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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549





FORM 10-Q/A

AMENDMENT NO. 1





(Mark one)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended September 30, 2007

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

000-29748

(Commission file number)





ECHELON CORPORATION

(Exact name of registrant as specified in its charter)







|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|Delaware                                                      |  | 77-0203595                         
|(State or other jurisdiction ofincorporation or organization) |  | (IRS EmployerIdentification Number)

550 Meridian Avenue

San Jose, CA 95126

(Address of principal executive office and zip code)

(408) 938-5200

(Registrants telephone number, including area code)





Indicate by check mark whether
the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports),
and (2) has been subject to filing requirements for the past 90 days.    Yes  x    No   ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the
definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):



|                           |  |                      |  |                                                                      |  |                             
|-------------------------- |  | -------------------- |  | -------------------------------------------------------------------- |  | ----------------------------
|Large accelerated filer   ̈ |  | Accelerated filer  x |  | Non-accelerated filer   ̈(do not check if a smallerreporting company) |  | Smaller reporting company   ̈

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).    Yes   ̈    No  x

As of October 31, 2007, 40,686,102 shares of the registrants common stock were outstanding.









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ECHELON CORPORATION

FORM 10-Q/A

AMENDMENT NO. 1

FOR THE QUARTER ENDED SEPTEMBER 30, 2007

INDEX



|              |  |                                                                                                                                      |  |     
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------ |  | ----
|              |  |                                                                                                                                      |  | Page
|Part I.       |  | FINANCIAL INFORMATION                                                                                                                |  | 5   
|Item 1.       |  | Unaudited Condensed Consolidated Financial Statements (As Restated)                                                                  |  | 5   
|              |  | Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006                                                 |  | 5   
|              |  | Condensed Consolidated Statements of Operations for the Three Months and Nine Months Ended September 30, 2007 and September 30, 2006 |  | 6   
|              |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and September 30, 2006                  |  | 7   
|              |  | Notes to Condensed Consolidated Financial Statements                                                                                 |  | 8   
|Item 2.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations (As Restated)                                  |  | 22  
|Item 3.       |  | Quantitative and Qualitative Disclosures About Market Risk                                                                           |  | 50  
|Item 4.       |  | Controls and Procedures (As Restated)                                                                                                |  | 51  
|              |  |                                                                                                                                     
|Part II.      |  | OTHER INFORMATION                                                                                                                    |  | 52  
|Item 1.       |  | Legal Proceedings                                                                                                                    |  | 52  
|Item 1A.      |  | Risk Factors                                                                                                                         |  | 52  
|Item 2.       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                          |  | 52  
|Item 6.       |  | Exhibits                                                                                                                             |  | 53  
|              | 
|SIGNATURE     |  | 53                                                                                                                                  
|EXHIBIT INDEX |  | 54                                                                                                                                  



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EXPLANATORY NOTE

In this Quarterly Report on Form 10-Q/A we are restating our condensed consolidated balance sheets as of September 30, 2007 and December 31, 2006, and our related condensed consolidated statements of
operations and cash flows for the three- and nine-month periods ended September 30, 2007 and 2006. As reported on April 22, 2008, during the preparation of our financial results for the quarter ended March 31, 2008, we identified an
error in our previously reported equity compensation expense. On April 30, 2008, we reported that we had also inappropriately accounted for the 1999 and 2001 leases of our San Jose, California corporate headquarters facilities.

The effects of all restatement adjustments on our condensed consolidated balance sheets as of September 30, 2007 and December 31, 2007 and 2006
are as follows:



|                                       |  |                   |              |              |      |              |  |   |             
|-------------------------------------- |  | ----------------- | ------------ | ------------ | ---- | ------------ |  | - | ------------
|                                       |  | September 30,2007 |              | December 31,
|                                       |  |                   | 2007         |              | 2006
|Increase in total assets               |  | $                 | 12.9 million |              | $    | 12.3 million |  | $ | 15.0 million
|Increase in total liabilities          |  | $                 | 15.9 million |              | $    | 15.2 million |  | $ | 17.9 million
|Increase in additional paid-in-capital |  | $                 | 1.4 million  |              | $    | 2.0 million  |  | $ | 0.8 million 
|Increase in accumulated deficit        |  | $                 | 4.4 million  |              | $    | 4.9 million  |  | $ | 3.7 million 

The effects of all restatement adjustments on our condensed consolidated statements of operations
for the three- and nine-month periods ended September 30, 2007 and 2006 are as follows:



|                                             |  |                                 |             |                                |   |             |  |      |             |  |   |            
|-------------------------------------------- |  | ------------------------------- | ----------- | ------------------------------ | - | ----------- |  | ---- | ----------- |  | - | -----------
|                                             |  | Three Months EndedSeptember 30, |             | Nine Months EndedSeptember 30,
|                                             |  | 2007                            |             | 2006                           |   | 2007        |  | 2006
|Decrease in rent expense                     |  | $                               | 1.0 million |                                | $ | 1.0 million |  | $    | 3.0 million |  | $ | 3.0 million
|Increase in depreciation expense             |  | $                               | 0.7 million |                                | $ | 0.7 million |  | $    | 2.0 million |  | $ | 2.0 million
|Increase in stock-based compensation expense |  | $                               | 0.3 million |                                | $ | 0.1 million |  | $    | 0.7 million |  | $ | 0.4 million
|Increase in interest expense                 |  | $                               | 0.3 million |                                | $ | 0.3 million |  | $    | 0.9 million |  | $ | 1.0 million
|Increase in net loss                         |  | $                               | 0.3 million |                                | $ | 0.1 million |  | $    | 0.7 million |  | $ | 0.5 million

Included in Note 2 of Notes to Condensed Consolidated Financial Statements in this Report are
tables that present the effects of all restatement adjustments on the condensed consolidated financial statements reconciling the previously reported data to the as restated data for the Condensed Consolidated Balance Sheets as of
September 30, 2007 and December 31, 2006, and the Condensed Consolidated Statements of Operations and Cash Flows for the three- and nine-month periods ended September 30, 2007 and 2006. The restatements are further discussed below.

Restatement of stock-based compensation expense:During the preparation of our financial results for the quarter ended
March 31, 2008, we identified an error in our previously reported stock-based compensation expense for the years ended December 31, 2007, 2006 and 2005, and each of the quarterly periods in 2007 and 2006. The error was isolated to share
awards and does not affect the other forms of our equity compensation awards, namely stock options and stock-settled stock appreciation rights. While the grant date fair value of the share awards was determined correctly in accordance with Statement
of Financial Accounting Standard (SFAS) No. 123R (revised 2004), Share-Based Payment, the amount of expense associated with these awards that was recognized in 2007, 2006 and 2005 was not correct. The error was caused by a
misapplication of the widely-used equity compensation software application we use to manage and account for our equity compensation awards. This misapplication caused the expense associated with these share awards to be calculated using the
straight-line, single-option method rather than the accelerated, multiple-option method, which we had elected to use for all of our equity compensation awards. Use of the straight-line, single-option method resulted in understatements of stock-based
compensation expense in 2007, 2006 and 2005 of $1.2 million, $535,000 and $263,000, respectively. For the three months ended September 30, 2007 and 2006, stock-based compensation expense was understated by $281,000 and $107,000,
respectively. For the nine months ended September 30, 2007 and 2006, stock-based compensation expense was understated by $622,000 and $416,000, respectively.

Restatement related to the leases of our San Jose, California headquarters facilities: In connection with the restatement of stock-based compensation expense, KPMG LLP, our independent registered public
accounting firm, brought to our attention that we had inappropriately accounted for the leases of our corporate headquarters facilities that were entered into in 1999 and 2001. Under the guidance in Emerging Issues Task Force Issue
No. 97-10,The Effect of Lessee Involvement in Asset Construction (EITF 97-10), and SFAS No. 98,Accounting for Leases: Sale-



3



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Leaseback transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing
Leases; an amendment of FASB Statements No. 13, 66, and 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11 (SFAS 98), we should have reflected an asset on our balance sheet for the costs paid
by the lessor to construct our headquarters facilities, as well as a corresponding liability, because we were the deemed owner of the headquarters facilities for accounting purposes during the construction periods. Upon completion of
construction, we did not meet the sale-leaseback criteria under SFAS 98 and therefore should have treated the leases as financing obligations and the assets and corresponding liabilities would not be derecognized. We had historically
accounted for these leases as operating leases under SFAS No. 13, Accounting for Leases(SFAS 13), whereby the total minimum lease payment obligations under the leases were recognized as monthly rent expense on a
straight-line basis over the terms of the leases.The restatement adjustments do not affect the total cash payments we have made or are obligated to make under the lease agreements, nor do they change the total expense to be recognized over
the lease terms. However, the timing and nature of expenses in the statement of operations is different under this treatment as compared to operating lease treatment. Specifically, we should have recognized land lease expense, depreciation expense
on the assets we are deemed to own and interest expense on the associated lease financing obligations. For a more detailed description of the effects on our condensed consolidated financial statements see Note 2 of Notes to Condensed Consolidated
Financial Statements included in Part I, Item 1 of this Report.

Our management and the Audit Committee of our Board of Directors
have concluded that these errors in our Condensed Consolidated Financial Statements were unintentional, and no misdeed or fraud was involved in any respect. The Audit Committee also determined that the error in stock-based compensation expense was
in no way caused by any backdating of or similar improper activity involving stock option grants. In conjunction with the Audit Committee, we have determined that the errors are a result of material weaknesses in our internal control over financial
reporting, as such term is defined by Securities and Exchange Commission Rule 1-02(a)(4) of Regulation S-X. See further explanation of the material weaknesses and remediation plans in Part I, Item 4 Controls and Procedures (as
restated) of this Report.

Except for the matters related to the aforementioned restatements and material weaknesses, this Amendment
No. 1 does not modify or update other disclosures in the originally filed Form 10-Q.

The Company will also file amendments to its
2007 Form 10-K and Forms 10-Q for each of the quarters ended March 31, and June 30, 2007. The amended 2007 filings will include restated information for periods affected by these restatements.

This Form 10-Q/A also reflects the restatement of related information contained in (i) Managements Discussion and Analysis of Financial
Condition and Results of Operations in Part I, Item 2.

FORWARD-LOOKING INFORMATION

This report contains forward-looking statements within the meaning of the U.S. federal securities laws that involve risks and uncertainties. Certain
statements contained in this report are not purely historical including, without limitation, statements regarding our expectations, beliefs, intentions, anticipations, commitments or strategies regarding the future that are forward-looking. These
statements include those discussed in Item 2, Managements Discussion and Analysis of Financial Condition and Results of Operations, including Critical Accounting Estimates, Results of Operations,
Off-Balance-Sheet Arrangements and Other Critical Contractual Obligations, Liquidity and Capital Resources, and Recently Issued Accounting Standards, and elsewhere in this report.

In this report, the words may, could, would, might, will, should,
plan,  forecast, anticipate, believe, expect, intend, estimate, predict, potential, continue, future, moving
toward or the negative of these terms or other similar expressions also identify forward-looking statements. Our actual results could differ materially from those forward-looking statements contained in this report as a result of a number of
risk factors including, but not limited to, those set forth in the section entitled Factors That May Affect Future Results of Operations and elsewhere in this report. You should carefully consider these risks, in addition to the other
information in this report and in our other filings with the SEC. All forward-looking statements and reasons why results may differ included in this report are made as of the date of this report, and we assume no obligation to update any such
forward-looking statement or reason why such results might differ.



4



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PART I. FINANCIAL INFORMATION



|ITEM 1. | UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|------- | -----------------------------------------------------

ECHELON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)



|                                                    |  |                                 |          |   |                                |   |          |  
|--------------------------------------------------- |  | ------------------------------- | -------- | - | ------------------------------ | - | -------- | -
|                                                    |  | September 30,2007(As Restated)1 |          |   | December 31,2006(As Restated)1 |  
|ASSETS                                              |  |                                 |          |   |                                |   |          |  
|CURRENT ASSETS:                                     |  |                                 |          |   |                                |   |          |  
|Cash and cash equivalents                           |  | $                               | 76,022   |   |                                | $ | 37,412   |  
|Short-term investments                              |  |                                 | 47,786   |   |                                |   | 86,745   |  
|Accounts receivable, net                            |  |                                 | 13,603   |   |                                |   | 13,918   |  
|Inventories                                         |  |                                 | 10,931   |   |                                |   | 11,359   |  
|Deferred cost of goods sold                         |  |                                 | 6,206    |   |                                |   | 19,060   |  
|Other current assets                                |  |                                 | 2,911    |   |                                |   | 2,138    |  
|                                                    |  |                                 |          |   |                                |   |          |  
|Total current assets                                |  |                                 | 157,459  |   |                                |   | 170,632  |  
|                                                    |  |                                 |          |   |                                |   |          |  
|Property and equipment, net                         |  |                                 | 31,064   |   |                                |   | 30,405   |  
|Goodwill                                            |  |                                 | 8,475    |   |                                |   | 8,278    |  
|Other long-term assets                              |  |                                 | 1,939    |   |                                |   | 1,957    |  
|                                                    |  |                                 |          |   |                                |   |          |  
|TOTAL ASSETS                                        |  | $                               | 198,937  |   |                                | $ | 211,272  |  
|                                                    |  |                                 |          |   |                                |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                |  |                                 |          |   |                                |   |          |  
|CURRENT LIABILITIES:                                |  |                                 |          |   |                                |   |          |  
|Accounts payable                                    |  | $                               | 9,207    |   |                                | $ | 6,893    |  
|Accrued liabilities                                 |  |                                 | 7,815    |   |                                |   | 4,796    |  
|Current portion lease financing obligations         |  |                                 | 2,817    |   |                                |   | 2,579    |  
|Deferred revenues                                   |  |                                 | 16,338   |   |                                |   | 26,843   |  
|                                                    |  |                                 |          |   |                                |   |          |  
|Total current liabilities                           |  |                                 | 36,177   |   |                                |   | 41,111   |  
|                                                    |  |                                 |          |   |                                |   |          |  
|LONG-TERM LIABILITIES:                              |  |                                 |          |   |                                |   |          |  
|Lease financing obligations, net of current portion |  |                                 | 13,912   |   |                                |   | 16,052   |  
|Deferred rent                                       |  |                                 | 383      |   |                                |   | 446      |  
|                                                    |  |                                 |          |   |                                |   |          |  
|Total long-term liabilities                         |  |                                 | 14,295   |   |                                |   | 16,498   |  
|                                                    |  |                                 |          |   |                                |   |          |  
|STOCKHOLDERS EQUITY:                               |  |                                 |          |   |                                |   |          |  
|Common stock                                        |  |                                 | 431      |   |                                |   | 416      |  
|Additional paid-in capital                          |  |                                 | 294,798  |   |                                |   | 283,728  |  
|Treasury stock                                      |  |                                 | (19,259  | ) |                                |   | (19,259  | )
|Accumulated other comprehensive income              |  |                                 | 1,565    |   |                                |   | 997      |  
|Accumulated deficit                                 |  |                                 | (129,070 | ) |                                |   | (112,219 | )
|                                                    |  |                                 |          |   |                                |   |          |  
|Total stockholders equity                          |  |                                 | 148,465  |   |                                |   | 153,663  |  
|                                                    |  |                                 |          |   |                                |   |          |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY          |  | $                               | 198,937  |   |                                | $ | 211,272  |  
|                                                    |  |                                 |          |   |                                |   |          |  



|1 | See Note 2 of Condensed Consolidated Financial Statements for explanation of the restatement.
|- | ---------------------------------------------------------------------------------------------

See accompanying notes to condensed consolidated financial statements.



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ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)



|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ------------------ |  | - | ------------------ | - |  | - | ------- | -
|                                                                                                        |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                                                        |  | 2007(As Restated)1              |        |   | 2006(As Restated)1             |   |        | 2007(As Restated)1 |  |   | 2006(As Restated)1 |  
|REVENUES:                                                                                               |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Product                                                                                                 |  | $                               | 23,733 |   |                                | $ | 13,110 |                    |  | $ | 89,247             |   |  | $ | 42,893  |  
|Service                                                                                                 |  |                                 | 980    |   |                                |   | 181    |                    |  |   | 1,431              |   |  |   | 517     |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Total revenues                                                                                          |  |                                 | 24,713 |   |                                |   | 13,291 |                    |  |   | 90,678             |   |  |   | 43,410  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|COST OF REVENUES:                                                                                       |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Cost of product2                                                                                        |  |                                 | 14,004 |   |                                |   | 4,935  |                    |  |   | 57,969             |   |  |   | 16,806  |  
|Cost of service2                                                                                        |  |                                 | 722    |   |                                |   | 499    |                    |  |   | 1,710              |   |  |   | 1,378   |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Total cost of revenues                                                                                  |  |                                 | 14,726 |   |                                |   | 5,434  |                    |  |   | 59,679             |   |  |   | 18,184  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|GROSS PROFIT                                                                                            |  |                                 | 9,987  |   |                                |   | 7,857  |                    |  |   | 30,999             |   |  |   | 25,226  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|OPERATING EXPENSES:                                                                                     |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Product development2                                                                                    |  |                                 | 7,820  |   |                                |   | 6,833  |                    |  |   | 23,716             |   |  |   | 20,934  |  
|Sales and marketing2                                                                                    |  |                                 | 4,884  |   |                                |   | 5,079  |                    |  |   | 15,279             |   |  |   | 15,349  |  
|General and administrative2                                                                             |  |                                 | 3,976  |   |                                |   | 3,597  |                    |  |   | 11,707             |   |  |   | 10,526  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Total operating expenses                                                                                |  |                                 | 16,680 |   |                                |   | 15,509 |                    |  |   | 50,702             |   |  |   | 46,809  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|LOSS FROM OPERATIONS                                                                                    |  |                                 | (6,693 | ) |                                |   | (7,652 | )                  |  |   | (19,703            | ) |  |   | (21,583 | )
|                                                                                                        |  |                                 |        |  
|INTEREST AND OTHER INCOME, NET                                                                          |  |                                 | 1,381  |   |                                |   | 1,586  |                    |  |   | 4,366              |   |  |   | 4,384   |  
|INTEREST EXPENSE ON LEASE FINANCING OBLIGATIONS                                                         |  |                                 | (297   | ) |                                |   | (340   | )                  |  |   | (924               | ) |  |   | (1,050  | )
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|LOSS BEFORE PROVISION FOR INCOME TAXES                                                                  |  |                                 | (5,609 | ) |                                |   | (6,406 | )                  |  |   | (16,261            | ) |  |   | (18,249 | )
|                                                                                                        |  |                                 |        |  
|INCOME TAX EXPENSE                                                                                      |  |                                 | 108    |   |                                |   | 80     |                    |  |   | 323                |   |  |   | 240     |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|NET LOSS                                                                                                |  | $                               | (5,717 | ) |                                | $ | (6,486 | )                  |  | $ | (16,584            | ) |  | $ | (18,489 | )
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|NET LOSS PER SHARE:                                                                                     |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Basic                                                                                                   |  | $                               | (0.14  | ) |                                | $ | (0.16  | )                  |  | $ | (0.42              | ) |  | $ | (0.47   | )
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Diluted                                                                                                 |  | $                               | (0.14  | ) |                                | $ | (0.16  | )                  |  | $ | (0.42              | ) |  | $ | (0.47   | )
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|SHARES USED IN COMPUTING NET LOSS PER SHARE:                                                            |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Basic                                                                                                   |  |                                 | 40,121 |   |                                |   | 39,354 |                    |  |   | 39,622             |   |  |   | 39,577  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|Diluted                                                                                                 |  |                                 | 40,121 |   |                                |   | 39,354 |                    |  |   | 39,622             |   |  |   | 39,577  |  
|                                                                                                        |  |                                 |        |   |                                |   |        |                    |  |   |                    |   |  |   |         |  
|                                                                                                        | 
|1See Note 2 of Notes to Condensed Consolidated Financial Statements for explanation of the restatement. | 
|2Amounts include stock-based compensation costs as follows (as restated)1:                              | 
|                                                                                                        |  |                                 |        |  
|Cost of product                                                                                         |  | $                               | 217    |   |                                | $ | 104    |                    |  | $ | 526                |   |  | $ | 350     |  
|Cost of service                                                                                         |  |                                 | 18     |   |                                |   | 11     |                    |  |   | 45                 |   |  |   | 41      |  
|Product development                                                                                     |  |                                 | 655    |   |                                |   | 421    |                    |  |   | 1,647              |   |  |   | 1,640   |  
|Sales and marketing                                                                                     |  |                                 | 383    |   |                                |   | 275    |                    |  |   | 1,020              |   |  |   | 1,017   |  
|General and administrative                                                                              |  |                                 | 489    |   |                                |   | 298    |                    |  |   | 1,450              |   |  |   | 1,085   |  

See accompanying notes to condensed consolidated financial statements.



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ECHELON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                                                             |  |                                |         |   |                    |   |         |  
|---------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ------------------ | - | ------- | -
|                                                                                                                             |  | Nine Months EndedSeptember 30, |        
|                                                                                                                             |  | 2007(As Restated)1             |         |   | 2006(As Restated)1 |  
|CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:                                                                       |  |                                |         |   |                    |   |         |  
|Net loss                                                                                                                     |  | $                              | (16,584 | ) |                    | $ | (18,489 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                                                  |  |                                |         |   |                    |   |         |  
|Depreciation and amortization                                                                                                |  |                                | 5,427   |   |                    |   | 5,313   |  
|Loss on disposal of fixed assets                                                                                             |  |                                | 4       |   |                    |   |        |  
|Increase in (reduction of) allowance for doubtful accounts                                                                   |  |                                | 47      |   |                    |   | (32     | )
|Reduction of (increase in) accrued investment income                                                                         |  |                                | 403     |   |                    |   | (271    | )
|Stock-based compensation                                                                                                     |  |                                | 4,688   |   |                    |   | 4,133   |  
|Change in operating assets and liabilities:                                                                                  |  |                                |         |   |                    |   |         |  
|Accounts receivable                                                                                                          |  |                                | 282     |   |                    |   | (6,048  | )
|Inventories                                                                                                                  |  |                                | 446     |   |                    |   | (5,699  | )
|Deferred cost of goods sold                                                                                                  |  |                                | 12,854  |   |                    |   | (11,745 | )
|Other current assets                                                                                                         |  |                                | (608    | ) |                    |   | (1,514  | )
|Accounts payable                                                                                                             |  |                                | 1,953   |   |                    |   | 3,662   |  
|Accrued liabilities                                                                                                          |  |                                | 2,883   |   |                    |   | (2,706  | )
|Deferred revenues                                                                                                            |  |                                | (10,510 | ) |                    |   | 18,737  |  
|Deferred rent                                                                                                                |  |                                | (52     | ) |                    |   | (73     | )
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|Net cash provided by (used in) operating activities                                                                          |  |                                | 1,233   |   |                    |   | (14,732 | )
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:                                                                       |  |                                |         |   |                    |   |         |  
|Purchases of available-for-sale short-term investments                                                                       |  |                                | (65,545 | ) |                    |   | (47,761 | )
|Proceeds from maturities and sales of available-for-sale short-term investments                                              |  |                                | 104,139 |   |                    |   | 68,411  |  
|Change in other long-term assets                                                                                             |  |                                | 44      |   |                    |   | 56      |  
|Capital expenditures                                                                                                         |  |                                | (5,752  | ) |                    |   | (4,103  | )
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|Net cash provided by investing activities                                                                                    |  |                                | 32,886  |   |                    |   | 16,603  |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:                                                                       |  |                                |         |   |                    |   |         |  
|Proceeds from issuance of common stock                                                                                       |  |                                | 10,094  |   |                    |   | 252     |  
|Principal payments of lease financing obligations                                                                            |  |                                | (1,902  | ) |                    |   | (1,696  | )
|Repurchase of common stock from employees for payment of taxes on vesting of share awards and upon exercise of stock options |  |                                | (4,029  | ) |                    |   | (257    | )
|Repurchase of common stock under stock repurchase program                                                                    |  |                                |        |   |                    |   | (5,102  | )
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|Net cash provided by (used in) financing activities                                                                          |  |                                | 4,163   |   |                    |   | (6,803  | )
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS                                                                 |  |                                | 328     |   |                    |   | 303     |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                         |  |                                | 38,610  |   |                    |   | (4,629  | )
|                                                                                                                             |  |                               
|CASH AND CASH EQUIVALENTS:                                                                                                   |  |                                |         |   |                    |   |         |  
|Beginning of period                                                                                                          |  |                                | 37,412  |   |                    |   | 59,080  |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|End of period                                                                                                                |  | $                              | 76,022  |   |                    | $ | 54,451  |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                                                                           |  |                                |         |   |                    |   |         |  
|Cash paid for income taxes                                                                                                   |  | $                              | 352     |   |                    | $ | 183     |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  
|Cash paid for interest on lease financing obligations                                                                        |  | $                              | 914     |   |                    | $ | 1,040   |  
|                                                                                                                             |  |                                |         |   |                    |   |         |  



|1 | See Note 2 of Notes to Condensed Consolidated Financial Statements for explanation of the restatement.
|- | ------------------------------------------------------------------------------------------------------

See accompanying notes to condensed consolidated financial statements.



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ECHELON CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting
Policies

Basis of Presentation

The
condensed consolidated financial statements include the accounts of Echelon Corporation (the Company), a Delaware corporation, and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been
eliminated.

While the financial information furnished is unaudited, the condensed consolidated financial statements included in this
report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the
Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the
Companys consolidated financial statements for the year ended December 31, 2007 included in its Annual Report on Form 10-K/A filed concurrently with this Quarterly Report on Form 10-Q/A.

Reclassifications

Certain reclassifications have
been made to the prior year amounts to conform with the fiscal year 2007 presentation. For the nine months ended September 30, 2006, $271,000 has been reclassified from operating cash flows to investing cash flows related to investment income
included in net income for which cash had not been received prior to September 30, 2006.

Revenue Recognition

The Companys revenues are derived from the sale and license of its products and to a lesser extent, from fees associated with training, technical
support, and custom software design services offered to its 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.

The Company recognizes revenue when persuasive
evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectibility is probable, and there are no post-delivery obligations. For hardware sales, including sales to third party manufacturers, these
criteria are generally met at the time of shipment. For sales made to the Companys distributor partners, these criteria are generally met at the time the distributor sells the products through to its end-use customer. For software licenses,
these criteria are generally met upon shipment to the final end-user. Service revenue is recognized as the training services are performed, or ratably over the term of the support period.

In accordance with AICPA Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition, as amended, revenue earned on software
arrangements involving multiple elements is allocated to each element based upon the relative fair values of the elements. The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be
delivered at a future date. In these instances, the amount of revenue deferred at the time of sale is based on vendor specific objective evidence (VSOE) of the fair value for each undelivered element. If VSOE of fair value does not exist
for each undelivered element, all revenue attributable to the multi-element arrangement is deferred until sufficient VSOE of fair value exists for each undelivered element or all elements have been delivered.

The Company currently sells a limited number of its LONWORKS® Infrastructure products that are considered multiple element arrangements under SOP 97-2. Revenue for the software license element is recognized at the time of delivery of the
applicable product to the end-user. The only undelivered element at the time of sale consists of post-contract customer support (PCS). The VSOE for this PCS is based on prices paid by the Companys customers for stand-alone
purchases of PCS. Revenue for the PCS element is deferred and recognized ratably over the PCS service period. The costs of providing these PCS services are expensed when incurred.



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In certain instances, the Companys Networked Energy Services (NES) System products are
sold as part of multiple element arrangements, which may include electricity meters and data concentrators (collectively, the Hardware); NES System software, for which a royalty is charged on a per-meter basis; PCS for the NES System
software; and extended warranties for the Hardware. These arrangements may require the Company to deliver Hardware over an extended period of time. In accordance with SOP 97-2, when the multiple element arrangement includes NES System software, the
Company defers the recognition of all revenue until all software required under the arrangement has been delivered to the customer. Once the software has been delivered, the Company recognizes revenues for the Hardware and NES System software
royalties upon customer acceptance of the Hardware based on a constant ratio of meters to data concentrators, which is determined on a contract-by-contract basis. To the extent actual deliveries of either meters or data concentrators is
disproportionate to the expected overall ratio for any given arrangement, revenue for the excess meters or data concentrators is deferred until such time as additional deliveries of meters or data concentrators has occurred. The Company has
established VSOE for the PCS on the NES System software, as well as for the warranties on its NES Hardware products, based on stated renewal rates. These revenues are recognized ratably over the associated service period, which generally commences
upon the latter of the delivery of all software, or the customers acceptance of any given Hardware shipment.

In arrangements which
include significant customization or modification of software, the Company recognizes revenue using the percentage-of-completion method, as described in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type
Contracts, if the Company believes it is able to make reasonably dependable estimates of the extent of progress toward completion. The Company measures progress toward completion using an input method based on the ratio of costs incurred,
principally labor, to date to total estimated costs of the project. These estimates are assessed continually during the term of the contract, and revisions are reflected when the changed conditions become known. Revenues from these types of
arrangements are included in service revenues in the condensed consolidated statement of operations.

The Company accounts for the rights
of return, price protection, rebates, and other sales incentives offered to its distributors in accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists,and
EITF 01-09,Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products). During the first and second quarters of 2006, the Company modified its revenue recognition method for sales made to
its distributor partners. Under the revised method, revenue on sales made to distributors is deferred until the distributor sells the products through to its end-use customers. The impact of this revenue recognition methodology revision was a
one-time reduction in revenues of approximately $3.9 million during the nine months ended September 30, 2006.

Deferred Revenue and Deferred Cost
of Goods Sold

Deferred revenue and deferred cost of goods sold result from transactions where the Company has shipped product or
performed services for which all revenue recognition criteria have not yet been met. Deferred cost of goods sold related to deferred product revenues includes direct product costs and applied overhead. Deferred cost of goods sold related to deferred
service revenues includes direct labor costs and applied overhead. Once all revenue recognition criteria have been met, the deferred revenues and associated cost of goods sold are recognized.

Recent Accounting Pronouncements

With the exception
of the Financial Accounting Standards Board ( FASB) statement described below, there have been no significant changes in recent accounting pronouncements during the three and nine months ended September 30, 2007, as compared to the
recent accounting pronouncements described in our Annual Report on Form 10-K for the year ended December 31, 2006.

In February 2007,
the FASB issued Statement of Financial Accounting Standards No. 159 (SFAS 159), The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 permits companies to choose to measure certain financial
instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS 159 is effective for the Company beginning in its
fiscal year ending December 31, 2008, although earlier adoption is permitted. The Company is currently evaluating the impact that SFAS 159 will have on its consolidated financial statements.



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2. Restatement of Condensed Consolidated Financial Statements:

During the preparation of its financial results for the quarter ended March 31, 2008, the Company identified an error in its previously reported
equity compensation expense and determined it had inappropriately accounted for the 1999 and 2001 leases of its San Jose, California corporate headquarters facilities.

Restatement of stock-based compensation expense:The Company identified an error in its previously reported stock-based compensation expense for the years ended December 31, 2007, 2006 and 2005 and
each of the quarterly periods in 2007 and 2006. The error was isolated to share awards and does not affect the other forms of our equity compensation awards, namely stock options and stock-settled stock appreciation rights. While the grant date fair
value of the share awards was determined correctly in accordance with SFAS No. 123R (revised 2004), Share-Based Payment (SFAS 123R), the amount of expense associated with these awards that was recognized in 2007, 2006
and 2005 was not correct. The error was caused by a misapplication of the widely-used equity compensation software application the Company uses to manage and account for its equity compensation awards. This misapplication caused the expense
associated with these share awards to be calculated using the straight-line, single-option method rather than the accelerated, multiple-option method, which the Company had elected to use for all of its equity compensation awards. Use of the
straight-line, single-option method resulted in understatements of stock-based compensation expense in 2007, 2006 and 2005 of $1.2 million, $535,000 and $263,000, respectively. For the three-month periods ended September 30, 2007 and 2006,
stock-based compensation expense was understated by $281,000 and $107,000, respectively. For the nine-month periods ended September 30, 2007 and 2006, stock-based compensation expense was understated by $622,000 and $416,000, respectively.

Restatement related to the leases of our San Jose, California headquarters facilities: The Company inappropriately accounted
for the leases of its corporate headquarters facilities that were entered into in 1999 and 2001. Under the guidance in Emerging Issues Task Force Issue No. 97-10,The Effect of Lessee Involvement in Asset Construction (EITF
97-10), and SFAS No. 98,Accounting for Leases: Sale-Leaseback transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases; an amendment of FASB
Statements No. 13, 66, and 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11 (SFAS 98), the Company should have reflected an asset on its balance sheet for the costs paid by the lessor to
construct its headquarters facilities, as well as a corresponding liability, because the Company was the deemed owner of the headquarters facilities for accounting purposes during the construction periods. Upon completion of
construction, the Company did not meet the sale-leaseback criteria under SFAS 98 and therefore should have treated the leases as financing obligations and the assets and corresponding liabilities would not be derecognized. The Company
has historically accounted for these leases as operating leases under SFAS No. 13, Accounting for Leases(SFAS 13), whereby the total minimum lease payment obligations under the leases was recognized as monthly rent expense
on a straight-line basis over the terms of the leases.The restatement adjustments do not affect the total cash payments the Company has made or is obligated to make under the lease agreements, nor do they change the total expense to be
recognized over the lease terms. However, the timing and nature of expenses in the statement of operations is different under this treatment as compared to operating lease treatment. Specifically, the Company should have recognized land lease
expense, depreciation expense on the assets it is deemed to own and interest expense on the associated lease financing obligations.

Therefore the Company has restated its consolidated balance sheets as of December 31, 2007 and 2006, and its consolidated statements of operations, stockholders equity, cash flows and comprehensive income (loss) for each of the
years in the three-year period ended December 31, 2007 and each of the quarters in 2007 and 2006, to reflect the restatement adjustments applicable to those periods.



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##### Table of Contents

The following table presents the effects of the adjustments made to the Companys previously
reported condensed consolidated balance sheets as of September 30, 2007 and December 31, 2006 (in thousands):



|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|--------------------------------------------------- |  | -------------------- | -------- | - | ----------------- | - | ------ | ---------- |  | - | -------------------- | - |  | ----------- | -------- | - | ---------- | - | ------ | - |  | - | -------- | -
|                                                    |  | September 30, 2007   |          |   | December 31, 2006 |  
|                                                    |  | AsPreviouslyReported |          |   | Adjustments       |   |        | AsRestated |  |   | AsPreviouslyReported |   |  | Adjustments |          |   | AsRestated |  
|ASSETS                                              |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Current Assets:                                     |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Cash and cash equivalents                           |  | $                    | 76,022   |   |                   | $ |       |            |  | $ | 76,022               |   |  | $           | 37,412   |   |            | $ |       |   |  | $ | 37,412   |  
|Short-term investments                              |  |                      | 47,786   |   |                   |   |       |            |  |   | 47,786               |   |  |             | 86,745   |   |            |   |       |   |  |   | 86,745   |  
|Accounts receivable, net                            |  |                      | 13,603   |   |                   |   |       |            |  |   | 13,603               |   |  |             | 13,918   |   |            |   |       |   |  |   | 13,918   |  
|Inventories                                         |  |                      | 10,931   |   |                   |   |       |            |  |   | 10,931               |   |  |             | 11,359   |   |            |   |       |   |  |   | 11,359   |  
|Deferred cost of goods sold                         |  |                      | 6,206    |   |                   |   |       |            |  |   | 6,206                |   |  |             | 19,060   |   |            |   |       |   |  |   | 19,060   |  
|Other current assets                                |  |                      | 3,143    |   |                   |   | (232   | )          |  |   | 2,911                |   |  |             | 2,359    |   |            |   | (221   | ) |  |   | 2,138    |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Total current assets                                |  |                      | 157,691  |   |                   |   | (232   | )          |  |   | 157,459              |   |  |             | 170,853  |   |            |   | (221   | ) |  |   | 170,632  |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Property and Equipment, net                         |  |                      | 17,890   |   |                   |   | 13,174 |            |  |   | 31,064               |   |  |             | 15,188   |   |            |   | 15,217 |   |  |   | 30,405   |  
|Goodwill                                            |  |                      | 8,475    |   |                   |   |       |            |  |   | 8,475                |   |  |             | 8,278    |   |            |   |       |   |  |   | 8,278    |  
|Other long-term assets                              |  |                      | 1,939    |   |                   |   |       |            |  |   | 1,939                |   |  |             | 1,957    |   |            |   |       |   |  |   | 1,957    |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|TOTAL ASSETS                                        |  | $                    | 185,995  |   |                   | $ | 12,942 |            |  | $ | 198,937              |   |  | $           | 196,276  |   |            | $ | 14,996 |   |  | $ | 211,272  |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|                                                    |  |                      |          |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Current Liabilities:                                |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Accounts payable                                    |  | $                    | 9,207    |   |                   | $ |       |            |  | $ | 9,207                |   |  | $           | 6,893    |   |            | $ |       |   |  | $ | 6,893    |  
|Accrued liabilities                                 |  |                      | 7,749    |   |                   |   | 66     |            |  |   | 7,815                |   |  |             | 4,697    |   |            |   | 99     |   |  |   | 4,796    |  
|Current portion lease financing obligations         |  |                      |         |   |                   |   | 2,817  |            |  |   | 2,817                |   |  |             |         |   |            |   | 2,579  |   |  |   | 2,579    |  
|Deferred revenues                                   |  |                      | 16,338   |   |                   |   |       |            |  |   | 16,338               |   |  |             | 26,843   |   |            |   |       |   |  |   | 26,843   |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Total current liabilities                           |  |                      | 33,294   |   |                   |   | 2,883  |            |  |   | 36,177               |   |  |             | 38,433   |   |            |   | 2,678  |   |  |   | 41,111   |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Long-Term Liabilities:                              |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Lease financing obligations, net of current portion |  |                      |         |   |                   |   | 13,912 |            |  |   | 13,912               |   |  |             |         |   |            |   | 16,052 |   |  |   | 16,052   |  
|Deferred rent, net of current portion               |  |                      | 1,318    |   |                   |   | (935   | )          |  |   | 383                  |   |  |             | 1,268    |   |            |   | (822   | ) |  |   | 446      |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Total long-term liabilities                         |  |                      | 1,318    |   |                   |   | 12,977 |            |  |   | 14,295               |   |  |             | 1,268    |   |            |   | 15,230 |   |  |   | 16,498   |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Stockholders Equity:                               |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Common stock                                        |  |                      | 431      |   |                   |   |       |            |  |   | 431                  |   |  |             | 416      |   |            |   |       |   |  |   | 416      |  
|Additional paid-in capital                          |  |                      | 293,378  |   |                   |   | 1,420  |            |  |   | 294,798              |   |  |             | 282,930  |   |            |   | 798    |   |  |   | 283,728  |  
|Treasury stock                                      |  |                      | (19,259  | ) |                   |   |       |            |  |   | (19,259              | ) |  |             | (19,259  | ) |            |   |       |   |  |   | (19,259  | )
|Accumulated other comprehensive income              |  |                      | 1,565    |   |                   |   |       |            |  |   | 1,565                |   |  |             | 997      |   |            |   |       |   |  |   | 997      |  
|Accumulated deficit                                 |  |                      | (124,732 | ) |                   |   | (4,338 | )          |  |   | (129,070             | ) |  |             | (108,509 | ) |            |   | (3,710 | ) |  |   | (112,219 | )
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|Total stockholders equity                          |  |                      | 151,383  |   |                   |   | (2,918 | )          |  |   | 148,465              |   |  |             | 156,575  |   |            |   | (2,912 | ) |  |   | 153,663  |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY          |  | $                    | 185,995  |   |                   | $ | 12,942 |            |  | $ | 198,937              |   |  | $           | 196,276  |   |            | $ | 14,996 |   |  | $ | 211,272  |  
|                                                    |  |                      |          |   |                   |   |        |            |  |   |                      |   |  |             |          |   |            |   |        |   |  |   |          |  



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##### Table of Contents

The following table presents the effects of the adjustments made to the Companys previously
reported condensed consolidated statements of operations for each of the three-month periods ended September 30, 2007 and 2006 (in thousands, except per share data):



|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|----------------------------------------------- |  | -------------------------------- | ------ | - | ----------- | - | ---- | ---------- |  | - | -------------------- | - |  | ----------- | ------ | - | ---------- | - | ---- | - |  | - | ------ | -
|                                                |  | Three Months Ended September 30, |       
|                                                |  | 2007                             |        |   | 2006        |  
|                                                |  | AsPreviouslyReported             |        |   | Adjustments |   |      | AsRestated |  |   | AsPreviouslyReported |   |  | Adjustments |        |   | AsRestated |  
|REVENUES:                                       |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Product                                         |  | $                                | 23,733 |   |             | $ |     |            |  | $ | 23,733               |   |  | $           | 13,110 |   |            | $ |     |   |  | $ | 13,110 |  
|Service                                         |  |                                  | 980    |   |             |   |     |            |  |   | 980                  |   |  |             | 181    |   |            |   |     |   |  |   | 181    |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Total revenues                                  |  |                                  | 24,713 |   |             |   |     |            |  |   | 24,713               |   |  |             | 13,291 |   |            |   |     |   |  |   | 13,291 |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|COST OF REVENUES:                               |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Cost of product                                 |  |                                  | 13,980 |   |             |   | 24   |            |  |   | 14,004               |   |  |             | 4,936  |   |            |   | (1   | ) |  |   | 4,935  |  
|Cost of service                                 |  |                                  | 729    |   |             |   | (7   | )          |  |   | 722                  |   |  |             | 509    |   |            |   | (10  | ) |  |   | 499    |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Total cost of revenues                          |  |                                  | 14,709 |   |             |   | 17   |            |  |   | 14,726               |   |  |             | 5,445  |   |            |   | (11  | ) |  |   | 5,434  |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Gross profit                                    |  |                                  | 10,004 |   |             |   | (17  | )          |  |   | 9,987                |   |  |             | 7,846  |   |            |   | 11   |   |  |   | 7,857  |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|                                                |  |                                  |        |   |             |  
|OPERATING EXPENSES:                             |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Product development                             |  |                                  | 7,789  |   |             |   | 31   |            |  |   | 7,820                |   |  |             | 6,875  |   |            |   | (42  | ) |  |   | 6,833  |  
|Sales and marketing                             |  |                                  | 4,850  |   |             |   | 34   |            |  |   | 4,884                |   |  |             | 5,076  |   |            |   | 3    |   |  |   | 5,079  |  
|General and administrative                      |  |                                  | 4,083  |   |             |   | (107 | )          |  |   | 3,976                |   |  |             | 3,746  |   |            |   | (149 | ) |  |   | 3,597  |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Total operating expenses                        |  |                                  | 16,722 |   |             |   | (42  | )          |  |   | 16,680               |   |  |             | 15,697 |   |            |   | (188 | ) |  |   | 15,509 |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Loss from operations                            |  |                                  | (6,718 | ) |             |   | 25   |            |  |   | (6,693               | ) |  |             | (7,851 | ) |            |   | 199  |   |  |   | (7,652 | )
|Interest and other income, net                  |  |                                  | 1,381  |   |             |   |     |            |  |   | 1,381                |   |  |             | 1,586  |   |            |   |     |   |  |   | 1,586  |  
|Interest expense on lease financing obligations |  |                                  |       |   |             |   | (297 | )          |  |   | (297                 | ) |  |             |       |   |            |   | (340 | ) |  |   | (340   | )
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Loss before provision for income taxes          |  |                                  | (5,337 | ) |             |   | (272 | )          |  |   | (5,609               | ) |  |             | (6,265 | ) |            |   | (141 | ) |  |   | (6,406 | )
|Provision for income taxes                      |  |                                  | 108    |   |             |   |     |            |  |   | 108                  |   |  |             | 80     |   |            |   |     |   |  |   | 80     |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|NET LOSS                                        |  | $                                | (5,445 | ) |             | $ | (272 | )          |  | $ | (5,717               | ) |  | $           | (6,345 | ) |            | $ | (141 | ) |  | $ | (6,486 | )
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Loss per share:                                 |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Basic                                           |  | $                                | (0.14  | ) |             |   |     |            |  | $ | (0.14                | ) |  | $           | (0.16  | ) |            |   |     |   |  | $ | (0.16  | )
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Diluted                                         |  | $                                | (0.14  | ) |             |   |     |            |  | $ | (0.14                | ) |  | $           | (0.16  | ) |            |   |     |   |  | $ | (0.16  | )
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Shares used in per share calculation:           |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Basic                                           |  |                                  | 40,121 |   |             |   |     |            |  |   | 40,121               |   |  |             | 39,354 |   |            |   |     |   |  |   | 39,354 |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  
|Diluted                                         |  |                                  | 40,121 |   |             |   |     |            |  |   | 40,121               |   |  |             | 39,354 |   |            |   |     |   |  |   | 39,354 |  
|                                                |  |                                  |        |   |             |   |      |            |  |   |                      |   |  |             |        |   |            |   |      |   |  |   |        |  



12



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##### Table of Contents

The following table presents the effects of the adjustments made to the Companys previously
reported condensed consolidated statements of operations for each of the nine-month periods ended September 30, 2007 and 2006 (in thousands, except per share data):



|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|----------------------------------------------- |  | ------------------------------- | ------- | - | ----------- | - | ----- | ---------- |  | - | -------------------- | - |  | ----------- | ------- | - | ---------- | - | ------ | - |  | - | ------- | -
|                                                |  | Nine Months Ended September 30, |        
|                                                |  | 2007                            |         |   | 2006        |  
|                                                |  | AsPreviouslyReported            |         |   | Adjustments |   |       | AsRestated |  |   | AsPreviouslyReported |   |  | Adjustments |         |   | AsRestated |  
|REVENUES:                                       |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Product                                         |  | $                               | 89,247  |   |             | $ |      |            |  | $ | 89,247               |   |  | $           | 42,893  |   |            | $ |       |   |  | $ | 42,893  |  
|Service                                         |  |                                 | 1,431   |   |             |   |      |            |  |   | 1,431                |   |  |             | 517     |   |            |   |       |   |  |   | 517     |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Total revenues                                  |  |                                 | 90,678  |   |             |   |      |            |  |   | 90,678               |   |  |             | 43,410  |   |            |   |       |   |  |   | 43,410  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|COST OF REVENUES:                               |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Cost of product                                 |  |                                 | 57,922  |   |             |   | 47    |            |  |   | 57,969               |   |  |             | 16,802  |   |            |   | 4      |   |  |   | 16,806  |  
|Cost of service                                 |  |                                 | 1,735   |   |             |   | (25   | )          |  |   | 1,710                |   |  |             | 1,406   |   |            |   | (28    | ) |  |   | 1, 378  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Total cost of revenues                          |  |                                 | 59,657  |   |             |   | 22    |            |  |   | 59,679               |   |  |             | 18,208  |   |            |   | (24    | ) |  |   | 18,184  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Gross profit                                    |  |                                 | 31,021  |   |             |   | (22   | )          |  |   | 30,999               |   |  |             | 25,202  |   |            |   | 24     |   |  |   | 25,226  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|                                                |  |                                 |         |   |             |  
|OPERATING EXPENSES:                             |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Product development                             |  |                                 | 23,720  |   |             |   | (4    | )          |  |   | 23,716               |   |  |             | 21,029  |   |            |   | (95    | ) |  |   | 20,934  |  
|Sales and marketing                             |  |                                 | 15,218  |   |             |   | 61    |            |  |   | 15,279               |   |  |             | 15,312  |   |            |   | 37     |   |  |   | 15,349  |  
|General and administrative                      |  |                                 | 12,082  |   |             |   | (375  | )          |  |   | 11,707               |   |  |             | 10,946  |   |            |   | (420   | ) |  |   | 10,526  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Total operating expenses                        |  |                                 | 51,020  |   |             |   | (318  | )          |  |   | 50,702               |   |  |             | 47,287  |   |            |   | (478   | ) |  |   | 46,809  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Loss from operations                            |  |                                 | (19,999 | ) |             |   | 296   |            |  |   | (19,703              | ) |  |             | (22,085 | ) |            |   | 502    |   |  |   | (21,583 | )
|Interest and other income, net                  |  |                                 | 4,366   |   |             |   |      |            |  |   | 4,366                |   |  |             | 4,384   |   |            |   |       |   |  |   | 4,384   |  
|Interest expense on lease financing obligations |  |                                 |        |   |             |   | (924  | )          |  |   | (924                 | ) |  |             |        |   |            |   | (1,050 | ) |  |   | (1,050  | )
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Loss before provision for income taxes          |  |                                 | (15,633 | ) |             |   | (628  | )          |  |   | (16,261              | ) |  |             | (17,701 | ) |            |   | (548   | ) |  |   | (18,249 | )
|Provision for income taxes                      |  |                                 | 323     |   |             |   |      |            |  |   | 323                  |   |  |             | 240     |   |            |   |       |   |  |   | 240     |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|NET LOSS                                        |  | $                               | (15,956 | ) |             | $ | (628  | )          |  | $ | (16,584              | ) |  | $           | (17,941 | ) |            | $ | (548   | ) |  | $ | (18,489 | )
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Loss per share:                                 |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Basic                                           |  | $                               | (0.40   | ) |             | $ | (0.02 | )          |  | $ | (0.42                | ) |  | $           | (0.45   | ) |            | $ | (0.02  | ) |  | $ | (0.47   | )
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Diluted                                         |  | $                               | (0.40   | ) |             | $ | (0.02 | )          |  | $ | (0.42                | ) |  | $           | (0.45   | ) |            | $ | (0.02  | ) |  | $ | (0.47   | )
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Shares used in per share calculation:           |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Basic                                           |  |                                 | 39,622  |   |             |   |      |            |  |   | 39,622               |   |  |             | 39,577  |   |            |   |       |   |  |   | 39,577  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  
|Diluted                                         |  |                                 | 39,622  |   |             |   |      |            |  |   | 39,622               |   |  |             | 39,577  |   |            |   |       |   |  |   | 39,577  |  
|                                                |  |                                 |         |   |             |   |       |            |  |   |                      |   |  |             |         |   |            |   |        |   |  |   |         |  



13



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##### Table of Contents

The following table presents the effects of the adjustments made to the Companys previously
reported condensed consolidated statements of cash flows for each of the nine-month periods ended September 30, 2007 and 2006 (in thousands):



|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|----------------------------------------------------- |  | ------------------------------- | ------ | ---- | ----------- | - | ------ | ---------- |  | -------------------- | ------ |  | ----------- | ------- | - | ---------- | - | ------ | - |  | - | ------- | -
|                                                      |  | Nine Months Ended September 30, |       
|                                                      |  | 2007                            |        | 2006 |            
|                                                      |  | AsPreviouslyReported            |        |      | Adjustments |   |        | AsRestated |  | AsPreviouslyReported |        |  | Adjustments |         |   | AsRestated |  
|Net cash provided by (used in) operating activities   |  | $                               | (669   | )    |             | $ | 1,902  |            |  | $                    | 1,233  |  | $           | (16,428 | ) |            | $ | 1,696  |   |  | $ | (14,732 | )
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Net cash provided by investing activities             |  |                                 | 32,886 |      |             |   |       |            |  |                      | 32,886 |  |             | 16,603  |   |            |   |       |   |  |   | 16,603  |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Net cash provided by (used in) financing activities   |  |                                 | 6,065  |      |             |   | (1,902 | )          |  |                      | 4,163  |  |             | (5,107  | ) |            |   | (1,696 | ) |  |   | (6,803  | )
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Effect of exchange rate changes on cash               |  |                                 | 328    |      |             |   |       |            |  |                      | 328    |  |             | 303     |   |            |   |       |   |  |   | 303     |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Net increase (decrease) in cash and cash equivalents  |  |                                 | 38,610 |      |             |   |       |            |  |                      | 38,610 |  |             | (4,629  | ) |            |   |       |   |  |   | (4,629  | )
|CASH AND CASH EQUIVALENTS:                            |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Beginning of period                                   |  |                                 | 37,412 |      |             |   |       |            |  |                      | 37,412 |  |             | 59,080  |   |            |   |       |   |  |   | 59,080  |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|End of period                                         |  | $                               | 76,022 |      |             | $ |       |            |  | $                    | 76,022 |  | $           | 54,451  |   |            | $ |       |   |  | $ | 54,451  |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|SUPPLEMENTAL DISCLOSURES:                             |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Cash paid for taxes                                   |  | $                               | 352    |      |             | $ |       |            |  | $                    | 352    |  | $           | 183     |   |            | $ |       |   |  | $ | 183     |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  
|Cash paid for interest on lease financing obligations |  | $                               |       |      |             | $ | 914    |            |  | $                    | 914    |  | $           |        |   |            | $ | 1,040  |   |  | $ | 1,040   |  
|                                                      |  |                                 |        |      |             |   |        |            |  |                      |        |  |             |         |   |            |   |        |   |  |   |         |  

3. Property and Equipment (As Restated)

Property and equipment are stated at cost. The cost of buildings and improvements for our leased San Jose, California headquarters facilities, for which
we are the deemed owner for accounting purposes only, includes both the costs paid for directly by the Company and the costs paid for by the builder (lessor).

Accounting for buildings and improvements

In December 1999, the Company entered into a lease
agreement with a real estate developer for its existing corporate headquarters in San Jose, California. This agreement requires minimum rental payments for ten years totaling approximately $20.6 million and also required that the Company
provide a $3.0 million security deposit, which requirement has since been reduced to $1.2 million. The Company satisfied the security deposit requirement by causing to have issued a standby letter of credit (LOC) in July 2000.
The LOC is subject to annual renewals and is currently secured by a $15.0 million line of credit at the bank that issued the LOC. The line of credit is maintained primarily for the purpose of providing standby letters of credit as required
under the Companys lease agreements, as well as for providing standby letters of credit that arise from time to time in the general course of business. As of September 30, 2007 and December 31, 2006, no amounts had been drawn against
the line of credit or the letters of credit.



14



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##### Table of Contents

In October 2000, the Company entered into another lease agreement with the same real estate developer for
an additional building at its headquarters site. Construction on the second building was completed in May 2003, at which time monthly rental payments commenced. This second lease agreement also requires minimum rental payments for ten years totaling
approximately $23.4 million. In addition, this second lease agreement also required a security deposit of $5.0 million. The Company satisfied this security deposit requirement by causing to have issued another LOC in October 2001. This LOC is
also subject to annual renewals and is currently secured by a line of credit at the bank that issued it.

Both the December 1999 and
October 2000 leases permit the Company to exercise an option to extend the respective lease for two sequential five-year terms.

As
discussed in Note 2, the Company has accounted for the two buildings at its San Jose, California headquarters site under EITF 97-10 and SFAS 98. EITF 97-10 applies to entities involved with the construction of an asset that will be
leased when the construction project is completed. During construction, the Company paid for certain tenant improvements, including structural elements of the buildings and, in accordance with EITF 97-10, is therefore the deemed
owner for accounting purposes of the two buildings at its San Jose, California headquarters site. Accordingly, the Company recorded assets for the total costs of the buildings and improvements, including the costs paid by the lessor (the legal
owner of the buildings that the Company leases), with corresponding liabilities for the costs paid by the lessor. Upon completion of construction of each building, the Company did not meet the sale-leaseback criteria in SFAS 98 for
derecognition of the building assets and liabilities. Therefore, the leases are accounted for as financing obligations.

For the December
1999 and October 2000 lease agreements, the Company initially recorded assets and corresponding lease financing obligations for the building and improvement costs paid by the lessor in the amount of $12.0 million and $15.2 million,
respectively. The Company has recorded depreciation expense associated with the building and improvement costs paid by the lessor of $681,000 in each of the three-month periods ended September 30, 2007 and 2006 and $2.0 million in each of
the nine-month periods ended September 30, 2007 and 2006. As of September 30, 2007 and December 31, 2006, the net book value of the buildings and improvements paid for by the lessor was $13.2 million and $15.2 million,
respectively.

Under the lease agreements, a portion of each lease payment is accounted for as an operating lease of land and recorded as
expense on a straight-line basis over the terms of the respective leases which includes the construction periods. The remaining lease payments are considered to be payments of principal and interest on the lease financing obligations. For the three
months ended September 30, 2007 and 2006, land lease expense was $113,000 for each quarter, principal reductions on the lease financing obligations were $650,000 and $581,000, respectively, and interest expense was $297,000 and $340,000,
respectively. For the nine months ended September 30, 2007 and 2006, land lease expense was $338,000 for each period, principal reductions on the lease financing obligations were $1.9 million and $1.7 million, respectively, and
interest expense was $924,000 and $1.0 million, respectively.

4. Short-Term Investments

As of September 30, 2007, the Companys available-for-sale short-term investments had contractual maturities from six to twenty-four months and
an average remaining term to maturity of eight months. Except as discussed below, the fair value of available-for-sale short-term investments was determined based on quoted market prices at the reporting date for those instruments.

As of September 30, 2007, $13.4 million in certain asset-backed commercial paper investments issued by Structured Investment Vehicles, $8.9 million
of which is recorded in short-term investments and $4.5 million of which is recorded in cash and cash equivalents in the condensed consolidated balance sheet, were considered illiquid based upon the fact that there were no open market bids for these
investments. As such, the fair value of these investments was estimated to approximate the amortized cost, or $13.4 million in total, by a third party pricing firm that supplies pricing estimates to the Companys investment manager. One of
these investments was repaid in full by the issuer on its maturity date of October 3, 2007. The two remaining investments mature on November 13, 2007 and January 18, 2008, and are rated A-1+ by Standard and Poors and P1 by
Moodys. In addition, the Company has reviewed the respective issuers liquidity for the two remaining investments as well as the quality of the underlying collateral to further support each issuers ability to repay the respective
investments at maturity. It is the Companys intent to hold these investments to maturity. As a result, the Company has not recorded an impairment charge or similar write-down of the reported values. However, if these securities were to begin
trading below these values in the future, or the issuer were to default on its repayment obligations, the Company may be required to record losses on these investments.



15



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As of September 30, 2007, the amortized cost basis, aggregate fair value, and gross unrealized
holding gains and losses of the Companys short-term investments by major security type were as follows (in thousands):



|                                                |  |               |        |                    |   |                                |  |   |    |  
|----------------------------------------------- |  | ------------- | ------ | ------------------ | - | ------------------------------ |  | - | -- | -
|                                                |  | AmortizedCost |        | AggregateFairValue |   | UnrealizedHoldingGains(Losses) | 
|U.S. corporate securities:                      |  |               |        |                    |   |                                |  |   |    |  
|Commercial paper                                |  | $             | 11,081 |                    | $ | 11,080                         |  | $ | (1 | )
|Corporate notes and bonds                       |  |               | 27,373 |                    |   | 27,368                         |  |   | (5 | )
|                                                |  |               |        |                    |   |                                |  |   |    |  
|                                                |  |               | 38,454 |                    |   | 38,448                         |  |   | (6 | )
|Foreign corporate notes and bonds               |  |               | 524    |                    |   | 530                            |  |   | 6  |  
|U.S. government securities                      |  |               | 8,797  |                    |   | 8,808                          |  |   | 11 |  
|                                                |  |               |        |                    |   |                                |  |   |    |  
|Total investments in debt and equity securities |  | $             | 47,775 |                    | $ | 47,786                         |  | $ | 11 |  
|                                                |  |               |        |                    |   |                                |  |   |    |  

5. Earnings Per Share (As Restated)

The following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations for the three and nine
months ended September 30, 2007 and September 30, 2006 (in thousands, except per share amounts):



|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|----------------------------------------------------------------------------- |  | ---------------------------------------------- | ------ | - | --------------------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                              |  | Three Months EndedSeptember 30,(As Restated)
1 |        |   | Nine Months EndedSeptember 30,(As Restated)
1 |  
|                                                                              |  | 2007                                           |        |   | 2006                                          |   |        | 2007 |  |   | 2006    |  
|Net loss (Numerator):                                                         |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Net loss, basic & diluted                                                     |  | $                                              | (5,717 | ) |                                               | $ | (6,486 | )    |  | $ | (16,584 | ) |  | $ | (18,489 | )
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Shares (Denominator):                                                         |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Weighted average common shares outstanding                                    |  |                                                | 40,121 |   |                                               |   | 39,354 |      |  |   | 39,622  |   |  |   | 39,577  |  
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Shares used in basic computation                                              |  |                                                | 40,121 |   |                                               |   | 39,354 |      |  |   | 39,622  |   |  |   | 39,577  |  
|Common shares issuable upon exercise of stock options (treasury stock method) |  |                                                |       |   |                                               |   |       |      |  |   |        |   |  |   |        |  
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Shares used in diluted computation                                            |  |                                                | 40,121 |   |                                               |   | 39,354 |      |  |   | 39,622  |   |  |   | 39,577  |  
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share:                                                           |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Basic                                                                         |  | $                                              | (0.14  | ) |                                               | $ | (0.16  | )    |  | $ | (0.42   | ) |  | $ | (0.47   | )
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Diluted                                                                       |  | $                                              | (0.14  | ) |                                               | $ | (0.16  | )    |  | $ | (0.42   | ) |  | $ | (0.47   | )
|                                                                              |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  



|(1) | See Note 2 of these Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------------

For the three and nine months ended September 30, 2007 and 2006, the diluted net loss per share calculation is
equivalent to the basic net loss per share calculation as there were no potentially dilutive stock options due to the Companys net loss position. The number of stock options and stock appreciation rights excluded from this calculation for the
three and nine months ended September 30, 2007 was 7,122,102. The number of stock options excluded from this calculation for the three and nine months ended September 30, 2006 was 7,561,024.

6. Stockholders Equity and Employee Stock Option Plans (As Restated)

Common Stock

In March and August 2004, the Companys board of directors approved a stock repurchase program, which
authorizes the Company to repurchase up to 3.0 million shares of the Companys common stock. During the three and nine months ended September 30, 2007, the Company did not repurchase any shares under the program. As of
September 30, 2007, 795,816 shares were available for repurchase. The stock repurchase program will expire in March 2008.

Comprehensive Loss (As
Restated)

Comprehensive loss for the Company consists of net loss plus the effect of unrealized holding gains or losses on investments
classified as available-for-sale and foreign currency translation adjustments. Comprehensive loss for the three and nine months ended September 30, 2007 and 2006 is as follows (in thousands):



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|                                                         |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------- |  | ---------------------------------------------- | ------ | - | --------------------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                         |  | Three Months EndedSeptember 30,(As Restated)
1 |        |   | Nine Months EndedSeptember 30,(As Restated)
1 |  
|                                                         |  | 2007                                           |        |   | 2006                                          |   |        | 2007 |  |   | 2006    |  
|Net loss                                                 |  | $                                              | (5,717 | ) |                                               | $ | (6,486 | )    |  | $ | (16,584 | ) |  | $ | (18,489 | )
|Other comprehensive income/(loss), net of tax:           |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Foreign currency translation adjustment                  |  |                                                | 406    |   |                                               |   | (63    | )    |  |   | 530     |   |  |   | 465     |  
|Unrealized holding gain on available-for-sale securities |  |                                                | 41     |   |                                               |   | 270    |      |  |   | 38      |   |  |   | 320     |  
|                                                         |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  
|Comprehensive loss                                       |  | $                                              | (5,270 | ) |                                               | $ | (6,279 | )    |  | $ | (16,016 | ) |  | $ | (17,704 | )
|                                                         |  |                                                |        |   |                                               |   |        |      |  |   |         |   |  |   |         |  



|(1) | See Note 2 of these Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------------

Stock Award Activity

The total intrinsic value of options exercised during the three and nine months ended September 30, 2007 was approximately $19.6 million and $23.6 million, respectively. The intrinsic value is calculated as the difference between the
market value on the date of exercise and the exercise price of the shares.

The total fair value of performance shares vested and released
during the three and nine months ended September 30, 2007 was approximately $1.5 million and $2.4 million, respectively. The fair value is calculated by multiplying the fair market value of the Companys stock on the vesting date by the
number of shares vested.

7. Significant Customers

The Company markets its products and services throughout the world to original equipment
manufacturers (OEMs) and systems integrators in the building, industrial, transportation, utility/home, and other automation markets. The Company currently has four customers that accounted for a majority of its revenues: EBV Electronik GmbH
(EBV), the Companys primary distributor of its LONWORKS® Infrastructure products in Europe, Enel S.p.A. (Enel), an Italian
utility company (including Enels third party meter manufacturers), and Telvent Energia y Medioambiente SA (Telvent) and ES Elektrosandberg AB (ES), value added resellers of the Companys NES products. For the three
and nine months ended September 30, 2007 and 2006, the percentage of the Companys revenues attributable to sales made to these customers was as follows:



|        |  |                                |   |  |                               |   |  |      |   |  |      |  
|------- |  | ------------------------------ | - |  | ----------------------------- | - |  | ---- | - |  | ---- | -
|        |  | Three MonthsEndedSeptember 30, |   |  | Nine MonthsEndedSeptember 30, |  
|        |  | 2007                           |   |  | 2006                          |   |  | 2007 |   |  | 2006 |  
|Telvent |  | 19.1                           | % |  |                              |   |  | 33.6 | % |  |     |  
|EBV     |  | 17.6                           | % |  | 32.0                          | % |  | 14.7 | % |  | 25.3 | %
|ES      |  | 14.0                           | % |  |                              |   |  | 12.2 | % |  | 0.1  | %
|Enel    |  | 12.3                           | % |  | 0.4                           | % |  | 8.8  | % |  | 16.4 | %
|        |  |                                |   |  |                               |   |  |      |   |  |      |  
|Total   |  | 63.0                           | % |  | 32.4                          | % |  | 69.3 | % |  | 41.8 | %
|        |  |                                |   |  |                               |   |  |      |   |  |      |  

The Companys contract with EBV, which has been in effect since 1997 and has been renewed
annually thereafter, expires in December 2007. Please refer to Note 13, Related Party, for additional information regarding the Companys agreement with Enel.

8. Commitments and Contingencies (As Restated)

Lease Commitments (As Restated)

As discussed in Note 3, the December 1999 and October 2000 leases of our corporate headquarters facilities are accounted for under EITF 97-10 and
SFAS 98.



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In addition, the Company leases facilities under operating leases for its sales, marketing, and product
development personnel located elsewhere within the United States and in nine foreign countries throughout Europe and Asia including a land lease for accounting purposes associated with the Companys corporate headquarters facilities. These
operating leases expire on various dates through 2018, and in some instances are cancelable with advance notice. Lastly, the Company also leases certain equipment and, for some of its sales personnel, automobiles. These operating leases are
generally less than five years in duration.

Royalties

The Company has certain royalty commitments associated with the shipment and licensing of certain of its 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 is recorded as a component of cost of product revenues in our condensed consolidated statements of operations, was approximately $133,000 during the three months ended September 30, 2007, and $142,000
for the comparable period in 2006. Royalty expense was approximately $432,000 for the nine months ended September 30, 2007, and $352,000 for the comparable period in 2006.

The Company will continue to be obligated for royalty payments in the future associated with the shipment and licensing of certain of its products. The
Company is currently unable to estimate the maximum amount of these future royalties. However, such amounts will continue to be dependent on the number of units shipped or the amount of revenue generated from these products.

Warranties

The Company typically sells its products
with a limited warranty against defects in manufacture or performance. When evaluating the 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 return rates, and historical costs of repair. In addition, certain other applicable factors, such as technical complexity, may also be taken into consideration when historical information is not yet available for recently
introduced products. Estimated reserves for warranty costs are recorded at the time of shipment. In addition, additional warranty reserves may be established when the Company becomes aware of a specific warranty related problem, such as a product
recall. Such additional warranty reserves are based on the Companys current estimate of the total out-of-pocket costs expected to be incurred to resolve the problem, including, but not limited to, costs to replace or repair the defective items
and shipping costs. The reserve for warranty costs was $211,000 as of September 30, 2007 and $224,000 as of December 31, 2006.

Guarantees

In the normal course of business, the Company provides indemnifications of varying scope to its customers against claims of
intellectual property infringement made by third parties arising from the use of its products. Historically, costs related to these indemnification provisions have not been significant. However, the Company is unable to estimate the maximum
potential impact of these indemnification provisions on its future results of operations.

As permitted under Delaware law, the Company has
entered into agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was serving, at the Companys 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 the Company could be required to make under these indemnification agreements is unlimited. However, the Company
has directors and officers insurance coverage that would enable it to recover a portion of any future amounts paid. The Company believes the estimated fair value of these indemnification agreements in excess of the applicable insurance coverage is
minimal.

Taxes

The Company conducts
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 the Companys operations in that particular
location. While the Company strives 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 accounting principles
generally accepted in the United States of America, the Company makes a provision for these exposures when it is both probable that a liability has been



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incurred and the amount of the exposure can be reasonably estimated. To date, such provisions have been immaterial, and the Company believes that, as of
September 30, 2007, it has adequately provided for such contingencies. However, it is possible that the Companys 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 the Company conducts its operations.

Legal Actions

From time to time, in the ordinary course of business, the Company is 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, the Company makes 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 the Company believes it has adequately provided for such contingencies as of September 30, 2007, the amounts of which were immaterial, it is
possible that the Companys results of operations, cash flows, and financial position could be harmed by the resolution of any such outstanding claims.

9. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and
manufacturing overhead. When required, provisions are made to reduce excess and obsolete inventories to their estimated net realizable value. Inventories consist of the following (in thousands):



|                    |  |                   |        |                  |   |       
|------------------- |  | ----------------- | ------ | ---------------- | - | ------
|                    |  | September 30,2007 |        | December 31,2006
|Purchased materials |  | $                 | 3,773  |                  | $ | 3,378 
|Work-in-process     |  |                   | 120    |                  |   | 107   
|Finished goods      |  |                   | 7,038  |                  |   | 7,874 
|                    |  |                   |        |                  |   |       
|                    |  | $                 | 10,931 |                  | $ | 11,359
|                    |  |                   |        |                  |   |       

10. Accrued Liabilities (As Restated)

Accrued liabilities consist of the following (in thousands):



|                                           |  |                                 |       |                                |   |      
|------------------------------------------ |  | ------------------------------- | ----- | ------------------------------ | - | -----
|                                           |  | September 30,2007(As Restated)1 |       | December 31,2006(As Restated)1
|Accrued payroll and related costs          |  | $                               | 3,132 |                                | $ | 2,776
|Customer deposits                          |  |                                 | 2,887 |                                |   |     
|Deferred and other tax-related liabilities |  |                                 | 1,290 |                                |   | 1,307
|Other accrued liabilities                  |  |                                 | 506   |                                |   | 713  
|                                           |  |                                 |       |                                |   |      
|                                           |  | $                               | 7,815 |                                | $ | 4,796
|                                           |  |                                 |       |                                |   |      



|(1) | See Note 2 of these Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------------

11. Segment Disclosure (As Restated)

The Company operates in one principal industry segment: the design, manufacture, and sale of control networking infrastructure products; and markets its products primarily to the building automation, industrial
automation, transportation, utility, and home automation markets. The Companys products provide the infrastructure and support required to implement and deploy open and interoperable control networks, enabling everyday devices  such as
air conditioners, appliances, electricity meters, light switches, thermostats, and valves  to be made smart and inter-connected. The Company also provides a range of services to its customers that consist of technical support, training courses
covering its networking technology and products, and custom software development.

In total, the Company offers a wide ranging set of
control networking infrastructure products and services. Any given customer may purchase a subset of such products and services that are appropriate for that customers application. For example, a utility might use the Companys Networked
Energy Services products to more



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efficiently manage its distribution grid, while another customer who installs building controls might use the Companys
LONWORKS Infrastructure transceivers and internet servers to enable the monitoring and management of building occupancy and energy consumption.

The Company manages its business primarily on a geographic basis. The Companys geographic areas are comprised of three main groups: the Americas;
Europe, Middle East and Africa (EMEA); and Asia Pacific / Japan (APJ). Each geographic area provides products and services as further described in Item 2, Managements Discussion and Analysis of Financial Condition
and Results of Operations. The Company evaluates the performance of its geographic areas based on profit or loss from operations. Profit or loss for each geographic area includes sales and marketing expenses and other charges directly attributable
to the geographic area and excludes certain expenses that are managed outside the geographic area. Costs excluded from geographic area profit or loss consist primarily of unallocated corporate expenses, which are comprised of product development
costs, corporate marketing costs, and other general and administrative expenses, which are separately managed. The Companys long-lived assets include property and equipment, goodwill, loans to certain key employees, purchased technology, and
deposits on its leased facilities. Long-lived assets are attributed to geographic areas based on the country where the assets are located. As of September 30, 2007 and December 31, 2006, long-lived assets of approximately
$38.1 million (as restated) and $37.4 million (as restated), respectively, were domiciled in the United States. Long-lived assets for all other locations are not material to the consolidated financial statements. Assets and the related
depreciation and amortization are not reported by geography because that information is not reviewed by the executive staff when making decisions about resource allocation to the geographic areas based on their performance.

The Company typically sells its products through a direct sales organization and select third-party electronics representatives in North America. Outside
North America, the Company typically sells its products through direct sales organizations in EMEA and APJ, value-added resellers, and local distributors. Revenues are attributed to geographic areas based on the country where the customer is
domiciled. Summary information by geography for the three and nine months ended September 30, 2007 and 2006 is as follows (in thousands) (as restated):



|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|------------------------------ |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                               |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                               |  | 2007                            |         |   | 2006                           |   |         | 2007 |  |   | 2006    |  
|Revenues from customers:       |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Americas                       |  | $                               | 4,544   |   |                                | $ | 5,193   |      |  | $ | 13,795  |   |  | $ | 14,688  |  
|EMEA                           |  |                                 | 15,347  |   |                                |   | 5,949   |      |  |   | 62,447  |   |  |   | 23,528  |  
|APJ                            |  |                                 | 4,822   |   |                                |   | 2,149   |      |  |   | 14,436  |   |  |   | 5,194   |  
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total                          |  | $                               | 24,713  |   |                                | $ | 13,291  |      |  | $ | 90,678  |   |  | $ | 43,410  |  
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Gross profit:                  |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Americas (As Restated)1        |  | $                               | 2,922   |   |                                | $ | 3,145   |      |  | $ | 9,120   |   |  | $ | 8,899   |  
|EMEA                           |  |                                 | 4,314   |   |                                |   | 3,347   |      |  |   | 13,374  |   |  |   | 13,302  |  
|APJ                            |  |                                 | 2,751   |   |                                |   | 1,365   |      |  |   | 8,505   |   |  |   | 3,025   |  
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total                          |  | $                               | 9,987   |   |                                | $ | 7,857   |      |  | $ | 30,999  |   |  | $ | 25,226  |  
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Income (loss) from operations: |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Americas (As Restated)1        |  | $                               | 1,902   |   |                                | $ | 1,875   |      |  | $ | 6,102   |   |  | $ | 5,486   |  
|EMEA                           |  |                                 | 2,909   |   |                                |   | 2,007   |      |  |   | 8,952   |   |  |   | 9,094   |  
|APJ                            |  |                                 | 1,662   |   |                                |   | 298     |      |  |   | 5,138   |   |  |   | (191    | )
|Unallocated                    |  |                                 | (13,166 | ) |                                |   | (11,832 | )    |  |   | (39,895 | ) |  |   | (35,972 | )
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total                          |  | $                               | (6,693  | ) |                                | $ | (7,652  | )    |  | $ | (19,703 | ) |  | $ | (21,583 | )
|                               |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  



|(1) | See Note 2 of these Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------------

Products and services sold to Enel and its designated manufacturers (see discussion of Enel below in Note 13- Related Party) accounted
for approximately $3.0 million, or 12.3% of total revenues for the three months ended September 30, 2007, and $53,000, or 0.4% for the comparable period in 2006; and $8.0 million, or 8.8% of total revenues for the nine months ended
September 30, 2007, and $7.1 million, or 16.4% for the comparable period in 2006. Of the $3.0 million and $8.0 million Enel project revenue recognized during the three and nine months ended September 30, 2007, respectively, approximately
$568,000 related to revenues generated from custom software development services, while the remaining $2.5 million and $7.5 million, respectively, related to products shipped to Enel and its designated manufacturers. There were no custom software
development services provided to Enel during the comparable periods in 2006. For the three months ended September 30, 2007, 81.3% of the revenues under the Enel program were derived from products shipped to customers in APJ, while the remaining
18.7% from products and services sold to customers in EMEA. For the nine months ended September 30, 2007, 90.0% of the revenues derived from products shipped under the Enel program were from customers in APJ and the remaining 10.0% were from
customers in EMEA.



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12. Income Taxes

We adopted FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes- an interpretation of FASB Statement No. 109, on January 1, 2007. This interpretation
prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. FIN 48 also provides guidance on de-recognition of tax benefits,
classification on the balance sheet, interest and penalties, accounting in interim periods, and disclosure and transition.

As a result of
the implementation of FIN 48, the Company recognized no material adjustment in the liability for unrecognized income tax benefits. The Company had unrecognized tax benefits of approximately $1.2 million as of January 1, 2007, all of which, if
recognized, would result in a reduction of the Companys effective tax rate. There have been no significant changes to the Companys unrecognized tax benefits since January 1, 2007.

In connection with the adoption of FIN 48, the Company will continue to include interest and penalties related to uncertain tax positions as a component
of income tax, which was immaterial for the three and nine months ended September 30, 2007. We do not believe it is reasonably possible that the Companys unrecognized tax benefits will change significantly within the next twelve months.

The Company is subject to taxation in the U.S. and various state and foreign jurisdictions. The tax years 1992-2006 remain open to
examination by the federal and most state tax authorities due to certain net operating loss and credit carryforward positions.

The
provision for income taxes for the three and nine month periods ended September 30, 2007 and 2006 includes a provision for state and foreign taxes based on the annual estimated effective tax rate applied to the Company and its subsidiaries for
the year. The difference between the statutory rate and the Companys effective tax rate is primarily due to the impact of foreign taxes and the valuation allowance on the Companys deferred tax assets.

13. Related Party

The law firm of Wilson Sonsini
Goodrich & Rosati, P.C. acts as principal outside counsel to our company. Mr. Sonsini, a director of our company, is a member of Wilson Sonsini Goodrich & Rosati, P.C.

In June 2000, the Company entered into a stock purchase agreement with Enel pursuant to which Enel purchased 3.0 million newly issued shares of our
common stock. At the same time, the Company also entered into a Research and Development and Technological Cooperation 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 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 Echelon. Under the
software enhancement agreement, the Company provides software enhancements to Enel for use in its Contatore Elettronico system. Both the new development and supply agreement and the software enhancement agreement expire in December 2009, although
delivery of products and services can extend beyond that date and the agreements may be extended under certain circumstances.

Revenues
associated with sales made to Enel and its designated manufacturers for the three and nine months ended September 30, 2007 and 2006 are discussed above in Note 11  Segment Disclosure. As of September 30, 2007 and September 30,
2006, $158,000 and $4.1 million, respectively, of the Companys total accounts receivable balance related to amounts owed by Enel and its designated manufacturers.



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##### Table of Contents

|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this
Quarterly Report. The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business. These statements may be identified by the use of words such as
we believe, expect, anticipate, intend, plan, goal, continues, may, and similar expressions. In addition, 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. Such statements are based on our current expectations and could be
affected by the uncertainties and risk factors described throughout this filing and particularly in the Factors That May Affect Future Results Of Operations section. Our actual results may differ materially.

RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS

During the preparation of our financial results for the quarter ended March 31, 2008, we identified an error in our previously reported equity compensation expense and determined we had inappropriately accounted
for the 1999 and 2001 leases of our San Jose, California corporate headquarters facilities.

Restatement of stock-based compensation
expense:We identified an error in our previously reported stock-based compensation expense for the years ended December 31, 2007, 2006 and 2005 and each of the quarterly periods in 2007 and 2006. The error was isolated to share awards
and does not affect the other forms of our equity compensation awards, namely stock options and stock-settled stock appreciation rights. While the grant date fair value of the share awards was determined correctly in accordance with Statement of
Financial Accounting Standard (SFAS) No. 123R (revised 2004), Share-Based Payment (SFAS 123R), the amount of expense associated with these awards that was recognized in 2007, 2006 and 2005 was not correct.
The error was caused by a misapplication of the widely-used equity compensation software application we use to manage and account for our equity compensation awards. This misapplication caused the expense associated with these share awards to be
calculated using the straight-line, single-option method rather than the accelerated, multiple-option method, which we had elected to use for all of our equity compensation awards. Use of the straight-line, single-option method resulted in
understatements of stock-based compensation expense in 2007, 2006 and 2005 of $1.2 million, $535,000 and $263,000, respectively. For the three months ended September 30, 2007 and 2006, stock-based compensation expense was understated by
$281,000 and $107,000, respectively. For the nine months ended September 30, 2007 and 2006, stock-based compensation expense was understated by $622,000 and $416,000, respectively.

Restatement related to the leases of our San Jose, California headquarters facilities: In connection with the restatement of stock-based
compensation expense, KPMG LLP, our independent registered public accounting firm, brought to our attention that we had inappropriately accounted for the leases of our corporate headquarters facilities that were entered into in 1999 and 2001. Under
the guidance in Emerging Issues Task Force Issue No. 97-10,The Effect of Lessee Involvement in Asset Construction (EITF 97-10), and SFAS No. 98,Accounting for Leases: Sale-Leaseback transactions Involving Real
Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases; an amendment of FASB Statements No. 13, 66, and 91 and a rescission of FASB Statement No. 26 and Technical Bulletin
No. 79-11 (SFAS 98), we should have reflected an asset on our balance sheet for the costs paid by the lessor to construct our headquarters facilities, as well as a corresponding liability, because we were the deemed
owner of the headquarters facilities for accounting purposes during the construction periods. Upon completion of construction, we did not meet the sale-leaseback criteria under SFAS 98 and therefore should have treated the leases
as financing obligations and the assets and corresponding liabilities would not be derecognized. We had historically accounted for these leases as operating leases under SFAS No. 13, Accounting for Leases(SFAS 13), whereby
the total minimum lease payment obligations under the leases were recognized as monthly rent expense on a straight-line basis over the terms of the leases.The restatement adjustments do not affect the total cash payments we have made or are
obligated to make under the lease agreements, nor do they change the total expense to be recognized over the lease terms. However, the timing and nature of expenses in the statement of operations is different under this treatment as compared to
operating lease treatment. Specifically, we should have recognized land lease expense, depreciation expense on the assets we are deemed to own and interest expense on the associated lease financing obligations.



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Our management and the Audit Committee of our Board of Directors have concluded that these errors in our
consolidated financial statements were unintentional, and no misdeed or fraud was involved in any respect. The Audit Committee also determined that the error in stock-based compensation expense was in no way caused by any backdating of or similar
improper activity involving stock option grants.

Therefore we have restated our condensed consolidated balance sheets as of
September 30, 2007, and December 31, 2006, and our condensed consolidated statements of operations and cash flows for the three- and nine-month periods ended September 30, 2007 and 2006, to reflect the restatement adjustments
applicable to those periods. We will also file amendments to our 2007 Form 10-K and Forms 10-Q for each of the quarters ended March 31 and June 30, 2007. The amended 2007 filings will include restated information for the periods
affected by these restatements.

The effects of all restatement adjustments on our condensed consolidated balance sheets as of
September 30, 2007, and December 31, 2007 and 2006 are as follows:



|                                       |  |                   |              |              |      |              |  |   |             
|-------------------------------------- |  | ----------------- | ------------ | ------------ | ---- | ------------ |  | - | ------------
|                                       |  | September 30,2007 |              | December 31,
|                                       |  |                   | 2007         |              | 2006
|Increase in total assets               |  | $                 | 12.9 million |              | $    | 12.3 million |  | $ | 15.0 million
|Increase in total liabilities          |  | $                 | 15.9 million |              | $    | 15.2 million |  | $ | 17.9 million
|Increase in additional paid-in-capital |  | $                 | 1.4 million  |              | $    | 2.0 million  |  | $ | 0.8 million 
|Increase in accumulated deficit        |  | $                 | 4.4 million  |              | $    | 4.9 million  |  | $ | 3.7 million 

The effects of all restatement adjustments on our condensed consolidated statements of operations
for the three- and nine-month periods ended September 30, 2007 and 2006 are as follows:



|                                             |  |                                 |             |                                |   |             |  |      |             |  |   |            
|-------------------------------------------- |  | ------------------------------- | ----------- | ------------------------------ | - | ----------- |  | ---- | ----------- |  | - | -----------
|                                             |  | Three Months EndedSeptember 30, |             | Nine Months EndedSeptember 30,
|                                             |  | 2007                            |             | 2006                           |   | 2007        |  | 2006
|Decrease in rent expense                     |  | $                               | 1.0 million |                                | $ | 1.0 million |  | $    | 3.0 million |  | $ | 3.0 million
|Increase in depreciation expense             |  | $                               | 0.7 million |                                | $ | 0.7 million |  | $    | 2.0 million |  | $ | 2.0 million
|Increase in stock-based compensation expense |  | $                               | 0.3 million |                                | $ | 0.1 million |  | $    | 0.7 million |  | $ | 0.4 million
|Increase in interest expense                 |  | $                               | 0.3 million |                                | $ | 0.3 million |  | $    | 0.9 million |  | $ | 1.0 million
|Increase in net loss                         |  | $                               | 0.3 million |                                | $ | 0.1 million |  | $    | 0.7 million |  | $ | 0.5 million

The correction of the accounting for our San Jose, California headquarters facilities leases
required us to calculate the adjustments by year beginning with the year ended December 31, 2000. The cumulative effect of the restatement adjustments related to the lease accounting errors for the years 2000 through 2004 is reported as a
$2.5 million increase to the 2005 beginning accumulated deficit balance. The financial statement effects of all restatement adjustments by year are summarized in the following table (in thousands):



|                                                  |  |                                           |                                       |                                                  |   |                                |   |                            |   |        |  |   |       |  |   |      
|------------------------------------------------- |  | ----------------------------------------- | ------------------------------------- | ------------------------------------------------ | - | ------------------------------ | - | -------------------------- | - | ------ |  | - | ----- |  | - | -----
|                                                  |  | Increase instock-basedcompensationexpense |                                       | Adjustments related to errors in leaseaccounting |   | Net increase inexpense        
|Fiscal Year                                       |  |                                           | Net increase(decrease) inrent expense |                                                  |   | Increase indepreciationexpense |   | Increase ininterestexpense |  
|2000                                              |  | $                                         |                                      |                                                  | $ | 281                            |   |                            | $ |       |  | $ |      |  | $ | 281  
|2001                                              |  |                                           |                                      |                                                  |   | 31                             |   |                            |   | 301    |  |   | 199   |  |   | 531  
|2002                                              |  |                                           |                                      |                                                  |   | (1,606                         | ) |                            |   | 1,204  |  |   | 945   |  |   | 543  
|2003                                              |  |                                           |                                      |                                                  |   | (3,173                         | ) |                            |   | 2,344  |  |   | 1,483 |  |   | 654  
|2004                                              |  |                                           |                                      |                                                  |   | (3,948                         | ) |                            |   | 2,724  |  |   | 1,666 |  |   | 442  
|                                                  |  |                                           |                                       |                                                  |   |                                |   |                            |   |        |  |   |       |  |   |      
|Cumulative effect of restatement on prior periods |  |                                           |                                      |                                                  |   | (8,415                         | ) |                            |   | 6,573  |  |   | 4,293 |  |   | 2,451
|2005                                              |  |                                           | 263                                   |                                                  |   | (3,947                         | ) |                            |   | 2,723  |  |   | 1,530 |  |   | 569  
|2006                                              |  |                                           | 535                                   |                                                  |   | (3,948                         | ) |                            |   | 2,724  |  |   | 1,379 |  |   | 690  
|2007                                              |  |                                           | 1,173                                 |                                                  |   | (3,948                         | ) |                            |   | 2,724  |  |   | 1,211 |  |   | 1,160
|                                                  |  |                                           |                                       |                                                  |   |                                |   |                            |   |        |  |   |       |  |   |      
|                                                  |  | $                                         | 1,971                                 |                                                  | $ | (20,258                        | ) |                            | $ | 14,744 |  | $ | 8,413 |  | $ | 4,870
|                                                  |  |                                           |                                       |                                                  |   |                                |   |                            |   |        |  |   |       |  |   |      



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Included in Note 2 of Notes to Condensed Consolidated Financial Statements in this Report are tables that
present the effects of all restatement adjustments on the condensed consolidated financial statements reconciling the previously reported data to the as restated data for the Condensed Consolidated Balance Sheets as of September 30,
2007 and December 31, 2006, and the Condensed Consolidated Statements of Operations and Cash Flows for the three- and nine-month periods ended September 30, 2007 and 2006.

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 nine foreign countries throughout Europe and Asia. We develop, market, and sell system and network infrastructure products
that enable everyday devices  such as air conditioners, appliances, electricity meters, light switches, thermostats, and valves  to be made smart and inter-connected. Working together, products and systems equipped with our technology
can monitor and save energy, lower costs, improve productivity and enhance service, quality, safety and convenience. We offer these hardware and software products and related services to OEMs and systems integrators in the building, industrial,
transportation, utility/home, and other automation markets.

We have been investing in products for use by electricity utilities in
management of electricity distribution. We refer to these products (and related services) as our networked energy services, or NES, offerings. We began to receive modest amounts of NES revenue in 2004, which increased to approximately $883,000 in
2005 and decreased slightly to $791,000 in 2006. During the first nine months of 2007, NES revenue increased significantly to $42.9 million due primarily to an increase in NES product shipments, as well as the recognition of a substantial
amount of NES revenues that were deferred at the end of 2006 related to NES products that had been shipped but for which the revenue recognition criteria had not yet been met. We sell certain of our products to Enel and certain suppliers of Enel for
use in Enels Contatore Elettronico electricity meter management project in Italy. We refer to Echelons revenue derived from sales to Enel and Enels designated manufacturers as Enel Project revenue. We refer to all other revenue as
LONWORKS Infrastructure, or LWI, revenue. We also provide a variety of technical training courses related to our products and the underlying technology. Some of our customers also rely on us to provide customer support
on a per-incident or term contract basis.

During the first and second quarters of 2006, we revised our revenue recognition methodology for
sales made to the distributors of our LWI products. Under the revised methodology, we now defer revenue, as well as cost of goods sold, on items shipped to these distributors that remain in their inventories at quarter-end. The revision
significantly reduced our first and second quarter 2006 revenues, but did not have an impact on cash flows from operations or require any changes to our historical financial statements. A more thorough explanation of this revision can be found later
in this Quarterly Report in the sections of our discussion on Results of Operations entitled LONWORKS Infrastructure revenues and EBV revenues.

We have a history of losses and incurred a net loss for the three and nine months ended September 30, 2007 and expect to incur an operating loss for
the full year ending December 31, 2007. This expectation is due primarily to two factors. First, while we expect our 2007 NES revenues will increase substantially compared to those generated in 2006, we do not currently expect that the gross
profit generated from these increased sales will be substantial enough to return us to an operating profit for the full year ending December 31, 2007. This is due to the fact that, in general, gross margins generated from sales of our NES
products tend to be much lower than those generated from our other revenue sources.

The second factor contributing to our expectation for
losses in 2007 relates to the fact that, effective January 1, 2006, we began recording compensation expense associated with stock options and other forms of equity compensation as required under Statement of Financial Accounting Standards
No. 123R (SFAS 123R), Share-Based Payment. For the year ended December 31, 2006, the adoption of this new accounting standard resulted in an increase in equity compensation expenses of approximately $4.6 million as
compared to the comparable period in 2005. Expenses associated with equity-based compensation were $1.8 million and $4.7 million for the three and nine months ended September 30, 2007, respectively, as compared to $1.1 million and $4.1 million
for the comparable periods in 2006. We expect equity compensation expense for the full year ending December 31, 2007 will be higher than the $5.5 million recognized in 2006, which will in turn contribute negatively to our efforts to return to
profitability.



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CRITICAL ACCOUNTING ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our revenues, allowance for doubtful accounts, inventories, commitments and
contingencies, income taxes, and asset impairments. 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 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.

Stock-Based Compensation. Effective January 1, 2006, we adopted the provisions of and account for stock-based compensation in accordance with
SFAS 123R. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date
based on the estimated fair value of the award and is recognized as expense ratably over the requisite service period, which is the vesting period.

We currently use the Black-Scholes-Merton (BSM) option-pricing model to estimate the fair value of stock options. The estimation of fair value of share-based payment awards on the date of grant using the BSM option-pricing model
is affected by the fair market value of our stock on the date of grant, as well as a number of highly complex and subjective variables. These variables include the expected term of the option, the expected volatility of our stock price over the
expected term of the option, risk-free interest rates, and expected dividends.

We estimate the expected term of options granted using the
simplified method as illustrated in SEC Staff Accounting Bulletin No. 107 (SAB 107). Under the simplified method, the expected term is calculated by taking the average of the vesting term and the contractual term of the option. The
expected volatility is based on the historical volatility of our common stock over the most recent period commensurate with the expected term of the option, and does not consider any implied volatility as there are currently no market traded options
on our stock that meet the criteria required for reliance on implied volatility in accordance with SAB 107. We base the risk-free interest rate that we use in the BSM option-pricing model on U.S. Treasury issues in effect at the time of option grant
that have remaining terms similar to the expected term of the option. We have never paid cash dividends on our common stock, and do not anticipate paying cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero
in the BSM option-pricing model.

SFAS 123R also requires us to record compensation expense for stock-based compensation net of estimated
forfeitures, and to revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards
that are expected to vest. All share-based payment awards are amortized using the multiple option method over their requisite service period, which is generally the vesting period.

There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This
may result in a lack of consistency in future periods and may materially affect the estimated fair value of stock-based payments. It may also result in a lack of comparability with other companies that use different models, methods, and assumptions.
The BSM option-pricing model was developed for use in estimating the fair value of traded options that have no vesting or hedging restrictions and that are fully transferable, characteristics that are not present in our option grants.

If factors change and we employ different assumptions for estimated stock-based compensation expense in future periods, or if we decide to use a
different option-pricing model, stock-based compensation expense in those future periods may differ significantly from what we have recorded in the current period and could materially affect our operating results and earnings per share.



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Sales Returns and Allowances. We sell our products and services to OEMs, systems integrators, and our other
customers directly through our sales force and indirectly through distributors located in the geographic markets that we serve. Net revenues consist of product and service revenues reduced by estimated sales returns and allowances. Provisions for
estimated sales returns and allowances are recorded at the time of sale, and are based on managements estimates of potential future product returns and allowances (such as pricing credits to certain of our distributor partners) related to
product revenues in the current period. In evaluating the adequacy of our sales returns and other allowances, management analyzes historical returns, current and historical economic trends, contractual terms, and changes in customer demand and
acceptance of our products.

Other than standard warranty repair work, Enel and its designated contract meter manufacturers do not have
rights to return products we ship to them. However, our agreement with Enel contains an acceptance provision, whereby Enel is entitled to inspect products we ship to them to ensure the products conform, in all material respects, to the
products specifications. Once the product has been inspected and approved by Enel, or if the acceptance period lapses before Enel inspects or approves the products, the goods are considered accepted. Prior to shipping our products to Enel, we
perform detailed reviews and tests to ensure the products will meet Enels acceptance criteria. We do not ship products unless they have passed these reviews and tests. As a result, we record revenue for these products upon shipment to Enel. If
Enel were to subsequently properly reject any material portion of a shipment for not meeting the agreed upon specifications, we would defer the revenue on that portion of the transaction until such time as Enel and we were able to resolve the
discrepancy. Such a deferral could have a material impact on the amount and timing of our Enel related revenues.

Our allowances for sales
returns and other sales-related reserves were approximately $730,000 as of September 30, 2007, and $791,000 as of December 31, 2006.

Allowance for Doubtful Accounts. We typically sell our products and services to customers with net 30-day payment terms. In certain instances, payment terms may extend to as much as net 90 days. For a customer whose credit-worthiness
does not meet our minimum criteria, we may require partial or full payment prior to shipment. Alternatively, customers may be required to provide us with an irrevocable letter of credit prior to shipment.

We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific
customers inability to meet its financial obligations to us, we record a specific allowance against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. These determinations are made based
on several sources of information, including, but not limited to, a specific customers payment history, recent discussions we have had with the customer, updated financial information for the customer, and publicly available news related to
that customer. For all other customers, we recognize allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, the credit-worthiness of our overall customer base, changes in our
customers payment patterns, and our historical experience. If the financial condition of our customers were to deteriorate, or if general economic conditions were to worsen, additional allowances may be required in the future, which could
materially impact our results of operations and financial condition. Our allowance for doubtful accounts was $290,000 as of September 30, 2007, and $250,000 as of December 31, 2006.

Inventory Valuation. At each balance sheet date, we evaluate our ending inventories for excess quantities and obsolescence. This evaluation includes analyses of
sales levels by product and projections of future demand. Inventories on hand, in excess of one years forecasted demand, are not valued. In addition, we write off 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.



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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 $211,000 as of September 30, 2007, and $224,000 as of December 31, 2006.

Deferred Income Taxes. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Based on our
historical net operating losses, and the uncertainty of our future operating results, we have recorded a valuation allowance that fully reserves our deferred tax assets. If we later determine that, more likely than not, some or all of the net
deferred tax assets will be realized, we would then need to reverse some or all of the previously provided valuation allowance. Our deferred tax asset valuation allowance was $61.2 million as of December 31, 2006.

Valuation of Goodwill. We assess the impairment of goodwill on an annual basis during the quarter ending March 31 and whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:



| |  |  | significant underperformance relative to expected historical or projected future operating results;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | significant changes in the manner or use of the acquired assets or the strategy for our overall business;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | significant negative industry or economic trends; and
| | - |  | -----------------------------------------------------



| |  |  | significant changes in the composition of the intangible assets acquired.
| | - |  | -------------------------------------------------------------------------

Our review during the quarter ended March 31, 2007 indicated no impairment. If, as a result of an annual or any other impairment review that we
perform in the future, we determine that there has been an impairment of our goodwill, we would be required to take an impairment charge. Such a charge could have a material adverse impact on our financial position and/or operating results.



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RESULTS OF OPERATIONS

The following table reflects the percentage of total revenues represented by each item in our Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2007 and September 30, 2006:



|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|----------------------------------------------- |  | ---------------------------------------------- | -- |  | --------------------------------------------- | -- |  | ----- | -- |  | ----- | --
|                                                |  | Three Months EndedSeptember 30,(As Restated) 1 |    |  | Nine Months EndedSeptember 30,(As Restated) 1 |   
|                                                |  | 2007                                           |    |  | 2006                                          |    |  | 2007  |    |  | 2006  |   
|Revenues:                                       |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Product                                         |  | 96.0                                           | %  |  | 98.7                                          | %  |  | 98.4  | %  |  | 98.8  | % 
|Service                                         |  | 4.0                                            |    |  | 1.3                                           |    |  | 1.6   |    |  | 1.2   |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Total revenues                                  |  | 100.0                                          |    |  | 100.0                                         |    |  | 100.0 |    |  | 100.0 |   
|                                                |  |                                                |    | 
|Cost of revenues:                               |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Cost of product                                 |  | 56.7                                           |    |  | 37.1                                          |    |  | 63.9  |    |  | 38.7  |   
|Cost of service                                 |  | 2.9                                            |    |  | 3.8                                           |    |  | 1.9   |    |  | 3.2   |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Total cost of revenues                          |  | 59.6                                           |    |  | 40.9                                          |    |  | 65.8  |    |  | 41.9  |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Gross profit                                    |  | 40.4                                           |    |  | 59.1                                          |    |  | 34.2  |    |  | 58.1  |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Operating expenses:                             |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Product development                             |  | 31.6                                           |    |  | 51.4                                          |    |  | 26.2  |    |  | 48.2  |   
|Sales and marketing                             |  | 19.8                                           |    |  | 38.2                                          |    |  | 16.8  |    |  | 35.4  |   
|General and administrative                      |  | 16.1                                           |    |  | 27.1                                          |    |  | 12.9  |    |  | 24.2  |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Total operating expenses                        |  | 67.5                                           |    |  | 116.7                                         |    |  | 55.9  |    |  | 107.8 |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Loss from operations                            |  | (27.1                                          | )  |  | (57.6                                         | )  |  | (21.7 | )  |  | (49.7 | ) 
|Interest and other income, net                  |  | 5.6                                            |    |  | 12.0                                          |    |  | 4.8   |    |  | 10.1  |   
|Interest expense on lease financing obligations |  | (1.2                                           | )  |  | (2.6                                          | )  |  | (1.0  | )  |  | (2.4  | ) 
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Loss before provision for income taxes          |  | (22.7                                          | )  |  | (48.2                                         | )  |  | (17.9 | )  |  | (42.0 | ) 
|Income tax expense                              |  | 0.4                                            |    |  | 0.6                                           |    |  | 0.4   |    |  | 0.6   |   
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   
|Net loss                                        |  | (23.1                                          | %) |  | (48.8                                         | %) |  | (18.3 | %) |  | (42.6 | %)
|                                                |  |                                                |    |  |                                               |    |  |       |    |  |       |   



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

Revenues

Total Revenues



|                       |  |                    |        |                       |   |                       |  |   |        |  |       |  
|---------------------- |  | ------------------ | ------ | --------------------- | - | --------------------- |  | - | ------ |  | ----- | -
|                       |  | Three Months Ended |        | 2007 over2006 $Change |   | 2007 over2006 %Change | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006     |   |                      
|Total Revenues         |  | $                  | 24,713 |                       | $ | 13,291                |  | $ | 11,422 |  | 85.9  | %
|                       |  |                    |       
|                       |  | Nine Months Ended  |        | 2007 over2006 $Change |   | 2007 over2006 %Change | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006     |   |                      
|Total Revenues         |  | $                  | 90,678 |                       | $ | 43,410                |  | $ | 47,268 |  | 108.9 | %

The $11.4 million increase in total revenues for the three months ended September 30, 2007 as
compared to the comparable period in 2006 was primarily the result of an $8.4 million increase in NES revenues and a $3.0 million increase in Enel Project revenues. The $47.3 million increase in total revenues for the nine months ended
September 30, 2007 as compared to the comparable period in 2006 was primarily the result of a $42.2 million increase in NES revenues, a $4.1 million increase in LONWORKS Infrastructure revenues, and a $920,000
increase in Enel Project revenues.



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NES revenues



|                       |  |                    |        |                   |   |                       |  |                       |        |  |         |  
|---------------------- |  | ------------------ | ------ | ----------------- | - | --------------------- |  | --------------------- | ------ |  | ------- | -
|                       |  | Three Months Ended |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |       
|NES revenues           |  | $                  | 8,624  |                   | $ | 199                   |  | $                     | 8,425  |  | 4,233.7 | %
|                       |  |                    |       
|                       |  | Nine Months Ended  |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |       
|NES revenues           |  | $                  | 42,896 |                   | $ | 693                   |  | $                     | 42,203 |  | 6,089.9 | %

NES revenues recognized during the three and nine months ended September 30, 2007 were
primarily related to large scale deployments of our NES system products. NES revenues recognized during the three and nine months ended September 30, 2006 were primarily related to the completion of system trials and, to a lesser extent,
shipments of NES products.

We expect that, during the remainder of 2007, shipments of our NES products will continue to increase over 2006
levels. Our ability to recognize revenue on these shipments depends on several factors, including, but not limited to, delivery to the customer of all of the software called for in any given agreement, modification of the existing shipment schedules
included in the contracts that have been awarded to us thus far, and certain contractual provisions, such as customer acceptance. In addition, the complex revenue recognition rules relating to products such as our NES system will likely require us
to defer some or all of the revenue associated with NES product shipments until certain conditions are met in a future period. In some instances, the reasons for these deferrals may not be fully under our control, which could result in the actual
timing of revenue being significantly different than we currently anticipate.

We also expect that some foreign utilities will require us
to price our NES system in the respective utilitys local currency, which will expose us to foreign currency risk. For the nine months ended September 30, 2007, the portion of our NES revenue transactions conducted in
currencies other than the U.S. dollar, principally the Australian dollar, was about $298,000, or 0.7%. There were no NES revenue transactions conducted in foreign currencies during the nine months ended September 30, 2006. In most cases, in the
event of a significant contract award, we intend to hedge this foreign currency risk so long as we can secure forward currency contracts that are reasonably priced and that are consistent with the scheduled deliveries for that project. In addition,
we will face foreign currency exposures from the time we submit our foreign currency denominated bid until the award of a contract by the utility (the bid to award term). This bid to award term can often exceed several months. If a
utility awards us a contract that gives the utility the right to exercise options for additional supply in the future, we would also be exposed to foreign currency risk until such time as these options, if any, were exercised. We may decide that it
is too expensive to hedge the foreign currency risks during the bid to award term or for any unexercised options. Any resulting adverse foreign currency fluctuations could significantly harm our revenues, results of operations, and financial
condition.

LONWORKS Infrastructure revenues



|                                 |  |                    |        |                   |   |                       |  |                       |       |  |      |  
|-------------------------------- |  | ------------------ | ------ | ----------------- | - | --------------------- |  | --------------------- | ----- |  | ---- | -
|                                 |  | Three Months Ended |        |                   |   |                       | 
|(Dollars in thousands)           |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|LONWORKS Infrastructure Revenues |  | $                  | 13,054 |                   | $ | 13,040                |  | $                     | 14    |  | 0.1  | %
|                                 |  |                    |       
|                                 |  | Nine Months Ended  |        |                   |   |                       | 
|(Dollars in thousands)           |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|LONWORKS Infrastructure Revenues |  | $                  | 39,759 |                   | $ | 35,614                |  | $                     | 4,145 |  | 11.6 | %



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##### Table of Contents

Our LONWORKS Infrastructure revenues are primarily comprised of sales of
our hardware and software products, and to a lesser extent, revenues we generate from our customer support and training offerings. The $4.1 million increase in LONWORKS Infrastructure revenues for the nine months
ended September 30, 2007 as compared to the comparable period in 2006 was primarily attributable to the one-time effect of revisions we made in 2006 to our revenue recognition methodology for sales made to our distributor partners. During the
first quarter of 2006, we modified our revenue recognition method for sales made to our European distributor, EBV (see EBV revenue discussion below). Under the revised method, revenue on sales made to EBV is deferred until EBV sells the products
through to its end use customers. During the second quarter of 2006, we completed a similar revision to our revenue recognition methodology for sales made to our Asian distributor partners. This revision was necessary as, during the quarter, we
modified our agreements with our Asian distributor partners. These contractual modifications, which allow the distributors to return certain of their excess inventory, were made to address changing business conditions in our Asian markets and to
expand our customer base there. The revenue recognition methodology revisions for EBV and our Asian distributors resulted in one-time reductions in revenue of approximately $3.9 million during the nine months ended September 30, 2006.

Excluding the impact of these revenue recognition revisions, LONWORKS Infrastructure revenues increased by
approximately $245,000 for the nine months ended September 30, 2007 as compared to the comparable period in 2006. We believe the $245,000 increase between the two nine-month periods is due, at least in part, to our customers utilization
of our products in new applications, such as energy management and street lighting controls.

Also impacting the fluctuations in
LONWORKS Infrastructure revenues between the two nine month periods ended September 30, 2007 and 2006, were the unfavorable impacts of exchange rates on sales made in foreign currencies, principally the Japanese
Yen. These exchange rate fluctuations resulted in a $42,000 decrease between the two nine month periods. The impact of exchange rate fluctuations between the two three month periods ended September 30, 2007 and 2006 was negligible.

We believe that, as long as current worldwide economic conditions do not deteriorate, full year 2007 LONWORKS
Infrastructure revenues will improve from the $49.4 million recorded in 2006. This expected improvement is primarily related to the fact that, as discussed above, in 2006 we revised our revenue recognition methodology for sales made to our
distributor partners, which had the one-time effect of reducing 2006 revenue by approximately $3.9 million.

Excluding the impact of the
2006 revenue recognition revision, we still currently expect full year 2007 LONWORKS Infrastructure revenues will improve modestly over amounts recorded in 2006. This expected improvement, however, will be subject to
further fluctuations in exchange rates between the U.S. dollar and the foreign currencies in which we generate revenues, principally the Japanese Yen. If the U.S. dollar were to strengthen against these currencies, our revenues would decrease.
Conversely, if the U.S. dollar were to weaken against these currencies, our revenues would increase. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of sales conducted in foreign currencies and the
magnitude of the exchange rate fluctuation from year to year. Through the first nine months of 2007, the portion of our LONWORKS Infrastructure revenues conducted in currencies other than the U.S. dollar, principally
the Japanese Yen, was about 6.9% as compared to 6.4% for the comparable period in 2006. We do not currently expect that, during the remainder of 2007, the amount of our LONWORKS Infrastructure revenues conducted in
these or other foreign currencies will fluctuate significantly from that experienced in 2006. 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 LONWORKS Infrastructure 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.



30



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Enel Project revenues



|                       |  |                    |       |                   |   |                       |  |                       |       |  |         |  
|---------------------- |  | ------------------ | ----- | ----------------- | - | --------------------- |  | --------------------- | ----- |  | ------- | -
|                       |  | Three Months Ended |       |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|Enel Project Revenues  |  | $                  | 3,036 |                   | $ | 53                    |  | $                     | 2,983 |  | 5,628.3 | %
|                       |  |                    |      
|                       |  | Nine Months Ended  |       |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|Enel Project Revenues  |  | $                  | 8,023 |                   | $ | 7,103                 |  | $                     | 920   |  | 13.0    | %

In October 2006, we entered into two new 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. There were no revenues from either of these new agreements during 2006. The $3.0 million and $8.0 million of Enel project revenue recognized during the quarter and nine months ended
September 30, 2007, respectively, related primarily to shipments under the new development and supply agreement, and to a lesser extent, from revenues attributable to the software enhancement agreement. Both the development and supply agreement
and the software enhancement agreement expire on December 31, 2009, although delivery of products and services can extend beyond that date and the agreements may be extended under certain circumstances.

Early in 2006, Enel asked us to provide them with spare parts for use in their system in Italy. The $53,000 and $7.1 million of Enel project revenue
recognized during the three and nine months ended September 30, 2006, respectively, represent shipments we made against that request. 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.

We believe that during the remainder of 2007, revenues attributable to the Enel
project will continue to increase over the $7.1 million reported in 2006, and will relate primarily to products shipped under the new development and supply agreement.

EBV revenues



|                       |  |                    |        |                   |   |                       |  |                       |       |  |      |  
|---------------------- |  | ------------------ | ------ | ----------------- | - | --------------------- |  | --------------------- | ----- |  | ---- | -
|                       |  | Three Months Ended |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|EBV Revenues           |  | $                  | 4,340  |                   | $ | 4,255                 |  | $                     | 85    |  | 2.0  | %
|                       |  |                    |       
|                       |  | Nine Months Ended  |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |      
|EBV Revenues           |  | $                  | 13,348 |                   | $ | 10,965                |  | $                     | 2,383 |  | 21.7 | %

Sales to EBV, our largest distributor and the sole independent distributor of our products in
Europe, accounted for 17.6% of our total revenues for the three months ended September 30, 2007 and 32.0% of our total revenues for the comparable period in 2006; and 14.7% of our total revenues for the nine months ended September 30, 2007
and 25.3% for the comparable period in 2006. While EBV revenues increased by only 2.0% during the quarter ended September 30, 2007 as compared to the comparable period in 2006, they increased substantially during the nine months ended
September 30, 2007 as compared to the comparable period in 2006. The primary factor contributing to the $2.4 million increase between the two nine-month periods was the fact that, during the first quarter of 2006, we revised our revenue
recognition methodology for sales made to EBV. Under the revised methodology, revenues, as well as cost of goods sold, are deferred on items shipped to EBV that remain in EBVs inventories at quarter-end. Revenue is then recognized on these
products, along with the corresponding gross margin, when EBV sells them to its customers in future periods. This revision resulted in a one-time revenue decrease of approximately $2.9 million for the quarter ended March 31, 2006. The revision
did not have an impact on cash flows from operations or require any changes to historical financial statements.



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Excluding the impact of the accounting method revision, EBVs shipments to its customers decreased
by approximately $517,000 during the first nine months of 2007 as compared to the comparable period in 2006. We believe this decrease is the result of the Restriction of Hazardous Substances, or RoHS, regulations, which became effective in the
European Union July 1, 2006. Under these new rules, manufacturers such as Echelon were required to eliminate certain hazardous substances (e.g., lead, cadmium, mercury, etc.) from the products they sell into the region. We believe that many of
EBVs customers increased their purchases of our non-RoHS compliant products during the first half of 2006, prior to effective date of the new regulations. This resulted in a high level of EBV revenue during the first half of 2006.

We currently sell our products to EBV in U.S. dollars. Therefore, the associated revenues are not subject to foreign currency exchange rate risks.
However, EBV has the right, on notice to our company, to require that we sell our products to them in Euros.

Our contract with EBV, which
has been in effect since 1997 and to date has been renewed annually thereafter, expires in December 2007. If our agreement with EBV is not renewed, or is renewed on terms that are less favorable to us, our revenues could decrease and our future
financial position could be harmed.

Product revenues



|                       |  |                    |        |                   |   |                       |  |                       |        |  |       |  
|---------------------- |  | ------------------ | ------ | ----------------- | - | --------------------- |  | --------------------- | ------ |  | ----- | -
|                       |  | Three Months Ended |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |       
|Product Revenues       |  | $                  | 23,733 |                   | $ | 13,110                |  | $                     | 10,623 |  | 81.0  | %
|                       |  |                    |       
|                       |  | Nine Months Ended  |        |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |        | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |       
|Product Revenues       |  | $                  | 89,247 |                   | $ | 42,893                |  | $                     | 46,354 |  | 108.1 | %

The $10.6 million increase in product revenues for the three months ended September 30, 2007
as compared to the comparable period in 2006 was primarily the result of an $8.2 million increase in NES product revenues and a $2.4 million increase in Enel Project product revenues. The $46.4 million increase in product revenues for the nine
months ended September 30, 2007 as compared to the comparable period in 2006 was primarily the result of a $41.9 million increase in NES product revenues, a $4.1 million increase in LONWORKS Infrastructure
product revenues, and a $353,000 increase in Enel Project product revenues.

Service revenues



|                       |  |                    |       |                   |   |                       |  |                       |     |  |       |  
|---------------------- |  | ------------------ | ----- | ----------------- | - | --------------------- |  | --------------------- | --- |  | ----- | -
|                       |  | Three Months Ended |       |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |    
|Service Revenues       |  | $                  | 980   |                   | $ | 181                   |  | $                     | 799 |  | 441.4 | %
|                       |  |                    |      
|                       |  | Nine Months Ended  |       |                   |   |                       | 
|(Dollars in thousands) |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |    
|Service Revenues       |  | $                  | 1,431 |                   | $ | 517                   |  | $                     | 914 |  | 176.8 | %

The $799,000 increase in service revenues during the three months ended September 30, 2007 as
compared to the comparable period in 2006, and the $914,000 increase during the nine months ended September 30, 2007 as compared to the comparable period in 2006, were primarily due to approximately $568,000 of custom software development
revenues generated from the Enel Project. To a lesser extent, NES support revenue increases of $201,000 and $338,000 for the three and nine months ended September 30, 2007, respectively, also contributed to



32



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##### Table of Contents

the increase in service revenues between the periods. Primarily due to the Enel software enhancement project, as well as increases in NES service revenues
associated with our large scale deployment projects, we currently expect that our full year 2007 service revenues will increase from the $761,000 recorded in 2006.

Gross Profit and Gross Margin (As Restated)



|                       |  |                                  |        |   |                                  |   |        |                         |  |                         |       |  |       |  
|---------------------- |  | -------------------------------- | ------ | - | -------------------------------- | - | ------ | ----------------------- |  | ----------------------- | ----- |  | ----- | -
|                       |  | Three Months Ended               |        |   |                                  |   |        |                        
|(Dollars in thousands) |  | September 30,2007(As Restated) 1 |        |   | September 30,2006(As Restated) 1 |   |        | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|Gross Profit           |  | $                                | 9,987  |   |                                  | $ | 7,857  |                         |  | $                       | 2,130 |  | 27.1  | %
|Gross Margin           |  |                                  | 40.4   | % |                                  |   | 59.1   | %                       |  |                         |      |  | (18.7 | )
|                       |  |                                  |       
|                       |  | Nine Months Ended                |        |   |                                  |   |        |                        
|(Dollars in thousands) |  | September 30,2007(As Restated)
1 |        |   | September 30,2006(As Restated)
1 |   |        | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|Gross Profit           |  | $                                | 30,999 |   |                                  | $ | 25,226 |                         |  | $                       | 5,773 |  | 22.9  | %
|Gross Margin           |  |                                  | 34.2   | % |                                  |   | 58.1   | %                       |  |                         |      |  | (23.9 | )



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

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

Both the 18.7 percentage point decrease in gross margin
during the third quarter of 2007, as well as the 23.9 percentage point decrease during the first nine months of 2007, were due primarily to the mix of revenues reported. In each case, the proportion of our revenues attributable to sales of our NES
system products increased significantly as compared to the comparable periods in 2006. In general, gross margins generated from sales of our NES system products are much lower than those generated from both sales of our
LONWORKS Infrastructure products and services as well as sales made under the Enel Project. As a result, when NES revenues are higher as a percentage of overall revenues, as they were during the quarter and nine months
ended September 30, 2007, overall gross margins will be lower. Conversely, when NES revenues comprise a lower percentage of overall revenues, as they were during the three and nine months ended September 30, 2006, overall gross margins
will be higher.

Partially offsetting the decrease in gross margins during the three and nine months ended September 30, 2007 as
compared to the comparable periods in 2006 was the impact of higher revenues. As discussed above, a portion of our cost of goods sold relates to indirect costs. Some of these costs do not increase or decrease in conjunction with revenue levels, but
rather remain relatively constant from quarter to quarter. As a result, when revenues increase, as they did in the three and nine months ended September 30, 2007 as compared to the comparable periods in 2006, gross margins are favorably
impacted.

We expect that, for full year 2007, overall gross margin will decrease significantly from the 58.2% experienced in 2006 due to
the significant increase we expect in NES revenues.



33



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##### Table of Contents

Operating Expenses

Product Development



|                       |  |                                  |        |                                  |   |                         |  |                         |       |  |      |  
|---------------------- |  | -------------------------------- | ------ | -------------------------------- | - | ----------------------- |  | ----------------------- | ----- |  | ---- | -
|                       |  | Three Months Ended               |        |                                  |   |                         | 
|(Dollars in thousands) |  | September 30,2007(As Restated) 1 |        | September 30,2006(As Restated) 1 |   | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|Product Development    |  | $                                | 7,820  |                                  | $ | 6,833                   |  | $                       | 987   |  | 14.4 | %
|                       |  |                                  |       
|                       |  | Nine Months Ended                |        |                                  |   |                         | 
|(Dollars in thousands) |  | September 30,2007(As Restated)
1 |        | September 30,2006(As Restated)
1 |   | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|Product Development    |  | $                                | 23,716 |                                  | $ | 20,934                  |  | $                       | 2,782 |  | 13.3 | %



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

Product development expenses consist primarily of payroll and related expenses for development personnel, facility costs, equipment and supplies, fees
paid to third party consultants, depreciation and amortization, and other costs associated with the development of new technologies and products.

The $987,000 and $2.8 million increases in product development expenses for the three and nine months ended September 30, 2007 as compared to the comparable periods in 2006 were primarily due to increases in compensation expenses for
our product development personnel, which was primarily due to an increase in headcount in our product development organization. To a lesser extent, fees paid to third party service providers and equipment and supplies used in the development process
also contributed to the increases between the two three and nine month periods.

We expect that, for full year 2007, product development
expenses will increase over 2006 levels. This increase will primarily be the result of increased development efforts related to our NES system products.

Sales and Marketing



|                       |  |                                  |        |                                  |   |                         |  |   |                         |   |  |      |   
|---------------------- |  | -------------------------------- | ------ | -------------------------------- | - | ----------------------- |  | - | ----------------------- | - |  | ---- | --
|                       |  | Three Months Ended               |        |                                  |   |                         |  |  
|(Dollars in thousands) |  | September 30,2007(As Restated) 1 |        | September 30,2006(As Restated) 1 |   | 2007 over2006 $Change 1 |  |   | 2007 over2006 %Change 1 |  
|Sales and Marketing    |  | $                                | 4,884  |                                  | $ | 5,079                   |  | $ | (195                    | ) |  | (3.8 | )%
|                       |  |                                  |       
|                       |  | Nine Months Ended                |        |                                  |   |                         |  |  
|(Dollars in thousands) |  | September 30,2007(As Restated)
1 |        | September 30,2006(As Restated)
1 |   | 2007 over2006 $Change 1 |  |   | 2007 over2006 %Change 1 |  
|Sales and Marketing    |  | $                                | 15,279 |                                  | $ | 15,349                  |  | $ | (70                     | ) |  | (0.5 | )%



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

Sales and marketing expenses consist primarily of payroll and related expenses for sales and marketing personnel, including commissions to sales
personnel, travel and entertainment, facilities costs, advertising and product promotion, and other costs associated with our sales and support offices.

The $195,000 and $70,000 reductions in sales and marketing expenses for the three and nine months ended September 30, 2007 as compared to the comparable periods in 2006 were primarily the result of decreases in
commission expenses for our sales and marketing personnel.

Also contributing to the changes in sales and marketing expenses between 2006
and 2007 were the impacts of foreign currency exchange rate fluctuations between the U.S. dollar and the local currencies in several of the foreign countries in which we have operations, including the Euro, the British Pound Sterling, and the
Japanese Yen. These exchange rate fluctuations caused sales and marketing expenses to increase by approximately $95,000 during the third quarter of 2007 as compared to the comparable period in 2006, and to increase by approximately $287,000 during
the nine months ended September 30, 2007 as compared to the comparable period in 2006.



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##### Table of Contents

We expect that, during 2007, our sales and marketing expenses will increase modestly over 2006 levels. In
addition, if the United States dollar were to weaken against the foreign currencies where we do business, our sales and marketing expenses could increase further. Conversely, if the dollar were to strengthen against these currencies, it would have a
favorable impact on our sales and marketing expenses.

General and Administrative



|                           |  |                                  |        |                                  |   |                         |  |                         |       |  |      |  
|-------------------------- |  | -------------------------------- | ------ | -------------------------------- | - | ----------------------- |  | ----------------------- | ----- |  | ---- | -
|                           |  | Three Months Ended               |        |                                  |   |                         | 
|(Dollars in thousands)     |  | September 30,2007(As Restated) 1 |        | September 30,2006(As Restated) 1 |   | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|General and Administrative |  | $                                | 3,976  |                                  | $ | 3,597                   |  | $                       | 379   |  | 10.5 | %
|                           |  |                                  |       
|                           |  | Nine Months Ended                |        |                                  |   |                         | 
|(Dollars in thousands)     |  | September 30,2007(As Restated)
1 |        | September 30,2006(As Restated)
1 |   | 2007 over2006 $Change 1 |  | 2007 over2006 %Change 1 |      
|General and Administrative |  | $                                | 11,707 |                                  | $ | 10,526                  |  | $                       | 1,181 |  | 11.2 | %



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

General and administrative expenses consist primarily of payroll and related expenses for executive, accounting, and administrative personnel,
professional fees for legal and accounting services rendered to the company, facility costs, insurance, and other general corporate expenses.

Both the $379,000 and $1.2 million increases in general and administrative expenses during the three and nine months ended September 30, 2007, respectively, as compared to the comparable periods in 2006, were primarily attributable to
increases in compensation related expenses for our executive, accounting, and administrative personnel, and to a lesser extent, fees paid to our independent accountants and other third party service providers.

We believe that, during 2007, general and administrative costs will increase over 2006 levels.

Interest and Other Income, Net



|                               |  |                    |       |                   |   |                       |  |   |                       |   |  |       |   
|------------------------------ |  | ------------------ | ----- | ----------------- | - | --------------------- |  | - | --------------------- | - |  | ----- | --
|                               |  | Three Months Ended |       |                   |   |                       |  |  
|(Dollars in thousands)         |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  |   | 2007 over2006 %Change |  
|Interest and Other Income, Net |  | $                  | 1,381 |                   | $ | 1,586                 |  | $ | (205                  | ) |  | (12.9 | )%
|                               |  |                    |      
|                               |  | Nine Months Ended  |       |                   |   |                       |  |  
|(Dollars in thousands)         |  | September 30,2007  |       | September 30,2006 |   | 2007 over2006 $Change |  |   | 2007 over2006 %Change |  
|Interest and Other Income, Net |  | $                  | 4,366 |                   | $ | 4,384                 |  | $ | (18                   | ) |  | (0.4  | )%

Interest and other income, net primarily reflects interest earned by our company on cash and
short-term investment balances. In addition, foreign exchange translation gains and losses related to short-term intercompany balances are also reflected in this amount.

During the third quarter of 2007, interest and other income, net decreased by approximately $205,000 as compared to the comparable period in 2006. This decrease was primarily due to a $159,000 increase in foreign
exchange translation losses, and to a lesser extent, by a $45,000 decrease in interest income. During the nine months ended September 30, 2007, interest and other income, net decreased by approximately $18,000 as compared to the comparable
period in 2006. This reduction was primarily the result of a $123,000 decrease in interest income, partially offset by a $97,000 reduction in foreign exchange translation and transaction losses. The reduction in interest income for both the three
and nine months ended September 30, 2007 as compared to the comparable periods in 2006 is primarily the result of a reduction in our average invested cash balance between the periods.

We expect that our anticipated operating losses for 2007 will require us to use a portion of our existing cash and short-term investment portfolio to
fund ongoing business operations. As a result, we expect that the average amount of our invested cash will decrease during 2007, which will result in reduced interest income if interest rates remain



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unchanged or were to decrease. In addition, future fluctuations in the exchange rates between the United States dollar and the currencies in which we
maintain our short-term intercompany balances (principally the European Euro and the British Pound Sterling) will also affect our interest and other income, net.

Interest Expense on Lease Financing Obligations (As Restated)



|                                                |  |                                 |     |                                 |   |                         |  |   |                         |   |  |       |   
|----------------------------------------------- |  | ------------------------------- | --- | ------------------------------- | - | ----------------------- |  | - | ----------------------- | - |  | ----- | --
|                                                |  | Three Months Ended              |     |                                 |   |                         |  |  
|(Dollars in thousands)                          |  | September 30,2007(As Restated)1 |     | September 30,2006(As Restated)1 |   | 2007 over2006 $Change 1 |  |   | 2007 over2006 %Change 1 |  
|Interest Expense on Lease Financing Obligations |  | $                               | 297 |                                 | $ | 340                     |  | $ | (43                     | ) |  | (12.6 | )%
|                                                |  |                                 |    
|                                                |  | Nine Months Ended               |     |                                 |   |                         |  |  
|(Dollars in thousands)                          |  | September 30,2007(As
Restated)1 |     | September 30,2006(As Restated)1 |   | 2007 over2006 $Change 1 |  |   | 2007 over2006 %Change 1 |  
|Interest Expense on Lease Financing Obligations |  | $                               | 924 |                                 | $ | 1,050                   |  | $ | (126                    | ) |  | (12.0 | )%



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

In December 1999 and October 2000, we entered into two separate lease agreements with a local real estate developer for the two buildings we currently
occupy at our San Jose headquarters site. As discussed in Notes 2 and 3 of Notes to Condensed Consolidated Financial Statements in Item 1 of this Report, we have accounted for these leases in accordance with EITF 97-10 and SFAS 98.
The application of this accounting literature causes Echelon to be considered the deemed owner of the two buildings for accounting purposes only.

Accordingly, we have recorded assets and corresponding financing liabilities for an amount equal to these lessor paid construction costs. The monthly rent payments we make to our lessor under our lease agreements are
recorded in our financial statements as land lease expense and principal and interest on the lease financing obligations. Interest expense on lease financing obligations reflects the portion of our monthly lease payments that is
allocated to interest expense.

We expect that, during 2008, interest expense on lease financing obligations will decrease from the amounts
reported for 2007. 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. Therefore, a higher percentage of the payments we make in 2008 will be allocated to principal repayment and less will be allocated to
interest expense.

Provision for Income Taxes



|                           |  |                    |     |                   |   |                       |  |                       |    |  |      |  
|-------------------------- |  | ------------------ | --- | ----------------- | - | --------------------- |  | --------------------- | -- |  | ---- | -
|                           |  | Three Months Ended |     |                   |   |                       | 
|(Dollars in thousands)     |  | September 30,2007  |     | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |   
|Provision for Income Taxes |  | $                  | 108 |                   | $ | 80                    |  | $                     | 28 |  | 35.0 | %
|                           |  |                    |    
|                           |  | Nine Months Ended  |     |                   |   |                       | 
|(Dollars in thousands)     |  | September 30,2007  |     | September 30,2006 |   | 2007 over2006 $Change |  | 2007 over2006 %Change |   
|Provision for Income Taxes |  | $                  | 323 |                   | $ | 240                   |  | $                     | 83 |  | 34.6 | %

The provision for income taxes for 2007 includes a provision for state and foreign taxes based on
our annual estimated effective tax rate for the year. The difference between the statutory rate and our effective tax rate is primarily due to the impact of foreign taxes and our valuation allowance on our deferred tax assets. Income taxes of
$108,000 and $80,000 for the three months ended September 30, 2007 and 2006, respectively, and $323,000 and $240,000 for the nine months ended September 30, 2007 and 2006, respectively, consist primarily of taxes related to profitable
foreign subsidiaries and various state minimum taxes.



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Although we expect to generate a loss before provision for income taxes in 2007, we will be required to
book income tax expense to cover, at a minimum, the foreign taxes owed on income generated by our profitable foreign subsidiaries as well as state minimum taxes. We currently expect our 2007 provision for income taxes will be slightly higher than
the amounts provided for in 2006.

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 Echelon 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. We lease our present corporate headquarters facility in San Jose, California, under two non-cancelable operating leases. The first lease agreement expires in 2011 and the second
lease agreement expires in 2013. Upon expiration, both lease agreements provide for extensions of up to ten years. As part of these lease transactions, we provided the lessor with security deposits in the form of two standby letters of credit
totaling $6.2 million. The leases of our corporate headquarters facilities are accounted for under EITF 97-10 and SFAS 98 (see Notes 2 and 3 of Notes to Condensed Consolidated Financial Statements).

In addition, we lease facilities under operating leases for our sales, marketing, and product development personnel located elsewhere within the United
States and in nine foreign countries throughout Europe and Asia including a land lease for accounting purposes associated with our corporate headquarters facilities (see Notes as referenced above). These operating leases expire on various dates
through 2018, 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 that 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 that range from one to six months, and in some
cases, up to one year. 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 ranging from one to nine months.

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.

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.

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 could 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 is
recorded under our cost of products revenue on our consolidated statements of operations, was approximately $133,000 during the three months ended September 30, 2007, and $142,000 for the comparable period in 2006. Royalty expense was
approximately $432,000 for the nine months ended September 30, 2007, and $352,000 for the comparable period in 2006.



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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 September 30, 2007, 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.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 September 30, 2007, it is possible that our results of operations, cash flows, and financial position could be harmed by the
resolution of any such outstanding claims.

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 the years 2002 through 2004, we were also able to finance our operations from operating cash flows. From inception through September 30, 2007, we raised $288.3 million from the sale of preferred
stock and common stock, including the exercise of stock options and warrants from our employees and directors.

In March and August
2004, March 2006, and February 2007, our board of directors approved a stock repurchase program, which authorizes us to repurchase up to 3.0 million shares of our common stock, in accordance with Rule 10b-18 and other applicable laws,
rules and regulations. There were no repurchases under the program during the three and nine months ended September 30, 2007. Since inception, we have repurchased a total of 2,204,184 shares under the program at a cost of $16.1 million. As of
September 30, 2007, 795,816 shares are available for repurchase. The stock repurchase program will expire in March 2008.

The
following table presents selected financial information as of September 30, 2007 and for each of the last three fiscal years (dollars in thousands):



|                                                   |  |                   |         |              |   |         |  |      |         |  |   |        
|-------------------------------------------------- |  | ----------------- | ------- | ------------ | - | ------- |  | ---- | ------- |  | - | -------
|                                                   |  |                   |         | December 31,
|                                                   |  | September 30,2007 |         | 2006         |   | 2005    |  | 2004
|Cash, cash equivalents, and short-term investments |  | $                 | 123,808 |              | $ | 124,157 |  | $    | 154,480 |  | $ | 160,364
|Trade accounts receivable, net                     |  |                   | 13,603  |              |   | 13,918  |  |      | 11,006  |  |   | 17,261 
|Working capital (as restated)1                     |  |                   | 121,282 |              |   | 129,521 |  |      | 154,869 |  |   | 171,032
|Stockholders equity (as restated)1                |  |                   | 148,465 |              |   | 153,663 |  |      | 178,551 |  |   | 208,611



|(1) | See Note 2 of Notes to Condensed Consolidated Financial Statements for an explanation of the restatement.
|--- | ---------------------------------------------------------------------------------------------------------

As of September 30, 2007, we had $123.8 million in cash, cash equivalents, and short-term investments, a decrease of $349,000 as compared to
December 31, 2006. Historically, our primary source of cash, other than stock



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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, and purchases under our stock repurchase program.

Cash flows from operating activities (as restated). Cash flows from operating activities have historically been driven by net income (loss)
levels, adjustments for non-cash charges such as depreciation, amortization, in-process research and development charges, and stock-based compensation, as well as fluctuations in operating asset and liability balances. Net cash provided by operating
activities was $1.2 million (as restated) for the nine months ended September 30, 2007, a $16.0 million (as restated) increase from the comparable period in 2006. During the nine months ended September 30, 2007, net cash provided by
operating activities was primarily a result of our net loss of $16.6 million, offset by changes in our operating assets and liabilities of $7.2 million (as restated), stock-based compensation expenses of $4.7 million (as restated), depreciation and
amortization expense of $5.4 million (as restated), a reduction of accrued investment income of $403,000, and an increase in our allowance for doubtful accounts of $47,000. During the nine months ended September 30, 2006, net cash used in
operating activities was primarily a result of our net loss of $18.5 million (as restated), changes in our operating assets and liabilities of $5.4 million (as restated), an increase in accrued investment income of $271,000, and a reduction in
our bad debt reserve balance of $32,000; partially offset by stock-based compensation expenses of $4.1 million (as restated) and depreciation and amortization expense of $5.3 million (as restated). For the nine months ended September 30, 2006,
$271,000 has been reclassified from operating cash flows to investing cash flows related to investment income included in net income for which cash had not been received prior to September 30, 2006.

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 provided by investing activities was $32.9 million for the nine months ended September 30, 2007, a $16.3 million increase from the
comparable period in 2006. During the nine months ended September 30, 2007, net cash provided by investing activities was primarily the result of proceeds from maturities and sales of available-for-sale short-term investments of $104.1 million,
and changes in our other long-term assets of $44,000; partially offset by purchases of available-for-sale short-term investments of $65.5 million, and capital expenditures of $5.8 million. During the nine months ended September 30, 2006, net
cash provided by investing activities was primarily the result of proceeds from maturities and sales of available-for-sale short-term investments of $68.4 million, and changes in our other long-term assets of $56,000; partially offset by purchases
of available-for-sale short-term investments of $47.8 million, and capital expenditures of $4.1 million.

Cash flows from financing activities (as
restated). 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. Net cash provided by financing activities
was $4.1 million (as restated) for the nine months ended September 30, 2007, an $11.0 million (as restated) increase over the comparable period in 2006. During the nine month period ended September 30, 2007, net cash provided by financing
activities was attributable to proceeds of $10.1 million from issuance of common stock as a result of options exercised by our employees; partially offset by $4.0 million of repurchases of common stock from our employees for payment of
income and other payroll taxes they owed upon the vesting of share awards and upon the exercise of stock options and principal payments on lease financing obligations of $1.9 million (as restated). During the nine-month period ended
September 30, 2006, net cash used in financing activities was attributable to $5.1 million of open-market purchases of our common stock under our stock repurchase program, $257,000 of repurchases of common stock from our employees for payment
of income and other payroll taxes they owed upon the vesting of share awards and upon the exercise of stock options, and principal payments on lease financing obligations of $1.7 million (as restated); partially offset by $252,000 of proceeds
from issuance of common stock as a result of options exercised by our employees.

We use well-regarded investment management firms to
manage our invested cash. Our portfolio of investments managed by these investment managers is primarily composed of highly rated United States corporate obligations, United States government securities, and to a lesser extent, foreign corporate
obligations, certificates of deposit, and 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.

As of September 30, 2007, our investment portfolio contained three asset backed commercial paper instruments issued by Structured Investment
Vehicles (SIVs) with a par value of $4.5 million each, or $13.5 million in total. In general, a SIV is an investment company that generates investment returns through yield curve arbitrage by



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purchasing high grade medium and long-term fixed income instruments and funding those purchases by issuing low cost, short-term senior debt instruments such
as asset-backed commercial paper and asset-backed medium term notes. These investments are considered illiquid based upon the fact that there were no open market bids for these investments as of September 30, 2007, or through November 9,
2007, the date of this filing. As such, the fair value of these investments was estimated to approximate the amortized cost, or $13.4 million in total, by a third party pricing firm that supplies pricing estimates to our investment manager. One of
these investments was repaid in full by the issuer on its maturity date of October 3, 2007. The two remaining investments mature on November 13, 2007 and January 18, 2008, and are rated A-1+ by Standard and Poors and P1 by
Moodys. In addition, we have reviewed the respective issuers liquidity for the two remaining investments as well as the quality of the underlying collateral to further support each issuers ability to repay the respective
investments at maturity. It is our intent to hold these investments to maturity. As a result, we have not recorded an impairment charge or similar write-down of the reported values. However, if these securities were to begin trading below these
values in the future, or the issuer were to default on its repayment obligations, we may be required to record losses on these investments, which would in turn negatively impact our results of operations and our financial condition.

We expect that cash requirements for our payroll and other operating costs will continue at or slightly above existing levels. We also expect that we
will continue to acquire capital assets such as manufacturing equipment, computer systems and related software, office equipment, furniture and fixtures, and leasehold improvements, as the need for these items arises. Furthermore, our cash reserves
may be used to strategically acquire other companies, products, or technologies that are complementary to our business.

Our existing cash,
cash equivalents, and investment balances will likely decline during the remainder of 2007 as a result of our anticipated operating losses. In addition, any weakening of current economic conditions, or changes in our planned cash outlay, could also
negatively affect our existing cash, cash equivalents, and investment balances. However, based on our current business plan and revenue prospects, we believe that our existing cash and short-term investment balances will be sufficient to meet our
projected working capital and other cash requirements for at least the next twelve months. Cash from operations could be affected by various risks and uncertainties, including, but not limited to, the risks detailed later in this discussion in the
section titled Factors That May Affect Future Results of Operations. In the unlikely event that we would require additional financing within this period, 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

During the three and nine months ended
September 30, 2007, and the years ended December 31, 2006, 2005, and 2004, the law firm of Wilson Sonsini Goodrich & Rosati, P.C. acted as principal outside counsel to our company. Mr. Sonsini, a director of our company, is a
member of Wilson Sonsini Goodrich & Rosati, P.C.

From time to time, M. Kenneth Oshman, our Chairman of the Board and Chief
Executive Officer, uses private air travel services for business trips for himself and for any employees accompanying him. Prior to January 1, 2005, a company controlled by Armas Clifford Markkula, a director of our company, provided these
private air travel services. Our net expense with respect to such private air travel services is no greater than comparable first class commercial air travel services. Such net outlays to date have not been material.

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 (see Note 13 to our accompanying condensed consolidated financial statements for additional information on our transactions with Enel). 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 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. As of October 31, 2007, a nominee of Enel has not been elected to our board.

At the time we entered into the stock
purchase agreement with Enel, we 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, we cooperated with Enel to integrate
LONWORKS technology into Enels remote metering management project in Italy, the Contatore Elettronico. We completed the sale of our components and products for the deployment phase



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of the Contatore Elettronico project during 2005. During 2006, we supplied Enel and its designated manufacturers with limited spare parts for the Contatore
Elettronico system. In October 2006, we 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 us. Under the software enhancement agreement, we provide software enhancements to Enel for use in its Contatore Elettronico system. Both the new development and supply agreement and the software
enhancement agreement expire in December 2009, although delivery of products and services can extend beyond that date and the agreements may be extended under certain circumstances.

For the three and nine months ended September 30, 2007, we recognized revenue from products and services sold to Enel and its designated
manufacturers of approximately $3.0 million and $8.0 million, respectively. As of September 30, 2007, $158,000 of our total accounts receivable balance related to amounts owed by Enel and its designated manufacturers. For the quarter and nine
months ended September 30, 2006, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $53,000 and $7.1 million, respectively. As of September 30, 2006, $4.1 million of our total
accounts receivable balance related to amounts owed by Enel and its designated manufacturers.

RECENTLY
ISSUED ACCOUNTING STANDARDS

In February 2007, the FASB issued Statement of Financial
Accounting Standards No. 159 (SFAS 159), The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair
value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS 159 is effective for Echelon beginning in our fiscal year ending December 31, 2008, although
earlier adoption is permitted. We are currently evaluating the impact that SFAS 159 will have on our consolidated financial statements.

FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

Interested persons should carefully consider the risks described below in evaluating our company. Additional risks and uncertainties not presently
known to us, or that we currently consider immaterial, may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that
case, the trading price of our common stock would likely decline.

Our NES revenues may not be predictable.

We and our partners sell our NES system to utilities. For several reasons sales cycles with utility companies are generally extended and unpredictable.
Utilities generally have complex budgeting, purchasing, and regulatory processes that govern their capital spending. In addition, in many instances, a utility may require one or more field trials of our NES system before moving to a volume
deployment. There is also generally an extended development and integration effort required in order to incorporate a new technology into a utilitys existing infrastructure. A number of other factors may also need to be addressed before the
utility decides to engage in a full-scale deployment of our NES system, including:



| |  |  | the time it takes for utilities to evaluate multiple competing bids, negotiate terms, and award contracts for large scale metering system deployments;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the deployment schedule for projects undertaken by our utility or systems integrator customers; and
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | delays in installing, operating, and evaluating the results of NES system field trials.
| | - |  | ---------------------------------------------------------------------------------------

In addition, shipment of NES products to a particular jurisdiction or customer is generally dependent on either obtaining regulatory approval for the NES
meter or other products from a third party for the relevant jurisdiction, or satisfying the customers internal testing requirements, or both. This approval process is often referred to as homologation or type testing. Further,
shipment of NES products into some jurisdictions requires our contract manufacturers to pass certain tests and meet various standards related to the production of our NES meters. Failure



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to receive any such approval on a timely basis or at all, or failure to maintain any such approval, would have a material adverse impact on our ability to
ship our NES system products, and would therefore have an adverse affect on our results of operations and our financial condition.

Once a
utility decides to move forward with a large-scale deployment of our NES system, the timing of and our ability to recognize revenue on our NES system product shipments will depend on several factors. These factors, some of which may not be under our
control, include shipment schedules that may be delayed or subject to modification, other contractual provisions, such as customer acceptance of all or any part of the system, and our ability to manufacture and deliver quality products according to
expected schedules. In addition, the complex revenue recognition rules relating to products such as our NES system may also require us to defer some or all of the revenue associated with NES product shipments until certain conditions are met in a
future period. As a consequence, our ability to predict the amount of NES revenues that we may expect to recognize in any given fiscal quarter is likely to be limited. As NES revenues account for an increasing percentage of our overall revenues, we
and our investors will have increasing difficulty in projecting our financial results.

Sales of our NES system may fail to meet our financial targets.

We have invested and intend to continue to invest significant resources in the development and sales of our NES system. Our long-term
financial goals include expectations for a reasonable return on these investments. However, to date the revenues generated from sales of our NES system products have yielded very little gross profit, while our NES related operating expenses have
increased significantly. Additionally, gross margins on our NES system offerings are currently lower than gross margins on our other product offerings.

In order to achieve our financial targets, we must meet the following objectives:



| |  |  | Increase market acceptance of our NES system products in order to increase revenues;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | Increase gross margin from our NES revenues by reducing the cost of manufacturing our NES system products;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | Manage the manufacturing transition to reduced-cost NES products; and
| | - |  | ---------------------------------------------------------------------



| |  |  | Manage our operating expenses to a reasonable percentage of revenues.
| | - |  | ---------------------------------------------------------------------

We cannot assure you that we will meet any or all of these objectives to the extent necessary to achieve our financial goals.

We depend on a limited number of key suppliers.

Our
future success will depend significantly on our ability to timely manufacture our products cost-effectively, in sufficient volumes, and in accordance with quality standards. For most of our products requiring assembly, we rely on a limited number of
contract electronic manufacturers (CEMs), principally WKK Technology, TYCO TEPC/Transpower, and Flextronics. These CEMs procure material and assemble, test, and inspect the final products to our specifications. This strategy involves certain risks,
including reduced control over quality, costs, delivery schedules, availability of materials, components, and finished products, and manufacturing yields. In addition, CEMs can experience turnover and instability, exposing us to additional risks as
well as missed commitments to our customers.

We also maintain manufacturing agreements with a limited number of semiconductor
manufacturers for the production of key products, including those used in our NES system. The Neuron Chip, which is an important component that we and our customers use in control network devices, is currently manufactured and distributed by two
providers, Toshiba and Cypress Semiconductor. Another semiconductor supplier, STMicroelectronics, manufactures our power line smart transceiver products, for which we have no alternative source. In addition, we currently purchase several key
products and components from sole or limited source suppliers with which we do not maintain signed agreements that would obligate them to supply to us on negotiated terms.



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We cannot be certain that these and other key suppliers will continue to supply us with critical products
or components. If any of our key suppliers were to stop manufacturing our products or supplying us with our key components, it could be expensive and time consuming to find a replacement. In addition, as our NES business grows, we will be required
to expand our business with our key suppliers or find additional sources of supply. There is no guarantee that we would be able to find acceptable alternative or additional sources. Additional risks that we face if we must transition between CEMs
include:



| |  |  | moving raw material and in-process inventory between locations in different parts of the world;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | reestablishing acceptable manufacturing processes with a new work force; and
| | - |  | ----------------------------------------------------------------------------



| |  |  | exposure to excess or obsolete inventory held by contract manufacturers for use in our products.
| | - |  | ------------------------------------------------------------------------------------------------

The failure of any key manufacturer to produce a sufficient number of products on time, at agreed quality levels, and fully compliant with our product,
assembly and test specifications could adversely affect our revenues and gross profit, and could result in claims against us by our customers, which could harm our results of operations and financial position.

We may incur penalties and/or be liable for damages with respect to sales of our NES system products.

In the event of late deliveries, late or improper installations or operations, failure to meet product specifications or other product failures, failure
to achieve performance specifications, indemnities or other compliance issues, the agreements governing the sales of the NES system may expose us to penalties, damages and other liabilities. Even in the absence of such contractual provisions, we may
agree to assume certain liabilities for the benefit of our customers. Any such liabilities would have an adverse effect on our financial condition and operating results.

Our products use components or materials that may be subject to price fluctuations, shortages, or interruptions of supply.

We may be vulnerable to price increases for products, components, or materials, such as copper and cobalt. In addition, in the past we have occasionally experienced shortages or interruptions in supply for certain of
these items, including products or components that have been or will be discontinued, which caused us to delay shipments beyond targeted or announced dates. To help address these issues, we may decide to purchase quantities of these items that are
in excess of our estimated requirements. As a result, we could be forced to increase our excess and obsolete inventory reserves to provide for these excess quantities, which could harm our operating results.

If we experience any shortage of products or components of acceptable quality, or any interruption in the supply of these products or components, or if
we are not able to procure them from alternate sources at acceptable prices and within a reasonable period of time, our revenues, gross profits or both could decrease. In addition, under the terms of some of our contracts with our customers, we may
also be subject to penalties if we fail to deliver our products on time.

The markets for our products are highly competitive.

Competition in our markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions, and
rapid changes in customer requirements. In each of our markets, we compete with a wide array of manufacturers, vendors, strategic alliances, systems developers and other businesses.

The principal competitive factors that affect the markets for our products include the following:



| |  |  | our ability to anticipate changes in customer requirements and to develop new or improved products that meet these requirements in a timely manner;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the price and features of our products such as adaptability, scalability, functionality, ease of use, and the ability to integrate with other products;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our product reputation, quality, performance, and conformance with established industry standards;
| | - |  | --------------------------------------------------------------------------------------------------



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| |  |  | our ability to meet a customers required delivery schedules;
| | - |  | -------------------------------------------------------------



| |  |  | our customer service and support;
| | - |  | ---------------------------------



| |  |  | warranties, indemnities, and other contractual terms; and
| | - |  | ---------------------------------------------------------



| |  |  | customer relationships and market awareness.
| | - |  | --------------------------------------------

Competitors for our NES system products include the Bayard Capital group of companies, DCSI, Elster, General Electric, Iskraemeco, Itron/Actaris, Kamstrup, Sensus, and Siemens, which directly or through IT integrators such as IBM or
telecommunications companies such as Telenor, offer metering systems that compete with our NES system offering.

For our LWI products, our
competitors include some of the largest companies in the electronics industry, operating either alone or together with trade associations and partners. Key company competitors include companies such as Siemens in the building industry; Allen-Bradley
(a subsidiary of Rockwell Automation), Groupe Schneider and Siemens in the industrial automation industry; Siemens in the transportation industry; and Zensys in the home control market. Key industry standard and trade group competitors include
BACnet, DALI, and Konnex in the buildings industry; DeviceNet, HART, and Profibus in the industrial control market; DLMS in the utility industry; Echonet, Zigbee and the Z-Wave alliance in the home control market; and the Train Control Network (TCN)
in the rail transportation market. Each of these standards and/or alliances is backed by one or more competitors. For example, the Zigbee alliance includes over 150 member companies with promoter members such as Eaton, Freescale, Motorola, Texas
Instruments, STMicroelectronics, Ember, Siemens, Honeywell, Mitsubishi Electric, Samsung, Schneider Electric, Tendril, Huawei Technologies, and Philips.

Many of our competitors, alone or together with their trade associations and partners, have significantly greater financial, technical, marketing, service and other resources, significantly greater name recognition,
and broader product offerings. In addition, the utility metering market is experiencing a trend towards consolidation. As a result, these competitors may be able to devote greater resources to the development, marketing, and sale of their products,
and may be able to respond more quickly to changes in customer requirements or product technology. If we are unable to compete effectively in any of the markets we serve, our revenues, results of operations, and financial position would be harmed.

Liabilities resulting from defects in or misuse of our products, whether or not covered by insurance, may delay our revenues and increase our
liabilities and expenses.

Our products may contain undetected errors or failures when first introduced, as new versions are released,
or as a result of the manufacturing process. In addition, our customers or their installation partners may improperly install or implement our products, which could delay completion of a deployment or hinder our ability to win a subsequent award.
Furthermore, because of the low cost and interoperable nature of our products, LONWORKS technology could be used in a manner for which it was not intended.

If errors or failures are found in our products, we may not be able to successfully correct them in a timely manner, or at all. Such errors or failures could delay our product shipments and divert our engineering
resources while we attempt to correct them. In addition, we could decide to extend the warranty period, or incur other costs outside of our normal warranty coverage, to help address any known errors or failures in our products and mitigate the
impact on our customers.

To address these issues, the agreements we maintain with our customers may contain provisions intended to limit
our exposure to potential errors and omissions claims as well as any liabilities arising from them. In certain very limited instances, these agreements require that we be named as an additional insured on our customers insurance policies.
However, our customer contracts and additional insured coverage may not effectively protect us against the liabilities and expenses associated with errors or failures attributable to our products.

Defects in our products may also cause us to be liable for losses in the event of property damage, harm or death to persons, claims against our directors
or officers, and the like. Such liabilities could harm our reputation, expose our company to liability, and adversely affect our operating results and financial position.



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To help reduce our exposure to these types of liabilities, we currently maintain property, general
commercial liability, errors and omissions, directors and officers, and other lines of insurance. However, it is possible that such insurance may not be available in the future or, if available, may be insufficient in amount to cover any particular
claim, or we might not carry insurance that covers a specific claim. In addition, we believe that the premiums for the types of insurance we carry will continue to fluctuate from period to period. Significant cost increases could also result in
increased premiums or reduced coverage limits. Consequently, if we elect to reduce our coverage, or if we do not carry insurance for a particular type of claim, we will face increased exposure to these types of claims.

If we do not maintain adequate distribution channels, our revenues will be harmed.

We market our NES system products directly, as well as through selected VARs and integration partners. We believe that a significant portion of our NES system sales will be made through our VARs and integration
partners, rather than directly by our company. To date, our VARs and integration partners have greater experience in overseeing projects for utilities. As a result, if our relationships with our VARs and integration partners are not successful, or
if we are not able to create similar distribution channels for our NES system products with other companies in various geographic areas, revenues from sales of our NES system products may not meet our financial targets, which will harm our operating
results and financial condition.

Currently, significant portions of our LWI revenues are derived from sales to distributors, including
EBV, the primary independent distributor of our products to OEMs in Europe. Historically, sales to EBV, as well as sales to our other distributor partners, have accounted for a substantial portion of our total LWI revenues. Agreements with our
distributor partners are generally renewed on an annual basis. If any of these agreements are not renewed, we would be required to locate another distributor or add our own distribution capability to meet the needs of our end-use customers. Any
replacement distribution channel could prove less effective than our current arrangements. In addition, if any of our distributor partners fail to dedicate sufficient resources to market and sell our products, our revenues would suffer. Furthermore,
if they significantly reduce their inventory levels for our products, service levels to our end-use customers could decrease.

We face financial and
operational risks associated with international operations.

We have operations located in nine countries around the world. Revenues
from international sales, which include both export sales and sales by international subsidiaries, accounted for about 81.6% of our total net revenues for the three months ended September 30, 2007, and 60.9% for the comparable period in 2006;
and 84.8% of our total net revenues for the nine months ended September 30, 2007, and 66.3% for the comparable period in 2006. We expect that international sales will continue to constitute a significant portion of our total net revenues as our
NES revenues, which currently result predominantly from international sales, will increase significantly in 2007 as compared to 2006.

Changes in the value of currencies in which we conduct our business relative to the U.S. dollar could cause fluctuations in our reported financial results. The three primary areas where we are exposed to foreign currency fluctuations are
revenues, cost of goods sold, and operating expenses.

With respect to revenues generated in foreign currencies, our historical foreign
currency exposure has been related primarily to the Japanese Yen and has not been material to our consolidated results of operations. However, in the future, we expect that some foreign utilities may require us to price our NES system in the
utilitys local currency, which will increase our exposure to foreign currency risk. In addition, we have agreed with EBV, our European distributor, that upon notice from EBV, we will sell our products to EBV in European Euros rather than U.S.
dollars. If EBV were to exercise this right, our revenue exposure to foreign currency fluctuations would increase.

For our cost of goods
sold, the majority of our products are assembled by CEMs in China, and to a lesser extent, in the European Union, although our transactions with these vendors have historically been denominated in U.S. dollars. These vendors may require us to pay in
their local currency, or demand a U.S. dollar price adjustment or other payment to address a change in exchange rates, which would increase our cost to procure our products. This is particularly a risk in China, where any future revaluations of the
Chinese currency against the U.S. dollar could result in significant cost increases.



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We use the local currency to pay for our operating expenses in the various countries where we have
operations. If the value of the U.S. dollar declines as compared to the local currency where the expenses are incurred, our expenses, when translated back into U.S. dollars, will increase.

To date, we have not hedged any of our foreign currency exposures and currently do not maintain any hedges to mitigate our foreign currency risks.
Consequently, any resulting adverse foreign currency fluctuations could significantly harm our revenues, cost of goods sold, or operating expenses.

Additional risks inherent in our international business activities include the following:



| |  |  | timing of and costs associated with localizing products for foreign countries and lack of acceptance of non-local products in foreign countries;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | inherent challenges in managing international operations;
| | - |  | ---------------------------------------------------------



| |  |  | the burdens of complying with a wide variety of foreign laws and unexpected changes in regulatory requirements, tariffs, and other trade barriers;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | economic and political conditions in the countries where we do business;
| | - |  | ------------------------------------------------------------------------



| |  |  | differing vacation and holiday patterns in other countries, particularly in Europe;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | labor actions generally affecting individual countries, regions, or any of our customers, which could result in reduced demand for our products;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | international terrorism and anti-American sentiment; and
| | - |  | --------------------------------------------------------



| |  |  | potentially adverse tax consequences, including restrictions on repatriation of earnings.
| | - |  | -----------------------------------------------------------------------------------------

Any of these factors could have a material adverse effect on our revenues, results of operations, and our financial condition.

The sales cycle for our LWI products is lengthy and unpredictable.

The sales cycle between initial LWI customer contact and execution of a contract or license agreement with a customer or purchase of our products, can vary widely. Initially, we must educate our customers about the
potential applications of and cost savings associated with our products. If we are successful in this effort, OEMs typically conduct extensive and lengthy product evaluations before making a decision to design our products into their offerings. Once
the OEM decides to incorporate our products, volume purchases of our products are generally delayed until the OEMs product development, system integration, and product introduction periods have been completed. In addition, changes in our
customers budgets, or the priority they assign to control network development, could also affect the sales cycle.

We generally have
little or no control over these factors, any of which could prevent or substantially delay our ability to complete a transaction and could adversely affect the timing of our revenues and results of operations.

If we sell our NES system products directly to a utility, we will face additional risks.

If we sell our NES system products to a utility directly, we may be required to assume responsibility for installing the NES system in the utilitys
territory, integrating the NES system into the utilitys operating and billing system, overseeing management of the combined system, and undertaking other activities. To date, we do not have any significant experience with providing these
types of services. As a result, if we sold directly to a utility, it may be necessary for us to contract with third parties to satisfy these obligations. We cannot assure you that we would find appropriate third parties to provide these services on
reasonable terms, or at all. Assuming responsibility for these or other services would add to the costs and risks associated with NES system installations, and could also negatively affect the timing of our revenues and cash flows related to
these transactions.



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Fluctuations in our operating results may cause our stock price to decline.

Our quarterly and annual results have varied significantly from period to period, and we have sometimes failed to meet securities analysts
expectations. Moreover, we have a history of losses and we expect to incur substantial losses again in 2007.Our future operating results will depend on many factors, many of which are outside of our control, including the following:



| |  |  | the mix of products and services that we sell may change to a less profitable mix;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | shipment and payment schedules may be delayed;
| | - |  | ----------------------------------------------



| |  |  | the complex revenue recognition rules relating to products such as our NES system could require us to defer some or all of the revenue associated with NES product
shipments until certain conditions, such as delivery and acceptance criteria, are met in a future period;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our contract electronic manufacturers may not be able to provide quality products on a timely basis, especially during periods where capacity in the CEM market is
limited;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our products may not be manufactured in accordance with specifications or our established quality standards, or may not perform as designed;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our products may not be accepted by utilities, OEMs, systems integrators, service providers and end-users at the levels we project;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | downturns in any customers or potential customers business, or declines in general economic conditions, could cause significant reductions in capital
spending, thereby reducing the levels of orders from our customers;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | recording of expense relating to equity compensation as required under SFAS No. 123R will decrease our earnings;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | we may incur costs associated with any future business acquisitions; and
| | - |  | ------------------------------------------------------------------------



| |  |  | results of impairment tests for goodwill and other intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, and SFAS
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, with respect to goodwill and other identified intangible assets that we acquired in the past or that we may acquire in the future may negatively affect our earnings
and financial condition.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Any of the above factors could, individually or in the aggregate, have a material adverse
effect on our results of operations and our financial condition, which could cause our stock price to decline.

We may be unable to promote and expand
acceptance of our open, interoperable control systems over competing protocols, standards, or technologies.

LONWORKS technology is
open, meaning that many of our technology patents are broadly licensed without royalties or license fees. As a result, our customers are able to develop hardware and software solutions that compete with some of our products. Because some of our
customers are OEMs that develop and market their own control systems, these customers in particular could develop competing products based on our open technology. For instance, we have published all of the network management commands required to
develop software that competes with our LNS software.

In addition, many of our competitors are dedicated to promoting closed or
proprietary systems, technologies, software and network protocols or product standards that differ from or are incompatible with ours. We also face strong competition from large trade associations that promote alternative technologies and standards
for particular vertical applications or for use in specific countries. These include BACnet, DALI, and KNX in the buildings market; DeviceNet, HART, and ProfiBus in the industrial controls market; TCN in the rail transportation market, DLMS in the
metering market, and Echonet, Zigbee, and Z-Wave in the home control market.



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Our technologies, protocols, or standards may not be successful or we may not be able to compete with new
or enhanced products or standards introduced by our competitors, which would have a material adverse affect on our revenues, results of operations, and financial condition.

Our business may suffer if it is alleged or found that our products infringe the intellectual property rights of others.

We may be contractually obligated to indemnify our customers or other third parties that use our products in the event our products are alleged to
infringe a third partys intellectual property rights. From time to time, we may also receive notice that a third party believes that our products may be infringing patents or other intellectual property rights of that third party. Responding
to those claims, regardless of their merit, can be time consuming, result in costly litigation, divert managements attention and resources, and cause us to incur significant expenses.

As the result of such a claim, we may elect or be required to redesign our products, some of our product offerings could be delayed, or we could be
required to cease distributing some of our products. In the alternative, we could seek a license to the third partys intellectual property. Even if our products do not infringe, we may elect to take a license or settle to avoid incurring
litigation costs. However, it is possible that we would not be able to obtain such a license or settle on reasonable terms, or at all.

Lastly, our customers may not purchase our products if they are concerned our products may infringe third party intellectual property rights. This could reduce the market opportunity for the sale of our products and services.

Any of the foregoing risks could have a material adverse affect on our revenues, results of operations, and financial condition.

We have limited ability to protect our intellectual property rights.

Our success depends significantly upon our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to
establish, maintain and protect these intellectual property rights, all of which afford only limited protection. If any of our patents fail to protect our technology, or if we do not obtain patents in certain countries, our competitors may find it
easier to offer equivalent or superior technology.

We have also registered or applied for registration for certain trademarks, and will
continue to evaluate the registration of additional trademarks as appropriate. If we fail to properly register or maintain our trademarks or to otherwise take all necessary steps to protect our trademarks, the value associated with the trademarks
may diminish. In addition, if we fail to protect our trade secrets or other intellectual property rights, we may not be able to compete as effectively in our markets.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or services or use information that we regard as proprietary. Any of our patents, trademarks,
copyrights or intellectual property rights could be challenged, invalidated or circumvented. In addition, we cannot assure you that we have taken or will take all necessary steps to protect our intellectual property rights. Third parties may also
independently develop similar technology without breach of our trade secrets or other proprietary rights. In addition, the laws of some foreign countries, including several in which we operate or sell our products, do not protect proprietary rights
to as great an extent as do the laws of the United States and it may take longer to receive a remedy from a court outside of the United States. Also, some of our products are licensed under shrink-wrap license agreements that are not signed by
licensees and therefore may not be binding under the laws of certain jurisdictions.

From time to time, litigation may be necessary to
defend and enforce our proprietary rights. As a result, we could incur substantial costs and divert management resources, which could harm our business, regardless of the final outcome. Despite our efforts to safeguard and maintain our proprietary
rights both in the United States and abroad, we may be unsuccessful in doing so. Also, the steps that we take to safeguard and maintain our proprietary rights may be inadequate to deter third parties from infringing, misusing, misappropriating, or
independently developing our technology or intellectual property rights, or to prevent an unauthorized third party from misappropriating our products or technology.



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Our executive officers and technical personnel are critical to our business.

Our companys success depends substantially on the performance of our executive officers and key employees. Due to the specialized technical nature
of our business, we are particularly dependent on our Chief Executive Officer, our President and Chief Operating Officer, and our technical personnel. Our future success will depend on our ability to attract, integrate, motivate and retain qualified
technical, sales, operations, and managerial personnel, as well as our ability to successfully implement a plan for management succession.

Competition for qualified personnel in our business areas is intense, and we may not be able to continue to attract and retain qualified executive officers and key personnel. Our product development and marketing functions are largely based
in Silicon Valley, which is a highly competitive marketplace. It may be particularly difficult to recruit, relocate and retain qualified personnel in this geographic area. Moreover, the cost of living, including the cost of housing, in Silicon
Valley is known to be high. Because we are legally prohibited from making loans to executive officers, we will not be able to assist potential key personnel as they acquire housing or incur other costs that might be associated with joining our
company. In addition, if we lose the services of any of our key personnel and are not able to find suitable replacements in a timely manner, our business could be disrupted, other key personnel may decide to leave, and we may incur increased
operating expenses in finding and compensating their replacements.

The trading price of our stock has been volatile, and may fluctuate due to factors
beyond our control.

The trading price of our common stock is subject to significant fluctuations in response to numerous factors,
including the following:



| |  |  | significant stockholders may sell some or all of their holdings of our stock;
| | - |  | -----------------------------------------------------------------------------



| |  |  | investors may be concerned about our ability to develop additional customers for our products and services;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | volatility in our stock price may be unrelated or disproportionate to our operating performance; and
| | - |  | ----------------------------------------------------------------------------------------------------



| |  |  | our stock has very limited analyst coverage.
| | - |  | --------------------------------------------

Any of these factors could have a negative impact on the market price of our stock.

Voluntary standards and governmental regulatory actions in
our markets could limit our ability to sell our products.

Standards bodies, which are formal and informal associations that attempt to
set voluntary, non-governmental product standards, are influential in many of our target markets. We participate in many voluntary standards organizations around the world in order to both help prevent the adoption of exclusionary standards and to
promote voluntary standards for our products. However, we do not have the resources to participate in all voluntary standards processes that may affect our markets.

In addition, many of our products and the industries in which they are used are subject to U.S. and foreign regulation. For example, the power line medium, which is the communications medium used by some of our
products, is subject to special regulations in North America, Europe and Japan. In general, these regulations limit the ability of companies to use power lines as a communication medium. In addition, some of our competitors have attempted to use
regulatory actions to reduce the market opportunity for our products or to increase the market opportunity for their own products.

The
adoption of voluntary standards or the passage of governmental regulations that are incompatible with our products or technology could limit the market opportunity for our products, which could harm our revenues, results of operations, and financial
condition.



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Our existing stockholders control a significant percentage of our stock, which will limit other stockholders
ability to influence corporate matters.

As of October 31, 2007, our directors and executive officers, together with certain
entities affiliated with them (including, for this purpose, Enel, which has the right to nominate a director to our board of directors), beneficially owned 33.7% of our outstanding stock.

When we sold 3.0 million newly issued shares of our common stock to Enel on September 11, 2000, we granted Enel the right to nominate a
director to our board of directors, although a nominee of Enel does not currently sit on our board. In connection with the stock sale, our directors and our Chief Financial Officer agreed to enter into a voting agreement with Enel in which each of
them agreed to vote in favor of Enels nominee to our board of directors. In addition, Enel agreed to vote for our boards recommendations for the election of directors, approval of accountants, approval of Echelons equity
compensation plans, and certain other matters. As a result, our directors and executive officers, together with certain entities affiliated with them, may be able to control substantially all matters requiring approval by our stockholders, including
the election of all directors and approval of certain other corporate matters.

Natural disasters, power outages, and other factors outside of our
control such as widespread pandemics could disrupt our business.

We must protect our business and our network infrastructure against
damage from earthquake, flood, hurricane and similar events, as well as from power outages. A natural disaster, power outage, or other unanticipated problem could also adversely affect our business by, among other things, harming our primary data
center or other internal operations, limiting our ability to communicate with our customers, and limiting our ability to sell our products. We do not insure against several natural disasters, including earthquakes.

Any outbreak of a widespread communicable disease pandemic could similarly impact our operations. Such impact could include, among other things, the
inability for our sales and operations personnel located in affected regions to travel and conduct business freely, the impact any such disease may have on one or more of the distributors for our products in those regions, and increased supply chain
costs. Additionally, any future health-related disruptions at our third-party contract manufacturers or other key suppliers could affect our ability to supply our customers with products in a timely manner, which would harm our results of
operations.



|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
|------- | -----------------------------------------------------------

We have not experienced any material change in our exposure to interest rate and foreign currency risks since the date of our Annual Report on Form 10-K for the year ended December 31, 2006.

Market Risk Disclosures. The following discussion about our market risk disclosures involves forward-looking statements. Actual
results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments to hedge
these exposures.

Interest Rate Sensitivity. We maintain a short-term investment portfolio consisting mainly of fixed income
securities with a weighted average maturity of less than one year. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market rates were to increase immediately and
uniformly by 10% from levels at September 30, 2007 and September 30, 2006, the fair value of the portfolio would decline by an immaterial amount. We currently intend to hold our fixed income investments until maturity, and therefore we
would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. If necessary, we may sell short-term investments prior to maturity to meet the liquidity needs of the company.

Foreign Currency Exchange Risk. We have international subsidiaries and operations and are, therefore, subject to foreign
currency rate exposure. To date, our exposure to exchange rate volatility has not been significant. If foreign exchange rates were to fluctuate by 10% from rates at September 30, 2007, and September 30, 2006, our financial position and
results of operations would not be materially affected. However, we could experience a material impact in the future.



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|ITEM 4. | CONTROLS AND PROCEDURES (As Restated)
|------- | -------------------------------------

Evaluation of
Effectiveness of Disclosure Controls and Procedures

We have designed our disclosure controls and procedures to ensure that
information we are required to disclose in reports that we file or submit under the Securities and Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive and principal financial officers, as
appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. As of the end of the period covered by this
Quarterly Report on Form 10-Q/A, under the supervision of our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such terms are defined in Rule 13a-15(e)
and Rule 15d-15(e) under the Securities and Exchange Act of 1934. Based on this evaluation and considering the material weaknesses in internal control over financial reporting described below, our Chief Executive Officer and our Chief Financial
Officer have concluded that our disclosure controls and procedures were not effective as of September 30, 2007.

In the Companys
previously filed Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, we concluded that the Companys disclosure controls and procedures as of September 30, 2007 were effective. However, in April 2008, the Company
identified the following material weaknesses in our internal control over financial reporting, which resulted in the need to restate our previously issued financial statements:



| |  |  | We lacked policies and procedures for the timely review of the amortization settings within our third-party equity compensation software application; these settings
ensure that the automated calculation of stock-based compensation expense uses our selected method of amortization under SFAS 123R; and,
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We lacked effectively designed policies and procedures for the accounting and disclosure of our San Jose, California facilities leases.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting,
such that there is a reasonable possibility that a material misstatement of our companys annual or interim financial statements will not be prevented or detected on a timely basis.

Changes in Internal Control Over Financial Reporting

There was no change in our internal
control over financial reporting (as defined in Rule 13a-15(e) of the Exchange Act) that occurred during the quarter ended September 30, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.

Subsequent to March 31, 2008, we have or are planning to take the following actions to address the material
weaknesses in our internal control over financial reporting noted above:



| |  |  | develop reports to show critical inputs within our third-party equity compensation software application;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | implement controls to ensure an appropriate and timely review of all critical input settings within our equity compensation software application;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | provide additional training for all employees who are users of the equity compensation software application or the information reported by the application; and,
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | design and implement controls to properly account and provide required disclosures for our San Jose, California headquarters facilities leases.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------

In conjunction with the restatement, we reviewed all amortization settings and corrected the settings within our
third-party equity compensation software application to ensure proper amortization of stock-based compensation expense. We have also corrected the accounting for our San Jose, California headquarters facilities leases.

We believe as a result of the actions we have taken in conjunction with the restatement, the information contained in this Form 10-Q/A fairly presents,
in all material respects, our financial condition and results of operations for the periods contained therein.



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PART II. OTHER INFORMATION



|ITEM 1. | LEGAL PROCEEDINGS
|------- | -----------------

For a discussion regarding our
legal proceedings and matters, please refer to the Legal Actions section of Note 8, Commitments and Contingencies, to our condensed consolidated financial statements included under Item 1 of Part I, Financial Information, which
information is incorporated herein by reference.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

A restated description of the risk
factors associated with our business is included under Factors That May Affect Future Results Of Operations in Managements Discussion and Analysis of Financial Condition and Results of Operations, contained in
Item 2 of Part I of this report. This restated description includes any material changes to and supersedes the description of the risk factors associated with our business previously disclosed in Part I Item 1A of our 2006 Annual Report on
Form 10-K and in Part II Item 1A of our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007 and June 30, 2007, and is incorporated herein by reference.



|ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
|------- | -----------------------------------------------------------

In March and August 2004, our board of directors approved a stock repurchase program, which authorizes us to repurchase up to 3,000,000 shares of our common stock in the open market, in accordance with Rule 10b-18 and other applicable laws,
rules and regulations. The board of directors extended the term of the stock repurchase program in March 2006 and again in February 2007. Since inception, we have repurchased a total of 2,204,184 shares under the program at a cost of $16.1 million.
As of September 30, 2007, 795,816 shares are available for repurchase. The stock repurchase program will expire in March 2008. The following table provides information about the repurchase of our common stock during the quarter ended
September 30, 2007:



|                          |  |                                  |  |                            |       |                                                                              |   |                                                                               |        
|------------------------- |  | -------------------------------- |  | -------------------------- | ----- | ---------------------------------------------------------------------------- | - | ----------------------------------------------------------------------------- | -------
|Period                    |  | TotalNumber ofSharesPurchased(1) |  | AveragePrice Paidper Share |       | Total Number ofShares Purchasedas Part of PubliclyAnnounced Plans orPrograms |   | MaximumNumber of Sharesthat May Yet BePurchased Underthe Plans orPrograms
(1)
|July 1- July 31           |  | 15,030                           |  | $                          | 22.15 |                                                                              |  |                                                                               | 795,816
|August 1- August 31       |  | 257,969                          |  | $                          | 27.58 |                                                                              |  |                                                                               | 795,816
|September 1- September 30 |  | 34,455                           |  | $                          | 28.97 |                                                                              |  |                                                                               | 795,816
|                          |  |                                  |  |                            |       |                                                                              |   |                                                                               |        
|Total                     |  | 307,454                          |  | $                          | 27.47 |                                                                              |  |                                                                               | 795,816
|                          |  |                                  |  |                            |       |                                                                              |   |                                                                               |        



|(1) | Shares purchased that were not part of our publicly announced repurchase program represent those shares surrendered to us by employees in order to satisfy stock-for-stock option
exercises and/or withholding tax obligations related to stock-based compensation. These purchases do not reduce the number of shares that may yet be purchased under our publicly announced repurchase program.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|ITEM 6. | EXHIBITS
|------- | --------



|            |  |                                                                                                                                                                                                           
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                                                   
|3.3*        |  | Amended and Restated Bylaws of Registrant.                                                                                                                                                                
|            | 
|31.1        |  | Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     
|            | 
|31.2        |  | Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     
|            | 
|32          |  | Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished
herewith.



|* | Previously filed.
|- | -----------------

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                   |  |                     |  |                                                                          
|------------------ |  | ------------------- |  | -------------------------------------------------------------------------
|                   |  | ECHELON CORPORATION
|                   |  |                    
|Date: May 16, 2008 |  | By:                 |  | /s/ Oliver R. Stanfield                                                  
|                   |  |                     |  | Oliver R. Stanfield, Executive Vice President and
Chief Financial Officer
|                   |  |                     |  | (Duly Authorized Officer and Principal Financial and Accounting Officer) 



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EXHIBIT INDEX



|            |  |                                                                                                                                                                                                           
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                                                   
|3.3*        |  | Amended and Restated Bylaws of Registrant.                                                                                                                                                                
|            | 
|31.1        |  | Certificate of Echelon Corporation Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     
|            | 
|31.2        |  | Certificate of Echelon Corporation Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                     
|            | 
|32          |  | Certification by the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished
herewith.



|* | Previously filed.
|- | -----------------



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