 In June 2000, we entered into a stock purchase agreement with Enel pursuant to which Enel purchased 3.0 million newly issued shares of our common stock for $130.7 million. The closing of this stock purchase occurred on September 11, 2000. At the closing, Enel had agreed that it would not, except under limited circumstances, sell or otherwise transfer any of those shares 48-------------------------------------------------------------------------------- Table of Contents for a specified time period. That time period expired September 11, 2003. To our knowledge, Enel has not disposed of any of its 3.0 million shares. Under the terms of the stock purchase agreement, Enel has the right to nominate a member of our board of directors. A representative of Enel served on our board until March 14, 2012; no Enel representative is presently serving on our board. At the time the company entered into the stock purchase agreement with Enel, it also entered into a research and development agreement with an affiliate of Enel (the "R&D Agreement"). Under the terms of the R&D Agreement, the company cooperated with Enel to integrate its LONWORKS technology into Enel's remote metering management project in Italy, the Contatore Elettronico. The company completed the sale of its components and products for the deployment phase of the Contatore Elettronico project during 2005. During 2006, the company supplied Enel and its designated manufacturers with limited spare parts for the Contatore Elettronico system. In October 2006, the company entered into a new development and supply agreement and a software enhancement agreement with Enel. Under the development and supply agreement, Enel and its contract manufacturers purchase additional electronic components and finished goods from the company. Under the software enhancement agreement, the company provides software enhancements to Enel for use in its Contatore Elettronico system. 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. For the years ended December 31, 2013 and 2012, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $11.8 million and $6.5 million, respectively. As of December 31, 2013 and 2012, $1.6 million of our total accounts receivable balance related to amounts owed by Enel and its designated manufacturers. RECENTLY ISSUED ACCOUNTING STANDARDS In March 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2013-05, Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity. This ASU addresses the accounting for the cumulative translation adjustment when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity. This ASU will be effective in 2014 for the Company. The Company is currently evaluating the impact of adopting this guidance, but does not expect it to have a material impact on the Company's consolidated financial condition or results of operations. In July 2013, the FASB issued Accounting Standards Update No. 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This ASU requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. The ASU does not require new recurring disclosures. This ASU will be effective in 2014 for the Company. The Company is currently evaluating the impact of adopting this guidance, but does not expect it to have a material impact on the Company's consolidated financial condition or results of operations. |