ENTERASYS NETWORKS INC /DE/ - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


[X]		QUARTERLY REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended September 28, 2002


[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-10228

Enterasys Networks, Inc.
(Exact name of registrant as specified in its charter)


Delaware		04-2797263
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

35 Industrial Way
Rochester, New Hampshire 03866
(603) 332-9400

(Address, including zip code, and telephone number, including area code, of
registrant’s principal executive offices)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12-2 in the Exchange Act) Yes [X] No [ ]

As of February 12, 2003, there were 201,966,247 shares of the Enterasys common stock, $0.01 par value, outstanding.

Explanatory Statement

This quarterly report on Form 10-Q contains consolidated financial statements for the quarterly period ended September 29, 2001 which have previously been restated. On November 26, 2002, we filed our transition report on Form 10-K for the ten-month transition period ended December 29, 2001. The Form 10-K contained restated consolidated financial statements for the fiscal year ended March 3, 2001, the fiscal quarters within that fiscal year and the first three fiscal quarters within the ten-month transition period ended December 29, 2001. On January 16, 2003, we filed our quarterly report on Form 10-Q for the three months ended March 30, 2002, which contained restated consolidated financial statements for the three months ended June 2, 2001; and on January 30, 2003, we filed our quarterly report on Form 10-Q for the three months and six months ended June 29, 2002, which contained restated consolidated financial statements for the three and six months ended September 1, 2001.

TABLE OF CONTENTS


PART I. Financial Information
	Item 1. Consolidated Financial Statements
		Consolidated Balance Sheets at September 28, 2002, December 29, 2001 and September 29, 2001
		Consolidated Statements of Operations for the three and nine months ended September 28, 2002 and the three and seven months ended September 29, 2001
		Consolidated Statements of Cash Flows for the nine months and seven months ended September 28, 2002 and September 29, 2001, respectively
		Notes to the Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. Other Information
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
	Signatures
	Chief Executive Officer Certification
	Chief Financial Officer Certification
Ex-99.1 Certification of Chief Executive Officer
Ex-99.2 Certification of Chief Financial Officer

TABLE OF CONTENTS


			Page

PART I. Financial Information
	Item 1. Consolidated Financial Statements
		Consolidated Balance Sheets at September 28, 2002, December 29, 2001 and September 29, 2001		3
		Consolidated Statements of Operations for the three and nine months ended September 28, 2002 and the three and seven months ended September 29, 2001		4
		Consolidated Statements of Cash Flows for the nine months and seven months ended September 28, 2002 and September 29, 2001, respectively		5
		Notes to the Consolidated Financial Statements		6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
	Item 3. Quantitative and Qualitative Disclosures About Market Risk			40
	Item 4. Controls and Procedures			41
PART II. Other Information
	Item 1. Legal Proceedings			43
	Item 6. Exhibits and Reports on Form 8-K			44
	Signatures			45
	Chief Executive Officer Certification			46
	Chief Financial Officer Certification			47

PART I — FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements

ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(unaudited)


				September 28,			December 29,			September 29,
				2002			2001			2001

(In thousands, except share and per share amounts)										(restated)
ASSETS
Current assets:
	Cash and cash equivalents			$	116,283		$	114,800		$	65,780
	Marketable securities				63,423			47,532			67,981
	Accounts receivable, net				47,473			67,698			101,750
	Inventories, net				79,807			118,214			146,256
	Income tax receivable				26,246			—			—
	Prepaid expenses and other current assets				29,449			25,368			135,015
	Current portion of notes receivable				1,000			15,000			14,152
	Assets of discontinued operations				—			103,415			138,277

		Total current assets			363,681			492,027			669,211
Long-term portion of notes receivable					—			—			7,125
Restricted cash, cash equivalents and marketable securities					31,878			27,882			26,063
Long-term marketable securities					69,619			63,920			83,806
Investments					46,279			63,684			105,418
Property, plant and equipment, net					47,928			56,924			63,012
Intangible assets, net					39,070			45,601			159,401

		Total assets		$	598,455		$	750,038		$	1,114,036

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	31,074		$	74,764		$	83,184
	Accrued expenses				89,351			78,162			97,408
	Deferred revenue				61,143			77,376			60,827
	Customer advances and billings in excess of revenues				7,377			56,115			77,734
	Income taxes payable				44,143			37,970			53,562
	Liabilities of discontinued operations				—			33,316			41,301

			Total current liabilities		233,088			357,703			414,016
Deferred income taxes					—			—			915

			Total liabilities		233,088			357,703			414,931
Commitments and contingencies
Contingent redemption value of common stock put options					—			842			842
Redeemable convertible preferred stock, $1.00 par value; 65,000 shares of Series D and 25,000 shares of Series E were designated, issued and outstanding at September 28, 2002, December 29, 2001 and September 29, 2001 (aggregate liquidation preference of Series D and E at September 28, 2002, $70,618 and $27,164, respectively; at December 29, 2001, $68,542 and $26,356, respectively; and at September 29, 2001, $67,636 and $26,017, respectively)					93,315			61,789			74,390
Stockholders’ equity:
	Undesignated preferred stock, $1.00 par value; authorized 1,859,000 shares; none outstanding				—			—			—
	Common stock, $0.01 par value; authorized 450,000,000 shares; issued 204,940,728, 202,941,544 and 196,488,542 shares, respectively				2,050			2,029			1,965
	Additional paid-in capital				1,176,001			1,141,089			1,117,346
	Accumulated deficit				(844,796	)		(748,199	)		(429,865	)
	Unearned stock-based compensation				(264	)		(2,802	)		(3,841	)
	Treasury stock, at cost (3,053,201 common shares at September 28, 2002 and December 29, 2001 and 2,653,201 common shares at September 29, 2001)				(64,890	)		(64,890	)		(62,403	)
	Accumulated other comprehensive income				3,951			2,477			671

Total stockholders’ equity					272,052			329,704			623,873

Total liabilities, redeemable convertible preferred stock and stockholders’ equity				$	598,455		$	750,038		$	1,114,036

See accompanying notes to consolidated financial statements.

ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)


											Nine months			Seven months
					Three months ended						ended			ended
					September 28,			September 29,			September 28,			September 29,
(In thousands, except per share amounts)					2002			2001			2002			2001

								(restated)						(restated)
Net revenue:
		Product			$	89,812		$	23,859		$	259,883		$	159,337
		Services				32,919			41,409			103,676			95,955

			Total revenue			122,731			65,268			363,559			255,292

Cost of revenue:
		Product				52,059			88,672			162,506			186,187
		Services (a)				11,613			15,867			33,553			32,241

			Total cost of revenue			63,672			104,539			196,059			218,428

				Gross margin		59,059			(39,271	)		167,500			36,864
Operating expenses:
		Research and development (a)				19,696			24,128			64,988			52,257
		Selling, general and administrative (a)				60,400			95,736			182,196			201,308
		Amortization of intangible assets				2,177			8,731			6,531			22,511
		Stock-based compensation				585			27,912			2,538			29,909
		Special charges				10,735			34,765			30,974			34,765

			Total operating expenses			93,593			191,272			287,227			340,750

				Loss from operations		(34,534	)		(230,543	)		(119,727	)		(303,886	)
Interest income, net						2,144			4,779			6,201			13,324
Other income (expense), net						(6,113	)		(33,498	)		(37,774	)		(13,286	)

	Loss from continuing operations before income taxes and cumulative effect of a change in accounting principle					(38,503	)		(259,262	)		(151,300	)		(303,848	)
Income tax benefit						(10,364	)		(6,461	)		(76,100	)		(4,920	)

	Loss from continuing operations before cumulative effect of a change in accounting principle					(28,139	)		(252,801	)		(75,200	)		(298,928	)
Discontinued operations:
		Operating loss (net of tax expense of $4,511 and $282, respectively)				—			(34,557	)		—			(56,401	)
		Loss on disposal (net of tax benefit of $0)				—			(41,501	)		(11,700	)		(41,501	)

			Loss from discontinued operations			—			(76,058	)		(11,700	)		(97,902	)
Cumulative effect of a change in accounting principle (net of tax expense of $4,950)						—			—			—			7,741

		Net loss				(28,139	)		(328,859	)		(86,900	)		(389,089	)
Accretive dividend and accretion of discount on preferred shares						(3,325	)		(3,110	)		(9,697	)		(7,208	)

		Net loss available to common shareholders			$	(31,464	)	$	(331,969	)	$	(96,597	)	$	(396,297	)

Basic and diluted loss per common share:
		Loss from continuing operations available to common shareholders			$	(0.16	)	$	(1.33	)	$	(0.42	)	$	(1.61	)

		Loss from discontinued operations			$	—		$	(0.40	)	$	(0.06	)	$	(0.51	)

		Cumulative effect of a change in accounting principle			$	—		$	—		$	—		$	0.04

		Net loss available to common shareholders			$	(0.16	)	$	(1.73	)	$	(0.48	)	$	(2.08	)

Weighted average number of basic and diluted common shares outstanding						201,888			192,195			201,452			190,377

(a) Excludes non-cash, stock-based compensation expense as follows:
			Cost of revenue:
				Services	$	—		$	2,292		$	—		$	2,292

			Total cost of revenue			—			2,292			—			2,292
			Research and development			585			10,696			2,538			12,693
			Selling, general and administrative			—			14,924			—			14,924

				Total stock-based compensation	$	585		$	27,912		$	2,538		$	29,909

See accompanying notes to consolidated financial statements.

ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)


			Nine months			Seven months
			ended			ended
(In thousands)			September 28, 2002			September 29, 2001

						(restated)
Cash flows from operating activities:
	Net loss		$	(86,900	)	$	(389,089	)
	Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
		Loss from discontinued operations		11,700			97,902
		Depreciation and amortization		32,364			43,477
		Provision for losses on accounts receivable		816			4,874
		Provision for excess and obsolete inventory		322			42,341
		Deferred income taxes		—			(12,117	)
		Stock-based compensation		2,538			29,909
		Net realized gain on sale of securities		(935	)		(58,309	)
		Gain on expiration of put options		(842	)		—
		Loss on investment write-downs		15,175			24,297
		Unrealized loss on Riverstone stock derivative		21,829			11,707
		Loss on disposals and impairment of property, plant and equipment		—			4,671
Changes in current assets and liabilities:
	Accounts receivable			19,409			31,091
	Inventories			38,085			(101,803	)
	Prepaid expenses and other assets			(4,082	)		21,225
	Accounts payable and accrued expenses			(42,569	)		30,795
	Customer advances and billings in excess of revenues			(48,738	)		77,734
	Deferred revenue			(16,233	)		(27,615	)
	Income taxes payable, net			12,336			2,168

		Net cash used in operating activities		(45,725	)		(166,742	)

Cash flows from investing activities:
	Capital expenditures			(17,240	)		(21,115	)
	Proceeds from sale of minority investments			3,907			—
	Cash paid for minority investments			(1,677	)		(22,000	)
	Purchase of available-for-sale securities			(99,151	)		(221,746	)
	Sales/maturities of marketable securities			113,518			608,912
	Net proceeds from sale of discontinued operations			7,568			—
	Proceeds from sale of fixed assets			—			2,000

		Net cash provided by investing activities		6,925			346,051

Cash flows from financing activities:
	Cash flows related to discontinued operations			21,941			(192,609	)
	Common stock issued pursuant to employee stock purchase plans			820			4,395
	Payments from notes receivable			14,000			1,723
	Issuance of notes receivable			—			(13,000	)
	Proceeds from sale of put options			—			135
	Repurchase of common stock			—			(5,924	)
	Proceeds from exercise of stock options and warrants			3,846			27,474

		Net cash provided by (used in) financing activities		40,607			(177,806	)

Effect of exchange rate changes on cash				(324	)		(101	)

Net increase in cash and cash equivalents				1,483			1,402
Cash and cash equivalents at beginning of period				114,800			64,378

Cash and cash equivalents at end of period			$	116,283		$	65,780

Supplemental disclosure of cash flow information:
	Cash paid (refunds received) for income taxes, net		$	(93,841	)	$	10,302
	Non-cash transactions:
		Accretive dividend and accretion of discount on preferred shares	$	9,697		$	7,208
		Product and services exchanged for investments	$	—		$	11,012
		Conversion of Series C preferred stock, options and warrants to common stock	$	—		$	35,545

See accompanying notes to consolidated financial statements.

ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Enterasys Networks, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 2 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments necessary for a fair presentation of the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. Certain prior period balances have been reclassified to conform to the current period presentation. The accompanying financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Transition Report on Form 10-K for the transition period ended December 29, 2001 filed with the SEC on November 26, 2002. The Company refers to the ten-month period ended December 29, 2001 as “transition year 2001.”

As explained in more detail under the Summary of Restatement Adjustments table in Note 2, the statement of operations included in this quarterly report on Form 10-Q corrects and updates the Company’s restated results of operations for the third quarter of transition year 2001 as originally reported in Note 30 of its report on Form 10-K for transition year 2001.

On September 28, 2001, the Company’s Board of Directors amended the by-laws to change the Company’s fiscal year-end from the Saturday closest to the last day in February of each year to the Saturday closest to the last day in December of each year. The Company implemented the change in fiscal year-end during its third quarter of transition year 2001. As a result, both the three months ended September 1, 2001 and September 29, 2001 include the results of operations for the months of July 2001 and August 2001. The consolidated results of operations for the duplicated months of July and August 2001 are summarized as follows: Net revenue of $142.4 million; gross margin of $62.8 million; loss from continuing operations available to common shareholders of $106.7 million; loss from discontinued operations of $73.8 million; and net loss available to common shareholders of $180.6 million. In addition, the accompanying consolidated financial statements and notes thereto include the three months and nine months ended September 28, 2002 and the three months and seven months ended September 29, 2001. Accordingly, the results of operations and cash flows for the nine months ended September 28, 2002 and the seven months ended September 29, 2001 are not comparable due to the change in the fiscal year. The Company has not included comparable nine-month financial information for the period ended September 29, 2001 because it was impracticable to do so due to certain inherent limitations in its interim monthly closing process and the complexity of the restatement of its transition year 2001 financial statements discussed in Note 2.

2. Restatement

On January 31, 2002, the Company discovered that a previously recognized $4.0 million sale in its Asia Pacific region did not qualify for revenue recognition during the period in which the Company had originally reported the revenue. Also on January 31, 2002, the Company learned that the SEC had opened a formal order of investigation into the financial accounting and reporting practices of the Company and its affiliates. In response to these developments, the Company’s Board of Directors formed a Special Committee to conduct an internal review into the Company’s financial accounting and reporting for the fiscal year ended March 3, 2001 and the ten-month transition period ended December 29, 2001. The Special Committee appointed the law firm of Ropes & Gray to conduct the internal review, and Ropes & Gray hired the forensic accounting group of Deloitte & Touche LLP to assist with the internal review. The Special Committee has completed the internal review, and the Company has restated its financial statements for the fiscal year ended March 3, 2001, the fiscal quarters within that fiscal year, and the first three fiscal quarters within the ten-month transition period ended December 29, 2001. The restatements are included in the Company’s Transition Report on Form 10-K filed with the SEC on November 26, 2002. The SEC investigation of the Company with respect to the Company’s accounting and reporting practices was settled in February 2003. Without admitting or denying any allegations, the Company consented to the entry of an administrative order pursuant to which it agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, the Company agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of the Board of Directors of the Company. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any further changes to the Company’s historical financial statements.

The principal adjustments to restate the financial statements for the three and seven months ended September 29, 2001 were as follows:

Sales/Investment Transactions

The Company entered into a number of transactions in which it made an investment in a customer in exchange for cash and/or the Company’s products and services. The amounts originally recorded by the Company relating to a number of these transactions were in error. The Company reviewed all investment transactions and corrected the amount recorded for each transaction for which an error was noted. In making those corrections, the investment value and the amount of revenue recorded by the Company were determined based upon the nature

of the transaction and fair value of the investment instrument received. When it was not appropriate to recognize revenue, the Company recorded the difference between the cost of the consideration given and the fair value of the investment received as other expense. The fair value of the investment in these instances was limited to the cost of the product given. For the three months ended September 29, 2001, these corrections resulted in a reduction to reported investments of $21.6 million, a reduction in revenue of $11.8 million and an increase in other expense, net, of $11.1 million. For the seven months ended September 29, 2001, these corrections resulted in a reduction to reported investments of $21.3 million, a reduction in revenue of $25.2 million and an increase in other expense, net, of $17.1 million.

Asia Pacific and Latin America Distributors

As a result of the internal review, the Company determined that beginning in the fiscal year ended March 3, 2001 practices related to several distributor relationships in the Asia Pacific and Latin America regions were such that, with respect to sales to these distributors, the Company should not recognize revenue until the distributor has paid the Company. As a result of these findings, and in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” the Company restated sales to such distributors in these two regions to a cash basis methodology. This resulted in a reduction to reported revenue of $20.2 million and $27.9 million for the three and seven months ended September 29, 2001, respectively.

Pricing Allowances

In the course of the internal review, the Company identified certain pricing allowances extended to customers that had not been recorded by the Company in the appropriate period. The impact of correcting these errors resulted in a reduction to reported revenue of $5.9 million and $7.9 million for the three and seven months ended September 29, 2001, respectively.

Return Rights

The Company determined that sales reserves established to account for future product returns in certain cases did not properly take into consideration all relevant information available at the time the estimates were made; and as a result, the Company has adjusted reserves for certain periods. The impact of correcting for these errors resulted in an increase to reported revenue of $4.4 million and $4.9 million for the three and seven months ended September 29, 2001, respectively.

Other Revenue Corrections

The Company determined that other increases to revenue for the three months ended September 29, 2001 were required to correct previously reported amounts including $10.6 million related to a deferral of revenue in the prior quarter due to premature recognition of intermediary shipments as revenue and $4.6 million related to the deferral of revenue associated with uncertain collectibility. In addition, during the three months ended September 29, 2001, the Company recorded decreases to revenue of $4.5 million related to premature recognition of revenue associated with incomplete integration projects and software arrangements, barter transactions of $0.3 million and other miscellaneous transactions aggregating $3.9 million. For the seven months ended September 29, 2001 other reductions to revenue to correct previously reported amounts included premature recognition of revenue associated with incomplete integration projects and software arrangements aggregating $4.7 million, barter transactions of $3.4 million, deferral of revenue associated with uncertain collectibility of $6.0 million and other miscellaneous transactions aggregating $7.8 million. During the seven months ended September 29, 2001, the Company recorded an increase to revenue of $4.0 million related to the deferral of revenue from prior periods due to the premature recognition of intermediary shipments as revenue.

Cost of Revenues

Cost of revenues increased by $0.3 million and decreased by $20.5 million in the three and seven months ended September 29, 2001, respectively, primarily as a result of the foregoing adjustments to revenue.

Operating Expenses

Operating expenses decreased by $1.3 million and $2.4 million in the three and seven months ended September 29, 2001, respectively, primarily as a result of expenses not properly recorded in Latin America and improper recognition of cooperative marketing expenses.

Other income (expense), net

Other income increased by $2.3 million and $16.3 million for the three and seven months ended September 29, 2001, respectively, primarily as a result of a reversal of previously recorded impairment charges due to a reduction in fair value of the reported investments as a result of the restatements discussed above.

Income Taxes

The restatements discussed above resulted in a decrease in the tax benefit of $2.2 million for the three months ended September 29, 2001, and an increase in the tax benefit of $5.4 million for the seven months ended September 29, 2001.

Discontinued Operations

The loss from discontinued operations increased by $21.0 million and $23.5 million in the three and seven months ended September 29, 2001, respectively, primarily due to sales/investment transactions and return rights.

Balance Sheet

The balance sheet impact at September 29, 2001 of correcting the revenue items discussed above decreased accounts receivable by $22.9 million, increased inventory by $18.5 million and decreased investments by $47.9 million. Other balance sheet corrections included an $11.4 million decrease in cash and cash equivalents and a $45.3 million increase in accounts payable to properly record outstanding checks and to record deposits in transit, a $4.1 million increase in intangible assets, a $5.3 million increase in accrued expenses to correct product credits, a $9.2 million increase in deferred revenue and a $6.1 million decrease in prepaid expenses and other current assets primarily as a result of the foregoing adjustments to revenue and cost of revenue.

Cash Flow

The restatements discussed above account for substantially all of the changes to the consolidated statement of cash flows for the seven months ended September 29, 2001.

Summary of Restatement Adjustments

The following table outlines the effect of the restatement adjustments on the three and seven months ended September 29, 2001 as well as the reclassifications of marketing development expenses as discussed in Note 3:


	Consolidated Statement of Operations

	Three months ended September 29, 2001

	As originally
	reported			Reclassifications			Restatements*			As restated*

(In thousands)
Net revenue	$	105,535		$	(13,311	)	$	(26,956	)	$	65,268
Gross margin	$	(15,604	)	$	3,598		$	(27,265	)	$	(39,271	)
Loss from continuing operations available to common shareholders	$	(218,978	)	$	—		$	(36,933	)	$	(255,911	)
Loss from discontinued operations	$	(55,101	)	$	—		$	(20,957	)	$	(76,058	)
Net loss available to common shareholders	$	(274,079	)	$	—		$	(57,890	)	$	(331,969	)
Basic and diluted loss per common share:
Loss from continuing operations available to common shareholders	$	(1.14	)	$	—		$	(0.19	)	$	(1.33	)
Loss from discontinued operations	$	(0.29	)	$	—		$	(0.11	)	$	(0.40	)
Net loss available to common shareholders	$	(1.43	)	$	—		$	(0.30	)	$	(1.73	)

*The restated results of operations for the three months ended September 29, 2001 above differ from the restated results of operations as originally reported in Footnote 30, “Quarterly Financial Data,” of the Company’s Transition Report on Form 10-K for the transition period ended December 29, 2001. The restated amounts as originally reported for the three months ended September 29, 2001 did not include the restatement adjustments for the months of July and August 2001, as well as adjustments for the September 2001 activity of Aprisma. This presentation results from the change in the fiscal year as described in Note 1. These changes did not impact the previously reported results of operations for the first and second quarters of transition year 2001 or for the transition year 2001.


	Consolidated Statement of Operations

	Seven months ended September 29, 2001

	As originally
	reported			Reclassifications			Restatements			As restated

(In thousands)
Net revenue	$	345,665		$	(16,237	)	$	(74,136	)	$	255,292
Gross margin	$	84,684		$	5,803		$	(53,623	)	$	36,864
Loss from continuing operations available to common shareholders	$	(259,049	)	$	—		$	(47,087	)	$	(306,136	)
Loss from discontinued operations	$	(74,402	)	$	—		$	(23,500	)	$	(97,902	)
Net loss available to common shareholders	$	(325,709	)	$	—		$	(70,588	)	$	(396,297	)
Basic and diluted income loss per common share:
Loss from continuing operations available to common shareholders	$	(1.36	)	$	—		$	(0.25	)	$	(1.61	)
Loss from discontinued operations	$	(0.39	)	$	—		$	(0.12	)	$	(0.51	)
Net loss available to common shareholders	$	(1.71	)	$	—		$	(0.37	)	$	(2.08	)


	Consolidated Balance Sheet

	September 29, 2001

	As originally
	reported		Reclassifications		Restatements			As restated

(In thousands)
Assets of continuing operations	$	963,442	$	77,734	$	(65,417	)	$	975,759
Assets of discontinued operations		99,355		40,471		(1,549	)		138,277

Total assets	$	1,062,797	$	118,205	$	(66,966	)	$	1,114,036
Liabilities of continuing operations	$	235,818	$	77,734	$	60,078		$	373,630
Liabilities of discontinued operations		—		40,471		830			41,301

Total liabilities	$	235,818	$	118,205	$	60,908		$	414,931
Total stockholders’ equity	$	751,747	$	—	$	(127,874	)	$	623,873

3. Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Enterasys Networks, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements and related notes have been reclassified to reflect the results of Aprisma, Riverstone and GNTS as discontinued operations as discussed in Note 4. In addition to the reclassification due to discontinued operations, certain prior year balances have been reclassified to conform to the current period presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates include assessing the fair value of acquired assets, the amount and timing of revenue recognition, the collectibility of accounts and notes receivable, the valuation of fair value investments, the use and recoverability of inventory and tangible and intangible assets, and the amounts of incentive compensation liabilities, accrued restructuring charges, litigation liabilities and contingencies, among others. The Company bases its estimates on historical experience, current conditions and various other assumptions that are believed to be reasonable under the circumstances. The

markets for the Company’s products are characterized by rapid technological development, intense competition and frequent new product introductions, all of which could affect the future realizability of the Company’s assets. Estimates and assumptions are reviewed on an on-going basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from those estimates under different assumptions or conditions.

New Accounting Pronouncements

Effective December 30, 2001, the Company adopted the Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products,” which requires among other things, that payments made to resellers by the Company for cooperative advertising, buy-downs and similar arrangements should be classified as reductions to net sales or an increase in selling expenses, depending upon the application of the funds by the customer. As a result, the financial statement presentation for the three and nine months ended September 28, 2002 conforms to the requirements of EITF No. 00-25, and the amounts for the three and seven months ended September 29, 2001 have been reclassified to comply with the guidelines of the consensus. The reclassification for the three and seven months ended September 29, 2001 resulted in a reduction of net revenue of $13.3 million and $16.2 million, respectively, a reduction of cost of revenue of $16.9 million and $22.0 million, respectively, and an increase in selling, general and administrative expenses of $3.6 million and $5.8 million, respectively. The above reclassification had no impact on net loss or loss per share.

Effective December 30, 2001, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” See Note 9 for further information concerning the Company’s adoption of SFAS 142.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires recognition of asset retirement obligations as a liability rather than a contra-asset. SFAS No. 143 is effective for the Company’s fiscal year ending January 3, 2004. The Company is currently evaluating the impact that the adoption will have on the consolidated financial statements.

Effective December 30, 2001, the Company adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which excludes from the definition of long-lived assets goodwill and other intangibles that are not amortized in accordance with SFAS No. 142. SFAS No. 144 requires long-lived assets disposed of by sale to be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. SFAS No. 144 also expands the reporting of discontinued operations to include components of an entity that have been or will be disposed of rather than limiting such discontinuance to a segment of a business.

The transition provisions of SFAS No. 144 require that disposal activities that were initiated before the initial application of SFAS No. 144 continue to be accounted for and displayed in the income statement in accordance with the prior pronouncement applicable to the disposal. However, SFAS No. 144 requires a company to reclassify previously issued statements of financial position presented for comparative purposes if a company presented as a single net line item the assets and liabilities of a disposal group. As a result, the Company continues to account for and present in its consolidated statements of operations, the Riverstone, Aprisma and GNTS discontinued operations in accordance with Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” and has reclassified the assets and liabilities of Aprisma on the consolidated balance sheets to conform to the presentation required by SFAS No. 144. See Note 4 for a discussion of the Company’s discontinued operations. The adoption of SFAS No. 144 on December 30, 2001 did not have any impact on the carrying amount of the Company’s long-lived assets.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145, among other things, rescinds SFAS No. 4, which required all gains and losses from the extinguishment of debt to be classified as an extraordinary item and amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement is effective for fiscal years beginning May 15, 2002 or later. The Company does not expect this statement will have an impact on its consolidated financial statements.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires companies to recognize costs associated with exit or disposal activities when a liability is incurred rather than at the date of a commitment to an exit or disposal plan. This statement is effective for fiscal years beginning after December 31, 2002. The Company is currently evaluating the

impact the adoption will have on the consolidated financial statements.

In January 2003, the FASB issued Interpretation No. 45 (“FIN No. 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which introduces the concept of two different obligations related to the issuance of a guarantee: (1) the contingent obligation to make future payments under the conditions of the guarantee and (2) the non-contingent obligation to stand ready to perform (stand-ready obligation). FIN No. 45 addresses the accounting for the stand-ready obligation under the guarantee, while SFAS No. 5, “Accounting for Contingencies,” addresses the recognition and measurement of the contingent obligation. A guarantor is required to recognize a liability with respect to its stand-ready obligation under the guarantee even if the probability of future payments under the conditions of a guarantee is remote. The initial liability will be measured as the fair value of the stand-ready obligation. FIN No. 45 excludes certain guarantees from its scope while others are subject to disclosure only. The disclosure requirements are effective for interim and annual financial statements ending after December 15, 2002. The initial recognition and measurement provisions are effective for all guarantees within the scope of FIN No. 45 issued or modified after December 31, 2002. Adoption of FIN No. 45 as of December 29, 2002 is not expected to have a material effect on the Company’s financial statements.

In January 2003, the FASB issued FIN No. No. 46 (“FIN No. 46”), which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. The Company does not expect that the adoption of FIN No. 46 will have a material effect on its consolidated financial statements.

In January 2003, the FASB issued SFAS No. 148, “Accounting for Stock-based Compensation—Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for enterprises that elect to change to the SFAS No. 123 fair value method of accounting for stock-based employee compensation. SFAS No. 148 will permit two additional transition methods for entities that adopt the preferable SFAS No. 123 fair value method of accounting for stock-based employee compensation. Both of those methods avoid the ramp-up effect arising from prospective application of the fair value method under the existing transition provisions of SFAS No. 123. In addition, under the provisions of SFAS No. 148, the original SFAS No. 123 prospective method of transition for changes to the fair value method will no longer be permitted in fiscal periods beginning after December 15, 2003. SFAS No.148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The disclosures to be provided in annual financial statements will be required for fiscal years ended after December 15, 2002, and the disclosures to be provided in interim financial reports will be required for interim periods begun after December 15, 2002.

4. Discontinued Operations

In February 2000, Cabletron Systems, Inc. (“Cabletron”) transferred substantially all of its operating assets and liabilities to four operating subsidiaries, Enterasys Networks, Inc. (“Enterasys Subsidiary”), Riverstone Networks, Inc. (“Riverstone”), Aprisma Management Technologies, Inc. (“Aprisma”), and GlobalNetwork Technology Services, Inc. (“GNTS”). In July 2001, the operations of GNTS were discontinued through the acquisition of a portion of GNTS by a third party, the assumption of certain contracts and employees of GNTS by Enterasys Subsidiary and Aprisma, and the discontinuance of the remaining business operations of GNTS. Following the initial public offering of a portion of Riverstone’s common stock in February 2001, Cabletron distributed its holdings of Riverstone’s common stock to Cabletron’s stockholders in a spin-off transaction on August 6, 2001. Also on August 6, 2001, Enterasys Subsidiary was merged with and into Cabletron and the name of the surviving corporation was changed to “Enterasys Networks, Inc.” During the first quarter of fiscal year 2002, the Company recorded an additional charge of $11.7 million due to a change in estimate of the loss on disposal of Aprisma. On August 9, 2002, the Company completed the sale of Aprisma to a third party for proceeds, net of expenses, of approximately $7.6 million. The consolidated financial statements present Aprisma as discontinued operations for all applicable periods presented and GNTS and Riverstone as discontinued operations for the three and seven months ended September 29, 2001.

The Company’s discontinued operations for the three and seven months ended September 29, 2001, included sales to customers in which the Company had investments in debt and equity securities accounted for under the cost method of accounting. These revenues are disclosed separately in the following table as “Revenue from related parties — minority investees.” The following revenue is recorded in the consolidated statements of operations in loss from discontinued operations:


		Three months ended			Seven months ended
		September 29, 2001			September 29, 2001

(In thousands)		(restated)			(restated)
Revenue (trade) from discontinued operations		$	17,217		$	76,564
Intercompany revenue — Enterasys, Aprisma, GNTS and Riverstone			6,138			11,836
Revenue from related parties — minority investees			2,367			21,624

	Subtotal		25,722			110,024
Eliminations			(6,138	)		(11,836	)

	Total revenue from discontinued operations	$	19,584		$	98,188

5. Segment Information

As a result of the Company’s decision to discontinue or dispose of the operations of Riverstone, GNTS and Aprisma, the Company operates its business as one segment, which is the business of developing, marketing and supporting comprehensive network solutions.

Net revenue by geography is as follows:


		Three months ended										Nine months ended					Seven months ended
		September 28, 2002					September 29, 2001					September 28, 2002					September 29, 2001

		Revenue		Percent			Revenue		Percent			Revenue		Percent			Revenue		Percent

($ in thousands)							(restated)		(restated)								(restated)		(restated)
North America		$	68,465		55.8	%	$	3,844		5.9	%	$	211,560		58.2	%	$	116,439		45.6	%
Europe, Middle East and Africa			35,067		28.6	%		46,430		71.1	%		104,963		28.9	%		90,919		35.6	%
Asia Pacific			11,228		9.1	%		11,236		17.2	%		22,916		6.3	%		32,425		12.7	%
Latin America			7,971		6.5	%		3,758		5.8	%		24,120		6.6	%		15,509		6.1	%

	Total net revenue	$	122,731		100.0	%	$	65,268		100.0	%	$	363,559		100.0	%	$	255,292		100.0	%

6. Accounts Receivable

Accounts receivable are summarized as follows:


			September 28,			December 29,
(In thousands)			2002			2001

Gross accounts receivable			$	90,218		$	125,617
Less: Deferred revenue on shipments to stocking distributors				(24,300	)		(25,350	)
	Allowance for doubtful accounts			(18,445	)		(32,569	)

		Accounts receivable, net	$	47,473		$	67,698

Beginning in September 2001, the Company deferred revenue on product shipments to certain stocking distributors until those distributors sold the product to their customer. At September 28, 2002 and December 29, 2001, $28.4 million and $68.9 million, respectively, of product shipments had been billed and deferred, of which $24.3 million and $25.4 million, respectively, are reflected as a reduction to accounts receivable and $4.1 million and $43.5 million, respectively, have been collected (or credited) and are included in customer advances and billings in excess of revenues.

7. Inventories, net

Inventories, net, consisted of the following:


		September 28,		December 29,
(In thousands)		2002		2001

Raw materials		$	9,982	$	8,130
Finished goods			69,825		110,084

	Inventories, net	$	79,807	$	118,214

Finished goods at September 28, 2002 and December 29, 2001 included $8.8 million and $21.2 million, respectively, of inventory held by certain distributors as a result of the Company’s decision in September 2001 to recognize revenue from certain distributors when those distributors ship the Company’s product to their customers and $9.0 million and $22.6 million, respectively, of inventory relating to sales on which the Company does not recognize revenue until the distributor has paid the Company for the inventory.

8. Income Taxes

The Company established an income tax receivable during the first quarter of fiscal year 2002 for $119.1 million to reflect the refunds anticipated as a result of the Job Creation and Workers Assistance Act of 2002. The receivable was comprised of the realization of tax benefits of approximately $88.9 million and an increase to additional paid-in capital of approximately $30.2 million, which was attributable to the exercise of employee stock options. The Company received net tax refunds during the second and third quarters of fiscal year 2002 of approximately $102.2 million and also realized additional domestic tax benefits of approximately $9.3 million. As of September 28, 2002, the Company had an income tax receivable of $26.2 million.

During the third quarter of fiscal year 2002, the Company made a payment of $12.2 million related to a settlement on the 1994 through 1996 federal income tax audits. Management believes that income taxes payable includes an adequate provision for any adjustments that may result from tax examinations.

9. Goodwill and Intangible Assets

On December 30, 2001, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 required the Company to discontinue amortizing goodwill as of the beginning of the fiscal year 2002. Existing and future acquired goodwill will be subject to impairment tests annually using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-lived Assets.” The Company has designated the end of the third quarter of the fiscal year as the date of the annual test. During the second quarter of fiscal year 2002, in conjunction with the implementation of SFAS 142, the Company completed the transition impairment review and found no impairment of recorded goodwill at December 30, 2001. At the end of the third quarter of fiscal year 2002, the Company completed its annual impairment review and found no impairment of recorded goodwill at September 28, 2002.

In addition to the annual impairment test, SFAS No. 142 also requires the Company to perform an impairment test if an event or circumstances indicate that it is more likely than not that an impairment loss has occurred. The Company considered its significant workforce reduction in April 2002 to be such an event. During the second quarter of fiscal year 2002, the Company completed an impairment test for this event and found no impairment of recorded goodwill at June 29, 2002.

Goodwill at September 28, 2002 and December 29, 2001 was $15,129.

A reconciliation of net income and earnings per share adjusted for the discontinuation of the amortization of goodwill, net of the related income tax effect, is as follows:


								Nine months			Seven months
		Three months ended						ended			ended
		September 28, 2002			September 29, 2001			September 28, 2002			September 29, 2001

					(restated)						(restated)
(In thousands, except per share amounts)
Net loss available to common shareholders		$	(31,464	)	$	(331,969	)	$	(96,597	)	$	(396,297	)
Add back: Goodwill amortization expense			—			7,483			—			17,536

	Adjusted net loss available to common shareholders	$	(31,464	)	$	(324,486	)	$	(96,597	)	$	(378,761	)

Basic and diluted loss per share:
Net loss available to common shareholders		$	(0.16	)	$	(1.73	)	$	(0.48	)	$	(2.08	)
Add back: Goodwill amortization expense			—			0.04			—			0.09

	Adjusted net loss available to common shareholders	$	(0.16	)	$	(1.69	)	$	(0.48	)	$	(1.99	)

The table below presents gross amortizable intangible assets and the related accumulated amortization at September 28, 2002:


		Gross				Net carrying
		carrying		Accumulated		value of
(In thousands)		amount		amortization		intangible assets

Customer relations		$	28,600	$	18,472	$	10,128
Patents and technology			32,200		18,387		13,813

	Total	$	60,800	$	36,859	$	23,941

Based on intangible assets recorded at September 28, 2002, the estimated amortization expense is $6.0 million for fiscal year 2003, $5.7 million for fiscal years 2004 and 2005, $3.0 million for fiscal year 2006, and $0.3 million for fiscal year 2007.

10. Accrued Expenses

Accrued expenses consisted of the following:


		September 28,		December 29,
(In thousands)		2002		2001

Salaries and benefits		$	29,505	$	31,525
Accrued restructuring charges			12,127		6,182
Accrued legal and audit costs			13,986		6,721
Accrued marketing development obligations			11,333		15,073
Accrued liability on lease guarantees			6,439		7,100
Accrued loss on disposal of Aprisma			—		1,281
Other			15,961		10,280

	Total accrued expenses	$	89,351	$	78,162

11. Special Charges

During the third quarter of fiscal year 2002, the Company recorded a special charge of $10.7 million related to restructuring costs, which consisted of exit costs of $5.1 million related to the closure or reduction in size of seven facilities and employee severance costs of $5.6 million. The employee severance costs were associated with the reduction of approximately 130 individuals or 8% of the Company’s global workforce.

During the second quarter of fiscal year 2002, the Company recorded a special charge of $20.2 million related to restructuring costs. These restructuring costs consisted of employee severance costs associated with the reduction of approximately 600 individuals or 26% of the Company’s global workforce. The reduction in the global workforce involved most functions within the Company.

During the fourth quarter of the transition year 2001, the Company recorded a special charge of $12.4 million related to restructuring costs. These restructuring costs consisted of employee severance costs associated with the reduction of approximately 400 individuals from the Company’s global workforce. The reduction in the global workforce involved principally sales, engineering and administrative personnel and also included targeted reductions impacting most functions within the Company.

During August 2001, the Company recorded a special charge of $34.8 million. Included in the special charge was $24.5 million related to the transformation of Cabletron’s business. The transformation-related charges included investment banking, legal and accounting fees associated with the establishment of the Enterasys Subsidiary, Riverstone, Aprisma and GNTS as stand-alone entities and the Riverstone spin-off. Also included in the special charge was $10.3 million of restructuring costs related to the reduction of the Company’s expense structure. These charges reflected a write-down of $2.2 million for a vacant office building in Rochester, NH to its estimated fair value of $1.5 million, exit costs of $2.6 million associated with the planned closure of eight sales offices worldwide and executive severance costs of $5.5 million.

The following table summarizes accrued restructuring activity:


		Severance			Facility exit
(In thousands)		Benefits			costs			Total

	Q2 of transition year 2001 restructuring charges	$	5,471		$	2,663		$	8,134
	Q4 of transition year 2001 restructuring charges		12,403			—			12,403
	Transition year 2001 cash payments		(13,922	)		(433	)		(14,355	)

Balance, December 29, 2001			3,952			2,230			6,182
	Q1 reclassification		(572	)		572			—
	Q1 cash payments		(2,086	)		(595	)		(2,681	)

Balance, March 30, 2002			1,294			2,207			3,501
	Q2 restructuring charge		20,239			—			20,239
	Q2 cash payments		(16,169	)		(336	)		(16,505	)

Balance, June 29, 2002			5,364			1,871			7,235
	Q3 restructuring charge		5,646			5,089			10,735
	Q3 cash payments		(4,536	)		(1,307	)		(5,843	)

Balance, September 28, 2002		$	6,474		$	5,653		$	12,127

The majority of remaining accrued severance costs of $6.5 million as of September 28, 2002 will be paid out during the fourth quarter of fiscal year 2002; and the remaining accrued exit costs of $5.7 million which consists of long-term lease commitments will be paid out over the next several years.

12. Other Income (Expense), Net

The following schedule reflects the components of other income (expense), net:


								Nine months			Seven months
		Three months ended						ended			ended
		September 28,			September 29,			September 28,			September 29,
		2002			2001			2002			2001

(In thousands)					(restated)						(restated)
Impairment of investments		$	(2,619	)	$	(3,844	)	$	(15,175	)	$	(24,297	)
Loss on exchange of products for investments			—			(11,077	)		—			(17,086	)
Recognition of deferred gain on Efficient investment			—			—			—			46,778
Unrealized loss on Riverstone stock derivative			(3,365	)		(11,707	)		(21,829	)		(11,707	)
Net gain on sale of available for sale securities			117			1,869			935			2,703
Gain on expiration of common stock put options			—			—			842			—
Other than temporary decline in available-for-sale securities			—			(1,712	)		—			(1,712	)
Other			(246	)		(7,027	)		(2,547	)		(7,965	)

	Total other income (expense), net	$	(6,113	)	$	(33,498	)	$	(37,774	)	$	(13,286	)

The Company reviews its minority investments in debt and equity securities of primarily privately held companies for potential impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Impairments in carrying value are based on investee-specific events including declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations and bankruptcy or insolvency. The Company recorded in other income (expense), net, impairments of investments of $2.6 million and $15.2 million for the three and nine months ended September 28, 2002, respectively, and $3.8 million and $24.3 million for the three and seven months ended September 29, 2001, respectively.

During transition year 2001, the Company entered into a number of transactions in which it made an investment in a customer in exchange for cash and/or its products and services. In certain of these transactions the Company recorded the difference between the cost of the consideration given and the fair value of the investment received as other expense. These transactions resulted in other expense of $11.1 million and $17.1 million for the three and seven months ended September 29, 2001, respectively.

During the first quarter of transition year 2001, the Company sold 2.0 million shares of Efficient common stock and tendered its remaining 8.5 million shares for proceeds of $242.7 million in connection with a tender offer to acquire the outstanding shares of Efficient common stock made by Siemens A.G. In connection with these transactions, the Company recognized the remaining deferred gain of $46.8 million to other income during the first quarter of transition year 2001.

The Company’s convertible preferred stock redemption liability is offset by the value of 1.3 million shares of Riverstone stock received by the holders of the redeemable convertible preferred stock in connection with the Riverstone spin off in August 2001. The value of the Riverstone shares decreased by $3.4 million and $21.8 million, for the three and nine months ended September 28, 2002, respectively, and decreased by $11.7 million for the three and seven months ended September 29, 2001. The associated increase in the Company’s redemption liability was recorded as other expense.

13. Comprehensive Income (Loss)

The Company’s total comprehensive loss, net of tax, was as follows:


									Nine months			Seven months
			Three months ended						ended			ended
			September 28, 2002			September 29, 2001			September 28, 2002			September 29, 2001

(In thousands)						(restated)						(restated)
Net loss			$	(28,139	)	$	(328,859	)	$	(86,900	)	$	(389,089	)
Other comprehensive income (loss):
	Unrealized gain on available-for-sale securities			18			889			1,342			3,503
	Foreign currency translation adjustment			(1,394	)		556			(324	)		(101	)
	Reclassification adjustment for gains (losses) on available-for-sale securities included in net loss			—			(849	)		456			(2,107	)

		Total comprehensive loss	$	(29,515	)	$	(328,263	)	$	(85,426	)	$	(387,794	)

14. Income (Loss) Per Share

Basic and diluted net loss per common share is computed using the weighted average number of common shares outstanding. Options to purchase 30.5 million and 45.3 million shares of common stock were outstanding at September 28, 2002 and September 29, 2001, respectively, and 7.4 million warrants to purchase shares of the Company’s common stock were outstanding at September 28, 2002 and September 29, 2001 but were not included in the computation of diluted net loss per share since the effect was anti-dilutive.

15. Stock Dividend

On April 26, 2002 the Board of Directors of the Company approved a dividend of one right to purchase one one-thousandth (1/1,000) of a share of Series F Preferred Stock, $1.00 par value per share, of the Company for each outstanding share of common stock, $.01 par value per share, of the Company. The Company paid this dividend on June 25, 2002 to shareholders of record at the close of business on June 11, 2002.

16. Commitments and Contingencies

Legal Proceedings

In the normal course of the Company’s business, it is subject to proceedings, litigation and other claims. Litigation in general, and securities and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of litigation are difficult to predict. The uncertainty associated with these and other unresolved or threatened legal actions could adversely affect the Company’s relationships with existing customers and impair the Company’s ability to attract new customers. In addition, the defense of these actions may result in the diversion of management’s resources from the operation of the Company’s business, which could impede the Company’s ability to achieve the Company’s business objectives. The unfavorable resolution of any specific action could materially harm the Company’s business, operating results and financial condition, and could cause the price of the Company’s common stock to decline significantly.

Described below are material legal proceedings in which the Company is involved:

Securities Class Action in the District of Rhode Island. Between October 24, 1997 and March 2, 1998, nine shareholder class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the District of New Hampshire. By order dated March 3, 1998, these lawsuits, which are similar in material respects, were consolidated into one class action lawsuit, captioned In re Cabletron Systems, Inc. Securities Litigation (C.A. No. 97-542-SD). The case has been transferred to the District of Rhode Island. The complaint alleges that the Company and several of its officers and directors disseminated materially false and misleading information about the Company’s operations and acted in violation of Section 10(b) and March 3, 1997 and December 2, 1997. The complaint further alleges

that certain officers and directors profited from the dissemination of such misleading information by selling shares of the Company’s common stock during this period. The complaint does not specify the amount of damages sought on behalf of the class. In a ruling dated May 23, 2001, the District Court dismissed this complaint with prejudice. The plaintiffs appealed that ruling to the First Circuit Court of Appeals, and, in a ruling issued on November 12, 2002, the Court of Appeals reversed and remanded the case to the District Court for further proceedings. On January 17, 2003, the defendants filed an answer denying all material allegations of the complaint. If the plaintiffs prevail on the merits of this case, we could be required to pay substantial damages.

Securities Class Action in the District of New Hampshire. Between February 7 and April 9, 2002, six class action lawsuits were filed in the United States District Court for the District of New Hampshire. Defendants are us, our former chairman and chief executive officer Enrique Fiallo and our former chief financial officer Robert Gagalis. By orders dated August 2, 2002 and September 25, 2002, these lawsuits, which are similar in material respects were consolidated into one class action lawsuit, captioned In re Enterasys Networks, Inc. Securities Litigation (C.A. No. 02-CV-71). On December 9, 2002, the plaintiffs filed an amended consolidated complaint, adding two additional defendants, Piyush Patel, former chief executive officer of Cabletron Systems, Inc. (“Cabletron”) and David Kirkpatrick, former chief financial officer of Cabletron. The amended complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 there under. Specifically, plaintiffs allege that during periods spanning from June 28, 2000 and August 3, 2001 and in the period between August 6, 2001 and February 1, 2002 (together the “Class Period”), defendants issued materially false and misleading financial statements and press releases that overstated the Company’s revenues, income, and cash, and understated our net losses, because we purportedly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”) and the Company’s own accounting policies in connection with various sales and/or investment transactions. The complaints seek unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all of the defendants, jointly and severally as well as fees, costs and interest and unspecified equitable relief. On February 10, 2003, the Company filed a motion to dismiss the amended complaint. If plaintiffs prevail on the merits of the case, the Company could be required to pay substantial damages.

Shareholder Derivative Action in State of New Hampshire. On February 22, 2002, a shareholder derivative action was filed on the Company’s behalf in the Superior Court of Rockingham County, State of New Hampshire. The suit is captioned Nemes v. Fiallo, et al. Individual defendants are former chairman and chief executive officer Fiallo and certain members of the Company’s Board of Directors. Plaintiffs allege that the individual defendants breached their fiduciary duty to shareholders by causing or allowing the Company to conduct its business in an unsafe, imprudent, and unlawful manner and failing to implement and maintain an adequate internal accounting control system. Plaintiffs allege that this breach caused the Company to improperly recognize revenue in violation of GAAP and the Company’s own accounting policies in connection with transactions in the Company’s Asia Pacific region, and that this alleged wrongdoing resulted in damages to the Company. Plaintiffs seek unspecified compensatory damages. On October 7, 2002, the Superior Court approved the parties’ joint stipulation to stay proceedings.

Shareholder Derivative Action in State of Delaware. On April 16, 2002, a shareholder derivative action was filed on the Company’s behalf in the Court of Chancery of the State of Delaware in and for New Castle County. It is captioned, Meisner v. Enterasys Networks, Inc., et al. Individual defendants are former chairman and chief executive officer Fiallo and members of the Company’s Board of Directors. Plaintiffs allege that the individual defendants permitted wrongful business practices to occur which had the effect of manipulating revenues and earnings, inadequately supervised the Company’s employees and managers, and failed to institute legal actions against those officers, directors and employees responsible for the alleged conduct. The complaint alleges counts for breach of fiduciary duty, misappropriation of confidential information for personal profit, and contribution and indemnification. Plaintiffs seek judgment directing defendants to account to the Company for all damages sustained by the Company by reason of the alleged conduct, return all compensation of whatever kind paid to them by the Company, pay interest on the damages as well as costs of the action. On July 11, 2002, the individual defendants filed a motion to dismiss the complaint. The plaintiff has not yet filed a brief with respect to this motion.

Securities and Exchange Commission Investigation. After the close of business on January 31, 2002, the Securities and Exchange Commission, or SEC, notified the Company that it had commenced a “Formal Order of Private Investigation” into the Company’s financial accounting and reporting practices. The Company cooperated fully with the SEC during the investigation. In February 2003, the Company settled the SEC investigation of the Company with respect to the Company’s accounting and reporting practices. Without admitting or denying any allegations, the Company consented to the entry of an administrative order pursuant to which it agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, the Company agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of the Board of Directors of the Company. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any further changes to the Company's historical financial statements.

Other. In addition, the Company is involved in various other legal proceedings and claims arising in the ordinary course of business. Management believes that the disposition of these additional matters, individually or in the aggregate, is not expected to have a materially adverse effect on the financial condition or results of operations of the Company.

Other

During fiscal year 2002, the Company incurred legal and forensic accounting fees of approximately $21 million for services rendered in connection with the SEC investigation into the Company’s financial accounting and reporting practices, the subsequent restatement of the Company’s fiscal year 2001 and transition year 2001 financial statements, and the various shareholder lawsuits discussed above. The Company has not received a determination as to whether and to what extent costs incurred to date are reimbursable under its insurance coverage. These costs are expensed to operating expenses as they are incurred. Costs incurred in the three and nine months ended September 28, 2002 were $6.7 million and $16.9 million, respectively.

On February 21, 2003, the holders of the Company’s Series D and E preferred stock notified the Company of their intention to exercise their right to redeem these shares effective as of February 23, 2003. While the Company continues to discuss the possibility of the preferred stockholders retaining an investment in the Company, it expects to redeem these shares within 30 days from February 23, 2003 for approximately $99.5 million in cash, less the proceeds from the sale of the approximately 1.3 million shares of Riverstone stock distributed to them in connection with the Company’s spin-off of Riverstone.

The Company committed to make up to $20 million of additional capital contributions to a venture capital fund in which it is already an investor. In the event of future capital calls, the Company could be required to fund some or all of this commitment. If the Company fails to make a required contribution, then the Company’s existing investment with a carrying value of $3.4 million at September 28, 2002 would be significantly diluted. The fund has not indicated that it expects to issue a material capital call in the near future.

17. Related Party Transactions

Investments

The Company has minority investments in debt and equity securities of certain companies. The Company does not have a controlling interest in these entities. In certain instances during the three and seven months ended September 29, 2001, the Company recorded revenue from transactions where it received equity instruments in exchange for products sold. Revenue recognized from investee transactions was as follows:


		Three months ended				Nine months		Seven months
						ended		ended
		September 28,2002		September 29, 2001		September 28, 2002		September 29, 2001

(In thousands)				(restated)				(restated)
Revenue recognized in connection with investment transactions		$	—	$	1,397	$	—	$	4,647
Revenue recognized from other sales to investee companies			2,785		26,290		8,242		34,764

	Total revenue recognized from investee transactions	$	2,785	$	27,687	$	8,242	$	39,411

Consulting Arrangements

In connection with the senior management resignations in September 2001, the Company entered into consulting arrangements with two former members of senior management to provide strategic advice and assistance to the Company for a period of one year. The Company paid consulting fees under these arrangements of $0.04 million and $0.16 million in the three and nine months ended September 28, 2002, respectively. These arrangements ended in September 2002.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion in conjunction with the section below titled “Cautionary Statements,” our consolidated financial statements and related notes, and other financial information appearing elsewhere in this report on Form 10-Q. We caution you that any statements contained in this report which are not strictly historical statements constitute forward-looking statements. Such statements include, but are not limited to, statements reflecting management’s expectations regarding our future financial performance; strategic relationships and market opportunities; and our other business and marketing strategies and objectives. These statements may be identified with such words as “we expect”, “we believe”, “we anticipate”, or similar indications of future Rule 10b-5 of the Exchange Act during the period between

expectations. These statements are neither promises nor guarantees, and involve risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Such risks and uncertainties include, among other things, the factors discussed below under “Cautionary Statements” and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward looking statements, which speak only as of the date hereof. We expressly disclaim any obligation to publicly update or revise any such statements to reflect any change in these forward-looking statements, or in events, conditions, or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements.

Our prior fiscal period consists of the ten-month transition period from March 4, 2001 through December 29, 2001, which we refer to as “transition year 2001” throughout this Item. We refer to our current fiscal year, the twelve-month period ended December 28, 2002, as “fiscal year 2002” throughout this Item.

All references in this quarterly report to “Enterasys Networks,” “we,” “our,” or “us” mean Enterasys Networks, Inc.

Business Overview

We design, develop, market and support comprehensive networking solutions focusing on the network security, availability and mobility needs of enterprises. Our solutions empower customers to use their internal networks and the Internet to facilitate the exchange of information, increase productivity and reduce operating costs. Using our products, customers make information, applications and services readily available and customized to the needs of their employees, customers, suppliers, business partners and other network users. Our significant installed base of customers consists of commercial enterprises; governmental entities; healthcare, educational, financial and non-profit institutions; and other organizations.

Restatement

We previously restated our financial statements for the fiscal year ended March 3, 2001, the fiscal quarters within that fiscal year, and the first three fiscal quarters within the ten-month transition period ended December 29, 2001. The principal adjustments to restate our financial statements for the three months and seven months ended September 29, 2001 are discussed in Note 2 to our consolidated financial statements included in this quarterly report.

Settlement of Securities and Exchange Commission Investigation

In February 2003, we settled the SEC investigation of us with respect to our accounting and reporting practices initiated by the SEC in January 2002. Without admitting or denying any allegations, we consented to an administrative order pursuant to which we agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, we agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of our Board of Directors. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any further changes to our historical financial statements.

Fiscal Year Change

On September 28, 2001, our Board of Directors amended the by-laws to change our fiscal year-end from the Saturday closest to the last day in February of each year to the Saturday closest to the last day in December of each year. We implemented the change in fiscal year-end during the third quarter of transition year 2001. As a result, both the second and third quarters of transition year 2001 include the results of operations for the months of July and August. The consolidated results of operations for the months of July and August 2001 are summarized as follows: Net revenue of $142.4 million; gross margin of $62.8 million; loss from continuing operations available to common shareholders of $106.7 million; loss from discontinued operations of $73.8 million; and net loss available to common shareholders of $180.6 million.

The periods covered in this report include the three months and nine months ended September 28, 2002 and the three months and seven months ended September 29, 2001. Due to our change in fiscal year, the results of operations and cash flows for the nine months ended September 28, 2002 and the seven months ended September 29, 2001 are not comparable. We have not included comparable nine-month financial information for the period ended September 29, 2001 because it was impracticable to do so due to certain inherent limitations in our interim monthly closing process and the complexity of the restatement of our transition year 2001 financial statements discussed in Note 2 to our consolidated financial statements included in this quarterly report.

Application of Critical Accounting Policies

Our significant accounting policies are described in Note 3 to the consolidated financial statements included in Item 8 of our transition report on Form 10-K for the transition period ended December 29, 2001. The preparation of our consolidated financial statements in accordance with generally accepted accounting principles requires estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. We base estimates and judgments on historical experience, market and industry trends, and other factors that we believe are reasonable under the circumstances. Actual results may differ materially from these estimates. We believe the following critical accounting policies impact our judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. Our revenue is comprised of product revenue, which includes revenue from sales of our switches and routers, other network equipment and software, and services revenue, which includes revenue from maintenance, installation and system integration services. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically 12 months. We generally recognize product revenue from our end-user and reseller customers at the time of shipment, provided that persuasive evidence of an arrangement exists, the price is fixed or determinable and collectibility of sales proceeds is reasonably assured. When significant obligations remain after products are delivered, such as integration or customer acceptance, revenue and related costs are deferred until such obligations are fulfilled.

We provide an allowance for sales returns based on historical returns, return policies and contractual product return rights granted to our customers. The allowance has been reflected as a reduction to revenue in the consolidated statement of operations. If the data used by us to calculate the estimated sales returns and allowances does not properly reflect future returns, these estimates would have to be modified, thus impacting revenue recognized in future periods. Beginning in September 2001, we determined that we could no longer estimate the amount of future product returns from certain stocking distributors located in the United States and Europe. We now recognize revenue from these distributors when they ship our product to their customers. During the third quarter of transition year 2001, we recorded an adjustment to defer approximately $76.0 million of revenue related to inventory on hand at these distributors that had previously been recognized as revenue based on shipments to these distributors. In addition, beginning in fiscal year 2001, we began recording revenue from certain distributors and resellers located in Asia Pacific and Latin America on a cash basis due to existing practices related to distribution/reseller arrangements.

During and prior to transition year 2001, we sold products and services to customers in exchange for minority investments, consisting of debt or equity securities, accounted for under the cost method of accounting. In some instances, we issued product credits, or the right to purchase products which, when used, were exchanged for debt or equity securities by the investee company, and in other cases, we invested cash that was then used by the investee company to purchase products from us. The amount of revenue that we recognized in connection with minority investments was based upon the nature of the transaction and fair value of the debt or equity instrument received.

Allowance for Doubtful Accounts. We estimate the collectibility of our accounts receivable and the amount of bad debts that may be incurred in the future. We analyze specific customer accounts, historical experience, customer concentrations, credit ratings and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Reserve for Excess and Obsolete Inventory. Inventory purchases and commitments are based upon future demand forecasts. Reserves for excess and obsolete inventory are established to account for the differences between our forecasted demand and the amount of purchased and committed inventory. In past years, we have experienced significant variances between the amount of inventory purchased and contractually committed to and our demand forecasts, resulting in material excess and obsolete inventory charges.

Valuation of Long-lived Assets. Long-lived assets are comprised of intangible assets and property, plant and equipment. We assess the impairment of identifiable intangibles, fixed assets and related goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. When we determine that the carrying value of intangibles, fixed assets and related goodwill may not be recoverable, we measure any impairment by the amount by which the carrying value of the long-lived asset or goodwill exceeds the related fair value. Estimated fair-value is generally based on projected discounted cash flows using a discount rate determined by management to be commensurate with the risk inherent in the underlying asset in question. In certain cases, we obtain an independent valuation of intangible assets to support the amount of our proposed impairment charge.

Valuation of Investments. Investments are comprised of privately held corporate debt and equity securities and in limited cases, common

stock in thinly traded publicly held companies. We review these investments for potential impairments by monitoring significant declines in the investee’s stock price in new rounds of financing, market capitalization relative to book value, bankruptcy or insolvency and deterioration in the financial condition or results of operations.

Restructuring Reserves. We have recorded restructuring charges in connection with our plans to reduce the cost structure of our business. These restructuring charges, which reflect management’s commitment to a termination or exit plan that will be completed within twelve months, are based on estimates of the expected costs associated with severance benefits and facility exit costs. If the actual cost incurred exceeds the estimated cost, an additional charge to earnings will result. If the actual cost is less than the estimated cost, a reduction to special charges will be recognized.

Deferred Tax Valuation Allowance. We estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we increase or decrease our income tax provision in our statement of operations. If any of our estimates of our prior period taxable income or loss prove to be incorrect, material differences could impact the amount and timing of income tax benefits or payments for any period.

Summary of Critical Estimates Included in Our Consolidated Results of Operations. The following table summarizes the impact on our results of operations arising from our critical accounting estimates:


							Nine months		Seven months
		Three months ended					ended		ended
		September 28, 2002			September 29,2001		September 28, 2002		September 29, 2001

(In millions)					(restated)				(restated)
Provision for losses on accounts receivable			$	1.3	$	4.0	$	0.8	$	4.9
Provision for excess and obsolete inventory				0.2		30.7		0.3		42.3
Impairment of investments				2.6		3.8		15.2		24.3
Restructuring charges				10.7		8.1		31.0		8.1
Deferred tax asset valuation provision				11.9		124.3		2.2		124.3

	Total		$	26.7	$	170.9	$	49.5	$	203.9

Results of Operations

The table below sets forth the principal line items from our consolidated statement of operations, each expressed as a percentage of net revenue:


					Three months ended						Nine months ended			Seven months ended
					September 28, 2002			September 29, 2001			September 28, 2002			September 29, 2001

								(restated)						(restated)
Net revenue:
	Product					73.2	%		36.6	%		71.5	%		62.4	%
	Service					26.8			63.4			28.5			37.6

			Total net revenue			100.0			100.0			100.0			100.0

Cost of revenue:
	Product					58.0			371.7			62.5			116.9
	Services					35.3			38.3			32.4			33.6

			Total cost of revenue			51.9			160.2			53.9			85.6

Gross margin:
	Product gross margin					42.0			(271.7	)		37.5			(16.9	)
	Services gross margin					64.7			61.7			67.6			66.4

			Total gross margin			48.1			(60.2	)		46.1			14.4

		Research and development				16.0			36.9			17.9			20.4
		Selling, general and administrative				49.2			146.7			50.1			78.9
		Amortization of intangible assets				1.8			13.4			1.8			8.8
		Stock-based compensation				0.5			42.8			0.7			11.7
		Special charges				8.7			53.2			8.5			13.6

				Total operating expenses		76.2			293.0			79.0			133.4

				Loss from operations		(28.1	)%		(353.2	)%		(32.9	)%		(119.0	)%

Third Quarter of Fiscal Year 2002 Compared to the Third Quarter of Transition Year 2001

Overview

For the third quarter of fiscal year 2002, we incurred a net loss from continuing operations available to common shareholders of $31.5 million primarily due to special charges associated with our cost reduction initiatives; expenses associated with the SEC investigation, our internal review and associated stockholder litigation; increased independent audit expenses; and the fact that our fixed overhead cost structure was too high to achieve break-even profitability at quarterly revenue levels of approximately of $120 million. Restructuring activities undertaken in the second and third quarters of fiscal year 2002 were designed to significantly lower our use of cash while at the same time preserving our ability to support future growth. During the third quarter of fiscal year 2002, we recorded a special charge of $10.7 million related to restructuring costs, which consisted of exit costs of $5.1 million related to the closure or reduction in size of seven facilities and $5.6 million for employee severance costs associated with the reduction of approximately 130 individuals or 8% of our global workforce. The reduction in our global workforce involved most functions. We expect the full impact of these cost reductions will not be fully realized for a few quarters. Going forward, we expect to further reduce our overhead costs through a combination of process improvements, workforce attrition and further reductions in excess office space.

Beginning in September 2001, we determined that we could no longer estimate the amount of future product returns from certain stocking distributors located in the United States and Europe. We now recognize revenue from these distributors when they ship our product to their customers. During the three months ended September 29, 2001, we recorded an adjustment to defer approximately $76.0 million of revenue related to inventory on hand at these distributors that had previously been recognized as revenue based on shipments to these distributors.

Net Revenue

Net revenue increased by $57.4 million, or 87.9%, from $65.3 million in the third quarter of transition year 2001 to $122.7 million in the third quarter of fiscal year 2002 primarily due to the previously discussed change in revenue recognition for stocking distributors which resulted in a revenue deferral of approximately $76.0 million in the third quarter of transition year 2001, partially offset by lower unit sales volume in fiscal year 2002. Net revenue for the third quarter of fiscal year 2002 slightly increased by $2.6 million from $120.1 million in the second quarter of fiscal year 2002 due to increased revenue to customers outside of North America partially offset by lower North American sales volume. We currently expect North American revenue to remain weak for at least the next couple quarters, primarily as a result of the continued weakness in the markets we serve.

During the third quarter of fiscal year 2002, we continued to face some unique challenges due to the uncertainty associated with the lack of detailed current financial information about us, the SEC investigation, our internal review and associated stockholder litigation. This resulted in hesitancy on the part of our customers and potential customers to purchase from us. In addition, the market for telecommunications and networking equipment and solutions continued to be challenging. We believe that our future revenue will generally fluctuate with overall changes in the markets that we currently serve and will be affected by the nature and timing of new product introductions by our competitors and us, as well as other competitive factors. Further, the uncertain worldwide economy and current geopolitical unrest have the potential to adversely impact future revenue.

Product revenue increased by $65.9 million, or 275.7%, from $23.9 million in the third quarter of transition year 2001 to $89.8 million in the third quarter of fiscal year 2002 primarily due to the previously discussed change in revenue recognition for stocking distributors during the third quarter of transition year 2001, partially offset by lower unit sales volume in fiscal year 2002. Product revenue for the third quarter of fiscal year 2002 increased by $4.8 million from the second quarter of fiscal year 2002 due to increased revenue to customers outside of North America.

Services revenue decreased by $8.5 million, or 20.5%, from $41.4 million in the third quarter of transition year 2001 to $32.9 million in the third quarter of fiscal year 2002. The decrease in services revenue was primarily due to non-renewals of expiring maintenance contracts on legacy products and a lower level of new product sales during 2002, which typically include associated maintenance. Services revenue is primarily revenue from maintenance contracts with customers in our installed base. Services revenue for the third quarter of fiscal year 2002 decreased by $2.1 million from the second quarter of fiscal year 2002.

Net revenue to customers outside of North America was $54.3 million, or 44% of total net revenue, for the third quarter of fiscal year 2002, compared to $61.4 million, or 94% of net revenue, for the third quarter of transition year 2001. The percentage of revenue for the prior year was significantly higher primarily due to the previously discussed change in revenue recognition for stocking distributors recorded during the third quarter of transition year 2001, which adversely affected last year’s North American revenue.

Gross Margin

Total gross margin improved by $98.3 million from a negative $39.3 million in the third quarter of transition year 2001 to $59.0 million in the third quarter of fiscal year 2002. The change in gross margin in the third quarter of fiscal year 2002 compared to the comparable quarter in the prior year consisted of the previously discussed $57.4 million increase in revenue and a $40.9 million reduction in cost of revenue. The decrease in cost of revenue in the third quarter of fiscal year 2002 was primarily due to a provision for excess and obsolete inventory of $30.7 million in the third quarter of transition year 2001, compared with a provision of $0.2 million in the third quarter of fiscal year 2002, and lower overhead and logistics costs.

Total gross margin as a percentage of revenue was 48.1% in the third quarter of fiscal year 2002, compared with 50.1% in the second quarter of fiscal year 2002. In connection with certain supply chain inventory reduction and process improvement initiatives, we are evaluating the need to record an additional provision for excess and obsolete inventory in the fourth quarter of fiscal year 2002. Absent this provision, we believe the margin percentage for the fourth quarter of fiscal year 2002 will be relatively consistent with those experienced in recent quarters. Our gross margin percentage varies depending on unit volumes and product mix sold as well as other factors.

Operating Expenses

Research and development expense was $19.7 million in the third quarter of fiscal year 2002 and $24.1 million in the third quarter of transition year 2001. Cost reduction initiatives implemented during the third quarter of fiscal year 2002 and initiatives implemented during prior periods, which included workforce reductions and facilities closings, have decreased research and development expense in the third quarter of the current year compared to the third quarter of the prior year. As a percentage of revenues, research and development expense for the third quarter of fiscal year 2002 was 16.0% and was 36.9% for the third quarter of transition year 2001. Research and development expense as a percentage of revenue in the prior year’s third quarter is not a meaningful measurement due to the fact that last year’s third quarter results included an adjustment to defer approximately $76.0 million of revenue related to inventory on hand at stocking distributors. Research and development expense for the third quarter of fiscal year 2002 remained basically unchanged compared to the second quarter of fiscal year 2002. We expect research and development expense in the fourth quarter of fiscal year 2002 to approximate the level of spending in the prior two quarters and to increase modestly in 2003 as we accelerate the funding of product development initiatives.

Selling, general and administrative expense (“SG&A”) was $60.4 million in the third quarter of fiscal year 2002 and $95.7 million in the third quarter of transition year 2001. SG&A for the third quarter of fiscal year 2002 included $6.7 million of costs associated with the SEC investigation into our financial accounting and reporting practices, the subsequent restatement of our fiscal year 2001 and transition year 2001 financial statements, and the various shareholder lawsuits discussed in this quarterly report; $5.7 million of audit fees; $1.3 million of bad debt expense and $0.9 million for various marketing and advertising programs. SG&A for the prior year included $9.8 million of equipment lease guarantee expense, $6.2 million for various marketing and advertising programs, $4.0 million of bad debt expense and approximately $1.0 million of audit fees. SG&A expense increased $4.2 million from the second quarter of fiscal year 2002 primarily due to higher professional fees. The change in SG&A year over year was due in part to the following: we no longer guarantee equipment leases for our customers, the bad debt expense in the prior year was higher due to the deteriorating financial condition of certain customers, and we reduced certain marketing and advertising expenses in fiscal year 2002. In addition, the various workforce reductions in the last several quarters and reduced rent and overhead associated with the closure of various sales offices has further decreased SG&A in the third quarter of the current year compared to the third quarter of the prior year.

SG&A as a percentage of revenue was 49.2% for the third quarter of fiscal year 2002 and was 146.7% for the third quarter of transition year 2001. SG&A excluding the items referenced above was 37.3% of revenue for the third quarter of fiscal year 2002, and was 114.4% of revenue for the third quarter of transition year 2001. SG&A as a percentage of revenue in the prior year’s third quarter is not a meaningful measurement due to the fact that last year’s third quarter results included an adjustment to defer approximately $76.0 million of revenue related to inventory on hand at stocking distributors.

We have implemented and expect to continue to implement process improvement and other cost reduction initiatives to further reduce our fixed overhead cost structure. However, we expect SG&A expense will continue to be adversely impacted by the increase in professional services fees incurred in connection with the SEC investigation, our internal review and associated stockholder litigation. During fiscal year 2002, we have incurred legal and forensic accounting fees of approximately $21 million for services rendered in connection with these matters. We have not received a determination as to whether and to what extent costs incurred to date are reimbursable under our insurance coverage. Such costs are expensed to operating expense as they are incurred.

Amortization of intangibles decreased by $6.5 million from $8.7 million in the third quarter of transition year 2001 to $2.2 million

in the third quarter of fiscal year 2002, primarily due to the fact that we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which required us to discontinue amortizing goodwill as of the beginning of the fiscal year 2002. See Note 9 to our consolidated financial statements included in this quarterly report.

Stock-based compensation was $0.6 million in the third quarter of fiscal year 2002 and $27.9 million in the third quarter of transition year 2001 and related to stock and stock options issued in connection with the acquisition of Network Security Wizards and Indus River Networks that were contingent upon continued employment of key employees.

Special charges decreased from $34.8 million in the third quarter of transition year 2001 to $10.7 million in the third quarter of fiscal year 2002. During the third quarter of fiscal year 2002, we recorded a special charge of $10.7 million related to restructuring costs which consisted of exit costs of $5.1 million related to the closure or reduction in size of seven facilities and $5.6 million for employee severance costs associated with the reduction of approximately 130 individuals or 8% of our global workforce. Special charges incurred during the third quarter of transition year 2001 included $24.5 million of costs related to the transformation of Cabletron’s business and $10.3 million of restructuring costs which included a write-down of $2.2 million for a vacant office building, facility exit costs of $2.6 million and executive severance costs of $5.5 million.

Loss from Operations

Loss from operations decreased from $230.5 million in the third quarter of transition year 2001 to $34.5 million in the third quarter of fiscal year 2002 due to the factors discussed above. During the third quarter of fiscal year 2002, we continued to implement process improvement and cost reduction initiatives, improve inventory management procedures and controls, and adopt other initiatives designed to further reduce our loss from operations. We expect to incur an operating loss for the fourth quarter of fiscal year 2002 due to continued weakness in the markets that we serve, expenses associated with cost reduction initiatives, and additional costs associated with the SEC investigation, our internal review and associated shareholder litigation. However, the operating loss in the fourth quarter of fiscal year 2002 is expected to be substantially lower than our comparable loss in the fourth quarter of the prior year.

Interest Income

Interest income declined from $4.8 million in the third quarter of transition year 2001 to $2.1 million in the third quarter of fiscal year 2002 due to lower average cash, cash equivalents and marketable securities balances and lower interest rates.

Other Income (Expense), Net

The following schedule reflects the components of other income (expense), net:


		Three months ended

		September 28, 2002			September 29, 2001

(In thousands)		(restated)
Impairment of investments		$	(2,619	)	$	(3,844	)
Loss on exchange of products for investments			—			(11,077	)
Unrealized loss on Riverstone stock derivative			(3,365	)		(11,707	)
Net gain on sale of available for sale securities			117			1,869
Other than temporary decline in available-for-sale securities			—			(1,712	)
Other			(246	)		(7,027	)

	Total other income (expense), net	$	(6,113	)	$	(33,498	)

We recorded, in other income (expense), net, impairments of investments of $2.6 million for the three months ended September 28, 2002 and $3.8 million for the three months ended September 29, 2001. These impairments of value are based on investee-specific events including declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations and bankruptcy or insolvency.

During transition year 2001, we entered into a number of transactions in which we made an investment in a customer in exchange for cash and/or our products and services. In certain of these transactions we recorded the difference between the cost of the consideration given and the fair value of the investment received as other expense. These transactions resulted in other expense of $11.1 million for the three months ended September 29, 2001.

Our convertible preferred stock redemption liability is offset by the value of 1.3 million shares of Riverstone stock received by the

holders of the redeemable convertible preferred stock in connection with the Riverstone spin off in August 2001. The value of the Riverstone shares decreased by $3.4 million and $11.7 million for the three months ended September 28, 2002 and September 29, 2001, respectively. The associated increase in our redemption liability was recorded as other expense.

Income Tax Benefit

For the third quarter of fiscal year 2002, we recorded an income tax benefit of $10.4 million primarily due to the tax loss carry back benefits associated with the passage of the Job Creation and Worker Assistance Act of 2002 which changed the allowable period to carry back net operating losses from two to five years. We recorded a tax benefit of $6.5 million related to a portion of the losses for the third quarter of transition year 2001.

Loss from Discontinued Operations

In the third quarter of transition year 2001, we recorded a loss from discontinued operations of $76.1 million due to operating losses from discontinued operations of Aprisma, Riverstone, and GNTS of $34.6 million and the loss on disposal of GNTS of $41.5 million.

Nine Months Ended September 28, 2002 Compared to the Seven Months Ended September 29, 2001

Net Revenue

Net revenue increased by $108.3 million, or 42.4%, from $255.3 million in the first seven months of transition year 2001 to $363.6 million in the first nine months of fiscal year 2002, primarily because the prior year period included only seven months of operations compared with nine months in fiscal year 2002 as a result of the change in our fiscal year. The nine months of fiscal year 2002 also benefited from three quarterly sales cycles, compared with only two quarterly sales cycles in the first seven months of transition year 2001, since product revenue is significantly higher in the last month of a quarterly sales cycle. In addition, during the third quarter of transition year 2001, we changed our method of revenue recognition for stocking distributors, which adversely affected last year’s revenue.

Product revenue increased by $100.6 million, or 63.2%, from $159.3 million in the first seven months of transition year 2001 to $259.9 million in the first nine months of fiscal year 2002 due to the reasons discussed above. Services revenue increased by $7.7 million, or 8.0% from $96.0 million in the first seven months of transition year 2001 to $103.7 million in the first nine months of fiscal year 2002. The increase was primarily due to the shorter fiscal period in the prior year. Net revenue to customers outside of North America was $152.0 million, or 42% of total net revenues, the first nine months of fiscal year 2002, compared to $138.9 million, or 54% of net revenues, for the first seven months of transition year 2001.

Gross Margin

Total gross margin increased by $130.6 million from $36.9 million in the first seven months of transition year 2001 to $167.5 million in the first nine months of fiscal year 2002. The increase was primarily due to the previously discussed shorter transition period. In addition, the prior year period included a provision for excess and obsolete inventory of $42.3 million, compared to $0.3 million in the first nine months of fiscal year 2002.

Total gross margin as a percentage of net revenue was 46.1% in the first nine months of fiscal year 2002, compared with 14.4% in the first seven months of transition year 2001. The margin percentage improvement was principally due to product gross margin, which increased to 37.5% compared to a negative gross margin of 16.9% in the seven-month period of the prior year. The increase in the product gross margin percentage was primarily due to the provision for excess and obsolete inventory, which negatively impacted margin 27 percentage points in the prior year period, and the previously discussed inventory reduction and process improvement initiatives.

Operating Expenses

Research and development expense increased by $12.7 million from $52.3 million in the first seven months of transition year 2001 to $65.0 million in the first nine months of fiscal year 2002, due to the fact that the prior year period included only seven months of operations compared with nine months in the fiscal year 2002 period. Based on average monthly spending during transition year 2001, research and development expense for the first nine months of transition year 2001 would have been approximately level with the first nine months of fiscal year 2002. As a percentage of revenues, research and development spending for the first nine months of fiscal year 2002 has decreased to 17.9% from 20.4% in the first seven months of transition year 2001.

SG&A expense was $182.2 million in the first nine months of fiscal year 2002 and $201.3 million in the first seven months of transition year 2001. SG&A for the current year included $16.9 million of costs associated with the SEC investigation into our financial accounting and reporting practices, the subsequent restatement of our fiscal year 2001 and transition year 2001 financial statements, and the various shareholder lawsuits discussed in this quarterly report; $10.7 million of audit fees; $6.1 million for various marketing and advertising programs; $2.7 million of lease guarantee expense and $0.8 million of bad debt expense. SG&A for the prior year included $14.1 million for

various marketing and advertising programs, $9.8 million of equipment lease guarantee expense, $4.9 million in bad debt expense and $2.2 million of audit fees.

SG&A as a percentage of revenue was 50.1% for the nine months ended September 28, 2002, compared to 78.9% for the seven months ended September 29, 2001. SG&A excluding the items referenced above was 39.9% of revenue for the nine months ended September 28, 2002, compared to 66.7% of revenue for the seven months ended September 29, 2001. The decrease as a percentage of revenue from the prior period excluding the items referenced above is primarily due to the workforce reductions in the past year and reduced rent and overhead associated with the closure of various sales offices.

Amortization of intangibles decreased by $16.0 million from $22.5 million in the first seven months of transition year 2001 to $6.5 million in the first nine months of fiscal year 2002, primarily due to the fact that we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which required us to discontinue amortizing goodwill as of the beginning of the fiscal year 2002. See Note 9 to our consolidated financial statements included in this quarterly report.

Stock-based compensation was $2.5 million in the first nine months of fiscal year 2002 and $29.9 million in the first seven months of transition year 2001 and related to stock and stock options issued in connection with the acquisition of Network Security Wizards and Indus River Networks that were contingent upon continued employment of key employees.

Special charges decreased from $34.8 million in the first seven months of transition year 2001 to $31.0 million in first nine months of fiscal year 2002. Special charges incurred during the first nine months of fiscal year 2002 related to restructuring costs and consisted of facility exit costs of $5.1 million and employee severance of $25.9 million. Special charges incurred during the first seven months of transition year 2001 included $24.5 million of costs related to the transformation of Cabletron’s business and $10.3 million of restructuring costs which included a write-down of $2.2 million for a vacant office building, facility exit costs of $2.6 million and executive severance costs of $5.5 million.

Loss from Operations

Loss from operations decreased from $303.9 million in the first seven months of transition year 2001 to $119.7 million in the first nine months of fiscal year 2002 due to the factors discussed above.

Interest Income

Interest income declined from $13.3 million in the first seven months of transition year 2001 to $6.2 million in the first nine months of fiscal year 2002, due to lower average cash, cash equivalents and marketable securities balances and lower interest rates.

Other Income (Expense), Net


		Nine months ended			Seven months ended
		September 28, 2002			September 29, 2001

(In thousands)					(restated)
Impairment of investments		$	(15,175	)	$	(24,297	)
Loss on exchange of products for investments			—			(17,086	)
Recognition of deferred gain on Efficient investment			—			46,778
Unrealized loss on Riverstone stock derivative			(21,829	)		(11,707	)
Net gain on sale of available for sale securities			935			2,703
Gain on expiration of common stock put options			842			—
Other than temporary decline in available-for-sale securities			—			(1,712	)
Other			(2,547	)		(7,965	)

	Total other income (expense), net	$	(37,774	)	$	(13,286	)

We recorded, in other income (expense), net, impairments of investments of $15.2 million for the nine months ended September 28, 2002, and $24.3 million for the seven months ended September 29, 2001. These impairments of value are based on investee-specific events including declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations and bankruptcy or insolvency.

September 29, 2001.

During the first quarter of transition year 2001, we sold 2.0 million shares of Efficient common stock and tendered our remaining 8.5 million shares for proceeds of $242.7 million in connection with a tender offer to acquire the outstanding shares of Efficient common stock made by Siemens A.G. In connection with these transactions, we recognized the remaining deferred gain of $46.8 million to other income during the first seven months of transition year 2001.

Our convertible preferred stock redemption liability is offset by the value of 1.3 million shares of Riverstone stock received by the holders of the redeemable convertible preferred stock in connection with the Riverstone spin off in August 2001. The value of the Riverstone shares decreased by $21.8 million and $11.7 million for the first nine months of fiscal year 2002 and first seven months of transition year 2001, respectively. The associated increase in our redemption liability was recorded as other expense.

Income Tax Benefit

For the first nine months of fiscal year 2002, we recorded an income tax benefit of $76.1 million due primarily to the tax loss carry back benefits associated with the passage of the Job Creation and Worker Assistance Act of 2002. For the first seven months of transition year 2001, we recorded a tax benefit of $4.9 million related to a portion of the losses.

Loss from Discontinued Operations

During the nine months of fiscal year 2002, we recorded an additional charge of $11.7 million due to a change in estimate of the loss on disposal of Aprisma. On August 9, 2002, we sold Aprisma to a third party for proceeds, net of expenses, of approximately $7.6 million. During the first seven months of transition year 2001, we recorded a loss from discontinued operations of $97.9 million due to operating losses from discontinued operations of Aprisma, Riverstone, and GNTS of $56.4 million and the loss on disposal of GNTS of $41.5 million.

Financial Condition

Liquidity and Capital Resources

As of September 28, 2002, liquid investments totaled $249.3 million and consisted of $116.3 million of cash and cash equivalents, $63.4 million of marketable securities and $69.6 million of long-term marketable securities. In connection with the issuance of letters of credit by several banking institutions, we have agreed to maintain specified amounts of cash, cash equivalents and marketable securities in collateral accounts controlled by those institutions. These assets totaled $31.9 million at September 28, 2002 and are classified as “Restricted cash, cash equivalents and marketable securities” on the balance sheet.

Net cash used by operating activities was $45.7 million for the nine months ended September 28, 2002 and consisted of the $86.9 million net loss and a net use of $41.8 million from changes in current assets and liabilities that was partially offset by non-cash reconciling items of $83.0 million. Significant components of the changes in current assets and liabilities included a decrease of $42.6 million in accounts payable and accrued expenses primarily associated with payments of non-cancelable raw material and finished goods inventory purchase commitments, a decrease in inventory of $38.1 million and reductions in accounts receivable and customer advances of $19.4 million and $48.7 million, respectively. Cash flows from investing included the net proceeds from the sale of Aprisma of $7.6 million. Our capital expenditures for the nine months ended September 28, 2002 were $17.2 million and related primarily to information technology purchases and upgrades and facility-related expenditures. Cash flows from financing activities for the nine months ended September 28, 2002 included $21.9 million of cash provided by discontinued operations. In addition, we received an income tax refund, net, of $93.8 million for the nine months ended September 28, 2002.

On February 21, 2003, the holders of our Series D and E preferred stock notified us of their intention to exercise their right to redeem these shares effective as of February 23, 2003. While we continue to discuss the possibility of the preferred stockholders retaining an investment in us, we expect to redeem these shares within 30 days from February 23, 2003 for approximately $99.5 million in cash, less proceeds from the sale of the approximately 1.3 million shares of Riverstone stock distributed to them in connection with our spin-off of Riverstone.

We committed to make up to $20 million of additional capital contributions to a venture capital fund in which we are already an investor. In the event of future capital calls, we could be required to fund some or all of this commitment. If we fail to make a required contribution, then our existing investment with a carrying value of $3.4 million at September 28, 2002 would be significantly diluted. The fund has not indicated that it expects to issue a material capital call in the near future.

The other significant contractual cash obligations and commercial commitments associated with future periods as disclosed in our Form 10-K for the transition year ended December 29, 2001, have not changed materially, except during fiscal year 2003, we expect future cash commitments related to inventory purchases to increase based on sales order demand.

We are focused on achieving cash-positive operations in the near-term and believe we have made, and will continue to make, substantial progress toward that goal in the fourth quarter of fiscal year 2002. Based on our liquid investment position at September 28, 2002, our expected redemption of the Series D and E preferred stock, and the approximately $30 million of estimated federal income tax refunds that we expect to receive in the first quarter of 2003, we believe that we have sufficient liquid investments to fund our on-going operations and future obligations for at least the next twelve months.

Changes in Financial Condition

Accounts receivable, net of allowance for doubtful accounts, were $47.5 million at September 28, 2002 compared with $67.7 million at December 29, 2001. The decrease in accounts receivable is due primarily to the decline in net revenue. We anticipate that in the future our accounts receivable balance will fluctuate at approximately the same rate of change as our revenue. The number of days sales outstanding was 35 days at September 28, 2002, compared to 44 days at December 29, 2001.

Inventories, net, were $79.8 million at September 28, 2002, compared with $118.2 million at December 29, 2001. Inventories have decreased throughout the first three quarters of fiscal year 2002 as we reduced finished goods levels toward targeted stocking levels, implemented better forecasting procedures and restructured arrangements with our contract manufacturers. We expect inventory levels to further decline in the fourth quarter. Over the course of the year we have utilized existing finished goods inventory to fulfill orders, which has benefited our cash flow. Future inventory purchases in fiscal year 2003 will fluctuate based on updated sales order demand.

As of September 28, 2002, we had an income tax receivable of $26.2 million. We established the income tax receivable during the first quarter of fiscal year 2002 for $119.1 million to reflect the refunds anticipated as a result of the Job Creation and Workers Assistance Act of 2002. The receivable was comprised of the realization of tax benefits of approximately $88.9 million and an increase to additional paid-in capital of approximately $30.2 million, which was attributable to the exercise of employee stock options. The Company received net tax refunds during the second and third quarters of fiscal year 2002 of approximately $102.2 million and also realized additional domestic tax benefits of approximately $9.3 million.

Accounts payable at September 28, 2002 of $31.1 million declined by $43.7 million from $74.8 million at December 29, 2001 principally due to $25 million of second quarter payments for previously accrued non-cancelable purchase commitments related to excess raw materials.

Customer advances and billings in excess of revenues at September 28, 2002 of $7.4 million declined by $48.7 million from $56.1 million at December 29, 2001. The December 29, 2001 balance is significantly higher, as it reflects the initial impact of our decision to recognize revenue from certain stocking distributors when they ship our product to their customers. This balance represents inventory at stocking distributors for which we have been paid but revenue has been deferred.

New Accounting Pronouncements

Effective December 30, 2001, we adopted the FASB Emerging Issues Task Force (“EITF”) No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products,” which requires among other things, that payments made to resellers by us for cooperative advertising, buy-downs and similar arrangements should be classified as reductions to net sales or an increase in selling expenses, depending upon the application of the funds by the customer. As a result, the financial statement presentation for the three and nine months ended September 28, 2002 conforms to the requirements of EITF No. 00-25, and the amounts for the three and seven months ended September 29, 2001 have been reclassified to comply with the guidelines of the consensus. The reclassification for the three and seven months ended September 29, 2001 resulted in a reduction of net revenue of $13.3 million and $16.2 million, respectively, a reduction of cost of revenue of $16.9 million and $22.0 million, respectively, and an increase in selling, general and administrative expenses of $3.6 million and $5.8 million, respectively. The above reclassification had no impact on net loss or loss per share.

Effective December 30, 2001, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” See Note 9 to our consolidated financial statements included in Part 1 Item 1 of this quarterly report on Form 10-Q for further information concerning our adoption of SFAS No. 142.

In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires recognition of asset retirement obligations as a liability rather than a contra-asset. SFAS No. 143 is effective for our fiscal year ending January 3, 2004. We are currently evaluating the impact that the adoption will have on the consolidated financial statements.

Effective December 30, 2001, we adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which excludes from the definition of long-lived assets goodwill and other intangibles that are not amortized in accordance with SFAS No. 142. SFAS No. 144 requires long-lived assets disposed of by sale to be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. SFAS No. 144 also expands the reporting of discontinued operations to include components of an entity that have been or will be disposed of rather than limiting such discontinuance to a segment of a business.

The transition provisions of SFAS No. 144 require that disposal activities that were initiated before the initial application of SFAS No. 144 continue to be accounted for and displayed in the income statement in accordance with the prior pronouncement applicable to the disposal. However, SFAS No. 144 requires a company to reclassify previously issued statements of financial position presented for comparative purposes if a company presented as a single net line item the asses and liabilities of a disposal group. As a result, we continue to account for and present in our consolidated statements of operations, the Riverstone, Aprisma and GNTS discontinued operations in accordance with Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” and have reclassified the assets and liabilities of Aprisma on the consolidated balance sheets to conform to the presentation required by SFAS No. 144. See Note 4 to our consolidated financial statements included in Part 1 Item 1 of this quarterly report on Form 10-Q for a discussion of our discontinued operations. The adoption of SFAS No. 144 did not have any impact on the carrying amount of our long-lived assets.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145, among other things, rescinds SFAS No. 4, which required all gains and losses from the extinguishment of debt to be classified as an extraordinary item and amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement is effective for fiscal years beginning May 15, 2002 or later. We do not expect this statement will have an impact on our consolidated financial statements.

In January 2003, the FASB issued Interpretation No. 45 (“FIN No. 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which introduces the concept of two different obligations related to the issuance of a guarantee: (1) the contingent obligation to make future payments under the conditions of the guarantee and (2) the non-contingent obligation to stand ready to perform (stand-ready obligation). FIN No. 45 addresses the accounting for the stand-ready obligation under the guarantee, while SFAS No. 5, “Accounting for Contingencies,” addresses the recognition and measurement of the contingent obligation. A guarantor is required to recognize a liability with respect to its stand-ready obligation under the guarantee even if the probability of future payments under the conditions of a guarantee is remote. The initial liability will be measured as the fair value of the stand-ready obligation. The Interpretation excludes certain guarantees from its scope while others are subject to disclosure only. The disclosure requirements are effective for interim and annual financial statements ending after December 15, 2002. The initial recognition and measurement provisions are effective for all guarantees within the scope of FIN No. 45 issued or modified after December 31, 2002. Adoption of FIN No. 45 as of December 29, 2002 will not have a material effect on our financial statements.

or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. We do not expect that the adoption of FIN No. 46 will have a material effect on our consolidated financial statements.

In January 2003, the FASB issued SFAS No. 148, “Accounting for Stock-based Compensation—Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for enterprises that elect to change to the SFAS No. 123 fair value method of accounting for stock-based employee compensation. SFAS No. 148 will permit two additional transition methods for entities that adopt the preferable SFAS No. 123 fair value method of accounting for stock-based employee compensation. Both of those methods avoid the ramp-up effect arising from prospective application of the fair value method under the existing transition provisions of SFAS No. 123. In addition, under the provisions of SFAS No. 148, the original SFAS No. 123 prospective method of transition for changes to the fair value method will no longer be permitted in fiscal periods beginning after December 15, 2003. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The disclosures to be provided in annual financial statements will be required for fiscal years ended after December 15, 2002, and the disclosures to be provided in interim financial reports will be required for interim periods begun after December 15, 2002.

CAUTIONARY STATEMENTS

We may occasionally make forward-looking statements and estimates such as forecasts and projections of our future performance or statements of our plans and objectives. These forward-looking statements may be contained in, among other things, SEC filings, including this quarterly report on Form 10-Q, and press releases made by us and in oral statements made by our officers. Actual results could differ materially from those contained in such forward-looking statements. Important factors that could cause our actual results to differ from those contained in such forward-looking statement include, among other things, the risks described below and the risks described below in our Form 10-K for the transition period ended December 29, 2002 filed with the SEC on November 26, 2002.

Risks Related to our Financial Results and Condition

Although settled, the lingering effects of the SEC investigation and our accounting restatements could materially harm our business, operating results and financial condition

On January 31, 2002, we learned that the SEC had opened a formal order of investigation into the financial accounting and reporting practices of us and our affiliates. In February 2003, we settled the SEC investigation of us with respect to our accounting and reporting practices. Without admitting or denying any allegations, we consented to an administrative order pursuant to which we agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, we agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of our Board of Directors. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any further changes to our historical financial statements. Despite the resolution of the investigation of us, the lingering effects of the SEC investigation and the restatement of our financials for the fiscal year ended March 3, 2001, the fiscal quarters within that year, and the first three fiscal quarters within the ten-month transition period ended December 29, 2001 could materially harm our business, financial condition and reputation. In particular, lingering concerns of potential and existing customers could impair our ability to attract new customers or maintain relationships with existing customers. We believe that due in part to the SEC investigation, purchasing decisions by potential and existing customers have been and may continue to be postponed. If potential and existing customers lose confidence in us, our competitive position in networking industry may be seriously harmed and our revenues could decline.

In addition, we are the defendant in a number of class action lawsuits alleging violations of the securities laws against us, as well as derivative actions against our Board of Directors. The findings of the SEC or the restatement of our financial statements may lead to further litigation, may strengthen and expand the claims and the class period in pending litigation, and may increase the cost of defending or resolving current litigation. We expect that resolution of these lawsuits will continue to involve significant management time and attention and significant expenses for professional fees, and could lead to the payment of significant damages, any of which could materially harm our financial condition and results of operations.

Worldwide economic weakness, deteriorating market conditions and recent political and social turmoil have and may continue to negatively affect our business and revenues and make forecasting more difficult, which could harm our financial condition

Our business is subject to the effects of general worldwide economic conditions, particularly in the United States and EMEA, and market conditions in the networking industry, which have been particularly unfavorable. Recent political and social turmoil, such as terrorist and military actions as well as the effects of any hostilities involving the U.S. in the Middle East or anywhere else in the world and any continuation or repercussions thereof or responses thereto may put further pressure on worldwide economic conditions. If economic or market conditions fail to improve or worsen, our business, revenues, and forecasting ability will continue to be negatively affected, which could harm our results of operations and financial condition.

Market conditions in the networking industry have been particularly unfavorable over the past two years, as companies have been reluctant to invest in their network infrastructures in light of continued economic uncertainty. In recent quarters, our product revenues have declined as a result of reduced capital spending and a lengthened sales cycle attributable to unfavorable economic and market conditions as well as other factors. Continued economic weakness could result in increased price competition in our industry and could further reduce demand for our products, either of which could harm our revenues and reduce our gross margin.

These unfavorable political, social and economic conditions and uncertainties also make it extremely difficult for us, our customers and our vendors to accurately forecast and plan future business activities. In particular, it is difficult for us to develop and implement strategies, forecast demand for our products, and effectively manage contract manufacturing and supply chain relationships. This reduced predictability challenges our ability to operate profitably and to grow our business.

We have a history of losses in recent years and may not operate profitably in the future

We have experienced losses in recent years and may not achieve or sustain profitability in the future. We will need to generate higher revenues and reduce our costs to achieve and maintain consistent profitability. We may not be able to generate higher revenues or reduce our costs, and if we do achieve consistent profitability, we may not be able to sustain or increase our profitability over subsequent periods. Our revenues have been negatively affected by weaker economic conditions worldwide, which have reduced demand and increased price competition for most of our products, as well as resulted in longer selling cycles. If weaker worldwide economic conditions continue for an extended period of time, our ability to maintain and increase our revenues may be significantly limited. In addition, while we recently implemented a cost reduction plan designed to decrease our expenses, which included a significant reduction in the size of our workforce and the sale of our operating subsidiary, Aprisma, we will continue to have large fixed expenses and expect to continue to incur significant sales and marketing, product development, customer support and service and other expenses. We continue to assess whether additional cost-cutting efforts may be required. Additional cost-cutting efforts may result in the recording of additional charges, such as workforce reduction costs, facilities reduction costs, asset write downs and contractual settlements. Further, our workforce reductions may impair our ability to realize our current or future business objectives, and costs incurred in connection with our cost-cutting efforts may be higher than the estimated costs of such actions and may not lead to anticipated cost savings. As a result, our cost-cutting efforts may not result in a return to profitability.

Our quarterly operating results are likely to fluctuate, which could cause us to fail to meet quarterly operating targets and result in a decline in our stock price

Our operating expenses are largely based on anticipated organizational size and revenue trends, and a high percentage of these expenses are, and will continue to be, fixed in the short term. As a result, if our revenue for a particular quarter is below our expectations, we will be unable to proportionately reduce our operating expenses for that quarter. Any revenue shortfall in a quarter may thus cause our financial results for that quarter to fall below the expectations of public market analysts or investors, which could cause the price of our common stock to fall. Any increase in our fixed expenses will increase the magnitude of this risk. In addition, the unpredictability of our operating results from quarter to quarter could cause our stock to trade at lower prices than it would if our results were consistent from quarter to quarter.

Our quarterly operating results may vary significantly from quarter to quarter in the future due to a number of factors, including:

• fluctuations in the demand for our products and services;

• the timing and size of sales of our products or the cancellation or rescheduling of significant orders;

• the length and variability of the sales cycle for our products;

• the timing of implementation and product acceptance by our customers and by customers of our distribution partners;

• the timing and success of new product introductions;

• the timing and level of non-cash, stock-based compensation charges;

• increases in the prices or decreases in the availability of the components we purchase;

• price and product competition in the networking industry;

• our ability to source and receive from third party sources appropriate product volumes and quality;

• manufacturing lead times and our ability to maintain appropriate inventory levels;

• the timing and level of research, development and prototype expenses;

• the mix of products and services sold;

• changes in the distribution channels through which we sell our products and the loss of distribution partners;

• the uncertainties inherent in our accounting estimates and assumptions and the impact of changes in accounting principles;

• our ability to achieve targeted cost reductions;

• the outcome of pending securities litigation and

• general economic conditions as well as those specific to the networking industry.

Due to these and other factors, you should not rely on quarter-to-quarter comparisons of our operating results as an indicator of our future performance.

We earn a substantial portion of our revenue for each quarter in the last month of each quarter, which reduces our ability to accurately forecast our quarterly results and increases the risk that we will be unable to achieve previously forecasted results

We have derived and expect to continue to derive a substantial portion of our revenues in the last month of each quarter, with such revenues frequently concentrated in the last two weeks of the quarter. Because we rely on the generation of a large portion of revenues at the end of the quarter, we traditionally have not been able, and in the future do not expect to be able, to predict our financial results for any quarter until very late in the quarter. Due to this end-of-quarter buying pattern, we may not achieve our financial forecasts, either because expected sales do not occur in the anticipated quarter or because they occur at lower prices or on terms that are less favorable to us than anticipated.

We may need additional capital to fund our future operations, commitments and contingencies and, if it is not available when needed, our business may be harmed

We believe our existing working capital, cash available from operations and anticipated tax refunds will enable us to meet our working capital requirements for at least the next twelve months. Our working capital requirements and cash flows historically have been, and are expected to continue to be, subject to quarterly and yearly fluctuations, depending on such factors as capital expenditures, sales levels, collection of receivables, inventory levels, supplier terms and obligations, and other factors impacting our financial performance and condition. On February 21, 2003, the holders of our Series D and E preferred stock notified us of their intention to exercise their right to redeem these shares effective as of February 23, 2003. While we continue to discuss the possibility of the preferred stockholders retaining an investment in us, we expect to redeem these shares within 30 days from February 23, 2003 for approximately $99.5 million in cash for their shares, less the proceeds from the sale of approximately 1.3 million shares of Riverstone stock distributed to them in connection with our spin-off of Riverstone. Our inability to manage cash flow fluctuations resulting from these and other factors could impair our ability to fund our

working capital requirements from operating cash flows and other sources of liquidity or to achieve our business objectives in a timely manner. We have not established any borrowing relationships with financial institutions and are primarily reliant on cash generated from operations to meet our cash requirements. If cash from future operations is insufficient, or if cash must be used for currently unanticipated uses, we may need to raise additional capital or reduce our expenses.

We cannot assure you that additional capital, if required, will be available on acceptable terms, or at all. As a result of the current unfavorable market environment as well as the pending securities litigation against us, our ability to access the capital markets and establish borrowing relationships with financial institutions has been impaired and may continue to be impaired for the foreseeable future. If we are unable to obtain additional capital when needed or must reduce our expenses, it is likely that our product development and marketing efforts will be restricted, which would harm our ability to develop new and enhanced products, expand our distribution relationships and customer base, and establish our brand name. This could adversely impact our competitive position and cause our revenues to decline. To the extent that we raise additional capital through the sale of equity or convertible debt securities, existing stockholders may suffer dilution. Also, these securities may provide the holders with certain rights, privileges and preferences senior to those of common stockholders. If we raise additional capital through the sale of debt securities, the terms of such debt could impose restrictions on our operations.

Pending and future litigation could materially harm our business, operating results and financial condition

Several lawsuits have been filed against us and our directors in recent years, including nine shareholder class action lawsuits filed between October 24, 1997 and March 2, 1998, and, more recently, six shareholder class action lawsuits filed between February 7, 2002 and April 9, 2002, as well as shareholder derivative actions filed in the State of New Hampshire on February 22, 2002 and in the State of Delaware on April 16, 2002. See “Part II, Item 1 - Legal Proceedings” of this quarterly report for a more detailed discussion of pending litigation. We may be required to pay significant damages as a result of these lawsuits. We are and may in the future be subject to other litigation arising in the normal course of our business or in connection with the recent restatement of our financial statements.

The uncertainty associated with these lawsuits could seriously harm our business, financial condition and reputation by, among other things, harming our relationships with existing customers and impairing our ability to attract new customers. In addition, the continued defense of these lawsuits will result in significant expense and the continued diversion of our management’s time and attention from the operation of our business, which could impede our ability to achieve our business objectives. The unfavorable resolution of any specific lawsuit could materially harm our business, operating results and financial condition, and could cause the price of our common stock to decline significantly.

The limitations of our director and officer liability insurance may materially harm our financial condition

Our director and officer liability insurance for the period during which events related to securities class action lawsuits against us and certain of our current and former officers and directors are alleged to have occurred provides only limited liability protection. If these policies do not adequately cover expenses and certain liabilities relating to these lawsuits, our financial condition could be materially harmed. Our certificate

of incorporation provides that we will indemnify and advance expenses to our directors and officers to the maximum extent permitted by Delaware law. The indemnification covers any expenses and liabilities reasonably incurred by a person, by reason of the fact that such person is or was or has agreed to be a director or officer, in connection with the investigation, defense and settlement of any threatened, pending or completed action, suit, proceeding or claim.

The facts underlying the SEC investigation and shareholder lawsuits will likely increase the premiums we must pay for director and officer liability insurance in the future, and may make this insurance coverage prohibitively expensive or unavailable. Increased premiums for this insurance could materially harm our financial results in future periods. The inability to obtain this coverage due to its unavailability or prohibitively expensive premiums would make it more difficult for us to retain and attract officers and directors.

Our failure to improve our management information systems and internal controls could harm our business

We currently use three disparate information systems in our domestic and international operations, resulting in delays in obtaining consistent and timely information on a worldwide basis and use of extensive manual procedures to generate our consolidated financial results. Further, our systems do not provide all of the information that we believe is necessary to successfully operate our business, and we have identified weaknesses in our internal controls and accounting procedures. We have implemented a number of changes designed to improve our information systems and controls, including organizational changes, communication of revenue recognition and other accounting policies to all of our employees, implementation of an internal audit function, new approval procedures and various other initiatives. We are evaluating additional changes which may require us to make investments in our systems and controls, which could result in higher future operating expenses and capital expenditures. If we fail to strengthen our management information systems and internal controls, our ability to manage our business and implement our strategies may be impaired, irregularities may occur or fail to be identified, and our financial condition could be harmed. In addition, even if we are successful in strengthening these systems and controls, they may not sufficiently improve our ability to manage our business and implement our strategies, or be adequate to prevent or identify irregularities.

We have experienced significant turnover of senior management and our current management team has been together for only a limited time, which could harm our business and operations

In connection with the merger of Enterasys Subsidiary into us in August 2001, our management team was restructured to include several senior Enterasys Subsidiary executives. In April 2002, we announced the departure of several of these senior executives, including our President and Chief Executive Officer. In October 2002, our Vice President of Finance was promoted to the position of Chief Financial Officer. In December 2002, our President resigned upon the completion of his employment agreement with us, and our Chief Executive Officer assumed the position of President in addition to his role as Chief Executive Officer. Because of these recent changes and their recent recruitment, our current management team has not worked together for a significant length of time and may not be able to work together effectively to successfully develop and implement business strategies. In addition, as a result of these management changes, management will need to devote significant attention and resources to preserve and strengthen relationships with employees and customers. If our new management team is unable to develop successful business strategies, achieve our business objectives, or maintain positive relationships with employees and customers, our ability to grow our business and successfully meet operational challenges could be impaired.

Retaining key management and employees is critical to our success

Our future success depends to a significant extent on the continued services of our key employees, many of whom have significant experience with the network communications market, as well as relationships with many of our existing and potential enterprise customers and business partners. The loss of several of our key employees or any significant portion of them could have a significant detrimental effect on our ability to execute our business strategy. Our future success also depends on our continuing ability to identify, hire, train, assimilate and retain large numbers of highly qualified engineering, sales, marketing, and managerial and support personnel. If we cannot successfully recruit and retain such persons, particularly in our engineering and sales departments, our development and introduction of new products could be delayed and our ability to compete successfully could be impaired.

Despite the current economic downturn, the competition for qualified employees in our industry is particularly intense in the New England area, where our principal operations are located, and it can be difficult to attract and retain quality employees at reasonable cost. We have from time to time experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In addition, the significant downturn in our business environment has caused us to significantly reduce our workforce and implement other cost-containment activities, including consolidating our operating locations and relocating some of our personnel to Rochester, New Hampshire and Andover, Massachusetts. These actions, as well as the SEC investigation and the pending

shareholder litigation, may lead to disruptions in our business, reduced employee morale and productivity, increased attrition and difficulty retaining existing employees and recruiting future employees, any of which could harm our business and operating results.

We maintain investments in early stage, privately held technology companies; the benefits we expect to achieve by investing in these companies may not be realized, and we could lose our entire investment in these companies

In the past we have made investments in privately-held technology companies and value-added resellers, many of which are in the start-up or development stage. The benefits we expected to achieve by investing in these companies may not be realized. Moreover, investments in these companies are inherently risky as the technologies or products they have under development, or the services they propose to provide, are often in early stages of development and may never materialize. We may never realize any benefits or financial returns from these investments, and, if these companies are not successful, we could lose our entire investment. The concentration of our investments in a small number of related industries, primarily telecommunications, exposes our investments to increased risk, particularly if these industries continue to be adversely affected by the worldwide economic slowdown. At September 28, 2002, these investments totaled approximately $46.3 million. During the three-month and nine-month period ended September 28, 2002, we recorded impairment losses of $2.6 million and $15.2 million, respectively, relating to these investments.

Risks Related to the Markets for our Products

There is intense competition in the market for enterprise network equipment, which could prevent us from increasing our revenue and achieving profitability

The network communications market is dominated by a small number of competitors, some of which, Cisco Systems in particular, have substantially greater resources and market share than other participants in that market, including us. In addition, this market is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and other market activities of industry participants. Competitive pressures could result in price reductions, reduced margins or loss of market share, which would materially harm our ability to increase revenues and profitability.

Our principal competitors include Alcatel; Avaya, formerly part of Lucent; Cisco Systems; Extreme Networks; Foundry Networks; Hewlett-Packard; Nortel Networks; and 3Com. We also experience competition from a number of other smaller public and private companies. We may experience reluctance by our prospective customers to replace or expand their current infrastructure solutions, which may be supplied by one or more of these competitors, with our products. There has also been a trend toward consolidation in our industry for several years, and we expect this trend will continue as companies attempt to strengthen or maintain their market share positions. Consolidation among our competitors and potential competitors may result in stronger competitors with expanded product offerings and a greater ability to accelerate their development of new technologies.

Some of our competitors have significantly more established customer support and professional services organizations and substantially greater selling and marketing, technical, manufacturing, financial and other resources than we do. Many of our competitors also have more customers, greater market recognition and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their products, pursue acquisitions and other opportunities more readily and adopt more aggressive pricing policies. Additional competitors with significant market presence and financial resources may enter our rapidly evolving market, thereby further intensifying competition.

We may be unable to expand our indirect distribution channels, which may hinder our ability to grow our customer base and increase our revenues

Our sales and distribution strategy relies heavily on our indirect sales efforts, including sales through distributors and channel partners, such as value-added resellers, systems integrators and telecommunications service providers. We believe that our future success will depend in part upon our ability to maintain and expand existing relationships, as well as establish successful new relationships, with a variety of these partners. If we are unable to expand our indirect distribution channels, we may be unable to increase or sustain market awareness or sales of our products and services, which may prevent us from maintaining or increasing our customer base and revenues.

Even if we are able to expand our indirect distribution channels, our revenues may not increase. Our distribution partners are not prohibited from selling products and services that compete with ours and may not devote adequate resources to selling our products and services. In

addition, we may be unable to maintain our existing agreements or reach new agreements with distribution partners on a timely basis or at all.

We expect the average selling prices of our products to decrease over time, which may reduce our revenue and gross margins

Our industry has experienced erosion of average selling prices in recent years, particularly as products reach the end of their life cycles. We anticipate that the average selling prices of our products will decrease in the future in response to increased sales discounts and new product or technology introductions by us and our competitors. Our prices will also likely be adversely affected by downturns in regional or industry economies, such as the recent downturn in the United States economy. We also expect our gross margins may be adversely affected by increases in material or labor costs and an increasing reliance on third party distribution channels. If we are unable to achieve commensurate cost reductions and increases in sales volumes, any decline in average selling prices will reduce our revenues and gross margins.

If we do not anticipate and respond to technological developments and evolving customer requirements, we may not retain our current customers or attract new customers

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The introduction by us or our competitors of new products and the emergence of new industry standards and practices can render existing products obsolete and unmarketable. Our success will depend upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and functionality that keep pace with technological developments and emerging standards. Any failure to introduce new products and enhancements on a timely basis will harm our future revenue and prospects.

Our future success will also depend upon our ability to develop and manage customer relationships and to introduce a variety of new products and product enhancements that address the increasingly sophisticated needs of our customers. Our current and prospective customers may require product features and capabilities that our products do not have. We must anticipate and adapt to customer requirements and offer products that meet those demands in a timely manner. Our failure to develop products that satisfy evolving customer requirements could seriously harm our ability to achieve or maintain market acceptance for our products and prevent us from recovering our product development investments.

Our focus on sales to enterprise customers subjects us to risks that may be greater than those for providers with a more diverse customer base

We focus principally on sales of products and services to enterprises, such as large corporations and government agencies that rely on network communications for many important aspects of their operations. This focus subjects us to risks that are particular to this customer segment. For example, many of our current and potential customers are health care, education and governmental agencies, all of whom are generally slower to incorporate information technology into their business practices due to the regulatory and privacy issues that must be addressed with respect to the sharing of their information. In addition, the use and growth of the Internet is critical to enterprises, which often have electronic networks, applications and other mission-critical functions that use the Internet. To the extent that there is any decline in use of the Internet for electronic commerce or communications, for whatever reason, including performance, reliability or security concerns, we may experience decreased demand for our products and lower than expected revenue growth.

Many of our competitors sell their products to both enterprises and service providers, which are companies who provide Internet-based services to businesses and individuals. In the future, the demand for network communications products from enterprises may not grow as rapidly as the demand from service providers. Enterprises may turn to service providers to supply them with services that obviate the need for enterprises to implement many of our solutions. Because we sell our products primarily to enterprises, our exposure to these risks is greater than that of vendors that sell to a more diversified customer base.

Risks Related to our Products

Our products are very complex, and undetected defects may increase our costs, harm our reputation with our customers and lead to costly litigation

Our network communications products are extremely complex and must operate successfully with complex products of other vendors.

Our products may contain undetected errors when first introduced or as we introduce product upgrades. The pressures we face to be the first to market new products or functionality increases the possibility that we will offer products in which we or our customers later discover problems. We have experienced new product and product upgrade errors in the past and expect similar problems in the future. These problems may cause us to incur significant warranty and other costs and divert the attention of our engineering personnel from our product development efforts. If we are unable to repair these problems in a timely manner, we may experience a loss of or delay in revenues and significant damage to our reputation and business prospects.

Many of our customers rely upon our products for business-critical applications. Because of this reliance, errors, defects or other performance problems in our products could result in significant financial and other damage to our customers. Our customers could attempt to recover these losses by pursuing product liability claims against us, which, even if unsuccessful, would likely be time-consuming and costly to defend and could adversely affect our reputation.

If our products do not comply with complex governmental regulations and evolving industry standards, our products may not be widely accepted, which may prevent us from sustaining our revenues or achieving profitability

The market for network communications equipment is characterized by the need to support industry standards as different standards emerge, evolve and achieve acceptance. In the past, we have had to delay the introduction of new products to comply with third party standards testing. We may be unable to address compatibility and interoperability problems that arise from technological changes and evolving industry standards. We also may devote significant resources developing products designed to meet standards that are not widely adopted. In the United States, our products must comply with various governmental regulations and industry regulations and standards, including those defined by the Federal Communications Commission, Underwriters Laboratories and Networking Equipment Building Standards. Internationally, our products are required to comply with standards or obtain certifications established by telecommunications authorities in various countries and with recommendations of the International Telecommunications Union. If we do not comply with existing or evolving industry standards, fail to anticipate correctly which standards will be widely adopted or fail to obtain timely domestic or foreign regulatory approvals or certificates, we will be unable to sell our products where these standards or regulations apply, which may prevent us from sustaining our revenues or achieving profitability.

The United States government may impose unique requirements on network equipment providers before they are permitted to sell to the government, such as that supplied products qualify as made in the United States. Such requirements may be imposed on some or all government procurements. We may not always satisfy all such requirements. Other governments or industries may establish similar performance requirements or tests that we may be unable to satisfy. If we are unable to satisfy the performance or other requirements of the United States government or other industries that establish them, our revenues growth may be lower than expected.

Because several of our significant competitors maintain dominant positions in selling network equipment products to enterprises and others, they may have the ability to establish de facto standards within the industry. Any actions by these competitors or other industry leaders that diminish compliance by our products with industry or de facto standards or the ability of our products to interoperate with other network communication products would be damaging to our reputation and our ability to generate revenue.

Our limited ability to protect our intellectual property may hinder our ability to compete

We regard our products and technology as proprietary. We attempt to protect them through a combination of patents, copyrights, trademarks, trade secret laws, contractual restrictions on disclosure and other methods. These methods may not be sufficient to protect our proprietary rights. We also generally enter into confidentiality agreements with our employees, consultants and customers, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise misappropriate and use our products or technology without authorization, particularly in foreign countries where the laws may not protect our proprietary rights to the same extent as do the laws of the United States, or to develop similar technology independently. We have resorted to litigation in the past and may need to resort to litigation in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation of this type could result in substantial costs and diversion of resources and could harm our business.

We may be subject to claims that our intellectual property infringes upon the proprietary rights of others, and a successful claim could harm our ability to sell and develop our products

We license technology from third parties and are continuing to develop and acquire additional intellectual property. Although we have not been involved in any material litigation relating to our intellectual property, we expect that participants in our markets will be increasingly

subject to infringement claims. Third parties may try to claim our products infringe their intellectual property, in which case we would be forced to defend ourselves or our customers, manufacturers and suppliers against those claims. Any claim, whether meritorious or not, could be time consuming, result in costly litigation and/or require us to enter into royalty or licensing agreements. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. In addition, any royalty or licensing agreements might not be available on terms acceptable to us or at all, in which case we would have to cease selling, incorporating or using the products that incorporate the challenged intellectual property and expend substantial amounts of resources to redesign our products. If we are forced to enter into unacceptable royalty or licensing agreements or to redesign our products, our business and prospects would suffer.

Risks Related to our Manufacturing and Components

We use several key components for our products that we purchase from single or limited sources, and we could lose sales if these sources fail to fulfill our needs

We currently work with third parties to manufacture our key proprietary application-specific integrated circuits, which are custom designed circuits built to perform a specific function more rapidly than a general purpose microprocessor. These proprietary circuits are very complex, and these third parties are our sole source suppliers for the specific types of application specific integrated circuits that they supply to us. We also have limited sources for the semiconductor chips that we use in our wireless RoamAbout solution, as well as several other key components used in the manufacture of our products. We do not carry significant inventories of these components, and we do not have a long-term, fixed price or minimum volume agreements with these suppliers. If we encounter future problems with these vendors, we likely would not be able to develop an alternate source in a timely manner. We have encountered shortages and delays in obtaining these components in the past and may experience similar shortages and delays in the future. If we are unable to purchase our critical components, particularly our application-specific integrated circuits, at such times and in such volumes as our business requires, we may not be able to deliver our products to our customers in accordance with schedule requirements. In addition, any delay in obtaining key components for new products under development could cause a significant delay in the initial launch of these products. Any delay in the launch of new products could harm our reputation and operating results.

Even if we are able to obtain these components in sufficient volumes and on schedules that permit us to satisfy our delivery requirements, we have little control over their cost. Accordingly, the lack of alternative sources for these components may force us to pay higher prices for them. If we are unable to obtain these components from our current suppliers or others at economical prices, our margins could be adversely impacted unless we raise the prices of our products in a commensurate manner. The existing competitive conditions may not permit us to do so, in which case our operating results may suffer.

We depend upon a limited number of contract manufacturers for substantially all of our manufacturing requirements, and the loss of our primary contract manufacturer would impair our ability to meet the demands of our customers

We do not have internal manufacturing capabilities. We outsource most of our manufacturing to one company, Flextronics International, Ltd., which procures material on our behalf and provides comprehensive manufacturing services, including assembly, test, control and shipment to our customers. Our agreement with Flextronics expired in February 2002 and, since that time, we have been operating under an informal extension of the expired contract while negotiating a new agreement with Flextronics. Our secondary contract manufacturer is Accton Technology Corporation, which provides services similar to those of Flextronics. If we experience increased demand for our products, we will need to increase our manufacturing capacity with Flextronics and Accton or add additional contract manufacturers. Flextronics and Accton also build products for other companies, and we cannot be certain that they will always have sufficient quantities of inventory and capacity available or that they will allocate their internal resources to fulfill our requirements. Further, qualifying a new contract manufacturer and commencing volume production is expensive and time consuming. The loss of our existing contract manufacturers, the failure of our existing contract manufacturers to satisfy their contractual obligations to us or our failure to timely qualify a new contract manufacturer to meet anticipated demand increases could result in a significant interruption in the supply of our products. In this event, we could lose revenue and damage our customer relationships.

If we fail to accurately predict our manufacturing requirements, we could incur additional costs or experience manufacturing delays

We use a forward-looking forecast of anticipated product orders to determine our product requirements for our contract manufacturer. The lead times for materials and components we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. For example, some of our application-specific integrated circuits have a lead time of up to

eight months. If we overestimate our requirements, our contract manufacturers may have excess inventory, which we may be obligated to pay for. If we underestimate our requirements, our contract manufacturers may have inadequate inventory, which could result in delays in delivery to our customers and our recognition of revenue.

In addition, because our contract manufacturers produce our products based on forward-looking demand projections that we supply to them, we may be unable to respond quickly to sudden changes in demand. For example, following the events of September 11, 2001, we experienced a sudden drop in demand for our products and were unable to reduce the amount of product manufactured by our contract manufacturers in the short term, which were based on demand forecasts provided prior to the sudden change in demand. This contributed to a $72.9 million charge for inventory obsolescence in transition year 2001 of which $30.7 million was incurred in the third quarter of transition year 2001 and $42.3 million was incurred for the first nine months of transition year 2001. With respect to sudden increases in demand, we may be unable to satisfy this demand with our products, thereby forfeiting revenue opportunities and damaging our customer relationships, and with respect to sudden decreases in demand, we may find ourselves with excess finished goods inventory, which could expose us to high manufacturing costs compared to our revenue in a financial quarter and increased risks of inventory obsolescence.

Other Risks Related to our Business

Our significant sales outside the United States subject us to increasing foreign political and economic risks, including foreign currency fluctuations

Our sales to customers outside of North America accounted for approximately 44% and 42% of our revenue in the three and nine months ended September 28, 2002, respectively. We are seeking to expand our international presence by establishing arrangements with distribution partners as well as through strategic relationships in international markets. Consequently, we anticipate that sales outside of the United States will continue to account for a significant portion of our revenues in future periods.

The sales of our products are denominated primarily in United States dollars. As a result, increases in the value of the United States dollar relative to foreign currencies could cause our products to become less competitive in international markets and could result in reductions in sales and profitability. To the extent our prices or expenses are denominated in foreign currencies, we will be exposed to increased risks of currency fluctuations.

Our international presence subjects us to risks, including:

• political and economic instability and changing regulatory environments in foreign countries;

• increased time to deliver solutions to customers due to the complexities associated with managing an international distribution system;

• increased time to collect receivables caused by slower payment practices in many international markets;

• managing export licenses, tariffs and other regulatory issues pertaining to international trade;

• increased effort and costs associated with the protection of our intellectual property in foreign countries;

• difficulties in hiring and managing employees in foreign countries; and

• political and economic instability.

The market price of our common stock has historically been volatile, and the recent decline in the market price of our common stock may negatively impact our ability to make future strategic acquisitions, raise capital, issue debt, and retain employees

Shares of our common stock have experienced, and may continue to experience, substantial price volatility, including significant recent decreases, particularly as a result of variations between our actual or anticipated financial results and the published expectations of analysts, announcements by our competitors and us, economic weakness and political instability, high turnover in our senior management, the SEC investigation of our accounting practices, and pending class action lawsuits. In addition, the stock markets have experienced extreme price

fluctuations that have affected the market price of many technology companies. These price fluctuations have, in some cases, been unrelated to the operating performance of these companies. A major decline in capital markets generally, or in the market price of our shares of common stock, may negatively impact our ability to make future strategic acquisitions, raise capital, issue debt, or retain employees. These factors, as well as general economic and political conditions and the outcome of the pending class action lawsuits, may in turn materially adversely affect the market price of our shares of common stock.

We may not be able to maintain our listing on the New York Stock Exchange, and if we fail to do so, the price and liquidity of our common stock may decline

The New York Stock Exchange has quantitative maintenance criteria for the continued listing of common stock on the exchange, including a requirement that we maintain a minimum 30-day average closing price per share of $1.00. Throughout much of 2002, our stock traded below $2.00 per share, at one point, falling below $1.00, and we received a notice from the New York Stock Exchange that our continued listing is under review. Although we are currently in compliance with the 30-day average closing price requirement, we must also meet this requirement on May 7, 2003.

The New York Stock Exchange recently proposed significant amendments to its rules relating to corporate governance. The proposed amendments to such rules, if adopted, will require us to make a number of changes in our business in order to remain in compliance. As a result, we are currently evaluating our compliance with the proposed rule changes to ensure our ability to comply with the proposed rules; however, we cannot assure you that, if the proposed rules are adopted, we will be able to achieve or maintain compliance with them.

If we fail to maintain the continued listing of our shares on the New York Stock Exchange, our stock price would likely decline, the ability of our stockholders to buy and sell shares of our common stock may be materially impaired and the efficiency of the trading market for our common stock would be adversely affected. In addition, delisting of our shares could harm our ability to recruit directors and employees, diminish customer confidence in us, harming our revenues and our financial condition, and would significantly impair our ability to raise capital in the public markets should we desire to do so in the future.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk primarily related to changes in interest rates and foreign currency exchange rates. Our hedging activity is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities.

Interest Rate Sensitivity. We maintain an investment portfolio consisting partly of debt securities of various issuers, types and maturities. The securities that we classify as held-to-maturity are recorded on the balance sheet at amortized cost, which approximates market value. Unrealized gains or losses associated with these securities are not material. The securities that we classify as available-for-sale are recorded on the balance sheet at fair market value with unrealized gains or losses reported as part of accumulated other comprehensive income, net of tax as a component of stockholders’ equity. A hypothetical 10 percent increase in interest rates would not have a material impact on the fair market value of these securities at the September 28, 2002. We are able to hold our fixed income investments until maturity, and therefore we do not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio, unless we are required to liquidate these securities earlier to satisfy immediate cash flow requirements.

Foreign Currency Exchange Risk. Due to our global operating and financial activities, we are exposed to changes in foreign currency exchange rates. At September 28, 2002, we had net asset exposures to the Australian Dollar, Eurodollar, Japanese Yen and Brazilian Real and a net liability exposure to the British Pound. We do not expect our operating results or cash flows to be affected to any significant degree by foreign currency exchange rate fluctuations.

To minimize the potential adverse impact of changes in foreign currency exchange rates, we, at times, have used foreign currency forward and option contracts to hedge the currency risk inherent in our global operations. We do not use financial instruments for trading or other speculative purposes, nor do we use leveraged financial instruments. Gains and losses on these contracts are largely offset by gains and losses on the underlying assets and liabilities. We had no foreign exchange forward or option contracts outstanding at September 28, 2002.

Equity Price Risk. We maintain a small amount of investments in marketable equity securities of publicly-traded companies. As of

September 28, 2002, these investments were considered available-for-sale with any unrealized gains or losses deferred as a component of stockholders’ equity. It is not customary for us to make investments in equity securities of publicly traded companies as part of our investment strategy. In the past, we have also made equity and convertible debt investments in privately-held technology companies, many of which are in the start-up or development stage. Investments in these companies are highly illiquid and inherently risky as the technologies or products they have under development, or the services they propose to provide, are typically in early stages of development and may never materialize. If these companies are not successful, we could lose our entire investment. The concentration of our investments in a small number of related industries, primarily telecommunications, exposes our investments to increased risk, particularly if these industries continue to be adversely affected by the worldwide economic slowdown. At September 28, 2002, these investments totaled approximately $46.3 million. During the three and nine months ended September 28, 2002, we recorded impairment losses of $2.6 million and $15.2 million, respectively, relating to these investments. While our operating results may be materially adversely affected by future reductions in the carrying value of these investments, we do not expect any material adverse impact in our cash flows.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Within the 90-day period prior to the filing of this report, an evaluation of the effectiveness of our disclosure controls and procedures was carried out under the supervision and with the participation of our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Based on and as of the date of that evaluation, the CEO and the CFO have concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

Notwithstanding management’s conclusions, the effectiveness of a system of disclosure controls and procedures is subject to certain inherent limitations, including cost limitations, judgments used in decision making, assumptions regarding the likelihood of future events, soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud or in making all material information known in a timely manner to the appropriate levels of management. As described below under “Changes in Internal Controls,” we have identified certain deficiencies in our internal controls. We believe the corrective actions we have taken and the additional procedures we have performed as described below in more detail, provide us with reasonable assurance that the identified internal control weaknesses have not limited the effectiveness of our disclosure controls and procedures.

Changes in Internal Controls

In January 2002, we discovered that a previously recognized $4 million sale in our Asia Pacific region did not qualify for revenue recognition during the period in which we had originally reported the revenue. We also learned that the SEC had opened a formal order of investigation relating to us and our affiliates. In response to these developments, our Board of Directors formed a Special Committee to oversee an internal review of our financial accounting and reporting for the fiscal year ended March 3, 2001 and the ten-month transition period ended December 29, 2001.

Our management has reassessed our internal controls in each of the regions in which we operate in connection with the audit of our financial statements for the ten-month transition period ended December 29, 2001. The Special Committee, management and KPMG have each advised the Audit Committee that during the course of the audit and the internal review, deficiencies in internal controls were identified relating to:

• accounting policies and procedures;

• inadequate systems integration and data reconciliation; and

• personnel and their roles and responsibilities.

We have assigned the highest priority to the short-term and long-term correction of these internal control deficiencies and have implemented and continue to implement changes to our accounting policies and procedures, systems and personnel to address these issues. We have also performed additional procedures designed to ensure that these internal control deficiencies do not lead to material misstatements in our consolidated financial statements notwithstanding the presence of the internal control weaknesses noted above.

Specifically, we have implemented the following corrective actions as well as additional procedures:

1. Review and revision of critical accounting policies and procedures, particularly in the areas of revenue recognition, contracting management, intercompany transactions, account reconciliation and variance analysis, as well as more formalized training of finance, sales and other staffs;

2. Retention of new management in senior finance and operations positions, and in many staff positions;

3. Creation of an internal audit department, including retention of an internal audit director and staff and engagement of a professional services firm to complement our internal audit department;

4. Review and revision of our code of conduct;

5. Communication of a zero tolerance policy for employees who engage in violations of our accounting policies and procedures;

6. Establishment of an anonymous hotline for employees to report potential violations of our policies and procedures or of applicable laws or regulations;

7. Additional management oversight and detailed reviews of personnel, disclosures and reporting;

8. Increased supervisory and management reviews of financial reporting;

9. Implementation of a quarterly representation and certification process applicable to key employees responsible for international operations and worldwide sales activities; and

10. Use of significant outside resources to supplement our employees in the preparation of the consolidated financial statements, as well as in evaluating and implementing the various internal control recommendations.

Longer term corrective actions, some of which we have already begun to implement, will include:

1. Retention of additional personnel in key areas throughout our organization;

2. Improved financial and management reporting systems;

3. Development of additional financial, accounting and other policies and procedures;

4. Additional training of our personnel;

5. Expanded certification by employees of their familiarity, and obligation to comply, with our policies and procedures; and

6. Periodic re-certification by employees of their continued compliance with our policies and procedures.

We continue to evaluate the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In the normal course of our business, we are subject to proceedings, litigation and other claims. Litigation in general, and securities and intellectual property litigation in particular, can be expensive and disruptive to our normal business operations. Moreover, the results of litigation are difficult to predict. Described below are material legal proceedings in which we are involved. The uncertainty associated with these and other unresolved or threatened legal actions could adversely affect our relationships with existing customers and impair our ability to attract new customers. In addition, the defense of these actions may result in the diversion of management’s resources from the operation of our business, which could impede our ability to achieve our business objectives. The unfavorable resolution of any specific action could materially harm our business, operating results and financial condition, and could cause the price of our common stock to decline significantly. See also “Cautionary Statements – Although concluded, the lingering effects of the SEC investigation and our accounting restatements could materially harm our business, operating results and financial condition” and “Cautionary Statements - - Pending and future litigation could materially harm our business, operating results and financial condition.”

Securities Class Action in the District of Rhode Island. Between October 24, 1997 and March 2, 1998, nine shareholder class action lawsuits were filed against us and certain of our officers and directors in the United States District Court for the District of New Hampshire. By order dated March 3, 1998 these lawsuits, which are similar in material respects, were consolidated into one class action lawsuit, captioned In re Cabletron Systems, Inc. Securities Litigation (C.A. No. 97-542-SD). The case has been transferred to the District of Rhode Island. The complaint alleges that we and several of our officers and directors disseminated materially false and misleading information about our operations and acted in violation of Section 10(b) and Rule 10b-5 of the Exchange Act during the period between March 3, 1997 and December 2, 1997. The complaint further alleges that certain officers and directors profited from the dissemination of such misleading information by selling shares of our common stock during this period. The complaint does not specify the amount of damages sought on behalf of the class. In a ruling dated May 23, 2001, the district court dismissed this complaint with prejudice. The plaintiffs appealed that ruling to the First Circuit Court of Appeals, and, in a ruling issued on November 12, 2002, the Court of Appeals reversed and remanded the case to the District Court for further proceedings. On January 17, 2003, the defendants filed an answer denying all material allegations of the complaint. If plaintiffs prevail on the merits of the case, we could be required to pay substantial damages.

Securities Class Action in the District of New Hampshire. Between February 7 and April 9, 2002, six class action lawsuits were filed in the United States District Court for the District of New Hampshire. Defendants are us, former chairman and chief executive officer Enrique Fiallo and former chief financial officer Robert Gagalis. By orders dated August 2, 2002 and September 25, 2002, these lawsuits, which are similar in material respects were consolidated into one class action lawsuit, captioned In re Enterasys Networks, Inc. Securities Litigation (C.A. No. 02-CV-71). On December 9, 2002, the plaintiffs filed an amended consolidated complaint, adding two additional defendants, Piyush Patel, former chief executive officer of Cabletron Systems, Inc. (“Cabletron”) and David Kirkpatrick, former chief financial officer of Cabletron. The amended complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 there under. Specifically, plaintiffs allege that during periods spanning from June 28, 2000 and August 3, 2001 and in the period between August 6, 2001 and February 1, 2002 (together the “Class Period”), defendants issued materially false and misleading financial statements and press releases that overstated the our revenues, income, and cash, and understated our net losses, because we purportedly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”) and the our own accounting policies in connection with various sales and/or investment transactions. The complaints seek unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all of the defendants, jointly and severally as well as fees, costs and interest and unspecified equitable relief. On February 10, 2003, we filed a motion to dismiss the amended complaint. If plaintiffs prevail on the merits of the case, we could be required to pay substantial damages.

Shareholder Derivative Action in State of New Hampshire. On February 22, 2002, a shareholder derivative action was filed on our behalf in the Superior Court of Rockingham County, State of New Hampshire. The suit is captioned Nemes v. Fiallo, et al. Individual defendants are former chairman and chief executive officer Fiallo and certain members of our Board of Directors. Plaintiffs allege that the individual defendants breached their fiduciary duty to shareholders by causing or allowing us to conduct our business in an unsafe, imprudent, and unlawful manner and failing to implement and maintain an adequate internal accounting control system. Plaintiffs allege that this breach caused us to improperly recognize revenue in violation of GAAP and our own accounting policies in connection with transactions in our Asia Pacific region, and that this alleged wrongdoing resulted in damages to us. Plaintiffs seek unspecified compensatory damages. On October 7, 2002, the Superior Court approved the parties joint stipulation to stay proceedings.

Shareholder Derivative Action in State of Delaware. On April 16, 2002, a shareholder derivative action was filed in the Court of Chancery of the State of Delaware in and for New Castle County on behalf of us. It is captioned, Meisner v. Enterasys Networks, Inc., et al. Individual defendants are former chairman and chief executive officer Fiallo and members of our Board of Directors. Plaintiffs allege that the individual defendants permitted wrongful business practices to occur which had the effect of manipulating revenues and earnings, inadequately supervised our employees and managers, and failed to institute legal actions against those officers, directors and employees responsible for the alleged conduct. The complaint alleges counts for breach of fiduciary duty, misappropriation of confidential information for personal profit, and contribution and indemnification. Plaintiffs seek judgment directing defendants to account to us for all damages sustained by us by reason of the alleged conduct, return all compensation of whatever kind paid to them by us, pay interest on the damages as well as costs of the action. On July 11, 2002, the individual defendants filed a motion to dismiss the complaint. The plaintiff has not yet filed a responsive brief with respect to this motion.

Securities and Exchange Commission Investigation. After the close of business on January 31, 2002, the Securities and Exchange Commission, or SEC, notified us that it had commenced a “Formal Order of Private Investigation” into our financial accounting and reporting practices. We cooperated fully with the SEC during the investigation. In February 2003, we settled the SEC investigation of us with respect to our accounting and reporting practices. Without admitting or denying any allegations, we consented to an administrative order pursuant to which we agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, we agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of our Board of Directors. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any further changes to our historical financial statements.

Other. In addition, we are involved in various other legal proceedings and claims arising in the ordinary course of business. Our management believes that the disposition of these additional matters, individually or in the aggregate, is not expected to have a materially adverse effect on our financial condition or results of operations.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

99.1 Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.

99.2 Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.

(b) Reports on Form 8-K:

On August 2, 2002, we filed a current report on Form 8-K dated July 31, 2002 announcing that we received a letter dated July 31, 2002 from our independent auditor, KPMG LLP, advising us that, in light of our decision to restate our financial statements for the fiscal year ended March 3, 2001, including the relevant fiscal quarters, and for the relevant fiscal quarters in the ten-month period ended December 29, 2001, KPMG's report on the Company's financial statements as of and for the fiscal year ended March 3, 2001 should no longer be relied upon.

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.


		*ENTERASYS NETWORKS, INC.*

February 26, 2003 Date	By:	/s/ WILLIAM K. O’BRIEN William K. O’Brien Chief Executive Officer and Director

		*ENTERASYS NETWORKS, INC.*

February 26, 2003 Date	By:	/s/ RICHARD S. HAAK, JR. Richard S. Haak, Jr. Chief Financial Officer (Principal Financial and Accounting Officer)

CERTIFICATION

I, William K. O’Brien, Chief Executive Officer of the registrant, certify that:

1. I have reviewed this quarterly report on Form 10-Q of the registrant;

2. Based on my knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The other certifying officers of the registrant and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b) Evaluated the effectiveness of the disclosure controls and procedures of the registrant as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

(c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The other certifying officers of the registrant and I have disclosed, based on our most recent evaluation, to the auditors of the registrant and the audit committee of the board of directors (or persons performing the equivalent function) of the registrant:

(a) All significant deficiencies in the design or operation of internal controls which could adversely affect the ability of the registrant to record, process, summarize and report financial data and have identified for the auditors of the registrant any material weaknesses in internal controls; and

(b) Any fraud, whether or not material that involved management or other employees who have a significant role in the internal controls of the registrant; and

6. The other certifying officers of the registrant and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


Date: February 26 , 2003		/s/ WILLIAM K. O’BRIEN William K. O’Brien

CERTIFICATION

I, Richard S. Haak, Jr., Chief Financial Officer of the registrant, certify that:


Date: February 26, 2003		/s/ RICHARD S. HAAK, JR. Richard S. Haak, Jr.

EXHIBIT INDEX


99.1		Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.
99.2		Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.

	•		the timing and size of sales of our products or the cancellation or rescheduling of significant orders;

	•		the length and variability of the sales cycle for our products;

	•		the timing of implementation and product acceptance by our customers and by customers of our distribution partners;

	•		the timing and success of new product introductions;

	•		the timing and level of non-cash, stock-based compensation charges;

	•		increases in the prices or decreases in the availability of the components we purchase;

	•		price and product competition in the networking industry;

	•		our ability to source and receive from third party sources appropriate product volumes and quality;

	•		manufacturing lead times and our ability to maintain appropriate inventory levels;

	•		the timing and level of research, development and prototype expenses;

	•		the mix of products and services sold;

	•		changes in the distribution channels through which we sell our products and the loss of distribution partners;

	•		the uncertainties inherent in our accounting estimates and assumptions and the impact of changes in accounting principles;

	•		our ability to achieve targeted cost reductions;

	•		the outcome of pending securities litigation and

	•		general economic conditions as well as those specific to the networking industry.

	•		political and economic instability and changing regulatory environments in foreign countries;

	•		increased time to deliver solutions to customers due to the complexities associated with managing an international distribution system;

	•		increased time to collect receivables caused by slower payment practices in many international markets;

	•		managing export licenses, tariffs and other regulatory issues pertaining to international trade;

	•		increased effort and costs associated with the protection of our intellectual property in foreign countries;

	•		difficulties in hiring and managing employees in foreign countries; and

	•		political and economic instability.

	•		accounting policies and procedures;

	•		inadequate systems integration and data reconciliation; and

	•		personnel and their roles and responsibilities.

(a)		Exhibits:

99.1		Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.

99.2		Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.

(b)		Reports on Form 8-K:

1.		I have reviewed this quarterly report on Form 10-Q of the registrant;

2.		Based on my knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The other certifying officers of the registrant and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	(a)		Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	(b)		Evaluated the effectiveness of the disclosure controls and procedures of the registrant as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	(c)		Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	(a)		All significant deficiencies in the design or operation of internal controls which could adversely affect the ability of the registrant to record, process, summarize and report financial data and have identified for the auditors of the registrant any material weaknesses in internal controls; and

	(b)		Any fraud, whether or not material that involved management or other employees who have a significant role in the internal controls of the registrant; and