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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 June 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
    
    04-3391805(State or other jurisdiction of
incorporation or organization)
    
    (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 o No x 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 August 6, 2004, Color Kinetics Incorporated had 17,880,306 shares of
common stock, par value $0.001 per share, outstanding.




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COLOR KINETICS INCORPORATED FORM 10-Q INDEX Page No.PART I. FINANCIAL INFORMATIONItem 1.    Financial StatementsCondensed Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003
    
    
    
    
    3Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2004
and June 30, 2003 (unaudited)
    
    
    
    
    4Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and June 30, 2003 (unaudited)
    
    
    
    
    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
    
    
    
    
    13Item 4.    Controls and Procedures
    
    
    
    
    14PART II. OTHER INFORMATIONItem 1.    Legal Proceedings
    
    
    
    
    14Item 2.    Changes in Securities and Use of Proceeds
    
    
    
    
    14Item 3.    Defaults Upon Senior Securities
    
    
    
    
    14Item 4.    Submission of Matters to a Vote of Security Holders
    
    
    
    
    14Item 5.    Other Information
    
    
    
    
    15Item 6.    Exhibits and Reports on Form 8-K
    
    
    
    
    15Signatures
    
    
    
    
    15Exhibit Index
    
    
    
    
    16EX-31.1 SECTION 302 CERTIFICATION OF C.E.O.EX-31.2 SECTION 302 CERTIFICATION OF C.F.O.EX-32.1 SECTION 906 CERTIFICATION OF C.E.O.EX-32.2 SECTION 906 CERTIFICATION OF C.F.O.
 2




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PART I. FINANCIAL INFORMATION 
 Item 1. Consolidated Financial Statements 
 Color Kinetics
Incorporated
Condensed Consolidated Balance Sheets
(In thousands) June 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCURRENT ASSETS:Cash and equivalents
    
    $
    54,675
    
    
    $
    5,686Restricted cash
    
    
    486
    
    
    
    479Accounts receivable, net of allowance for doubtful
accounts of approximately $300 and $270 in 2004
and 2003, respectively
    
    
    4,641
    
    
    
    4,015Accounts receivable from related parties
    
    
    109
    
    
    
    30Inventory
    
    
    5,799
    
    
    
    5,024Prepaid expenses and other current assets
    
    
    1,168
    
    
    
    429Total current assets
    
    
    66,878
    
    
    
    15,663PROPERTY AND EQUIPMENT  net
    
    
    1,058
    
    
    
    1,065INVESTMENT IN JOINT VENTURE
    
    
    448
    
    
    
    289RESTRICTED CASHLong-term portion
    
    
    1,100
    
    
    
    1,100TOTAL ASSETS
    
    $
    69,484
    
    
    $
    18,117LIABILITIES
AND STOCKHOLDERS EQUITY (DEFICIENCY)CURRENT LIABILITIES:Accounts payable
    
    $
    3,052
    
    
    $
    1,483Accounts payable to related party
    
    
    
    
    
    
    21Accrued expenses
    
    
    1,481
    
    
    
    812Accrued compensation
    
    
    1,025
    
    
    
    1,471Accrued restructuring
    
    
    416
    
    
    
    426Accrued warranty
    
    
    701
    
    
    
    404Deferred revenue
    
    
    446
    
    
    
    387Total current liabilities
    
    
    7,121
    
    
    
    5,004ACCRUED RESTRUCTURING
    
    
    831
    
    
    
    1,034COMMITMENTS AND CONTINGENCIESREDEEMABLE CONVERTIBLE PREFERRED STOCK, at liquidation value
    
    
    
    
    
    
    47,999STOCKHOLDERS EQUITY (DEFICIENCY):Common stock, authorized, 100,000 shares; issued and
outstanding
17,880 and 2,804 shares in 2004 and
2003, respectively
    
    
    18
    
    
    
    3Additional paid-in capital
    
    
    96,953
    
    
    
    304Accumulated other comprehensive income (loss)
    
    
    (22
    )
    
    
    14Accumulated deficit
    
    
    (35,417
    )
    
    
    (36,241
    )Total stockholders equity (deficiency)
    
    
    61,532
    
    
    
    (35,920
    )TOTAL LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIENCY)
    
    $
    69,484
    
    
    $
    18,117
 See accompanying notes to unaudited condensed consolidated financial statements. 3




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Color Kinetics
Incorporated
Condensed Consolidated Statements of Operations (Unaudited)
(In thousands, except per share data) Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003REVENUES (1):Lighting systems
    
    $
    8,734
    
    
    $
    6,711
    
    
    $
    15,492
    
    
    $
    12,435OEM and licensing
    
    
    1,424
    
    
    
    584
    
    
    
    2,884
    
    
    
    941Total revenues
    
    
    10,158
    
    
    
    7,295
    
    
    
    18,376
    
    
    
    13,376COST OF REVENUES:Lighting systems
    
    
    4,279
    
    
    
    3,200
    
    
    
    7,646
    
    
    
    6,189OEM and licensing
    
    
    771
    
    
    
    309
    
    
    
    1,453
    
    
    
    521Total cost of revenues
    
    
    5,050
    
    
    
    3,509
    
    
    
    9,099
    
    
    
    6,710GROSS PROFIT
    
    
    5,108
    
    
    
    3,786
    
    
    
    9,277
    
    
    
    6,666OPERATING EXPENSES:Selling and marketing
    
    
    2,065
    
    
    
    2,086
    
    
    
    3,893
    
    
    
    4,040Research and development
    
    
    804
    
    
    
    612
    
    
    
    1,605
    
    
    
    1,255General and administrative (2)
    
    
    1,729
    
    
    
    1,032
    
    
    
    3,104
    
    
    
    2,213Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    161Total operating expenses
    
    
    4,598
    
    
    
    3,730
    
    
    
    8,602
    
    
    
    7,669INCOME (LOSS) FROM OPERATIONS
    
    
    510
    
    
    
    56
    
    
    
    675
    
    
    
    (1,003
    )INTEREST INCOME (EXPENSE):Interest income
    
    
    46
    
    
    
    18
    
    
    
    77
    
    
    
    36Interest expense
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    (3
    )Total interest income, net
    
    
    46
    
    
    
    17
    
    
    
    77
    
    
    
    33EQUITY IN EARNINGS OF JOINT VENTURE
    
    
    19
    
    
    
    11
    
    
    
    152
    
    
    
    185NET INCOME (LOSS)
    
    $
    575
    
    
    $
    84
    
    
    $
    904
    
    
    $
    (785
    )EARNINGS (LOSS) PER SHARE:Basic
    
    $
    0.13
    
    
    $
    0.03
    
    
    $
    0.25
    
    
    $
    (0.28
    )Diluted
    
    $
    0.04
    
    
    $
    0.01
    
    
    $
    0.06
    
    
    $
    (0.28
    )WEIGHTED AVERAGE SHARES OUTSTANDING:Basic
    
    
    4,295
    
    
    
    2,786
    
    
    
    3,549
    
    
    
    2,784Diluted
    
    
    15,772
    
    
    
    12,411
    
    
    
    15,416
    
    
    
    2,784Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003(1) Includes revenues from related parties as follows:Lighting systems
    
    $
    1,039
    
    
    $
    1,344
    
    
    $
    1,919
    
    
    $
    2,581OEM and licensing
    
    
    30
    
    
    
    43
    
    
    
    60
    
    
    
    90Total related party revenues
    
    $
    1,069
    
    
    $
    1,387
    
    
    $
    1,979
    
    
    $
    2,671(2) Includes stock-based compensation as follows:
    
    $
    269
    
    
    $
    18
    
    
    $
    331
    
    
    $
    37
 See accompanying notes to unaudited condensed consolidated financial statements. 4




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Color Kinetics
Incorporated
Condensed Consolidated Statements of Cash Flows (Unaudited)
(In thousands) Six Months Ended June 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    904
    
    
    $
    (785
    )Adjustments to reconcile net income (loss) to cash
from operating activities:Depreciation and amortization
    
    
    381
    
    
    
    458Stock-based compensation
    
    
    331
    
    
    
    37Equity in earnings of joint venture
    
    
    (152
    )
    
    
    (185
    )Changes in current assets and liabilities:Accounts receivable
    
    
    (705
    )
    
    
    (1,379
    )Inventory
    
    
    (775
    )
    
    
    (72
    )Prepaid expenses and other current assets
    
    
    (739
    )
    
    
    45Restricted cash
    
    
    (7
    )
    
    
    250Accounts payable
    
    
    1,548
    
    
    
    (396
    )Accrued expenses
    
    
    520
    
    
    
    4Deferred revenue
    
    
    59
    
    
    
    136Accrued restructuring
    
    
    (213
    )
    
    
    (273
    )Cash flows from operating activities
    
    
    1,152
    
    
    
    (2,160
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property and equipment
    
    
    (374
    )
    
    
    (184
    )Cash flows from investing activities
    
    
    (374
    )
    
    
    (184
    )CASH FLOWS FROM FINANCING ACTIVITIES:Payments under equipment note payable and line of credit
    
    
    
    
    
    
    (60
    )Proceeds from the exercise of stock options
    
    
    24
    
    
    
    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
    
    
    48,254
    
    
    
    (53
    )EFFECT OF EXCHANGE RATE CHANGES ON CASH
    
    
    (43
    )
    
    
    2INCREASE (DECREASE) IN CASH AND EQUIVALENTS
    
    
    48,989
    
    
    
    (2,395
    )CASH AND EQUIVALENTSBeginning of period
    
    
    5,686
    
    
    
    7,689CASH AND EQUIVALENTSEnd of period
    
    $
    54,675
    
    
    $
    5,294SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:Cash paid for interest
    
    $
    
    
    
    $
    2SUPPLEMENTAL DISCLOSURE OF NONCASH
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 quarters. 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. 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, during the quarter ended June 30, 2004, 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. 6




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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): Three Months Ended June
    
    Six,Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    575
    
    
    $
    84
    
    
    $
    904
    
    
    $
    (785
    )Less:
stock-based compensation expense determined
under
fair value method for all awards, net of tax
    
    
    (105
    )
    
    
    (43
    )
    
    
    (176
    )
    
    
    (86
    )Pro forma net income (loss)
    
    $
    470
    
    
    $
    41
    
    
    $
    728
    
    
    $
    (871
    )Basic earnings (loss) per shareAs reported
    
    $
    0.13
    
    
    $
    0.03
    
    
    $
    0.25
    
    
    $
    (0.28
    )Pro forma
    
    $
    0.11
    
    
    $
    0.01
    
    
    $
    0.21
    
    
    $
    (0.31
    )Diluted earnings (loss) per shareAs reported
    
    $
    0.04
    
    
    $
    0.01
    
    
    $
    0.06
    
    
    $
    (0.28
    )Pro forma
    
    $
    0.03
    
    
    $
    0.00
    
    
    $
    0.05
    
    
    $
    (0.31
    )
 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
    
    
    50
    %
    
    
    50
    %Dividend yield
    
    
    0
    %
    
    
    0
    %Expected life in years
    
    
    4
    
    
    
    4
 The weighted average fair value of options granted during the three months
ended June 30, 2004 and 2003 was $3.99 and $0.34, respectively. The weighted
average fair value of options granted during the six months ended June 30, 2004
and 2003 was $3.44 and $0.38, respectively. Stock-based compensation charges in the second quarter of 2004 included
$147,000 resulting from acceleration of the remaining unvested portion of stock
options granted to advisory board members. 5. Inventory Inventory is stated at the lower of cost (first-in, first-out method) or market
and consists of the following (in thousands): June 30,
    
    December 31,2004
    
    2003Finished goods
    
    $
    3,369
    
    
    $
    2,973Raw material components
    
    
    2,430
    
    
    
    2,051Total
    
    $
    5,799
    
    
    $
    5,024
 6. 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 six
months ended June 30, 2004 and 2003 (in thousands): 2004
    
    2003Balance, December 31,
    
    $
    404
    
    
    $
    549Provisions included in cost of revenues
    
    
    311
    
    
    
    84Expenditures
    
    
    (14
    )
    
    
    (161
    )Balance, June 30,
    
    $
    701
    
    
    $
    472
 7




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7. Earnings Per Share 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. 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 and six months ended June 30, 2004 and 2003, outstanding stock
options to purchase approximately 9,000, 154,000, 1,545,000 and 1,469,000
shares of common stock, respectively, were excluded from the calculation of
diluted earnings per share, because these options were anti-dilutive. 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 June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Weighted average shares for basic computation
    
    
    4,295
    
    
    
    2,786
    
    
    
    3,549
    
    
    
    2,784Potential common shares from:Options
    
    
    983
    
    
    
    145
    
    
    
    893
    
    
    
    Warrants
    
    
    409
    
    
    
    153
    
    
    
    394
    
    
    
    Preferred stock
    
    
    10,085
    
    
    
    9,327
    
    
    
    10,580
    
    
    
    Weighted average shares for diluted computation
    
    
    15,772
    
    
    
    12,411
    
    
    
    15,416
    
    
    
    2,784
 On a pro forma basis, earnings (loss) per basic share for the three and six
months periods ended June 30, 2004 and 2003 would have been $0.04, $0.06, $0.01
and ($0.28) 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. 8. 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 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 good 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 June 30,
    
    2004
    
    2003Lighting
    
    OEM and
    
    
    
    
    
    Lighting
    
    OEM andSystems
    
    Licensing
    
    Total
    
    Systems
    
    Licensing
    
    TotalRevenues
    
    $
    8,734
    
    
    $
    1,424
    
    
    $
    10,158
    
    
    $
    6,711
    
    
    $
    584
    
    
    $
    7,295Cost of revenues
    
    
    4,279
    
    
    
    771
    
    
    
    5,050
    
    
    
    3,200
    
    
    
    309
    
    
    
    3,509Gross profit
    
    
    4,455
    
    
    
    653
    
    
    
    5,108
    
    
    
    3,511
    
    
    
    275
    
    
    
    3,786Other direct costs
    
    
    1,984
    
    
    
    169
    
    
    
    2,153
    
    
    
    1,875
    
    
    
    357
    
    
    
    2,232Direct contribution margin
    
    $
    2,471
    
    
    $
    484
    
    
    
    2,955
    
    
    $
    1,636
    
    
    $
    (82
    )
    
    
    1,554Reconciling items to income from operations:Unallocated selling and marketing
    
    
    
    
    
    
    
    
    
    
    334
    
    
    
    
    
    
    
    
    
    
    
    230Unallocated research and development
    
    
    
    
    
    
    
    
    
    
    382
    
    
    
    
    
    
    
    
    
    
    
    236Unallocated general and administrative
    
    
    
    
    
    
    
    
    
    
    1,729
    
    
    
    
    
    
    
    
    
    
    
    1,032Income from operations
    
    
    
    
    
    
    
    
    
    $
    510
    
    
    
    
    
    
    
    
    
    
    $
    56
 Six Months Ended June 30,
    
    2004
    
    2003Lighting
    
    OEM and
    
    
    
    
    
    Lighting
    
    OEM andSystems
    
    Licensing
    
    Total
    
    Systems
    
    Licensing
    
    TotalRevenues
    
    $
    15,492
    
    
    $
    2,884
    
    
    $
    18,376
    
    
    $
    12,435
    
    
    $
    941
    
    
    $
    13,376Cost of revenues
    
    
    7,646
    
    
    
    1,453
    
    
    
    9,099
    
    
    
    6,189
    
    
    
    521
    
    
    
    6,710Gross profit
    
    
    7,846
    
    
    
    1,431
    
    
    
    9,277
    
    
    
    6,246
    
    
    
    420
    
    
    
    6,666Other direct costs
    
    
    3,744
    
    
    
    386
    
    
    
    4,130
    
    
    
    3,639
    
    
    
    741
    
    
    
    4,380Direct contribution margin
    
    $
    4,102
    
    
    $
    1,045
    
    
    
    5,147
    
    
    $
    2,607
    
    
    $
    (321
    )
    
    
    2,286Reconciling items to income (loss) from operations:Unallocated selling and marketing
    
    
    
    
    
    
    
    
    
    
    626
    
    
    
    
    
    
    
    
    
    
    
    447Unallocated research and development
    
    
    
    
    
    
    
    
    
    
    742
    
    
    
    
    
    
    
    
    
    
    
    468Unallocated general and administrative
    
    
    
    
    
    
    
    
    
    
    3,104
    
    
    
    
    
    
    
    
    
    
    
    2,213Unallocated restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    161Income (loss) from operations
    
    
    
    
    
    
    
    
    
    $
    675
    
    
    
    
    
    
    
    
    
    
    $
    (1,003
    )
 8




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##### Table of Contents



9. 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 shareholders equity. The
following table sets forth the calculation of comprehensive income (loss) on an
interim basis (in thousands): Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    575
    
    
    $
    84
    
    
    $
    904
    
    
    $
    (785
    )Foreign
currency translation adjustments and other
items of comprehensive income (loss)
    
    
    (17
    )
    
    
    
    
    
    
    1
    
    
    
    Total comprehensive income (loss)
    
    $
    558
    
    
    $
    84
    
    
    $
    905
    
    
    $
    (785
    )
 10. 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, infringe five of
the patents at issue in Super Visions declaratory judgment action. Proceedings
in our lawsuit against Super Vision were temporarily stayed for the purpose of
pursuing settlement negotiations, but these negotiations were not fruitful. Upon renewal of the proceedings, Super Visions lawsuit in Florida was removed
by the court to the United States District Court for the District of
Massachusetts, where our motion to consolidate the two cases is pending. The
cases are in the discovery phase, with a so-called Markman hearing on patent
claim interpretation scheduled for October 2004 and trial scheduled for January
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. With the permission of the court, we amended the complaint that we filed
against Super Vision in The United States District Court for the District of
Massachusetts to include requests for declarations that the High End patent is
not infringed by Color Kinetics, is invalid and is not enforceable. We are now
seeking to transfer Super Visions High End patent lawsuit to federal court in
Massachusetts as well. Since all of the claims are now before the court in
Massachusetts, we may request that the court adjust the discovery and trial
schedule. 
 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 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 or distributors 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. 9




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##### Table of Contents



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. 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,
generally 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 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. 10




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##### Table of Contents



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 RevenuesThree Months Ended
    
    Six Months Ended
    
    Period to Period ChangeJune 30,
    
    June 30,
    
    ThreeMonth
    
    SixMonth2004
    
    2003
    
    2004
    
    2003
    
    Period
    
    PeriodRevenues:Lighting systems
    
    
    86
    %
    
    
    92
    %
    
    
    84
    %
    
    
    93
    %
    
    
    30
    %
    
    
    25
    %OEM and licensing
    
    
    14
    
    
    
    8
    
    
    
    16
    
    
    
    7
    
    
    
    144
    
    
    
    207Total revenues
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    39
    
    
    
    37Cost of Revenues:Cost of
lighting systems, as a percentage of
lighting systems revenues
    
    
    49
    
    
    
    48
    
    
    
    49
    
    
    
    50
    
    
    
    34
    
    
    
    24Cost of OEM and licensing, as a percentage of
OEM and licensing revenues
    
    
    54
    
    
    
    53
    
    
    
    50
    
    
    
    55
    
    
    
    150
    
    
    
    179Total cost of revenues
    
    
    50
    
    
    
    48
    
    
    
    50
    
    
    
    50
    
    
    
    44
    
    
    
    36Gross Profit
    
    
    50
    
    
    
    52
    
    
    
    50
    
    
    
    50
    
    
    
    35
    
    
    
    39Operating Expenses:Selling and marketing
    
    
    20
    
    
    
    29
    
    
    
    21
    
    
    
    30
    
    
    
    (1
    )
    
    
    (4
    )Research and development
    
    
    8
    
    
    
    8
    
    
    
    8
    
    
    
    9
    
    
    
    31
    
    
    
    28General and administrative
    
    
    17
    
    
    
    14
    
    
    
    17
    
    
    
    17
    
    
    
    68
    
    
    
    40Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    (100
    )Total operating expenses
    
    
    45
    
    
    
    51
    
    
    
    46
    
    
    
    57
    
    
    
    23
    
    
    
    12Income (loss) from operations
    
    
    5
    
    
    
    1
    
    
    
    4
    
    
    
    (7
    )
    
    
    817
    
    
    
    (167
    )Interest income (expense), net
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    168
    
    
    
    133Equity in earnings of joint venture
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    1
    
    
    
    74
    
    
    
    (17
    )Net income (loss)
    
    
    6
    %
    
    
    1
    %
    
    
    5
    %
    
    
    (6
    %)
    
    
    586
    %
    
    
    (215
    %)
 Revenues.Total revenues increased 39%, from $7.3 million in the second quarter
of 2003 to $10.2 million in the first quarter of 2004 and increased 37%, from
$13.4 million in the first half of 2003 to $18.4 million in the first half of
2004. Lighting systems revenues increased 30%, from $6.7 million in the second
quarter of 2003 to $8.7 million in the second quarter of 2004 and increased
25%, from $12.4 million in the first half of 2003 to $15.5 million in the first
half of 2004. Lighting systems revenues in North America increased 43%, from
$4.1 million in the second quarter of 2003 to $5.8 million in the second
quarter of 2004 and increased 36%, from $7.4 million in the first half of 2003
to $10.1 million in the first half of 2004. Lighting systems revenues in
markets outside North America increased 10%, from $2.6 million in the second
quarter of 2003 to $2.9 million in the second quarter of 2004 and increased 7%,
from $5.0 million in the first half of 2003 to $5.4 million in the first half
of 2004. The increases in lighting systems revenues for the second quarter and first
half of 2004 were primarily attributable to increased 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 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 $306,000
and $668,000 during the second quarter and first half of 2004, respectively,
compared to the same periods in the prior year. In addition, sales of branded
consumer products declined to zero in the second quarter of 2004, representing
a decline of $22,000 and $420,000 in revenues compared to the second quarter
and first half 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 144%, from $584,000 in the second
quarter of 2003 to $1.4 million in the second quarter of 2004 and increased
207%, from $941,000 in the first half of 2003 to $2.9 million in the first half
of 2004. The increases in the three and six month periods were primarily
attributable to increases of $458,000 and $970,000, respectively, in sales of
our OEM pool products, due to a product launch by an OEM customer in late 2003
and the commencement of related volume purchases of our OEM products, and a
$353,000 increase in our licensing revenues in the first half of 2004, due
primarily to a large upfront license payment received in connection with a new
licensing agreement signed in the first quarter of 2004. At June 30, 2004, we
had agreements with 27 OEM and licensing customers that we believe were
actively engaged in developing or marketing products incorporating our
technology compared with 24 such customers at March 31, 2004 and 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 19% of total revenues to 10% of total revenues in both the
second quarter and first half of June 30, 2003 and 2004, respectively. We
expect revenues from sales to Color Kinetics Japan to increase in the second
half of 2004, in comparison to those recorded in the first half of 2004. 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
13% of total revenues in both the second quarter and first half of 2004. 11




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##### Table of Contents



Gross Profit.Total gross profit increased from $3.8 million in the second
quarter of 2003 to $5.1 million in the second quarter of 2004 and from $6.7
million in the first half of 2003 to $9.3 million in the first half 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 and spa
products and sales to CKDI. Gross profit as a percentage of revenues, or gross
margin, decreased from 52% in the second quarter of 2003 to 50% in the second
quarter of 2004 and amounted to 50% in both the first half of 2003 and the
first half of 2004. Gross margin may vary from period to period depending on
relative product mix. Gross margin from lighting systems decreased from 52% in the second quarter of
2003 to 51% in the second quarter of 2004 and increased from 50% in the first
half of 2003 to 51% in the first half of 2004. The decrease in the second
quarter of 2004 compared to the second quarter of 2003 is primarily
attributable to variation in product mix. The increase for the first half of
2004 compared to the first half of 2003 was attributable primarily 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 47% in the
second quarter of 2003 to 46% in the second quarter of 2004 and increased from
45% in the first half of 2003 to 50% in the first half of 2004. The decrease in
the second quarter of 2004 was primarily attributable to increased sales of
lower-margin OEM pool products compared to the second quarter of 2003. The
increase in the first half of 2004 compared to the first half of 2003was
primarily attributable to an increased percentage of licensing revenues in the
first half of 2004, which more than offset the lower margin associated with
increased sales of our OEM pool products. 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 remained
constant at $2.1 million for each of the second quarters of 2004 and 2003 and
decreased 4%, from $4.0 million in the first half of 2003 to $3.9 million in
the first half of 2004. The decrease in dollar amount for the first half of
2004 compared to the same period in 2003 was primarily attributable to unfilled
vacancies for sales positions 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 29% in the second quarter of 2003 to 20% in the second
quarter of 2004 and from 30% in the first half of 2003 to 21% in the first half
of 2004. The declines in selling and marketing expense as a percentage of
revenues were attributable primarily to our revenue growth. We plan to expand
our sales force with the hiring of additional sales personnel in the second
half of 2004. As a result, we expect our selling and marketing expenses to
increase in dollar amount during the balance of 2004. Research and Development Expenses.Research and development expenses increased
31%, from $612,000 in the second quarter of 2003 to $804,000 in the second
quarter of 2004 and 28%, from $1.3 million in the first half of 2003 to $1.6
million in the first half of 2004. These increases were primarily attributable
to increases in our research and development headcount based both in our Boston
and China offices. As a percentage of total revenues, research and development
expenses remained constant at 8% for each of the periods presented. 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 during 2004, as we devote
additional resources to developing new products and technologies and supporting
scheduled new product introductions in 2004. General and Administrative Expenses.General and administrative expenses
increased 68%, from $1.0 million in the second quarter of 2003 to $1.7 million
in the second quarter of 2004 and from $2.2 million in the first half of 2003
to $3.1 million in the first half of 2004. Payroll-related expenses increased
by $125,000 and $206,000 for the second quarter and first half of 2004,
respectively, compared to the same periods in the prior year, primarily due to
increased headcount and executive bonus accruals. In 2003, executive bonuses
were heavily weighted toward the second half of the year, consistent with our
business plan. Stock-based compensation charges, primarily associated with
options granted to members of our advisory board, increased by $264,000 and
$326,000 for the second quarter and first half of 2004, respectively, compared
to the same periods in the prior year. Stock-based compensation charges in the
second quarter of 2004 included $147,000 resulting from acceleration of the
remaining unvested portion of stock options granted to advisory board members.
Under our current accounting policy for stock-based compensation, we expect
future stock-based compensation charges to decline to a fixed amount of $8,000
per quarter through the second quarter of 2008. Outside legal expenses
increased by $123,000 and $141,000 for the second quarter and first half of
2004, respectively, compared to the same periods in the prior year, primarily
as a result of increased patent application activity and other general legal
matters. 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 the first half of 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 $18,000 in the
second quarter of 2003 to $46,000 in the second quarter of 2004 and from
$36,000 in the first half of 2003 to $77,000 in the first half 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 of Joint Venture.Equity in earnings of joint venture
increased from $11,000 in the second quarter of 2003 to $19,000 in the second
quarter of 2004 and decreased from $185,000 in the first half of 2003 to
$152,000 in the first half of 2004, as a result of fluctuation in net earnings
of Color Kinetics Japan caused primarily by fluctuation in its revenues during
these periods. We expect net earnings of Color Kinetics Japan to increase, and
our equity in earnings of joint venture to increase, in the second half of 2004
compared to the first half of 2004. 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 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. Liquidity and Capital Resources At June 30, 2004, we had $54.7 million in cash and equivalents, representing an
increase of $49.0 million compared to our $5.7 million balance of cash and
equivalents at December 31, 2003. During the first half of 2004, we generated $1.2 million of cash from operating
activities. During the first half of 2004, the improvement in our cash flows
from operating activities resulted primarily from our net income of $904,000,
offset partially by an increase in inventory levels to support more rapid
fulfillment of increasing order volumes, and higher accounts receivable that
resulted from increased sales. Net cash used in investing activities was $374,000 during the first half of
2004, 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. 12




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Net cash provided by financing activities was $48.3 million for the first half
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. No borrowings are
outstanding against our $3.0 million bank line of credit scheduled to expire in
September 2004. We presently do not intend to renew the bank line of credit. We anticipate that our cash and equivalents at June 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;
    
    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 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 $7.5
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 June 30, 2004, our investment in Color Kinetics Japan was
carried at $448,000. 13




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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. 
 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, infringe five of
the patents at issue in Super Visions declaratory judgment action. Proceedings
in our lawsuit against Super Vision were temporarily stayed for the purpose of
pursuing settlement negotiations, but these negotiations were not fruitful. Upon renewal of the proceedings, Super Visions lawsuit in Florida was removed
by the court to the United States District Court for the District of
Massachusetts, where our motion to consolidate the two cases is pending. The
cases are in the discovery phase, with a so-called Markman hearing on patent
claim interpretation scheduled for October 2004 and trial scheduled for January
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. With the permission of the court, we amended the complaint that we filed
against Super Vision in The United States District Court for the District of
Massachusetts to include requests for declarations that the High End patent is
not infringed by Color Kinetics, is invalid and is not enforceable. We are now
seeking to transfer Super Visions High End patent lawsuit to federal court in
Massachusetts as well. Since all of the claims are now before the court in
Massachusetts, we may request that the court adjust the discovery and trial
schedule. TIR Systems, Ltd. In April 2004, we commenced an action in the United States District Court for
the District of Massachusetts against TIR Systems, Ltd., a supplier of
traditional lighting products used primarily in corporate identity, commercial
and industrial applications that has recently begun to market solid-state
lighting products. In our complaint, we allege that solid-state lighting
products sold by the defendant infringe multiple patents owned by us, and we
seek injunctive relief, damages, and attorneys fees. TIR Systems has responded
to our complaint denying all liability and has asserted counterclaims seeking
declaratory judgment that certain of our patents are not infringed, are invalid
and are not enforceable. 
 Item 2. Changes in Securities and Use of Proceeds In connection with our initial public offering, we effected a 1-for-2 reverse
stock split of our common stock on May 28, 2004. In June 2004, in connection
with our initial public offering, our Seventh Amended and Restated Certificate
of Incorporation and our Second Amended and Restated By-Laws became effective. During the three months ended June 30, 2004, we granted options to purchase an
aggregate of 168,000 shares of our common stock to employees and directors
under our 1998 Incentive and Non-Statutory Stock Plan at exercise prices
ranging from $9.00 to $10.80 per share. During this period, 6,950 shares of
common stock were purchased pursuant to exercises of stock options. The
securities issued in the foregoing transactions were offered and sold in
reliance on exemptions from registration set forth in Section 4(2) of the
Securities Act of 1933, as amended, or regulations promulgated thereunder,
relating to sales by an issuer not involving a public offering, or an exemption
from registration under Rule 701 promulgated under the Securities Act. No
underwriters or placement agents were involved in the foregoing transactions. Our initial public offering of common stock was completed through our
Registration Statement on Form S-1 that was declared effective by the
Securities and Exchange Commission on June 22, 2004. In connection with the
offering, we sold 4,000,000 shares of common stock at an initial public
offering price of $10.00 per share, for an aggregate offering price of
$40,000,000. We received net proceeds from the offering of approximately $35.2 million,
after deducting the underwriting discount and other offering costs. In
connection with the initial public offering, all outstanding shares of our
preferred stock were converted into 11,069,031 shares of common stock. No
offering expenses were paid directly or indirectly to any of our directors or
officers (or their associates) or persons owning ten percent or more of any
class of our equity securities or to any other affiliates. We intend to use our net proceeds for working capital and other general
corporate purposes, which will include expansion of our sales and marketing
organizations and acceleration of our research and development efforts to
develop new technologies and products and enter new markets, and may also
include acquisitions of businesses, products and technologies that are
complementary to our business. Although we have from time to time evaluated
possible acquisitions, we currently have no commitments or agreements to make
any acquisitions and we cannot assure you that we will make any acquisitions in
the future. Until we use the net proceeds of the offering, we have invested the
net proceeds cash equivalents. 
 Items 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders During the three months ended June 30, 2004, we solicited the written consent
of our stockholders pursuant to Section 228 of the General Corporation Law of
the State of Delaware in connection with the following proposals: 14




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(a)
    
    To approve a one-for-two reverse stock split of our common stock;(b)
    
    To approve an amendment to Certificate of Incorporation to (i) authorize
100,000,000 shares of our common stock, (ii) authorize 5,000,000 shares of
our preferred stock, (iii) delete all references to our Series A through
Series F Convertible Preferred Stock, and (iv) effect certain other
changes relating to corporate governance, liability of our directors,
indemnification of our directors, officers and others, and other matters;(c)
    
    To approve our 2004 Stock Incentive Plan; and(d)
    
    To approve our 2004 Employee Stock Purchase Plan. The written consent was given by holders of 12,573,797 shares of our common
stock on an as converted basis, representing approximately 90.6% of the shares
outstanding and entitled to vote on such matters. 
 Item 5. Other Information None. 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits ExhibitNumber
    
    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 Incorporated32.2
    
    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 None. 
 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: August 16, 2004
    
    COLOR KINETICS INCORPORATED(Registrant)By:
    
    /s/    George G. MuellerGeorge G. Mueller
Chief Executive OfficerBy:
    
    /s/    David K. JohnsonDavid K. Johnson
Chief Financial Officer
 15