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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549    FORM 10-Q    (Mark One)x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2004ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from:
________ to ________
 Commission File Number: 000-50798    Color Kinetics Incorporated (Exact name of registrant as specified in its charter)
    Delaware(State or other jurisdiction of
incorporation or organization)
    
    04-3391805(I.R.S. Employer
Identification Number)
 10 Milk Street, Suite 1100 Boston, Massachusetts 02108
(Address of principal executive offices)
 (617) 423-9999 (Registrants telephone number, including area code)
    Indicate by check mark whether 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 o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act): Yes o  No x As of November 1, 2004, Color Kinetics Incorporated had 17,886,535 shares of
common stock, par value $0.001 per share, outstanding.    1




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##### Table of Contents



COLOR KINETICS INCORPORATED FORM 10-Q INDEX Page No.PART I. FINANCIAL INFORMATIONItem 1.
    
    Unaudited Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2004 and September 30, 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September
30, 2004 and September 30, 2003
    
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    9Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    15Item 4.
    
    Controls and Procedures
    
    
    15PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    15Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    16Item 3.
    
    Defaults Upon Senior Securities
    
    
    16Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    16Item 5.
    
    Other Information
    
    
    16Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    16Signatures
    
    
    17Exhibit IndexEX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
 2




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PART I. FINANCIAL INFORMATION 
 Item 1.  Unaudited Condensed Consolidated Financial Statements 
 Color Kinetics Incorporated
Condensed Consolidated Balance Sheets
(In thousands, except per share data) September 30,
    
    December 31,2004
    
    2003ASSETSCURRENT ASSETS:Cash and equivalents
    
    $
    39,954
    
    
    $
    5,686Short-term investments
    
    
    15,000
    
    
    
    Restricted cash
    
    
    116
    
    
    
    479Accounts receivable, net of allowance for doubtful accounts
of approximately $385 and $270 in 2004 and 2003, respectively
    
    
    4,760
    
    
    
    4,015Accounts receivable from related parties
    
    
    163
    
    
    
    30Inventory
    
    
    6,095
    
    
    
    5,024Prepaid expenses and other current assets
    
    
    974
    
    
    
    429Total current assets
    
    
    67,062
    
    
    
    15,663PROPERTY AND EQUIPMENT net
    
    
    1,042
    
    
    
    1,065INVESTMENT IN JOINT VENTURE
    
    
    536
    
    
    
    289RESTRICTED CASHlong-term portion
    
    
    1,000
    
    
    
    1,100TOTAL ASSETS
    
    $
    69,640
    
    
    $
    18,117LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIENCY)CURRENT LIABILITIES:Accounts payable
    
    $
    1,915
    
    
    $
    1,483Accounts payable to related party
    
    
    
    
    
    
    21Accrued expenses
    
    
    1,643
    
    
    
    812Accrued compensation
    
    
    1,482
    
    
    
    1,471Accrued restructuring
    
    
    309
    
    
    
    426Accrued warranty
    
    
    714
    
    
    
    404Deferred revenue
    
    
    330
    
    
    
    387Total current liabilities
    
    
    6,393
    
    
    
    5,004ACCRUED RESTRUCTURING
    
    
    831
    
    
    
    1,034COMMITMENTS AND CONTINGENCIESREDEEMABLE CONVERTIBLE PREFERRED STOCK, at liquidation value
    
    
    
    
    
    
    47,999STOCKHOLDERS EQUITY (DEFICIENCY):Common stock, $0.001 par valueauthorized, 100,000 shares;
issued and outstanding 17,887 and 2,804 shares in 2004 and 2003,
respectively
    
    
    18
    
    
    
    3Additional paid-in capital
    
    
    96,965
    
    
    
    304Accumulated other comprehensive income (loss)
    
    
    (3
    )
    
    
    14Accumulated deficit
    
    
    (34,564
    )
    
    
    (36,241
    )Total stockholders equity (deficiency)
    
    
    62,416
    
    
    
    (35,920
    )TOTAL LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIENCY)
    
    $
    69,640
    
    
    $
    18,117
 See accompanying notes to unaudited condensed consolidated financial statements. 3




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Color Kinetics Incorporated
Condensed Consolidated Statements of Operations
(In thousands, except per share data) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003REVENUES (1):Lighting systems
    
    $
    9,275
    
    
    $
    7,076
    
    
    $
    24,767
    
    
    $
    19,511OEM and licensing
    
    
    1,786
    
    
    
    700
    
    
    
    4,670
    
    
    
    1,641Total revenues
    
    
    11,061
    
    
    
    7,776
    
    
    
    29,437
    
    
    
    21,152COST OF REVENUES:Lighting systems
    
    
    4,392
    
    
    
    3,735
    
    
    
    12,038
    
    
    
    9,924OEM and licensing
    
    
    1,089
    
    
    
    326
    
    
    
    2,542
    
    
    
    847Total cost of revenues
    
    
    5,481
    
    
    
    4,061
    
    
    
    14,580
    
    
    
    10,771GROSS PROFIT
    
    
    5,580
    
    
    
    3,715
    
    
    
    14,857
    
    
    
    10,381OPERATING EXPENSES:Selling and marketing
    
    
    2,284
    
    
    
    1,760
    
    
    
    6,177
    
    
    
    5,800Research and development
    
    
    886
    
    
    
    594
    
    
    
    2,491
    
    
    
    1,849General and administrative (2)
    
    
    1,807
    
    
    
    1,218
    
    
    
    4,911
    
    
    
    3,431Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    161Total operating expenses
    
    
    4,977
    
    
    
    3,572
    
    
    
    13,579
    
    
    
    11,241INCOME (LOSS) FROM OPERATIONS
    
    
    603
    
    
    
    143
    
    
    
    1,278
    
    
    
    (860
    )INTEREST INCOME (EXPENSE), net:Interest income
    
    
    181
    
    
    
    5
    
    
    
    258
    
    
    
    41Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3
    )Total interest income, net
    
    
    181
    
    
    
    5
    
    
    
    258
    
    
    
    38EQUITY IN EARNINGS (LOSS) OF JOINT VENTURE
    
    
    69
    
    
    
    (140
    )
    
    
    221
    
    
    
    45NET INCOME (LOSS)
    
    $
    853
    
    
    $
    8
    
    
    $
    1,757
    
    
    $
    (777
    )EARNINGS (LOSS) PER SHARE:Basic
    
    $
    0.05
    
    
    $
    0.00
    
    
    $
    0.21
    
    
    $
    (0.28
    )Diluted
    
    $
    0.04
    
    
    $
    0.00
    
    
    $
    0.11
    
    
    $
    (0.28
    )WEIGHTED AVERAGE SHARES OUTSTANDING:Basic
    
    
    17,881
    
    
    
    2,796
    
    
    
    8,560
    
    
    
    2,788Diluted
    
    
    19,409
    
    
    
    12,531
    
    
    
    16,648
    
    
    
    2,788Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(1)  Includes revenues from related parties as follows:Lighting systems
    
    $
    1,019
    
    
    $
    1,252
    
    
    $
    2,938
    
    
    $
    3,832OEM and licensing
    
    
    30
    
    
    
    30
    
    
    
    90
    
    
    
    120Total related party revenues
    
    $
    1,049
    
    
    $
    1,282
    
    
    $
    3,028
    
    
    $
    3,952(2)  Includes stock-based compensation as follows:
    
    $
    8
    
    
    $
    18
    
    
    $
    339
    
    
    $
    54
 See accompanying notes to unaudited condensed consolidated financial statements. 4




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Color Kinetics Incorporated
Condensed Consolidated Statements of Cash Flows
(In thousands) Nine Months Ended September 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    1,757
    
    
    $
    (777
    )Adjustments to reconcile net income (loss) to cash from operating activities:Depreciation and amortization
    
    
    536
    
    
    
    678Stock-based compensation
    
    
    339
    
    
    
    54Equity in earnings of joint venture
    
    
    (221
    )
    
    
    (45
    )Changes in current assets and liabilities:Accounts receivable
    
    
    (878
    )
    
    
    (1,681
    )Inventory
    
    
    (1,071
    )
    
    
    (353
    )Prepaid expenses and other current assets
    
    
    (545
    )
    
    
    (265
    )Restricted cash
    
    
    463
    
    
    
    225Accounts payable
    
    
    411
    
    
    
    (20
    )Accrued expenses
    
    
    1,152
    
    
    
    414Deferred revenue
    
    
    (57
    )
    
    
    33Accrued restructuring
    
    
    (320
    )
    
    
    (273
    )Cash flows from operating activities
    
    
    1,566
    
    
    
    (2,010
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of short-term investments
    
    
    (15,000
    )
    
    
    Purchase of property and equipment
    
    
    (513
    )
    
    
    (184
    )Cash flows from investing activities
    
    
    (15,513
    )
    
    
    (184
    )CASH FLOWS FROM FINANCING ACTIVITIES:Payments under equipment note payable and line of credit
    
    
    
    
    
    
    (60
    )Proceeds from the exercise of stock options
    
    
    28
    
    
    
    7Proceeds from issuance of redeemable convertible preferred
stock  net of issuance costs
    
    
    13,003
    
    
    
    Proceeds from issuance of common stocknet of
issuance costs
    
    
    35,227
    
    
    
    Cash flows from financing activities
    
    
    48,258
    
    
    
    (53
    )EFFECT OF EXCHANGE RATE CHANGES ON CASH
    
    
    (43
    )
    
    
    3INCREASE (DECREASE) IN CASH AND EQUIVALENTS
    
    
    34,268
    
    
    
    (2,244
    )CASH AND EQUIVALENTSbeginning of period
    
    
    5,686
    
    
    
    7,688CASH AND EQUIVALENTSend of period
    
    $
    39,954
    
    
    $
    5,444SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:Cash paid for interest
    
    $
    
    
    
    $
    3SUPPLEMENTAL DISCLOSURE OF NONCASH
INVESTING AND FINANCING ACTIVITIES:Conversion of redeemable convertible preferred stock
    
    $
    61,082
    
    
    $
    
 See accompanying notes to unaudited condensed consolidated financial statements. 5




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Color Kinetics Incorporated
Notes to Unaudited Condensed Consolidated Financial Statements 1. Nature of Business and Basis of Presentation Nature of Business Color Kinetics Incorporated, incorporated on September 15,
1997, is a pioneer in the design, marketing and licensing of intelligent
solid-state lighting systems. We sell our products through our direct sales
force and network of manufacturers representatives and distributors. Basis of Presentation The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with the rules and
regulations of the Securities and Exchange Commission regarding interim
financial reporting. Certain information and footnote disclosures normally
included in consolidated financial statements prepared in accordance with
accounting principles generally accepted in the United States of America
(GAAP) have been condensed or omitted in accordance with such rules and
regulations. These condensed consolidated financial statements should be read
in conjunction with the annual audited consolidated financial statements and
notes thereto as of and for the year ended December 31, 2003 included in our
Registration Statement on Form S-1 (File No. 333-114386) (the Registration
Statement on Form S-1) filed with the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed consolidated
financial statements reflect all adjustments, consisting only of normal
recurring adjustments, necessary for their fair presentation in conformity with
GAAP. Our operating results for interim periods presented are not necessarily
indicative of the results that may be expected for the fiscal year ending
December 31, 2004 or future periods. 2. Initial Public Offering On June 22, 2004, we completed the initial public offering of 4,000,000 shares
of our common stock at a price to the public of $10.00 per share. We received
net proceeds from the offering of $35,227,311, after deducting the underwriting
discount of $2,800,000 and other direct costs of $1,972,689. We have invested
the net proceeds in cash equivalents and short-term investments. In connection
with the initial public offering, all 20,381,610 shares of our preferred stock
then issued and outstanding were converted into 11,069,031 shares of common
stock. Included in the conversion of preferred stock to common stock were
3,484,849 shares of Series F Preferred Stock issued in January and February
2004 for net proceeds of $13,002,687. In addition, we:  
    
    Completed a 1-for-2 reverse stock split of our common stock in May
2004. All share and per share information presented herein has been
adjusted to reflect this split;
    
    Increased the number of authorized shares of our common stock from
41,000,000 to 100,000,000 shares in May 2004; and
    
    Adopted in April 2004 the 2004 employee stock purchase plan and 2004
employee stock incentive plan under which we are authorized to issue up
to a maximum of 400,000 and 1,750,000 shares, respectively, of common
stock. 3.  Revenue Recognition We recognize revenues in connection with sales of our lighting systems and OEM
products when all of the following conditions have been met: (1) evidence
exists of an arrangement with the customer, typically consisting of a purchase
order or contract; (2) our products have been delivered and risk of loss has
passed to the customer, which typically occurs when a product is shipped under
our customary terms, generally FOB shipping point; (3) the amount of revenue to
which we are entitled is fixed or determinable; and (4) we believe it is
probable that we will be able to collect the amount due to us from our
customer. To the extent that one or more of these conditions is not present, we
delay recognition of revenue until all the conditions are present. We classify
the amount of freight that is invoiced to our customers as revenue, with the
corresponding cost classified as cost of revenues. We offer our lighting systems customers limited rights of return, which
typically provide that within 30 days of shipment products in unopened and
saleable condition may, at our discretion, be returned to us for refund, net of
a 15% restocking fee. We also provide certain distributors with limited stock
rotation rights. Based on historical experience, we provide for potential
returns from customers through a sales return reserve. The reserve is evaluated
and adjusted as conditions warrant. An allowance for doubtful accounts is
provided to reserve for credit losses as a result of customers inability to
pay. 4. Stock-Based Compensation We apply the intrinsic value method of accounting for stock options granted to
employees and apply the fair value method for stock options and awards granted
to non-employees. In accordance with the intrinsic value method, we determine the compensation
associated with stock awards to employees as the difference, if any, between
the fair value of the underlying common stock on the date compensation is
measured and the price an employee must pay to exercise the award. The
measurement date for employee awards is generally the date of grant. Under the
fair value method, we determine the compensation associated with stock awards
to non-employees based on the estimated fair value of the award, measured using
either current market data or an established option pricing model. The
measurement date for non-employee awards is generally the date the performance
of services is complete. Had we used the fair value method to measure compensation related to stock
awards to employees, pro forma net income and pro forma earnings per share
would have been as follows (in thousands, except per share data): 6




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Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    853
    
    
    $
    8
    
    
    $
    1,757
    
    
    $
    (777
    )Add: stock-based compensation determined under
intrinsic value method for all awards, net of tax
    
    
    8
    
    
    
    
    
    
    
    13
    
    
    
    Less: stock-based compensation expense determined under
fair value method for all awards, net of tax
    
    
    (70
    )
    
    
    (43
    )
    
    
    (246
    )
    
    
    (129
    )Pro forma net income (loss)
    
    $
    791
    
    
    $
    (35
    )
    
    $
    1,524
    
    
    $
    (906
    )Basic earnings (loss) per shareAs reported
    
    $
    0.05
    
    
    $
    0.00
    
    
    $
    0.21
    
    
    $
    (0.28
    )Pro forma
    
    $
    0.04
    
    
    $
    (0.01
    )
    
    $
    0.18
    
    
    $
    (0.32
    )Diluted earnings (loss) per shareAs reported
    
    $
    0.04
    
    
    $
    0.00
    
    
    $
    0.11
    
    
    $
    (0.28
    )Pro forma
    
    $
    0.04
    
    
    $
    (0.01
    )
    
    $
    0.09
    
    
    $
    (0.32
    )
 The fair value of options was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions: 2004
    
    2003Risk-free interest rate
    
    
    3.6
    %
    
    
    2.7
    %Volatility
    
    
    58
    %
    
    
    50
    %Dividend yield
    
    
    0
    %
    
    
    0
    %Expected life in years
    
    
    4
    
    
    
    4
 The weighted average fair value of options granted during the three months
ended September 30, 2004 and 2003 was $4.39 and $0.50, respectively. The
weighted average fair value of options granted during the nine months ended
September 30, 2004 and 2003 was $1.24 and $0.40, respectively. Stock-based compensation charges in the nine months ended September 30, 2004
included $147,000 resulting primarily from acceleration in June 2004 of the
remaining unvested portion of stock options granted to advisory board members
and other non-employee consultants. 5. Short-Term Investments Short-term investments consist of a certificate of deposit from a bank
purchased with a seven month maturity. 6. Inventory Inventory is stated at the lower of cost (first-in, first-out method) or market
and consists of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Finished goods
    
    $
    3,858
    
    
    $
    2,973Raw material components
    
    
    2,237
    
    
    
    2,051Total
    
    $
    6,095
    
    
    $
    5,024
 7. Warranty Reserve Our products are generally warranted against defects for 12 months following
purchase. Reserves for potential warranty claims are provided at the time of
revenue recognition based on historical claims experience, repair costs and
current sales levels. Activity within the reserve was as follows in the nine
months ended September 30, 2004 and 2003 (in thousands): 2004
    
    2003Balance, beginning of period
    
    $
    404
    
    
    $
    549Provisions included in cost of revenues
    
    
    516
    
    
    
    277Expenditures
    
    
    (206
    )
    
    
    (245
    )Balance, end of period
    
    $
    714
    
    
    $
    581
 8. Earnings per Share 7




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Basic earnings per share is calculated using the weighted average number of
common shares outstanding. Diluted earnings per share is computed on the basis
of the weighted average number of common shares outstanding plus the effect of
outstanding stock options, stock warrants, and preferred stock using the
treasury stock method. Due to our net loss in the nine months ended September
30, 2003, the effect of these items would be antidilutive in this period and,
accordingly, are excluded from the computation. When such shares would be
dilutive to the periods presented, preferred shares converted to common shares
in connection with our initial public offering on June 22, 2004 (Note 2) were
included in the weighted average computations of diluted earnings per share
until the date of actual conversion on an if-converted basis and in the
weighted average computations of basic earnings per share from the date of such
conversion. For the three months ended September 30, 2003 and nine months ended September
30, 2004 and 2003, outstanding stock options to purchase approximately,
616,000, 29,000 and 629,000 shares of common stock, respectively, were excluded
from the calculation of diluted earnings per share, because these options were
anti-dilutive. For the three months ended September 30, 2004, all stock options
were considered dilutive and, hence, included in the calculation of diluted
earnings per share. A reconciliation of shares used in the computation of
basic earnings (loss) per share and diluted earnings (loss) per share is as
follows (in thousands): Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares for basic computation
    
    
    17,881
    
    
    
    2,796
    
    
    
    8,560
    
    
    
    2,788Potential common shares from:Options
    
    
    1,099
    
    
    
    204
    
    
    
    894
    
    
    
    Warrants
    
    
    429
    
    
    
    204
    
    
    
    402
    
    
    
    Preferred stock
    
    
    
    
    
    
    9,327
    
    
    
    6,792
    
    
    
    Weighted average shares for diluted computation
    
    
    19,409
    
    
    
    12,531
    
    
    
    16,648
    
    
    
    2,788
 On a pro forma basis, earnings (loss) per basic share for the three and nine
months periods ended September 30, 2004 and 2003 would have been $0.04, $0.09,
$0.00 and ($0.32) per share, respectively, if the conversion of preferred stock
to common stock in connection with our initial public offering had occurred at
the beginning of all periods in which such preferred shares were outstanding. 9. Segment Information We operate in two distinct segments. These segments are identified by reference
to the manner in which the chief operating decision maker views the business,
which is generally by the type of customer each segment serves. The first
segment is Lighting Systems, which consists primarily of completed products
that we have developed and sourced. The second segment is OEM and Licensing,
which consists primarily of subassemblies and completed products sold to original equipment
manufacturers for combination with their own developed products and licenses to
utilize our technology sold to the same class of customer. Direct contribution margin includes direct costs normally associated with costs
of goods sold determined using GAAP and additional direct costs, such as direct
selling expenses, included in other expense categories contained in the
accompanying statements of operations. We do not generate information regarding
indirect costs by segment or assets or cash flows by segment, and hence, such
information is not provided below. The information set forth below is prepared
in accordance with the accounting principles referred to in Note 1, with the
exception that direct costs includes some expenses normally allocated to
different expense categories on our consolidated statement of operations. There
are no inter-segment transactions. The following tables set forth revenue and contribution margin from our
reportable segments on an interim basis (in thousands): Three Months Ended September 30,
    
    2004
    
    2003Lighting
    
    OEM and
    
    
    
    
    
    Lighting
    
    OEM andSystems
    
    Licensing
    
    Total
    
    Systems
    
    Licensing
    
    TotalRevenues
    
    $
    9,275
    
    
    $
    1,786
    
    
    $
    11,061
    
    
    $
    7,076
    
    
    $
    700
    
    
    $
    7,776Cost of revenues
    
    
    4,392
    
    
    
    1,089
    
    
    
    5,481
    
    
    
    3,735
    
    
    
    326
    
    
    
    4,061Gross profit
    
    
    4,883
    
    
    
    697
    
    
    
    5,580
    
    
    
    3,341
    
    
    
    374
    
    
    
    3,715Other direct costs
    
    
    2,327
    
    
    
    169
    
    
    
    2,496
    
    
    
    1,542
    
    
    
    284
    
    
    
    1,826Direct contribution margin
    
    $
    2,556
    
    
    $
    528
    
    
    
    3,084
    
    
    $
    1,799
    
    
    $
    90
    
    
    
    1,889Reconciling items to income from operations:Unallocated selling and marketing
    
    
    
    
    
    
    
    
    
    
    296
    
    
    
    
    
    
    
    
    
    
    
    237Unallocated research and development
    
    
    
    
    
    
    
    
    
    
    377
    
    
    
    
    
    
    
    
    
    
    
    291Unallocated general and administrative
    
    
    
    
    
    
    
    
    
    
    1,808
    
    
    
    
    
    
    
    
    
    
    
    1,218Income from operations
    
    
    
    
    
    
    
    
    
    $
    603
    
    
    
    
    
    
    
    
    
    
    $
    143
 8




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##### Table of Contents



Nine
Months Ended September 30,
    
    2004
    
    2003Lighting
    
    OEM and
    
    
    
    
    
    Lighting
    
    OEM andSystems
    
    Licensing
    
    Total
    
    Systems
    
    Licensing
    
    TotalRevenues
    
    $
    24,767
    
    
    $
    4,670
    
    
    $
    29,437
    
    
    $
    19,511
    
    
    $
    1,641
    
    
    $
    21,152Cost of revenues
    
    
    12,038
    
    
    
    2,542
    
    
    
    14,580
    
    
    
    9,924
    
    
    
    847
    
    
    
    10,771Gross profit
    
    
    12,729
    
    
    
    2,128
    
    
    
    14,857
    
    
    
    9,587
    
    
    
    794
    
    
    
    10,381Other direct costs
    
    
    6,070
    
    
    
    554
    
    
    
    6,624
    
    
    
    5,181
    
    
    
    1,025
    
    
    
    6,206Direct contribution margin
    
    $
    6,659
    
    
    $
    1,574
    
    
    
    8,233
    
    
    $
    4,406
    
    
    $
    (231
    )
    
    
    4,175Reconciling items to income (loss) from operations:Unallocated selling and marketing
    
    
    
    
    
    
    
    
    
    
    923
    
    
    
    
    
    
    
    
    
    
    
    685Unallocated research and development
    
    
    
    
    
    
    
    
    
    
    1,120
    
    
    
    
    
    
    
    
    
    
    
    758Unalloacted general and administrative
    
    
    
    
    
    
    
    
    
    
    4,912
    
    
    
    
    
    
    
    
    
    
    
    3,592Unallocated restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Income (loss) from operations
    
    
    
    
    
    
    
    
    
    $
    1,278
    
    
    
    
    
    
    
    
    
    
    $
    (860
    )
 10. Comprehensive Income (Loss) Comprehensive income (loss) includes foreign currency translation gains and
losses and other items of comprehensive income (loss) that have been excluded
from net income (loss) and reflected instead in stockholders equity. The
following table sets forth the calculation of comprehensive income (loss) on an
interim basis (in thousands): Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    853
    
    
    $
    8
    
    
    $
    1,757
    
    
    $
    (777
    )Foreign currency translation adjustments and
other items of comprehensive income
    
    
    25
    
    
    
    
    
    
    
    25
    
    
    
    Total comprehensive income (loss)
    
    $
    878
    
    
    $
    8
    
    
    $
    1,782
    
    
    $
    (777
    )
 11. Contingencies In March 2002, Super Vision International, Inc., or Super Vision, filed a
lawsuit in the United States District Court for the Middle District of Florida
seeking a declaratory judgment that certain of our patents are invalid, that
Super Visions products do not infringe the patents in question, and that the
patents are unenforceable. Super Vision subsequently amended the complaint to
add claims for interference with prospective business relationships, unfair
competition, trade disparagement and defamation. In June 2002, we filed a lawsuit against Super Vision in the United States
District Court for the District of Massachusetts. In this litigation, we
alleged that certain products of Super Vision, including solid-state
architectural lighting fixtures, pool lights and spa lights, infringes four of
the patents at issue in Super Visions declaratory judgment action; this
complaint has been amended to assert infringement of a fifth patent. Super Visions lawsuit in Florida was transferred by the court to the United
States District Court for the District of Massachusetts. The cases are in the
discovery phase, with discovery closing in January, dispositive motions due in
February, and trial expected in the second quarter of 2005. We believe that
Super Visions claims of invalidity, unenforceability and non-infringement of
the patents at issue in our infringement suit against Super Vision, and its
claims against us of interference with prospective business relationships,
unfair competition, trade disparagement and defamation, are without merit. On March 4, 2004, Super Vision announced that it had acquired from High End
Systems a patent relating to variable color lighting systems. On March 5, 2004,
Super Vision filed a lawsuit in the United States District Court for the Middle
District of Florida alleging that we have infringed the High End patent and
seeking damages of $10.5 million. We had previously investigated the High End
patent and concluded that our products and technology do not infringe any valid
claim of the patent. Accordingly, we believe that Super Visions High End
patent lawsuit is without merit and intend to defend against it vigorously. We
are now seeking to transfer Super Visions High End patent lawsuit to federal
court in Massachusetts. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations Cautionary Statements The Private Securities Litigation Reform Act of 1995 contains certain safe
harbor provisions regarding forward-looking statements. This Form 10-Q
contains, and other information provided by Color Kinetics Incorporated or
statements made by our directors, officers or employees from time to time may
contain, forward-looking statements and information, which involve risks and
uncertainties. Actual future results may differ materially. Forward-looking
statements include statements concerning plans, objectives, goals, strategies,
expectations, intentions, projections, developments, future events, performance
or products, underlying assumptions and other statements which are other than
statements of historical facts. In some 9




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cases, forward-looking statements are identified by terminology such as may,
will, should, expects, intends, plans, anticipates, estimates,
believes, contemplates, predicts, projects, continue and other
similar terminology or the negative of these terms. All such forward-looking
statements, whether written or oral, are expressly qualified by the cautionary
statements contained in this Form 10-Q, including those set forth below under
the heading Factors That May Affect Future Results, and any other cautionary
statements which may accompany the forward-looking statements. Although we have
sought to identify the most significant risks to our business, we cannot
predict whether, or to what extent, any of such risks may be realized, nor can
there be any assurance that we have identified all possible issues which we
might face. We undertake no obligation to update any forward-looking statements
we make. Overview We design, market and license intelligent solid-state lighting systems. We
outsource the manufacture of our systems to contract manufacturers, primarily
in Asia. We operate in two lines of business:  
    
    Lighting systems:we offer intelligent solid-state lighting systems
under the Color Kinetics brand for installation in lighting projects
where their use has typically been specified by a designer or
architect.
    
    OEM and licensing:we offer a standard line of intelligent solid-state
lighting modules that are incorporated by manufacturers in products
sold under their own brands. We also license our technology on a
royalty-bearing basis. We sell our lighting systems and OEM products through our direct sales force
and through distributors and manufacturers representatives in North America,
Asia, Europe, Latin America and the Middle East. Licensing arrangements are
handled through our direct sales force, often with the involvement of our
senior management. In a typical lighting systems sale, our direct sales force, in cooperation with
a distributor or manufacturers representative (or, outside North America, a
dealer/ distributor or VAR), works with a lighting designer, architect or other
specifier to have our system designed in to a particular new construction or
renovation project. Typically, this is followed by a bid process in which
pricing and other terms are negotiated with the project owner or owners
representative. When construction on the project has reached the appropriate
stage, our product is shipped, typically to an electrical equipment or lighting
equipment distributor, which purchases the system from us and, in turn, sells
it to the project owner or its electrical contractor for installation. We sell our OEM products primarily through our direct sales force and, in
certain cases, manufacturers representatives with strong
industry relationships and expertise in a particular vertical market. In a
typical OEM sales cycle, our direct sales personnel first work with a
manufacturer to qualify our systems for incorporation into one or more of its
products. Initially, the manufacturer may purchase only small quantities of our
system. Once a product incorporating our system is introduced and successfully
marketed by our OEM customer, purchases of our OEM products in larger volumes
may occur. Our products are distributed in Japan by Color Kinetics Japan, a joint venture
in which we hold a 50% equity interest. An unrelated third party holds the
other 50% interest. The terms of our distribution agreement with Color Kinetics
Japan are substantially similar to those that we employ with unaffiliated
distributors. We account for our investment in Color Kinetics Japan using the
equity method of accounting, whereby we record our proportionate share of the
income or loss earned by the joint venture. We record revenue from sales to
Color Kinetics Japan as revenue from a related party. We eliminate our profit
associated with inventory we have sold to Color Kinetics Japan that is held by
it at the end of the period. Because Color Kinetics Japan uses the Japanese yen
as its functional currency, we translate the results of operations of Color
Kinetics Japan into United States dollars using the average rates of exchange
during the reporting periods. We also record on our balance sheet translation
adjustments reflecting the changes in Color Kinetics Japans equity measured in
dollars resulting from changes in exchange rates. Description of Our Revenues, Costs and Expenses Our lighting systems revenues include amounts from the sale of our intelligent
solid-state lighting systems as well as any fees from our customers for
applications engineering, integration or technical support services we provide
to assist them in specifying, designing, installing and operating our systems. Our OEM and licensing revenues include amounts from the sale of our OEM
products, license fees and related fees attributable to the licensing of our
proprietary technology, and fees for any engineering support services that are
requested by our OEM and licensing customers. Our cost of lighting systems revenues and cost of OEM and license revenues
consist primarily of the cost of the lighting products sold, including amounts
paid to our contract manufacturers, the costs of any components that we
provide, other direct and indirect manufacturing support costs, shipping and
handling, tooling and provisions for product warranty, scrap and inventory
obsolescence, as well as overhead cost allocated to these activities. It may
also include an allocation of salaries and related benefits of engineering
personnel when they provide engineering support services for which we charge
fees. Our selling and marketing expenses consist primarily of salaries, commissions,
travel expense and related benefits of personnel engaged in sales, product
management and marketing activities, commissions paid to our manufacturers
representatives, costs of marketing programs and promotional materials, trade
show expenses and overhead cost related to these activities. Our research and development expenses consist primarily of salaries, bonuses
and related benefits of personnel engaged in research and development and
product quality activities, out-of-pocket product development costs, travel
expenses and overhead cost related to these activities. Research and
development expenses are expensed as incurred. 10




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Our general and administrative expenses consist primarily of salaries, bonuses
and related benefits of personnel engaged in corporate administration, finance,
human resources, information systems and legal functions, outside legal
expenses related to patent prosecution, patent litigation, trademarks and
general corporate matters, other professional fees, bad debt expense, other
general corporate expenditures, and overhead cost related to these activities. Critical Accounting Estimates We make estimates and assumptions in the preparation of our consolidated
financial statements that affect the reported amounts of assets and
liabilities, revenues and expenses, and related disclosures of contingent
assets and liabilities. We base our estimates on historical experience and
various other assumptions that we believe to be reasonable under the
circumstances. However, actual results may differ from these estimates. We have identified the following critical accounting policies that require the
use of significant judgments and estimates in the preparation of our
consolidated financial statements. This listing is not a comprehensive list of
all of our accounting policies. For further information regarding the
application of these and other accounting policies, see Note 1 in the Notes to
Consolidated Financial Statements for the year ended December 31, 2003 included
in our Registration Statement on Form S-1 filed with the Securities and
Exchange Commission. Revenue Recognition.We recognize revenues in connection with sales of our
lighting systems and OEM products when all of the following conditions have
been met:  
    
    evidence exists of an arrangement with the customer, typically consisting of a purchase order;
    
    our products have been delivered and risk of loss has passed to the customer, which typically
occurs when a product is shipped under our customary terms, generally FOB shipping point;
    
    the amount of revenue to which we are entitled is fixed or determinable; and
    
    we believe it is probable that we will be able to collect the amount due us from our customer. To the extent that one or more of these conditions is not present, we delay
recognition of revenue until all the conditions are present. We classify the
amount of freight invoiced to the customer as revenue, with the corresponding
cost classified as cost of revenues. We offer our lighting systems customers limited rights of return, which
typically provide that within 30 days of shipment products in unopened and
saleable condition may, at our discretion, be returned to us for refund, net of
a 15% restocking fee. We also provide certain distributors with limited stock
rotation rights. Based on historical experience, we provide for potential
returns from customers through a sales return reserve. The reserve is evaluated
and adjusted as conditions warrant. Allowance for Doubtful Accounts.We estimate the uncollectibility of our
accounts receivable and we maintain allowances for estimated losses. This
allowance is established using estimates that management makes based on factors
such as the composition of the accounts receivable aging, historical bad debts,
changes in payment patterns, customer creditworthiness and current economic
trends. If we used different estimates, or if the financial condition of our
customers were to deteriorate, resulting in an impairment of their ability to
make payments, additional provisions for doubtful accounts would be required
and would increase bad debt expense. Product Warranty.We generally warrant our products against defects in
materials and workmanship for one year after sale and provide for estimated
future warranty costs at the time revenues are recognized. Warranty expense is
based on historical claims experience, repair costs, and current sales levels,
as well as various other assumptions that we believe to be reasonable under the
circumstances. Should actual product failure rates differ from our estimates,
revisions to the estimated warranty liability would be required. Inventory Reserves.We state our inventories at the lower of cost or market,
computed on a standard cost basis, which approximates actual cost on a
first-in, first-out basis, with market being determined as the lower of
replacement cost or net realizable value. We provide reserves equal to the
difference between the cost of the inventory and the estimated market value of
our inventory using estimates of their net realizable value that are based upon
our assumptions about future demand and market conditions. If actual market
conditions are less favorable than those expected by management, additional
inventory reserves may be required. Accounting for Income Taxes.We account for income taxes using a liability
approach. Our deferred tax assets consist primarily of net operating loss and
credit carryforwards, for which we have provided a full valuation allowance,
due to our limited operating history and the unlikelihood that we would realize
those assets based on that history. To the extent that we begin to generate
significant taxable income, such that it becomes more likely than not that
these assets will be recoverable, we will reverse those valuation allowances
through income. To the extent that we are unable to operate profitably, our tax
assets could expire unutilized. The occurrence of certain events, such as
significant changes in ownership interests in Color Kinetics, could result in
limitations on the amount of those assets that could be utilized in any given
year. Stock-Based Compensation.We use the intrinsic value method to account for
stock-based compensation provided to employees and the fair value method to
account for stock-based compensation to non-employees, such as consultants and
members of our advisory board. Under the intrinsic value method, compensation
associated with awards of stock or stock options is measured as the difference
between the price the employee must pay to exercise the award and the fair
value of our common stock on the date compensation is measured, which is
generally the date of the award. To date, most awards to employees have had
exercise prices equal to the fair value of the common stock on the date of
award, and as a result no material compensation charges have been recorded for
awards to employees. Under the fair value method, compensation is measured
using the estimated fair value of an award, established either through the
estimated value of the share of stock or, in the case of options, through the
use of an option pricing 11




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##### Table of Contents



model, such as the Black-Scholes option pricing model. We disclose the
difference between the two methods in our notes to our consolidated financial
statements, and those differences have been significant. In addition, use of an
option pricing model invariably involves assumptions about future events, such
as the volatility of the underlying stock and the estimated life of an award.
These assumptions are difficult to predict and could generally result in
changing levels of compensation expense for these awards in our financial
statements. We do not currently have any intentions to change our accounting
for employee awards from the intrinsic value method to the fair value method.
However, the Financial Accounting Standards Board has approved for public
comment an exposure draft on stock-based compensation which, if adopted, would
have the effect of requiring us to adopt the fair value method in the future. Results of Operations The following table sets forth certain income and expense items as a percentage
of total revenues (or, in the case of our cost of lighting systems revenues and
cost of OEM and licensing revenues, as a percentage of the related revenues),
and the percentage change in dollar amounts of such items compared with the
corresponding periods in the previous fiscal year: Percentage of Total Revenues
    
    Period to Period ChangeThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    Three
Months
    
    Nine
Months2004
    
    2003
    
    2004
    
    2003
    
    Period
    
    PeriodRevenues:Lighting systems
    
    
    84
    %
    
    
    91
    %
    
    
    84
    %
    
    
    92
    %
    
    
    31
    %
    
    
    27
    %OEM and licensing
    
    
    16
    
    
    
    9
    
    
    
    16
    
    
    
    8
    
    
    
    155
    
    
    
    185Total revenues
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    42
    
    
    
    39Cost of Revenues:Cost of lighting systems, as a percentage of
lighting systems revenues
    
    
    47
    
    
    
    53
    
    
    
    49
    
    
    
    51
    
    
    
    18
    
    
    
    21Cost of OEM and licensing, as a percentage of
OEM and licensing revenues
    
    
    61
    
    
    
    47
    
    
    
    54
    
    
    
    52
    
    
    
    234
    
    
    
    200Total cost of revenues
    
    
    50
    
    
    
    52
    
    
    
    50
    
    
    
    51
    
    
    
    35
    
    
    
    35Gross Profit
    
    
    50
    
    
    
    48
    
    
    
    50
    
    
    
    49
    
    
    
    50
    
    
    
    43Operating Expenses:Selling and marketing
    
    
    21
    
    
    
    22
    
    
    
    21
    
    
    
    27
    
    
    
    30
    
    
    
    7Research and development
    
    
    8
    
    
    
    8
    
    
    
    8
    
    
    
    9
    
    
    
    49
    
    
    
    35General and administrative
    
    
    16
    
    
    
    16
    
    
    
    17
    
    
    
    16
    
    
    
    48
    
    
    
    43Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    (100
    )Total operating expenses
    
    
    45
    
    
    
    46
    
    
    
    46
    
    
    
    53
    
    
    
    39
    
    
    
    21Income (loss) from operations
    
    
    5
    
    
    
    2
    
    
    
    4
    
    
    
    (4
    )
    
    
    322
    
    
    
    (249
    )Interest income (expense), net
    
    
    2
    
    
    
    0
    
    
    
    1
    
    
    
    0
    
    
    
    3520
    
    
    
    579Equity in earnings of joint venture
    
    
    1
    
    
    
    (2
    )
    
    
    1
    
    
    
    0
    
    
    
    (149
    )
    
    
    391Net income (loss)
    
    
    8
    %
    
    
    0
    %
    
    
    6
    %
    
    
    (4
    %)
    
    
    10563
    %
    
    
    (326
    %)
 Revenues.Total revenues increased 42%, from $7.8 million in the third quarter
of 2003 to $11.1 million in the third quarter of 2004 and increased 39%, from
$21.2 million in the first nine months of 2003 to $29.4 million in the first
nine months of 2004. Lighting systems revenues increased 31%, from $7.1 million in the third quarter
of 2003 to $9.3 million in the third quarter of 2004 and increased 27%, from
$19.5 million in the first nine months of 2003 to $24.8 million in the first
nine months of 2004. Lighting systems revenues in North America increased 46%,
from $4.2 million in the third quarter of 2003 to $6.1 million in the third
quarter of 2004 and increased 40%, from $11.6 million in the first nine months
of 2003 to $16.2 million in the first nine months of 2004. Lighting systems
revenues in markets outside North America increased 9%, from $2.9 million in
the third quarter of 2003 to $3.1 million in the third quarter of 2004 and
increased 8%, from $7.9 million in the first nine months of 2003 to $8.5
million in the first nine months of 2004. 12




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The increases in lighting systems revenues for the third quarter and first nine
months of 2004 were primarily attributable to increased worldwide market
acceptance of our intelligent solid-state lighting systems and the addition of
new products to our product line in prior periods. Growth in sales in North
America was also attributable to our ongoing efforts to expand and support our
North American manufacturers representative network. These factors more than
offset declines in sales in the Japanese market to our joint venture partner,
Color Kinetics Japan, of $232,000 and $893,000 during the third quarter and
first nine months of 2004, respectively, compared to the same periods in the
prior year. In addition, sales of branded consumer products declined to zero
in the third quarter of 2004, representing a decline of $332,000 and $752,000
in revenues compared to the third quarter and first nine months of 2003,
respectively, resulting from our decision in 2003 to discontinue selling these
as branded Color Kinetics products and to distribute them instead through our
OEM and licensing program. Our OEM and licensing revenues increased 155%, from $700,000 in the third
quarter of 2003 to $1.8 million in the third quarter of 2004 and increased
185%, from $1.6 million in the first nine months of 2003 to $4.7 million in the
nine months of 2004. The increases in the three and nine month periods were
primarily attributable to increases of $1.0 million and $1.7 million,
respectively, in sales of our OEM pool products. At September 30, 2004, we had
agreements with 31 OEM and licensing customers compared with 17 such customers at December 31, 2003. Revenues derived from sales of lighting systems and OEM products to Color
Kinetics Japan, the joint venture that distributes our products in Japan,
decreased from 16% and 18% of total revenues to 9% and 10% of total revenues in
both the third quarter and first nine months of September 30, 2003 and 2004,
respectively. Revenues derived from sales of lighting systems products to Color Kinetics
Distribution, Inc., or CKDI, a distributor unaffiliated with us that fulfills
smaller orders (generally those having a value less than $10,000), as well as
all orders for specifically defined regions of the Canadian marketplace, were
less than 10% of total revenues in 2003 and amounted to 11% and 12% of total
revenues during the third quarter and first nine months of 2004, respectively. Gross Profit.Total gross profit increased from $3.7 million in the third
quarter of 2003 to $5.6 million in the third quarter of 2004 and from $10.4
million in the first nine months of 2003 to $14.9 million in the first nine
months of 2004. The dollar increase was attributable primarily to increased
sales, to improved profit margins on certain of our lighting systems products
and to increased licensing revenues that more than offset lower margins on our
OEM pool lights and sales to CKDI. Gross profit as a percentage of revenues, or
gross margin, increased from 48% in the third quarter of 2003 to 50% in the
third quarter of 2004 and amounted to 49% and 51% in the first nine months of
2003 and 2004, respectively. Gross margin may vary from period to period
depending on relative product mix. Gross margin from lighting systems increased from 47% in the third quarter of
2003 to 53% in the third quarter of 2004 and increased from 49% in the first
nine months of 2003 to 51% in the first nine months of 2004. The increases in
the third quarter and first nine months of 2004 compared to the same periods in
2003 are primarily attributable to reduced raw materials and product costs and
to an overall more favorable product mix, in part reflecting our decision to
discontinue direct distribution of our lower-margin consumer products. Gross
margin from lighting systems may vary from period to period depending on
relative product mix. Gross margin from our OEM and licensing business decreased from 53% in the
third quarter of 2003 to 39% in the third quarter of 2004 and decreased from
48% in the first nine months of 2003 to 46% in the first nine months of 2004.
The decrease in the third quarter of 2004 was primarily attributable to
increased sales of lower-margin OEM pool products compared to the third quarter
of 2003. The decrease in the first nine months of 2004 compared to the first
nine months of 2003 was primarily attributable to lower margin associated with
increased sales of our OEM pool products partially offset by an increased
percentage of licensing revenues in the first half of 2004. Gross margin for
our OEM and licensing business may vary in future periods depending on the mix
of higher and lower-margin OEM product revenues and the relative percentage of
higher-margin licensing revenues. Selling and Marketing Expenses.Selling and marketing expenses increased 30%
from $1.8 million in the third quarter of 2003 to $2.3 million in the third
quarter of 2004 and increased 7%, from $5.8 million in the first nine months of
2003 to $6.2 million in the first nine months of 2004. The increase in dollar
amount for the third quarter of 2004 compared to the same period in the prior
year was primarily attributed to an increase in commissions to our
manufacturers representatives as a result of our revenue growth. The decrease
in dollar amount for the first nine months of 2004 compared to the same period
in 2003 was primarily attributable to unfilled vacancies for sales positions in
early 2004 and elimination of direct sales costs associated with our branded
consumer products business, offset partially by an increase in commissions to
our manufacturers representatives as a result of our revenue growth and
increased marketing spending on trade shows and other related marketing
programs. Certain vacant sales positions were filled in the second quarter of
2004. As a percentage of total revenues, sales and marketing expenses
decreased from 23% in the third quarter of 2003 to 21% in the third quarter of
2004 and from 27% in the first nine months of 2003 to 21% in the first nine
months of 2004. The declines in selling and marketing expense as a percentage
of revenues were attributable primarily to our revenue growth. We plan to
further expand our sales force with the hiring of additional sales personnel
during the remainder of 2004 and into 2005. As a result, we expect our selling
and marketing expenses to increase in dollar amount in subsequent periods. Research and Development Expenses.Research and development expenses increased
49%, from $594,000 in the third quarter of 2003 to $886,000 in the third
quarter of 2004 and 35%, from $1.8 million in the first nine months of 2003 to
$2.5 million in the first nine months of 2004. These increases were primarily
attributable to increases in our research and development headcount based both
in our Boston and China offices, as well as to increased spending on materials
and equipment for new product development and testing. As a percentage of total
revenues, research and development expenses remained constant at 8% for each of
the third quarter periods presented and decreased from 9% in the first nine
months of 2003 to 8% in the first nine months of 2004. The decreases in
research and development expenses as a percentage of revenues were attributable
primarily to our revenue growth. We expect our research and development
expenses to increase in dollar amount in subsequent periods, as we devote
additional resources to developing new products and technologies and supporting
scheduled new product introductions during the remainder of 2004 and into 2005. 13




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General and Administrative Expenses.General and administrative expenses
increased 48%, from $1.2 million in the third quarter of 2003 to $1.8 million
in the third quarter of 2004 and increased 43% from $3.4 million in the first
nine months of 2003 to $4.9 million in the first nine months of 2004. Outside
legal expenses increased by $309,000 and $557,000 in the third quarter and
first nine months of 2004, respectively, compared to the same periods in the
prior year, primarily as a result of increased patent application activity and
litigation matters. Stock-based compensation charges increased by $8,000 and
$339,000 in the third quarter and first nine months of 2004, respectively,
compared to the same periods in the prior year, primarily as a result of
options granted to advisory board members, including the impact of acceleration
of the remaining unvested portion of such options in June 2004. The remaining
increases in general and administrative expenses for the three and nine periods
are primarily the result of increased personnel-related costs to support
overall growth in the business. We expect our general and administrative
expenses to increase in future periods to support our expanding operations, the
additional reporting and other obligations associated with our being a public
company, and protection of our intellectual property. Restructuring Expenses.No restructuring expenses were recorded in 2004. The
$161,000 of restructuring expenses in 2003 was attributable to an adjustment
made to the restructuring reserve established in 2001, to reflect a change in
estimate related to the amount of income we expect to receive from the sublease
of our vacated space. Interest Income (Expense), Net.Interest income increased from $5,000 in the
third quarter of 2003 to $181,000 in the third quarter of 2004 and from $41,000
in the first nine months of 2003 to $258,000 in the first nine months of 2004,
due to higher average cash and cash equivalent balances in 2004. We incurred
$3,000 of interest expense in the first half of 2003 and none in 2004, as a
result of our repayment of all bank debt in 2003. Equity in Earnings (Loss) of Joint Venture.Equity in earnings of joint venture
increased from a $140,000 loss in the third quarter of 2003 to a $69,000 gain
in the third quarter of 2004 and increased from $45,000 in the first nine
months of 2003 to $221,000 in the first nine months of 2004. The loss in the
third quarter of 2003 was primarily attributed to unrealized losses during that
period on open foreign exchange forward contracts that were purchased by Color
Kinetics Japan in order to hedge anticipated dollar-denominated purchases.
Differences period to period in equity in earnings of Color Kinetics Japan was
also attributed to fluctuation in net earnings of Color Kinetics Japan. Provision for Income Taxes.We recorded no provision for income tax in either
2003 or 2004 due to our net loss carryforward position. At December 31, 2003,
we had net loss carryforwards available to offset future taxable income of
$31.2 million and federal research and development tax credit carryforwards
available to reduce future taxes payable of $526,000. Should it become more
likely than not that these assets will be recovered, we would remove the
allowances provided, which would have the effect of reducing or eliminating our
provision for income tax and possibly creating a tax benefit to earnings. Liquidity and Capital Resources At September 30, 2004, we had $40.0 million in cash and equivalents, as well as
$15.0 million in short-term investments, representing an increase of $34.3
million compared to our $5.7 million balance of cash and equivalents at
December 31, 2003, as well as a $15 million increase in short-term investments
over the same time period. During the first nine months of 2004, we generated $1.6 million of cash from
operating activities. The increase in cash flows from operating activities
during the first nine months of 2004 as compared to the same period in the
prior year was primarily due to higher net income and changes in operating
assets and liabilities. Net operating assets increased year over year
primarily as a result of increased sales. Net cash used in investing activities was $15.5 million during the first nine
months of 2004, reflecting $15 million used for purchase of short-term
investments, with the remaining $500,000 reflecting purchases of property and
equipment, primarily computers, a trade show booth for marketing purposes, and
tooling and test equipment related to our product development efforts.
Short-term investments are composed of a certificate of deposit from a bank
purchased with a seven month maturity. Net cash provided by financing activities was $48.3 million for the first nine
months of 2004, primarily attributable to $13.0 million from issuance of
preferred stock in January and February of 2004 and $35.2 million of proceeds
from our initial public offering of 4,000,000 million shares of common stock in
June 2004. In connection with the initial public offering, all 20.4 million
shares of then outstanding preferred stock with a carrying value of $61.1
million were converted into 11.1 million shares of common stock. Our previous
bank line of credit expired unused in September 2004. We presently have no
plans to obtain additional bank financing. We anticipate that our cash and equivalents and short-term investments at
September 30, 2004 will be sufficient to fund our foreseeable cash requirements
for at least the next twelve months. Factors That May Affect Future Results We have experienced, and may in the future experience, significant
quarter-to-quarter fluctuations in our revenue, gross profit and operating
results. Because our sales cycles are long and our customers generally do not
enter into long-term purchase commitments, forecasting our revenues is
difficult. Even after our lighting systems have been specified for a particular
project or installation, the timing of our receipt of revenue may be difficult
to predict, as shipment of our systems can be postponed or cancelled due to
construction delays, design changes or cost overruns. Similarly, receipt of
substantial revenues from an OEM or licensing customer depends on the success
of the OEM or licensing customer in developing, introducing and marketing a
product including our OEM product or technology, a process that is beyond our
control. As is the case for many technology companies, a substantial portion of
our revenue in each quarter is attributable to purchase orders issued and
shipments made near the end of the quarter. A delay in shipment near the end of
the quarter, due, for example, to an unanticipated construction delay or
project cancellation, may cause our revenues to fall significantly below our
expectations. Because a substantial portion of our expenses is relatively fixed
and cannot rapidly be reduced, a shortfall in quarterly revenue may materially
adversely affect our operating results for the quarter. Other factors that may
contribute to fluctuations in our quarterly operating results include:  
    
    changes in product mix; 14




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
    
    changes in our distribution and sales channels;
    
    seasonal patterns in purchases of our products;
    
    changes in gross margin associated with inventory and supply chain management issues;
    
    increases or decreases in legal expenses associated with intellectual property litigation initiated by or against us;
    
    changes in the results of operations of Color Kinetics Japan, our joint venture in Japan;
    
    introduction by us and our competitors of new products; and
    
    competitive factors, including pricing and availability of, and demand for, products that compete with ours. In addition, we face a number of risks and challenges, many of which we
describe under the heading Risk Factors in our Registration Statement on Form
S-1. Among the challenges which we think are most significant, and which have
in the past, and will in the future affect our financial performance, are the
following:  
    
    Market acceptance of intelligent solid-state lighting:The success of
our business depends on growing acceptance of intelligent solid-state
lighting, both as a replacement for traditional lighting solutions and
in new applications. Our senior management team spends a significant
amount of time, and we expend significant resources, on efforts to
promote the adoption of solid-state lighting in general, and our
intelligent solid-state lighting systems in particular.
    
    Ability to meet demand and maintain quality:The success of our
business also depends on our ability to supply our products in
quantities adequate to meet demand, and to maintain the high standards
of quality that our customers require. Our senior management spends a
significant amount of its time, and we devote substantial resources, to
efforts to ensure our sources of supply and to improve our supply chain
management and quality control processes.
    
    Need for continued product and technology innovation:Our competitive
position depends on our ability to innovate, and to anticipate the
rapid changes in lighting technology, changing customer requirements
and evolving standards which characterize our industry. Driving and
supporting this process of continuous innovation is a key priority of
our senior management team and will require continuing expenditures by
us.
    
    Defending our intellectual property:We believe that our proprietary
intellectual property is an important source of competitive advantage
and is critical to our growing OEM and licensing business. We will
continue to devote substantial resources to extending our intellectual
property portfolio and, where necessary, we will take appropriate steps
to defend it. This could involve substantial expenditures on our part.
    
    Management of growth:We recognize that if our business plans are
successful, we may be required to manage a larger and rapidly growing
enterprise. We will also be required to meet the reporting, regulatory
and other obligations of a public company. This will impose new burdens
on management and involve additional costs that we have not
historically borne. 
 Item 3.  Quantitative and Qualitative Disclosures About Market Risk Market risk to which we are subject consists of the risk of loss arising from
adverse changes in market rates and foreign exchange rates. Our joint venture, Color Kinetics Japan, has entered into forward currency
contracts to hedge anticipated dollar denominated purchases of product from us.
These contracts consist solely of forward contracts to acquire dollars at a
fixed yen rate. These contracts are reflected on the balance sheet of Color
Kinetics Japan at current fair value and cover a notional amount of $7.2
million, settling at various dates through 2010. Our exposure to these
contracts is limited to the impact on our proportional share of the income or
loss of Color Kinetics Japan. We have provided no guarantees with respect to
Color Kinetics Japan, and as a result the maximum loss we would record with
respect to our investment would be the carrying value of that investment at any
point in time. At September 30, 2004, our investment in Color Kinetics Japan
was carried at $536,000. 
 Item 4. Controls and Procedures (a)  Evaluation of disclosure controls and procedures. Our management, including our Chief Executive Officer and our Chief Financial
Officer, carried out an evaluation of the effectiveness of our disclosure
controls and procedures as of the end the period covered by this quarterly
report. Based on this evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures were
effective to provide a reasonable level of assurance that the information
required to be disclosed in the reports filed or submitted by us under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the requisite time periods. (b)  Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting that
occurred during the last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting. 15




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PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings Super Vision International, Inc. In March 2002, Super Vision International, Inc., or Super Vision, filed a
lawsuit in the United States District Court for the Middle District of Florida
seeking a declaratory judgment that certain of our patents are invalid, that
Super Visions products do not infringe the patents in question, and that the
patents are unenforceable. Super Vision subsequently amended the complaint to
add claims for interference with prospective business relationships, unfair
competition, trade disparagement and defamation. In June 2002, we filed a lawsuit against Super Vision in the United States
District Court for the District of Massachusetts. In this litigation, we
alleged that certain products of Super Vision, including solid-state
architectural lighting fixtures, pool lights and spa lights, infringes four of
the patents at issue in Super Visions declaratory judgment action; this
complaint has been amended to assert infringement of a fifth patent. Super Visions lawsuit in Florida was transferred by the court to the United
States District Court for the District of Massachusetts. The cases are in the
discovery phase, with discovery closing in January, dispositive motions due in
February, and trial expected in the second quarter of 2005. We believe that
Super Visions claims of invalidity, unenforceability and non-infringement of
the patents at issue in our infringement suit against Super Vision, and its
claims against us of interference with prospective business relationships,
unfair competition, trade disparagement and defamation, are without merit. On March 4, 2004, Super Vision announced that it had acquired from High End
Systems a patent relating to variable color lighting systems. On March 5, 2004,
Super Vision filed a lawsuit in the United States District Court for the Middle
District of Florida alleging that we have infringed the High End patent and
seeking damages of $10.5 million. We had previously investigated the High End
patent and concluded that our products and technology do not infringe any valid
claim of the patent. Accordingly, we believe that Super Visions High End
patent lawsuit is without merit and intend to defend against it vigorously. We
are now seeking to transfer Super Visions High End patent lawsuit to federal
court in Massachusetts. TIR Systems, Ltd. In December 2003, we filed a lawsuit against TIR Systems Ltd, a Canadian
corporation, in the United States District Court for the District of
Massachusetts. In this litigation, we alleged that certain products of TIR
infringe three patents of Color Kinetics. The Complaint has been amended to
add a fourth patent. TIR has filed counterclaims seeking declarations that it
does not infringe and that the patents are invalid. We believe that these
claims by TIR are without merit. The present scheduling order specifies that
all discovery is to be completed by February 2006 and dispositive motions filed
by April 2006. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds No change. 
 Items 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other Information None. 
 Item 6. Exhibits and Reports on Form 8-K (a)  Exhibits Exhibit
Number
    
    Description31.1
    
    Certification by George G. Mueller pursuant to Rule 13a-14(a) and
15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, relating to Color Kinetics Incorporated31.2
    
    Certification by David K. Johnson pursuant to Rule 13a-14(a) and
15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002, relating to Color Kinetics Incorporated32.1
    
    Certification by George G. Mueller pursuant to Section 1350,
Chapter 63 of Title 18, United States Code, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, relating to Color
Kinetics Incorporated
 16




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32.2
    
    Certification by David K. Johnson pursuant to Section 1350, Chapter
63 of Title 18, United States Code, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002, relating to Color Kinetics
Incorporated
 (b)   Reports on Form 8-K We filed a report on Form 8-K on August 5, 2004, furnishing, under Item 7,
a copy of a press release related to our second quarter financial results,
and identifying such press release as required by Item 12. 
 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. Date: November 15, 2004
    COLOR KINETICS INCORPORATED(Registrant)By:
    /s/    George G. MuellerGeorge G. MuellerChief Executive OfficerBy:
    /s/    David K. JohnsonDavid K. JohnsonChief Financial Officer 17