Echelon Corp. (ELON)

[GGraessle]

Here are the comments made by Brett Miller and analyst for A.G. Edwards who also asked some questions at yesterday's conference call.

10:12am EST 23-Jan-03 A.G. Edwards & Sons, Inc. (Miller, Brett 314-955-2620)
ELON:E OUTLOOK IMPROVING, MANAGEMENT NO LONGER FORECASTING NEW CUSTOMERS.PART 1

A.G. Edwards & Sons, Inc.
Equity Research - Networking Equipment
January 22, 2003

Analyst: Brett Miller 314-955-2620
Associate: Gavin Duffy

WHILE OUTLOOK IMPROVING, MANAGEMENT NO LONGER FORECASTING NEW CUSTOMERS
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ECHELON CORPORATION (ELON 11.15 - NASDAQ)
BUY/SPECULATIVE
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Disclosure Information. Please refer to the final pages of this report for
important disclosure information.

Market Cap ($mil.): $457 Est. Long-Term EPS CAGR:
Dividend: $0.00 Book Value Per Share:
Yield: 0.0% Price Objective: 16

Fiscal Year Ends Dec
EPS 2002A 2003E Prior 2004E Prior 2005E Prior
Qtr1 $0.07 $0.08
Qtr2 $12.00 $0.09
Qtr3 $0.13 $0.11
Qtr4 $0.09 $0.12
Year $41.00 $0.40
P/E 27.9X

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Summary:

- Solid fourth quarter execution. Revenues $30.581 and GM at 50.3%, inline
with expectations. Solid execution on operating expenses generated EPS of
$0.09 versus our $0.08 est.
- Company no longer giving any predictions for new service provider
contracts. Says more optimistic than ever. No investor should expect company
to be able to predict disruptive market shift.
- Momentum in its core device networking market remains economically
challenging and came in at expected levels. Conversations with Johnson Controls
and others indicate early signs of stronger retro fit market.
- Operating execution was world class with DSO's down 20 days sequentially,
accounts receivable down $9 million, cash up $30 million, operating profit of
$3 million.
- Enel's Contatore Elettronico program remains intact and came in above
previously expected levels as orders expected to ship in October were taken in
September.
- Company to provide materially higher functionality in two-way metering
solutions for follow-on customers.
- S&M lower seq., while G&A increased. Indicates high activity levels of
senior management. Addition of internal legal council both indicate high level
contractual issues are moving into overdrive.
- New integrated PL-3120 microcontroller/transceiver to be used in Enel
project beginning in Q2. Enel already qualifying it.
- Quarter above expectations on the bottom line with Enel program forging
ahead but offset by continued weakness in core business markets. Must sign new
material customers as Enel revenues are showing age down 6% year over year.
Crunch time is now in order to have new revenues beginning in 2004. Q1 going
from $0.10 to $0.08. Very little change to full year 2003 estimates, $126
million revenue and $0.40 EPS. Higher gross margins offset by higher than
anticipated operating expenses.

Conclusion:
We remain positive about Echelon's progress in both the device and service
provider markets, especially given the slow pace of service providers and the
global economic conditions. We may see more volatility to revenues primarily
from Enel and the changing demand tides between North America, Europe and Asia
Pacific. Core revenues will likely remain flat going forward until we see a
broader based recovery in the control end markets. We are looking for gross
margins to continue moderate improvements throughout next year with operating
expenses up only slightly to generate a full year estimate of $0.40, flat with
2002. This of course does not take into account any potential economic
recovery nor any new service provider customers.

The shares were weak yesterday due to the cautionary statements made in their
press release the evening of January 21st. The company waited a day to host
its conference call due to a death of a member of managements family. ELON put
cautionary language in its press release about the ongoing collection issues
with one of Enel's contract manufacture partners, Finmek, where there is little
collection default risk just slow payment and always the possibility of
Echelon not shipping to them accordingly. Secondly the upcoming technology
transition within the Enel meter project to a standardized part called the
PL-3120 could cause a production hiccup. Both of these are standard statements
the company has been making for over a year now in all their filings and on
conference calls.

The only material implications is that there could be a minor push out of Enel
revenues coming in the first and second quarter into the next corresponding
quarter yet that risk is always present with a large customer project.

Lastly and to a greater degree, there may some investors who had hoped for a
new service provider customer to be announced in the press release last night
and are therefore disappointed. The company was clear on its December 4th
call, though hedging, that it would most likely sign a new customer late in the
first quarter. Also the addition of internal legal council points credibly to
the level of contractual and equity structural dealings the company is now
engaged in.

We would use the share pullback as a buying opportunity for speculative
investors. The next two quarters is going to be crunch time for the company as
it must sign new material customers for revenues in 2004 or face continued
declining revenues as Enel plateaus.

The next catalyst for Echelon remains the signing of a new service provider
customer with some semblance of a pipeline behind it. We feel this should
happen in late February to early March and is really limited by finalization of
contracts and deployment schedule issues. The likelihood remains that 2003
will be the year when service provider momentum begins to build. The fact
remains that consumers want more cheap electricity while it is becoming
increasingly difficult politically to build new power generation facilities.
Trends in the commercial building, transportation and other controls markets
all look towards open standards networking and LonWorks leads in market share
by a wide margin.

Analysis:

On last night's conference call, management was upbeat about its own business
activities while becoming less cautious on the broader global economy saying
its core business prospects are indicating early positive signs. We still
expect Europe and Asia Pacific to be stronger for a couple of years however as
high population density in emerging markets is much more active in smart
buildings while Europe has been the global leader in green activities.

Operating expenses are expected to increase year over year by $5-$6 million due
to higher overhead cost including benefits, small selected salary increases,
and continued aggressive research and development spending along with marketing
increases.

Core Device Networking Business
Although the company's core networking business continues to be negatively
impacted by the ongoing worldwide economic slump, Echelon did make positive
strides on the new product front during the quarter. As previously announced
during Q3, the company added to its i.LON(TM) family of Internet connectivity
products with the introduction of the i.LON 10 and i.Lon 1000 adapters that are
both now shipping, which the company markets as a cost-effective way to
monitor and control small networks of everyday devices in homes, apartments,
and small buildings over the Internet. The i.LON adapter works in conjunction
with Echelon's LNS network management system to give remote facility managers,
homeowners and service providers access to everyday LonWorks devices. These
devices along with the addition of new integrated transceivers (Nueron chip and
power line or twisted pair transceiver in one chip) have seen high demand and
are opening new market opportunities.

Accordingly we are hearing about early signs of life in the retrofit building
controls arena, which is the real bread-and-butter of Echelons' core markets.
On the call last night president, Bea Yormark made the first positive market
comments in 2 years, stating several times that she was quite optimistic about
this core business.

Service provider market
Enel's Contatore Elettronico project appears to continue on track with revenues
coming in as expected on a dollar basis and 100 basis points higher in gross
margins. To date, Enel, has installed 5.7 million meters, above the 5.5 it had
forecast for year end.

Enel Pricing and Margins
The third generation of Enel meters, beginning in the second quarter, will for
the first time utilize a fully standardized product with the recently announced
PL-3120. This should allow worldwide power line volume to be concentrated on
a single product, driving cost out rapidly and thus materially increasing gross
margins. We point out that pricing to Enel is based on total volume levels to
date where cost of manufacturing for Echelon decreases with time due to normal
semiconductor design improvements. So the longer the program takes to deploy
the higher the gross margin dollars the program generates for the same revenue
dollars. The program is expected to go into early 2005 instead of ending in
the summer of 2004. We would anticipate Enel to begin trials of value added
services in the spring at the earliest as it is waiting until it has sold off
its final generating capacity triggering deregulation.

Enel Outlook
Enel continues to give Echelon two quarters worth of build schedules with the
full forecasted Q1 of $21.5 million fully booked. Of that amount, $3 million
is with Finmek, which must sign a letter of credit before Echelon will ship
them components. This thorn in the side is expected to continue as Finmek has
won a contract in a public tender with Enel thus Echelon will continue to
manage it with a steel hand. Management, with limited visibility into
quarterly revenues for 2003, speculated that they should mirror the current
year's levels at roughly $80 million with a higher mix going to metering kits
and fewer concentrators and software.

By incorporating the PL-3120 into the third generation meters associated gross
margins should increase rather dramatically through 2003 from the 48 percent in
Q4 2002 to the high 50 percent level by year end.


10:15am EST 23-Jan-03 A.G. Edwards & Sons, Inc. (Miller, Brett 314-955-2620)
ELON: OUTLOOK IMPROVING, MANAGEMENT NO LONGER FORECASTING NEW CUSTOMERS. PART 2




New Service Provider Customers and What They Will Likely Mean
The biggest news out of the conference call was CEO Ken Oshman's New Years
resolution, likely based on the company's newly hired legal council, to no
longer give service provider contract predictions. This will be widely seen
negatively, yet it should come as no surprise that a company the size of
Echelon, still in the early stages of market penetration cannot predict that
long established electric utility companies will completely scrap their entire
metering infrastructure and replace it during these weak economic times. We
continue to believe new customer contracts will likely be in the $20 to $50
million range with revenue recognition likely not beginning until at least the
second half of 2003, depending on the nature of the project and the timing of
the contract. The 5 or so customers Echelon is working with have between 1 and
5 million customers and will likely not enjoy the same economies of scale as
Enel due to size alone. In fact, Echelon last night gave credence to our
belief that Enel did much of its own R&D on its project and that subsequent
customers would purchase more fully integrated solutions. To quantify Ken
Oshman stated that it would likely be 5 times higher contribution to Echelon
than the roughly $11 per meter Enel is currently paying. That said, the
potential could be for higher overall combined revenues than Enel currently
represents, coupled with a smoother learning curve due to the experience
Echelon has gained from working with Enel. We feel these service provider
deals are where a meaningful amount of the BeAtHome software development group
is focused and the major market for the i.Lon 10 product.

New Product
The next generation of meters in the Enel project will utilize the newly
announced PL-3120 Power Line Smart Transceiver with integrated network
processor core and transceiver in a micro package. With production volumes
available in April, the announcement of Enel using this new product will
rapidly drive pricing lower. As we found out last night Enel already has been
sampling and testing the product. Just a couple years ago, a stand-alone power
line transceiver used to cost around $20. The PL-3120 should be under $10 in
single unit quantity at launch.

This new product has been highly anticipated as it allows device makers to
retain their silicon investment while adding connectivity with a single device
at a market leading price point. Combined with then new i.Lon gateway
products, Echelon is able to offer materially lower priced solutions with an
order of magnitude in terms of greater functionality.

Balance Sheet Items:

The company retains a very solid balance sheet with $134 million in cash, no
long-term debt, $9 million lower high quality receivables for a total of $23
million. Days sales outstanding decreased from 86 to 66 days sequentially, due
primarily to the change in Enel contract manufactures and also the timing of
other payments received by the close of the quarter. Core days outstanding
were 51 while those related to Enel were 77, down from 103 days.

We continue to believe Echelon's technology is disruptive and will change the
way everyday devices impact our daily lives, increasing functionality and
lowering operating costs. There have been so many press releases over the past
couple of years, including some from very large companies, about how their
technology was going to revolutionize device networking. Competition continues
to go by the wayside with the demise of GE Smart, the continued difficulties
at Lantronix, emWare and others.

We believe Echelon alone has the combination of true peer-to-peer networking,
scaleable standardized, large commercial deployments, with customers
representing the top device makers in virtually every market and geography.
The rest of the field still appears to be at the starting gate.

Valuation and Risk
Our new price objective of $16 per share is consistent with our assumption of a
P/E multiple of 40 times our fiscal 2003 earnings estimate and would be in
line with five times price to sales, well below the five-year median of 12
times. We are using more conservative multiples of revenue and earnings growth
rates to set our price objective as a way to discount for the risk exposure to
quarterly results and lack of longer-term visibility. Risks that could keep
the company from attaining our projected operating results include lower
upfront cost competitive products, the inability to drive end user demand for
open standards products and dependence on key customers including Enel at over
60 percent of revenues.


Echelon Corporation
January 23, 2003
Buy/Speculative
ELON/Nasdaq/11.15
Price Objective: 16


Price Objective Changes
=======================
Date Price New PO
---------- ---------- ----------
08/09/2000 40.25 50.00
04/09/2001 11.61 35.00
09/28/2001 12.48 26.00
10/11/2002 10.65 16.00

* NA: Positive rating removed; no price objective supplied.

Rating Changes
==============
Date Price New Rating
---------- ---------- ------------------------------
08/09/2000 40.25 Accumulate/Speculative
09/29/2001 12.48 Strong Buy/Speculative





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