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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2008

OR



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

For the transition period from  to .

Commission file number: 000-29748

ECHELON CORPORATION

(Exact name of registrant as specified in its charter)



|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 77-0203595                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)

550 Meridian Avenue

San Jose, California 95126

(Address of principal executive office and zip
code)

(408) 938-5200

(Registrants telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:



|                              |  |                                                       
|----------------------------- |  | ------------------------------------------------------
|Title of each class           |  | Name of each exchange on which registered             
|Common Stock, par value $0.01 |  | The NASDAQ Stock Market LLC (The Nasdaq Global Market)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes   ̈    No  x

Indicate by check mark if the registrant is not
required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes   ̈    No  x

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 such filing requirements for the past 90 days.  Yes  x    No   ̈

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.  x

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   ̈            Smaller reporting company   ̈

(do not check if a 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 June 30, 2008, the last business day of the registrants most recently completed second fiscal quarter, there were 40,749,043 shares of the registrants common stock outstanding, and the aggregate
market value of such shares held by non-affiliates of the registrant (based on the per share closing sale price of $10.90 of such shares on the Nasdaq Global Market on June 30, 2008) was approximately $313.5 million. Shares of the
registrants common stock held by each executive officer and director and by each entity that owns 5% or more of the registrants outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of February 28, 2009, 40,505,160 shares of the
registrants common stock, $.01 par value per share, were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE



|                                                                                                 |  |                              
|------------------------------------------------------------------------------------------------ |  | -----------------------------
|Document                                                                                         |  | Parts Into Which Incorporated
|Proxy Statement for the Annual Meeting of Stockholders to be held May 14, 2009 (Proxy Statement) |  | Part III                     









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ECHELON CORPORATION

FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2008

INDEX



|              |  |                                                                                                |  |     
|------------- |  | ---------------------------------------------------------------------------------------------- |  | ----
|              |  |                                                                                                |  | Page
|              |  | PART I                                                                                         |  |     
|              |  |                                                                                               
|Item 1.       |  | Business                                                                                       |  | 3   
|              |  |                                                                                               
|Item 1A.      |  | Risk Factors                                                                                   |  | 10  
|              |  |                                                                                               
|Item 1B.      |  | Unresolved Staff Comments                                                                      |  | 19  
|              |  |                                                                                               
|Item 2.       |  | Properties                                                                                     |  | 19  
|              |  |                                                                                               
|Item 3.       |  | Legal Proceedings                                                                              |  | 20  
|              |  |                                                                                               
|Item 4.       |  | Submission of Matters to a Vote of Security Holders                                            |  | 20  
|              |  | PART II                                                                                        |  |     
|              |  |                                                                                               
|Item 5.       |  | Market for the Registrants Common Equity and Related Stockholder Matters                      |  | 20  
|              |  |                                                                                               
|Item 6.       |  | Selected Financial Data                                                                        |  | 22  
|              |  |                                                                                               
|Item 7.       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations          |  | 23  
|              |  |                                                                                               
|Item 7A.      |  | Quantitative and Qualitative Disclosures About Market Risk                                     |  | 36  
|              |  |                                                                                               
|Item 8.       |  | Financial Statements and Supplementary Data                                                    |  | 37  
|              |  |                                                                                               
|Item 9.       |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure           |  | 37  
|              |  |                                                                                               
|Item 9A.      |  | Controls and Procedures                                                                        |  | 37  
|              |  |                                                                                               
|Item 9B.      |  | Other Information                                                                              |  | 38  
|              |  | PART III                                                                                       |  |     
|              |  |                                                                                               
|Item 10.      |  | Directors, Executive Officers and Corporate Governance Matters                                 |  | 39  
|              |  |                                                                                               
|Item 11.      |  | Executive Compensation                                                                         |  | 39  
|              |  |                                                                                               
|Item 12.      |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |  | 39  
|              |  |                                                                                               
|Item 13.      |  | Certain Relationships and Related Transactions and Director Independence                       |  | 39  
|              |  |                                                                                               
|Item 14.      |  | Principal Accountant Fees and Services                                                         |  | 39  
|              |  | PART IV                                                                                        |  |     
|              |  |                                                                                               
|Item 15.      |  | Exhibits, Financial Statement Schedule                                                         |  | 39  
|              | 
|SIGNATURES    |  | 71                                                                                            
|EXHIBIT INDEX |  | 72                                                                                            



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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 or strategies regarding the future that are forward-looking. These statements include those
discussed in Item 1, Business, including General, Markets, Products and Services, Product Development, Marketing, Competition, and Government Regulation in
Item 1A, Risk Factors, in Item 2, Properties, in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, including Critical Accounting Policies, Results of
Operations, Off-Balance-Sheet Arrangements and Other Contractual Obligations, Liquidity and Capital Resources, Related Party Transactions, Recently Issued Accounting Standards, and elsewhere in
this report. In this report, the words anticipate, believe, expect, intend, future, moving toward and 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 factors including, but not limited to, those set forth in the section entitled Risk Factors and elsewhere in this
report. 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.

PART I



|ITEM 1. | BUSINESS
|------- | --------

General

Echelon was incorporated in California in 1988 and reincorporated in Delaware in 1989. We are an ISO 9001 certified company that develops, markets, and
sells 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.

In the building, home, industrial, transportation, and other automation markets, we sell a suite
of network infrastructure products to original equipment manufacturers (OEMs). OEMs design in, or embed, our products into their products and systems in order to give their products local intelligence and networking capability. We call
the products that we sell to OEMs our LONWORKS® Infrastructure, or LWI, product line. Our LWI products include transceivers, control modules,
routers, network interfaces, development tools, and software tools and toolkits. In December 2008, the protocols used in our LonWorks products and signaling used by our free topology and power line transceivers were approved as a global control
standard by the International Organization for Standardization (ISO) and the International Electrotechnical Commission (IEC). Representative customers include BOC Edwards, EnerNOC, Fuji Electric, Fujitsu General, Groupe Schneider, Honeywell, Johnson
Controls, NTT Data, Samsung, Schindler Elevator, Siemens, and Trane. We believe that by using our LWI products, OEMs can reduce their development time and expense and bring higher quality, more functional products to market than without our LWI
products or than would be possible using alternative development approaches. Most important, we believe the resulting products can also be energy aware and save energy, and are also lower cost for end-users to install, maintain and
operate.

For the electric utility industry we have developed an advanced metering infrastructure system that we call the Networked Energy
Services (NES) system. The NES system provides a two-way information and control path between the utility and its customer, which we believe enables utilities to reduce operating costs; improve customer service; offer multiple tariff plans,
including time-of-use metering and prepay metering; promote energy efficiency; better utilize distribution assets; improve grid quality and reliability; control loads and reduce peak demand; and respond more rapidly to changing customer and
regulatory requirements. Our primary channel to market for the NES system is through value-added resellers (VARs). Examples of NES VARs and partners include ES Elektrosandberg AB, ES Mätteknik, EVB, Görlitz, Limited Liability Company
Engineering Center ENERGOAUDITCONTROL, and Telvent. These VARs in turn add application software, project management, and other value-added services to provide utilities with complete advanced metering systems offerings. Representative end-use
customers include Vattenfall and E.ON in Sweden, Nuon in the Netherlands, Limited Liability Company Engineering Center ENERGOAUDITCONTROL in Russia, and Duke Energy in the United States.

For system integrators serving the street lighting, remote facility monitoring, and energy
management markets, we have developed the i.LON® Internet server family of products, which provides a low-cost, robust Internet interface and local control capability for remote
devices and systems. We believe that the i.LON product family provides a compelling platform for applications that can monitor and substantially reduce energy consumption, lower maintenance costs, and enhance safety and convenience.
Representative resellers of i.LONbased, managed street lighting solutions include EnerNOC, Streetlight Vision, Device Insight, and Intron. Representative end-use customers include the City of Oslo, Norway and the City of Bremen,
Germany.



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In quick-service restaurants, our LonWorks technology and i.LON Internet Server are used to monitor and
control kitchen equipment and key building systems (including HVAC and lighting) through a single network, in an effort to manage energy use and improve efficiency. For example, the quick-serve giant McDonalds is encouraging its kitchen
equipment manufacturers to incorporate our LonWorks technology into new equipment as a way to lower operating costs and improve operations. The potential savings for quick-service restaurants is considerable since the average restaurant, operating
without an effective control system, spends thousands of dollars a year in energy costs.

We view our system infrastructure and network
infrastructure product lines as complementary to each other, tied together by a common theme of energy management. We believe that, while each offering has substantial value on its own, together they bring a more comprehensive and valuable solution
to the end user and that, over time, our success in system infrastructure applications helps drive success in the network infrastructure applications and vice-versa. For example, we believe that utilities that adopt our NES system become better
prospects for i.LON-based street lighting systems and for in-home and in-building energy management applications based on our LWI products. We believe the same synergy is present for utilities that first adopt an i.LON-based street
lighting system. Likewise we believe that because our system products are built on our LWI products, the availability of home and commercial devices based on our LWI products represents an opportunity for utilities to extend the reach of energy
management into homes and buildings.

Markets

We market our products and services primarily in North America, Europe, Japan, China and other selected Asia Pacific countries. Our principal target markets include the following:

Electric Utilities

We believe the worldwide electric
metering industry is transitioning from stand-alone meters or limited-function automatic metering reading (AMR) systems to advanced metering infrastructure (AMI) or smart grid systems. These advanced systems offer two-way communication
and multiple services over a common infrastructure to utilities and their customers, and provide the ability to add new functionality over time to future proof the system. While the timing and speed of the transition varies by geography,
and even within a given geography by utility, we believe that two principal factors will drive this change: opening of energy markets to retail competition, which motivates utilities to increase service quality and flexibility while lowering their
cost-to-serve; and growing concerns regarding energy availability and sustainability, which drive regulators and utilities toward time-of-use pricing, demand response, load shifting, and other programs to reduce both energy consumption and peak-load
demand.

To capitalize on this opportunity, Echelon developed the NES system. With a strategy of selling the NES system through our VAR
partners, we launched the NES VAR channel and shipped the first release of our NES system products for use in trials in December 2003. We, or more often our VARs or other partners, have installations that are underway or completed in Australia,
Austria, Denmark, Germany, the Netherlands, Russia, Sweden, the United States, and other countries. To date, we have shipped over 1.6 million NES meters to customers around the world and, through our partners, have trials or deployments at
nearly 100 utilities worldwide. We believe that the NES system serves a worldwide market opportunity arising from the need to save energy and reduce carbon emissions. In addition to announced installations, Echelon, and more often our VARs, are
participating in many trial and pilot projects.

In June 2000, we began working with the Italian utility Enel to incorporate
our technology into Enels Contatore Elettronico project. Under this project, Enel replaced its existing stand-alone electricity meters with advanced, networked electricity meters at about 27 million of its customers locations
in Italy. We completed our scheduled deliveries under this project in 2005. 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 the Contatore Elettronico system. The development and
supply agreement expires in December 2011, and the software enhancement agreement expires in December 2009, although delivery of products and services can extend beyond those dates and the agreements may be extended under certain circumstances.
Sales to Enel and its meter manufacturers accounted for 9.1% of our total revenues in 2008, 10.3% in 2007, and 12.4% in 2006.

Building Automation

Our LWI product line is used by companies worldwide in most areas of the building automation industry, including access control; automatic
doors; elevators; energy management; fire/life/safety; heating, ventilation, and air conditioning (HVAC); lighting; metering; security; and automated window blinds. We believe that our products are widely accepted because they lower installed system
cost, reduce ongoing life-cycle costs, and increase functionality. We also believe that an increased global interest in reducing energy consumption  both to reduce cost and minimize impact to the environment  has become a driving force
behind the adoption of our LWI and i.LON Internet server products. For example, using a LONWORKS building management system to integrate and optimize HVAC, lighting, security, and other subsystems, the Crown
Estate headquarters building in London was able to achieve



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37% less carbon dioxide emissions than that of a comparable building and was awarded the highest rating possible by BREEAM, a U.K. assessment method that
rates the environmental performance of new and existing buildings. Our OEM customers in the building automation market include Groupe Schneider, Honeywell, Johnson Controls, Philips Lighting, Schindler Elevator, Siemens, and Yamatake. Sales to
Honeywell, both direct and through distribution, accounted for approximately 4.5% of our total revenues in 2008, 4.3% in 2007, and 11.0% in 2006.

Industrial Automation

Our LWI products are used in a wide range of industrial automation applications, including
semiconductor fabrication plants, gas compressor stations, gasoline tank farms, oil pumping stations, water pumping stations, textile dyeing machinery, pulp and paper processing equipment, automated conveyor systems, and many other industrial
environments. In such industrial installations, among other advantages, our control networks can replace complex wiring harnesses, reduce installation costs, eliminate expensive programmable logic controllers and distribute control among sensors,
actuators and other devices, thereby reducing system costs, improving control and eliminating the problem of a single point of failure. For example, BOC Edwards, a leading supplier of vacuum pumping systems to the semiconductor industry, uses our
products within certain vacuum pump products to replace complex wiring used to connect various motors, sensors, actuators, and displays. In addition to BOC Edwards, our OEM customers in the industrial automation market include Fuji Electric,
Hitachi, and Yokagawa.

Demand Response

Echelons products, including the i.LON Internet Server and i.LON SmartServer, are being used by several energy management companies, including EnerNOC, Inc., to implement automated demand response solutions that help business
customers manage energy use and control energy costs during peak electricity periods.

Street Lighting

We believe that the street lighting market represents a large market opportunity for our LWI and i.LON Internet server products. Through the
combination of our power line smart transceiver product built into ballasts to provide local intelligence, control, and reliable networking, and our i.LON Internet server, which provides local control and remote Internet connectivity,
LONWORKS based street lighting systems can reduce energy consumption and cut maintenance costs through remote diagnostics and predictive failure reporting while enhancing safety and lighting quality. For example, the
City of Oslo, Norway is in the process of replacing ballasts in 55,000 streetlights with electronic ballasts that communicate over existing power lines using Echelons power line technology. Preliminary results have demonstrated energy
reduction of over 50% and increased operating efficiencies on the order of 30%. Our OEM customers and reseller partners in the street lighting market include Device Insight, Luminext, Kongsberg Analogic, Philips Lighting Control, SELC, and
Streetlight Vision.

Home Control

While the market for home automation and control is still developing, we believe that product innovations we have made to simplify the installation of such devices, coupled with a growing consumer demand for green products that
can help devices manage and reduce and control their energy costs, has created a new opportunity in the market for networked home control products.

Transportation

Our products are used in important transportation applications, including railcars, light rail, buses, motor
coaches, fire trucks, naval vessels, and aircraft. Our control networks can be used in these transportation systems to improve efficiency, reduce maintenance costs, and increase safety and comfort. LONWORKS technology
is one of the standards required by the New York City Transit Authority when evaluating replacement alternatives for its subway cars. Key OEMs in the transportation market include Bombardier, Kawasaki, New York Air Brake, and Siemens.

Products & Services

We offer a wide-ranging
set of products and services. These products help our customers maximize development efficiency, minimize product cost, and maximize the opportunity to integrate across product lines and industry segments. Our products are built on a common
technology base with sharing between products wherever possible.

Our LWI network infrastructure products include transceivers,
control modules, routers, network interfaces, development tools, and software tools and toolkits. Transceivers and control modules are products that our OEM customers use to embed networking and
intelligence into their products. Sales of transceivers and control modules generated approximately 25.4% of our revenues during both 2008 and 2007, and 53.5% of our revenues during 2006. In this product area, we offer an embedded control networking
platform, called Pyxos, which is designed to be built into the sensors and actuators embedded inside a machine. Routers are used to control and partition network traffic, increasing the total throughput and speed of the system or to
provide transparent support for multiple



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media, which makes it possible to signal between different types of media, such as twisted pair, power line, radio frequency, and optical fiber. Network
interfaces are products that can be used to connect computers and controllers to a LONWORKS network. Our Mini EVK and NodeBuilder® development tools
are designed to make it easy for OEMs to design our transceivers and control modules into their products and systems. Our software tools and toolkits include our LNS® network
operating system, which provides a client-server platform for installing, maintaining, monitoring, and interfacing with LONWORKS networks, and the LNS based LonMaker® Integration Tool, which is built on the Microsoft Visio technical drawing package to give users a graphical, drag and drop environment for designing their networks control system. In March 2009, we announced a new set of
products that we collectively call LonWorks 2.0. These products include the Neuron® 5000 processor, the FT 5000 Smart Transceiver, LNS® FX network operating system, LonMaker® FX installation tool, the NodeBuilder® FX Development Tool and the Mini FX
Evaluation Kit. The new and updated products offer a number of benefits to OEMs including increased performance, reduced cost, and simplified installation.

Our system infrastructure products include the i.LON family of Internet servers and the NES system. Our i.LON products provide cost-effective, secure LAN, WAN, and Internet connectivity to everyday
devices in control networks. The i.LON 100 Internet server also includes a number of capabilities specifically designed to simplify the implementation and increase the functionality of LONWORKS-based street
lighting and remote facility monitoring and energy management applications.

Our NES system is designed to provide the core networking
infrastructure necessary to build and deploy an advanced metering system. It includes a family of digital electricity meters, a family of data concentrators, and the NES system software. NES electricity meters are designed to meet the needs of
residential and light commercial users. Since electricity meters are measurement devices used to bill consumers, some countries require that meters be certified (or homologated) by a recognized authority to verify their accuracy. As of
December 31, 2008, NES meters had been homologated in 17 countries and also had been homologated under the EU Measurement Instrumentation Directive (MID). As new versions of our meters are introduced, they generally must be re-homologated in a
given country before they can be installed and used there. The mechanical form-factor and characteristics also vary by country. Our initial set of NES meters conformed to the IEC standards used throughout most of Europe and parts of Asia. In 2006,
we added additional products that meet the BS standards used in the UK and many former British Colonies, the AS standards used in Australia, and meters that conform to the ANSI form-factor used throughout the United States and Canada. NES data
concentrators are designed to reduce system cost by enabling all of the electricity on a given low voltage transformer to share a single wide area connection. Data concentrators are offered in different configurations based upon the number of meters
that they are designed to manage. Data concentrators connect to the wide area network using an industry standard modem interface. They communicate using Internet standard TCP/IP, allowing our resellers and their utility customers to select a wide
variety of available connectivity options including GPRS (general packet radio service), GSM (Global System for Mobile communications), PSTN (public switched telephone networks), BPL (broadband over power line), WiFi, WiMax, Fiber Optic, Ethernet
and others. The NES system software is enterprise software designed to allow our customers to quickly integrate the NES system into a utilitys business processes and systems. Through the NES system software, the NES system, in effect, looks
like a collection of web services and events, allowing a wide range of industry standard tools and operating environments to be used. The NES system software is designed to scale from low cost, single server implementations for small pilots, to
large scale systems distributed physically and geographically across multiple servers to support millions of meters with high reliability, availability, and scalability requirements.

We also offer a variety of technical training courses covering our products and technology. These courses are designed to provide hands-on, in-depth and
practical experience that can be used immediately by our customers to build products and systems based on our products. In some instances these classes are licensed to third-parties in foreign markets who present them in the local language.
Additionally, we offer a variety of computer-based training courses that can be taken over the Internet. We also offer telephone, e-mail, and on-site technical support to our customers on a term contract or per-incident basis. The goal of these
support services is to resolve customers technical problems on a timely basis, ensure that our products will be used properly, and shorten the time required for our customers to develop products that use our technology.

Product Development

Our future success depends in
large part on our ability to enhance existing products, reduce product cost, and develop new products that maintain technological competitiveness. We have made and intend to continue to make substantial investments in product development. We obtain
extensive product development input from customers and by monitoring end-user needs and changes in the marketplace. We continue to make significant engineering investments in developing and enhancing our products and broadening the markets they
serve.

Our total expenses for product development were $37.8 million for 2008, $32.6 million for 2007, and $28.2 million
for 2006. Included in these totals were stock-based compensation expenses of $6.0 million, $2.8 million, and $2.1 million, for the years ended December 31, 2008, 2007, and 2006, respectively. We anticipate that we will continue to
commit substantial resources to product development in the future and, as a result, product development expenses may continue to increase over historical levels. To date, we have not capitalized any software development costs from our development
efforts.



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Marketing

Our marketing efforts focus on creating awareness of our brand, the products and solutions that we
offer, and the capabilities and benefits that they bring. We conduct an integrated marketing program comprised of press releases, brochures, published papers, case studies, participation in industry trade shows, speaking at industry conferences,
webinars, advertising, direct mail, newsletters, our global website, and the LONWORLD® industry exhibition and conference. We have also formed and actively
participate in two associations directly focused on the adoption of our products, LONMARK® International and the Energy Services Network Association (ESNA),
and participate in other relevant industry organizations.

Sales and Distribution

In most regions of the world we market and sell our products and services using our direct sales
organization, distributors, value-added resellers, and integration partners. We rely solely on distributors in certain markets in the Asia Pacific and Latin America regions. During the three years ended December 31, 2008, we had six customers
that accounted for a majority of our revenues: EBV Electronik GmbH (EBV), our primary distributor of our LONWORKS® Infrastructure products in
Europe, Enel S.p.A. (Enel), an Italian utility company (including Enels third party meter manufacturers), Duke Energy Corporation (Duke), a U.S. utility company that purchases NES products directly from us, and Telvent
Energia y Medioambiente SA (Telvent), Limited Liability Company Engineering Center ENERGOAUDITCONTROL (EAC), and ES Elektrosandberg AB (ES), European based value added resellers of our NES products. For the years
ended December 31, 2008, 2007, and 2006, the percentages of our revenues attributable to sales made to these customers were as follows:



|        |  |                         |   |  |      |   |  |      |  
|------- |  | ----------------------- | - |  | ---- | - |  | ---- | -
|        |  | Year Ended December 31, |  
|        |  | 2008                    |   |  | 2007 |   |  | 2006 |  
|EBV     |  | 15.3                    | % |  | 12.8 | % |  | 27.1 | %
|ES      |  | 14.9                    | % |  | 11.4 | % |  | 0.1  | %
|Duke    |  | 10.3                    | % |  |     | % |  |     | %
|Enel    |  | 9.1                     | % |  | 10.3 | % |  | 12.4 | %
|Telvent |  | 8.9                     | % |  | 28.3 | % |  |     | %
|EAC     |  | 8.3                     | % |  | 7.2  | % |  |     | %
|        |  |                         |   |  |      |   |  |      |  
|Total   |  | 66.8                    | % |  | 70.0 | % |  | 39.6 | %
|        |  |                         |   |  |      |   |  |      |  

We support our worldwide sales personnel with application engineers and technical and industry
experts working in our headquarters. Outside the United States, direct sales, applications engineering, and customer support are conducted through our offices in China, France, Germany, Hong Kong, Italy, Japan, the Netherlands, South Korea, and the
United Kingdom. Each of these offices is staffed primarily with local employees.

Our international sales include both export sales and
sales by international subsidiaries and accounted for 75.0% of our total revenues for 2008, 86.6% of our total revenues for 2007, and 65.5% of our total revenues for 2006.

Manufacturing

Our manufacturing strategy is
to outsource production to third parties where it reduces our costs and to limit our internal manufacturing to such tasks as quality inspection, system integration, custom configuration, testing, and order fulfillment. We maintain manufacturing
agreements with Cypress and Toshiba related to the Neuron® Chip. Toshiba has informed Echelon that it does not intend to renew its Neuron Chip agreement with Echelon when it expires in
January 2010. However, Toshiba and Echelon have agreed that Toshiba will continue to accept orders for Neuron Chips from its customers through September 2011 for deliveries through December 2012. In the meantime, Echelon is working closely with
Toshiba to provide a smooth migration path for Toshibas customers using Echelons new Neuron 5000 processor, which Echelon intends to purchase from Open-Silicon. We also maintain manufacturing agreements with STMicroelectronics for
production of our power line transceiver, with Cypress for production of our free topology transceiver, and with Cypress, On Semiconductor, and AMI Semiconductor for the production of certain other components we sell.

For most of our products requiring assembly, we use contract electronic manufacturers including Jabil, Flextronics, and TYCO. These contract electronic
manufacturers procure material and assemble, test, and inspect the final products to our specifications.



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Working Capital

As of December 31, 2008, we had working capital, defined as current assets less current liabilities, of $108.8 million, which was a decrease of approximately $17.9 million compared to working capital of
$126.7 million as of December 31, 2007.

As of December 31, 2008, we had cash, cash equivalents, and short-term investments
of $87.3 million, which was a decrease of approximately $19.9 million compared to a balance of $107.2 million as of December 31, 2007. Cash used in operating activities in 2008 of $3.5 million was primarily the result of our
net loss of $25.8 million and a net increase in our operating assets and liabilities of $242,000, all of which was partially offset by non-cash charges for stock-based compensation expenses of $14.5 million, depreciation and amortization
expenses of $7.4 million, and a decrease in accrued investment income of $721,000.

Competition

Competition in our markets is intense and involves rapidly changing technologies, evolving industry standards, frequent new product introductions, and
changes in customer requirements. To maintain and improve our competitive position, we must keep pace with the evolving needs of our customers and continue to develop and introduce new products, features and services in a timely and efficient
manner. The principal competitive factors that affect the markets for our products include:



| |  |  | 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;
| | - |  | --------------------------------------------------------------------------------------------------



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



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



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

In each of our markets, our competitors include both small companies as well as some of the largest companies in the electronics industry operating either alone or together with trade associations and partners. Our key 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; Aclara, Elster, Enel, GE, IBM, Iskraemeco, Itron/Actaris, the Landis+Gyr
group of companies, Siemens, and Silver Springs Networks in the utility industry; Siemens in the transportation industry; and Ember and Texas Instruments in the home control market. Key industry standard and trade group competitors include BACnet,
Konnex, and DALI in the buildings industry; DeviceNet, HART, and Profibus in the industrial control market; DLMS in the utility industry; Zigbee and the ZWave 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 300 member companies with promoter members such as Eaton, Ember, Freescale, Huawei Technologies,
Itron, Landis+Gyr, Philips, Reliant Energy, Samsung, Schneider Electric, Siemens, STMicroelectronics, Tendril, and Texas Instruments.

Additionally, while our product implementations are proprietary to Echelon and are often protected by unique, patented implementations, LONWORKS technology is open, meaning that many of our basic control
networking patents are broadly licensed without royalties or license fees. For instance, all of the network management commands required to develop software that competes with our LNS software are published. As a result, our customers are capable of
developing hardware and software solutions that compete with many of our products.

Government Regulation

Many of our products and the industries in which they are used are subject to U.S. and foreign regulation as well as local, industry-specific codes and
requirements. While we believe that changes in environmental regulations can benefit our sales due to the demonstrated ability of our products to reduce and better manage energy consumption, government regulatory action could also greatly reduce the
market for our products or cause us to undertake significant development efforts to make our products compliant, as was the case with the Restriction of Hazardous Substances (RoHS) regulations that went into effect in Europe in 2006. Some of our
competitors have also attempted to use regulatory actions to reduce the market opportunity for our products or to increase the market opportunity for their products. We have resisted these efforts and will continue to oppose competitors
efforts to use regulation to impede competition in the markets for our products.



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Proprietary Rights

We own numerous patents, trademarks, and logos. As of February 28, 2009, we had received 100 United States patents, and had 7 patent applications pending. Some of these patents have also been granted in selected
foreign countries. Many of the specific patents that are fundamental to LONWORKS technology have been licensed to our customers with no license fee or royalties. At present, the principal value of the remaining patents
relates to our specific implementation of our products and designs.

We hold several
trademarks in the United States, many of which are registered, including Echelon, LonBuilder®, LONMARK, LonTalk®, LONWORKS, Neuron, LON, LonPoint®, LonUsers®, LonMaker, 3120®, 3150®, LNS, LonManager®, Digital Home, and NodeBuilder. We have also
registered some of our trademarks and logos in foreign countries.

Employees

As of February 28, 2009, we had 325 employees worldwide, of which 152 were in product development, 70 were in sales and marketing, 53 were in general
and administrative, 37 were in operations, and 13 were in customer support and training. About 214 employees are located at our headquarters in California and 45 employees are located in other offices throughout the United States. Our remaining
employees are located in eleven countries worldwide, with the largest concentrations in Germany, Hong Kong, the Netherlands, the United Kingdom, and Japan. None of our employees is represented by a labor union. We have not experienced any work
stoppages and we believe relations with our employees are good.

Where to Find More Information

We make our public filings with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,
Current Reports on Form 8-K, and all exhibits and amendments to these reports, available free of charge at our website, www.echelon.com, as soon as reasonably practicable after we file such material with the SEC. These materials are located
in the Investor Relations portion of our Web site under the link SEC Filings. The inclusion of our Web site address in this report does not include or incorporate by reference into this report any information on our Web site.
Copies of our public filings may also be obtained from the SEC Web site at www.sec.gov.

Executive Officers of the Registrant

M. Kenneth Oshman, age 68, has been our Chairman and Chief Executive Officer since December 1988. He also served as our President from 1988 to
2001. Prior to joining Echelon, Mr. Oshman, with three associates, founded ROLM Corporation, a telecommunications equipment company, in 1969. He was Chief Executive Officer, President, and a director of ROLM from its founding until its merger
with IBM in 1984. Following the merger, he became a Vice President of IBM and a member of the Corporate Management Board. He remained in that position until 1986. Prior to founding ROLM, Mr. Oshman was a member of the technical staff at
Sylvania Electric Products from 1963 to 1969. In addition to his responsibilities at our company, Mr. Oshman serves as a director of Sun Microsystems. Mr. Oshman earned B.A. and B.S.E.E. degrees from Rice University and M.S. and Ph.D.
degrees in Electrical Engineering from Stanford University.

Oliver R. Stanfield, age 59,has been our Executive Vice
President & Chief Financial Officer since September 2001. He served as our Vice President and Chief Financial Officer from March 1989 to August 2001. Mr. Stanfield joined our company from ROLM, where he served in several positions
since 1980, including: Director of Pricing; Vice President, Plans and Controls; Vice President, Business Planning; Vice President, Financial Planning and Analysis; Treasurer; and Controller, Mil Spec Division. Prior to joining ROLM,
Mr. Stanfield worked for ITEL Corporation, Computer Automation and Rockwell International. Mr. Stanfield began his business career with Ford Motor Company in 1969 in various accounting positions while completing a B.S. degree in Business
Administration and an M.B.A. degree from the University of Southern California.

Anders B. Axelsson, age 49, has been our Senior
Vice President of Sales & Marketing since June 2003. Prior to joining our company, he was Chief Executive Officer of PowerFile, Inc. From 1999 to 2001, he was President/General Manager of Snap Appliances, Inc. Between 1992 and 1999, he
worked for Measurex, which was later acquired by Honeywell, and served in several positions, including Vice President of Engineering and Marketing and President/Managing Director for Europe. Mr. Axelsson started his career with ABB in 1981
where he worked for 11 years in various sales, marketing, and engineering management positions. He holds a B.S. in Electrical Engineering from ED Technical Institute in Jonkpoing, Sweden and is a graduate of the Executive Program at the University
of Michigan.

Kathleen Bloch, age 52, has been our Senior Vice President and General Counsel since February 2003. Prior to joining
our company, Ms. Bloch was a partner in the law firm of Wilson Sonsini Goodrich & Rosati, P.C., where she practiced from 1996 to 2003. Prior to joining Wilson Sonsini Goodrich & Rosati, she was a partner with the San Francisco
and Los Angeles offices of Sheppard Mullin Richter & Hampton. Ms. Bloch received a B.S. degree in Business Administration from the University of Southern California and her law degree from Stanford Law School.



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Frederik Bruggink, age 53,has been our Senior Vice President and General Manager of
our Service Provider Group since July 2002. He served as our Senior Vice President of Sales and Marketing from September 2001 to June 2002, and as our Vice President, Europe, Middle East and Africa, from April 1996 to August 2001. Mr. Bruggink
joined our company in 1996 from Banyan Systems, where he was Vice President, Europe. From 1985 to 1993, Mr. Bruggink held several positions at Stratus Computer, including General Manager for Holland, Benelux, and Northern Europe. His last
position at Stratus was Vice President, Northern Europe. Prior to joining Stratus, he held sales positions at Burroughs Computers. Mr. Bruggink attended the University of Leiden.

Russell Harris, age 47, joined us in September 2001 as our Senior Vice President of Operations. Prior to joining our company, he served as the
Vice President of Operations for NetDynamics from 1996 until its acquisition by Sun Microsystems in 1998. From 1998 to 1999, Mr. Harris served in a management transition role for Sun Microsystems. From 1991 to 1996, Mr. Harris was the
Director of Operations at Silicon Graphics, Inc. From 1985 through 1991, he held various positions at Convergent Technologies and Unisys Corporation. His last position at Unisys was as Director of IT for Worldwide Operations. Mr. Harris earned
B.S. and M.S. degrees in Industrial Engineering from Stanford University.

Robert Machlin, age 51, has been our Senior Vice
President of Products since August 2008. Prior to joining our company, he served as President and CEO of SkyPilot Networks, AirFlow Networks and Catena Networks (now part of Ciena). He also held executive positions at Ascend Communications (now
Alcatel-Lucent), Cascade Communications (now Alcatel-Lucent), Motorola, and Honeywell Information Systems. Mr. Machlin holds a B.S. degree in mechanical engineering from Tufts University and an M.B.A from Harvard Business School.



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

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.

Adverse changes in general economic or political conditions in any of the major countries in which we do business could adversely affect our operating results.

Our business can be affected by a number of factors that are beyond our control, such as general geopolitical, economic, and business
conditions. Recent turmoil in the worldwide financial markets, and the present economic slowdown and the uncertainty over its breadth, depth and duration will continue to put pressure on the global economy and have a negative effect on our business.
Further, the recent worldwide financial and credit crisis has reduced the availability of liquidity and credit to fund the continuation and expansion of business operations worldwide. The shortage of liquidity and credit combined with recent
substantial losses in worldwide equity markets may lead to an extended economic recession in the United States or worldwide.

While we
currently do not depend on access to the credit markets to finance our operations, there can be no assurance that the deterioration in financial markets will not impair our ability to obtain financing in the future, including, but not limited to,
our ability to draw on funds under our existing credit facilities or our ability to incur indebtedness if that became necessary. In addition, there could be a number of follow-on effects from the credit crisis on our business, including insolvency
of certain of our key customers, which could impair our distribution channels, and result in the inability of our customers to obtain credit to finance purchases of our products. Also, the recently enacted U.S. economic stimulus legistlation may
also cause potential customers to delay their deployments until they can determine whether the economic incentives may become available to them under the legislation.

This uncertainty about future economic and political conditions makes it difficult for us to forecast operating results and to make decisions about future investments. If economic activity in the United States and
other countries economies remains weak, many customers may delay, reduce, or even eliminate their purchases of networking technology products. This could result in reductions in sales of our products, longer sales cycles, slower adoption of
new technologies, increased price competition, and increased exposure to excess and obsolete inventory. For example, distributors could decide to reduce inventories of our products. Also, the inability to obtain credit could cause a utility to
postpone its decision to move forward with a large scale deployment of our NES system. If conditions in the global economy, U.S. economy or other key vertical or geographic markets we serve remain uncertain or weaken further, we would experience
material negative impacts on our business, financial condition, results of operations, cash flow, capital resources, and liquidity.



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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 an automated meter infrastructure (AMI) system
(such as one based on 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:



| |  |  | regulatory factors that may affect the requirements of the AMI system or the timing of its deployment;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | 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 an AMI field trial that is based on our NES system.
| | - |  | ------------------------------------------------------------------------------------------------------------------

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 certification approval process is often referred to as homologation. 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 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 an AMI project that is based on 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 AMI 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, such as the acceptance of software deliverables, 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 may 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 not yielded gross margins in line with our long term goals for this product line, while our NES
related operating expenses have increased significantly.

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 continuing to reduce the cost of manufacturing our NES system products, while at the same time managing manufacturing
cost pressures associated with commodity prices and foreign exchange fluctuations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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.



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We are exposed to credit risk and payment delinquencies on our accounts receivable, and this risk has been heightened
during the current decline in economic conditions.

Almost none of our outstanding accounts receivables are covered by collateral or
credit insurance. In addition, our standard terms and conditions permit payment within a specified number of days following shipment of product, or in some cases, after the customers acceptance of our products. While we have procedures to
monitor and limit exposure to credit risk on our receivables, there can be no assurance such procedures will effectively limit our credit risk and avoid losses. As economic conditions change and worsen, certain of our customers may face liquidity
concerns and may be unable to timely satisfy their payment obligations to us, which could have a material adverse effect on our financial condition and results of operations.

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 Jabil and TYCO. 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, 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. Toshiba has informed Echelon
that it does not intend to renew its Neuron Chip agreement with Echelon when it expires in January 2010. However, Toshiba and Echelon have agreed that Toshiba will continue to accept orders for Neuron Chips from its customers through September 2011
for deliveries through December 2012. In the meantime, Echelon is working closely with Toshiba to provide a smooth migration path for Toshibas customers using Echelons new Neuron 5000 processor, which Echelon intends to purchase from
Open-Silicon. 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.

We
are currently reviewing the impact the ongoing worldwide financial crisis is having on our suppliers. Some of these suppliers are large, well capitalized companies, while others are smaller and more highly leveraged. In order to mitigate these
risks, we may take actions such as increasing our inventory levels and/or adding additional sources of supply. Such actions may increase our costs and increase the risk of excess and obsolete inventories. Even if we undertake such actions, there can
be no assurance that we will be able to prevent any disruption in the supply of goods and services we receive from these suppliers.

We may
also elect to change any of these key suppliers. For example, we are currently in the process of ending our relationship with a former CEM partner, Flextronics. As part of this transition, we have moved the production of products Flextronics built
for us to alternative CEMs. We have also been required to purchase certain raw material and in-process inventory from Flextronics that Flextronics procured in anticipation of our production requirements. In addition, we currently have capital
equipment located at Flextronics that must be relocated to another CEM in order to continue manufacturing our products there. In addition, 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. Also, as our NES business grows, we will be required to expand our business with our key suppliers or find additional sources of supply, as we have recently done with Jabil. 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, in-process inventory, and capital equipment between locations, some of which may be 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.

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



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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.

If we are not able to develop or enhance our products in a timely manner, our revenues will suffer.

Due to the nature of development efforts in general, we often experience delays in the introduction of new or improved products beyond our original
projected shipping date for such products. Historically, when these delays have occurred, we experienced an increase in our development costs and a delay in our ability to generate revenues from these new products. We believe that similar new
product introduction delays in the future, particularly with respect to the NES system, could also increase our costs and delay our revenues.

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.

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, rapid
changes in customer or regulatory requirements, and localized market 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 or regulatory requirements and to develop or improve our products to 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;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | 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 Aclara, Elster, Enel, GE, IBM, Iskraemeco, Itron/Actaris, the Landis+Gyr group of companies, Siemens, and Silver Springs Networks, 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



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rail transportation market. Each of these standards and/or alliances is backed by one or more competitors. For example, the Zigbee alliance includes over 300
member companies with promoter members such as Eaton, Ember, Freescale, Huawei Technologies, Itron, Landis+Gyr, Philips, Reliant Energy, Samsung, Schneider Electric, Siemens, STMicroelectronics, Tendril, and Texas Instruments.

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 or shipping 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. This could delay our revenues and increase our expenses.

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.

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.



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We face financial and operational risks associated with international operations.

We have operations located in ten countries around the world. Revenues from international sales, which include both export sales and sales by
international subsidiaries, accounted for about 75.0%, 86.6%, and 65.5% of our total net revenues for the years ended December 31, 2008, 2007, and 2006, respectively. We expect that international sales will continue to constitute a significant
portion of our total net revenues.

Changes in the value of currencies in which we conduct our business relative to the U.S. dollar have
caused and could continue to 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.

In general, we sell our products to foreign customers primarily in U.S. dollars. As such, fluctuations in exchange rates could have an impact on
revenues. As the value of the dollar rises, our products will become more expensive to our foreign customers, which could result in their decision to postpone or cancel a planned purchase.

With respect to the relatively minimal amount of our 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, our products are generally
assembled by CEMs in China. Although our transactions with these vendors have historically been denominated in U.S. dollars, in the future they 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. In addition, any future increase in labor costs in the markets where our products are manufactured could also result in higher costs to procure our products.

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, or could delay delivery or
acceptance of, our products;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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

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 and our technical personnel. In May 2008, our President and Chief Operating Officer, Beatrice Yormark, passed away unexpectedly. Her duties have been assumed by our Chief
Executive Officer. 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 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 purchaser 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 sell 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.

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 cannot assure you that we will achieve sustained profitability in the future. 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, payment schedules, and product acceptance may be delayed;
| | - |  | -------------------------------------------------------------------



| |  |  | we may be required to modify or add to our NES product offerings to meet a utilitys requirements, which could delay delivery and/or acceptance of our
products;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 for our software and/or hardware products, are met in a future period;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | 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, Share-Based Payment, 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.

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.



17



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##### Table of Contents

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, or it may not be economically feasible to enforce them. 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.

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; and
| | - |  | ---------------------------------------------------------------------------------------------------------------



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

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 February 28, 2009, 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 28.5% 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 1B. | UNRESOLVED STAFF COMMENTS
|-------- | -------------------------

None.



|ITEM 2. | PROPERTIES
|------- | ----------

At our corporate headquarters in San
Jose, California, we lease two buildings, each of which contains approximately 75,000 square feet of useable space. We moved to this location in October 2001. The leases for the two buildings were scheduled to expire in 2011 and 2013, respectively.

In June 2008, the building leases were amended resulting in an extension of the lease term for both buildings through March 2020. The
extended leases require minimum lease payments through March 2020 totaling approximately $48.9 million. For accounting purposes only, we are the deemed owner of these buildings; see Note 3 of Notes to Consolidated Financial Statements in
Part II, Item 8 of this report for further explanation of the accounting treatment for these leases.

We also lease office space
for some of our sales and marketing employees in China, France, Germany, Hong Kong, India, Italy, Japan, the Netherlands, South Korea, and the United Kingdom and for some of our research and development employees in Fargo, North Dakota, and Germany.
The leases for these offices expire at various dates through 2018. As of December 31, 2008, the future minimum rental payments for all of our leased office space, including those for our corporate headquarters facilities, totaled approximately
$49.4 million. For the year ended December 31, 2008, the aggregate rental expense for all leased office space was approximately $1.1 million.

We believe that our facilities will be adequate for at least the next 12 months. For additional information regarding our obligations under property leases, please see Note 8 of Notes to Consolidated Financial Statements included in Part
II, Item 8 of this Report.



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##### Table of Contents

|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

None.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------

No matters were submitted to a vote of security holders during the fourth quarter of our fiscal year ended December 31, 2008.

PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
|------- | ---------------------------------------------------------------------

Our common stock is traded on the Nasdaq Global Market under the symbol ELON. We began trading on NASDAQ on July 28, 1998, the date of our initial public offering. The following table sets forth, for
the quarter indicated, the high and low sales price per share of our common stock as reported on the Nasdaq Global Market.



|                             |  |             |       |     |   |      
|---------------------------- |  | ----------- | ----- | --- | - | -----
|                             |  | Price Range
|Year Ended December 31, 2008 |  | High        |       | Low
|Fourth quarter               |  | $           | 10.73 |     | $ | 4.92 
|Third quarter                |  |             | 15.74 |     |   | 9.45 
|Second quarter               |  |             | 16.56 |     |   | 10.36
|First quarter                |  |             | 22.49 |     |   | 10.84
|                             |  |            
|Year Ended December 31, 2007 |  | High        |       | Low
|Fourth quarter               |  | $           | 30.66 |     | $ | 14.70
|Third quarter                |  |             | 32.49 |     |   | 14.93
|Second quarter               |  |             | 18.75 |     |   | 10.50
|First quarter                |  |             | 10.68 |     |   | 7.19 

As of February 28, 2009, there were approximately 432 stockholders of record. Because brokers
and other institutions hold many shares on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.

Dividend Policy

We have never paid dividends on our capital stock and do not currently expect to pay any dividends in the
foreseeable future. We intend to retain future earnings, if any, for use in our business.

Equity Compensation Plan Summary Information

For information on our equity compensation plans, please refer to Note 4 to our accompanying consolidated financial statements.

Recent Sales of Unregistered Securities

There were
no sales of unregistered securities during the fourth quarter of our fiscal year ended December 31, 2008.



20



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##### Table of Contents

Stock Price Performance Graph

The graph below compares the cumulative total stockholder return on our common stock (assuming reinvestment of dividends) with the cumulative total return on the S&P 500 Index and the S&P 500 Information
Technology Index (which is comprised of those companies in the information technology sector of the S&P 500 Index). The graph assumes that $100 was invested in our common stock on December 31, 2003 and in the S&P 500 Index and the
S&P 500 Information Technology Index. Historic stock price performance is not necessarily indicative of future stock performance.

LOGO

Repurchase of Equity Securities by the Company

In April 2008, 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 months ended December 31, 2008, no shares were repurchased under the repurchase program. Since inception, we have repurchased a total of 750,000 shares under the
program at a cost of $8.9 million. As of December 31, 2008, 2,250,000 shares were available for repurchase. The stock repurchase program will expire in April 2011. The following table provides information about the repurchase of our common
stock during the quarter ended December 31, 2008:



|                        |  |                                    |  |                            |      |                                                                               |   |                                                                                 |          
|----------------------- |  | ---------------------------------- |  | -------------------------- | ---- | ----------------------------------------------------------------------------- | - | ------------------------------------------------------------------------------- | ---------
|                        |  | Total Number ofSharesPurchased (1) |  | AveragePrice Paidper Share |      | Total Number of SharesPurchased as Part ofPublicly AnnouncedPlans or Programs |   | Maximum Number ofShares that May YetBe Purchased Under thePlans or Programs (1)
|October 1- October 31   |  | 17,074                             |  | $                          | 8.13 |                                                                               |  |                                                                                 | 2,250,000
|November 1- November 30 |  | 437                                |  | $                          | 6.01 |                                                                               |  |                                                                                 | 2,250,000
|December 1- December 31 |  | 1,596                              |  | $                          | 7.09 |                                                                               |  |                                                                                 | 2,250,000
|                        |  |                                    |  |                            |      |                                                                               |   |                                                                                 |          
|Total                   |  | 19,107                             |  | $                          | 7.99 |                                                                               |  |                                                                                 | 2,250,000
|                        |  |                                    |  |                            |      |                                                                               |   |                                                                                 |          



|(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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##### Table of Contents

|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------

The following selected
consolidated financial data is derived from our consolidated financial statements. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7,
Managements Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and Notes in Item 8 of this Form 10-K in order to fully understand factors that may affect the
comparability of the information presented below.



|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------- |  | ------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                  |  | Year Ended December 31,               |        
|                                                  |  | 2008                                  |         |   | 2007 |   |         | 2006 |  |   | 2005    |   |  | 2004 |        
|                                                  |  | (in thousands, except per share data) |        
|Consolidated Statement of Operations Data:        |  |                                       |         |  
|Net revenues:                                     |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Product                                           |  | $                                     | 131,073 |   |      | $ | 135,405 |      |  | $ | 56,515  |   |  | $    | 73,563  |   |  | $ | 108,947 |  
|Service                                           |  |                                       | 2,974   |   |      |   | 2,172   |      |  |   | 761     |   |  |      | 865     |   |  |   | 974     |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total revenues                                    |  |                                       | 134,047 |   |      |   | 137,577 |      |  |   | 57,276  |   |  |      | 74,428  |   |  |   | 109,921 |  
|Cost of revenues:                                 |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cost of product                                   |  |                                       | 79,984  |   |      |   | 85,035  |      |  |   | 22,039  |   |  |      | 30,928  |   |  |   | 46,059  |  
|Cost of service                                   |  |                                       | 2,587   |   |      |   | 2,360   |      |  |   | 1,877   |   |  |      | 2,081   |   |  |   | 1,957   |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total cost of revenues                            |  |                                       | 82,571  |   |      |   | 87,395  |      |  |   | 23,916  |   |  |      | 33,009  |   |  |   | 48,016  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Gross profit                                      |  |                                       | 51,476  |   |      |   | 50,182  |      |  |   | 33,360  |   |  |      | 41,419  |   |  |   | 61,905  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Operating expenses:                               |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Product development                               |  |                                       | 37,753  |   |      |   | 32,644  |      |  |   | 28,221  |   |  |      | 24,853  |   |  |   | 24,914  |  
|Sales and marketing                               |  |                                       | 23,635  |   |      |   | 21,181  |      |  |   | 20,408  |   |  |      | 20,994  |   |  |   | 19,347  |  
|General and administrative                        |  |                                       | 17,143  |   |      |   | 16,083  |      |  |   | 13,949  |   |  |      | 19,401  |   |  |   | 12,702  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total operating expenses                          |  |                                       | 78,531  |   |      |   | 69,908  |      |  |   | 62,578  |   |  |      | 65,248  |   |  |   | 56,963  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Operating income (loss)                           |  |                                       | (27,055 | ) |      |   | (19,726 | )    |  |   | (29,218 | ) |  |      | (23,829 | ) |  |   | 4,942   |  
|Interest and other income, net                    |  |                                       | 2,925   |   |      |   | 5,717   |      |  |   | 5,817   |   |  |      | 5,225   |   |  |   | 2,140   |  
|Interest expense on lease financing obligations   |  |                                       | (1,404  | ) |      |   | (1,211  | )    |  |   | (1,379  | ) |  |      | (1,530  | ) |  |   | (1,666  | )
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income (loss) before provision for income taxes   |  |                                       | (25,534 | ) |      |   | (15,220 | )    |  |   | (24,780 | ) |  |      | (20,134 | ) |  |   | 5,416   |  
|Provision for income taxes                        |  |                                       | 297     |   |      |   | 452     |      |  |   | 350     |   |  |      | 154     |   |  |   | 586     |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net income (loss)                                 |  | $                                     | (25,831 | ) |      | $ | (15,672 | )    |  | $ | (25,130 | ) |  | $    | (20,288 | ) |  | $ | 4,830   |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income (loss) per share 1:                        |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Basic                                             |  | $                                     | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | ) |  | $    | (0.50   | ) |  | $ | 0.12    |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Diluted                                           |  | $                                     | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | ) |  | $    | (0.50   | ) |  | $ | 0.12    |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Shares used in per share calculation 1:           |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Basic                                             |  |                                       | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |   |  |      | 40,377  |   |  |   | 40,918  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Diluted                                           |  |                                       | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |   |  |      | 40,377  |   |  |   | 41,007  |  
|                                                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Consolidated Balance Sheet Data:                  |  |                                       |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cash, cash equivalents and short-term investments |  | $                                     | 87,316  |   |      | $ | 107,190 |      |  | $ | 124,157 |   |  | $    | 154,480 |   |  | $ | 160,364 |  
|Working capital                                   |  |                                       | 108,811 |   |      |   | 126,711 |      |  |   | 129,521 |   |  |      | 154,869 |   |  |   | 171,032 |  
|Total assets                                      |  |                                       | 185,517 |   |      |   | 204,707 |      |  |   | 211,272 |   |  |      | 213,671 |   |  |   | 244,384 |  
|Total stockholders equity                        |  |                                       | 132,571 |   |      |   | 153,211 |      |  |   | 153,663 |   |  |      | 178,551 |   |  |   | 208,611 |  



|1 | See Note 1 of Notes to Consolidated Financial Statements for an explanation of shares used in computing basic net income (loss) per share, and diluted net income (loss) per share.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual
Report. The following discussion contains predictions, estimates, and other forward-looking statements that involve a number of risks and uncertainties about our business. These statements may be identified by the use of words such as we
believe, expect, anticipate, intend, plan, goal, continues, may and similar expressions. 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 Business and Risk Factors sections. Our actual results may differ materially.

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 ten 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 for use in management of electricity distribution. We began to receive modest amounts of revenue resulting from these investments in 2004, which grew to approximately $883,000 in 2005, decreased slightly to $791,000 in 2006,
grew substantially to $70.6 million in 2007, and decreased slightly again to $67.1 million in 2008. We refer to this revenue as networked energy services, or NES, revenue. 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 report in the LONWORKS Infrastructure revenues and EBV revenues sections of our discussion on Results of Operations.

We have a history of losses and although we achieved profitability in past fiscal periods, we incurred a loss for the years ended December 31, 2008,
2007, and 2006.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States of America. Note 1, Significant Accounting Policies of Notes to Consolidated Financial Statements in this Annual Report on Form
10-K describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to our stock-based compensation, allowance for
doubtful accounts, inventories, and commitments and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and estimates relate to those policies that are most important to the presentation of our consolidated financial statements and require the most difficult,
subjective and complex judgments.

Revenue Recognition.Our revenues are derived from the sale and license of our products and to a
lesser extent, from fees associated with training, technical support, and custom software design services offered to our customers. Product revenues consist of revenues from hardware sales and software licensing arrangements. Service revenues
consist of product technical support (including software post-contract support services), training, and custom software development services.



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We recognize 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 non-distributor hardware sales, including sales to third party manufacturers, these criteria are generally met at the time of shipment. For
hardware sales made to our 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.

In most instances involving large-scale deployments, our Networked Energy Services, or NES, system products are sold as part of
multiple element arrangements as that term is defined under AICPA Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition, as amended. These arrangements may include electricity meters and data concentrators
(collectively, the Hardware); NES system software, for which a royalty is charged on a per-meter basis; post-contract customer support (PCS) for the NES system software; and extended warranties for the Hardware. These
arrangements may require us to deliver Hardware over an extended period of time. In accordance with SOP 97-2, when the multiple element arrangement includes NES system software, we defer the recognition of all revenue until all software required
under the arrangement has been delivered to the customer. Once the software has been delivered, we recognize 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. We have established vendor specific objective evidence for the PCS on the NES system software, as well as for extended
warranties on our 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.

We account for the rights of return, price protection, rebates, and other sales
incentives offered to distributors of our products in accordance with Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists,and EITF Issue
No. 01-09,Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products).

Stock-Based Compensation. We account for stock-based compensation in accordance with SFAS 123R. 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.

For options and SARs granted prior to January 1, 2008, the expected
term has been calculated using the simplified method as permitted under the Securities and Exchange Commission Staff Accounting Bulletin No. 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. For options and SARs granted subsequent to December 31, 2007, the expected term has been calculated by applying a Monte Carlo simulation model that incorporates Echelons historical data on
post-vest exercise activity and employee termination behavior. The expected volatility is based on both the historical volatility of the our common stock over the most recent period commensurate with the expected life of the option as well as on
implied volatility calculated from the market traded options on our companys stock. 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 accelerated multiple option method over their requisite service period, which is generally the vesting period.

Certain of the stock-based compensation awards we issue vest upon the achievement of specific financial-based performance requirements. SFAS 123R
requires us to estimate whether or not it is probable that these financial-based performance requirements will be met, and, in some cases, when they will be met. These estimates of future financial performance are based on the best information
available at the time of grant, and each quarterly period thereafter until the awards are either earned or forfeited. Any changes we make to our estimates of future financial performance could have a material impact on the amount and timing of
compensation expense associated with these awards.



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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 estimating 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.

In December 2008, the Company completed a stock option exchange program (the Exchange Program) whereby eligible
employees were given an opportunity to exchange some or all of their outstanding stock options and stock appreciation rights (SARs), collectively the Surrendered Awards, for a predetermined number of new SARs. Under the
Exchange Program, participating eligible employees would receive one new SAR for each exchanged option with an exercise price less than $12.00 per share. For exchanged options with an exercise price equal to or greater than $12.00 per share,
participants would receive between 0.33 and 0.67 new SAR for each option exchanged, depending on the exercise price of the exchanged option. The Exchange Offer resulted in incremental stock-based compensation expense of approximately $2.3 million.
In determining the amount of incremental compensation expense associated with the Exchange Program, significant judgement was required to determine the fair value of the Surrendered Awards on the cancellation date, including the estimated remaining
life of those awards. The Company has elected to combine both the incremental value and the unamortized original grant date fair value of the Surrendered Awards, the total of which will be recognized as compensation expense over the vesting term of
the new SARs. The Companys board of directors and Compensation Committee approved the Exchange Program to restore the retention and incentive benefits of the Companys equity awards. Non-employee members of the Companys board of
directors were not eligible to participate in the Exchange Program.

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 approximately 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 continue 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 $323,000
as of December 31, 2008, and $330,000 as of December 31, 2007.

Inventory Valuation. At each balance sheet date, we evaluate our ending
inventories for excess quantities and obsolescence. In general, the evaluation for excess quantities includes analyses of historical sales levels by product and projections of future demand. Inventories on hand in excess of one years
forecasted demand are generally deemed to be excess.

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

For our LWI products, our customers generally buy from a portfolio of off-the-shelf or standard products. In addition, whereas for our NES
customers our revenues are attributable to a relatively few customers buying substantial quantities of any given product, our LWI revenues are composed of a larger volume of smaller dollar transactions. Accordingly, while any single LWI
customers



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demand for a given product may fluctuate from quarter to quarter, the fact that there are so many LWI customers buying a standard product tends to average
out increases or decreases in any individual customers demand. This has historically resulted in a relatively stable future demand forecast for our LWI products, which, absent outside forces such as worsening general economic conditions,
management evaluates in determining its requirement for an excess inventory reserve.

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

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

Warranty Reserves. We evaluate our reserve for warranty costs based on a combination of factors. In circumstances where we are aware of a specific warranty related problem, for example a product recall, we reserve an estimate of the
total out-of-pocket costs we expect to incur to resolve the problem, including, but not limited to, costs to replace or repair the defective items and shipping costs. When evaluating the need for any additional reserve for warranty costs, management
takes into consideration the term of the warranty coverage, the quantity of product in the field that is currently under warranty, historical warranty-related return rates, historical costs of repair, and knowledge of new products introduced. If any
of these factors were to change materially in the future, we may be required to increase our warranty reserve, which could have a material negative impact on our results of operations and our financial condition. Our reserve for warranty costs was
$849,000 as of December 31, 2008, and $301,000 as of December 31, 2007.

Results of Operations

The following table reflects the percentage of total revenues represented by each item in our Consolidated Statements of Operations for the years ended
December 31, 2008, 2007, and 2006:



|                                                |  |                        |    |  |       |    |  |       |   
|----------------------------------------------- |  | ---------------------- | -- |  | ----- | -- |  | ----- | --
|                                                |  | Year EndedDecember 31, |   
|                                                |  | 2008                   |    |  | 2007  |    |  | 2006  |   
|Revenues:                                       |  |                        |    |  |       |    |  |       |   
|Product                                         |  | 97.8                   | %  |  | 98.4  | %  |  | 98.7  | % 
|Service                                         |  | 2.2                    |    |  | 1.6   |    |  | 1.3   |   
|                                                |  |                        |    |  |       |    |  |       |   
|Total revenues                                  |  | 100.0                  |    |  | 100.0 |    |  | 100.0 |   
|Cost of revenues:                               |  |                        |    |  |       |    |  |       |   
|Cost of product                                 |  | 59.7                   |    |  | 61.8  |    |  | 38.5  |   
|Cost of service                                 |  | 1.9                    |    |  | 1.7   |    |  | 3.3   |   
|                                                |  |                        |    |  |       |    |  |       |   
|Total cost of revenues                          |  | 61.6                   |    |  | 63.5  |    |  | 41.8  |   
|                                                |  |                        |    |  |       |    |  |       |   
|Gross profit                                    |  | 38.4                   |    |  | 36.5  |    |  | 58.2  |   
|                                                |  |                        |    |  |       |    |  |       |   
|Operating expenses:                             |  |                        |    |  |       |    |  |       |   
|Product development                             |  | 28.2                   |    |  | 23.7  |    |  | 49.3  |   
|Sales and marketing                             |  | 17.6                   |    |  | 15.4  |    |  | 35.6  |   
|General and administrative                      |  | 12.8                   |    |  | 11.7  |    |  | 24.4  |   
|                                                |  |                        |    |  |       |    |  |       |   
|Total operating expenses                        |  | 58.6                   |    |  | 50.8  |    |  | 109.3 |   
|                                                |  |                        |    |  |       |    |  |       |   
|Loss from operations                            |  | (20.2                  | )  |  | (14.3 | )  |  | (51.1 | ) 
|Interest and other income, net                  |  | 2.2                    |    |  | 4.1   |    |  | 10.1  |   
|Interest expense on lease financing obligations |  | (1.1                   | )  |  | (0.9  | )  |  | (2.3  | ) 
|                                                |  |                        |    |  |       |    |  |       |   
|Loss before provision for income taxes          |  | (19.1                  | )  |  | (11.1 | )  |  | (43.3 | ) 
|Provision for income taxes                      |  | 0.2                    |    |  | 0.3   |    |  | 0.6   |   
|                                                |  |                        |    |  |       |    |  |       |   
|Net loss                                        |  | (19.3                  | )% |  | (11.4 | )% |  | (43.9 | )%
|                                                |  |                        |    |  |       |    |  |       |   



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Revenues

Total revenues



|                       |  |                         |         |                       |   |         |                       |   |                       |  |    |                       |   |  |   |        |  |      |    |  |       |  
|---------------------- |  | ----------------------- | ------- | --------------------- | - | ------- | --------------------- | - | --------------------- |  | -- | --------------------- | - |  | - | ------ |  | ---- | -- |  | ----- | -
|                       |  | Year Ended December 31, |         | 2008 over2007$ Change |   |         | 2007 over2006$ Change |   | 2008 over2007% Change |  |    | 2007 over2006% Change |  
|(Dollars in thousands) |  | 2008                    |         | 2007                  |   | 2006    |                       |   |                       | 
|Total revenues         |  | $                       | 134,047 |                       | $ | 137,577 |                       | $ | 57,276                |  | ($ | 3,530                 | ) |  | $ | 80,301 |  | (2.6 | %) |  | 140.2 | %

The $3.5 million decrease in total revenues in 2008 as compared to 2007 was primarily attributable
to a $3.4 million decrease in NES revenues and a $1.3 million decrease in Enel Project revenues, partially offset by a $1.2 million increase in LONWORKS Infrastructure revenues. The $80.3 million increase in total
revenues in 2007 as compared to 2006 was primarily attributable to a $69.8 million increase in NES revenues, a $7.1 million increase in Enel Project revenues, and a $3.5 million increase in LONWORKS Infrastructure
revenues.

NES revenues



|                       |  |                         |        |                       |   |        |                       |   |                       |  |    |                       |   |  |   |        |  |      |    |  |         |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | ------ | --------------------- | - | --------------------- |  | -- | --------------------- | - |  | - | ------ |  | ---- | -- |  | ------- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   |        | 2007 over2006$ Change |   | 2008 over2007% Change |  |    | 2007 over2006% Change |  
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006   |                       |   |                       | 
|NES Revenues           |  | $                       | 67,118 |                       | $ | 70,558 |                       | $ | 791                   |  | ($ | 3,440                 | ) |  | $ | 69,767 |  | (4.9 | %) |  | 8,820.1 | %

During 2008 and 2007, NES revenues were generated primarily from large scale deployments of our
NES system products, whereas in 2006, NES revenues were generated primarily from the completion of system trials and, to a lesser extent, from limited shipments of NES products.

2007 NES revenues of $70.6 million included $14.4 million of shipments of hardware products that were accepted by our customers and in some cases paid
for, in 2006. However, we could not record this revenue in 2006 since we had not yet met all of the required criteria for revenue recognition.

Our ability to recognize revenue on shipments of our NES products depends on several factors, including, but not limited to, delivery to the customer of all of the software called for in any given agreement, the impact on delivery dates of
any modifications to existing shipment schedules included in the contracts that have been awarded to us thus far, and 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. For example, once all other revenue recognition criteria have been
met, we recognize revenues for the meters (and related NES system software royalties) and data concentrators 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. 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. During 2008, the portion of our NES revenue transactions conducted in currencies other than the U.S. dollar, principally the European Euro and the Australian dollar, was about $205,000, or 0.3%. During 2007, the portion of
our NES revenue transactions conducted in currencies other than the U.S. dollar, principally the European Euro and the Australian dollar, was about $3.9 million, or 5.6%. NES revenue transactions conducted in foreign currencies during 2006 were
immaterial. To date, we have not hedged any of these foreign currency risks. 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.

LWI revenues



|                       |  |                         |        |                       |   |                       |  |                       |        |  |                       |       |  |   |       |  |     |   |  |     |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | --------------------- |  | --------------------- | ------ |  | --------------------- | ----- |  | - | ----- |  | --- | - |  | --- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |        |  | 2007 over2006% Change |      
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006                  |  |                       |        | 
|LWI Revenues           |  | $                       | 54,040 |                       | $ | 52,840                |  | $                     | 49,382 |  | $                     | 1,200 |  | $ | 3,458 |  | 2.3 | % |  | 7.0 | %



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##### Table of Contents

Our LWI revenues are primarily comprised of sales of our hardware products, and to a lesser extent,
revenues we generate from sales of our software products and from our customer support and training offerings.

The $1.2 million increase
in LWI revenues in 2008 as compared to 2007 was primarily due to increases in revenues in the EMEA and Americas regions, partially offset by a reduction in sales in the APJ region. Within the LWI family of products, the increase was attributable to
increases in our power line transceiver and i.Lon products, partially offset by a reduction in sales of our network services and development tools products.

The $3.5 million increase in LWI revenues in 2007 as compared to 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 $2.9 million and $1.0 million during the first and
second quarters of 2006, respectively. Excluding the impact of these revenue recognition revisions, LWI revenues decreased by approximately $442,000, or 0.9%, during 2007 as compared to 2006.

Our future LWI revenues will also be subject to further fluctuations in the exchange rates between the United States dollar and the foreign currencies in
which we sell our LWI products and services. In general, if the dollar were to weaken against these currencies, our revenues from those foreign currency sales, when translated into United States dollars, would increase. Conversely, if the dollar
were to strengthen against these currencies, our revenues from those foreign currency sales, when translated into United States dollars, would decrease. The extent of this exchange rate fluctuation increase or decrease will depend on the amount of
sales conducted in these currencies and the magnitude of the exchange rate fluctuation from year to year. The portion of our LWI revenues conducted in currencies other than the United States dollar, principally the Japanese Yen, was about 5.9% in
2008, 6.8% in 2007, and 6.3% in 2006. To date, we have not hedged any of these foreign currency risks. We do not currently expect that, during the first quarter of 2009, the amount of our LWI revenues conducted in these foreign currencies will
fluctuate significantly from prior year levels. Given the historical and expected future level of sales made in foreign currencies, we do not currently plan to hedge against these currency rate fluctuations. However, if the portion of our revenues
conducted in foreign currencies were to grow significantly, we would re-evaluate these exposures and, if necessary, enter into hedging arrangements to help minimize these risks.

Enel Project revenues



|                       |  |                         |        |                       |   |        |                       |   |                       |  |    |                       |   |  |   |       |  |      |    |  |      |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | ------ | --------------------- | - | --------------------- |  | -- | --------------------- | - |  | - | ----- |  | ---- | -- |  | ---- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   |        | 2007 over2006$ Change |   | 2008 over2007% Change |  |    | 2007 over2006% Change |  
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006   |                       |   |                       | 
|Enel Project Revenues  |  | $                       | 12,889 |                       | $ | 14,180 |                       | $ | 7,103                 |  | ($ | 1,291                 | ) |  | $ | 7,077 |  | (9.1 | %) |  | 99.6 | %

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. Both the $12.9 million and the $14.2 million of Enel project revenue recognized during 2008 and 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. The development and supply agreement expires in December 2011, and the software
enhancement agreement expires in December 2009, although delivery of products and services can extend beyond that date and the agreements may be extended under certain circumstances.

The $7.1 million in Enel Project revenues in 2006 was composed of spare parts for use in Enels Contatore Elettronico system.

We sell our products to Enel and its designated manufacturers in United States dollars. Therefore, the associated revenues are not subject to foreign
currency risks.



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EBV revenues



|                       |  |                         |        |                       |   |                       |  |                       |        |  |                       |       |  |   |       |  |      |   |  |      |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | --------------------- |  | --------------------- | ------ |  | --------------------- | ----- |  | - | ----- |  | ---- | - |  | ---- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |        |  | 2007 over2006% Change |      
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006                  |  |                       |        | 
|EBV Revenues           |  | $                       | 19,787 |                       | $ | 17,564                |  | $                     | 15,511 |  | $                     | 2,223 |  | $ | 2,053 |  | 12.7 | % |  | 13.2 | %

Sales to EBV, our largest distributor and the sole independent distributor of our
LONWORKS Infrastructure products in Europe, accounted for 14.8% of our total revenues in 2008, 12.8% in 2007, and 27.1% in 2006. The primary factor contributing to the $2.2 million increase during 2008 as compared to
2007 was an increase in sales of our control and connectivity transceiver products.

The primary factor contributing to the
$2.1 million increase in EBV revenues during 2007 as compared to 2006 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.

Excluding the impact of the accounting method revision, EBVs shipments to its customers decreased by approximately
$847,000 during 2007 as compared to 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 2009. 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 results of
operations could be harmed.

Product revenues



|                       |  |                         |         |                       |   |         |                       |   |                       |  |    |                       |   |  |   |        |  |      |    |  |       |  
|---------------------- |  | ----------------------- | ------- | --------------------- | - | ------- | --------------------- | - | --------------------- |  | -- | --------------------- | - |  | - | ------ |  | ---- | -- |  | ----- | -
|                       |  | Year Ended December 31, |         | 2008 over2007$ Change |   |         | 2007 over2006$ Change |   | 2008 over2007% Change |  |    | 2007 over2006% Change |  
|(Dollars in thousands) |  | 2008                    |         | 2007                  |   | 2006    |                       |   |                       | 
|Product Revenues       |  | $                       | 131,073 |                       | $ | 135,405 |                       | $ | 56,515                |  | ($ | 4,332                 | ) |  | $ | 78,890 |  | (3.2 | %) |  | 139.6 | %

The $4.3 million decrease in product revenues between 2008 and 2007 was primarily attributable to
a $4.5 million decrease in NES product revenues and a $1.3 million decrease in Enel Project product revenues, partially offset by a $1.5 million increase in LonWorks Infrastructure product revenues. The $78.9 million increase in product revenues
between 2007 and 2006 was primarily attributable to a $69.2 million increase in NES product revenues, a $6.3 million increase in Enel Project product revenues, and a $3.4 million increase in LonWorks Infrastructure product revenues.

Service revenues



|                       |  |                         |       |                       |   |                       |  |                       |     |  |                       |     |  |   |       |  |      |   |  |       |  
|---------------------- |  | ----------------------- | ----- | --------------------- | - | --------------------- |  | --------------------- | --- |  | --------------------- | --- |  | - | ----- |  | ---- | - |  | ----- | -
|                       |  | Year Ended December 31, |       | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |     |  | 2007 over2006% Change |    
|(Dollars in thousands) |  | 2008                    |       | 2007                  |   | 2006                  |  |                       |     | 
|Service Revenues       |  | $                       | 2,974 |                       | $ | 2,172                 |  | $                     | 761 |  | $                     | 802 |  | $ | 1,411 |  | 36.9 | % |  | 185.4 | %

The $802,000 increase in service revenues during 2008 as compared to 2007 was primarily
attributable to a $1.1 million increase in NES support revenues, partially offset by a $262,000 decrease in LWI training and customer support revenues. The $1.4 million increase in service revenues during 2007 as compared to 2006 was primarily due
to approximately $732,000 of custom software development revenues generated from the Enel Project, and, to a lesser extent, an increase in NES support revenues of approximately $623,000.



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##### Table of Contents

Gross Profit and Gross Margin



|                       |  |                         |        |   |                       |   |                       |      |                       |   |        |                       |  |   |       |  |   |        |  |     |   |  |       |  
|---------------------- |  | ----------------------- | ------ | - | --------------------- | - | --------------------- | ---- | --------------------- | - | ------ | --------------------- |  | - | ----- |  | - | ------ |  | --- | - |  | ----- | -
|                       |  | Year Ended December 31, |        |   | 2008 over2007$ Change |   | 2007 over2006$ Change |      | 2008 over2007% Change |   |        | 2007 over2006% Change | 
|(Dollars in thousands) |  | 2008                    |        |   | 2007                  |   |                       | 2006 |                       |   |        |                       | 
|Gross Profit           |  | $                       | 51,476 |   |                       | $ | 50,182                |      |                       | $ | 33,360 |                       |  | $ | 1,294 |  | $ | 16,822 |  | 2.6 | % |  | 50.4  | %
|Gross Margin           |  |                         | 38.4   | % |                       |   | 36.5                  | %    |                       |   | 58.2   | %                     |  |   |      |  |   |       |  | 1.9 |   |  | (21.7 | )

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.

2008
gross margins of 38.4% improved slightly as compared to those generated in 2007. Favorably impacting gross margins during 2008 was the impact of improved gross margins in our NES product line. During 2007, our NES revenues were primarily generated
from sales of earlier versions of our NES products. These older versions were generally more expensive to manufacture. In late 2007, we began shipping newer, cost reduced versions of our NES products that, when sold at approximately the same price
as the earlier versions, yield higher gross margins. As our 2008 NES revenues were generated primarily from sales of these newer, cost reduced NES products, the gross margin attributable to our NES revenues improved.

Partially offsetting the gross margin improvements in our NES products during 2008 was the negative impact of excess and obsolete inventory reserves,
warranty expenses, and purchase price variances we recorded during the year, which collectively had the effect of reducing full year gross margins by approximately 3%. The largest contributor to these additional expenses were the excess and obsolete
reserves we recorded, which were primarily attributable to excess raw material inventory we purchased from our former contract electronic manufacturer (CEM), WKK (see further discussion below). As mentioned in our discussion of
Critical Accounting Estimates above, reserves for excess and obsolete inventory are highly subjective and complex, and are based on managements best estimate of future demand at each reporting date. To the extent actual demand
differs from these estimates, additional reserves could be required in the future, which could have a material negative effect on our results of operations.

Lastly, during 2008, our inventory levels increased substantially as a result of our transition between CEMs. Much of this inventory remained on our balance sheet as of December 31, 2008. As a result, the amount
of indirect overhead spending that was capitalized in inventory as of December 31, 2008 was higher than what was capitalized as of December 31, 2007. This had the effect of improving gross margin during 2008 by approximately 1%, as those
costs would otherwise have been expensed during the respective periods. We expect that, over time, our inventory levels will decrease to more historical levels, which will result in the reduction of capitalized overhead in inventory. When this
occurs, it will cause gross margin rates to decrease.

The 21.7 percentage point decrease in gross margin during 2007 as compared to 2006
was due primarily to the mix of revenues reported. During 2007, the proportion of our revenues attributable to sales of our NES system products increased significantly as compared to 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 2007, overall gross margins will be lower. Conversely, when NES revenues comprise a lower percentage of overall revenues, as they were during 2006, overall gross margins will be higher.

Partially offsetting the decrease in gross margins during 2007 as compared to 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 overall revenues increase, as they
did during 2007 as compared to 2006, gross margins are favorably impacted.

Operating Expenses

Product development



|                       |  |                         |        |                       |   |                       |  |                       |        |  |                       |       |  |   |       |  |      |   |  |      |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | --------------------- |  | --------------------- | ------ |  | --------------------- | ----- |  | - | ----- |  | ---- | - |  | ---- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |        |  | 2007 over2006% Change |      
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006                  |  |                       |        | 
|Product Development    |  | $                       | 37,753 |                       | $ | 32,644                |  | $                     | 28,221 |  | $                     | 5,109 |  | $ | 4,423 |  | 15.7 | % |  | 15.7 | %

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



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The $5.1 million increase in product development expenses during 2008 as compared to 2007 was primarily
due to a $6.2 million increase in compensation and other employee related expenses attributable to an increase in our product development personnel headcount, including a $3.1 million increase in stock-based compensation expenses. Partially
offsetting these increases were decreases in equipment and supply expenses and recruiting and other fees paid to third-party service providers.

The $4.4 million increase in product development expenses during 2007 as compared to 2006 was primarily due to a $3.1 million increase in compensation and other employee related expenses attributable to an increase in our product
development personnel headcount and increased stock-based compensation expenses. To a lesser extent, increases in fees paid to third party service providers, equipment and supply expenses, and facility costs also contributed to the year-over-year
increase.

Sales and marketing



|                       |  |                         |        |                       |   |                       |  |                       |        |  |                       |       |  |   |     |  |      |   |  |     |  
|---------------------- |  | ----------------------- | ------ | --------------------- | - | --------------------- |  | --------------------- | ------ |  | --------------------- | ----- |  | - | --- |  | ---- | - |  | --- | -
|                       |  | Year Ended December 31, |        | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |        |  | 2007 over2006% Change |      
|(Dollars in thousands) |  | 2008                    |        | 2007                  |   | 2006                  |  |                       |        | 
|Sales and Marketing    |  | $                       | 23,635 |                       | $ | 21,181                |  | $                     | 20,408 |  | $                     | 2,454 |  | $ | 773 |  | 11.6 | % |  | 3.8 | %

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

The $2.5 million increase in sales and marketing expenses in 2008 as compared to 2007 was primarily due to a $2.1 million increase in compensation and
other employee related expenses, including a $1.3 million increase in stock-based compensation expenses. Also contributing to the year-over-year increase was approximately $370,000 of unfavorable foreign currency exchange rate fluctuations between
the United States dollar and the local currencies in several of the foreign countries in which we operate.

Of the $773,000 increase in
sales and marketing expenses in 2007 as compared to 2006, approximately $460,000 was attributable to the unfavorable impact of foreign currency exchange rate fluctuations. Excluding the impact of these exchange rate fluctuations, sales and marketing
expenses increased by approximately $313,000, or 1.5%, between the two years.

General and administrative



|                           |  |                         |        |                       |   |                       |  |                       |        |  |                       |       |  |   |       |  |     |   |  |      |  
|-------------------------- |  | ----------------------- | ------ | --------------------- | - | --------------------- |  | --------------------- | ------ |  | --------------------- | ----- |  | - | ----- |  | --- | - |  | ---- | -
|                           |  | Year Ended December 31, |        | 2008 over2007$ Change |   | 2007 over2006$ Change |  | 2008 over2007% Change |        |  | 2007 over2006% Change |      
|(Dollars in thousands)     |  | 2008                    |        | 2007                  |   | 2006                  |  |                       |        | 
|General and Administrative |  | $                       | 17,143 |                       | $ | 16,083                |  | $                     | 13,949 |  | $                     | 1,060 |  | $ | 2,134 |  | 6.6 | % |  | 15.3 | %

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 our company, facility costs, insurance, and other general corporate expenses.

The $1.1 million increase in general and administrative expenses in 2008 as compared to 2007 was primarily due to a $1.3 million increase in stock-based
compensation expenses. Excluding the impact of this increase, general and administrative expenses decreased by approximately $238,000, or 1.5% between the two years.

Of the $2.1 million increase in general and administrative expenses during 2007 as compared to 2006, approximately $842,000 related to an increase in stock-based compensation expenses. The remaining $1.3 million
increase between the two periods was primarily attributable to increases in other compensation related expenses for our executive, accounting, and administrative personnel, and to a lesser extent, increases in cash compensation paid to our Board of
Directors, fees paid to our independent accountants, and costs associated with other third party service providers.

Interest and Other Income, Net



|                               |  |                         |       |                       |   |       |                       |   |       |                       |    |       |                       |  |    |     |   |  |       |    |  |      |   
|------------------------------ |  | ----------------------- | ----- | --------------------- | - | ----- | --------------------- | - | ----- | --------------------- | -- | ----- | --------------------- |  | -- | --- | - |  | ----- | -- |  | ---- | --
|                               |  | Year Ended December 31, |       | 2008 over2007$ Change |   |       | 2007 over2006$ Change |   |       | 2008 over2007% Change |    |       | 2007 over2006% Change | 
|(Dollars in thousands)         |  | 2008                    |       | 2007                  |   | 2006  |                       |   |       |                      
|Interest and Other Income, Net |  | $                       | 2,925 |                       | $ | 5,717 |                       | $ | 5,817 |                       | ($ | 2,792 | )                     |  | ($ | 100 | ) |  | (48.8 | %) |  | (1.7 | %)

Interest and other income, net primarily reflects interest earned by our company on cash and
short-term investment balances as well as foreign exchange translation gains and losses related to short-term intercompany balances.

During 2008, interest and other income, net decreased by approximately $2.8 million as compared to 2007. This decrease was primarily due to a $3.9 million decrease in interest income. The reduction in interest income is primarily the result
of a reduction in our average invested cash balance between the periods coupled with reductions in the weighted average yield on our investment portfolio.



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##### Table of Contents

Partially offsetting the reduction in interest income during 2008 was a $1.1 million increase in foreign
currency translation gains. In accordance with SFAS No. 52, Foreign Currency Translation, we account for foreign currency translation gains and losses associated with our short-term intercompany balances by reflecting these amounts as
either other income or loss in our consolidated statements of operations. During periods when the U.S. dollar weakens in value against these foreign currencies, the associated translation losses negatively impact other income. Conversely, when the
U.S. dollar strengthens, as it did during 2008, the resulting translation gains favorably impact other income.

During 2007, interest and
other income, net decreased by approximately $100,000 as compared to 2006. This decrease was primarily due to a $331,000 decrease in interest income, partially offset by a $214,000 reduction in foreign exchange translation and transaction losses.
The reduction in interest income is primarily the result of a reduction in our average invested cash balance between the periods, which was primarily attributable to our operating losses. To a lesser extent, recent reductions in the weighted average
yield our investment portfolio earns also contributed to the year-over-year decline in interest income.

Interest Expense on Lease Financing
Obligations



|                                                |  |                         |       |                       |   |                       |  |   |                       |  |   |                       |  |    |     |   |  |      |   |  |       |   
|----------------------------------------------- |  | ----------------------- | ----- | --------------------- | - | --------------------- |  | - | --------------------- |  | - | --------------------- |  | -- | --- | - |  | ---- | - |  | ----- | --
|                                                |  | Year Ended December 31, |       | 2008 over2007$ Change |   | 2007 over2006$ Change |  |   | 2008 over2007% Change |  |   | 2007 over2006% Change | 
|(Dollars in thousands)                          |  | 2008                    |       | 2007                  |   | 2006                  |  |   |                       | 
|Interest Expense on Lease Financing Obligations |  | $                       | 1,404 |                       | $ | 1,211                 |  | $ | 1,379                 |  | $ | 193                   |  | ($ | 168 | ) |  | 15.9 | % |  | (12.2 | %)

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 Note 3 of Notes to Consolidated Financial Statements in Item 15 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 as an asset on our balance sheet the costs paid by our lessor to construct our headquarters facility, along with a
corresponding financing liability 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 partially as land lease expense and
partially as principal and interest on the financing liability. Interest expense on lease financing obligations reflects the portion of our monthly lease payments that is allocated to interest expense.

In June 2008, the building leases were amended resulting in an extension of the lease term for both buildings through March 2020. The extended leases
require minimum lease payments through March 2020 totaling approximately $48.9 million. As a result of the lease extension, our company increased the carrying amount of its lease financing obligations by approximately $12.5 million to
approximately $27.6 million (an amount equal to the present value of the revised lease payments at the date of the lease extension). This had the effect of increasing the amount of our monthly attributable to interest expense. As with any amortizing
fixed rate loan, payments made earlier in the term of the loan are comprised primarily of interest expense with little being allocated to principal repayment. Payments made later in the term of the loan, however, have an increasing proportion of
principal repayment, with less being attributable to interest expense. Accordingly, we currently expect a higher proportion of the payments we make in 2009 will be allocated to principal repayment and less will be allocated to interest expense.

Provision for Income Taxes



|                           |  |                         |     |                       |   |      |                       |   |                       |  |    |                       |   |  |   |     |  |       |    |  |      |  
|-------------------------- |  | ----------------------- | --- | --------------------- | - | ---- | --------------------- | - | --------------------- |  | -- | --------------------- | - |  | - | --- |  | ----- | -- |  | ---- | -
|                           |  | Year Ended December 31, |     | 2008 over2007$ Change |   |      | 2007 over2006$ Change |   | 2008 over2007% Change |  |    | 2007 over2006% Change |  
|(Dollars in thousands)     |  | 2008                    |     | 2007                  |   | 2006 |                       |   |                       | 
|Provision for Income Taxes |  | $                       | 297 |                       | $ | 452  |                       | $ | 350                   |  | ($ | 155                   | ) |  | $ | 102 |  | (34.3 | %) |  | 29.1 | %

The provision for income taxes for 2008, 2007, and 2006 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 $297,000 in 2008, $452,000 in 2007, and $350,000 in 2006 consist primarily of taxes related to profitable foreign subsidiaries and various state minimum taxes.



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Off-Balance-Sheet Arrangements and Other Contractual Obligations

Off-Balance-Sheet Arrangements. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees,
subordinated retained interests, derivative instruments, or other contingent arrangements that expose our company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity
that provides financing, liquidity, market risk, or credit risk support to us.

Lease Commitments. In December 1999,
we entered into a lease agreement with a real estate developer for our existing corporate headquarters in San Jose, California. In October 2000, we entered into a second lease agreement with the same real estate developer for an additional building
at our headquarters site. These leases were scheduled to expire in 2011 and 2013, respectively.

Effective June 2008, the building leases
were amended resulting in an extension of the lease term for both buildings through March 2020. The extended leases require minimum lease payments through March 2020 totaling approximately $48.9 million. Both leases permit us to exercise an
option to extend the respective lease for two sequential five-year terms. In addition, the amended leases eliminated our requirement to provide the landlord with security deposits totaling $6.2 million, which we had previously satisfied by causing
to have issued standby letters of credit (LOCs). As of June 30, 2008, the previously issued LOCs had been returned to the bank that issued them and were cancelled. The leases of our corporate headquarters facilities are accounted
for under EITF 97-10 and SFAS 98 (see Note 3 of Notes to Consolidated Financial Statements in Item 8 of this Report).

In
addition, we lease facilities under operating leases for our sales, marketing, and product development personnel located elsewhere within the United States and in ten 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 2020, and in some instances are cancelable with advance notice. Lastly, we also lease
certain equipment and, for some of our sales personnel, automobiles. These operating leases are generally less than five years in duration.

Purchase Commitments. We utilize several contract manufacturers who manufacture and test our products requiring assembly. These contract manufacturers acquire components and build product based on demand information supplied by us in
the form of purchase orders and demand forecasts. These purchase orders and demand forecasts generally cover periods 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 would enable us to recover a portion of any future amounts paid. We believe the estimated fair value of these
indemnification agreements in excess of the applicable insurance coverage is minimal.

Royalties. We have certain
royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a U.S. dollar amount per unit shipped or a percentage of the underlying revenue. Royalty expense, which was recorded as cost of
products revenue in our consolidated statements of income, was approximately $513,000 during 2008, $573,000 during 2007, and $493,000 during 2006.

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



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principles, we make a provision for these exposures when it is both probable that a liability has been incurred and the amount of the exposure can be
reasonably estimated. To date, such provisions have been immaterial, and we believe that, as of December 31, 2008, 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 December 31, 2008, it is possible that our results of operations, cash flows, and financial position could be harmed by the
resolution of any such outstanding claims.

As of December 31, 2008, our contractual obligations were as follows (in thousands):



|                            |  |                        |        |                 |   |           |  |           |       |                  |   |       |  |   |       
|--------------------------- |  | ---------------------- | ------ | --------------- | - | --------- |  | --------- | ----- | ---------------- | - | ----- |  | - | ------
|                            |  | Payments due by period
|                            |  | Total                  |        | Less than 1year |   | 2-3 years |  | 4-5 years |       | More than 5years
|Lease financing obligations |  | $                      | 37,998 |                 | $ | 3,097     |  | $         | 6,309 |                  | $ | 6,468 |  | $ | 22,124
|Operating leases            |  |                        | 11,663 |                 |   | 1,838     |  |           | 2,885 |                  |   | 1,885 |  |   | 5,055 
|Purchase commitments        |  |                        | 17,877 |                 |   | 17,871    |  |           | 6     |                  |   |      |  |   |      
|                            |  |                        |        |                 |   |           |  |           |       |                  |   |       |  |   |       
|Total                       |  | $                      | 67,538 |                 | $ | 22,806    |  | $         | 9,200 |                  | $ | 8,353 |  | $ | 27,179
|                            |  |                        |        |                 |   |           |  |           |       |                  |   |       |  |   |       

The amounts in the table above exclude $1.3 million of income tax liabilities and related interest
and penalties under FIN 48 as we are unable to reasonably estimate the timing of settlement. See Note 9, Income Taxes of Notes to Consolidated Financial Statements for further discussion.

Liquidity and Capital Resources

Since our inception, we have financed our operations and met our capital expenditure requirements primarily from the sale of preferred stock and common stock, although during the years 2002 through 2004, we were also able to finance our
operations through operating cash flow. From inception through December 31, 2008, we raised $291.4 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 authorized
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. Since inception, we repurchased a total of 2,204,184 shares under the program at a cost of $16.1
million. The stock repurchase program expired in March 2008.

In April 2008, our board of directors approved a new 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. Since inception, we have repurchased a total of 750,000 shares under the
program at a cost of $8.9 million. As of December 31, 2008, 2,250,000 shares were available for repurchase. The new stock repurchase program will expire in April 2011.

The following table presents selected financial information for each of the last three fiscal years (dollars in thousands):



|                                                   |  |                    |         |      |   |         |  |   |        
|-------------------------------------------------- |  | ------------------ | ------- | ---- | - | ------- |  | - | -------
|                                                   |  | As of December 31,
|                                                   |  | 2008               |         | 2007 |   | 2006   
|Cash, cash equivalents, and short-term investments |  | $                  | 87,316  |      | $ | 107,190 |  | $ | 124,157
|Trade accounts receivable, net                     |  |                    | 23,480  |      |   | 33,469  |  |   | 13,918 
|Working capital                                    |  |                    | 108,811 |      |   | 126,711 |  |   | 129,521
|Stockholders equity                               |  |                    | 132,571 |      |   | 153,211 |  |   | 153,663

As of December 31, 2008, we had $87.3 million in cash, cash equivalents, and short-term
investments, a decrease of $19.9 million as compared to December 31, 2007. Historically, our primary source of cash, other than stock sales and exercises of stock options and warrants as discussed above, has been receipts from revenue. Our
primary uses of cash have been cost of revenues, compensation related payments and other operating expenses, acquisitions, capital expenditures, and purchases under our stock repurchase programs.



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Cash flows from operating activities. Cash flows from operating activities have historically been
driven by net income levels, adjustments for non-cash charges such as stock-based compensation expenses, depreciation, and amortization; changes in accrued investment income; and fluctuations in operating asset and liability balances. Net cash used
in operating activities was $3.5 million in 2008, a $9.6 million decrease from 2007. During 2008, net cash used in operating activities was primarily the result of our net loss of $25.8 million and a net increase in our operating
assets and liabilities of $242,000, all of which was partially offset by non-cash charges for stock-based compensation expenses of $14.5 million, depreciation and amortization expenses of $7.4 million, and a decrease in accrued investment
income of $721,000. During 2007, net cash used in operating activities was primarily the result of our net loss of $15.7 million and changes in our operating assets and liabilities of $13.2 million; partially offset by stock-based
compensation charges of $7.8 million, depreciation and amortization of $7.4 million, and a decrease in accrued investment income of $436,000. Cash used in operating activities in 2006 of $18.4 million was primarily the result of our
net loss of $25.1 million; changes in our operating assets and liabilities of $5.3 million; and an increase in accrued investment income of $446,000; partially offset by stock-based compensation charges of $5.5 million and
depreciation and amortization of $7.1 million.

Cash flows from investing activities. Cash flows from investing activities have
historically been driven by transactions involving our short-term investment portfolio, capital expenditures, changes in our long-term assets, and acquisitions. Net cash used in investing activities was $23.8 million for 2008, a $71.0 million
increase over 2007. Net cash used in investing activities in 2008 was primarily the result of net purchases of available-for-sale short-term investments and by capital expenditures of $4.6 million. Net cash provided by investing activities in 2007
was primarily the result of proceeds from maturities and sales of our available-for-sale short-term investments; partially offset by capital expenditures of $8.1 million. During 2006, net cash provided by investing activities of $4.8 million was
primarily the result of proceeds from maturities and sales of our available-for-sale short-term investments; partially offset by capital expenditures of $4.7 million.

Cash flows from financing activities. Cash flows from financing activities have historically been driven by the proceeds from issuance of common
and preferred stock offset by transactions under our stock repurchase program and principal payments under our lease financing obligations. Net cash used in financing activities was $10.1 million for 2008, a $14.2 million increase over
2007. Net cash used in financing activities in 2008 was primarily attributable to $8.9 million of open-market repurchases of our common stock under our stock repurchase program, $1.8 million of principal payments on our lease financing
obligations, and $1.6 million of repurchases of common stock from our employees for payment of income and other payroll taxes they owed upon the vesting of performance shares and upon the exercise of options; partially offset by proceeds of
$2.1 million from issuance of common stock upon exercise of options by our employees. Net cash provided by financing activities in 2007 was primarily attributable to proceeds of $11.2 million from issuance of common stock upon exercise of
options by our employees, partially offset by $4.5 million of repurchases of common stock from our employees for payment of income and other payroll taxes they owed upon the vesting of performance shares and upon the exercise of options, and
$2.6 million of principal payments on our lease financing obligations. During 2006, net cash used in financing activities of $8.6 million was primarily attributable to $6.3 million of open-market repurchases of our common stock under
our stock repurchase program, and repurchases of $239,000 of our common stock from our employees for payment of income and other payroll taxes they owed upon the vesting of performance shares and upon the exercise of stock options, and
$2.3 million of principal payments on our lease financing obligations; partially offset by proceeds of $265,000 from issuance of common stock as a result of options exercised by our employees.

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

We maintain a $15.0 million line of credit with our primary bank. As of
December 31, 2008, our primary bank has issued, against the line of credit, a standby letter of credit totaling $217,000. Other than causing to have issued standby letters of credit, we have never drawn against the line of credit, nor have amounts
ever been drawn against the standby letters of credit issued by the bank.

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 computer systems and related software, office and manufacturing 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. In addition, any continued weakening
of 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 in Part I, Item 1A - Risk Factors. 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.



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Related Party Transactions

During the years ended December 31, 2008, 2007, and 2006, 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, our Chairman and Chief Executive Officer, M. Kenneth Oshman, uses his private plane or charter aircraft for Company business for himself and any employees that accompany him. In August 2008, our Board of Directors approved a
reimbursement arrangement whereby our company will reimburse Mr. Oshman for 50% of the costs incurred for his private plane or charter aircraft travel used while on company business. Such costs include flight charges (subject to any discounted
rate that may apply), fuel, fuel surcharges, landing fees, crew costs and related expenses. During 2008, we recognized a total of approximately $258,000 in expenses pursuant to the reimbursement arrangement, all of which has been included in general
and administrative expenses in the Consolidated Statements of Operations.

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 11 to our accompanying 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 February 28, 2009, a representative of Enel has not been appointed 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 our 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 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. The development and supply agreement expires in December 2011, and the
software enhancement agreement expires in December 2009, although delivery of products and services can extend beyond those dates and the agreements may be extended under certain circumstances.

During 2008, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $12.9 million, $5.0 million
of which was included in accounts receivable at December 31, 2008. During 2007, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $14.2 million, $3.0 million of which was included in
accounts receivable at December 31, 2007. During 2006, we recognized revenue from products and services sold to Enel and its designated manufacturers of approximately $7.1 million.

Recently Issued Accounting Standards

See Note 1(t) Recent Accounting
Pronouncements in Notes to the Consolidated Financial Statements in Item 15 of Part IV of this Annual Report on Form 10-K for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated
effects on financial condition and results of operations, which is incorporated herein by reference.



|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

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 100 basis points from levels at December 31, 2008, the fair market value of the portfolio
would decline by an immaterial amount, due primarily to the fact that current interest rates remain at historically low levels. We currently intend to hold our fixed income investments until maturity or for a period of time as needed to recover any
decline in value due to interest rate fluctuation, and therefore we would not expect our



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operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. However, in the unlikely event it was
necessary, we could decide to sell some or all of our 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. Due to our
modest exposure to foreign currency fluctuations, if foreign exchange rates were to fluctuate by 10% from rates at December 31, 2008, our financial position and results of operations would not be materially affected. However, it is possible
that there could be a material impact in the future.



|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------

The
Financial Statements and Supplementary Data required by this item are set forth in Item 6 and at the pages indicated in Item 15(a).



|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------

None.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------

(a) Evaluation of Effectiveness of
Disclosure Controls and Procedure

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 Annual Report on
Form 10-K, 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, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of December 31, 2008.

(b) Managements Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934). Because
of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as
of December 31, 2008. This evaluation was based on the framework in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the
framework in Internal Control  Integrated Framework, our management concluded that our internal control over financial reporting is effective at this reasonable assurance level as of December 31, 2008. The Companys
independent registered public accounting firm, KPMG LLP, has issued an attestation report on the Companys internal control over financial reporting. The report on the audit of internal control over financial reporting appears on page 41 of
this Form 10-K.



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(c) Changes in Internal Control Over Financial Reporting

There were no changes in our internal controls over financial reporting (as defined in Rule 13a-15(e) of the Exchange Act) that occurred during the
quarter ended December 31, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

Echelon is scheduled to hold its
2009 annual meeting of stockholders on May 14, 2009. The meeting will commence at 10:00 a.m., PDT, and will be held at our corporate headquarters located at 570 Meridian Avenue, San Jose, California 95126. The date of record for the annual
meeting is March 23, 2009.



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PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE MATTERS
|-------- | --------------------------------------------------------------

The information regarding our executive officers required by this Item is incorporated herein by reference from the section titled Executive Officers of Registrant in Part I of this annual report on Form
10-K. The remaining information required by this Item is incorporated herein by reference from our Proxy Statement for the 2009 Annual Meeting of Stockholders (the 2009 Proxy Statement), which will be filed with the Securities and
Exchange Commission no later than 120 days after the end of our fiscal year ended December 31, 2008.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

The information required by
this Item is incorporated herein by reference from our 2009 Proxy Statement.



|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
|-------- | --------------------------------------------------------------

The information required by this Item is incorporated herein by reference from our 2009 Proxy Statement.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
|-------- | ------------------------------------------------------------------------

The information required by this Item is incorporated herein by reference from our 2009 Proxy Statement.



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

The
information required by this Item is incorporated herein by reference from our 2009 Proxy Statement.

PART IV



|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|-------- | ---------------------------------------------------------------

(a) The following documents are filed as part of this Form:



| | 1. | Financial Statements
| | -- | --------------------



|                                                        |  |     
|------------------------------------------------------- |  | ----
|                                                        |  | Page
|Report of Independent Registered Public Accounting Firm |  | 41  
|Consolidated Balance Sheets                             |  | 42  
|Consolidated Statements of Operations                   |  | 43  
|Consolidated Statements of Stockholders Equity         |  | 44  
|Consolidated Statements of Cash Flows                   |  | 45  
|Consolidated Statements of Comprehensive Loss           |  | 46  
|Notes to Consolidated Financial Statements              |  | 47  



| | 2. | Financial Statement Schedule
| | -- | ----------------------------



|                                                          |  |   
|--------------------------------------------------------- |  | --
|See Note 12 in Notes to Consolidated Financial Statements |  | 68

All other schedules have been omitted because they are not applicable or the required information
is included in the Consolidated Financial Statements or the Notes thereto.



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| | 3. | Exhibits
| | -- | --------

Item 601 of Regulation S-K requires the
following exhibits listed below. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K has been identified.



|            |  |                                                                                                                                                                                       
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                               
|            | 
|3.2*        |  | Amended and Restated Certificate of Incorporation of Registrant.                                                                                                                      
|            | 
|3.3*        |  | Amended and Restated Bylaws of Registrant.                                                                                                                                            
|            | 
|4.1*        |  | Form of Registrants Common Stock Certificate.                                                                                                                                        
|            | 
|4.2*        |  | Second Amended and Restated Modification Agreement dated May 15, 1997.                                                                                                                
|            | 
|10.1*       |  | Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers.                                                                       
|            | 
|10.2*+      |  | 1997 Stock Plan and forms of related agreements.                                                                                                                                      
|            | 
|10.2(a)*+   |  | Form of 1997 Stock Plan Stock Option Agreement with early exercise feature                                                                                                            
|            | 
|10.2(b)*+   |  | Form of 1997 Stock Plan Nonqualified Stock Option Agreement with early exercise feature                                                                                               
|            | 
|10.2(c)*+   |  | Form of 1997 Stock Plan Nonqualified Stock Option Agreement                                                                                                                           
|            | 
|10.2(d)*+   |  | Form of 1997 Stock Plan Performance Share Agreement                                                                                                                                   
|            | 
|10.2(e)*+   |  | Form of 1997 Stock Plan Performance Share Agreement for non-US employees                                                                                                              
|            | 
|10.2(f)*+   |  | Form of 1997 Stock Plan Performance Share Agreement with performance based vesting criteria for non-US employees                                                                      
|            | 
|10.2(g)*+   |  | Form of 1997 Stock Plan Stock Appreciation Right Agreement for non-US employees                                                                                                       
|            | 
|10.2(h)*+   |  | Form of 1997 Stock Plan Performance Share Agreement with performance based vesting criteria                                                                                           
|            | 
|10.2(i)*+   |  | Form of 1997 Stock Plan Performance Share Agreement                                                                                                                                   
|            | 
|10.2(j)*+   |  | Form of 1997 Stock Plan Stock Appreciation Right Agreement                                                                                                                            
|            | 
|10.3*+      |  | 1988 Stock Option Plan and forms of related agreements.                                                                                                                               
|            | 
|10.4*       |  | Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2).                                                                                      
|            | 
|10.5*       |  | Form of International Distributor Agreement.                                                                                                                                          
|            | 
|10.6*       |  | Form of OEM License Agreement.                                                                                                                                                        
|            | 
|10.7*       |  | Form of Software License Agreement.                                                                                                                                                   
|            | 
|10.8*       |  | International Distributor Agreement between the Company and EBV Elektronik GmbH as of December 1, 1997.                                                                               
|            | 
|10.9*+      |  | 1998 Director Option Plan.                                                                                                                                                            
|            | 
|21.1*       |  | Subsidiaries of the Registrant.                                                                                                                                                       
|            | 
|23.1        |  | Consent of KPMG LLP, Independent Registered Public Accounting Firm.                                                                                                                   
|            | 
|24.1*       |  | Power of Attorney (see signature page).                                                                                                                                               
|            | 
|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.



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



|+ | Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.
|- | -----------------------------------------------------------------------------------------------------------------------------------------



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Echelon Corporation:

We have audited the accompanying consolidated balance sheets of Echelon Corporation and subsidiaries as of December 31, 2008 and 2007, and the
related consolidated statements of operations, stockholders equity, comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2008. We also have audited Echelon Corporations internal
control over financial reporting as of December 31, 2008, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Echelon
Corporations management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting,
included in the accompanying Managements Annual Report on Internal Control over Financial Reporting appearing under Item 9A(b). Our responsibility is to express an opinion on these consolidated financial statements and the Companys
internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal
control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures
as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A companys
internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions
and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.

Because of
its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the
consolidated financial statements referred to above present fairly, in all material respects, the financial position of Echelon Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of its operations and its cash flows
for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also in our opinion, Echelon Corporation maintained, in all material respects, effective internal control
over financial reporting as of December 31, 2008, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.



|                         
|-------------------------
|/s/ KPMG LLP             
|                         
|                         
|Mountain View, California
|March 16, 2009           



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ECHELON CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                |  |              |          |   |      |   |          |  
|------------------------------------------------------------------------------- |  | ------------ | -------- | - | ---- | - | -------- | -
|                                                                                |  | December 31, |         
|                                                                                |  | 2008         |          |   | 2007 |  
|ASSETS                                                                          |  |              |          |   |      |   |          |  
|Current Assets:                                                                 |  |              |          |   |      |   |          |  
|Cash and cash equivalents                                                       |  | $            | 37,669   |   |      | $ | 76,062   |  
|Short-term investments                                                          |  |              | 49,647   |   |      |   | 31,128   |  
|Accounts receivable, net of allowances of $1,010 in 2008 and $1,428 in 20071    |  |              | 23,480   |   |      |   | 33,469   |  
|Inventories                                                                     |  |              | 16,513   |   |      |   | 14,012   |  
|Deferred cost of goods sold                                                     |  |              | 2,482    |   |      |   | 6,656    |  
|Other current assets                                                            |  |              | 4,707    |   |      |   | 2,092    |  
|                                                                                |  |              |          |   |      |   |          |  
|Total current assets                                                            |  |              | 134,498  |   |      |   | 163,419  |  
|                                                                                |  |              |          |   |      |   |          |  
|Property and equipment, net                                                     |  |              | 40,574   |   |      |   | 30,776   |  
|Goodwill                                                                        |  |              | 8,417    |   |      |   | 8,548    |  
|Other long-term assets                                                          |  |              | 2,028    |   |      |   | 1,964    |  
|                                                                                |  |              |          |   |      |   |          |  
|TOTAL ASSETS                                                                    |  | $            | 185,517  |   |      | $ | 204,707  |  
|                                                                                |  |              |          |   |      |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                            |  |              |          |   |      |   |          |  
|Current Liabilities:                                                            |  |              |          |   |      |   |          |  
|Accounts payable                                                                |  | $            | 10,675   |   |      | $ | 12,945   |  
|Accrued liabilities                                                             |  |              | 5,053    |   |      |   | 4,551    |  
|Current portion lease financing obligations                                     |  |              | 1,439    |   |      |   | 2,900    |  
|Deferred revenues                                                               |  |              | 8,520    |   |      |   | 16,312   |  
|                                                                                |  |              |          |   |      |   |          |  
|Total current liabilities                                                       |  |              | 25,687   |   |      |   | 36,708   |  
|                                                                                |  |              |          |   |      |   |          |  
|Long-Term Liabilities:                                                          |  |              |          |   |      |   |          |  
|Lease financing obligations, excluding current portion                          |  |              | 25,350   |   |      |   | 13,151   |  
|Other long-term liabilities                                                     |  |              | 1,909    |   |      |   | 1,637    |  
|                                                                                |  |              |          |   |      |   |          |  
|Total long-term liabilities                                                     |  |              | 27,259   |   |      |   | 14,788   |  
|                                                                                |  |              |          |   |      |   |          |  
|Commitments and Contingencies (Note 8)                                          |  |              |          |   |      |   |          |  
|Stockholders Equity:                                                           |  |              |          |   |      |   |          |  
|Preferred stock, $0.01 par value:                                               |  |              |          |   |      |   |          |  
|Authorized5,000,000 shares; none outstanding                                   |  |              |         |   |      |   |         |  
|Common stock, $0.01 par value:                                                  |  |              |          |   |      |   |          |  
|Authorized100,000,000 shares                                                   |  |              |          |   |      |   |          |  
|Issued43,676,229 shares in 2008 and 43,205,524 shares in 2007                  |  |              |          |   |      |   |          |  
|Outstanding40,457,045 shares in 2008 and 40,736,340 shares in 2007             |  |              | 437      |   |      |   | 432      |  
|Additional paid-in capital                                                      |  |              | 313,549  |   |      |   | 298,556  |  
|Treasury stock, at cost (3,219,184 shares in 2008 and 2,469,184 shares in 2007) |  |              | (28,130  | ) |      |   | (19,259  | )
|Accumulated other comprehensive income                                          |  |              | 784      |   |      |   | 1,718    |  
|Accumulated deficit                                                             |  |              | (154,069 | ) |      |   | (128,236 | )
|                                                                                |  |              |          |   |      |   |          |  
|Total stockholders equity                                                      |  |              | 132,571  |   |      |   | 153,211  |  
|                                                                                |  |              |          |   |      |   |          |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                      |  | $            | 185,517  |   |      | $ | 204,707  |  
|                                                                                |  |              |          |   |      |   |          |  



|1 | Includes related party amounts of $4,970 in 2008 and $3,000 in 2007. See Note 11 for additional information on related
party transactions.
|- | ------------------------------------------------------------------------------------------------------------------------------------------

See accompanying notes to the consolidated financial statements.



42



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ECHELON CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                |  | Year Ended December 31, |        
|                                                |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|REVENUES:                                       |  |                         |         |   |      |   |         |      |  |   |         |  
|Product                                         |  | $                       | 131,073 |   |      | $ | 135,405 |      |  | $ | 56,515  |  
|Service                                         |  |                         | 2,974   |   |      |   | 2,172   |      |  |   | 761     |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Total revenues1                                 |  |                         | 134,047 |   |      |   | 137,577 |      |  |   | 57,276  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|COST OF REVENUES:                               |  |                         |         |   |      |   |         |      |  |   |         |  
|Cost of product                                 |  |                         | 79,984  |   |      |   | 85,035  |      |  |   | 22,039  |  
|Cost of service                                 |  |                         | 2,587   |   |      |   | 2,360   |      |  |   | 1,877   |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Total cost of revenues                          |  |                         | 82,571  |   |      |   | 87,395  |      |  |   | 23,916  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Gross profit                                    |  |                         | 51,476  |   |      |   | 50,182  |      |  |   | 33,360  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|OPERATING EXPENSES:                             |  |                         |         |   |      |   |         |      |  |   |         |  
|Product development                             |  |                         | 37,753  |   |      |   | 32,644  |      |  |   | 28,221  |  
|Sales and marketing                             |  |                         | 23,635  |   |      |   | 21,181  |      |  |   | 20,408  |  
|General and administrative                      |  |                         | 17,143  |   |      |   | 16,083  |      |  |   | 13,949  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                        |  |                         | 78,531  |   |      |   | 69,908  |      |  |   | 62,578  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Loss from operations                            |  |                         | (27,055 | ) |      |   | (19,726 | )    |  |   | (29,218 | )
|Interest and other income, net                  |  |                         | 2,925   |   |      |   | 5,717   |      |  |   | 5,817   |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Interest expense on lease financing obligations |  |                         | (1,404  | ) |      |   | (1,211  | )    |  |   | (1,379  | )
|Loss before provision for income taxes          |  |                         | (25,534 | ) |      |   | (15,220 | )    |  |   | (24,780 | )
|Provision for income taxes                      |  |                         | 297     |   |      |   | 452     |      |  |   | 350     |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|NET LOSS                                        |  | $                       | (25,831 | ) |      | $ | (15,672 | )    |  | $ | (25,130 | )
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Loss per share:                                 |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic                                           |  | $                       | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | )
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Diluted                                         |  | $                       | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | )
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Shares used in per share calculation:           |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic                                           |  |                         | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Diluted                                         |  |                         | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |  
|                                                |  |                         |         |   |      |   |         |      |  |   |         |  



|1 | Includes related party amounts of $12,889 in 2008, $14,180 in
2007, and $7,103 in 2006. See Note 11 for additional information on related party transactions
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

See accompanying notes to
the consolidated financial statements.



43



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ECHELON CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands)



|                                                                                                                 |  |              |   |  |                |     |   |                   |        |   |                                     |   |         |             |  |   |         |   |  |         |       |   |       |   |          |   |  |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------ | - |  | -------------- | --- | - | ----------------- | ------ | - | ----------------------------------- | - | ------- | ----------- |  | - | ------- | - |  | ------- | ----- | - | ----- | - | -------- | - |  | - | ------- | -
|                                                                                                                 |  | Common Stock |   |  | Treasury Stock |     |   | AdditionalPaid-In |        |   | AccumulatedOtherComprehensiveIncome |   |         | Accumulated |  |   |         |  
|                                                                                                                 |  | Shares       |   |  | Amount         |     |   | Shares            |        |   | Amount                              |   |         | Capital     |  |   | (Loss)  |   |  | Deficit |       |   | Total |  
|BALANCE AT DECEMBER 31, 2005                                                                                     |  | 41,473       |   |  | $              | 415 |   |                   | (1,673 | ) |                                     | $ | (12,925 | )           |  | $ | 278,268 |   |  | $       | (118  | ) |       | $ | (87,089  | ) |  | $ | 178,551 |  
|Exercise of stock options                                                                                        |  | 125          |   |  |                | 1   |   |                   |       |   |                                     |   |        |             |  |   | 763     |   |  |         |      |   |       |   |         |   |  |   | 764     |  
|Release of performance shares                                                                                    |  | 72           |   |  |                | 1   |   |                   |       |   |                                     |   |        |             |  |   | (1      | ) |  |         |      |   |       |   |         |   |  |   |        |  
|Stock received for payment of option exercise price                                                              |  | (61          | ) |  |                | (1  | ) |                   |       |   |                                     |   |        |             |  |   | (498    | ) |  |         |      |   |       |   |         |   |  |   | (499    | )
|Stock received for payment of employee taxes on vesting of performance shares and upon exercise of stock options |  | (29          | ) |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | (239    | ) |  |         |      |   |       |   |         |   |  |   | (239    | )
|Repurchase of stock                                                                                              |  |             |   |  |                |    |   |                   | (796   | ) |                                     |   | (6,334  | )           |  |   |        |   |  |         |      |   |       |   |         |   |  |   | (6,334  | )
|Repurchase of employee shares                                                                                    |  | (3           | ) |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | (25     | ) |  |         |      |   |       |   |         |   |  |   | (25     | )
|Stock-based compensation                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | 5,460   |   |  |         |      |   |       |   |         |   |  |   | 5,460   |  
|Foreign currency translation adjustment                                                                          |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | 751   |   |       |   |         |   |  |   | 751     |  
|Unrealized holding gain on available-for-sale securities                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | 364   |   |       |   |         |   |  |   | 364     |  
|Net loss                                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         |      |   |       |   | (25,130  | ) |  |   | (25,130 | )
|                                                                                                                 |  |              |   |  |                |     |   |                   |        |   |                                     |   |         |             |  |   |         |   |  |         |       |   |       |   |          |   |  |   |         |  
|BALANCE AT DECEMBER 31, 2006                                                                                     |  | 41,577       |   |  | $              | 416 |   |                   | (2,469 | ) |                                     | $ | (19,259 | )           |  | $ | 283,728 |   |  | $       | 997   |   |       | $ | (112,219 | ) |  | $ | 153,663 |  
|Exercise of stock options                                                                                        |  | 1,949        |   |  |                | 19  |   |                   |       |   |                                     |   |        |             |  |   | 18,378  |   |  |         |      |   |       |   |         |   |  |   | 18,397  |  
|Release of performance shares                                                                                    |  | 228          |   |  |                | 2   |   |                   |       |   |                                     |   |        |             |  |   | (2      | ) |  |         |      |   |       |   |         |   |  |   |        |  
|Stock received for payment of option exercise price                                                              |  | (332         | ) |  |                | (3  | ) |                   |       |   |                                     |   |        |             |  |   | (7,166  | ) |  |         |      |   |       |   |         |   |  |   | (7,169  | )
|Stock received for payment of employee taxes on vesting of performance shares and upon exercise of stock options |  | (213         | ) |  |                | (2  | ) |                   |       |   |                                     |   |        |             |  |   | (4,127  | ) |  |         |      |   |       |   | (345     | ) |  |   | (4,474  | )
|Repurchase of employee shares                                                                                    |  | (3           | ) |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | (54     | ) |  |         |      |   |       |   |         |   |  |   | (54     | )
|Stock-based compensation                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | 7,799   |   |  |         |      |   |       |   |         |   |  |   | 7,799   |  
|Foreign currency translation adjustment                                                                          |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | 651   |   |       |   |         |   |  |   | 651     |  
|Unrealized holding gain on available-for-sale securities                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | 70    |   |       |   |         |   |  |   | 70      |  
|Net loss                                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         |      |   |       |   | (15,672  | ) |  |   | (15,672 | )
|                                                                                                                 |  |              |   |  |                |     |   |                   |        |   |                                     |   |         |             |  |   |         |   |  |         |       |   |       |   |          |   |  |   |         |  
|BALANCE AT DECEMBER 31, 2007                                                                                     |  | 43,206       |   |  | $              | 432 |   |                   | (2,469 | ) |                                     | $ | (19,259 | )           |  | $ | 298,556 |   |  | $       | 1,718 |   |       | $ | (128,236 | ) |  | $ | 153,211 |  
|Exercise of stock options                                                                                        |  | 405          |   |  |                | 4   |   |                   |       |   |                                     |   |        |             |  |   | 3,913   |   |  |         |      |   |       |   |         |   |  |   | 3,917   |  
|Release of performance shares                                                                                    |  | 322          |   |  |                | 3   |   |                   |       |   |                                     |   |        |             |  |   | (3      | ) |  |         |      |   |       |   |         |   |  |   |        |  
|Stock received for payment of option exercise price                                                              |  | (130         | ) |  |                | (1  | ) |                   |       |   |                                     |   |        |             |  |   | (1,799  | ) |  |         |      |   |       |   |         |   |  |   | (1,800  | )
|Stock received for payment of employee taxes on vesting of performance shares and upon exercise of stock options |  | (124         | ) |  |                | (1  | ) |                   |       |   |                                     |   |        |             |  |   | (1,540  | ) |  |         |      |   |       |   | (2       | ) |  |   | (1,543  | )
|Repurchase of stock                                                                                              |  |             |   |  |                |    |   |                   | (750   | ) |                                     |   | (8,871  | )           |  |   |        |   |  |         |      |   |       |   |         |   |  |   | (8,871  | )
|Repurchase of employee shares                                                                                    |  | (3           | ) |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | (36     | ) |  |         |      |   |       |   |         |   |  |   | (36     | )
|Stock-based compensation                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   | 14,458  |   |  |         |      |   |       |   |         |   |  |   | 14,458  |  
|Foreign currency translation adjustment                                                                          |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | (967  | ) |       |   |         |   |  |   | (967    | )
|Unrealized holding gain on available-for-sale securities                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         | 33    |   |       |   |         |   |  |   | 33      |  
|Net loss                                                                                                         |  |             |   |  |                |    |   |                   |       |   |                                     |   |        |             |  |   |        |   |  |         |      |   |       |   | (25,831  | ) |  |   | (25,831 | )
|                                                                                                                 |  |              |   |  |                |     |   |                   |        |   |                                     |   |         |             |  |   |         |   |  |         |       |   |       |   |          |   |  |   |         |  
|BALANCE AT DECEMBER 31, 2008                                                                                     |  | 43,676       |   |  | $              | 437 |   |                   | (3,219 | ) |                                     | $ | (28,130 | )           |  | $ | 313,549 |   |  | $       | 784   |   |       | $ | (154,069 | ) |  | $ | 132,571 |  
|                                                                                                                 |  |              |   |  |                |     |   |                   |        |   |                                     |   |         |             |  |   |         |   |  |         |       |   |       |   |          |   |  |   |         |  

See accompanying notes to the consolidated financial statements.



44



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ECHELON CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                                          |  | Year Ended December 31, |        
|                                                                                                                                                          |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Net loss                                                                                                                                                  |  | $                       | (25,831 | ) |      | $ | (15,672 | )    |  | $ | (25,130 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                                                                               |  |                         |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                                                                                                             |  |                         | 7,406   |   |      |   | 7,441   |      |  |   | 7,120   |  
|Increase in (reduction of) allowance for doubtful accounts                                                                                                |  |                         | (29     | ) |      |   | 88      |      |  |   | (23     | )
|Loss (gain) on disposal of fixed assets                                                                                                                   |  |                         | 10      |   |      |   | 10      |      |  |   | (2      | )
|Reduction of (increase in) accrued investment income                                                                                                      |  |                         | 721     |   |      |   | 436     |      |  |   | (446    | )
|Stock-based compensation                                                                                                                                  |  |                         | 14,458  |   |      |   | 7,799   |      |  |   | 5,460   |  
|Change in operating assets and liabilities:                                                                                                               |  |                         |         |   |      |   |         |      |  |   |         |  
|Accounts receivable                                                                                                                                       |  |                         | 10,079  |   |      |   | (19,621 | )    |  |   | (2,889  | )
|Inventories                                                                                                                                               |  |                         | (2,428  | ) |      |   | (2,631  | )    |  |   | (8,119  | )
|Other current assets                                                                                                                                      |  |                         | (2,647  | ) |      |   | 93      |      |  |   | (380    | )
|Accounts payable                                                                                                                                          |  |                         | (2,382  | ) |      |   | 6,262   |      |  |   | 2,921   |  
|Deferred cost of goods sold                                                                                                                               |  |                         | 4,177   |   |      |   | 12,404  |      |  |   | (18,738 | )
|Accrued liabilities                                                                                                                                       |  |                         | 654     |   |      |   | 925     |      |  |   | (2,776  | )
|Deferred revenues                                                                                                                                         |  |                         | (7,669  | ) |      |   | (10,518 | )    |  |   | 24,747  |  
|Deferred rent                                                                                                                                             |  |                         | (26     | ) |      |   | (75     | )    |  |   | (105    | )
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Net cash used in operating activities                                                                                                                     |  |                         | (3,507  | ) |      |   | (13,059 | )    |  |   | (18,360 | )
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Purchase of available-for-sale short-term investments                                                                                                     |  |                         | (91,239 | ) |      |   | (65,545 | )    |  |   | (85,971 | )
|Proceeds from sales and maturities of available-for-sale short-term investments                                                                           |  |                         | 72,033  |   |      |   | 120,796 |      |  |   | 95,436  |  
|Changes in other long-term assets                                                                                                                         |  |                         | (42     | ) |      |   | 31      |      |  |   | 37      |  
|Capital expenditures                                                                                                                                      |  |                         | (4,570  | ) |      |   | (8,053  | )    |  |   | (4,696  | )
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) investing activities                                                                                                       |  |                         | (23,818 | ) |      |   | 47,229  |      |  |   | 4,806   |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Net proceeds from exercise of stock options                                                                                                               |  |                         | 2,117   |   |      |   | 11,216  |      |  |   | 265     |  
|Principal payments of lease financing obligations                                                                                                         |  |                         | (1,789  | ) |      |   | (2,580  | )    |  |   | (2,297  | )
|Repurchase of common stock from employees for payment of taxes on vesting of performance shares and upon exercise of stock
options                        |  |                         | (1,574  | ) |      |   | (4,520  | )    |  |   | (239    | )
|Repurchase of common stock under stock repurchase program                                                                                                 |  |                         | (8,871  | ) |      |   |        |      |  |   | (6,334  | )
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) financing activities                                                                                                       |  |                         | (10,117 | ) |      |   | 4,116   |      |  |   | (8,605  | )
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|EFFECT OF EXCHANGE RATES ON CASH                                                                                                                          |  |                         | (951    | ) |      |   | 364     |      |  |   | 491     |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                                                      |  |                         | (38,393 | ) |      |   | 38,650  |      |  |   | (21,668 | )
|CASH AND CASH EQUIVALENTS:                                                                                                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Beginning of year                                                                                                                                         |  |                         | 76,062  |   |      |   | 37,412  |      |  |   | 59,080  |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|End of year                                                                                                                                               |  | $                       | 37,669  |   |      | $ | 76,062  |      |  | $ | 37,412  |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                                                                                                        |  |                         |         |   |      |   |         |      |  |   |         |  
|Cash paid for interest on lease financing obligations                                                                                                     |  | $                       | 1,454   |   |      | $ | 1,196   |      |  | $ | 1,366   |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Cash paid for income taxes                                                                                                                                |  | $                       | 562     |   |      | $ | 431     |      |  | $ | 199     |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  
|Noncash investing and financing informationIncrease in property and equipment and related lease financing obligation due to lease
extension (see Note 3) |  | $                       | 12,526  |   |      | $ |        |      |  | $ |        |  
|                                                                                                                                                          |  |                         |         |   |      |   |         |      |  |   |         |  

See accompanying notes to the consolidated financial statements.



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ECHELON CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)



|                                                         |  |                         |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                         |  | Year Ended December 31, |        
|                                                         |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|Net loss                                                 |  | $                       | (25,831 | ) |      | $ | (15,672 | )    |  | $ | (25,130 | )
|Other comprehensive income (loss), net of tax:           |  |                         |         |   |      |   |         |      |  |   |         |  
|Foreign currency translation adjustment                  |  |                         | (967    | ) |      |   | 651     |      |  |   | 751     |  
|Unrealized holding gain on available-for-sale securities |  |                         | 33      |   |      |   | 70      |      |  |   | 364     |  
|                                                         |  |                         |         |   |      |   |         |      |  |   |         |  
|Comprehensive loss                                       |  | $                       | (26,765 | ) |      | $ | (14,951 | )    |  | $ | (24,015 | )
|                                                         |  |                         |         |   |      |   |         |      |  |   |         |  

See accompanying notes to the consolidated financial statements.



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ECHELON CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.
SIGNIFICANT ACCOUNTING POLICIES:

(a) Operations

Echelon Corporation (the Company) was incorporated in California in February 1988 and was reincorporated in Delaware in January 1989. The Company develops, markets, and supports a wide range of hardware
and software products and services that enable OEMs and systems integrators to design and implement open, interoperable, distributed control networks. The Companys products are based on its LonWorks networking technology, an open standard for
interoperable networked control. In a LonWorks control network, intelligent control devices, called nodes, communicate using the Companys LonWorks protocol. For the electric utility industry, the Company has developed an advanced metering
infrastructure system called the Networked Energy Services (NES) system. The NES system provides a two-way information and control path between the utility and its customer, which enables utilities to reduce operating costs; improve customer
service; offer multiple tariff plans, including time-of-use metering and prepay metering; promote energy efficiency; better utilize distribution assets; improve grid quality and reliability; control loads and reduce peak demand; and respond more
rapidly to changing customer and regulatory requirements. The Company sells its products and services around the world to the building, industrial, transportation, utility/home and other automation markets.

(b) Basis of Presentation

The Companys
consolidated financial statements reflect operations of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated.

(c) Risks and Uncertainties

The Companys operations and performance depend significantly on
worldwide economic conditions and their impact on purchases of the Companys products as well as the ability of suppliers to provide the Company with products and services in a timely manner. The impact of any of the matters described below
could have an adverse affect on the Companys business, results of operations and financial condition.



| |  | The Companys sales are currently concentrated with a relatively small group of customers, as approximately 67% of net revenues for the year ended
December 31, 2008 was derived from six customers. Customers in any of the Companys target market sectors may experience unexpected reductions in demand for their products and reduce their purchase orders from us, resulting in either the
loss of a significant customer or a notable decrease in the level of sales to a significant customer. In addition, if any of these customers are unable to obtain the necessary capital to operate their business, they may be unable to satisfy their
payment obligations to the Company.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company utilizes third-party contract electronic manufacturers to manufacture, assemble, and test its products. As a result of current credit market conditions,
if any of these third-parties were unable to obtain the necessary capital to operate their business, they may be unable to provide the Company with timely services or to make timely deliveries of products.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Due to the continuing current worldwide economic crisis, coupled with the fact that the Companys NES customers generally procure products that have been
customized to meet their requirements, the Company has limited visibility into ultimate product demand, which makes sales forecasting more difficult. As a result, anticipated demand may not materialize, which could subject the Company to increased
levels of excess and obsolete inventories.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(d) Use of Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of
America requires management to make judgements, assumptions, and estimates that affect amounts reported in the Consolidated Financial Statements and accompanying notes. Significant estimates and judgements are used for revenue recognition,
stock-based compensation, allowance for doubtful accounts, inventory valuation, allowance for warranty costs, income taxes, and other loss contingencies. In order to determine the carrying values of assets and liabilities that are not readily
apparent from other sources, the Company bases its estimates and assumptions on current facts, historical experience, and various other factors that it believes to be reasonable under the circumstances. Actual results experienced by the Company may
differ materially from managements estimates.



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(e) 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, collectability is probable, and there are no post-delivery obligations. For non-distributor hardware sales, including sales to third party manufacturers, these criteria are generally met at the time of shipment. For
hardware 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.

In most instances involving large-scale deployments, 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 extended 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 later 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 Issue No. 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 impacts of this revenue recognition methodology revision were one-time
reductions in revenues of approximately $2.9 million and $1.0 million during the first and second quarters of 2006, respectively.



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(f) 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.

(g) Stock-Based Compensation

Effective January 1, 2006, the Company began recording compensation expense associated
with stock options and other forms of equity compensation in accordance with SFAS No. 123R (SFAS 123R), Share-Based Payment, and Securities and Exchange Commission Staff Accounting Bulletin No. 107 (SAB 107).
SFAS 123R eliminated the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and
instead generally requires that such transactions be accounted for using a fair-value-based method.

The Company uses the
Black-Scholes-Merton (BSM) option-pricing model to determine the fair value of stock-based awards. The BSM model is consistent with the option-pricing model the Company used to value stock-based awards granted prior to January 1,
2006 for pro forma disclosure purposes under SFAS No. 123 (SFAS 123), Accounting for Stock-Based Compensation. Stock-based compensation expense for awards granted prior to January 1, 2006 is based on the BSM calculated
grant date fair value as determined under the pro forma provisions of SFAS 123.

Further information regarding stock-based compensation can
be found in Note 5 of these Notes to Consolidated Financial Statements.

(h) Cash and Cash Equivalents

The Company considers bank deposits, money market investments and all debt and equity securities with an original maturity of three months or less to be
cash and cash equivalents.

(i) Short-Term Investments

The Company classifies its investments in marketable debt securities as available-for-sale in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain
Investments in Debt and Equity Securities. Securities classified as available-for-sale are reported at fair value with the related unrealized holding gains and losses, net of tax, being included in accumulated other comprehensive income (loss).

(j) Fair Value Measurements

The
Company measures at fair value its cash equivalents and available-for-sale investments in accordance with SFAS No. 157 (SFAS 157), Fair Value Measurements. SFAS 157 specifies a valuation hierarchy based on whether the
inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Companys own assumptions. These two types of inputs have
created the following fair value hierarchy:



| |  |  | Level 1  Quoted prices for identical instruments in active markets;
| | - |  | --------------------------------------------------------------------



| |  |  | Level 2  Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and
model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Level 3  Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------

This hierarchy requires the Company to minimize the use of unobservable inputs and to use observable market data, if
available, when estimating fair value. Other than cash and money market funds, the Companys only financial assets or liabilities required to be measured at fair value on a recurring basis at December 31, 2008, are fixed income
available-for-sale securities. See Note 2 for a summary of the input levels used in determining the fair value of the Companys cash equivalents and short-term investments as of December 31, 2008.



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(k) 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):



|                    |  |              |        |      |   |       
|------------------- |  | ------------ | ------ | ---- | - | ------
|                    |  | December 31,
|                    |  | 2008         |        | 2007
|Purchased materials |  | $            | 6,844  |      | $ | 4,379 
|Work-in-process     |  |              | 89     |      |   | 360   
|Finished goods      |  |              | 9,580  |      |   | 9,273 
|                    |  |              |        |      |   |       
|                    |  | $            | 16,513 |      | $ | 14,012
|                    |  |              |        |      |   |       

(l) Impairment of Long-Lived Assets Including Goodwill

The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be
recoverable. Recoverability is measured by comparing the assets carrying value to the future undiscounted cash flows the asset is expected to generate. If long-lived assets are considered to be impaired, the impairment to be recognized equals
the amount by which the carrying value of the asset exceeds its fair value. For the three years ended December 31, 2008, the Company recognized no material impairments.

Costs in excess of the fair value of tangible and other identifiable intangible assets acquired and liabilities assumed in a purchase business
combination are recorded as goodwill, which is tested for impairment using a two-step approach. The Company evaluates goodwill, at a minimum, on an annual basis during the first quarter and whenever events and changes in circumstances suggest that
the carrying amount may not be recoverable. Impairment of goodwill is tested at the reporting unit level by comparing the reporting units carrying amount, including goodwill, to the fair value of the reporting unit. For purposes of this
analysis, the Company considers itself as a single reporting unit. If the carrying amount of the reporting unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any.
To date, the Company has recorded no impairment of goodwill.

(m) Software Development Costs

For software to be sold, leased, or otherwise marketed, the Company capitalizes eligible computer software development costs upon the establishment of
technological feasibility, which the Company has defined as completion of a working model. For the three years ended December 31, 2008, costs that were eligible for capitalization were insignificant and, thus, the Company has charged all
software development costs to product development expense in the accompanying consolidated statements of operations.

(n) Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):



|                                  |  |              |       |      |   |      
|--------------------------------- |  | ------------ | ----- | ---- | - | -----
|                                  |  | December 31,
|                                  |  | 2008         |       | 2007
|Accrued payroll and related costs |  | $            | 2,666 |      | $ | 3,006
|Accrued taxes                     |  |              | 70    |      |   | 37   
|Customer deposits                 |  |              | 643   |      |   | 932  
|Warranty reserve                  |  |              | 849   |      |   | 301  
|Other accrued liabilities         |  |              | 825   |      |   | 275  
|                                  |  |              |       |      |   |      
|                                  |  | $            | 5,053 |      | $ | 4,551
|                                  |  |              |       |      |   |      

(o) Foreign Currency Translation

The functional currency of the Companys subsidiaries is the local currency. Accordingly, all assets and liabilities are translated into U.S. dollars
at the current exchange rate as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rate prevailing during the period. Gains and losses resulting from the translation of the financial statements are
included in accumulated other comprehensive income (loss).

Remeasurement adjustments for non-functional currency monetary assets and
liabilities, including short-term intercompany balances, are included in other income (expense) in the accompanying consolidated statements of operations. Currently, the Company does not employ a foreign currency hedge program utilizing foreign
currency exchange contracts as the foreign currency transactions and risks to date have not been significant.



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(p) Concentrations of Credit Risk and Suppliers

The Companys financial instruments consist of cash equivalents, short-term investments, accounts receivable, accounts payable, and lease financing
obligations. The carrying value of the Companys financial instruments approximates fair value. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of investments, which are classified
as either cash equivalents or short-term, and trade receivables. With respect to its investments, the Company has an investment policy that limits the amount of credit exposure to any one financial institution and restricts placement of the
Companys investments to financial institutions independently evaluated as highly creditworthy. With respect to its trade receivables, the Company performs ongoing credit evaluations of each of its customers financial condition. For a
customer whose credit worthiness does not meet the Companys minimum criteria, the Company may require partial or full payment prior to shipment. Alternatively, prior to shipment, customers may be required to provide the Company with an
irrevocable letter of credit or arrange for some other form of coverage to mitigate the risk of uncollectibility, such as a bank guarantee. Additionally, the Company establishes an allowance for doubtful accounts and sales return allowances based
upon factors surrounding the credit risk of specific customers, historical trends, and other available information.

With the exception of
amounts owed the Company on sales made to certain significant customers, concentrations of credit risk with respect to trade receivables are generally limited due to the Companys large number of customers and their dispersion across many
different industries and geographies. For the years ended December 31, 2008 and 2007, the percentage of the Companys total accounts receivable balance that were due from the following significant customers is as follows (refer to Note 6
Significant Customers for a discussion of revenues generated from the Companys significant customers):



|                                                                |  |              |   |  |      |  
|--------------------------------------------------------------- |  | ------------ | - |  | ---- | -
|                                                                |  | December 31, |  
|                                                                |  | 2008         |   |  | 2007 |  
|Duke Energy Corporation                                         |  | 21.9         | % |  |     | %
|Enel (and its contract manufacturers)                           |  | 21.2         | % |  | 9.0  | %
|Limited Liability Company Engineering Center ENERGOAUDITCONTROL |  | 6.7          | % |  | 27.7 | %
|ES Elektrosandberg AB                                           |  | 4.7          | % |  | 12.0 | %
|EBV                                                             |  | 4.2          | % |  | 1.7  | %
|Telvent Energia Y Medio Ambeinte                                |  | 1.9          | % |  | 35.7 | %
|                                                                |  |              |   |  |      |  
|Total                                                           |  | 60.6         | % |  | 86.1 | %
|                                                                |  |              |   |  |      |  

For most of the Companys products requiring assembly, it relies on a limited number of
contract electronic manufacturers, principally Jabil, Flextronics, and TYCO. The Company also maintains manufacturing agreements with a limited number of semiconductor manufacturers for the production of key products, including those used in the
Companys NES system. The Neuron Chip, which is an important component that the Company and its customers use in control network devices, is currently manufactured and distributed by two providers, Toshiba and Cypress Semiconductor. Toshiba has
informed the Company that it does not intend to renew its Neuron Chip agreement with Echelon when it expires in January 2010. Another semiconductor supplier, STMicroelectronics, manufactures the Companys power line smart transceiver products,
for which the Company has no alternative source. In addition, the Company currently purchases several key products and components from sole or limited source suppliers with which it does not maintain signed agreements that would obligate them to
supply to the Company on negotiated terms.

If any of the Companys key suppliers were to stop manufacturing the Companys
products or cease supplying the Company with its key components, it could be expensive and time consuming to find a replacement. Also, as the Companys NES business grows, it will be required to expand its business with its key suppliers
or find additional sources of supply. There is no guarantee that the Company would be able to find acceptable alternative or additional sources.

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



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(q) Computation of Basic and Diluted Net Loss Per Share and Pro Forma Basic Net Loss Per Share

Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average shares of common stock outstanding during the
period. Diluted net income per share is calculated by adjusting the weighted average number of outstanding shares assuming conversion of all potentially dilutive stock options and warrants under the treasury stock method.

The following is a reconciliation of the numerators and denominators of the basic and diluted net income (loss) per share computations for the years
ended December 31, 2008, 2007, and 2006 (in thousands, except per share amounts):



|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                    |  | Year Ended December 31, |        
|                                                    |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|Net loss (Numerator):                               |  |                         |         |   |      |   |         |      |  |   |         |  
|Net loss, basic and diluted                         |  | $                       | (25,831 | ) |      | $ | (15,672 | )    |  | $ | (25,130 | )
|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  
|Shares (Denominator):                               |  |                         |         |   |      |   |         |      |  |   |         |  
|Weighted average shares used in basic computation   |  |                         | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |  
|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  
|Weighted average shares used in diluted computation |  |                         | 40,636  |   |      |   | 39,891  |      |  |   | 39,487  |  
|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  
|Net loss per share:                                 |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic                                               |  | $                       | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | )
|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  
|Diluted                                             |  | $                       | (0.64   | ) |      | $ | (0.39   | )    |  | $ | (0.64   | )
|                                                    |  |                         |         |   |      |   |         |      |  |   |         |  

For the years ended December 31, 2008, 2007, and 2006, the diluted net loss per share
calculation is equivalent to the basic net loss per share calculation as there are no potentially dilutive stock options due to the Companys net loss position. The number of stock options and performance shares excluded from these calculations
in 2008, 2007, and 2006 were 6,860,098, 7,907,702, and 8,985,716, respectively.

(r) Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date.

Effective January 1, 2007, the Company adopted FASB Interpretation No. 48
(FIN 48), Accounting for Uncertainty in Income Taxes  An Interpretation of FASB Statement No. 109. FIN 48 requires the Company to take a two-step approach to recognizing and measuring uncertain tax positions. The first
step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the tax position will be sustained on audit, including resolution of any related appeals or
litigation processes. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon effective settlement. The Company re-evaluates its income tax positions on a quarterly basis to consider
factors such as changes in facts or circumstances, changes in or interpretations of tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement would result in recognition of a tax benefit or
an additional charge to the tax provision. Upon adoption of FIN 48, the Company adopted an accounting policy to classify interest and penalties on unrecognized tax benefits as income tax expense. For years prior to the adoption of FIN 48, the
Company also reported interest and penalties on unrecognized tax benefits as income tax expense.

(s) Comprehensive Loss

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.

(t) Recent Accounting Pronouncements

In April 2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets(FSP FAS 142-3). FSP
FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used in determining the useful life of a recognized intangible asset under Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets.This new guidance applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP FAS 142-3 is effective
for fiscal years beginning after December 15, 2008, and early adoption is prohibited. The impact of FSP FAS 142-3 will depend upon the nature, terms, and size of the acquisitions the Company consummates after the effective date.



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In February 2008, the FASB issued FSP FAS 157-2, Effective date of SFAS No. 157(FSP FAS 157-2). FSP FAS 157-2 delays the effective date for SFAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on
a recurring basis to the fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Company does not expect its adoption of SFAS 157 for nonfinancial assets and liabilities on January 1, 2009,
will impact its consolidated results of operations or financial condition. In October 2008, the FASB issued FSP 157-3, Determining Fair Value of a Financial Asset in a Market That Is Not Active(FSP 157-3).
FSP 157-3 clarifies the application of SFAS No. 157, Fair Value Measurements,in an inactive market. It demonstrates how the fair value of a financial asset is determined when the market for that financial asset is inactive.
FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The implementation of this standard did not impact the Companys consolidated results of operations or financial condition.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations(SFAS 141R).
SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the
acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and
financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Earlier application of SFAS 141R is prohibited. Accordingly, any business
combinations the Company may engage in will be recorded and disclosed following existing GAAP until January 1, 2009. The impact of SFAS 141R will depend upon the nature, terms, and size of the acquisitions the Company consummates after the
effective date.

2. CASH EQUIVALENTS AND INVESTMENTS

The amortized cost basis, aggregate fair value and gross unrealized holding gains and losses for the Companys available-for-sale short-term investments, by major security type, were as follows (in thousands):



|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------- | ------ | ------------------ | ------------------- | ------ | ------------------------- |  | -------------- | -- | ------------------ | - | ------------------------- |  | - | ------ |  | - | -- | -
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | December 31,        |       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | 2008                |        | 2007               |                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | AmortizedCost       |        | AggregateFairValue |                     |        | NetUnrealizedHoldingGains |  | AmortizedCost  |    | AggregateFairValue |   | NetUnrealizedHoldingGains | 
|U.S. corporate securities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|Commercial paper                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | $                   | 14,964 |                    | $                   | 14,965 |                           |  | $              | 1  |                    | $ |                          |  | $ |       |  | $ |   |  
|Corporate notes and bonds                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |  |                     | 3,172  |                    |                     | 3,191  |                           |  |                | 19 |                    |   | 22,442                    |  |   | 22,462 |  |   | 20 |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     | 18,136 |                    |                     | 18,156 |                           |  |                | 20 |                    |   | 22,442                    |  |   | 22,462 |  |   | 20 |  
|Foreign corporate notes and bonds                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  |                     | 5,502  |                    |                     | 5,502  |                           |  |                |   |                    |   | 515                       |  |   | 517    |  |   | 2  |  
|U.S. government agency securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  |                     | 25,933 |                    |                     | 25,989 |                           |  |                | 56 |                    |   | 8,141                     |  |   | 8,149  |  |   | 8  |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|Total investments in debt securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |  | $                   | 49,571 |                    | $                   | 49,647 |                           |  | $              | 76 |                    | $ | 31,098                    |  | $ | 31,128 |  | $ | 30 |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|As of December 31, 2008 and 2007, the Companys available-for-sale securities had original contractual
maturities of between three to twenty-four months, and from ten to twenty-four months, respectively. As of December 31, 2008 and 2007, the average remaining term to maturity for the Companys available-for-sale securities was three and six
months, respectively.  The following tables show gross unrealized
losses and fair value for those investments that were in an unrealized loss position as of December 31, 2008 and 2007, aggregated by investment category and the length of time that individual securities have been in a continuous loss position
(in thousands): | 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | December 31, 2008   |       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | Less than 12 Months |        |                    | More than 12 Months |        | Total                     | 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  | Fair Value          |        | UnrealizedLoss     |                     |        | Fair Value                |  | UnrealizedLoss |    | Fair Value         |   | UnrealizedLoss            | 
|Foreign corporate notes and bonds                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  |                     | 517    |                    |                     | (1     | )                         |  |                |   |                    |   |                          |  |   | 517    |  |   | (1 | )
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  
|Total                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |  | $                   | 517    |                    | $                   | (1     | )                         |  | $              |   |                    | $ |                          |  | $ | 517    |  | $ | (1 | )
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |                     |        |                    |                     |        |                           |  |                |    |                    |   |                           |  |   |        |  |   |    |  



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|                          |  |                     |       |                |                     |     |            |       |                |     |  |            |    |                |  |   |       |  |   |     |  
|------------------------- |  | ------------------- | ----- | -------------- | ------------------- | --- | ---------- | ----- | -------------- | --- |  | ---------- | -- | -------------- |  | - | ----- |  | - | --- | -
|                          |  | December 31, 2007   |      
|                          |  | Less than 12 Months |       |                | More than 12 Months |     |            | Total |               
|                          |  | Fair Value          |       | UnrealizedLoss |                     |     | Fair Value |       | UnrealizedLoss |     |  | Fair Value |    | UnrealizedLoss | 
|Corporate notes and bonds |  |                     | 5,946 |                |                     | (14 | )          |       |                | 769 |  |            | (1 | )              |  |   | 6,715 |  |   | (15 | )
|                          |  |                     |       |                |                     |     |            |       |                |     |  |            |    |                |  |   |       |  |   |     |  
|Total                     |  | $                   | 5,946 |                | $                   | (14 | )          |       | $              | 769 |  | $          | (1 | )              |  | $ | 6,715 |  | $ | (15 | )
|                          |  |                     |       |                |                     |     |            |       |                |     |  |            |    |                |  |   |       |  |   |     |  

Market values were determined for each individual security in the investment portfolio. The
decline in value of these investments is primarily related to changes in interest rates and is considered to be temporary in nature. Investments are reviewed periodically to identify possible impairment. When evaluating the investments, the Company
reviews factors such as length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Companys ability and intent to hold the investment for a period of time which may be sufficient for
anticipated recovery in market value. For each of the three years ended December 31, 2008, gross realized gains and losses on the Companys investment portfolio were not material.

The fair value of cash equivalents and short-term investments was determined using the following inputs at December 31, 2008 (in thousands):



|                                           |  |                                                 |        |                                                   |   |                                  |  |                               |        |  |   |  
|------------------------------------------ |  | ----------------------------------------------- | ------ | ------------------------------------------------- | - | -------------------------------- |  | ----------------------------- | ------ |  | - | -
|                                           |  | Fair Value Measurements at Reporting Date Using
|                                           |  |                                                 |        | Quoted Prices inActive Marketsfor
IdenticalAssets |   | SignificantOtherObservableInputs |  | SignificantUnobservableInputs
|                                           |  | Total                                           |        | (Level 1)                                         |   | (Level 2)                        |  | (Level 3)                    
|Money market funds                         |  | $                                               | 2,399  |                                                   | $ | 2,399                            |  | $                             |       |  | $ | 
|Fixed income available-for-sale securities |  |                                                 | 82,641 |                                                   |   |                                 |  |                               | 82,641 |  |   | 
|                                           |  |                                                 |        |                                                   |   |                                  |  |                               |        |  |   |  
|Total                                      |  | $                                               | 85,040 |                                                   | $ | 2,399                            |  | $                             | 82,641 |  | $ | 
|                                           |  |                                                 |        |                                                   |   |                                  |  |                               |        |  |   |  

Fixed income available-for-sale securities are included in cash and cash equivalents and
short-term investments in the Companys condensed consolidated balance sheet. Of the $82.6 million of fixed income available-for-sale securities, approximately $33.0 million are classified as cash equivalents, while the remaining
$49.6 million are classified as short-term investments. As discussed in Note 1, cash equivalents consist of either investments with remaining maturities of three months or less at the date of purchase, or money market funds for which the
carrying amount is a reasonable estimate of fair value.

3. PROPERTY AND EQUIPMENT

A summary of property and equipment, net as of December 31, 2008 and December 31, 2007 is as follows (in thousands):



|                                                |  |                  |         |   |                  |   |         |  
|----------------------------------------------- |  | ---------------- | ------- | - | ---------------- | - | ------- | -
|                                                |  | December 31,2008 |         |   | December 31,2007 |  
|Buildings and improvements                      |  | $                | 37,356  |   |                  | $ | 40,850  |  
|Computer and other equipment                    |  |                  | 22,869  |   |                  |   | 19,403  |  
|Software                                        |  |                  | 4,674   |   |                  |   | 4,511   |  
|Furniture and fixtures                          |  |                  | 2,792   |   |                  |   | 2,666   |  
|Leasehold improvements                          |  |                  | 3,917   |   |                  |   | 3,809   |  
|                                                |  |                  |         |   |                  |   |         |  
|                                                |  |                  | 71,608  |   |                  |   | 71,239  |  
|Less: Accumulated depreciation and amortization |  |                  | (31,034 | ) |                  |   | (40,463 | )
|                                                |  |                  |         |   |                  |   |         |  
|Property and equipment, net                     |  | $                | 40,574  |   |                  | $ | 30,776  |  
|                                                |  |                  |         |   |                  |   |         |  

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) from the period
commencing with the start of construction through the lease commencement date for each building. These building assets are reflected as Buildings and Improvements in the schedule above. Building improvements paid for by the
Company subsequent to the lease commencement date of each building are reflected as Leasehold Improvements in the schedule above.



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Effective June 2008, the building leases were amended, resulting in an extension of the lease term for
both buildings through March 2020. As a result of the lease extensions, the lease financing obligations for each building were increased based on the present value of the revised lease payments on the date of the extension, with a corresponding
increase to the net carrying amount of the cost of the building assets (see further information below).

Depreciation is provided using the
straight-line method as follows:



| |  |  | Building assets and leasehold improvements are depreciated over the shorter of the remaining lease term or estimated useful lives (see further information below);
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Computer equipment and related software, other equipment, and furniture and fixtures are depreciated over their estimated useful lives of two to five years; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Certain telecommunications equipment is depreciated over its estimated useful life of 10 years.
| | - |  | -----------------------------------------------------------------------------------------------

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. In October 2000, the Company entered into a second lease agreement with the same real estate
developer for an additional building at its headquarters site. These leases were scheduled to expire in 2011 and 2013, respectively.

Effective June 2008, the building leases were amended resulting in an extension of the lease term for both buildings through March 2020. The extended leases require minimum lease payments through March 2020 totaling approximately
$48.9 million. Both leases permit the Company to exercise an option to extend the respective lease for two sequential five-year terms. In addition, the amended leases eliminated the Companys requirement to provide the landlord with
security deposits totaling $6.2 million, which the Company had previously satisfied by causing to have issued standby letters of credit (LOCs). As of June 30, 2008, the previously issued LOCs had been returned to the bank that
issued them and were cancelled.

The Company has historically accounted for the two buildings at its San Jose, California headquarters site
under EITF Issue No. 97-10 (EITF 97-10), The Effect of Lessee Involvement in Asset Construction, and SFAS No. 98 (SFAS 98), Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate,
Sales-Type Leases of Real Estate, Definition of the Lease Term, and 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. 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), 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 de-recognition 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 lease financing obligations of $12.0 million and
$15.2 million, respectively, which corresponded to the building asset costs paid for by the lessor. As a result of the lease extension in June 2008, the Company increased the carrying amount of its lease financing obligations by approximately
$12.5 million to approximately $27.6 million (an amount equal to the present value of the revised lease payments at the date of the lease extension), with a corresponding increase to the net carrying amount of the building assets. In addition, all
of accumulated depreciation on the building assets at the date of the lease extensions (approximately $16.0 million) was eliminated with a corresponding decrease to the gross carrying amount of the building assets. As a result of the extension in
lease terms, the Company also extended the estimated useful lives of the building assets and the leasehold improvements to equal the amended lease term.

For the years ended December 31, 2008, 2007, and 2006, the Company has recorded depreciation expense associated with the building assets of $2.3 million, $2.7 million, and $2.7 million, respectively. As of
December 31, 2008 and December 31, 2007, the net book value of the building assets was $22.7 million and $12.5 million, respectively.

Under the lease agreements, a portion of the total lease payments is accounted for as an operating lease of land and recorded as expense on a straight-line basis over the term of the lease. The remaining portions of
the monthly lease payments are considered to be payments of principal and interest on the lease financing obligations. For the years ended December 31, 2008, 2007 and 2006, land lease expense was $604,000, $452,000, and $452,000, respectively;
principal reductions on the lease financing obligations were $1.8 million, $2.6 million and $2.3 million, respectively; and interest expense was $1.4 million, $1.2 million, and $1.4 million, respectively. See Note 8 for
further information on commitments for future minimum lease payments associated with the lease financing obligations.



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4. STOCKHOLDERS EQUITY AND EMPLOYEE STOCK OPTION PLANS

(a) Preferred Stock

As of December 31, 2008, the
Company was authorized to issue 5,000,000 shares of new $0.01 par value preferred stock, of which none was outstanding.

(b) Common Stock

As of December 31, 2008, the Company was authorized to issue 100,000,000 shares of $0.01 par value common stock, of which
40,457,045 were outstanding.

In March and August 2004, March 2006, and February 2007, the Companys board of directors approved
a stock repurchase program, which authorized the Company to repurchase up to 3.0 million shares of the Companys common stock. Since inception, the Company repurchased a total of 2,204,184 shares under the program at a cost of $16.1
million. The stock repurchase program expired in March 2008.

In April 2008, the Companys board of directors approved a new stock
repurchase program, which authorizes the Company to repurchase up to 3.0 million shares of the Companys common stock. Since inception, the Company has repurchased a total of 750,000 shares under the program at a cost of $8.9 million. As
of December 31, 2008, 2,250,000 shares were available for repurchase. The new stock repurchase program will expire in April 2011.

(c) Stock Option
Programs

The Company grants equity compensation awards under the 1997 Stock Plan (the 1997 Plan). Prior to July 2008, the
Company also issued options to certain members of its Board of Directors under the 1998 Director Option Plan (the Director Option Plan). A more detailed description of each plan can be found below.

Stock option and other equity compensation grants are designed to reward employees, officers, and directors for their long-term contribution to the
Company, to align their interest with those of the Companys stockholders in creating stockholder value, and to provide incentives for them to remain with the Company. The number and frequency of equity compensation grants is based on
competitive practices, operating results of the Company, and accounting regulations. Since the inception of the 1997 Plan, the Company has granted options to all of its employees.

Historically, the Company has issued new shares upon the exercise of stock options. However, treasury shares are also available for issuance, although
the Company does not currently intend to use treasury shares for this purpose.

1997 Stock Plan

During 1997, the Company adopted the 1997 Stock Plan (the 1997 Plan) for employees, officers and directors, which was amended and restated in
May 2004. As of December 31, 2008, a total of 15,110,662 shares of Common Stock were reserved for issuance under the 1997 Plan. This plan includes annual increases on the first day of the Companys fiscal year (beginning in 2000) not to
exceed the lesser of (i) 5,000,000 shares or (ii) 4% of the outstanding shares on such date. Incentive stock options to purchase shares of common stock may be granted at not less than 100% of the fair market value. Options granted prior to
June 15, 2000 and after May 5, 2003, generally have a term of five years from the date of grant. Options granted June 15, 2000 through May 5, 2003, generally have a term of ten years. The exercise price of stock options granted
under the 1997 Plan is determined by the Board of Directors (or a Committee of the Board of Directors), but will be at least equal to 100% of the fair market value per share of common stock on the date of grant (or at least 110% of such fair market
value for an incentive stock option granted to a stockholder with greater than 10% voting power of all our stock), except that up to 10% of the aggregate number of shares reserved for issuance under the 1997 Plan (including shares that have been
issued or are issuable in connection with options exercised or granted under the 1997 Plan) may have exercise prices that are from 0% to 100% of the fair market value of the common stock on the date of grant. Options generally vest ratably over four
years.

The 1997 Plan also allows for the issuance of stock purchase rights and options that are immediately exercisable through execution
of a restricted stock purchase agreement. Shares purchased pursuant to a stock purchase agreement generally vest ratably over four years. In the event of termination of employment, the Company, at its discretion, may repurchase unvested shares at a
price equal to the original issuance price. In addition, the 1997 Plan allows for the issuance of stock appreciation rights, performance shares and performance units. Stock appreciation rights (SARs) are rights to receive, in cash or
shares of our common stock, as designated on the grant date, the appreciation in fair market value of common stock between the exercise date and the date of grant. To date, the



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Company has only issues SARs that can be settled in shares of the Companys common stock. SARs may be granted alone
or in tandem with options. The exercise price of a SAR will be at least equal to 100% of the fair market value per share of common stock on the date of grant. SARs issued by the Company generally vest in equal, annual installments over four years,
and expire on the fifth anniversary of the grant date. Performance units and performance shares are awards that result in a payment to a participant, generally in the form of an issuance of shares of the Companys common stock, at such time as
specified performance goals or other vesting criteria are achieved or the awards otherwise vest. Performance shares issued by the Company generally vest in equal, annual installments over four years, although certain of these performance shares vest
100% after two years while others have additional financial-based performance requirements that must be met before vesting can occur. Performance shares with performance-based vesting conditions expire no later than the fourth anniversary of the
grant date if the performance criteria have not been met.

1998 Directors Option Plan

Non-employee directors are entitled to participate in the 1998 Director Option Plan (the Director Plan). The Director Plan was adopted by the
Board of Directors in May 1998 and became effective upon the closing of the initial public offering of the Companys stock in July 1998. The Director Plan expired in July 2008. Future grants made to members of our Board of Directors will be
made from the 1997 Plan. Prior to its expiration, options granted under the Director Plan were generally fully vested on the date of grant and had exercise prices equal to the per share fair market value of the Companys common stock on the
date of grant. During 2008, 2007, and 2006, options to purchase an aggregate of 75,000, 60,000 and 50,000 shares, respectively, were granted under the Director Plan. The weighted average exercise prices for the option grants in 2008, 2007, and 2006,
were $13.12, $13.74, and $7.99, respectively.

In the event of a merger of the Company with or into another corporation or the sale of
substantially all of the assets of the Company, each option granted under the Director Plan shall be assumed or an equivalent option may be substituted by the successor corporation. Following such assumption or substitution, if the optionees
status as a director of the successor corporation terminates other than upon a voluntary resignation by the optionee, the option shall become fully exercisable, including as to shares as to which it would not otherwise be exercisable. If the
outstanding options are not assumed or substituted, the options shall become fully vested and exercisable. Options granted must be exercised within three months of the end of the optionees tenure as a director of the Company, or within twelve
months after such directors termination by death or disability, but in no event later than the expiration of the options five year term; provided, however, that shares subject to an option granted to a director who has served as a
director with the Company for at least five years shall become fully vested and exercisable for the remainder of the options five year term upon such directors termination. No option granted under the Director Plan is transferable by the
optionee other than by will or the laws of descent and distribution, and each option is exercisable, during the lifetime of the optionee, only by such optionee.

(d) Employee Stock Option Exchange Program

On November 19, 2008, the Company announced a voluntary employee stock
option exchange program (the Exchange Program) whereby eligible employees were given an opportunity to exchange some or all of their outstanding stock options and SARs, collectively the Surrendered Awards, for a predetermined
number of new SARs. Under the Exchange Program, participating eligible employees would receive one new SAR for each Surrendered Award with an exercise price less than $12.00 per share. For exchanged options with an exercise price equal to or greater
than $12.00 per share, participants would receive between 0.33 and 0.67 new SARs for each Surrendered Award exchanged, depending on the exercise price of the Surrendered Award. The Companys board of directors and Compensation Committee
approved the Exchange Program to restore the retention and incentive benefits of the Companys equity awards. Non-employee members of the Companys board of directors were not eligible to participate in the Exchange Program.

On December 17, 2008, in accordance with the Exchange Program, the Company accepted and cancelled options and SARs to purchase 4,659,926 shares of
its common stock. On the same day, the Company granted new SARs totaling 3,240,890 shares. The new SARs were granted at an exercise price of $7.69, the closing price of the Companys stock on December 17, 2008. The new SARs granted under
the Exchange Program have vesting schedules and maximum terms as follows:



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|                                                               |  |                                                                                                                     |  |                         
|-------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------- |  | ------------------------
|Percentage of Surrendered Award Vested as of December 17, 2008 |  | Vesting Schedule of New SARs                                                                                        |  | Maximum Term of New SARs
|Fully vested                                                   |  | 100% of the new SARs will be scheduled to vest on the first anniversary of the new grant date                       |  | two (2) years           
|                                                               |  |                                                                                                                    
|75% vested                                                     |  | 50% of the new SARs will be scheduled to vest on each of the first and second anniversaries of the new grant date   |  | three (3) years         
|                                                               |  |                                                                                                                    
|50% vested                                                     |  | 33.33% of the new SARs will be scheduled to vest on each of the first three (3) anniversaries of the new grant date |  | four (4) years          
|                                                               |  |                                                                                                                    
|25% or less vested                                             |  | 25% of the new SARs will be scheduled to vest on each of the first four (4) anniversaries of the new grant date     |  | five (5) years          

See Note 5 for a discussion of the accounting for the Exchange Program.

(e) Stock Award Activity

The following table
summarizes stock award activity under all plans for the years ended December 31, 2008, 2007, and 2006:



|                                                |  |                          |   |  |                                         |   |  |   |      
|----------------------------------------------- |  | ------------------------ | - |  | --------------------------------------- | - |  | - | -----
|                                                |  | SharesAvailable forGrant |   |  | Options Outstanding                    
|                                                |  | NumberOutstanding        |   |  | Weighted-AverageExercise PricePer Share
|BALANCE AT DECEMBER 31, 2005                    |  | 6,949,420                |   |  | 8,089,473                               |   |  | $ | 11.24
|Options and stock appreciation rights granted   |  | (852,734                 | ) |  | 852,734                                 |   |  |   | 8.40 
|Performance shares granted                      |  | (387,909                 | ) |  |                                        |   |  |   |     
|Options and stock appreciation rights cancelled |  | 534,902                  |   |  | (534,902                                | ) |  |   | 12.94
|Performance shares cancelled                    |  | 25,896                   |   |  |                                        |   |  |   |     
|Options exercised                               |  |                         |   |  | (124,625                                | ) |  |   | 6.13 
|Additional shares reserved                      |  | 1,692,020                |   |  |                                        |   |  |   |     
|                                                |  |                          |   |  |                                         |   |  |   |      
|BALANCE AT DECEMBER 31, 2006                    |  | 7,961,595                |   |  | 8,282,680                               |   |  | $ | 10.91
|Options and stock appreciation rights granted   |  | (1,022,219               | ) |  | 1,022,219                               |   |  |   | 24.72
|Performance shares granted                      |  | (441,871                 | ) |  |                                        |   |  |   |     
|Options and stock appreciation rights cancelled |  | 323,070                  |   |  | (323,070                                | ) |  |   | 12.35
|Performance shares cancelled                    |  | 42,183                   |   |  |                                        |   |  |   |     
|Options exercised                               |  |                         |   |  | (1,949,006                              | ) |  |   | 9.44 
|Additional shares reserved                      |  | 1,664,301                |   |  |                                        |   |  |   |     
|                                                |  |                          |   |  |                                         |   |  |   |      
|BALANCE AT DECEMBER 31, 2007                    |  | 8,527,059                |   |  | 7,032,823                               |   |  | $ | 13.26
|Options and stock appreciation rights granted   |  | (4,297,547               | ) |  | 4,297,547                               |   |  |   | 8.98 
|Performance shares granted                      |  | (777,732                 | ) |  |                                        |   |  |   |     
|Options and stock appreciation rights cancelled |  | 5,266,484                |   |  | (5,266,484                              | ) |  |   | 14.96
|Performance shares cancelled                    |  | 128,109                  |   |  |                                        |   |  |   |     
|Options exercised                               |  |                         |   |  | (405,561                                | ) |  |   | 9.66 
|Unissued shares returned to plan                |  | 6,510                    |   |  |                                        |   |  |   |     
|1998 Directors Plan shares expired              |  | (855,000                 | ) |  |                                        |   |  |   |     
|Additional shares reserved                      |  | 1,729,454                |   |  |                                        |   |  |   |     
|                                                |  |                          |   |  |                                         |   |  |   |      
|BALANCE AT DECEMBER 31, 2008                    |  | 9,727,337                |   |  | 5,658,325                               |   |  | $ | 8.69 
|                                                |  |                          |   |  |                                         |   |  |   |      



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The total intrinsic value of options exercised during the years ended December 31, 2008, 2007, and
2006 was approximately $1.6 million, $24.8 million, and $261,000, 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 following table provides additional information regarding performance share activity for the years ended December 31, 2008, 2007, and 2006:



|                                       |  |                               |   |  |                                       |      
|-------------------------------------- |  | ----------------------------- | - |  | ------------------------------------- | -----
|                                       |  | NumberNonvestedandOutstanding |   |  | Weighted-Average GrantDate Fair-Value
|BALANCE AT DECEMBER 31, 2005           |  | 412,968                       |   |  | $                                     | 7.82 
|Performance shares granted             |  | 387,909                       |   |  |                                       | 8.59 
|Performance shares vested and released |  | (71,945                       | ) |  |                                       | 8.19 
|Performance shares forfeited           |  | (25,896                       | ) |  |                                       | 8.05 
|                                       |  |                               |   |  |                                       |      
|BALANCE AT DECEMBER 31, 2006           |  | 703,036                       |   |  | $                                     | 8.20 
|Performance shares granted             |  | 441,871                       |   |  |                                       | 21.61
|Performance shares vested and released |  | (227,845                      | ) |  |                                       | 7.60 
|Performance shares forfeited           |  | (42,183                       | ) |  |                                       | 9.84 
|                                       |  |                               |   |  |                                       |      
|BALANCE AT DECEMBER 31, 2007           |  | 874,879                       |   |  | $                                     | 15.05
|Performance shares granted             |  | 777,732                       |   |  |                                       | 10.88
|Performance shares vested and released |  | (322,729                      | ) |  |                                       | 12.93
|Performance shares forfeited           |  | (128,109                      | ) |  |                                       | 13.22
|                                       |  |                               |   |  |                                       |      
|BALANCE AT DECEMBER 31, 2008           |  | 1,201,773                     |   |  | $                                     | 13.11
|                                       |  |                               |   |  |                                       |      

The fair value of each performance share grant was estimated on the date of grant by multiplying
the number of shares granted times the fair market value of the Companys stock on the grant date. The total intrinsic value of performance shares vested and released during the years ended December 31, 2008, 2007, and 2006 was
approximately $3.9 million, $3.5 million, and $582,000, respectively. The intrinsic value is calculated by multiplying the fair market value of the Companys stock on the vesting date by the number of shares vested.

The following table provides additional information for significant ranges of outstanding and exercisable stock options and stock appreciation rights as
of December 31, 2008:



|                            |  |                     |                |                   |           |                                                   |      |                                       |   |                         |  |   |          
|--------------------------- |  | ------------------- | -------------- | ----------------- | --------- | ------------------------------------------------- | ---- | ------------------------------------- | - | ----------------------- |  | - | ---------
|                            |  | Exercise PriceRange |                | NumberOutstanding |           | WeightedAverageRemainingContractualLife(in
years) |      | WeightedAverageExercisePrice perShare |   | AggregateIntrinsicValue
|                            |  | $                   | 6.11           |                   | 649,463   |                                                   | 1.70 |                                       | $ | 6.11                    |  | $ | 1,324,905
|                            |  |                     | 6.29 - 7.65    |                   | 185,541   |                                                   | 1.96 |                                       |   | 6.76                    |  |   | 258,717  
|                            |  |                     | 7.69           |                   | 3,240,890 |                                                   | 3.13 |                                       |   | 7.69                    |  |   | 1,490,809
|                            |  |                     | 7.81 - 9.13    |                   | 565,665   |                                                   | 3.21 |                                       |   | 8.29                    |  |   | 9,198    
|                            |  |                     | 9.27 - 13.32   |                   | 653,598   |                                                   | 3.10 |                                       |   | 11.51                   |  |   |         
|                            |  | $                   | 13.56 - $30.76 |                   | 363,168   |                                                   | 3.23 |                                       |   | 18.71                   |  |   |         
|                            |  |                     |                |                   |           |                                                   |      |                                       |   |                         |  |   |          
|Outstanding                 |  |                     |                |                   | 5,658,325 |                                                   | 2.84 |                                       | $ | 8.69                    |  | $ | 3,083,629
|                            |  |                     |                |                   |           |                                                   |      |                                       |   |                         |  |   |          
|Vested and expected to vest |  |                     |                |                   | 5,383,689 |                                                   | 2.83 |                                       | $ | 8.71                    |  | $ | 2,964,465
|                            |  |                     |                |                   |           |                                                   |      |                                       |   |                         |  |   |          
|Exercisable                 |  |                     |                |                   | 1,973,829 |                                                   | 2.24 |                                       | $ | 9.51                    |  | $ | 1,517,598
|                            |  |                     |                |                   |           |                                                   |      |                                       |   |                         |  |   |          

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value,
based on the Companys closing stock price of $8.15 as of December 31, 2008, the last market trading day of 2008, which would have been received by the option holders had all option holders exercised their options as of that date.



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5. STOCK-BASED COMPENSATION:

(a) Valuation of Options, SARs, and Performance Shares Granted

The Company has elected to use the BSM option-pricing model
to estimate the fair value of stock options and SARs that it grants. The BSM model incorporates various assumptions including volatility, expected term of the option from the date of grant to the time of exercise, risk-free interest rates, and
dividend yields. Excluding SARs granted in December 2008 as part of the Exchange Program, which is discussed further below, the weighted average fair value of options and SARs granted during the years ended December 31, 2008, 2007, and 2006,
was $6.33, $10.86, and $3.49, respectively, and was determined using the following weighted average assumptions:



|                         |  |                         |   |  |      |   |  |      |  
|------------------------ |  | ----------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Year Ended December 31, |  
|                         |  | 2008                    |   |  | 2007 |   |  | 2006 |  
|Expected dividend yield  |  | 0.0                     | % |  | 0.0  | % |  | 0.0  | %
|Risk-free interest rate  |  | 2.7                     | % |  | 4.1  | % |  | 4.6  | %
|Expected volatility      |  | 61.1                    | % |  | 54.6 | % |  | 50.5 | %
|Expected term (in years) |  | 4.1                     |   |  | 3.6  |   |  | 3.6  |  

The expected dividend yield reflects the fact that the Company has not paid any dividends in the
past and does not currently intend to pay dividends in the foreseeable future. The risk-free interest rate assumption is based on U.S. Treasury yields in effect at the time of grant for the expected term of the option. The expected volatility is
based on both the historical volatility of the Companys common stock over the most recent period commensurate with the expected life of the option as well as on implied volatility calculated from the market traded options on the Companys
stock. For options and SARs granted prior to January 1, 2008, the expected term has been calculated using the simplified method as permitted under 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. For options and SARs granted subsequent to December 31, 2007, the expected term has been calculated by applying a Monte Carlo simulation model that incorporates the Companys
historical data on post-vest exercise activity and employee termination behavior.

The grant date fair value of performance shares granted
to employees is determined by multiplying the fair market value of the Companys stock on the grant date times the number of performance shares awarded. During 2008, the Company issued a limited number of performance shares to a consultant. The
fair value for these awards is determined at the earlier of the date at which a commitment for performance by the consultant to earn the performance shares is reached, or the date at which the consultants performance necessary for the
performance shares to vest has been completed.

(b) Accounting for Employee Stock Option Exchange Program

As discussed in Note 4, the Company completed a stock option exchange program for eligible employees on December 17, 2008. Under SFAS 123R, the
Exchange Program is considered a modification to the Surrendered Awards, which requires the calculation of incremental compensation cost. The incremental compensation cost is calculated by comparing the fair value of each newly issued SAR to the
fair value of the corresponding Surrendered Award, each of which was calculated as of December 17, 2008 using the BSM option-pricing model. To the extent the fair value of the newly issued SARs exceeds the fair value of the Surrendered Awards,
there is incremental compensation cost. The total incremental compensation cost resulting from the Exchange Program was $2.3 million, and was calculated using the following weighted average assumptions.



|                         |  |                   |   |  |                  |  
|------------------------ |  | ----------------- | - |  | ---------------- | -
|                         |  | SurrenderedAwards |   |  | Newly IssuedSARs |  
|Expected dividend yield  |  | 0.0               | % |  | 0.0              | %
|Risk-free interest rate  |  | 0.8               | % |  | 1.0              | %
|Expected volatility      |  | 77.1              | % |  | 73.7             | %
|Expected term (in years) |  | 2.5               |   |  | 2.9              |  

The Company must also continue to amortize previously unrecognized compensation expense related to
the original grant date fair value of the Surrendered Awards. The Company has elected to combine both the incremental value and the unamortized original grant date fair value of the Surrendered Awards, the total of which will be recognized as
compensation expense over the vesting term of the new SARs.



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(c) Expense Allocation

Compensation expense for all share-based payment awards, including those granted prior to January 1, 2006, has been recognized in accordance with SFAS 123R using the accelerated multiple-option approach. As
stock-based compensation expense recognized in the Consolidated Statement of Operations for the years ended December 31, 2008, 2007, and 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS
123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures have been estimated based on historical experience.

As of December 31, 2008, there were 186,581 nonvested performance shares outstanding (with a grant date fair value of $1.9 million) that were
subject to certain financial-based performance requirements that must be achieved before vesting can occur. Cumulative compensation expense of $631,000 through December 31, 2008 associated with 119,148 of these performance shares (with a grant
date fair value of approximately $1.0 million) has been recognized assuming that those financial performance requirements will be achieved. If such requirements are not met, no compensation cost is recognized and any recognized compensation cost
will be reversed. No compensation expense has been recognized associated with the remaining 67,433 performance shares (with a grant date fair value of $898,000) as management does not currently expect the financial performance requirements for these
awards will be met.

As of December 31, 2008, total compensation cost related to non-vested stock options and other equity based
awards not yet recognized was $25.0 million, which is expected to be recognized over the next 19 months on a weighted-average basis, and of which $410,000 relates to awards subject to certain financial based performance requirements.

The following table summarizes the stock-based compensation expense related to employee stock options and share awards under SFAS 123R for the years
ended December 31, 2008, 2007, and 2006, which was allocated as follows (in thousands):



|                                                                                       |  |                         |        |      |   |       |  |   |      
|-------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ----- |  | - | -----
|                                                                                       |  | Year Ended December 31,
|                                                                                       |  | 2008                    |        | 2007 |   | 2006 
|Cost of sales  product                                                                |  | $                       | 1,628  |      | $ | 901   |  | $ | 487  
|Cost of sales  service                                                                |  |                         | 209    |      |   | 87    |  |   | 55   
|                                                                                       |  |                         |        |      |   |       |  |   |      
|Stock-based compensation expense included in cost of sales                             |  |                         | 1,837  |      |   | 988   |  |   | 542  
|Product development                                                                    |  |                         | 6,032  |      |   | 2,849 |  |   | 2,147
|Sales and marketing                                                                    |  |                         | 2,986  |      |   | 1,683 |  |   | 1,334
|General and administrative                                                             |  |                         | 3,603  |      |   | 2,279 |  |   | 1,437
|                                                                                       |  |                         |        |      |   |       |  |   |      
|Stock-based compensation expense included in operating expenses                        |  |                         | 12,621 |      |   | 6,811 |  |   | 4,918
|                                                                                       |  |                         |        |      |   |       |  |   |      
|Total stock-based compensation expense related to stock options and share awards       |  |                         | 14,458 |      |   | 7,799 |  |   | 5,460
|Tax benefit                                                                            |  |                         |       |      |   |      |  |   |     
|                                                                                       |  |                         |        |      |   |       |  |   |      
|Stock-based compensation expense related to stock options and share awards, net of tax |  | $                       | 14,458 |      | $ | 7,799 |  | $ | 5,460
|                                                                                       |  |                         |        |      |   |       |  |   |      

Of the $14.5 million of compensation expense recorded for the year ended December 31,
2008, approximately $4.3 million related to equity compensation awards granted during 2008, while the remaining $10.2 million related to equity compensation awards granted on or before December 31, 2007. Of the $7.8 million of
compensation expense recorded for the year ended December 31, 2007, approximately $3.3 million related to equity compensation awards granted during 2007, while the remaining $4.5 million related to equity compensation awards granted
on or before December 31, 2006. Of the $5.5 million of compensation expense recorded for the year ended December 31, 2006, approximately $941,000 related to equity compensation awards granted during 2006, while the remaining
$4.5 million related to equity compensation awards granted on or before December 31, 2005.

As of December 31, 2008,
approximately $146,000 and $24,000 of stock-based compensation expense was capitalized as part of the cost of inventory and deferred cost of goods sold, respectively. As of December 31, 2007, approximately $74,000 and $37,000 of stock-based
compensation expense was capitalized as part of the cost of inventory and deferred cost of goods sold, respectively. As of December 31, 2006, no stock-based compensation expense was capitalized as part of the cost of an asset.

6. 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. During the three years ended



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December 31, 2008, the Company had six 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), Duke Energy Corporation (Duke), a US utility company that purchases NES products directly from the Company, and Telvent Energia y Medioambiente SA (Telvent), Limited Liability
Company Engineering Center ENERGOAUDITCONTROL (EAC), and ES Elektrosandberg AB (ES), European based value added resellers of the Companys NES products. For the years ended December 31, 2008, 2007, and 2006, the
percentages of the Companys revenues attributable to sales made to these customers were as follows:



|        |  |                         |   |  |      |   |  |      |  
|------- |  | ----------------------- | - |  | ---- | - |  | ---- | -
|        |  | Year Ended December 31, |  
|        |  | 2008                    |   |  | 2007 |   |  | 2006 |  
|EBV     |  | 15.3                    | % |  | 12.8 | % |  | 27.1 | %
|ES      |  | 14.9                    | % |  | 11.4 | % |  | 0.1  | %
|Duke    |  | 10.3                    | % |  |     | % |  |     | %
|Enel    |  | 9.1                     | % |  | 10.3 | % |  | 12.4 | %
|Telvent |  | 8.9                     | % |  | 28.3 | % |  |     | %
|EAC     |  | 8.3                     | % |  | 7.2  | % |  |     | %
|        |  |                         |   |  |      |   |  |      |  
|Total   |  | 66.8                    | % |  | 70.0 | % |  | 39.6 | %
|        |  |                         |   |  |      |   |  |      |  

Of the percentage of sales made to EBV, approximately 0.5% for the year ended December 31,
2008, related to sales of components we sold to EBV, which EBV in turn sold to one of Enels third party meter manufacturers. Elsewhere in these Consolidated Financial Statements, those sales are reported as Enel Project revenues. The
Companys contract with EBV, which has been in effect since 1997 and has been renewed annually thereafter, expires in December 2009. Please refer to Note 11, Related Parties, for additional information regarding the Companys agreements
with Enel

7. GOODWILL:

The carrying
amount of goodwill as of December 31, 2008, 2007, and 2006 relates to three acquisitions, including ARIGO Software GmbH (ARIGO) in 2001, BeAtHome in 2002, and MTC in 2003. The goodwill acquired as part of the ARIGO transaction is
valued in Euros, and is therefore subject to foreign currency translation gains and losses. The changes in the carrying amount of goodwill, net for the years ended December 31, 2007 and 2008 are as follows (in thousands):



|                                             |  |        |       |  
|-------------------------------------------- |  | ------ | ----- | -
|                                             |  | Amount |      
|Balance as of December 31, 2006              |  | $      | 8,278 |  
|Unrealized foreign currency translation gain |  |        | 270   |  
|                                             |  |        |       |  
|Balance as of December 31, 2007              |  |        | 8,548 |  
|Unrealized foreign currency translation loss |  |        | (131  | )
|                                             |  |        |       |  
|Balance as of December 31, 2008              |  | $      | 8,417 |  
|                                             |  |        |       |  



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8. COMMITMENTS AND CONTINGENCIES:

(a) Lease Commitments

As discussed in Note 3, the leases of our corporate headquarters facilities
are accounted for under EITF 97-10 and SFAS 98. As of December 31, 2008, future minimum lease payments for these lease financing obligations were as follows (in thousands):



|                                                    |  |   |         |  
|--------------------------------------------------- |  | - | ------- | -
|2009                                                |  | $ | 3,097   |  
|2010                                                |  |   | 3,135   |  
|2011                                                |  |   | 3,174   |  
|2012                                                |  |   | 3,214   |  
|2013                                                |  |   | 3,254   |  
|2014 and thereafter                                 |  |   | 22,124  |  
|                                                    |  |   |         |  
|Total payments                                      |  | $ | 37,998  |  
|Amount representing interest                        |  |   | (11,209 | )
|                                                    |  |   |         |  
|Present value of future minimum lease payments      |  | $ | 26,789  |  
|                                                    |  |   |         |  
|Lease financing obligations classified as current   |  | $ | 1,439   |  
|                                                    |  |   |         |  
|Lease financing obligations classified as long-term |  | $ | 25,350  |  
|                                                    |  |   |         |  

The Company also leases facilities under operating leases for its sales, marketing, and product
development personnel located elsewhere within the United States and in ten 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 2020, 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.

As of December 31, 2008, future minimum lease payments under all operating leases,
including $8.7 million related to the land lease associated with the Companys corporate headquarters facilities (see Note 3), were as follows (in thousands):



|                    |  |   |       
|------------------- |  | - | ------
|2009                |  | $ | 1,838 
|2010                |  |   | 1,646 
|2011                |  |   | 1,239 
|2012                |  |   | 995   
|2013                |  |   | 890   
|2014 and thereafter |  |   | 5,055 
|                    |  |   |       
|Total               |  | $ | 11,663
|                    |  |   |       

Rent expense for all operating leases was approximately $1.9 million for 2008,
$1.7 million for 2007, and $1.6 million for 2006. Although certain of the operating lease agreements provide for escalating rent payments over the term of the lease, rent expense under these agreements is recognized on a straight-line
basis. As of December 31, 2008, the Company has accrued approximately $447,000 of deferred rent related to these agreements, of which approximately $37,000 is reflected in current liabilities while the remainder is reflected in other long-term
liabilities in the accompanying consolidated balance sheet. As of December 31, 2007, the Company had accrued approximately $467,000 of deferred rent related to these agreements, of which approximately $99,000 is reflected in current liabilities
while the remainder is reflected in other long-term liabilities. See Note 3 for explanation of land lease expense on the Companys corporate headquarters facilities.

(b) 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 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 the Companys
consolidated statements of income, was approximately $513,000, $573,000, and $493,000 for the years ended December 31, 2008, 2007, and 2006, respectively.

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.

(c) 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



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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.

(d) 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 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 December 31, 2008, 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.

(e) 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 December 31, 2008, 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.

(f) Line of Credit

The Company maintains a $15.0 million line of credit with its primary bank. As of
December 31, 2008, the Companys primary bank has issued, against the line of credit, a standby letter of credit totaling $217,000. Other than causing to have issued standby letters of credit, the Company has never drawn against the line
of credit, nor have amounts ever been drawn against the standby letters of credit issued by the bank.

9. INCOME TAXES:

The provision for income taxes attributable to continuing operations is based upon income (loss) before income taxes from continuing operations as follows
(in thousands):



|         |  |                         |         |   |      |   |         |      |  |   |         |  
|-------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|         |  | Year Ended December 31, |        
|         |  | 2008                    |         |   | 2007 |   |         | 2006 | 
|Domestic |  | $                       | (25,842 | ) |      | $ | (15,802 | )    |  | $ | (24,612 | )
|Foreign  |  |                         | 308     |   |      |   | 582     |      |  |   | (168    | )
|         |  |                         |         |   |      |   |         |      |  |   |         |  
|         |  | $                       | (25,534 | ) |      | $ | (15,220 | )    |  | $ | (24,780 | )
|         |  |                         |         |   |      |   |         |      |  |   |         |  

The Company accounts for income taxes in accordance with SFAS No. 109 (SFAS 109),
Accounting for Income Taxes. SFAS 109 provides for an asset and liability approach under which deferred income taxes are based upon enacted tax laws and rates applicable to the periods in which the taxes become payable.



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The provision for income taxes consists of the following (in thousands):



|                                 |  |                         |      |   |      |   |      |  |   |    
|-------------------------------- |  | ----------------------- | ---- | - | ---- | - | ---- |  | - | ---
|                                 |  | Year Ended December 31,
|                                 |  | 2008                    |      |   | 2007 |   | 2006
|Federal:                         |  |                         |      |   |      |   |      |  |   |    
|Current                          |  | $                       | (136 | ) |      | $ |     |  | $ |   
|Deferred                         |  |                         |     |   |      |   |     |  |   |   
|                                 |  |                         |      |   |      |   |      |  |   |    
|Total federal provision          |  |                         | (136 | ) |      |   |     |  |   |   
|                                 |  |                         |      |   |      |   |      |  |   |    
|State:                           |  |                         |      |   |      |   |      |  |   |    
|Current                          |  |                         | 5    |   |      |   | 10   |  |   | 10 
|Deferred                         |  |                         |     |   |      |   |     |  |   |   
|                                 |  |                         |      |   |      |   |      |  |   |    
|Total state provision            |  |                         | 5    |   |      |   | 10   |  |   | 10 
|                                 |  |                         |      |   |      |   |      |  |   |    
|Foreign:                         |  |                         |      |   |      |   |      |  |   |    
|Current                          |  |                         | 428  |   |      |   | 442  |  |   | 340
|Deferred                         |  |                         |     |   |      |   |     |  |   |   
|                                 |  |                         |      |   |      |   |      |  |   |    
|Total foreign provision          |  |                         | 428  |   |      |   | 442  |  |   | 340
|                                 |  |                         |      |   |      |   |      |  |   |    
|Total provision for income taxes |  | $                       | 297  |   |      | $ | 452  |  | $ | 350
|                                 |  |                         |      |   |      |   |      |  |   |    

The provision for income taxes differs from the amount estimated by applying the statutory Federal
income tax rate to income before taxes as follows (in thousands):



|                                     |  |                         |        |   |      |   |        |      |  |   |        |  
|------------------------------------ |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                     |  | Year Ended December 31, |       
|                                     |  | 2008                    |        |   | 2007 |   |        | 2006 | 
|Federal tax at statutory rate of 35% |  | $                       | (8,937 | ) |      | $ | (5,327 | )    |  | $ | (8,673 | )
|State taxes, net of federal benefit  |  |                         | 5      |   |      |   | 10     |      |  |   | 10     |  
|U.S.-Foreign rate differential       |  |                         | 155    |   |      |   | 239    |      |  |   | 399    |  
|Change in Valuation Allowance        |  |                         | 9,766  |   |      |   | 5,346  |      |  |   | 8,134  |  
|Others                               |  |                         | (692   | ) |      |   | 184    |      |  |   | 480    |  
|                                     |  |                         |        |   |      |   |        |      |  |   |        |  
|Total provision for income taxes     |  | $                       | 297    |   |      | $ | 452    |      |  | $ | 350    |  
|                                     |  |                         |        |   |      |   |        |      |  |   |        |  

As of December 31, 2008 and 2007, a valuation allowance has been recorded for the entire
gross deferred tax asset as a result of uncertainties regarding the realization of the asset balance. As of December 31, 2008 and 2007, the Company had no significant deferred tax liabilities. The components of the net deferred income tax asset
are as follows (in thousands):



|                                                    |  |              |         |   |      |   |         |  
|--------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                    |  | December 31, |        
|                                                    |  | 2008         |         |   | 2007 |  
|Net operating loss carry forwards                   |  | $            | 38,876  |   |      | $ | 34,898  |  
|Tax credit carry forwards                           |  |              | 15,231  |   |      |   | 13,250  |  
|Fixed and intangible assets                         |  |              | 8,021   |   |      |   | 7,191   |  
|Capitalized research and development costs          |  |              | 32      |   |      |   | 56      |  
|Reserves and other cumulative temporary differences |  |              | 14,168  |   |      |   | 10,546  |  
|                                                    |  |              |         |   |      |   |         |  
|Gross deferred income tax assets                    |  |              | 76,328  |   |      |   | 65,941  |  
|Valuation allowance                                 |  |              | (76,328 | ) |      |   | (65,941 | )
|                                                    |  |              |         |   |      |   |         |  
|Net deferred income tax assets                      |  | $            |        |   |      | $ |        |  
|                                                    |  |              |         |   |      |   |         |  

As of December 31, 2008, part of our valuation allowance on deferred tax assets pertains to
certain tax credits and net operating loss carry forwards. In the future, we will reduce the valuation allowance associated with these credits and losses upon the earlier of the period in which we utilize them to reduce the amount of income tax we
would otherwise be required to pay on our income tax returns, or when it becomes more likely than not that the deferred tax assets are realizable. If the valuation allowance associated with these credits and losses is realized, the tax benefit of
certain of these credits and losses will be accounted for as a credit to stockholders equity rather than as a reduction of income tax expense. In addition, the Internal Revenue Code of 1986, as amended,



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contains provisions that limit the net operating loss and credit carryforwards available for use in any given period upon the occurrence of certain events,
including a significant change in ownership interests. The Company performed an analysis of the ownership changes in 2001. Since that time, some ownership changes may have occured, which could cause certain of the Companys net operating loss
and credit carryforwards to be limited in future periods.

As of December 31, 2008, the Company had net operating loss carryforwards
of $132.3 million for federal income tax reporting purposes and $48.2 million for state income tax reporting purposes, which expire at various dates through 2028. In addition, as of December 31, 2008, the Company had approximately $8.6 million
and $9.7 million of tax credit carry forwards for increased research expenditures for federal and California purposes, respectively. The federal research tax credits will expire at various dates if not utilized by 2028 and the state tax credit can
be carried over indefinitely. In accordance with current Internal Revenue Code rules, federal net operating loss carryforwards must be utilized in full before federal research and development tax credits can be used to offset current tax
liabilities. As a result, depending on the Companys future taxable income in any given year, some or all of the federal increased research tax credits, as well as portions of the Companys federal and state net operating loss
carryforwards, may expire before being utilized.

Amounts held by foreign subsidiaries are generally subject to United States income
taxation on repatriation to the United States. The Company currently intends to permanently reinvest its undistributed earnings from its foreign subsidiaries outside the United States and United States income taxes have not been provided on
cumulative total earnings of $6.6 million. It is not practicable to determine the income tax liability that might be incurred if these earnings were to be distributed.

The Company adopted FIN 48 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.

The following is a rollforward of the Companys uncertain tax benefits for the years ended December 31, 2008 and 2007 (in thousands):



|                                        |  |                         |        |   |      |   |       |  
|--------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ----- | -
|                                        |  | Year Ended December 31, |       
|                                        |  | 2008                    |        |   | 2007 |  
|Balance as of the beginning of the year |  | $                       | 5,808  |   |      | $ | 4,697 |  
|Tax positions related to current year:  |  |                         |        |   |      |   |       |  
|Additions                               |  |                         | 549    |   |      |   | 1,136 |  
|Reductions                              |  |                         |       |   |      |   |      |  
|Tax positions related to prior years:   |  |                         |        |   |      |   |       |  
|Additions                               |  |                         | 707    |   |      |   | 229   |  
|Reductions                              |  |                         | (2,278 | ) |      |   | (187  | )
|Settlements                             |  |                         |       |   |      |   |      |  
|Lapses in statute of limitations        |  |                         | (124   | ) |      |   | (67   | )
|                                        |  |                         |        |   |      |   |       |  
|Balance as of the end of the year       |  | $                       | 4,662  |   |      | $ | 5,808 |  
|                                        |  |                         |        |   |      |   |       |  

Included in the balance of total unrecognized tax benefits at December 31, 2008 are potential
benefits of $1.0 million, which if recognized, would affect the effective rate on income from continuing operations.

Upon adoption, the
Company had accrued interest and penalties related to the uncertain tax benefits of approximately $293,000. In 2007, the Company decreased the prior year balance by $13,000 and accrued $47,000 of additional penalties and interest. In 2008, the
Company decreased the prior year balance by $59,000 and accrued $42,000 of additional penalties and interest.

The Company is subject to
taxation in the United States and various state and foreign jurisdictions. In the United States, the tax years from 1992 remain open to examination by federal and most state tax authorities due to certain net operating loss and credit carryforward
positions. In the foreign jurisdictions, the number of tax years open to examination by local tax authorities ranges from three to six years.

10.
WARRANTY RESERVES:

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,



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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 generally provided for when the associated revenue is recognized. 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 $849,000 as of December 31, 2008 and $301,000 as of December 31, 2007.

11. RELATED PARTIES:

During the years ended December 31, 2008, 2007, and 2006, 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, our Chairman and Chief Executive Officer, M. Kenneth Oshman, uses his private plane or charter aircraft for Company business for
himself and any employees that accompany him. In August 2008, our Board of Directors approved a reimbursement arrangement whereby Echelon will reimburse Mr. Oshman for 50% of the costs incurred for his private plane or charter aircraft travel
used while on company business. Such costs include flight charges (subject to any discounted rate that may apply), fuel, fuel surcharges, landing fees, crew costs and related expenses. During 2008, we recognized a total of approximately $258,000 in
expenses pursuant to the reimbursement arrangement, all of which has been included in general and administrative expenses in the Consolidated Statements of Operations.

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. Under the terms of the stock purchase agreement,
Enel has the right to nominate a member of the Companys board of directors. A representative of Enel is not presently serving on the Companys board.

At the same time as the Company entered into the stock purchase agreement with Enel, it 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 may 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. The development and supply agreement expires
in December 2011, and the software enhancement agreement expires in December 2009, although delivery of products and services can extend beyond those dates and the agreements may be extended under certain circumstances.

For the years ended December 31, 2008, 2007, and 2006, the Company recognized revenues of approximately $12.9 million, $14.2 million, and $7.1
million, respectively, related to products and services sold to Enel and its contract manufacturers. As of December 31, 2008, approximately $5.0 million of the 2008 revenues were included in accounts receivable. As of December 31, 2007,
approximately $3.0 million of the 2007 revenues were included in accounts receivable.



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12. VALUATION AND QUALIFYING ACCOUNTS (in thousands):



|                                                 |  |                              |       |                                           |   |       |                                        |  |                        |       |  |   |      
|------------------------------------------------ |  | ---------------------------- | ----- | ----------------------------------------- | - | ----- | -------------------------------------- |  | ---------------------- | ----- |  | - | -----
|                                                 |  | Balance atBeginningof Period |       | Charged/(Credited) toRevenues andExpenses |   |       | Write-Off ofPreviouslyProvidedAccounts |  | Balance atEnd ofPeriod
|Year Ended December 31, 2008:                    |  |                              |       |                                           |   |       |                                        |  |                        |       |  |   |      
|Allowance for Doubtful Accounts                  |  | $                            | 330   |                                           | $ | (5    | )                                      |  | $                      | 2     |  | $ | 323  
|Allowance for Customer Returns and Sales Credits |  | $                            | 1,098 |                                           | $ | 7,058 |                                        |  | $                      | 7,469 |  | $ | 687  
|Year Ended December 31, 2007:                    |  |                              |       |                                           |   |       |                                        |  |                        |       |  |   |      
|Allowance for Doubtful Accounts                  |  | $                            | 250   |                                           | $ | 88    |                                        |  | $                      | 8     |  | $ | 330  
|Allowance for Customer Returns and Sales Credits |  | $                            | 791   |                                           | $ | 6,531 |                                        |  | $                      | 6,224 |  | $ | 1,098
|Year Ended December 31, 2006:                    |  |                              |       |                                           |   |       |                                        |  |                        |       |  |   |      
|Allowance for Doubtful Accounts                  |  | $                            | 300   |                                           | $ | (23   | )                                      |  | $                      | 27    |  | $ | 250  
|Allowance for Customer Returns and Sales Credits |  | $                            | 1,211 |                                           | $ | 5,673 |                                        |  | $                      | 6,093 |  | $ | 791  

13. SEGMENT:

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate
resources and in assessing business performance. The Companys chief operating decision-making group is the Executive Staff, which is comprised of the Chief Executive Officer and his direct reports. SFAS 131 also requires disclosures about
products and services, geographic areas, and major customers.

The Company operates
in one principal industry segment, its reportable segment: the design, manufacture and sale of products for the controls network industry, and markets its products primarily to the building automation, industrial automation, transportation, and
utility/home automation markets. The Companys products provide the infrastructure and support required to implement and deploy open, interoperable, control network solutions. For the electric utility industry, the Company has developed an
advanced metering infrastructure system called the Networked Energy Services (NES) system. The NES system provides a two-way information and control path between the utility and its customer, which enables utilities to reduce operating costs;
improve customer service; offer multiple tariff plans, including time-of-use metering and prepay metering; promote energy efficiency; better utilize distribution assets; improve grid quality and reliability; control loads and reduce peak demand; and
respond more rapidly to changing customer and regulatory requirements. All of the Companys products either incorporate or operate with the Neuron® Chip and/or the LonWorks protocol.
The Company also provides a range of services to its customers that consist of technical support, training courses covering its LonWorks network technology and products, and custom software development. In total, the Company offers a wide ranging
set of products and services that together constitute the LonWorks system. Any given customer purchases a small subset of such products and services that are appropriate for that customers application.

The Company operates in three main geographic areas: the Americas; Europe, Middle East and Africa (EMEA); and Asia Pacific/ Japan
(APJ). Each geographic area provides products and services to the Companys customers located in the respective region. 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 December 31, 2008 and 2007, long-lived assets of approximately
$47.5 million and $37.7 million, respectively, were domiciled in the United States. Long-lived assets for all other locations are not material to the consolidated financial statements.

The Company has three primary product lines: NES, LonWorks Infrastructure, and products and services sold to Enel. Summary revenue information by product
line for the years ended December 31, 2008, 2007, and 2006 is as follows (in thousands):



|                        |  |                         |         |      |   |         |  |   |       
|----------------------- |  | ----------------------- | ------- | ---- | - | ------- |  | - | ------
|                        |  | Year Ended December 31,
|                        |  | 2008                    |         | 2007 |   | 2006   
|NES                     |  | $                       | 67,118  |      | $ | 70,558  |  | $ | 791   
|LonWorks Infrastructure |  |                         | 54,040  |      |   | 52,840  |  |   | 49,382
|Enel                    |  |                         | 12,889  |      |   | 14,179  |  |   | 7,103 
|                        |  |                         |         |      |   |         |  |   |       
|Total                   |  | $                       | 134,047 |      | $ | 137,577 |  | $ | 57,276
|                        |  |                         |         |      |   |         |  |   |       



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In North America, the Company sells its products primarily through a direct sales organization and select
third-party electronics representatives. Outside North America, the Company 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 revenue information by geography for the years ended December 31, 2008, 2007 and 2006 is as follows (in thousands):



|         |  |                         |         |      |   |         |  |   |       
|-------- |  | ----------------------- | ------- | ---- | - | ------- |  | - | ------
|         |  | Year Ended December 31,
|         |  | 2008                    |         | 2007 |   | 2006   
|Americas |  | $                       | 33,448  |      | $ | 18,561  |  | $ | 19,748
|EMEA     |  |                         | 88,312  |      |   | 99,164  |  |   | 29,991
|APJ      |  |                         | 12,287  |      |   | 19,852  |  |   | 7,537 
|         |  |                         |         |      |   |         |  |   |       
|Total    |  | $                       | 134,047 |      | $ | 137,577 |  | $ | 57,276
|         |  |                         |         |      |   |         |  |   |       

For information regarding the Companys major customers, please refer to Note 6, Significant
Customers.

14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED):

The following tables set forth certain consolidated statement of operations data for each of the quarters in 2008 and 2007. This information has been derived from our quarterly unaudited consolidated financial
statements. The quarterly unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements included in this report and include all adjustments, consisting only of normal recurring
adjustments, that we consider necessary for a fair presentation of such information when read in conjunction with our annual audited consolidated financial statements and notes appearing in this report. The operating results for any quarter do not
necessarily indicate the results for any subsequent period or for the entire fiscal year.



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|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|------------------------------------------------------- |  | ------------------------------------- | ------ | - | -------- | - | ------ | -------- |  | - | --------- | - |  | -------- | ------ | - | -------- | - | ------ | -------- |  | - | --------- | - |  | - | ------ | - |  | - | ------ | -
|                                                        |  | Three Months Ended                    |       
|                                                        |  | Dec.2008                              |        |   | Sep.2008 |   |        | June2008 |  |   | March2008 |   |  | Dec.2007 |        |   | Sep.2007 |   |        | June2007 |  |   | March2007 |  
|                                                        |  | (in thousands, except per share data) |       
|Selected Quarterly Financial Data                       |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Consolidated Statement of Operations Data:              |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Revenues:                                               |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Product                                                 |  | $                                     | 36,065 |   |          | $ | 28,875 |          |  | $ | 31,466    |   |  | $        | 34,667 |   |          | $ | 46,158 |          |  | $ | 23,733    |   |  | $ | 26,437 |   |  | $ | 39,077 |  
|Service                                                 |  |                                       | 730    |   |          |   | 625    |          |  |   | 691       |   |  |          | 928    |   |          |   | 741    |          |  |   | 980       |   |  |   | 259    |   |  |   | 192    |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Total revenues                                          |  |                                       | 36,795 |   |          |   | 29,500 |          |  |   | 32,157    |   |  |          | 35,595 |   |          |   | 46,899 |          |  |   | 24,713    |   |  |   | 26,696 |   |  |   | 39,269 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Cost of revenues:                                       |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Cost of product                                         |  |                                       | 22,986 |   |          |   | 15,715 |          |  |   | 18,751    |   |  |          | 22,532 |   |          |   | 27,066 |          |  |   | 14,004    |   |  |   | 15,331 |   |  |   | 28,634 |  
|Cost of service                                         |  |                                       | 607    |   |          |   | 592    |          |  |   | 675       |   |  |          | 713    |   |          |   | 650    |          |  |   | 722       |   |  |   | 505    |   |  |   | 483    |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Total cost of revenues                                  |  |                                       | 23,593 |   |          |   | 16,307 |          |  |   | 19,426    |   |  |          | 23,245 |   |          |   | 27,716 |          |  |   | 14,726    |   |  |   | 15,836 |   |  |   | 29,117 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Gross profit                                            |  |                                       | 13,202 |   |          |   | 13,193 |          |  |   | 12,731    |   |  |          | 12,350 |   |          |   | 19,183 |          |  |   | 9,987     |   |  |   | 10,860 |   |  |   | 10,152 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Operating expenses:                                     |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Product development                                     |  |                                       | 9,602  |   |          |   | 9,713  |          |  |   | 9,402     |   |  |          | 9,036  |   |          |   | 8,928  |          |  |   | 7,820     |   |  |   | 8,118  |   |  |   | 7,778  |  
|Sales and marketing                                     |  |                                       | 5,815  |   |          |   | 5,653  |          |  |   | 6,162     |   |  |          | 6,005  |   |          |   | 5,902  |          |  |   | 4,884     |   |  |   | 4,968  |   |  |   | 5,427  |  
|General and administrative                              |  |                                       | 4,146  |   |          |   | 3,761  |          |  |   | 4,721     |   |  |          | 4,515  |   |          |   | 4,376  |          |  |   | 3,976     |   |  |   | 4,163  |   |  |   | 3,568  |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Total operating expenses                                |  |                                       | 19,563 |   |          |   | 19,127 |          |  |   | 20,285    |   |  |          | 19,556 |   |          |   | 19,206 |          |  |   | 16,680    |   |  |   | 17,249 |   |  |   | 16,773 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Loss from operations                                    |  |                                       | (6,361 | ) |          |   | (5,934 | )        |  |   | (7,554    | ) |  |          | (7,206 | ) |          |   | (23    | )        |  |   | (6,693    | ) |  |   | (6,389 | ) |  |   | (6,621 | )
|Interest and other income, net                          |  |                                       | 606    |   |          |   | 1,141  |          |  |   | 519       |   |  |          | 659    |   |          |   | 1,351  |          |  |   | 1,381     |   |  |   | 1,488  |   |  |   | 1,497  |  
|Interest expense on lease financing obligations         |  |                                       | (430   | ) |          |   | (435   | )        |  |   | (265      | ) |  |          | (274   | ) |          |   | (287   | )        |  |   | (297      | ) |  |   | (308   | ) |  |   | (319   | )
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Income (loss) before provision for income taxes         |  |                                       | (6,185 | ) |          |   | (5,228 | )        |  |   | (7,300    | ) |  |          | (6,821 | ) |          |   | 1,041  |          |  |   | (5,609    | ) |  |   | (5,209 | ) |  |   | (5,443 | )
|Income tax expense                                      |  |                                       | 67     |   |          |   | 136    |          |  |   | 74        |   |  |          | 20     |   |          |   | 129    |          |  |   | 108       |   |  |   | 107    |   |  |   | 108    |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Net income (loss)                                       |  | $                                     | (6,252 | ) |          | $ | (5,364 | )        |  | $ | (7,374    | ) |  | $        | (6,841 | ) |          | $ | 912    |          |  | $ | (5,717    | ) |  | $ | (5,316 | ) |  | $ | (5,551 | )
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Income (loss) per share:                                |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Basic                                                   |  | $                                     | (0.15  | ) |          | $ | (0.13  | )        |  | $ | (0.18     | ) |  | $        | (0.17  | ) |          | $ | 0.02   |          |  | $ | (0.14     | ) |  | $ | (0.13  | ) |  | $ | (0.14  | )
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Diluted                                                 |  | $                                     | (0.15  | ) |          | $ | (0.13  | )        |  | $ | (0.18     | ) |  | $        | (0.17  | ) |          | $ | 0.02   |          |  | $ | (0.14     | ) |  | $ | (0.13  | ) |  | $ | (0.14  | )
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Shares used in net income (loss) per share calculation: |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Basic                                                   |  |                                       | 40,433 |   |          |   | 40,554 |          |  |   | 40,774    |   |  |          | 40,788 |   |          |   | 40,690 |          |  |   | 40,121    |   |  |   | 39,508 |   |  |   | 39,227 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  
|Diluted                                                 |  |                                       | 40,433 |   |          |   | 40,554 |          |  |   | 40,774    |   |  |          | 40,788 |   |          |   | 43,721 |          |  |   | 40,121    |   |  |   | 39,508 |   |  |   | 39,227 |  
|                                                        |  |                                       |        |   |          |   |        |          |  |   |           |   |  |          |        |   |          |   |        |          |  |   |           |   |  |   |        |   |  |   |        |  



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SIGNATURES

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
|               |  |                    
|March 16, 2009 |  | By:                 |  | /s/ Oliver R. Stanfield                                                                                                                          
|               |  |                     |  | Oliver R. Stanfield Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Principal
Financial and Accounting Officer)

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints M. Kenneth Oshman and Oliver R. Stanfield his
true and lawful attorney-in-fact and agent, with full power of substitution and, for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits
thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be
done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by
virtue hereof.

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS
ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.



|                                                              |  |                                                                                                             |  |               
|------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------- |  | --------------
|Signatures                                                    |  | Title                                                                                                       |  | Date          
|                                                              |  |                                                                                                            
|/S/ M. KENNETH OSHMAN M. Kenneth Oshman                       |  | Chairman of the Board and Chief Executive Officer (Principal Executive Officer)                             |  | March 16, 2009
|                                                              |  |                                                                                                            
|/S/ OLIVER R. STANFIELD Oliver R. Stanfield                   |  | Executive Vice President and Chief Financial Officer (Principal Financial and Principal Accounting Officer) |  | March 16, 2009
|                                                              |  |                                                                                                            
|/S/ ARMAS CLIFFORD MARKKULA,
JR. Armas Clifford Markkula, Jr. |  | Vice Chairman                                                                                               |  | March 6, 2009 
|                                                              |  |                                                                                                            
|/S/ ROBYN M. DENHOLM Robyn M. Denholm                         |  | Director                                                                                                    |  | March 13, 2009
|                                                              |  |                                                                                                            
|/S/ ROBERT J. FINOCCHIO, JR. Robert J. Finocchio, Jr.         |  | Director                                                                                                    |  | March 8, 2009 
|                                                              |  |                                                                                                            
|/S/ ROBERT R. MAXFIELD Robert R. Maxfield                     |  | Director                                                                                                    |  | March 7, 2009 
|                                                              |  |                                                                                                            
|/S/ RICHARD M. MOLEY Richard M. Moley                         |  | Director                                                                                                    |  | March 11, 2009
|                                                              |  |                                                                                                            
|/S/ BETSY RAFAEL Betsy Rafael                                 |  | Director                                                                                                    |  | March 13, 2009
|                                                              |  |                                                                                                            
|/S/ LARRY W. SONSINI Larry W. Sonsini                         |  | Director                                                                                                    |  | March 16, 2009



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EXHIBIT INDEX



|            |  |                                                                                                                                                                                       
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                               
|            | 
|3.2*        |  | Amended and Restated Certificate of Incorporation of Registrant.                                                                                                                      
|            | 
|3.3*        |  | Amended and Restated Bylaws of Registrant.                                                                                                                                            
|            | 
|4.1*        |  | Form of Registrants Common Stock Certificate.                                                                                                                                        
|            | 
|4.2*        |  | Second Amended and Restated Modification Agreement dated May 15, 1997.                                                                                                                
|            | 
|10.1*       |  | Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers.                                                                       
|            | 
|10.2*+      |  | 1997 Stock Plan and forms of related agreements.                                                                                                                                      
|            | 
|10.2(a)*+   |  | Form of 1997 Stock Plan Stock Option Agreement with early exercise feature                                                                                                            
|            | 
|10.2(b)*+   |  | Form of 1997 Stock Plan Nonqualified Stock Option Agreement with early exercise feature                                                                                               
|            | 
|10.2(c)*+   |  | Form of 1997 Stock Plan Nonqualified Stock Option Agreement                                                                                                                           
|            | 
|10.2(d)*+   |  | Form of 1997 Stock Plan Performance Share Agreement                                                                                                                                   
|            | 
|10.2(e)*+   |  | Form of 1997 Stock Plan Performance Share Agreement for non-US employees                                                                                                              
|            | 
|10.2(f)*+   |  | Form of 1997 Stock Plan Performance Share Agreement with performance based vesting criteria for non-US employees                                                                      
|            | 
|10.2(g)*+   |  | Form of 1997 Stock Plan Stock Appreciation Right Agreement for non-US employees                                                                                                       
|            | 
|10.2(h)*+   |  | Form of 1997 Stock Plan Performance Share Agreement with performance based vesting criteria                                                                                           
|            | 
|10.2(i)*+   |  | Form of 1997 Stock Plan Performance Share Agreement                                                                                                                                   
|            | 
|10.2(j)*+   |  | Form of 1997 Stock Plan Stock Appreciation Right Agreement                                                                                                                            
|            | 
|10.3*+      |  | 1988 Stock Option Plan and forms of related agreements.                                                                                                                               
|            | 
|10.4*       |  | Second Amended and Restated Modification Agreement dated May 15, 1997 (included in Exhibit 4.2).                                                                                      
|            | 
|10.5*       |  | Form of International Distributor Agreement.                                                                                                                                          
|            | 
|10.6*       |  | Form of OEM License Agreement.                                                                                                                                                        
|            | 
|10.7*       |  | Form of Software License Agreement.                                                                                                                                                   
|            | 
|10.8*       |  | International Distributor Agreement between the Company and EBV Elektronik GmbH as of December 1, 1997.                                                                               
|            | 
|10.9*+      |  | 1998 Director Option Plan.                                                                                                                                                            
|            | 
|21.1*       |  | Subsidiaries of the Registrant.                                                                                                                                                       
|            | 
|23.1        |  | Consent of KPMG LLP, Independent Registered Public Accounting Firm.                                                                                                                   
|            | 
|24.1*       |  | Power of Attorney (see signature page).                                                                                                                                               
|            | 
|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.



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



|+ | Indicates management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.
|- | -----------------------------------------------------------------------------------------------------------------------------------------



72