Echelon Corp. (ELON)

[GGraessle]

10:07am EST 23-Jan-03 C.L. King & Associates (Joseph A. Gomes, Jr. 518-431-3)
Echelon Corp.(ELON-NASDAQ): Fourth Quarter on Target, 2003 Expectations Lowered

ECHELON CORPORATION (ELON** - NASDAQ)

Analyst: Joseph A. Gomes, Jr., CFA Rating - Accumulate
[phone]/[e-mail] Target Price - $13.00
Estimate Changes Previous Revised
FY03 $0.60 $0.45
Target Price $15.00 $13.00

52-Week EPS FY (12/31) PE Shares
Price Range 01A 02A 03E 01 02 03 Div Yld Rating Out
$11.15 $22.44-$8.36 $0.15 $0.41 $0.45 NM 27.2 24.8 NM NM A 40.6MM

**Designates companies in which CL King & Associates currently maintains a
market.

Echelon is the world leader in networking everyday devices. The company offers
a comprehensive line of hardware and software products for automating
building, home, industrial, transportation and utility applications. Echelon's
products are based on its LonWorks networking technology, an open standard for
interoperable-networked control.

Q4-2002 Q4-2001 2002 2001
Revenue $30.6MM $32.1MM $122.8MM $76.6MM
Net Income 3.6MM 5.2MM 16.8MM 6.0MM
EPS $0.09 $0.13 $0.41 $0.15


Fourth Quarter on Target; Lowering 2003 Expectations

Echelon reported fourth quarter 2002 earnings of $3.6MM, or $0.09 per share,
exceeding our estimate of $3.3MM, or $0.08 per share. In the same period last
year, the company reported net income of $5.2MM, or $0.13 per share. Revenue
for the quarter was $30.6MM compared to $32.1MM in the fourth quarter of 2001.
We were looking for revenue of $30.6MM. The year-over-year decline in results
reflects the impact of the pull forward of ENEL revenue into the third quarter,
the weak worldwide economy affecting Echelon's core business and a higher
expense level. ENEL-related revenue was $20.3MM in the quarter compared to
$23.2MM in Q3 and our expectation of $19.4MM. "Core" revenue in the quarter
totaled $10.3MM, versus our estimate of $10.6MM, and continues to be negatively
impacted by a weak worldwide economy. Echelon's revenue for the full year grew
60.3% to $122.8MM; ENEL accounted for $81.5MM and the core business $41.3MM.
ENEL revenue for the year was up 163%, while core revenue declined 9.4%.
Full-year gross margin was 51.2% compared to 51.5% in 2001. Net income rose to
$16.8MM, or $0.41 per share, from $6.0MM, or $0.15 per share in 2001.

FY02Q4 gross margin was 50.3%, slightly above our 50.0% estimate and up from
47.5% in FY01Q4. As we have mentioned in the past, last year's gross margin was
negatively impact by the first large scale shipments of metering kits for the
ENEL contract. With ENEL revenue at a lower gross margin level than the core
business, the influx of its revenue negatively impacted gross margin in FY01Q4.
Selling, general and administrative expenses came in at $12.3MM, in-line with
our estimate. Interest income for the quarter was $0.8MM, and the tax rate was
7.7%.

The ENEL contract continues to move forward. At the end of December 5.7 million
meters had been installed, modestly above the previous expectation of 5.5
million and up from the 3.5 million meters installed at the end of September.
During the call management did not provide any updated indications as to when
another utility customer may emerge. Previously, Echelon CEO Ken Oshman stated
he was confident Echelon would ink another contract before the end of the first
quarter. Last night Mr. Oshman made a "New Year's resolution" not make any more
predictions in this regard. Mr. Oshman did state he was more confident than
ever in the long-term prospects for the Network Energy Services Systems, i.e.,
service provider, business. In spite of Mr. Oshman's confidence, we believe the
lack of clarity on new business will be seen as a negative by investors.
Echelon's core business continues to be impacted by difficult economic
conditions.

Echelon ended the year with a superb balance sheet. Year-end cash and
equivalents totaled $134.5MM ($3.39 per share) compared to $111.7MM at December
31, 2001. Days sales outstanding fell to 68 at quarter's end compared to 88
days at the end of September. DSOs in the core business fell to 51 from 53,
while DSOs in the ENEL business dropped to 77 from 103. The company had $156MM
of working capital, no debt and shareholder equity of $195.0MM ($4.91 per
share), up from $174.7MM in December 31, 2001. Net cash provided by operations
improved to a positive $38.7MM during 2002 from a negative $17.8MM in 2001.

Our previous operating estimates for 2003 are too high, as the ongoing worldwide
economic softness and a more conservative forecast of ENEL revenue will result
in lowered numbers. We now are projecting core revenue of $46MM, up 11%
year-over-year, and ENEL revenue of $80MM, flat with last year. Although the
ENEL revenue is flat, in part due to its ability per the terms of the contract
to receive lower pricing on the metering kits, gross margin on the project will
increase. The impact of the higher gross margin from ENEL sales will increase
overall gross margin for 2003 to 56%, up from 51% in 2002. We expect operating
expenses to increase to $54MM from $48.5MM in 2002. Net income is now projected
to be $18.6MM, or $0.45 per share. For the first quarter we project revenue of
$31.5MM, with ENEL accounting for roughly $21MM of the total. First quarter
net income is projected to be $0.07 per share. As usual, the ENEL forecast is
dependent upon meter manufacturer Finmek maintaining its good standing with
Echelon to continue to receive the parts necessary to construct the meters. We
also expect ENEL to begin transitioning during the second quarter to the PL 3120
Power Line Smart Transceiver from the current metering kits. Any transition
difficulties could impact the ENEL forecast.

Net net, we expect Echelon shares to sell-off today as investors digest Mr.
Oshman's statements and the further push out of expected results. Nonetheless,
we continue to believe in the long-term prospects of Echelon, both in its core
business and its ability to attract more ENEL-like customers. Given the rock
solid nature of the firm's balance sheet, we believe the company has the
resources to continue to plug along until we see additional ENEL-like customers.
We believe a sell off today would present investors with a long-term investing
horizon and an attractive entry point. We are maintaining our Accumulate
rating, but reducing our target price to $13 from $15.


Previous research update - 12/03/02

Disclosures

Rating Changes
Date Rating Closing Price
05/24/01 Accumulate 22.71
08/22/01 Strong Buy 16.75
09/24/02 Accumulate 9.24

Price Target Changes
Date Price Target Closing Price
05/24/01 30.00 22.71
10/23/01 24.00 14.90
09/24/02 15.00 9.24
01/23/03 13.00 11.15




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