Management’s Discussion and Analysis of

You should read this discussion together with the financial statements and other financial information included in this prospectus.

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:

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.

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.

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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.

Factors and Trends That Have Affected Our Results of Operations

In reading our financial statements, you should be aware of the following factors and trends that our management believes are important in understanding our financial performance.

Gross Margins. The gross profit as a percentage of sales, or gross margin, that we realize from the sale of our products varies from product to product. Many factors can influence the gross margins that we are able to achieve, including:

We have taken many steps to improve our gross margins since 2001. We have restructured our sales and distribution efforts to concentrate our sales efforts on higher-margin products that can effectively be sold by our direct sales force and our distributors and manufacturer’s representatives. We have taken steps to reduce our costs of raw materials and components whenever possible. We have also acted to improve our supply chain management and quality control processes. We have also sought to expand our higher-margin OEM and licensing business. Maintaining and improving our gross margins is an important priority of management.

Changing Distribution and Sales Models. Since 2001, we have made a number of changes in the way in which we distribute and sell our products which have affected our results of operations. For example, until

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These changes in our distribution and sales models have significantly influenced our revenues, our gross margins and our selling and marketing expenses since 2001. Management will continue to devote substantial time and energy to ensuring that the sales models and channels of distribution that we employ are as efficient, and appropriate to our products, technology and markets, as possible.

2001 Restructuring and Cost Reduction Initiatives. In 2001, we implemented a restructuring plan to reorganize our operations and recorded a restructuring charge of approximately $3.9 million. The restructuring charge included an estimated loss of approximately $3.3 million for the minimum future rent commitment under our office facility lease due to the abandonment of a portion of the leased facility, as well as the write-off of approximately $592,000 of leasehold improvements related to that portion of the lease. These amounts are offset by estimated future sublease income. The restructuring charge also included severance costs of $41,000 related to the termination of eleven employees. The actions included in the restructuring plan were substantially completed during 2001, including the payment of all severance costs. The restructuring reserves recorded on our balance sheet at December 31, 2002 and 2003 and March 31, 2004 represent amounts due under leases for abandoned space, net of anticipated subleasing income.

The following details the accrued restructuring reserves and related activity in these reserves through March 31, 2004:

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Manufacturing Outsourcing Initiatives. We outsource our manufacturing operations to contract manufacturers, which supply the facilities, labor and raw materials (other than LEDs and certain other key components) necessary to manufacture our finished products. Prior to 2002, we used contract manufacturers located primarily in North America and Ireland. As a strategic initiative to reduce costs, improve quality and increase the efficiency of our supply chain, we have consolidated our contract manufacturing with a small number of manufacturers in The People’s Republic of China. Most of our products are now manufactured in China.

We opened an office in Shenzhen, China in early 2003 to facilitate the management of our supply relationships through the use of on-site personnel. We intend to devote additional resources in 2004 to the expansion of our manufacturing support operations in China.

Challenges. In our business, we face a number of risks and challenges, many of which we describe in greater length under “Risk Factors” beginning on page 7. 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:

Critical Accounting Estimates

Our significant accounting policies are summarized in Note 2 to our consolidated financial statements included elsewhere in this prospectus. Some of our accounting policies require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. The following items are those which, in our opinion, involve the most significant application of judgment (often involving complex estimation) and which could, if different judgments were made, materially affect our reported results of operations:

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:

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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, all 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 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

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Recent Accounting Pronouncements

In May 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards, or SFAS, No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain freestanding financial instruments, such as outstanding redeemable convertible preferred stock, and requires that a company classify instruments within the scope of the standard as either debt or equity, depending on the underlying features of the instrument. We adopted SFAS No. 150 as of January 1, 2004. There was no impact of adoption.

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Results of Operations

The following table sets forth certain statement of operations data derived from our consolidated financial statements included elsewhere in this prospectus as a percentage of our total revenue (or, in the case of our cost of lighting systems revenue and cost of OEM and licensing revenue, as a percentage of the related revenue) for each of the periods presented:

Three months ended March 31, 2004 compared to three months ended March 31, 2003

Revenues. Total revenues increased 35.1%, from $6.1 million in the first quarter of 2003 to $8.2 million in the first quarter of 2004.

Lighting systems revenues increased 18.1%, from $5.7 million in the first quarter of 2003 to $6.8 million in the first quarter of 2004. Lighting systems revenues in North America increased 27.5%, from $3.3 million in the first quarter of 2003 to $4.2 million in the first quarter of 2004. Lighting systems revenues in markets outside North America increased 4.7%, from $2.4 million in the first quarter of 2003 to $2.6 million in the first quarter of 2004.

The increase in lighting systems revenues was 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 a $399,000 decline in sales of branded consumer products, 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, as well as a $356,000 decline in sales in the Japanese market to our joint venture, Color Kinetics Japan.

Our OEM and licensing revenues increased 309.6%, from $356,000 in the first quarter of 2003 to $1.5 million in the first quarter of 2004. The increase was primarily attributable to a $512,000 increase in sales of our OEM pool products, due primarily to a product launch by an OEM customer in late 2003 and

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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 20.3% of total revenues for the first quarter of 2003 to 10.7% of total revenues in the first quarter of 2004. We expect quarterly revenues from sales to Color Kinetics Japan to increase, particularly in the last half of 2004, in comparison to those recorded in the first quarter of 2004.

Revenues derived from sales of lighting systems products to Color Kinetics Distribution, Inc., a distributor unaffiliated with us that fulfills smaller orders (generally those having a value less than $10,000) in North America, were 13.4% of total revenues in the first quarter of 2004. No other customer accounted for more than 10.0% of our total revenues in the first quarter of 2003 or 2004.

Gross Profit. Total gross profit increased from $2.9 million in the first quarter of 2003 to $4.2 million in the first quarter of 2004. The dollar increase was attributable primarily to increased sales, to improved profit margins on our lighting systems products and to increased licensing revenues that more than offset lower margins on our OEM pool and spa products. Gross profit as a percentage of revenues, or gross margin, increased from 47.3% in the first quarter of 2003 to 50.7% in the first quarter of 2004.

Gross margin from lighting systems increased from 47.8% in the first quarter of 2003 to 50.2% in the first quarter of 2004. This increase was attributable primarily to reduced raw materials and product costs and to a more favorable product mix, in part reflecting our decision to discontinue direct distribution of our lower-margin consumer products.

Gross margin from our OEM and licensing business increased from 40.4% in the first quarter of 2003 to 53.3% in the first quarter of 2004. This increase was primarily attributable to shifts in revenue mix, with an increased percentage of licensing revenues in the first quarter of 2004 as compared with the first quarter of 2003. The increase in higher-margin licensing revenues in the first quarter of 2004 more than offset the lower gross margins associated with increased sales of our OEM pool products. We expect the gross profit for our OEM and licensing business to 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 decreased 6.5%, from $2.0 million in the first quarter of 2003 to $1.8 million in the first quarter of 2004, representing 32.1% of total revenues in the first quarter of 2003 and 22.2% of total revenues in the first quarter of 2004. The decrease in dollar amount was primarily attributable to the elimination of $143,000 in selling expenses previously supporting the sale of our branded consumer products. Also, payroll-related selling expenses decreased $261,000, primarily due to unfilled vacancies in several senior sales management and international sales positions that were occupied during the first quarter of 2003, as well as elimination and consolidation of other sales positions. Partially offsetting these decreases in expenses were a $95,000 increase in payroll and other expenses primarily for our lighting systems product management program, a $68,000 increase in marketing expenses, primarily related to our participation in trade shows, and a $49,000 increase in commissions payable to manufacturer’s representatives, which was attributable to higher sales volumes. The decline in selling and marketing expense as a percentage of revenue was attributable primarily to our revenue growth. We are currently in the process of expanding our worldwide sales force, including the recruitment of two senior sales management positions. 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 24.7%, from $642,000 in the first quarter of 2003 to $800,000 in the first quarter of 2004, representing 10.6% of total

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General and Administrative Expenses. General and administrative expenses increased 16.5%, from $1.2 million in the first quarter of 2003 to $1.4 million in the first quarter of 2004, representing 19.4% of total revenues in the first quarter of 2003 and 16.7% of total revenues in the first quarter of 2004. Payroll-related expenses increased by $160,000, primarily due to a $111,000 increase in executive bonus accruals in the first quarter of 2004 in comparison with the corresponding period in 2003. In 2003, executive bonuses were heavily weighted toward the second half of the year, consistent with our business plan. Also contributing to the increase in 2004 was approximately $61,000 of stock-based compensation charges primarily associated with options granted to members of our advisory board, which were partially offset by $12,000 of reductions in miscellaneous headcount-related expenses. Legal expenses related to patent prosecution and litigation remained essentially unchanged from quarter to quarter. However, we expect legal expenses to increase in subsequent quarters, primarily as a result of increased activity in legal actions commenced by us to enforce our patents. The decline as a percentage of revenue was attributable to our revenue growth. We expect our general and administrative expenses to increase in dollar amount during 2004 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 quarter 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 $16,000 in the first quarter of 2003 to $31,000 in the first quarter of 2004, due to higher average cash and cash equivalent balances in the first quarter of 2004. There was no interest expense in the first quarter of 2004, because all equipment notes payable were fully paid in 2003.

Equity in Earnings of Joint Venture. Equity in earnings of joint venture was $133,000 in the first quarter of 2004, compared with $174,000 in the first quarter of 2003. The three months ended March 31, 2004 were the second most profitable quarter in the history of Color Kinetics Japan.

Provision for Income Taxes. We recorded no provision for income tax in the first quarter of 2004 due to our net loss carryforward position. At March 31, 2004, we had net loss carryforwards available to offset future taxable income of $30.4 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.

2003 Compared to 2002

Revenues. Total revenues increased 43.1%, from $20.2 million in 2002 to $28.8 million in 2003.

Lighting systems revenues increased 45.2%, from $18.0 million in 2002 to $26.2 million in 2003. This increase is attributable primarily to increased market acceptance of our intelligent solid-state lighting systems. We believe demand for our lighting systems was also stimulated by price reductions that we implemented in the second half of 2002 to reflect savings in materials costs and accelerate acceptance of our products. The addition of new products to our product line and expansion of our manufacturer’s representative network also contributed to the revenue increase. These factors more than offset a $1.7 million decline in sales of branded pool and spa and consumer products, reflecting our decision to

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Our OEM and licensing revenues increased 24.6%, from $2.1 million in 2002 to $2.7 million in 2003. The increase was attributable to an increase in the number of our OEM and licensing arrangements and to the commencement of larger volume purchases by certain of our OEM and licensing customers as a result of their commercial introduction of products incorporating our OEM products and technology. On December 31, 2003, we had agreements with 17 OEM and licensing customers that we believe were actively engaged in developing or marketing products incorporating our technology, compared with eight such customers on December 31, 2002. OEM and licensing revenues attributable to pool and spa products, including products that we formerly sold directly as lighting systems products under the Color Kinetics brand, was $1.3 million in 2002 and $1.2 million in 2003.

Revenues derived from sales of lighting systems and OEM products to Color Kinetics Japan, our joint venture partner that distributes our products in Japan, increased from 16.7% of total revenues in 2002 to 17.4% of total revenues in 2003. No other customer accounted for more than 10% of our total revenues for either 2002 or 2003.

Gross Profit. Total gross profit increased from $7.5 million in 2002 to $14.1 million in 2003. The dollar increase is attributable primarily to increased sales, and also to improved gross margins. Gross profit as a percentage of revenues, or gross margin, increased from 37.2% in 2002 to 48.8% in 2003.

Gross margin from lighting systems increased from 37.8% in 2002 to 49.3% in 2003. This increase is attributable primarily to an improved product mix, reflecting our decision to discontinue direct distribution of our lower-margin pool and consumer products, as well as to reduced raw materials and product costs, improved freight and inventory management programs, stable manufacturing support expenses and reduced warranty expense as a result of improved product quality. Charges for inventory obsolescence decreased by $672,000 in 2003, compared to 2002, due primarily to improvements in our supply chain management and manufacturing processes. In addition, our provision for warranty costs decreased by $418,000 compared to 2002, due to general improvements in product quality and also to resolution in early 2003 of a warranty issue relating to a specific installation, for which we had recorded a substantial provision in 2002.

Gross margin from our OEM and licensing business increased from 32.0% in 2002 to 43.8% in 2003. This increase is primarily attributable to shifts in revenue mix, with an increased percentage of higher-margin licensing revenues and fees for engineering services in 2003 as compared with 2002. We expect the gross profit for our OEM and licensing business to vary depending on the relative mix of OEM product revenues and licensing revenues.

Selling and Marketing Expenses. Selling and marketing expenses decreased 3%, from $7.8 million in 2002 to $7.6 million in 2003, representing 38.9% of total revenues in 2002 and 26.4% of total revenues in 2003. The decrease in dollar amount is attributable primarily to the elimination of $350,000 of selling expenses which previously supported the sale of our branded consumer products, pool lighting products and spa lighting products. We decided in late 2002 (in the case of our pool and spa products) and early 2003 (in the case of our branded consumer products) that we would no longer market these products directly, and would instead distribute these through our OEM and licensing channels. Sales and marketing expense associated with our OEM and licensing business decreased by $117,000, due primarily to a vacancy in a senior sales position for which we are currently recruiting. These decreases were partly offset by increases in selling expenses related to our lighting systems products, attributable in large part to expansion of our international sales force. These included a $304,000 increase in payroll-related expense and a $64,000 increase in travel and other related expenses, which were partly offset by a $53,000 reduction in variable marketing expenses. Commissions payable to manufacturer’s representatives also increased by $162,000, reflecting our increasing reliance on this indirect channel. The decline in selling and marketing expenses as a percentage of revenue was attributable primarily to our revenue growth.

Research and Development Expenses. Research and development expenses decreased 12.7%, from $2.8 million in 2002 to $2.5 million in 2003, representing 14.0% of total revenues in 2002 and 8.5% of total

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General and Administrative Expenses. General and administrative expenses increased 2.5%, from $4.5 million in 2002 to $4.6 million in 2003, representing 22.3% of total revenues in 2002 and 16.0% of total revenues in 2003. Outside legal expenses were $936,000 in 2002 and $929,000 in 2003. Although total legal expenses remained essentially unchanged, patent and trademark filing fees and patent prosecution related spending decreased by $107,000, primarily as a result of the timing of when United States patents and patent applications are processed and, to a lesser extent, a more selective patent prosecution strategy in international markets and a reduction in trademark filing activity. Offsetting this decrease were increased legal expenses for litigation as a result of the pending proceedings and increased legal expenses on general corporate matters. Payroll-related expenses increased by $141,000 primarily as a result of higher bonus expenses directly attributable to our improved operating performance. Other increases included $74,000 in non-cash compensation charges primarily related to stock options awarded to members of the Company’s advisory board, $67,000 in executive travel and $43,000 in bank charges primarily related to an increased number of secured letters of credits that were required as collateral for orders with one of our contract manufacturers. Offsetting these charges were reductions of $109,000 for executive recruiting, $64,000 for outside contractors and support services and $37,000 for the lease of a corporate apartment that was terminated in 2003. The decline as a percentage of revenue was attributable to our revenue growth. We expect our general and administrative expenses to increase in dollar amount during 2004 to support our expanding operations and the additional reporting and other obligations associated with our being a public company. Our legal expenses related to patent litigation may also increase in 2004, depending upon the level of activity in the several patent infringement lawsuits in which we are involved.

Restructuring Expenses. The $161,000 of restructuring expenses in 2003 is 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 decreased from $156,000 in 2002 to $50,000 in 2003, due to lower average cash and cash equivalent balances in 2003. Interest expense decreased from $31,000 in 2002 to $3,500 in 2003, due to a lower outstanding balance on our equipment notes payable in 2003.

Equity in Earnings of Joint Venture. Equity in earnings of joint venture decreased from $85,000 in 2002 to $3,000 in 2003, due to unrealized losses on open foreign exchange forward contracts that were purchased by Color Kinetics Japan in order to hedge anticipated dollar-denominated purchases. These contracts were adversely affected by the decline in the United States dollar in relation to the yen during the second half of 2003. This unrealized loss more than offset improved profits on operations of the joint venture.

Provision of Income Taxes. We recorded no provision for income tax in either 2002 or 2003, due to our generation of tax losses in both years, for which no income statement benefit was recorded as a result of uncertainty about our ability to utilize these losses on a tax return. 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 some or all of the allowances provided, which would have the effect of reducing or eliminating our provision for income tax.

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2002 Compared to 2001

Revenues. Total revenues increased 21.7%, from $16.6 million in 2001 to $20.2 million in 2002.

Our lighting systems revenues increased 19.6%, from $15.1 million in 2001 to $18.0 million in 2002. The increase was primarily attributable to increased market acceptance of our products and, to a lesser extent, to increased demand stimulated by price reductions in the second half of 2002. In addition, sales of our branded consumer and pool and spa products increased from $1.8 million in 2001 to $2.7 million in 2002. In 2002 we began the transition from marketing consumer and pool and spa products directly as Color Kinetics branded products to distributing them through our OEM and licensing programs.

Our OEM and licensing revenues increased 43.3%, from $1.5 million in 2001 to $2.1 million in 2002. In 2001, all but $100,000 of our OEM and licensing revenues were attributable to the pool and spa market. In 2002, OEM and licensing revenues attributable to the pool and spa market decreased 5.7%, to $1.3 million, while OEM and licensing revenues from markets other than the pool and spa market increased from $122,000 to $843,000, as we signed new OEM agreements and certain OEM customers introduced products in their markets. On December 31, 2002, we had agreements with eight OEM and licensing customers that we believe were actively engaged in developing or marketing products incorporating our technology, compared with four such customers on December 31, 2001. Sales to Color Kinetics Japan increased from 12.5% of total revenues for 2001 to 16.7% of total revenues in 2002. No other customer accounted for more than 10% of our total revenues for either 2001 or 2002.

Gross Profit. Gross profit increased 50.0%, from $5.0 million in 2001 to $7.5 million in 2002. This increase is attributable to increased sales of products and improved gross margins. Gross margin increased from 30.2% in 2001 to 37.2% in 2002.

Gross margin from lighting systems increased from 30.0% in 2001 to 37.8% in 2002. This increase is primarily attributable to reduced raw materials and product costs, reduced manufacturing support expenses of $213,000 and reduced rework expenses of approximately $85,000, partially offset by increased provisions for estimated future warranty costs of $654,000, including $395,000 for a warranty issue related to a specific installation, which was ultimately resolved in early 2003. Charges for inventory obsolescence increased by $320,000 in 2002 as compared to 2001. This increase was a result of a provision of approximately $581,000 that was recorded for defective and unusable product that was manufactured for us and held in inventory throughout 2002. Because we did not have to pay for this product, the amounts owed to the vendor were used to offset this increased obsolescence provision. This inventory was ultimately scrapped in 2003 and written off against the reserve that was established in 2002. Gross margin from our OEM and licensing business increased from 31.8% in 2001 to 32.0% in 2002. This slight increase was attributable to reduced raw materials and product costs offset by unfavorable margins related to product mix.

Selling and Marketing Expenses. Selling and marketing expenses decreased 16.0%, from $9.3 million in 2001 to $7.8 million in 2002, representing 56.4% of total revenues in 2001 and 38.9% of total revenues in 2002. The decrease in dollar amount is primarily attributable to our decision to reorient our lighting systems sales efforts from a direct sales model to an indirect sales model more heavily reliant on third party manufacturer’s representatives, and also to more aggressive management of variable expenses associated with the sales and marketing processes. These decreases were offset in part by increased expenditures related to sales and marketing of our branded consumer products, pool products and spa products and to establishment of a sales and marketing organization for our OEM and licensing products. Payroll-related selling expenses for our lighting systems products were reduced by $1.0 million, due primarily to reductions in the number of highly compensated direct sales personnel and implementation of new, performance-oriented variable sales compensation plans. Travel and other expenses associated with sales of lighting systems were reduced by $675,000 and variable marketing expenses for lighting systems products were reduced by $444,000, through tighter expense management. These reductions were offset in part by a $432,000 increase in commissions payable to manufacturer’s representatives, and by a $403,000 increase in sales and marketing expenses associated with our branded consumer products, which had been planned before our decision to discontinue direct marketing of these products in 2003. Sales and marketing

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Research and Development Expenses. Research and development expenses were $2.8 million for both 2001 and 2002, representing 17.0% of revenues in 2001 and 14.0% of revenues in 2002. Payroll-related expenses declined by $226,000 as a result of cost reductions consistent with our goal of improving operational performance. This was offset by an increase of $249,000 in product development costs, including expenses directly related to branded consumer, pool and spa products. The decline of research and development expenses as a percentage of revenues was attributable to our revenue growth.

General and Administrative Expenses. General and administrative expenses increased 21.2%, from $3.7 million in 2001 to $4.5 million in 2002, representing 22.4% of total revenues in 2001 and 22.3% of total revenues in 2002. The higher dollar amount was attributable to an increase of $524,000 in additional payroll-related expenses, including the full year salary and bonus of a senior executive who was hired in September 2001 and increased bonuses for other executive management and other employees as a result of our improved performance, an increase of $132,000 in outside contractor fees related to improvements to our information systems and an increase of $67,000 in our allowance for doubtful accounts that was provided for as a result of our increased sales levels in 2002. Outside legal expenses were $893,000 in 2001 and $936,000 in 2002. Though total legal expenses remained essentially unchanged, patent and trademark filing fees and patent prosecution-related spending increased by $148,000, primarily as a result of increased filing and prosecution-related activity. Patent litigation expenses were $100,000 in 2002 as a result of pending legal proceedings. There were no litigation expenses in 2001. Partially offsetting these increases was a reduction of $206,000 in general corporate legal expenses in comparison with 2001, when we incurred substantial expense in connection with the formation of Color Kinetics Japan. The decline as a percentage of revenues was attributable to our revenue growth.

Restructuring Expenses. Restructuring expenses were $3.9 million in 2001, while no restructuring expenses were recorded in 2002. The charge consisted primarily of the estimated amount of future lease payments for vacated space, net of estimated sublease income, of $3.3 million, along with a $592,000 write off of leasehold improvements related to the vacated space. The charge also included estimated severance costs of $41,000 associated with the termination of eleven employees. Changes in the amounts accrued for the restructuring in 2001 (other than the initial charge) and in 2002 consisted solely of payments made in connection with the lease commitments, net of cash received for sublease income.

Interest Income (Expense), Net. Interest income increased from $110,000 in 2001 to $156,000 in 2002 due to higher cash balances in 2002. Interest expense decreased from $62,000 in 2001 to $31,000 in 2002, due to a lower outstanding balance on our equipment notes payable in 2002 and no borrowing requirements under our working capital line of credit during that year.

Equity in Earnings of Joint Venture. Equity in earnings of joint venture increased 249.1%, from $24,000 in 2001 to $85,000 in 2002. This increase is attributable to increased profitability of Color Kinetics Japan.

Provision of Income Taxes. We recorded no provisions for income tax in either 2002 or 2001. This lack of provision was attributable to our generation of continued tax losses in both years, for which no income statement benefit was recorded due to uncertainty about our ability to utilize these losses for tax purposes.

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Selected Quarterly Results of Operations

The following table sets forth certain unaudited financial information for each of the nine quarters ended March 31, 2004:

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 by 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:

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For example, sales of our architectural lighting systems products have historically been lower in the last quarter of each year, due to the impact of the holidays and winter weather on construction schedules and to deferral of purchases in certain market segments, such as the retail segment, during the holiday retail season. Our lighting systems revenue includes sales of our branded consumer products, which for the most part we no longer sell directly, but distribute through our OEM and licensing channels. However, our light system sales in the third quarter of 2002 were favorably affected by our sale into retail channels of approximately $1.3 million of our Sauce brand consumer products.

Information concerning our lighting systems revenues excluding sales of our branded consumer products for each of the nine quarters ended March 31, 2004 is set forth below. We believe information concerning our lighting systems revenues excluding sales of these products is useful, as it enables us to better evaluate the pattern of sales of the lighting systems products that we will continue to distribute directly.

Gross profit in the fourth quarter of 2002 was adversely affected by high air freight costs associated with inventory shortages and supply chain management issues, and also due to adjustments to inventory reserves.

Our equity in earnings of our Color Kinetics Japan joint venture was adversely affected during the third and fourth quarters of 2003 by the recognition by Color Kinetics Japan of unrealized losses associated with forward currency contracts entered into by Color Kinetics Japan to hedge anticipated dollar-denominated purchases, which were adversely affected by significant weakening of the United States dollar in relation to the yen during the second half of 2003.

If, due to the factors described above and other factors, our quarter-to-quarter operating results fluctuate in future periods, or fall short of our expectations or those of securities analysts or investors, the price of our common stock could be adversely affected.

Liquidity and Capital Resources

Since our inception, we have financed our operations primarily through sales of our equity securities. We have received total net proceeds of $61.1 million from private placements of our securities. In addition, we have occasionally used borrowings under bank line of credit arrangements. At March 31, 2004, we had no borrowings under our current bank facility, which expires on September 1, 2004 and provides for borrowings up to $3.0 million dependent on the level of qualifying receivables, as defined in the agreement. Any borrowings are secured by substantially all of our assets. The loan agreement contains certain covenants with which we have to comply, including maintenance of defined levels of liquidity and minimum quarterly net revenues. Under the loan agreement, we would be required to obtain the consent of the bank prior to obtaining debt financing from any lender other than the bank. In January and February 2004, we raised $13.0 million in cash, through the issuance in a private placement of additional shares of preferred stock. As of March 31, 2004, we had $18.3 million in cash and equivalents. We

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Operating Activities. Net cash used in operations was $11.4 million in 2001, $5.4 million in 2002, $1.4 million in 2003 and $236,000 for the quarter ending March 31, 2004. During 2002, the improvement in our cash flows from operating activities resulted primarily from decreasing losses and reduced inventory levels, attributable to improved inventory management programs, offset partially by increased levels of accounts payable, accrued expenses and restricted cash necessary to support the growth of the business. During 2003, the improvement in our cash flows from operating activities resulted primarily from decreasing losses, 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.

Investing Activities. Net cash used in investing activities was $1.3 million in 2001, $500,000 in each of 2002 and 2003 and $143,000 for the quarter ending March 31, 2004. Net cash used for investing activities in 2001 included a $165,000 initial investment in Color Kinetics Japan and included $592,000 of leasehold improvements for leased space that was subsequently written off in that same year as part of our restructuring plan. For 2002, 2003 and for the quarter ending March 31, 2004, net cash used in investing activities reflected purchases of property and equipment primarily related to the general purchases of computers and information system upgrades as well as tooling and test equipment related to our product development efforts. Our capital expenditures budget for 2004 is approximately $1.1 million, of which approximately $800,000 is targeted towards product development and testing, including the tooling costs associated with new products. The remaining budget includes capital expenditures allocated for the purchase of a new trade show booth as well as other general computer and information system upgrades.

Financing Activities. Net cash provided by financing activities was $18.4 million in 2001, $5.2 million in 2002 and $13.0 million for the quarter ending March 31, 2004. During 2001, net cash provided by financing activities was primarily attributable to proceeds from the issuance of preferred stock and borrowings under our line of credit. During 2002, net cash provided by financing activities was primarily attributable to proceeds from the issuance of preferred stock, partially offset by the payment of the outstanding balance of our line of credit. In 2003, net cash used in financing activities was $100,000 and reflected the payments made under an equipment note payable, offset partially by proceeds received from the exercise of common stock options. For the quarter ending March 31, 2004, net cash provided by financing activities was attributable to the proceeds from the issuance of our Series F preferred stock.

Summary of Contractual Obligations. We lease our facilities under non-cancelable operating leases expiring through August 31, 2007, with a five-year renewal option. Future minimum lease payments as of December 31, 2003, including amounts relating to space we vacated, are set forth in the table below. We entered into a sublease through August 31, 2003 relating to the vacated space pursuant to which we expect to receive sublease income which will partially offset the above lease obligations.

In 2003, we entered into an agreement with a raw materials supplier under which we have a minimum purchase obligation of $365,000.

Set forth below is information concerning our known contractual obligations as of December 31, 2003 that are fixed and determinable.

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Except as set forth above, as of December 31, 2003, we had no long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or other long-term liabilities required to be reflected on our balance sheet.

Inflation. Inflation has not had a significant impact on our results of operations and is not expected to have a significant impact in the foreseeable future.

Quantitative and Qualitative Disclosures about Market Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At March 31, 2004, we did not have any balances outstanding under our bank line of credit arrangement, and thus had no exposure to interest rate risk.

We derived approximately 38% of our revenues from sales outside the United States in 2003. We have limited foreign currency risk on certain operating expenses such as salaries and overhead costs of our foreign operations and the small amount of cash maintained by these operations. However, we believe this exposure is limited. The risks of our international operations are mitigated to a large degree as currently all of our sales are denominated in U.S. dollars and, accordingly, we are not exposed to foreign currency risk with respect to our accounts receivable.

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 $8.1 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 March 31, 2004, our investment in Color Kinetics Japan was carried at $439,000.

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