Back to GetFilings.com
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 28, 2002
OR
| | 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.)
50 MINUTEMAN ROAD
ANDOVER, MASSACHUSETTS 01801
(978) 684-1000
(Address, including zip code, and telephone number, including area
code, of registrant's principal executive offices)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH LISTED
COMMON STOCK, PAR VALUE $.01 PER SHARE NYSE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No | |
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of the registrant's knowledge, in definitive proxy for information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. | |
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes |X| No | |
As of March 12, 2003 202,886,205 shares of the Registrant's common stock
were outstanding. The aggregate market value of the registrant's voting stock
held by non-affiliates of the registrant as of the last business day of the
Registrant's most recently completed second fiscal quarter was approximately
$313.5 million (based upon the closing price for shares of the Registrant's
common stock on the New York Stock Exchange on that date).
DOCUMENTS INCORPORATED BY REFERENCE
We expect to file a definitive proxy statement pursuant to Regulation 14A
no later than April 28, 2003. Portions of such proxy statement are incorporated
by reference into Part III of this annual report on Form 10-K.
================================================================================
TABLE OF CONTENTS
ITEM PAGE
- ---- ----
PART I
1. Business ............................................................ 3
2. Properties .......................................................... 10
3. Legal Proceedings ................................................... 10
4. Submission of Matters to a Vote of Security Holders ................. 12
PART II
5. Market for the Registrant's Common Equity and Related Stockholder
Matters ........................................................... 12
6. Selected Consolidated Financial Data ................................ 14
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations ............................................. 15
7a. Quantitative and Qualitative Disclosures about Market Risk ......... 40
8. Consolidated Financial Statements and Supplementary Data ........... 41
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure .......................................... 41
PART III
10. Directors and Executive Officers of the Registrant ................. 41
11. Executive Compensation ............................................. 41
12. Security Ownership of Certain Beneficial Owners and Management ..... 41
13. Certain Relationships and Related Transactions ..................... 41
14. Controls and Procedures ............................................ 41
PART IV
15. Exhibits, Financial Statement Schedules and Reports on Form 8-K .... 43
Chief Executive Officer Certification .............................. 48
Chief Financial Officer Certification .............................. 49
2
PART I
ITEM 1. BUSINESS
This annual report on Form 10-K and the following disclosure contain
forward-looking statements. 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 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 following factors: the lingering effects of the
recently settled SEC investigation and our financial statement restatements
could materially harm our business, operating results and financial condition;
worldwide economic weakness, deteriorating market conditions and recent
political and social turmoil have negatively affected our business and revenues
and made forecasting more difficult, which could harm our financial condition;
we have a history of losses in recent years and may not operate profitably in
the future; 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; 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 may need additional capital to fund
our future operations and, if it is not available when needed, our business and
financial condition may be harmed; pending and future litigation could
materially harm our business, operating results and financial condition; the
limitations of our director and officer liability insurance may materially harm
our financial condition; our failure to improve our management information
systems and internal controls could harm our business; 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 operations;
retaining key management and employees is critical to our success; there is
intense competition in the market for enterprise network equipment, which could
prevent us from increasing our revenue and achieving profitability; we may be
unable to expand our indirect distribution channels, which may hinder our
ability to grow our customer base and increase our revenue; we expect the
average selling prices of our products to decrease over time, which may reduce
our revenue and gross margins; 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 need on a timely basis; we depend upon a
limited number of contract manufacturers for substantially all of our
manufacturing requirements, and the loss of any of our primary contract
manufacturers would impair our ability to meet the demands of our customers; and
those additional risks and uncertainties discussed in "Management's Discussion
and Analysis of Financial Condition and Results of Operations" 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.
All references in this annual report to "Enterasys Networks," "we," "our,"
or "us" mean Enterasys Networks, Inc.
INTRODUCTION
We design, develop, market and support comprehensive networking solutions
designed to address the networking challenges facing global 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, while maintaining security. 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, financial,
educational and non-profit institutions; and various other organizations.
We were founded in 1983 as a Delaware corporation and are listed on the
New York Stock Exchange under the symbol "ETS." Our corporate headquarters is
located at 50 Minuteman Road, Andover, MA 01810. Our telephone number is
978-684-1000, and our web site is located at www.enterasys.com. We make our
periodic and current reports available, free of charge, on our web site as soon
as reasonably practicable after these reports are filed with, or furnished to,
the SEC. Aurorean(TM), Business-Driven Networks(TM), Enterasys Dragon(TM),
Enterasys Matrix(TM), Enterasys Networks(R), Enterasys RoamAbout(TM),
NetSight(R), RoamAbout(R), X-Pedition(TM) User Personalized Networking(TM) and
Vertical Horizon(TM) are several of our trademarks.
3
SETTLEMENT OF SEC INVESTIGATION
After the close of business on January 31, 2002, the SEC notified us that
it had issued a "Formal Order of Private Investigation" relating to our
financial accounting and reporting practices. We cooperated fully with the SEC
during the investigation and, in February 2003, we reached a settlement of the
SEC investigation. 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 and 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 changes to our historical financial statements
which were restated in our Form 10-K for the transition period ended December
29, 2001 filed with the SEC on November 26, 2002.
MANAGEMENT CHANGES
Since April 2002, we have made numerous changes in our management as a
result of employee reductions, resignations and, in some cases, terminations. In
April 2002, William K. O'Brien was appointed Interim Chief Executive Officer and
joined our Board of Directors, and Yuda Doron was appointed our President. In
July 2002, the interim designation was removed from Mr. O'Brien's title. We also
appointed a number of other senior officers in the period from March through
October of 2002, including: Richard S. Haak, Jr. as our Chief Financial Officer,
Mads Lillelund as our Executive Vice President of Worldwide Sales, Raymond G.
Hunt as our Executive Vice President of Supply Chain, Kimberly A. Buxton as Vice
President of Human Resources, Steven A. Caparco as Vice President and
Controller, and Michael A. Barry as Director of Internal Audit. In December
2002, upon the expiration of his employment agreement with us, Mr. Doron
resigned from the position of President and Mr. O'Brien assumed this position in
addition to his duties as Chief Executive Officer. In January 2003, we appointed
Laura Howard as our Executive Vice President of Worldwide Marketing and Product
Management.
OUR SOLUTIONS
Today's enterprises require comprehensive network solutions that provide
users with real-time access to information as well as technology applications.
For enterprises to remain competitive, information and applications must be
securely available on-demand 24 hours a day, 7 days a week, from locations
around the world. Networks must be accessible to a wide range of users,
including employees, customers, vendors, partners and other users, across
multiple network types, including hardware-based switching and routing
infrastructures, support services, wireless access networks, and virtual private
networks, or VPNs. In addition, networks increasingly must prioritize and route
traffic to users and allocate bandwidth to specified applications based on
business priorities instead of technology standards. Our networking solutions
provide enterprises with the internal infrastructure and connectivity to meet
these needs.
BUSINESS-DRIVEN NETWORKS
Our network solutions are business-driven, enabling enterprises by
delivering enhancements in security, productivity and agility. Designed to meet
the specific business needs of each unique customer, our business-driven
networks incorporate our networking and security products, offering the ability
to customize solutions within distinct vertical markets, and using products that
are designed to grow with customers' evolving enterprises. We believe the
ability to manage, use and protect information is important to our customers,
and our solutions are designed to address these requirements by enabling
on-demand access to information while maintaining network security and
simplifying network administration. Our solutions offer the following benefits:
Security. We believe network security is a fundamental concern for all
enterprises. Our solutions offer a layered approach to security, integrating a
wide range of security features, services and devices throughout the network,
providing enterprise networks with protection from both external and internal
security threats. Our solutions combine security products and technology,
including intrusion detection systems, VPNs, encryption, firewalls and user
authentication at all points of network access to enhance security at every
level of the global enterprise network. We deliver purpose-built security
devices and incorporate security features within many of our other networking
products, such as our switches and routers.
Productivity. We incorporate advanced design features in our products to
improve productivity and ensure high levels of network availability at both the
device and system levels, even during periods of heavy traffic. As a result, at
the user level applications can run faster and more efficiently with the highest
quality of service, which means users spend less time waiting for the network to
respond and are able to accomplish more in less time. At the network
administrator level, system-level management tools help to automate routine
tasks and simplify network administration, freeing information technology staff
to focus on strategic initiatives.
4
Agility. Our wireless and VPN solutions increase network flexibility and
mobility by providing network users with personalized access throughout the
deployed network infrastructure and over the Internet. Using our solutions,
network users can more quickly and dynamically respond to business
opportunities, and network administrators, using our centralized management
platform to view the network as a whole, are able to more swiftly react to
events within the network.
Customization. By personalizing the network and providing users with
on-demand, secure access to information and network services, enterprises can
create an organization that works and responds faster. Our business-driven
network solutions feature our User Personalized Networking, or UPN, technology
which allows enterprises to prioritize use of the network infrastructure and
optimize network performance consistent with business priorities. UPN allows an
enterprise to restrict bandwidth and access to specific applications, databases
or servers by user, department, division or geographic location. This technology
allows the network to authenticate and distinguish among different types of
users and network traffic, enabling enterprises to create customized
communications environments for individuals or groups of users. For example, an
enterprise might allocate a significant portion of its network bandwidth to
individuals in the finance group at the end of financial reporting cycles or
allow visitors limited access to authorized applications, such as the Internet,
while maintaining network security.
Convergence and Expansion. Our products are designed to support the
convergence of voice, video and data traffic as well as to provide for
interoperability and cost-effective network expansion. Our products are designed
to take advantage of the trend toward multi-service infrastructures that
converge voice, video and data networks to meet business demands, and contain
functionalities important to convergence such as the ability to securely switch
and route network traffic, assign different priorities to different types of
application-related traffic and audit network traffic usage. By basing our
products on industry standards, our customers are able to operate our products
with prior generations of our products and with standards-based products from
other vendors, thereby reducing the operational costs often incurred maintaining
a multi-vendor network. Our products also enable an enterprise to quickly and
cost-effectively upgrade its network for additional users, greater capacity or
the latest technology, thereby delivering long-term value to customers as their
networking needs increase.
HIGH-QUALITY CUSTOMER SUPPORT
We believe high-quality comprehensive customer support is essential to
building long-term customer relationships. Accordingly, we are committed to
providing high-quality customer support to meet customer needs, and offer a
comprehensive portfolio of support services, including pre-installation
assessment, system installation and integration assistance, and
post-installation maintenance and support services. Our support services are
designed to help customers simplify network operation and maintenance, with the
goal of maximizing network availability and performance.
OUR PRODUCTS
Our products are classified into the following principal categories:
multilayer switching, routing, wireless networking and security. We believe our
products provide the key components that enable customers to build secure,
high-performance, highly adaptable networking infrastructures. We design our
products for customers of all sizes and types, from large multinational
enterprises with many locations, thousands of employees and advanced
communications requirements, to medium-sized businesses seeking to take
advantage of the latest improvements in network communications. Our solutions
and products are built with the common goal of reducing the cost and complexity
of network administration and management.
MULTILAYER SWITCHING
Switches provide connectivity within a network. Designed to fit into any
environment and grow with a customer's changing requirements, our Matrix and
Vertical Horizon switches address the broad market for secure, high-speed
connectivity to individual users and departments within the enterprise network.
We expect to introduce a new series of our Matrix switches during 2003.
Matrix switching products operate at multiple layers and comply with
international standards to ensure that computer systems from different vendors
can exchange data using common languages or protocols. While standard switches
communicate over the data-link layer, or Layer 2, our Matrix switches have the
flexibility to communicate at Layer 3, also called the network layer, providing
the added security and control over network traffic that is associated with
traditional software-based routers.
Our Matrix switches use proprietary application-specific integrated
circuits, or ASICs, which process data and information much faster than
software-based routers while offering the desired security, network traffic
control, performance, auditing and management services that enterprises require
for day-to-day operation. Our Matrix switches are an integral part of our User
Personalized Networking solution, enabling these switches to differentiate among
network users and applications. This functionality, in conjunction with our
NetSight Atlas Policy Manager software, allows our customers to deploy a network
that is more aligned with their business
5
priorities than more traditional networks.
ROUTING
Routers connect computer networks and transmit information from one
network to another. Specifically designed for core routing in the enterprise
network, our X-Pedition family of routers combines advanced features and
functionality with wire-speed performance and essential security, while offering
precise control over applications. Our routers also incorporate proprietary
hardware-based ASIC designs that enable them to process information faster than
software-based routers. Our routers are typically deployed in the core, or
center, of the enterprise network, where security and traffic control are most
important to enterprises. When linked to our multilayer Matrix switches, our
X-Pedition routers provide a complete network solution, where both switches and
routers share similar, complementary security and management features and
communicate over Layer 3. This allows network administrators to better
prioritize and more precisely control network usage, resulting in improved
productivity and network availability throughout the enterprise.
We have also developed a standards-based operating environment that gives
our X-Pedition routers the flexibility to operate in multi-vendor and
multi-protocol networks. The most widely used local area networking technology
in new installations is Ethernet. Our system also supports multi-Gigabit
Ethernet networks at speeds up to 10 billion bits per second and operates over
wide area networks, or WANs.
In 2002, we launched a series of WAN routers, the X-Pedition 1800 Series
of security routers, or XSRs, specially designed for branch office locations.
These routers combine high-performance routing, VPN capabilities, and a built-in
firewall all in a single compact device, providing a simple, cost-effective
solution for secure, high-speed networking. Later this year, we expect to
introduce a new series of security routers specifically designed for regional
office locations.
WIRELESS NETWORKING
Wireless local area networks enable mobile connectivity to the network.
Our RoamAbout product family allows easy, secure, high-speed and economical
access to the network from within enterprise buildings or campuses located
within 25 miles of each other, using a mobile device such as a laptop or
handheld computer. Our RoamAbout wireless networks function like standard wired
Ethernet networks, but use radio frequencies instead of cables for network
connection. Our RoamAbout access products power themselves over the existing
Ethernet connection, allowing enterprises to deploy wireless local area networks
without concern for the location of power supplies.
RoamAbout technology is based on industry standards, which currently
enable two connection speeds to support higher bandwidth applications. Our
RoamAbout Access Point 2000 provides a secure, 11 megabits per second, or Mbps,
wireless connection and a 10 Mbps Ethernet connection into the wired network
infrastructure. The RoamAbout R2 Access Point provides support for multiple
wireless networks enabling secure connections at speeds of 11 Mbps and 54 Mbps
with a 10/100 Mbps Ethernet connection into the wired network infrastructure.
SECURITY
Virtually all of our products incorporate security features to prevent
unauthorized access to the network using authentication procedures, encryption,
and network monitoring. We believe our security solutions offer a high level of
protection against both external and internal security threats. We also offer
dedicated security devices and products, which include our Dragon, Netsight
Atlas and Aurorean product lines. Our Dragon intrusion detection system, or IDS,
detects a wide variety of security attacks using sophisticated algorithms and an
extensive library of over 3,000 patterns. Our Dragon technology also offers an
integrated management system for monitoring selected devices throughout the
network, enabling an enterprise to quickly respond to security threats. NetSight
Atlas is a multi-device management application that provides system level
configuration and administration of our products within the enterprise network.
Our Aurorean products provide VPN solutions for telecommuting, branch office and
regional site connectivity and enable secure access to the enterprise network
using dial-up, dedicated line, digital subscriber line or cable modem.
OUR SERVICES
Our support services are designed to address our enterprise customers'
unique needs, including initial network assessment and design, system
installation and integration, and post-installation maintenance and technical
support, with the goals of maximizing a customer's overall network availability
and performance. We provide high-quality support for both standard and
mission-critical network environments using the appropriate level of expertise
and resources to supplement a customer's internal capabilities. To provide
service at all levels, we complement our internal service staff with those of
our channel partners.
6
Our post-installation maintenance and technical support, or Availability
Services, help customers minimize network interruption and downtime, and consist
of the following options:
- Extended Warranty consists of technical telephone support during our
normal business hours, around the clock on-line support, and repair
or replacement of failed products.
- Technical Access Service represents around the clock technical
telephone support and on-line support, access to upgrades and repair
or replacement of failed products.
- Express Parts Service includes Technical Access Service and express
shipment of products and parts in the event of equipment failure.
- On-Site Response includes all the features of our Express Parts
Service and the on-site assistance of our customer support
engineers.
SALES OVERVIEW
We sell most of our products and services to our enterprise customers
through stocking distributors and through channel partners such as systems
integrators, value-added resellers, telecommunications service providers and
managed security service providers. Our distributors sell our products to
value-added resellers, system integrators and consultants, and provide us and
these partners with inventory management, credit and collection, product
shipment and other services. Our network of distributors allows us to sell to
and support a wide range of channel partners across the world and in specific
industries. We believe our reseller customers benefit from the broad service and
product fulfillment capabilities these distributors offer. We generally give our
distributors limited rights to rotate a portion of inventory, exchanging slower
moving products for faster moving products, and to participate in various
marketing programs designed to promote the sale of our products.
Our channel partners identify, qualify and design optimal networking
solutions to meet the needs of end-users and, as necessary, seek guidance from
our sales and technical support personnel. We have established, and continue to
establish, relationships with value-added resellers worldwide in order to
increase our market penetration and leverage the expertise of these resellers in
particular industries, applications and/or geographic areas. In addition, we
have formed and continue to form relationships with system integrators that
provide complete technology solutions, international reach, broad technology
integration and development capabilities, and generally high-level service and
outsourcing offerings. We also intend to establish relationships with large
telecommunications service providers that offer data, voice and/or video
communication services to businesses, governments, utilities and consumers and
that will remarket our products to their installed customer base. Such service
providers include regional, national and international telecommunications
carriers, as well as Internet, cable and wireless service providers.
International sales represent a significant portion of our business. We
conduct sales operations primarily in four regions around the world including
North America (United States and Canada), EMEA (Europe, Middle East and Africa),
Asia Pacific (Asia and Australia), and Latin America (South America, Mexico and
Caribbean). Key countries include the United States, Germany, the United
Kingdom, France, Italy, Spain, Japan, Australia, Korea and China. North America
has the highest level of direct sales followed by EMEA. Asia Pacific and Latin
American sales are generated primarily through channel partners. In the fiscal
year ended December 28, 2002, sales to customers outside of North America,
including exports, accounted for approximately 43% of our consolidated net
revenue, compared to approximately 50% for the ten-month transition period ended
December 29, 2001 and 47% for fiscal year 2001.
MARKETING
Our marketing objectives are to build awareness and acceptance of our
brand and products, create demand for our products and solutions, develop
successful channel partnerships to improve our market coverage and grow new
business, and provide education and training to customers and partners. To
accomplish these objectives, we market our products using direct advertising,
indirect publicity, press releases, publication of educational articles in
industry journals, and participation in industry roundtables and speaker venues.
We also maintain relationships with industry analysts, such as Gartner, Current
Analysis, IDC and Meta Group, that produce and distribute industry information
and product analysis to customers.
We use a number of marketing programs to promote new products and
solutions to our installed customer base and prospective customers. These
programs include participation in prominent industry trade shows, co-sponsorship
of seminar series with other industry leaders and communication of virtual
advertorials to broad audiences, as well as a number of local and field-based
customer and tradeshow activities in targeted geographic regions. Our channel
partners and distributors extend our direct marketing efforts to
7
our current and prospective customers. We provide some of these partners with
marketing funds to facilitate their marketing efforts and have developed various
incentive programs designed to encourage these partners to market and sell our
products.
We believe our training programs provide us with the ability to educate
and inform our partners and end-user customers about our products and new
product developments. We have launched a number of new programs to advance the
delivery of these programs. For example, during 2002, we introduced a new
virtual classroom and certification program to enable users to participate in
our training programs remotely.
CUSTOMERS
Over the years we have developed a significant installed base of end-user
customers, which is an important source of revenue. We seek to generate revenue
from sales of our products and solutions to new customers and by upgrading the
technology used by existing customers. Our end-user customers include commercial
enterprises, including financial institutions; government entities; healthcare,
educational and non-profit institutions; and other organizations.
During the fiscal year ended December 28, 2002, two distributors, Tech
Data and Ingram Micro, accounted for approximately 17% and 12% of total revenue,
respectively. No individual direct sales customer accounted for more than 10% of
total revenue. During the ten months ended December 29, 2001, Azlan Group PLC, a
European distributor, and Tech Data accounted for approximately 14% and 10% of
total revenue, respectively. During the year ended March 3, 2001, no individual
direct sales customer, distributor or channel partner accounted for more than
10% of our total revenue. Our top ten direct sales customers, distributors and
channel partners represented in the aggregate, approximately 62% of our total
revenue for the fiscal year ended December 28, 2002, 56% for the ten
month-period ended December 29, 2001 and 32% for the fiscal year ended March 3,
2001, reflecting our increased use of distributors and channel partners.
During the fiscal year ended December 28, 2002, the ten months ended
December 29, 2001 and the fiscal year ended March 3, 2001, the United States
federal government accounted for approximately 11%, 13% and 10% of net revenue,
respectively; however, our sales to the United States federal government are
distributed across a wide variety of government departments and agencies and,
therefore, we do not believe our revenues would be materially impacted by
fluctuations in federal government spending.
COMPETITION
The market for enterprise network communications products is very
competitive, subject to rapid technological change and significantly affected by
new product introductions and other market activities of industry participants.
This market is dominated by several large companies, both domestically and
internationally, many of which, in particular Cisco Systems, have substantially
greater market share than other competitors, including us. The remainder of the
network communications products market is highly fragmented. Our principal
competitors include Alcatel, Avaya, Cisco Systems, Extreme Networks, Foundry
Networks, Hewlett-Packard, Nortel Networks and 3Com, although we also experience
competition from a number of smaller public and private companies. Prospective
customers may be reluctant to replace or expand their current infrastructure
solutions, which may have been supplied by one or more of these established
competitors, with our products.
We believe that the principal competitive factors in the enterprise
networking market are:
- provision of effective and reliable customer solutions and service
offerings;
- technology leadership;
- compatibility with industry standards, other vendor products and
prior generations;
- price of products, total cost of ownership and cost to change
vendors;
- access to customers and size of installed customer base; and
- customer service and support.
We believe that we compete favorably with our competitors on the basis of
the foregoing factors; however, we operate in an extremely competitive
marketplace and may not compete favorably on the basis of one or more of these
factors in the future. We intend to compete by investing in product development,
expanding our customer base, developing our name recognition and branding, and
focusing on operating efficiencies. Because certain of our competitors have
greater name recognition, larger installed customer
8
bases and greater financial, technical, sales, marketing and other resources,
they may have greater access to customers, the ability to more aggressively
adjust product pricing, and greater resources to devote to product development.
MANUFACTURING AND COMPONENTS
We outsource the manufacture of our products to third party contractors
that provide comprehensive services, including procurement of raw materials and
components, assembly and repair work. Our contract manufacturers use automated
testing equipment to perform inspection testing and use statistical process
controls to assure the quality and reliability of our products. Our engineering
and supply chain management personnel work closely with our contract
manufacturers to ensure that products are manufactured to specifications and
supplied on a timely basis. We design and develop the key components of our
products, including ASICs and printed circuit boards. We also determine the
components that are incorporated in our products and select the appropriate
suppliers of these components. In addition, we conduct quality assurance,
manufacturing engineering, document control and test development.
Flextronics International, Ltd. is one of our primary contract
manufacturers. Flextronics manufactures our products primarily at its newly
constructed facility in Portsmouth, NH as well as at its facility in Cork,
Ireland. Our contract with Flextronics expired in February 2002. Since that
time, we have been operating under extensions of the expired contract that
include modifications primarily to provide us with more flexibility with respect
to production lead times and payment. In addition, we have been negotiating a
new manufacturing agreement with Flextronics.
We also contract with Accton Technology Corporation, which manufactures
certain of our products at its facility in Taiwan. Our agreement with Accton
renews for successive one year periods unless terminated by written notice from
either party at least ninety days prior to the expiration of the then current
term of the contract.
We source several key components used in the manufacture of our products
that may be considered custom or unique, including ASICs, from single or limited
sources and are dependent upon these sources to meet our needs. These custom
components typically require longer lead times in order to minimize the impact
of shortages and delays. Although we may have encountered shortages and delays
in obtaining custom components in the past, we do not believe that such
shortages have impaired our ability to provide products to customers on a timely
basis. Historically, we have relied heavily on custom components and components
that are not used across multiple products, resulting in excess raw materials
and finished goods inventory. We continuously seek to incorporate fewer custom
components in our products and use more common components across multiple
products.
RESEARCH AND DEVELOPMENT
The networking industry is highly competitive and subject to evolving
industry standards and technological advancements. We believe that strong
product development capabilities are essential to our strategy of enhancing our
core technology, which we use across multiple product lines, and developing new
and enhanced products to maintain our competitiveness in the enterprise network
market. Accordingly, our research and development efforts are focused on
improving our existing products and developing innovative products that meet the
evolving networking needs of enterprises.
As of December 28, 2002, we had approximately 465 engineers in our
research and development organization, located in five research and development
facilities in the United States and Canada. Our research and development
organization has produced an international patent portfolio that allows us to
implement advanced technologies within our network solutions. Our engineers and
technologists are active in key industry standards organizations, and have
leadership roles in several, allowing us to better understand and influence
technological developments in the networking industry. We also have
relationships with leading component suppliers, including Intel, IBM, Broadcom,
Motorola, Marvell and LSI, which provide us with early insight into new
technologies.
We have made and will continue to make a substantial investment in
research and development. We plan to continue to investing in emerging
technologies for use in existing and future products primarily through internal
efforts as well as through alliances and acquisitions. However, we cannot assure
you that our investment in research and development will enable us to
successfully develop new and enhanced products or maintain our competitiveness
in the enterprise networking market. For the fiscal year ended December 28,
2002, the ten-month transition period ended December 29, 2001, and the fiscal
year ended March 3, 2001, we spent approximately $85 million, $76 million and
$82 million, respectively, on research and development.
9
INTELLECTUAL PROPERTY
We generally rely on a combination of patent, copyright, trademark and
trade secret laws and contractual restrictions to establish and protect our
technology. As of December 28, 2002, we had a total of 658 issued patents and an
additional 131 patents pending for examination worldwide. Our products are also
protected by trade secret and copyright laws of the United States and other
jurisdictions. However, these legal protections provide only limited protection.
Further, the market for network communications solutions is subject to rapid
technological change. Accordingly, while we intend to continue to protect our
proprietary rights where appropriate, we believe that our success in maintaining
a technology leadership position is more dependent on the technical expertise
and innovative abilities of our personnel than on these legal protections.
Despite our efforts to protect our proprietary technology, we cannot
assure you that the steps we take will be adequate to prevent misappropriation
of our technology or that our competitors will not independently develop
technologies that are substantially equivalent or superior to our technology.
The laws of many countries do not protect proprietary technology as extensively
as the laws of the United States. We 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 our proprietary rights or
those of others. We are also subject to the risk of adverse claims and
litigation alleging infringement of the intellectual property rights of others.
Any resulting litigation could result in substantial costs and diversion of
management and adverse effect on our business and financial condition.
BACKLOG
Our products are often sold on the basis of standard purchase orders that
are cancelable prior to shipment without significant penalties. In addition,
purchase orders are subject to changes in quantities of products and delivery
schedules in order to reflect changes in customer requirements and manufacturing
capacity. Our business is characterized by quarter-end variability in demand and
short lead-time orders and delivery schedules. Actual shipments depend on the
then-current capacity of our contract manufacturers and the availability of
materials and components from our vendors. We believe that only a small portion
of our order backlog is non-cancelable and that the dollar amount associated
with the non-cancelable portion is immaterial. Accordingly, we do not believe
that backlog at any given time is a meaningful indicator of future sales.
EMPLOYEES
As of December 28, 2002, we had approximately 1,627 full-time employees,
compared with approximately 2,300 full-time employees as of December 29, 2001,
excluding all employees associated with businesses accounted for as discontinued
operations. The decrease in the number of employees was largely a result of the
termination of employees in accordance with our cost reduction initiatives. Our
employees are not represented by a union or other collective bargaining agent
and we consider our relations with our employees to be good.
ITEM 2. PROPERTIES
We lease several facilities, including our corporate headquarters, a
152,000 square foot facility in Andover, Massachusetts. We also lease a 110,000
square foot warehousing and distribution center located in Rochester, NH, a
75,000 square foot warehousing and distribution center located in Shannon,
Ireland, and a 32,000 square foot building in Toronto, Canada. We lease a 47,000
square foot facility in Portsmouth, New Hampshire and a 41,000 square foot
building in Salt Lake City, Utah. Remaining leased sales offices range from
1,000 to 28,000 square feet.
We own two buildings totaling 210,750 square feet in Rochester, New
Hampshire. These buildings accommodate certain engineering, information
technology and customer support departments.
We are continuing efforts to consolidate and reduce our worldwide
facilities and as a part of this process may pursue the sale, lease or sublease
of one or more of our existing facilities.
ITEM 3. 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
10
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 assigned to a judge of the
District of Rhode Island sitting by designation in the District of New
Hampshire. 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, 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. On March 7, each of the individual
defendants filed motions 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.
11
Settlement of SEC Investigation. After the close of business on January
31, 2002 the 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 and, in February 2003, we
settled the SEC investigation. 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 and 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 changes to our historical financial statements
which were restated in our Form 10-K for the transition period ended December
29, 2001 filed with the SEC on November 26, 2002.
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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We held our annual meeting of shareholders on December 20, 2002. At this
meeting our shareholders voted upon the election of Class I Directors with the
accompanying results:
NUMBER OF NUMBER OF VOTES
NAME VOTES FOR WITHHELD AUTHORITY
-------------- --------- ------------------
Paul R. Duncan .... 171,062,699 1,347,646
Edwin A. Huston.... 171,067,787 1,342,558
Shareholders also voted upon an amendment to our 1998 Equity Incentive
Plan to increase the number of shares of our common stock authorized for
issuance thereunder by 5,000,000 with the accompanying results:
NUMBER OF NUMBER OF NUMBER OF
VOTES FOR VOTES AGAINST VOTES ABSTAINING
--------- ------------- ----------------
142,616,315 29,636,431 157,599
Shareholders also voted upon the adoption of our 2002 Employee Stock
Purchase Plan with the accompanying results:
NUMBER OF NUMBER OF NUMBER OF
VOTES FOR VOTES AGAINST VOTES ABSTAINING
--------- ------------- ----------------
168,813,375 3,421,689 175,281
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
STOCK PRICE HISTORY
The following table sets forth the high and low sale prices for our Common
Stock as reported on the New York Stock Exchange (symbol -- "ETS" since August
6, 2001 and symbol "CS" prior to August 6, 2001) during the last two fiscal
years.
YEAR ENDED DECEMBER 28, 2002 HIGH LOW
---------------------------------------------------- ---------- -------
First quarter ended March 30, 2002.................. $ 11.20 $ 3.50
Second quarter ended June 29, 2002.................. 4.25 1.02
Third quarter ended September 28, 2002.............. 1.69 0.80
Fourth quarter ended December 28, 2002.............. $ 1.82 $ 0.81
TEN MONTHS ENDED DECEMBER 29, 2001 HIGH LOW
---------------------------------------------------- ---------- -------
First quarter ended June 2, 2001.................... $ 22.00 $ 10.61
Second quarter ended September 1, 2001.............. 24.38 8.50
Third quarter ended September 29, 2001.............. 10.27 4.90
Fourth quarter ended December 29, 2001.............. $ 11.91 $ 5.90
As of March 12, 2003, we had approximately 2,500 stockholders of record.
We have not paid dividends on our common stock, and do not anticipate paying
dividends in the future. We expect we will continue to reinvest any earnings to
finance future growth.
Our stock price history prior to August 6, 2001 reflects our value
including value inherent in our interest in Riverstone Networks, Inc. Riverstone
made an initial public offering of its common stock in February 2001, and we
distributed Riverstone's common stock
12
to our stockholders on August 6, 2001. The price per share of our common stock
dropped $7.00 from the market close of $20.75 on the day prior to our
distribution of our Riverstone shares to $13.75 at the opening trade on the day
immediately following our distribution of Riverstone shares.
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information about our equity compensation
plans as of December 28, 2002.
(C)
NUMBER OF SECURITIES
(A) REMAINING AVAILABLE
NUMBER OF SECURITIES (B) FOR ISSUANCE
TO BE ISSUABLE UPON WEIGHTED-AVERAGE UNDER EQUITY
EXERCISE OF EXERCISE PRICE OF COMPENSATION PLANS
OUTSTANDING OPTIONS, OUTSTANDING (EXCLUDING
WARRANTS AND OPTIONS, WARRANTS SECURITIES REFLECTED
PLAN CATEGORY RIGHTS (#) AND RIGHTS ($) IN COLUMN(A)) (#)
- ------------- ----------------------- -------------------- ---------------------
Equity Compensation Plans
Approved by Security Holders........................ 8,251,166(1) $ 2.77 14,473,590(2)
Equity Compensation Plans Not
Approved by Security Holders........................ 21,519,984(3) $ 3.33(4) 0
----------- -------------
Total................................................. 29,771,150 $ 3.18 14,473,590
========== =============
- ----------
(1) Of this amount, 50,000 were issued under the Directors Option Plan,
747,238 were issued under the 1989 Employee Stock Purchase Plan, and
7,453,928 were issued under the 1998 Equity Incentive Plan.
(2) Of this amount, 9,473,590 shares were available for issuance under the
1998 Equity Incentive Plan and 5,000,000 shares were available for
issuance under the 2002 Employee Stock Purchase Plan.
(3) Of this amount, 20,619,984 shares were issued under the 2001 Equity
Incentive Plan and 900,000 shares were issued under the 2002 Stock Option
Plan for Eligible Executives. No additional options may be granted under
these plans. Options issued under the 2001 Equity Incentive Plan were
issued in connection with the merger of our subsidiary, then known as
Enterasys Networks, Inc., (the "Enterasys Subsidiary") with and into us in
August 2001, replacing options previously outstanding under the Enterasys
Subsidiary 2000 Equity Incentive Plan. In exchange for previously
outstanding options, and subject to their agreement to forfeit any
pre-existing options to purchase our stock, holders of Enterasys
Subsidiary options were granted options to purchase 1.39105 shares of our
stock for each share of the Enterasys Subsidiary covered by the previously
outstanding options. The 2002 Stock Option Plan for Eligible Executives
and the Enterasys 2001 Equity Incentive Plan are each described below in
more detail.
(4) The replacement options were granted at an exercise price equal to the
exercise price of the original Enterasys Subsidiary Plan options, divided
by 1.39105 to reflect the effect of the merger.
ENTERASYS 2002 STOCK OPTION PLAN FOR ELIGIBLE EXECUTIVES
On April 5, 2002, our Board of Directors adopted the Enterasys 2002 Stock
Option Plan for Eligible Executives (the "2002 SOPEE") solely for the purpose of
granting options in connection with the acceptance by certain executives of
offers of employment with us. Pursuant to the 2002 SOPEE, up to 900,000 shares
of common stock may be issued pursuant to the exercise of stock options granted
under the plan. Options granted under the plan vest over a period of 12 months,
or sooner if certain performance targets outlined in the plan are met, and
expire ten years from the date of grant. Upon termination of employment, the
unvested portion of these options terminates and the remainder remains
exercisable until the later to occur of the one-year anniversary or the date of
termination or December 31, 2004. At December 28, 2002, options to purchase all
900,000 shares were outstanding. This plan is not required to be, and has not
been, approved by our stockholders.
ENTERASYS 2001 EQUITY INCENTIVE PLAN
On July 30, 2001, our Board of Directors adopted the Enterasys 2001 Equity
Incentive Plan (the "2001 EIP") solely for the purpose of granting options to
purchase shares of our stock in replacement for options to purchase shares of
the Enterasys Subsidiary. No additional options may be granted under this plan.
Pursuant to the 2001 EIP, each option vests and becomes exercisable at the same
time or times, and subject to the same conditions, as the original Enterasys
Subsidiary option to which the option relates. Accordingly, the options expire
ten years from the date of grant of the original Enterasys Subsidiary option and
generally vest as to one-quarter of the shares subject to the options one year
from the date of grant of the original Enterasys Subsidiary option with monthly
vesting of the remainder ratably over the following three years. Upon
termination of employment, the unvested portion of these options terminates and
the remainder remains exercisable for ninety days from the date of termination.
This plan is not required to be, and has not been, approved by our stockholders.
13
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data for
the fiscal year ended December 28, 2002, the ten-month transition period ended
December 29, 2001 and the fiscal years ended March 3, 2001, February 29, 2000
and February 28, 1999, which has been derived from our Consolidated Financial
Statements. For a detailed analysis of the fiscal year ended December 28, 2002,
the ten-month period ended December 29, 2001 and the fiscal year ended March 3,
2001, please refer to "Item 7 -- Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Item 8 -- Consolidated
Financial Statements and Supplementary Financial Data."
TEN MONTHS YEAR ENDED
YEAR ENDED ENDED -------------------------------------------------
DECEMBER 28, DECEMBER 29, MARCH 3, FEBRUARY 29, FEBRUARY 28,
2002 2001 (1) 2001(1) 2000 (1) 1999(1)
------------ ------------ ------------ ------------ ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENTS OF
OPERATIONS DATA:
Net revenue:
Enterasys segment ..................... $ 484,797 $ 394,545 $ 704,665 $ 638,235 $ 637,895
Other segment (2) ..................... -- -- 69,702 712,462 740,838
------------ ------------ ------------ ------------ ------------
Total net revenue ..................... 484,797 394,545 774,367 1,350,697 1,378,733
------------ ------------ ------------ ------------ ------------
Gross margin ............................ 209,795 44,169 342,600 597,698 587,957
Research and development ................ 85,019 76,471 81,723 131,852 158,819
Selling, general and administrative ..... 234,960 284,735 335,303 348,922 378,430
Amortization of intangible assets ....... 8,708 32,366 23,176 28,952 27,978
Stock-based compensation ................ 2,644 30,572 1,442 -- --
Special charges ......................... 31,978 47,168 63,187 21,096 84,505
Impairment of intangible assets ......... -- 104,147 14,104 12,318 --
------------ ------------ ------------ ------------ ------------
Total operating expenses .............. 363,309 575,459 518,935 543,140 649,732
------------ ------------ ------------ ------------ ------------
Income (loss) from operations ....... (153,514) (531,290) (176,335) 54,558 (61,775)
Interest income, net .................... 8,347 17,672 29,981 18,614 15,203
Other income (expense), net ............. (42,625) (41,209) (557,355) 746,282 92
------------ ------------ ------------ ------------ ------------
Income (loss) from continuing
operations before income taxes
and cumulative effect of a change
in accounting principle ............. (187,792) (554,827) (703,709) 819,454 (46,480)
Income tax expense (benefit) ............ (85,247) 60,242 (98,187) 317,185 (2,659)
------------ ------------ ------------ ------------ ------------
Income (loss) from continuing
operations before cumulative
effect of a change in accounting
principle ........................... $ (102,545) $ (615,069) $ (605,522) $ 502,269 $ (43,821)
============ ============ ============ ============ ============
Income (loss) from continuing
operations available to common
shareholders per common share:
Basic ................................. $ (0.57) $ (3.24) $ (3.40) $ 2.83 $ (0.26)
============ ============ ============ ============ ============
Diluted ............................... $ (0.57) $ (3.24) $ (3.40) $ 2.66 $ (0.26)
============ ============ ============ ============ ============
DECEMBER 28, DECEMBER 29, MARCH 3, FEBRUARY 29, FEBRUARY 28,
2002 2001 2001 2000 1999
------------ ------------ ------------ ------------ ------------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Working capital(3) ................... $ 28,299 $ 134,324 $ 848,179 $ 469,364 $ 365,669
Total assets ......................... $ 578,040 $ 750,038 $ 1,733,514 $ 3,121,705 $ 1,517,778
Redeemable convertible preferred stock $ -- $ 61,789 $ 109,589 $ -- $ --
Stockholders' equity ................. $ 245,950 $ 329,704 $ 1,214,319 $ 2,147,439 $ 1,058,932
- ----------
(1) Certain marketing development costs paid to channel partners have been
reclassified for the periods noted above to comply with EITF No. 00-25 as
further defined by EITF No. 01-9, which the Company adopted in the first
quarter of fiscal year 2002. Product revenue was reduced by $20.7 million,
$9.3 million and $4.3 million, cost of revenue was reduced by $28.1
million, $14.7 million and $7.0 million and selling, general and
administrative expense was increased by $7.4 million, $5.4 million and
$2.7 million for the ten month period ended December 29, 2001, the year
ended March 3, 2001 and the year ended February 29, 2000, respectively.
The above reclassification had no impact on income (loss) from continuing
operations available to common stockholders in total or on a per share
basis. The results for the fiscal year ended February 28, 1999 have not
been reclassified because it was impracticable to do so due to a lack of
available information.
(2) The Other Segment included the revenue and cost of revenue relating to
non-standards-based products.
(3) Including current portion of redeemable convertible preferred stock of
$94.8 million at December 28, 2002.
14
ITEM 7. 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
annual report on Form 10-K. Our current fiscal year consists of the twelve-month
period ended December 28, 2002 which we refer to as "fiscal year 2002"
throughout this Item 7. 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 7. For fiscal years prior to
transition year 2001, our fiscal year ended on the Saturday closest to the last
calendar day of February in each year. We refer to the twelve-month period ended
March 3, 2001 as "fiscal year 2001" throughout this Item 7.
BUSINESS OVERVIEW
We design, develop, market and support comprehensive networking solutions
to address the networking challenges facing global 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,
while maintaining security. 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; health care, financial, educational and non-profit
institutions; and other various organizations.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are described in Note 2 to the
consolidated financial statements included in Item 8 of this annual report on
Form 10-K. 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. We base our estimates on historical experience,
current conditions and various other assumptions that are believed to be
reasonable under the circumstances. The markets for our products are
characterized by rapid technological development, intense competition and
frequent new product introductions, any of which could affect the future
realizability of our assets. Estimates and assumptions are reviewed on an
ongoing 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. 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, routers, and other network
equipment and software, and services revenue, which includes maintenance,
installation, and system integration services. Our revenue recognition policy
follows SEC Staff Accounting Bulletin No. 101,"Revenue Recognition in Financial
Statements," and Statement of Position ("SOP") No. 97-2, "Software Revenue
Recognition," as amended by SOP No. 98-9, "Modification of SOP No. 97-2,
Software Recognition, With Respect to Certain Transactions." 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 for system integration or customer acceptance, revenue and
related costs are deferred until such obligations are fulfilled. Software
revenue is deferred in instances when vendor specific objective evidence
("VSOE") of fair value of undelivered elements is not determinable. VSOE of fair
value is the price charged when the element is sold separately. Revenue from
service obligations under maintenance contracts is deferred and recognized on a
straight-line basis over the contractual period, which is typically twelve
months.
Beginning in September 2001, we determined that we could no longer
estimate the amount of future product returns from stocking distributors located
in the United States and Europe. We now recognize revenue from these
distributors when they ship our products to our customers. We record payments
from these distributors as customer advances and billings in excess of revenues
when they pay for our products in advance of shipments to their customers.
Beginning in fiscal year 2001, we began recording revenue from certain
distributors and resellers located in Asia Pacific and Latin America when they
paid us, due to existing practices related to the distributor/reseller
relationships.
We provide an allowance for sales returns based on return policies and
return rights granted to our customers and historical returns. We also provide
for pricing allowances in the period when granted. These allowances have been
recorded as a reduction of net revenue in the accompanying consolidated
statements of operations.
15
Allowance for Doubtful Accounts and Notes Receivable. We estimate the
collectibility of our accounts receivable and notes receivable and the related
amount of bad debts that may be incurred in the future. The allowance for
doubtful accounts results from an analysis of specific customer accounts,
historical experience, customer concentrations, credit ratings and current
economic trends. The allowance for notes receivable is based on specific
customer 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. 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 Goodwill. Goodwill is the excess of the purchase price over
the fair value of identifiable net assets acquired in business combinations. On
December 30, 2001, we adopted Financial Accounting Standards Board ("FASB")
Statement of Financial Standards ("SFAS") No. 142 and discontinued amortizing
goodwill. Existing and future acquired goodwill will be subject to an annual
impairment test using a fair-value-based approach. In assessing the fair value
of goodwill, we made projections regarding future cash flow and other estimates.
If these projections or other estimates change in the future, we may be required
to record an impairment charge. Prior to the adoption of SFAS No. 142, we
amortized goodwill on a straight-line basis over their respective useful lives
that ranged from three to ten years.
Valuation of Long-lived Assets. Long-lived assets are comprised of
property, plant and equipment and intangible assets with definite lives. We
assess the impairment of long-lived assets whenever events or changes in
circumstances indicate that the carrying value may not be recoverable through
projected undiscounted cash flows expected to be generated by the asset. When we
determine that the carrying value of intangible assets and fixed assets may not
be recoverable, we measure impairment by the amount by which the carrying value
of the asset exceeds the related fair value. Estimated fair value is generally
based on a projected discounted cash flow method using a discount rate
determined by management to be commensurate with the risk inherent in the
business underlying the asset in question.
Valuation of Investments. We have certain minority investments in debt and
equity securities of companies that were acquired for cash and in non-monetary
transactions whereby we exchanged inventory or product credits for preferred or
common stock or convertible notes. We review investments for potential
impairment whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Such events include declines in the
investees' stock price in new rounds of financing, market capitalization
relative to book value, bankruptcy or insolvency, and deterioration in the
financial position or results of operations. Appropriate reductions in carrying
value are recognized in other income (expense), net in the consolidated
statements of operations.
Restructuring Reserves. We have periodically 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, require
management's judgement and may include severance benefits and costs for future
lease commitments or excess facilities, net of estimated future sublease income.
In determining the amount of the facility exit costs, we are required to
estimate such factors as future vacancy rates, the time required to sublet
properties and sublease rates. These estimates are reviewed and potentially
revised on a quarterly basis based on known real estate market conditions and
the credit worthiness of subtenants, resulting in revisions to established
facility reserves. 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 in the
statement of operations.
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:
16
FISCAL YEAR TRANSITION YEAR FISCAL YEAR
(IN MILLIONS) 2002 2001 2001
- ------------- ----------- --------------- -----------
Provision for doubtful accounts and notes receivable $ (0.9) $ 18.6 $ 47.8
Provision for excess and obsolete inventory ........ 17.9 72.9 44.7
Impairment of goodwill ............................. -- 104.1 12.8
Impairment of long-lived assets .................... -- -- 1.3
Impairment of investments .......................... 22.1 65.9 17.2
Restructuring charges .............................. 32.0 22.7 24.3
Deferred tax asset valuation provision ............. 19.8 260.0 173.2
------- ------- -------
Total ............................................ $ 90.9 $ 544.2 $ 321.3
======= ======= =======
RESULTS OF OPERATIONS
The table below sets forth the principal line items from our consolidated
statements of operations, each expressed as percentages of net revenue for the
three years ended December 28, 2002:
FISCAL YEAR TRANSITION YEAR FISCAL YEAR
2002 2001 2001
----------- --------------- -----------
Net revenue:
Product ......................................... 71.5% 65.4% 77.4%
Services ........................................ 28.5 34.6 22.6
------- ------- -------
Total revenue .................................. 100.0 100.0 100.0
------- ------- -------
Cost of revenue:
Product ......................................... 66.7 117.4 62.7
Services ........................................ 31.6 34.8 32.0
------- ------- -------
Total cost of revenue .......................... 56.7 88.8 55.8
------- ------- -------
Gross margin:
Product gross margin ........................... 33.3 (17.4) 37.3
Services gross margin .......................... 68.4 65.2 68.0
------- ------- -------
Total gross margin .............................. 43.3 11.2 44.2
------- ------- -------
Research and development ........................... 17.5 19.4 10.5
Selling, general and administrative ................ 48.5 72.2 43.3
Amortization of intangible assets .................. 1.8 8.2 3.0
Stock-based compensation ........................... 0.6 7.7 0.2
Special charges .................................... 6.6 12.0 8.2
Impairment of intangible assets .................... -- 26.4 1.8
------- ------- -------
Total operating expenses ..................... 75.0 145.9 67.0
------- ------- -------
Loss from operations ......................... (31.7)% (134.7)% (22.8)%
======= ======= =======
COMPARISON OF FISCAL YEAR 2002 WITH TRANSITION YEAR 2001
Overview
For fiscal year 2002, we incurred a net loss from continuing operations
available to common shareholders of $115.5 million primarily due to special
charges of $32.0 million associated with our cost reduction initiatives; charges
for excess and obsolete inventory of $17.9 million; investment write-downs of
$22.1 million; expenses associated with the SEC investigation, our internal
review and associated stockholder litigation of approximately $21.0 million;
increased independent audit expenses of $13.5 million; and the fact that our
fixed overhead cost structure was too high to achieve break-even profitability
at quarterly revenue levels of approximately $120 million partially offset by
the income tax benefit recognized of $85.2 million.
17
The cost reduction initiatives undertaken during fiscal year 2002 were
designed to lower our use of cash significantly, while at the same time preserve
our ability to support future growth. The special charges associated with these
initiatives were restructuring charges consisting of facility exit costs of $6.2
million and employee severance costs of $25.8 million. 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.
Partially offsetting these costs reductions will be the costs associated with
the pending shareholder litigation and compliance with the Sarbanes-Oxley Act of
2002.
Net Revenue
Net revenue increased by $90.3 million, or 22.9%, from $394.5 million in
transition year 2001 to $484.8 million for fiscal year 2002, primarily because
transition year 2001 included only ten months of operations compared with twelve
months in fiscal year 2002 as a result of the change in our fiscal year end.
Fiscal year 2002 revenue also benefited from four quarterly sales cycles,
compared with only three quarterly sales cycles in transition year 2001, since
product revenue is significantly higher in the last month of a quarterly sales
cycle.
During the third quarter of transition year 2001, we also determined that
we could no longer estimate the amount of future product returns from certain
stocking distributors located in the United States and Europe and recorded a
revenue adjustment of approximately $76 million related to inventory on hand at
these distributors that had previously been recorded as revenue based on
shipments to them. Since that time we have recognized revenue from these
distributors when they ship our product to their customers. During fiscal year
2002, we also improved pricing discipline and utilized price incentives with our
stocking distributors at more industry-normal levels.
During fiscal year 2002, we faced 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. We believe this sometimes 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
depressed. 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 our new product introductions and those of our
competitors, 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 $88.7 million, or 34.4%, from $257.9 million
in transition year 2001 to $346.6 million in fiscal year 2002 for the reasons
discussed above. Our product revenue was derived principally from sales of our
multilayer switching and routing products. In the future our product mix could
potentially be affected by the nature and timing of new product introductions by
our competitors and us, as well as other competitive factors.
Services revenue increased by $1.6 million, or 1.2% from $136.6 million in
transition year 2001 to $138.2 million in fiscal year 2002. The slight increase
was due to the shorter fiscal period in the prior ten-month transition year
offsetting lower fiscal year 2002 maintenance revenue renewal rates related to
our legacy products.
Net revenue to customers in North America was $276.9 million, or 57.1% of
total net revenues, in fiscal year 2002, compared to $196.6 million, or 49.9% of
net revenues, in transition year 2001. During the fourth quarter of fiscal year
2002, revenue from customers in North America decreased by approximately $7.0
million from previous quarterly levels. We currently expect revenue from
customers in North America to remain weak for a least the next couple quarters,
primarily as a result of the continued weakness in that market.
Gross Margin
Total gross margin increased by $165.6 million, from $44.2 million in
transition year 2001 to $209.8 million in fiscal year 2002 as a result of
several factors, including increased revenue as discussed above, a $55.0 million
decrease in provision for excess and obsolete inventory, and lower supply chain
overhead costs resulting from headcount reductions and process improvement
initiatives. In transition year 2001, we recorded $72.9 million of provision for
excess and obsolete inventory, principally as a result of lower sales volume
than forecast. Fiscal year 2002 excess and obsolete charges of $17.9 million
related principally to fourth quarter customer returns, and increased reserves
for customer evaluation units and service inventory. The fourth quarter charge
also included a reserve for the carrying value of inventory held by certain
cash-basis partners in Asia Pacific where we have concluded that neither payment
18
nor return of the inventory held by them is probable.
Total gross margin as a percentage of net revenue was 43.3% in fiscal year
2002, compared with 11.2% in transition year 2001. The margin percentage
improvement was principally due to product gross margin, which increased to
33.3% compared to a negative gross margin of 17.4% in transition year 2001.
Services margin percentage improved slightly from 65.2% in transition year 2001
to 68.4% in fiscal year 2002. The product gross margin percentage improvement
was primarily due to the lower provision for excess and obsolete inventory in
fiscal year 2002. The fiscal year 2002 provision negatively impacted product
margin by 5.2 percentage points compared with 28.3 percentage points in
transition year 2001. Other contributing factors to the product margin
improvement include the previously discussed inventory reduction and supply
chain process improvement initiatives, improved pricing discipline, and lower
handling and evaluation costs resulting from decreased product rotations and
returns. Our gross margin percentage varies depending on unit volumes and
product mix sold as well as other factors. In addition, the nature and timing of
our new product introductions as well as our competitors' new products entering
the markets we serve could have an adverse affect on our inventory levels in the
future and may result in additional excess and obsolete inventory provisions.
Operating Expenses
Research and development expense increased by $8.5 million from $76.5
million in transition year 2001 to $85.0 million in fiscal year 2002, due to the
fact that transition year 2001 included only ten months of operations compared
with twelve months in fiscal year 2002. Based on average monthly spending during
transition year 2001, research and development expense for the twelve months of
transition year 2001 would have been slightly higher than fiscal year 2002. Cost
reduction initiatives implemented during fiscal year 2002, which included
workforce reductions and facilities closings, have decreased research and
development expense in the current year compared to transition year 2001. As a
percentage of revenue, research and development spending for fiscal year 2002
has decreased to 17.5% from 19.4% in transition year 2001. We expect research
and development to increase slightly in fiscal year 2003 primarily as a result
of the acceleration of new product introductions.
Selling, general and administrative ("SG&A") expense was $235.0 million in
fiscal year 2002 and $284.7 million in transition year 2001. SG&A for the
current year included approximately $21.0 million of costs associated with the
SEC investigation into our financial accounting and reporting practices, the
subsequent restatement of our fiscal year 2001 and the quarterly transition year
2001 financial statements, and the various shareholder lawsuits discussed in
this annual report; $13.5 million of audit fees; $16.6 million for various
marketing and advertising programs; $2.3 million of lease guarantee expense
related to lessee defaults on guarantees provided in prior years; and $1.6
million of bad debt expense. SG&A for transition year 2001 included $26.2
million for various marketing and advertising programs, $17.4 million of
equipment lease guarantee expense, $12.5 million of bad debt expense, $3.1
million of audit fees and a loss on disposal of a building of $2.5 million. 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 transition
year 2001 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 have further decreased SG&A in fiscal year 2002 compared to
transition year 2001.
SG&A as a percentage of revenue was 48.5% for fiscal year 2002, compared
to 72.2% for transition year 2001. SG&A excluding the items referenced above was
37.1% of revenue for fiscal year 2002, compared to 56.5% of revenue for
transition year 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.
We have implemented and continue to implement process improvements and
other cost reduction initiatives designed 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 initial cost of compliance with the Sarbanes-Oxley Act of 2002 and the
pending stockholder litigation. During fiscal year 2002, we incurred legal and
forensic accounting fees of approximately $21.0 million for services rendered in
connection with the SEC investigation, our internal review and associated
stockholder litigation. We have not received a determination as to whether and
to what extent those costs are reimbursable under our insurance coverage. Such
costs have been recorded as operating expense as they were incurred.
Amortization of intangibles decreased by $23.7 million from $32.4 million
in transition year 2001 to $8.7 million in fiscal year 2002, primarily due to
the fact that we adopted SFAS No. 142, "Goodwill and Other Intangible Assets,"
and discontinued amortizing goodwill as of the beginning of fiscal year 2002.
See Note 9 to our consolidated financial statements included in Item 8 of this
annual report on Form 10-K.
19
Stock-based compensation was $2.6 million in fiscal year 2002 and $30.6
million in 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 $47.2 million in transition year 2001 to
$32.0 million in fiscal year 2002. During fiscal year 2002, we recorded special
charges of $32.0 million related to restructuring costs, which included exit
costs of $6.2 million related to the closure or reduction in size of ten
facilities and $25.8 million for employee severance costs. Special charges
incurred during transition year 2001 included $24.5 million of costs related to
the transformation of Cabletron's business and $22.7 million of restructuring
costs which included a write-down of $2.2 million for a vacant office building
in Rochester, New Hampshire, to its estimated fair value, facility exit costs of
$2.6 million and severance costs of $17.9 million.
Impairment of intangible assets in transition year 2001 reflects a charge
of $104.1 million in the fourth quarter of that year relating to goodwill
recorded in connection with our acquisition of Indus River Networks.
Loss from Operations
Loss from operations decreased from $531.3 million in transition year 2001
to $153.5 million in fiscal year 2002 due to the factors discussed above.
Interest Income
Interest income declined from $17.7 million in transition year 2001 to
$8.3 million in the fiscal year 2002, due to lower average cash, cash
equivalents and marketable securities balances and lower interest rates.
Other Income (Expense), net
FISCAL YEAR TRANSITION YEAR
(IN MILLIONS) 2002 2001
----------- ---------------
Impairment of investments .................................... $ (22.1) $ (65.9)
Loss on exchange of products for investments ................. -- (17.1)
Recognition of deferred gain on Efficient investment ......... -- 46.8
Unrealized (loss) gain on Riverstone stock derivative ........ (20.0) 4.0
Net gain on sale of available-for-sale securities ............ 1.1 4.1
Recovery (write-down) of note receivable ..................... 2.5 (6.1)
Foreign currency losses, net ................................. (2.7) (4.9)
Other than temporary decline in available-for-sale securities -- (1.7)
Other ........................................................ (1.4) (0.4)
------- -------
Total other income (expense), net ......................... $ (42.6) $ (41.2)
======= =======
We recorded impairments of investments of $22.1 million for fiscal year
2002 and $65.9 million for transition year 2001. These impairments of value are
based on investee-specific events including declines in the investees' stock
price as reflected 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 losses of
$17.1 million for the transition year 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 during the transition year 2001.
Our Series D and E 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 those Riverstone shares
decreased by $20.0 million during the fiscal year 2002 and increased $4.0 during
the transition year
20
2001. The associated increase in fiscal year 2002 and decrease in transition
year 2001 of our redemption liability were recorded as other expense and other
income, respectively.
Income Tax Expense (Benefit)
For fiscal year 2002, we recorded an income tax benefit of $85.2 million
primarily due to the utilization of 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.
For the transition year 2001, we incurred income tax expense of $60.2 million
due primarily to the increase in the deferred tax asset valuation allowance of
$82.3 million, partially offset by a reduction in current tax liabilities of
$22.0 million. In addition, we did not record any income tax benefit relating to
losses incurred in the period because expected income from operations and gains
did not materialize in transition year 2001.
For fiscal year 2003, we will no longer record an income tax benefit for
future losses generated in the U.S. due to the uncertainty of realizing such
benefits and the fact that we have fully utilized our tax loss carryback
benefits. The tax provision for fiscal year 2003 will be based on foreign and
state generated income.
Loss from Discontinued Operations
During 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. During
transition year 2001, we recorded a loss from discontinued operations of $101.9
million that consisted of $59.1 million of operating losses from discontinued
operations of Aprisma, Riverstone, and GNTS and provision for losses on disposal
of GNTS and Aprisma of $41.5 million and $1.3 million, respectively.
Cumulative Effect of a Change in Accounting Principle
During the first quarter of transition year 2001, we adopted SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," and recorded a
transition adjustment, which resulted in an after tax increase in net income of
$12.7 million related to our written call options on Efficient Networks, Inc.
common stock held as of March 4, 2001. This transition adjustment is reflected
in our results of operations for transition year 2001 as the cumulative effect
of a change in accounting principle.
COMPARISON OF TRANSITION YEAR 2001 WITH FISCAL YEAR 2001
On December 30, 2001, we 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."
EITF No. 00-25, as further defined by EITF No. 01-9, "Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products)," requires that payments made to resellers by us for
cooperative advertising, buy-downs and similar arrangements be classified as a
reduction to net sales or an increase in selling expenses, depending upon the
application of the funds by the customer. As a result, certain amounts for
transition year 2001 and fiscal year 2001 have been reclassified to comply with
the guidelines of EITF No. 00-25. The reclassification for transition year 2001
and fiscal year 2001 resulted in a reduction of net revenue of $20.7 million and
$9.3 million, respectively; a reduction of cost of revenue of $28.1 million and
$14.7 million, respectively; and an increase in selling, general and
administrative expenses of $7.4 million and $5.4 million, respectively. The
above reclassification had no impact on net loss or loss per share.
Net Revenue
Net revenue declined by $379.9 million, or 49.1%, from $774.4 million in
fiscal year 2001 to $394.5 million in transition year 2001. Services revenue
decreased by $38.3 million, or 21.9%, from $174.9 million in fiscal year 2001 to
$136.6 million in transition year 2001. Transition year 2001 included only ten
months of operations compared with twelve months in fiscal year 2001, which
accounted for approximately $11 million of the decline based on average monthly
services revenue for transition year 2001. Lower product sales, which typically
include associated maintenance, is the principal reason for the remaining
decrease.
Product revenue decreased by $341.6 million, or 57.0%, from $599.5 million
in fiscal year 2001 to $257.9 million in transition year 2001. Based on average
monthly product revenue for transition year 2001, approximately $125.0 million
of the decrease may be attributable to the fact that transition year 2001
included only ten months of operations compared with twelve months in fiscal
year 2001. During fiscal year 2001 we eliminated non-standards-based products
from our product portfolio, resulting in a decline of
21
approximately $70 million, and as a result of a change in accounting estimate
made in the third quarter of transition year 2001, we began recognizing revenue
when product was shipped by North American and European stocking distributors to
their customers. Approximately $69 million of inventory held by these
distributors at December 29, 2001 was not recorded as revenue in transition year
2001 as the products had not yet been shipped to their customers. In contrast,
in fiscal year 2001 we recognized revenue from these distributors when we
shipped product to them, subject to provisions for returns. The remaining
decline in revenue was attributable to a variety of factors, including increased
use of and higher levels of pricing incentives to stocking distributors, an
industry-wide slowdown and associated lengthening sales cycles, particularly in
the fourth quarter of transition year 2001.
Gross Margin
Total gross margin declined from $342.6 million, or 44.2% of revenue, in
fiscal year 2001 to $44.2 million, or 11.2% of revenue, in transition year 2001.
Services gross margin declined by $29.9 million from $118.9 million in fiscal
year 2001 to $89.0 million in transition year 2001, due primarily to the shorter
transition year. Services gross margin as a percent of services revenue remained
relatively constant.
Product gross margins declined from $223.7 million, or 37.3% of product
revenue, in fiscal year 2001, to a negative $44.9 million, or negative 17.4% of
product revenue, in transition year 2001, due primarily to: a $341.6 million
decline in product revenue; an increase in excess and obsolete inventory charges
of $28.2 million; $3.0 million in penalties to our contract manufacturers
related to reducing production levels below minimum contractual requirements; an
increase in the use of stocking distributors and other indirect channel
partners, the sales to which inherently carry lower margins than direct sales;
an increase in the levels of product rotations and returns; and our cost
structure, which was designed to support a higher revenue base than we achieved.
Operating Expenses
Research and development expenses declined by $5.2 million from $81.7
million in fiscal year 2001 to $76.5 million in transition year 2001 due
primarily to the fact that transition year 2001 included only ten months of
operations compared with twelve months in fiscal year 2001, offset by increased
spending in transition year 2001. Based on average monthly spending during
transition year 2001, research and development spending for the full year would
have exceeded fiscal year 2001 by approximately $10 million, or an increase of
12.2%, due primarily to sustained investments in new product development
initiatives.
Selling, general and administrative expenses ("SG&A") declined by $50.6
million from $335.3 million in fiscal year 2001 to $284.7 million in transition
year 2001, due primarily to the fact that transition year 2001 included only ten
months of operations compared with twelve months in fiscal year 2001 and
headcount reductions implemented in connection with the Cabletron
transformation, offset by $17.4 million of net expense associated with lease
guarantee payments.
Amortization of intangibles increased by $9.2 million from $23.2 million
in fiscal year 2001 to $32.4 million in transition year 2001, due primarily to
the fact that transition year 2001 included ten months of Indus River Networks
intangible assets amortization as compared with one month of such amortization
in fiscal year 2001.
Stock-based compensation in transition year 2001 was $30.6 million and
related to the granting of options to purchase shares of the Enterasys
Subsidiary primarily to employees of Cabletron of $1.9 million and the
acceleration of vesting of previously granted options to purchase our common
stock to our employees of $24.5 million. We recorded stock-based compensation in
transition year 2001 and fiscal year 2001 of $4.2 million and $1.4 million,
respectively, 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 consisted of the following:
TRANSITION YEAR FISCAL YEAR
2001 2001
--------------- -----------
(IN MILLIONS)
In-process research and development related to
Acquisition .................................... $ -- $ 25.6
Transformation charges ........................... 24.5 13.3
Restructuring charges ............................ 22.7 24.3
------- -------
Total special charges .......................... $ 47.2 $ 63.2
======= =======
22
In the second quarter of transition year 2001, we recorded special charges
of $24.5 million related to the transformation of Cabletron's business. We
incurred $13.3 million of similar expense in fiscal year 2001. The
transformation-related charges include investment banking, legal and accounting
fees related to the establishment of the Enterasys Subsidiary, Riverstone,
Aprisma and GNTS as independent, stand-alone entities.
Also during the second quarter of transition year 2001, we recorded
restructuring charges of $10.3 million to reduce our expense structure. These
charges reflected a write-down of $2.2 million for a vacant office building in
Rochester, New Hampshire, to its estimated fair value, 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 exit costs that we incurred
related primarily to long-term lease commitments which will be paid out over
several years. In the fourth quarter of transition year 2001, we recorded a
restructuring charge of $12.4 million for employee severance costs associated
with the reduction of approximately 400 individuals from our global workforce.
The reduction in the global workforce involved principally sales, engineering
and administrative personnel and has also included targeted reductions impacting
most functions within the organization.
In fiscal year 2001, we recorded net restructuring charges of $24.3
million. These charges reflected the expected sale of an office building in
Rochester, NH, exit costs associated with the planned closure of 20 sales
offices worldwide, the write-off of certain assets that were not required
subsequent to the Cabletron transformation and the planned reduction of
approximately 570 individuals from our global workforce. The reduction in the
global workforce involved principally sales, engineering and administrative
personnel and has also included targeted reductions impacting most functions
within the organization. The exit costs that we incurred related primarily to
long-term lease commitments.
On January 31, 2001, we acquired Indus River Networks, a designer and
marketer of virtual private networks for enterprise-class customers. In
connection with the acquisition, approximately $25.6 million of the purchase
price was allocated to in-process research development and recorded in special
charges for fiscal year 2001.
Impairment of intangible assets reflects a charge of $104.1 million in the
fourth quarter of transition year 2001 relating to goodwill recorded in
connection with our acquisition of Indus River Networks. This impairment was
primarily due to the complex, proprietary nature of the Indus River VPN
architecture, which had to be substantially redesigned in order to conform with
emerging industry standards and market expectations; the introduction of new,
low cost VPN products and technologies by a leading provider of network security
products who captured a market leadership position in 2001; and abandonment of
our propriety development efforts in conjunction with a significant reduction in
the acquired workforce in the fourth quarter of transition 2001. These factors
led to significantly lower projections for future sales of products using the
Indus River VPN architecture.
Loss from Operations
Loss from operations increased from $176.3 million in fiscal year 2001 to
$531.3 million in transition year 2001 due to the factors discussed above. Loss
from operations in transition year 2001 included several significant costs,
including the Indus River impairment, excess and obsolete inventory charges,
stock-based compensation expense, Cabletron transformation costs, and
restructuring charges.
Interest Income
Interest income declined from $30.0 million in fiscal year 2001 to $17.7
million in transition year 2001 due to lower 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:
TRANSITION YEAR FISCAL YEAR
2001 2001
--------------- -----------
(IN MILLIONS)
Impairment of investments .............................. $ (65.9) $ (17.2)
Loss on exchange of product for investments ............ (17.1) (13.0)
Transactions related to Efficient:
Recognition of deferred gain on Efficient investment . 46.8 30.4
Other than temporary decline of Efficient investment . -- (376.5)
Other than temporary decline in available for sale
securities, excluding Efficient investment ........... (1.7) (18.1)
Loss on sale of DNPG division .......................... -- (143.1)
Write-down of note receivable .......................... (6.1) --
Unrealized gain on Riverstone stock derivative ......... 4.0 --
Net gain (loss) on sale of available for sale securities 4.1 (21.4)
Foreign currency losses, net ........................... (4.9) 0.5
Other .................................................. (0.4) 1.0
-------- -------
Total other income (expense) ......................... $ (41.2) $(557.4)
======= =======
23
We recorded net impairments of investments of $65.9 million for transition
year 2001, and $17.2 million for fiscal year 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.
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 losses of $17.1 million for transition
year 2001 and $13.0 million for fiscal year 2001.
During fiscal year 2001, we sold 1.0 million shares of Efficient common
stock for net proceeds of approximately $46.6 million and recognized
approximately $30.4 million of deferred gain in other income. Also during fiscal
year 2001, we wrote call options to sell 2.0 million shares of Efficient at a
weighted average price of $62.50 and received premiums of approximately $14.0
million which were recorded as a deferred gain. At March 3, 2001, we determined
that in accordance with SFAS No. 115, the Efficient shares, classified as
available-for-sale securities, had experienced an other-than-temporary decline
in value. We recognized a reduction in value of the Efficient investment of
$487.9 million based on the expected realizable value of approximately $23.50
per share. There was an associated reduction in the deferred gain of $111.4
million, which resulted in other expense of $376.5 million during fiscal year
2001.
During 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 in
other income. Additionally, the outstanding call options discussed above expired
between March 30, 2001 and December 4, 2001 and we recognized the previously
recorded deferred gain of $14.0 million, net of the related transaction costs of
$1.3 million as a cumulative effect of a change in accounting principle during
transition year 2001.
During fiscal year 2001, we completed the sale of our DNPG division and
certain legacy product lines. The sale included certain inventory, accounts
receivable, net fixed assets and related intangible assets, resulting in a loss
on sale included in other expense of $143.1 million.
Income Tax Expense (Benefit)
We incurred income tax expense of $60.2 million in transition year 2001
due primarily to the increase in the deferred tax asset valuation reserve of
$82.3 million, partially offset by a reduction in current tax liabilities of
$22.0 million. In addition, we did not record any income tax benefit relating to
losses incurred in the period because expected income from operations and gains
did not materialize in transition year 2001. In fiscal year 2001, we recorded an
income tax benefit of $98.2 million which was a result of the losses incurred in
that period, partially offset by a non-deductible in-process research and
development charge of $25.6 million and an increase in the deferred tax asset
valuation allowance of $157.4 million.
Loss from Discontinued Operations
In transition year 2001 we incurred $59.1 million of operating losses from
discontinued operations compared with $76.3 million in fiscal year 2001,
principally as a result of transition year 2001 being two months shorter than
fiscal year 2001, and the fact that Riverstone and GNTS were only a part of us
for a portion of transition year 2001. In addition, we incurred a loss on
disposition in transition year 2001 of $42.8 million relating to the shutdown
and sale of GNTS and the sale of Aprisma.
24
Cumulative Effect of a Change in Accounting Principle
During the first quarter of transition year 2001, we adopted SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," and recorded a
transition adjustment, which resulted in an after tax increase in net income of
$12.7 million related to our written call options on Efficient Networks, Inc.
common stock held as of March 4, 2001. The call options expired. This transition
adjustment is reflected in our results of operations for transition year 2001 as
the cumulative effect of a change in accounting principle.
BUSINESS ACQUISITIONS AND DISPOSITIONS
On January 31, 2001, we acquired Indus River Networks ("Indus River") for
approximately $187.3 million. Approximately $25.6 million of the purchase price
was allocated to in-process research development. The excess of cost over the
estimated fair value of net assets acquired of $156.4 million was allocated to
goodwill and other intangible assets, which were being amortized on a
straight-line basis over periods of three to ten years until December 30, 2001,
when we adopted SFAS No. 142, "Goodwill and Other Intangible Assets," and
discontinued amortizing goodwill. On September 7, 2000, we acquired Network
Security Wizards, Inc. ("NSW") for approximately $8.3 million. The excess of
cost over the estimated fair value of the net assets acquired of $8.1 million
was allocated to goodwill and was being amortized on a straight line basis over
a period of four years until December 30, 2001. Both of the acquisitions were
accounted for as purchases.
In July 2001, we distributed our shares of Riverstone common stock to our
shareholders and recorded a non-cash charge to retained earnings of
approximately $329.6 million, which reflected the distribution of the net value
of the Riverstone shares to our shareholders. In July 2001, the operations of
GNTS were discontinued through the acquisition of a portion of GNTS by a third
party. The remaining results were either absorbed by us or Aprisma or
discontinued. In August 2002, we sold Aprisma to a third party. As a result of
these events, we have presented Aprisma as a discontinued operation for all
periods presented and GNTS and Riverstone as discontinued operations for
transition year 2001 and fiscal year 2001.
FINANCIAL CONDITION
Liquidity and Capital Resources
As of December 28, 2002, liquid investments totaled $288.9 million and
consisted of $136.2 million of cash and cash equivalents, $82.9 million of
marketable securities and $69.8 million of long-term marketable securities.
Liquid investments consist of unrestricted cash and cash equivalents, marketable
securities, and long-term marketable securities. Marketable securities and
long-term marketable securities consist of highly rated debt securities of the
U.S. Government or its agencies that are expected to be held until maturity or
are readily convertible into cash or cash equivalents. We have agreed to
maintain specified amounts of cash, cash equivalents and marketable securities
in collateral accounts controlled by several banking institutions. These assets
totaled $24.5 million at December 28, 2002 and are classified as "Restricted
cash, cash equivalents and marketable securities" on the balance sheet.
Net cash used by operating activities was $11.2 million for the year ended
December 28, 2002 and consisted of the $114.2 million net loss adjusted for
non-cash related items of $115.2 million, including depreciation and
amortization of $42.8 million, and a net use of $12.2 million from changes in
current assets and liabilities. Significant components of the changes in current
assets and liabilities included a decrease of $34.4 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 $55.8 million, a decrease in deferred revenue of $21.4 million, and
reductions in accounts receivable and customer advances of $24.4 million and
$48.7 million, respectively. Cash flows from financing activities included $4.7
million of proceeds from the employee stock option and stock purchase plans. In
addition, we received an income tax refund of $102.2 million during fiscal year
2002.
Our capital expenditures were $24.6 million in fiscal year 2002, $21.1
million in transition year 2001 and $16.9 million in fiscal year 2001. Capital
expenditures during fiscal year 2002 primarily consisted of assets purchased to
support outsourcing contracts, equipment and software used in research and
development activities, and internal information technology purchases and
upgrades. We anticipate that capital expenditures in 2003 will be higher than
the amounts incurred during fiscal year 2002 primarily due to new product
development initiatives and enhancements to internal information technology
systems.
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. On March 3, 2003, we redeemed all of these
shares for approximately $98.6
25
\million in cash.
The following is a summary of our significant contractual cash obligations
and other commercial commitments:
CONTRACTUAL CASH OBLIGATIONS LESS THAN 1-3 4-5 OVER 5
(IN MILLIONS) TOTAL 1 YEAR YEARS YEARS YEARS
--------- --------- --------- --------- ---------
Series D&E preferred stock redemption (1) $ 98.6 $ 98.6 $ -- $ -- $ --
Non-cancelable lease obligations .......... 53.6 12.9 20.5 12.0 8.2
Non-cancelable purchase commitments ....... 20.1 20.1 -- -- --
--------- --------- --------- --------- ---------
Total contractual cash obligations ........ $ 172.3 $ 131.6 $ 20.5 $ 12.0 $ 8.2
========= ========= ========= ========= =========
OTHER COMMERCIAL COMMITMENTS LESS THAN 1-3 4-5 OVER 5
(IN MILLIONS) TOTAL 1 YEAR YEARS YEARS YEARS
--------- --------- --------- --------- ---------
Aprisma lease payment guarantees (2) ...... $ 4.0 $ -- $ -- $ -- $ 4.0
Equipment lease guarantees ................ 4.3 4.3 -- -- --
Venture capital commitments (3) ........... 20.0 n/a n/a n/a n/a
--------- --------- --------- --------- ---------
Total commercial commitments .............. $ 28.3 $ 4.3 $ -- $ -- $ 4.0
========= ========= ========= ========= =========
(1) On March 3, 2003, all of the shares were redeemed for approximately $98.6
million in cash.
(2) This guarantee reduces to $3.0 million in 2009, $2.0 million in 2010, $1.0
million in 2011 and terminates in 2012. The Company is indemnified for up
to $3.5 million in losses.
(3) 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 $2.2 million at December 28,
2002 would be significantly diluted. The fund has not indicated that it
expects to issue a material capital call in the near future.
Accrued severance costs of $1.6 million as of December 28, 2002 will be
paid out during fiscal 2003; and the remaining accrued exit costs of $6.1
million, which consisted of long-term lease commitments, will be paid out over
the next several years.
We are focused on achieving sustainable cash-positive operations and
believe we have made substantial progress toward that goal in fiscal year 2002.
Based on our liquid investment position at December 28, 2002, the 2003
redemption of the Series D and E preferred stock in March of 2003, and the $31.9
million of federal income tax refunds we expect to receive in the first half of
2003, we believe that we have sufficient liquidity 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 $41.7
million at December 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 in the fourth quarter of fiscal year 2002 compared with the fourth
quarter of transition year 2001. 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 31 days at December 28,
2002, compared to 44 days at December 29, 2001.
Inventories, net, were $44.6 million at December 28, 2002 or 3.4 turns per
annum, compared with $118.2 million at December 29, 2001 or 3.2 turns per
annum. Inventories have decreased during 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
also recorded additional charges for excess and obsolete inventory of $17.9
million in fiscal year 2002. Over the course of the year we have utilized
existing finished goods inventory to fulfill orders, which has benefited our
cash flow. We expect future cash commitments related to inventory purchases to
increase based on sales order demand . In addition, the nature and timing of our
new product introductions as well as our competitors' new products entering the
markets we serve could have an adverse affect on our inventory levels in the
future and may result in additional excess and obsolete inventory provisions.
As of December 2002, we had an income tax receivable of $31.9 million due
to the realization of net operating loss tax benefits of approximately $110.7
million. The Company expects to receive this refund in the first half of fiscal
year 2003.
Accounts payable at December 28, 2002 of $47.6 million declined by $27.2
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
26
excess raw materials.
Customer advances and billings in excess of revenues at December 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
includes inventory at stocking distributors for which we have been paid but
revenue has not been recognized.
The redeemable convertible preferred stock of $94.8 million at December
28, 2002 was classified as a current liability due to the expected redemption of
the Series D and E Preferred Stock, which occurred on March 3, 2003.
NEW ACCOUNTING PRONOUNCEMENTS
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 an asset
retirement obligation as a liability rather than a contra-asset. SFAS No. 143 is
effective for our fiscal year beginning December 29, 2002. We do not expect the
adoption of this statement will have a material impact on our consolidated
financial statements.
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 extraordinary items, 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 our fiscal year beginning December 29, 2002. We do
not expect the adoption of this statement will have a material impact on our
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 exit or disposal activities that are initiated
after December 31, 2002.
In November 2002, the FASB issued interpretation No. 45 ("FIN No. 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness to Others." FIN No. 45 requires that a
liability be recorded in the guarantor's balance sheet upon issuance of a
guarantee. In addition, FIN No. 45 requires disclosures about the guarantees
that an entity has issued, including a roll-forward of the entity's product
warranty liabilities. Our warranty experience has not been significant. We
adopted the annual disclosure provisions of FIN No. 45 at December 28, 2002. We
will adopt the provisions for initial recognition and measurement and interim
disclosures during the first quarter of 2003. We are currently evaluating the
impact the adoption will have on our consolidated financial statements.
In November 2002, the FASB issued EITF No. 00-21, "Revenue Arrangements
with Multiple Deliverables," which provides guidance on how to account for
revenue arrangements that involve the delivery or performance of multiple
products, services and/or rights to use assets. The provisions of this EITF are
effective for revenue arrangements entered into beginning in our third quarter
of fiscal year 2003. We are currently evaluating the impact the adoption will
have on our consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation, Transition and Disclosure," which provides alternative
methods of transition for a voluntary change to the fair-value-based method of
accounting for stock-based employee compensation. SFAS No. 148 also requires
disclosures of the pro forma effect of using the fair value method of accounting
for stock-based employee compensation be displayed more prominently and in a
tabular format in annual and interim financial statements. We adopted the
disclosure requirements at December 28, 2002. The transition requirements are
effective for our fiscal year 2003. We are currently evaluating the impact the
adoption will have on our consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46 ("FIN No. 46"),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN No. 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN No. 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN No. 46 must be applied for the first
interim or annual period beginning after June 25, 2003. We have no variable
interest entities at this time and as such, the adoption of FIN No. 46 will not
have an effect on the consolidated financial statements.
27
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 annual report on Form 10-K, 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.
RISKS RELATED TO OUR FINANCIAL RESULTS AND CONDITION
THE LINGERING EFFECTS OF THE RECENTLY SETTLED SEC INVESTIGATION AND OUR
FINANCIAL STATEMENT 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. 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 changes
to our historical financial statements which were restated in our Form 10-K for
the transition period ended December 29, 2001 filed with the SEC on November 26,
2002. Despite the resolution of the investigation of us, the lingering effects
of the SEC investigation and the restatement of our financial statements 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 the 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, and derivative actions
have been brought 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 HAS NEGATIVELY AFFECTED OUR BUSINESS AND REVENUES
AND HAS MADE FORECASTING MORE DIFFICULT, WHICH COULD HARM OUR FINANCIAL
CONDITION AND MAY CONTINUE TO DO SO
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 hostilities involving the U.S. in the Middle East, North Korea or
anywhere else in the world, and any continuation or repercussions thereof or
responses thereto, may put further pressure on worldwide economic conditions,
particularly if they continue for an extended period of time. 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.
28
The effects of hostilities involving the U.S. in the Middle East, North
Korea or anywhere else in the world, and any continuation or repercussions
thereof or responses thereto, particularly if they continue for an extended
period of time, could disrupt our operations or those of our suppliers and
contract manufacturers, which could harm our business and negatively affect our
revenues. The disaster recovery plans of us and our suppliers and contract
manufacturers may not adequately protect us in the event hostilities involving
the U.S. disrupt our operations or those of our suppliers and contract
manufacturers. In addition, our business interruption insurance may not
adequately protect us in the event these hostilities disrupt our operations, or
we may be unable to obtain this insurance at a reasonable cost.
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
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 financial 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. 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:
o fluctuations in the demand for our products and services;
o the timing and size of sales of our products or the cancellation or
rescheduling of significant orders;
o the length and variability of the sales cycle for our products;
o the timing of implementation and product acceptance by our customers
and by customers of our distribution partners;
o the timing and success of new product introductions;
o the timing and level of non-cash, stock-based compensation charges;
o increases in the prices or decreases in the availability of the
components we purchase;
o price and product competition in the networking industry;
o our ability to source and receive from third party sources
appropriate product volumes and quality;
o manufacturing lead times and our ability to maintain appropriate
inventory levels;
29
o the timing and level of research, development and prototype
expenses;
o the mix of products and services sold;
o changes in the distribution channels through which we sell our
products and the loss of distribution partners;
o the uncertainties inherent in our accounting estimates and
assumptions and the impact of changes in accounting principles;
o our ability to achieve targeted cost reductions;
o the outcome of pending securities litigation; and
o 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 AND
FINANCIAL CONDITION 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. 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 grow our business. 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 I, Item 3 -
Legal Proceedings" of this annual report for a more detailed discussion of
pending securities litigation. We may be required to pay significant damages as
a result of these lawsuits. We are and may in the
30
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
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 and ensure the effectiveness of our system of
controls and procedures.
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 the use of extensive manual procedures to
generate and review 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. Pursuant to rules expected to be promulgated under
the Sarbanes-Oxley Act of 2002, we will be required to include in our future
Form 10-K filings a report by our management as to their conclusions as to the
effectiveness of our internal controls and procedures for financial reporting,
and our independent auditors will be required to attest to and report on this
evaluation by management. We have implemented a number of changes designed to
improve our 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, including extensive supervisory and management
oversight along with systems and process improvement programs. 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.
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
31
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, 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 pending securities
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 AND
VALUE-ADDED RESELLERS TO ESTABLISH RELATIONSHIPS THAT WE BELIEVE MAY BENEFIT US
AS WE EXECUTE OUR BUSINESS STRATEGY, BUT THESE RELATIONSHIPS MAY NOT PROVE
HELPFUL TO US, AND WE COULD LOSE OUR ENTIRE INVESTMENT IN THESE COMPANIES
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 December 28, 2002, these
investments totaled approximately $39.1 million. During the fiscal year ended
December 28, 2002, we recorded impairment losses of $22.1 million relating to
these investments.
WE ARE EXPOSED TO THE CREDIT RISK OF SOME OF OUR CUSTOMERS
Our payment terms are typically 30 days in the United States, and
sometimes longer internationally. We assess the payment ability of our customers
in granting such terms and maintain reserves that we believe are adequate to
cover doubtful accounts, however, as a result of the current economic slowdown,
our exposure to the credit risk of our customers has increased. Some of our
customers are experiencing, or may experience, reduced revenues and cash flow
problems, and may be unable to pay, or may delay payment for, amounts owed to
us. Although we monitor the credit risk of our customers, we may not be
effective in managing our exposure. If our customers are unable to pay amounts
owed to us or cancel outstanding orders, our forecasting ability, cash flow and
revenues could be harmed and our business and results of operations may be
adversely affected.
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.
32
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.
33
WE MAY EXPEND SIGNIFICANT RESOURCES EDUCATING POTENTIAL CUSTOMERS ABOUT OUR
PRODUCTS WITHOUT ACHIEVING ACTUAL SALES
Purchases of our products often represent a significant capital investment
by our customers related to their enterprise network infrastructure. They are
often subject to budgetary constraints and typically involve significant
internal procedures involving the evaluation, testing, implementation and
acceptance of new technologies. We typically must provide a significant level of
education to enterprises on the benefits of our products and services, which
often results in a lengthy sales process. During this time we may incur
substantial sales and marketing expenses and expend significant management
effort. If we fail to recognize revenue from a particular customer after making
such a substantial investment, our operating results may be negatively impacted.
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
34
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.
WE INTEND TO WORK WITH OTHER COMPANIES TO DEVELOP PRODUCTS, WHICH INCREASES OUR
RELIANCE ON OTHERS FOR GENERATING REVENUES AND MAY LEAD TO DISPUTES ABOUT
OWNERSHIP OF INTELLECTUAL PROPERTY
We intend to establish strategic partnerships with organizations in
complementary markets to incorporate our network communications technology into
products and solutions sold by these organizations. We may be unable to enter
into agreements of this type on favorable terms, if at all. If we are able to
enter into these agreements, we will likely be unable to control the amount and
timing of resources our partners devote to developing products that incorporate
our technology and the efforts they devote to selling these products. If we are
unable to enter into these agreements on favorable terms, or if our partners do
not devote sufficient resources to developing and selling the products that
incorporate our technology, our revenue growth will be lower than expected.
Although we intend to retain all rights in our technology in these
arrangements, we may be unable to negotiate the retention of these rights.
Furthermore, disputes may arise over the ownership of technology developed as a
result of these partnerships. These and other potential disagreements between us
and these partners could lead to delays in the research, development or sale of
products we are developing with them or more serious disputes, which may be
costly to resolve. Disputes with partners who also serve as indirect
distribution channels for our products could reduce our revenues from sales of
our products.
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.
35
WE JOINTLY OWN WITH RIVERSTONE SOME OF OUR INTELLECTUAL PROPERTY, AND OUR
BUSINESS COULD BE HARMED IF RIVERSTONE USES THIS INTELLECTUAL PROPERTY TO
COMPETE WITH US
In the transformation agreement among Aprisma, Riverstone and us and the
related contribution agreements, each of we, Aprisma and Riverstone received
intellectual property related to the products to be sold by each of us or to be
used in each of our respective businesses. In addition, we and Riverstone both
own rights in technology within a family of application-specific integrated
circuits used in both our X-Pedition product family and Riverstone's switch
router product family. Riverstone is primarily a provider of infrastructure
equipment to service providers in metropolitan area networks. There are no
contractual provisions between us and Riverstone that prohibit Riverstone from
developing products that are competitive with our products, including products
based upon these commonly owned rights. If Riverstone is acquired by one of our
competitors, there are no contractual provisions that would prohibit the
combined entity from selling or developing products competitive with our
products.
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 ON A TIMELY BASIS
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 ANY OF OUR PRIMARY CONTRACT
MANUFACTURERS 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 two companies, Flextronics International, Ltd. and Accton
Technology Corporation, which procure material on our behalf and provide
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. 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.
36
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. 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. These factors contributed to a $17.9 million charge for inventory
obsolescence in fiscal year 2002 and a $72.9 million charge for inventory
obsolescence in transition year 2001.
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 the United States accounted for
approximately 43% of our revenue in the fiscal year ended December 28, 2002, 50%
of our revenue in the ten months ended December 29, 2001 and 47% of our revenue
in the fiscal year ended March 3, 2001. 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; and
- difficulties in hiring and managing employees in foreign countries.
37
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 against us. 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 to maintain our listing.
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.
WE HAVE NOT ESTABLISHED A COMPREHENSIVE DISASTER RECOVERY PLAN FOR OUR
INFORMATION TECHNOLOGY SYSTEMS, AND IF OUR INFORMATION TECHNOLOGY SYSTEMS FAIL
OR BECOME INOPERABLE FOR ANY EXTENDED PERIOD OF TIME, OUR REVENUES AND OUR
BUSINESS COULD BE HARMED.
We have not established and tested a comprehensive plan for recovering or
otherwise operating our information technology systems in the event of a
catastrophic systems failure or a natural or other disaster. If there is a
catastrophic failure or extended inoperability of our information technology
systems, our ability to service customers, ship products, process transactions,
test and develop products, and communicate internally and externally could be
materially impaired and our revenues and business could be harmed. We are in the
process of developing a disaster recover plan which we expect will conform to
industry standards and is intended to limit our business and financial exposure
in the event of a catastrophic failure. Notwithstanding, in the event of a
catastrophic systems failure, we may be unable to successfully implement this
plan and restore, or operate at an alternate location, our information
technology systems and, to the extent it is implemented, this plan may not
adequately prevent or limit the adverse effects on our business of such a
failure.
WE HAVE CHANGED OUR NAME AND THE NAMES OF SOME OF OUR PRODUCTS, AND OUR EXISTING
AND POTENTIAL CUSTOMERS AND BUSINESS PARTNERS MAY NOT RECOGNIZE OUR NEW BRAND,
WHICH COULD ADVERSELY AFFECT OUR SALES AND MARKETING EFFORTS AND CAUSE OUR
REVENUE TO DECLINE
Before the transformation, we sold our products and services under the
Cabletron name, and we believe that the sale of our products and services
significantly benefited from the use of the Cabletron brand name. We now sell
our products and services under our new name, Enterasys and have also changed
the names of some of our products. Our existing and potential customers and
business partners and investors may not recognize our new brand or the new names
of our products. We have incurred and expect to continue to incur significant
sales and marketing expenses to build a strong new brand identity. The expenses
we incur toward building our brand, however, will not result in immediate
returns and it may be a long time before enterprises and business partners
recognize and make positive connections with our new brand. If we fail to
promote our new brand and new product names successfully in local and
38
international markets, our business may suffer.
THE TAX IMPLICATIONS OF RIVERSTONE SPIN-OFF MAY PLACE RESTRICTIONS ON US AND
SUBJECT US TO RISKS
We have received a ruling from the Internal Revenue Service that the
distribution of Riverstone qualifies as a tax-free spin-off under Section 355 of
the Internal Revenue Code of 1986, as amended. Rulings and opinions of this
nature are subject to various representations and limitations, and in any event,
are not binding upon the Internal Revenue Service or any court. If the
distribution of Riverstone's shares fails to qualify as a tax-free spin-off
under Section 355 of the Internal Revenue Code, we will recognize a taxable gain
equal to the difference between the fair market value of Riverstone on the date
of the distribution and our adjusted tax basis in Riverstone's stock on the date
of the distribution. In addition, each of our stockholders will be treated as
having received a taxable corporate distribution in an amount equal to the fair
market value of Riverstone's stock received by the stockholder on the date of
distribution. Any taxable gain recognized by us or our stockholders as a result
of a failure of the Riverstone distribution to qualify as tax-free under Section
355 is likely to be substantial.
Limitations under Section 355 of the Internal Revenue Code may restrict
our ability to use our capital stock following the Riverstone distribution.
These limitations will generally prevent us from issuing capital stock if the
issuance of the capital stock occurs in conjunction with the Riverstone
distribution, and results in one or more persons acquiring more than 50% of our
capital stock. Stock issuance transactions which occur during the two years
following any distribution are presumed to occur in conjunction with the
distribution. These limitations may restrict our ability to undertake
transactions involving the issuance of our capital stock that we believe would
be beneficial.
WE HAVE MADE AND MAY MAKE FUTURE ACQUISITIONS, WHICH INVOLVE NUMEROUS RISKS
We have supplemented and may further supplement our internal growth by
acquiring complementary businesses, technologies or product lines. We may be
unable to identify and acquire suitable candidates on reasonable terms, if at
all. Our financial condition and stock price may make it difficult for us to
complete acquisitions. We compete for acquisition candidates with other
companies that have substantially greater financial, management and other
resources than we do. This competition may increase the prices we pay to acquire
other companies, which are often high when compared to the assets and sales of
these companies. Our acquisitions may not generate sufficient revenues to offset
increased expenses associated with the acquisition in the short term or at all.
Acquisitions, particularly multiple acquisitions over a short period of
time, involve a number of risks that may result in our failure to achieve the
desired benefits of the transaction. These risks include, among others, the
following:
- difficulties and unanticipated costs incurred in assimilating the
operations of the acquired businesses;
- potential disruption of our existing operations;
- an inability to integrate, train and retain key personnel;
- diversion of management attention and employees from day-to-day
operations;
- an inability to incorporate, develop or market acquired technologies
or products;
- unexpected liabilities of the acquired business;
- operating inefficiencies associated with managing companies in
different locations; and
- impairment of relationships with employees, customers, suppliers and
strategic partners.
We may finance acquisitions by issuing shares of our common stock, which
could dilute our existing stockholders. We may also use cash or incur debt to
pay for these acquisitions. In addition, we may be required to expend
substantial funds to develop acquired technologies or to amortize significant
amounts of goodwill or other intangible assets in connection with future
acquisitions, which could adversely affect our operating results. We have made
acquisitions and may make future acquisitions that result in in-process research
and development expenses being charged in a particular quarter, which could
adversely affect our operating results for that quarter.
39
PROVISIONS OF OUR ARTICLES OF INCORPORATION AND BYLAWS AND OUR INVESTOR RIGHTS
PLAN COULD DELAY OR PREVENT A CHANGE IN CONTROL, WHICH COULD REDUCE OUR STOCK
PRICE
Pursuant to our certificate of incorporation, our Board of Directors has
the authority to issue preferred stock and to determine the price, rights,
preferences, privileges and restrictions, including voting rights, of those
shares without any vote or action by our stockholders. The issuance of preferred
stock could have the effect of making it more difficult for a third party to
acquire a majority of our outstanding voting stock. Our certificate of
incorporation requires the affirmative vote of the holders of not less than 85%
of the outstanding shares of our capital stock for the approval or authorization
of certain business combinations as described in our certificate of
incorporation. In addition, our staggered Board of Directors and certain advance
notification requirements for submitting nominations for election to our Board
of Directors contained in our bylaws, as well as other provisions of Delaware
law and our certificate of incorporation and bylaws, could delay or make a
change in control more difficult to accomplish.
In April 2002, our Board of Directors adopted a stockholder rights plan
pursuant to which we paid a dividend of one right for each share of common stock
held by stockholders of record on June 11, 2002. As a result of the plan, our
acquisition by a party not approved by our Board of Directors could be
prohibitively expensive. This plan is designed to protect stockholders from
attempts to acquire us while our stock price is inappropriately low or on terms
or through tactics that could deny all stockholders the opportunity to realize
the full value of their investment. Under the plan, each right initially
represents the right, under certain circumstances, to purchase 1/1,000 of a
share of a new series of our preferred stock at an exercise price of $20 per
share. Initially the rights will not be exercisable and will trade with our
common stock. If a person or group acquires beneficial ownership of 15% or more
of the then outstanding shares of our common stock or announces a tender or
exchange offer that would result in such person or group owning 15% or more of
our then outstanding common stock, each right would entitle its holder (other
than the holder or group which acquired 15% or more of our common stock) to
purchase shares of our common stock having a market value of two times the
exercise price of the right. Our Board of Directors may redeem the rights at the
redemption price of $.01 per right, subject to adjustment, at any time prior to
the earlier of June 11, 2012, the expiration date of the rights, or the date of
distribution of the rights, as determined under the plan.
ITEM 7A. 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 due to their short maturity.
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
December 28, 2002, we had net asset exposures to the Australian Dollar,
Eurodollar, Japanese Yen and Brazilian Real. 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 December 28,
2002.
Equity Price Risk. We maintain a small amount of investments in marketable
equity securities of publicly-traded companies. At December 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 strategic equity and
convertible debt investments in privately-held technology
40
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 December 28, 2002, these investments totaled
approximately $39.1 million. During fiscal year 2002, we recorded impairment
losses of $22.1 million relating to these investments. While our operating
results may be materially adversely affected by fluctuations in the value of
these investments, we do not expect any material adverse impact in our cash
flows.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and related notes and report of
independent auditors are included beginning on page F-1 of this annual report
on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required under this item may be found under the sections
captioned "Proposal I: Election of Class II Directors," "Executive Officers,"
and "Section 16(a) Beneficial Ownership Reporting and Compliance" in our 2003
Proxy Statement, which will be filed with the SEC no later than April 28, 2003,
and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this item may be found under the sections
captioned "Summary Compensation Table," "Option Grants in the Last Fiscal Year,"
and "Option Exercises and Fiscal Year-End Values" in our 2003 Proxy Statement,
and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required under this item may be found under the section
captioned "Securities Ownership of Certain Beneficial Owners and Management" in
our 2003 Proxy Statement, and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required under this item may be found under the section
captioned "Certain Relationships and Related Transactions" in our 2003 Proxy
Statement, and is incorporated herein by reference.
ITEM 14. 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
our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"). Based
on and as of the date of that evaluation, the CEO and CFO concluded that our
disclosure controls and procedures are sufficient 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
41
identified certain deficiencies in our internal controls. We believe the
corrective actions we have taken and the additional procedures we have
performed, as described in more detail below, 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
Our management has assessed our internal controls in each of the regions
in which we operate in connection with the audit of our financial statements for
the fiscal year ended December 28, 2002. In connection with this assessment,
management has identified significant deficiencies in our internal controls
relating to:
- accounting policies and procedures;
- systems integration and data reconciliation; and
- personnel and their roles and responsibilities.
Management has assigned the highest priority to the short-term and
long-term correction of these internal control deficiencies, and we have
implemented and continue to implement changes to our accounting policies,
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. Specifically, we have implemented the following corrective actions
as well as additional procedures:
1. Adoption of our code of conduct;
2. Retention of an internal auditor and establishment of an internal
audit department;
3. Establishment of a Disclosure Review Committee;
4. Implementation of a quarterly and annual representation and
certification process applicable to key employees responsible for
international operations and worldwide sales activity;
5. Review and revision of revenue recognition policies and
contracting management policies and procedures, including more formalized
training of finance, sales and other staffs;
6. Development of additional financial, accounting and other
policies and procedures;
7. Increased supervisory and management reviews of procedures,
reconciliation activities and financial reporting; and
8. Additional management oversight and detailed reviews of
personnel, disclosures and reporting.
Longer term corrective actions, some of which we have already begun to
implement, include:
1. Improved financial and management reporting systems;
2. Continued development of additional financial, accounting and
other policies and procedures;
3. Additional training of our personnel;
4. Expanded certification by employees of their familiarity, and
obligation to comply, with our policies and procedures;
5. Periodic re-certification by employees of their continued
compliance with our policies and procedures; and
6. Expanded internal audit processes 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.
42
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. CONSOLIDATED FINANCIAL STATEMENTS (SEE ITEM 8)
STATEMENT PAGE
----------------------------------------------------------------- ----
Independent Auditors' Report ..................................... F-1
Consolidated Balance Sheets at December 28, 2002 and
December 29, 2001 ............................................. F-2
Consolidated Statements of Operations for the year ended
December 28, 2002, the ten months ended December 29, 2001, and
the year ended March 3, 2001 .................................. F-3
Consolidated Statements of Redeemable Convertible Preferred Stock
and Stockholders' Equity for the year ended December 28, 2002,
the ten months ended December 29, 2001 and the year ended
March 3, 2001 ................................................. F-4
Consolidated Statements of Cash Flows for the year ended
December 28, 2002, the ten months ended December 29, 2001, and
the year ended March 3, 2001 .................................. F-7
Notes to Consolidated Financial Statements ....................... F-8
2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
SCHEDULE PAGE
----------------------------------------------------------------- ----
Schedule II-- Valuation and Qualifying Accounts ................ S-1
Independent Auditors' Report ................................... S-2
All other schedules have been omitted since they are not required, not
applicable or the information has been included in the consolidated financial
statements or the notes thereto.
3. EXHIBITS
(a) Exhibits:
3.1 -- Restated Certificate of Incorporation of the Registrant, a
Delaware corporation, incorporated by reference to Exhibit
3.1 to the Registrant's Registration Statement on Form S-1,
No. 33-28055.
3.2 -- Certificate of Correction of the Registrant's Restated
Certificate of Incorporation, incorporated by reference to
Exhibit 3.1.2 to the Registrant's Registration Statement on
Form S-1, No. 33-42534.
3.3 -- Certificate of Amendment of the Restated Certificate of
Incorporation of the Registrant, incorporated by reference
to Exhibit 4.3 to the Registrant's Registration Statement on
Form S-3, No. 33-544666.
3.4 -- Certificate of Amendment of the Restated Certificate of
Incorporation of the Registrant, incorporated by reference
to Exhibit 3.5 to the Registrant's annual report on Form
10-K filed on May 30, 2000.
3.5 -- Certificate of Designations, Preferences and Rights for
Series D and Series E Participating Convertible Preferred
Stock of the Registrant, incorporated by reference to
Exhibit 4.1 to the Registrant's quarterly report on Form
10-Q for the period ended September 1, 2001, filed October
16, 2001 (the "October 2001 10-Q").
3.6 -- Certificate of Designations, Preferences and Rights for Series F
43
Convertible Preferred Stock of the Registrant, incorporated by
reference to Exhibit 4.2 to the Registrant's current report on
Form 8-K filed May 31, 2002.
3.7 -- Certificate of Elimination of Designation, Preferences and
Rights of the Series A, Series B and Series C Participating
Convertible Preferred Stock of the Registrant.
3.8 -- Amended and Restated By-laws of the Registrant, incorporated by
reference to the Registrant's transition report on Form 10-K,
filed on November 26, 2002 (the "November 2002, 10-K)
4.1 -- Specimen stock certificate of the Registrant's Common Stock,
incorporated by reference to Exhibit 4.1 to the November 2002,
10-K.
4.2 -- Standstill Agreement, dated August 29, 2000, between the
Registrant and the Investors named therein, incorporated by
reference to Exhibit 2.3 to the Silver Lake 8-K.
4.3 -- Form of Class A Warrant of the Registrant, incorporated by
reference to Exhibit 2.5 to the Silver Lake 8-K.
4.4 -- Form of Class B Warrant of the Registrant, incorporated by
reference to Exhibit 2.6 of the Silver Lake 8-K.
4.5 -- Form of Common Stock Purchase Warrant issued to certain
Investors in connection with the merger of a subsidiary into the
Registrant, incorporated by reference to Exhibit 4.2 to the
October 2001 10-Q.
4.6 -- Rights Agreement, dated May 28, 2002, between the Registrant and
EquiServe Trust Company, N.A., as Rights Agent, incorporated by
reference to Exhibit 4.1 to the Registrants current report on
Form 8-K, filed May 31, 2002.
4.7 -- Form of Rights Certificate, incorporated by reference to Exhibit
4.3 to the Registrant's current report on Form 8-K, filed May
31, 2002.
10.1 -- Amended and Restated Transformation Agreement, effective as
of June 3, 2000, among Cabletron, Aprisma, Enterasys, GNTS
and Riverstone, incorporated by reference to Exhibit 2.1 to
the Registrant's quarterly report on Form 10-Q filed on
January 16, 2001 (the "January 2001 10-Q").
10.2 -- Amended and Restated Asset Contribution Agreement, effective
as of June 3, 2000, between Cabletron and Enterasys,
incorporated by reference to Exhibit 2.3 to the January 2001
10-Q.
10.3 -- Amended and Restated Asset Contribution Agreement, effective
as of June 3, 2000, between Cabletron and Riverstone,
incorporated by reference to Exhibit 2.5 of the January 2001
10-Q.
10.4 -- Tax Sharing Agreement, dated as of June 3, 2000, among
Cabletron, Aprisma, Enterasys, GNTS and Riverstone,
incorporated by reference to Exhibit 2.6 of Cabletron's
quarterly report on Form 10-Q, filed on October 18, 2000
(the "October 2000 10-Q).
10.5 -- Assignment and Assumption Agreement, dated as of June 3,
2000, by and between Cabletron and Enterasys pertaining to
the Manufacturing Services Agreement, dated as of February
29, 2000, between the Registrant and Flextronics
International USA, Inc., incorporated by reference to
Exhibit 2.8 of the October 2000 10-Q.
10.6 -- Agency Agreement between the Registrant and International
Cable Networks Inc., incorporated by reference to Exhibit
10.6 to the Registrant's Registration Statement on Form S-1,
No. 33-28055.
10.7 -- Letter Sublease Agreement, dated June 4, 1998, between the
Registrant and Picturetel Corporation, together with related
documents, incorporated by reference to Exhibit 10.8 to the
Registrant's Annual report on Form 10-K, filed on June 4, 2001
(the "2001 10K")
44
10.8 -- Lease, dated as of October 31, 2001, between Thomas J. Flatley
d/b/a The Flatley Company, and Enterasys Networks, Inc.,
relating to a leased premises in Portsmouth, New Hampshire,
incorporated by reference to Exhibit 10.12 to the November 2002
10-K.
10.9 -- Registration Rights Agreement, dated as of August 29, 2000,
among the Registrant and the Investors, incorporated by
reference to Exhibit 2.7 to the Silver Lake 8-K.
10.10 -- Manufacturing Services Agreement, dated as of March 1, 2000,
between the Registrant and Flextronics International USA,
Inc., incorporated by reference to Exhibit 10.6 to the
February 2001 10-Q/A.
10.11 -- 2002 Employee Stock Purchase Plan, incorporated by reference to
Exhibit 4.1 to the Registrant's registration statement on Form
S-8, No. 333-103587.
10.12 -- 2002 Stock Option Plan for Eligible Executives, incorporated by
reference to Exhibit 10.8 to the Registrant's Quarterly Report
on Form 10-Q for the three-month period ended June 29, 2002,
filed with the Commission on January 30, 2003 (the "January 2003
10-Q").
10.13 -- 2001 Equity Incentive Plan, incorporated by reference to Exhibit
4.1 to the Registrant's registration statement on Form S-8, No.
333-66774.
10.14 -- 1998 Equity Incentive Plan, as amended, incorporated by
reference to Exhibit 4.2 to the Registrant's registration
statement on Form S-8, No. 333-103587.
10.15 -- 1989 Employee Stock Purchase Plan, as restated, incorporated by
reference to Exhibit 10.18 to the November 2001 10-K.
10.16 -- 1995 Employee Stock Purchase Plan, as restated, incorporated by
reference to Exhibit 10.19 to the November 2001 10-K.
10.17 -- Amended and Restated Change-in-Control Severance Benefit Plan
for Key Employees, incorporated by reference to Exhibit 10.7 to
the January 2003 10-Q.
10.18 -- Deferral Plan for Directors, incorporated by reference to
Exhibit 10.4 to the November 2002 10-K.
10.19 -- Promissory Note, dated August 23, 1999 of Enrique P. (Henry)
Fiallo, incorporated by reference to Exhibit 10.28 to the
2000 10-K.
10.20 -- Promissory Note, dated January 1, 2000 of Enrique P. (Henry)
Fiallo, incorporated by reference to Exhibit 10.27 to the
2000 10-K.
10.21 -- Employment Agreement, dated April 1, 2002, between the
Registrant and William O'Brien, incorporated by reference to
Exhibit 10.1 to the January 2003 10-Q.
10.22 -- Employment Agreement, dated May 1, 2002, between the Registrant
and Yuda Doron, incorporated by reference to Exhibit 10.2 to the
January 2003 10-Q.
10.23 -- Separation Agreement and Release, dated April 5, 2002, between
the Registrant and Enrique Fiallo, incorporated by reference to
Exhibit 10.3 to the January 2003 10-Q.
10.24 -- Separation Agreement and Release, dated October 29, 2002, by and
between the Registrant and Robert J. Gagalis.
21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Independent Auditors.
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.
45
(b) Reports on Form 8-K:
For the quarter ended December 28, 2002, we did not file any current
reports on Form 8-K.
46
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
March 28, 2003 By: /s/ WILLIAM K. O'BRIEN
------------------ --------------------------------------
Date William K. O'Brien
Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE(S) DATE
- ---------------------------------- ----------------------------- --------------
/s/ WILLIAM K. O'BRIEN Chief Executive Officer and March 28, 2003
- ---------------------------------- Director (Principal Executive
William K. O'Brien Officer)
/s/ RICHARD S. HAAK, JR. Chief Financial Officer March 28, 2003
- ---------------------------------- (Principal Financial and
Richard S. Haak, Jr. Accounting Officer)
/s/ RONALD T. MAHEU Director March 28, 2003
- ----------------------------------
Ronald T. Maheu
/s/ PAUL R. DUNCAN Director March 28, 2003
- ----------------------------------
Paul R. Duncan
/s/ EDWIN A. HUSTON Director March 28, 2003
- ----------------------------------
Edwin A. Huston
/s/ JAMES A. DAVIDSON Director March 28, 2003
- ----------------------------------
James A. Davidson
47
CERTIFICATIONS
I, William K. O'Brien, Chief Executive Officer of the Registrant, certify that:
1. I have reviewed this annual report on Form 10-K 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 the report;
3. Based on my knowledge, the financial statements, and other financial
information included in the 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 the 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 annual 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 annual report (the "Evaluation Date"); and
c. Presented in this annual 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 annual 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: March 28, 2003 /s/ WILLIAM K. O'BRIEN
---------------------------------
William K. O'Brien
48
CERTIFICATIONS
I, Richard S. Haak, Jr., Chief Financial Officer of the Registrant, certify
that:
1. I have reviewed this report on Form 10-K 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 the report;
3. Based on my knowledge, the financial statements, and other financial
information included in the 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 the 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 annual 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 annual report (the "Evaluation Date"); and
c. Presented in this annual 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 annual 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: March 28, 2003 /s/ RICHARD S. HAAK, JR.
-------------------------------
Richard S. Haak, Jr.
49
EXHIBIT INDEX
3.1 -- Restated Certificate of Incorporation of the Registrant, a
Delaware corporation, incorporated by reference to Exhibit
3.1 to the Registrant's Registration Statement on Form S-1,
No. 33-28055.
3.2 -- Certificate of Correction of the Registrant's Restated
Certificate of Incorporation, incorporated by reference to
Exhibit 3.1.2 to the Registrant's Registration Statement on
Form S-1, No. 33-42534.
3.3 -- Certificate of Amendment of the Restated Certificate of
Incorporation of the Registrant, incorporated by reference
to Exhibit 4.3 to the Registrant's Registration Statement on
Form S-3, No. 33-544666.
3.4 -- Certificate of Amendment of the Restated Certificate of
Incorporation of the Registrant, incorporated by reference
to Exhibit 3.5 to the Registrant's annual report on Form
10-K filed on May 30, 2000.
3.5 -- Certificate of Designations, Preferences and Rights for
Series D and Series E Participating Convertible Preferred
Stock of the Registrant, incorporated by reference to
Exhibit 4.1 to the Registrant's quarterly report on Form
10-Q for the period ended September 1, 2001, filed October
16, 2001 (the "October 2001 10-Q").
3.6 -- Certificate of Designations, Preferences and Rights for Series F
Convertible Preferred Stock of the Registrant, incorporated by
reference to Exhibit 4.2 to the Registrant's current report on
Form 8-K filed May 31, 2002.
3.7 -- Certificate of Elimination of Designation, Preferences and
Rights of the Series A, Series B and Series C Participating
Convertible Preferred Stock of the Registrant.
3.8 -- Amended and Restated By-laws of the Registrant, incorporated by
reference to the Registrant's transition report on Form 10-K,
filed on November 26, 2002 (the "November 2002, 10-K)
4.1 -- Specimen stock certificate of the Registrant's Common Stock,
incorporated by reference to Exhibit 4.1 to the November 2002,
10-K.
4.2 -- Standstill Agreement, dated August 29, 2000, between the
Registrant and the Investors named therein, incorporated by
reference to Exhibit 2.3 to the Silver Lake 8-K.
4.3 -- Form of Class A Warrant of the Registrant, incorporated by
reference to Exhibit 2.5 to the Silver Lake 8-K.
4.4 -- Form of Class B Warrant of the Registrant, incorporated by
reference to Exhibit 2.6 of the Silver Lake 8-K.
4.5 -- Form of Common Stock Purchase Warrant issued to certain
Investors in connection with the merger of a subsidiary into the
Registrant, incorporated by reference to Exhibit 4.2 to the
October 2001 10-Q.
4.6 -- Rights Agreement, dated May 28, 2002, between the Registrant and
EquiServe Trust Company, N.A., as Rights Agent, incorporated by
reference to Exhibit 4.1 to the Registrants current report on
Form 8-K, filed May 31, 2002.
4.7 -- Form of Rights Certificate, incorporated by reference to Exhibit
4.3 to the Registrant's current report on Form 8-K, filed May
31, 2002.
10.1 -- Amended and Restated Transformation Agreement, effective as
of June 3, 2000, among Cabletron, Aprisma, Enterasys, GNTS
and Riverstone, incorporated by reference to Exhibit 2.1 to
the Registrant's quarterly report on Form 10-Q filed on
January 16, 2001 (the "January 2001 10-Q").
10.2 -- Amended and Restated Asset Contribution Agreement, effective
as of June 3, 2000, between Cabletron and Enterasys,
incorporated by reference to Exhibit 2.3 to the January 2001
10-Q.
50
10.3 -- Amended and Restated Asset Contribution Agreement, effective
as of June 3, 2000, between Cabletron and Riverstone,
incorporated by reference to Exhibit 2.5 of the January 2001
10-Q.
10.4 -- Tax Sharing Agreement, dated as of June 3, 2000, among
Cabletron, Aprisma, Enterasys, GNTS and Riverstone,
incorporated by reference to Exhibit 2.6 of Cabletron's
quarterly report on Form 10-Q, filed on October 18, 2000
(the "October 2000 10-Q).
10.5 -- Assignment and Assumption Agreement, dated as of June 3,
2000, by and between Cabletron and Enterasys pertaining to
the Manufacturing Services Agreement, dated as of February
29, 2000, between the Registrant and Flextronics
International USA, Inc., incorporated by reference to
Exhibit 2.8 of the October 2000 10-Q.
10.6 -- Agency Agreement between the Registrant and International
Cable Networks Inc., incorporated by reference to Exhibit
10.6 to the Registrant's Registration Statement on Form S-1,
No. 33-28055.
10.7 -- Letter Sublease Agreement, dated June 4, 1998, between the
Registrant and Picturetel Corporation, together with related
documents, incorporated by reference to Exhibit 10.8 to the
Registrant's Annual report on Form 10-K, filed on June 4, 2001
(the "2001 10K")
10.8 -- Lease, dated as of October 31, 2001, between Thomas J. Flatley
d/b/a The Flatley Company, and Enterasys Networks, Inc.,
relating to a leased premises in Portsmouth, New Hampshire,
incorporated by reference to Exhibit 10.12 to the November 2002
10-K.
10.9 -- Registration Rights Agreement, dated as of August 29, 2000,
among the Registrant and the Investors, incorporated by
reference to Exhibit 2.7 to the Silver Lake 8-K.
10.10 -- Manufacturing Services Agreement, dated as of March 1, 2000,
between the Registrant and Flextronics International USA,
Inc., incorporated by reference to Exhibit 10.6 to the
February 2001 10-Q/A.
10.11 -- 2002 Employee Stock Purchase Plan, incorporated by reference to
Exhibit 4.1 to the Registrant's registration statement on Form
S-8, No. 333-103587.
10.12 -- 2002 Stock Option Plan for Eligible Executives, incorporated by
reference to Exhibit 10.8 to the Registrant's Quarterly Report
on Form 10-Q for the three-month period ended June 29, 2002,
filed with the Commission on January 30, 2003 (the "January 2003
10-Q").
10.13 -- 2001 Equity Incentive Plan, incorporated by reference to Exhibit
4.1 to the Registrant's registration statement on Form S-8, No.
333-66774.
10.14 -- 1998 Equity Incentive Plan, as amended, incorporated by
reference to Exhibit 4.2 to the Registrant's registration
statement on Form S-8, No. 333-103587.
10.15 -- 1989 Employee Stock Purchase Plan, as restated, incorporated by
reference to Exhibit 10.18 to the November 2001 10-K.
10.16 -- 1995 Employee Stock Purchase Plan, as restated, incorporated by
reference to Exhibit 10.19 to the November 2001 10-K.
10.17 -- Amended and Restated Change-in-Control Severance Benefit Plan
for Key Employees, incorporated by reference to Exhibit 10.7 to
the January 2003 10-Q.
10.18 -- Deferral Plan for Directors, incorporated by reference to
Exhibit 10.4 to the November 2002 10-K.
10.19 -- Promissory Note, dated August 23, 1999 of Enrique P. (Henry)
Fiallo, incorporated by reference to Exhibit 10.28 to the
2000 10-K.
51
10.20 -- Promissory Note, dated January 1, 2000 of Enrique P. (Henry)
Fiallo, incorporated by reference to Exhibit 10.27 to the
2000 10-K.
10.21 -- Employment Agreement, dated April 1, 2002, between the
Registrant and William O'Brien, incorporated by reference to
Exhibit 10.1 to the January 2003 10-Q.
10.22 -- Employment Agreement, dated May 1, 2002, between the Registrant
and Yuda Doron, incorporated by reference to Exhibit 10.2 to the
January 2003 10-Q.
10.23 -- Separation Agreement and Release, dated April 5, 2002, between
the Registrant and Enrique Fiallo, incorporated by reference to
Exhibit 10.3 to the January 2003 10-Q.
10.24 -- Separation Agreement and Release, dated October 29, 2002, by and
between the Registrant and Robert J. Gagalis.
21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Independent Auditors.
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.
52
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of Enterasys Networks, Inc.:
We have audited the accompanying consolidated balance sheets of Enterasys
Networks, Inc. and subsidiaries as of December 28, 2002 and December 29, 2001
and the related consolidated statements of operations, redeemable convertible
preferred stock and stockholders' equity, and cash flows for the year ended
December 28, 2002, the ten-month period ended December 29, 2001 and the year
ended March 3, 2001. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit also includes assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Enterasys Networks,
Inc. and subsidiaries as of December 28, 2002 and December 29, 2001, and the
results of their operations and their cash flows for the year ended December 28,
2002, the ten-month period ended December 29, 2001 and the year ended March 3,
2001, in conformity with accounting principles generally accepted in the United
States of America.
As discussed in Note 2 to the consolidated financial statements, effective
December 30, 2001, the Company changed its method of accounting for goodwill and
other intangible assets. In addition, also as discussed in Note 2 to the
consolidated financial statements, effective March 4, 2001, the Company changed
its method of accounting for derivative financial instruments and hedging
activities.
/s/ KPMG LLP
Boston, Massachusetts
March 25, 2003
ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 28, DECEMBER 29,
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) 2002 2001
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents .................................................................... $ 136,193 $ 114,800
Marketable securities ........................................................................ 82,853 47,532
Accounts receivable, net ..................................................................... 41,683 67,698
Inventories, net ............................................................................. 44,552 118,214
Income tax receivable ........................................................................ 31,916 --
Notes receivable ............................................................................. 2,500 15,000
Prepaid expenses and other current assets .................................................... 20,692 25,368
Assets of discontinued operations ............................................................ -- 103,415
----------- -----------
Total current assets ...................................................................... 360,389 492,027
Restricted cash, cash equivalents and marketable securities ..................................... 24,450 27,882
Long-term marketable securities ................................................................. 69,766 63,920
Investments ..................................................................................... 39,135 63,684
Property, plant and equipment, net .............................................................. 47,407 56,924
Goodwill ........................................................................................ 15,129 15,129
Intangible assets, net .......................................................................... 21,764 30,472
----------- -----------
Total assets .............................................................................. $ 578,040 $ 750,038
=========== ===========
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .............................................................................. $ 47,589 $ 74,764
Accrued compensation and benefits ............................................................. 30,909 31,525
Other accrued expenses ........................................................................ 50,477 46,637
Deferred revenue .............................................................................. 55,982 77,376
Customer advances and billings in excess of revenues .......................................... 7,398 56,115
Income taxes payable .......................................................................... 44,935 37,970
Current portion of redeemable convertible preferred stock ..................................... 94,800 --
Liabilities of discontinued operations ........................................................ -- 33,316
----------- -----------
Total current liabilities ................................................................... 332,090 357,703
Commitments and contingencies (Note 21)
Contingent redemption value of common stock put options ......................................... -- 842
Redeemable convertible preferred stock, $1.00 par value; 65,000 shares of Series D and 25,000
shares of Series E designated, issued and outstanding at December 28, 2002 and
December 29, 2001 (aggregate liquidation preference of Series D and E at December 28, 2002,
$71,390 and $27,461, respectively; and at December 29, 2001, $68,542 and $26,365, respectively) -- 61,789
Stockholders' equity:
Series F preferred stock, $1.00 par value; 300,000 shares authorized; none outstanding ....... -- --
Undesignated preferred stock, $1.00 par value; 1,610,000 shares authorized; none outstanding . -- --
Common stock, $0.01 par value; 450,000,000 shares authorized; 204,940,728 and
202,941,544 shares issued at December 28, 2002 and December 29, 2001, respectively ....... 2,049 2,029
Additional paid-in capital ................................................................... 1,176,843 1,141,089
Accumulated deficit .......................................................................... (875,407) (748,199)
Unearned stock-based compensation ............................................................ (158) (2,802)
Treasury stock, at cost; 3,053,201 common shares at December 28, 2002 and December 29, 2001 .. (64,890) (64,890)
Accumulated other comprehensive income ....................................................... 7,513 2,477
----------- -----------
Total stockholders' equity ............................................................... 245,950 329,704
----------- -----------
Total liabilities, redeemable convertible preferred stock and stockholders' equity ....... $ 578,040 $ 750,038
=========== ===========
See accompanying notes to consolidated financial statements.
F-2
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Net revenue:
Product ....................................................... $ 346,610 $ 257,947 $ 599,492
Services ...................................................... 138,187 136,598 174,875
--------- --------- ---------
Total revenue ............................................... 484,797 394,545 774,367
Cost of revenue:
Product ....................................................... 231,359 302,820 375,788
Services (a) .................................................. 43,643 47,556 55,979
--------- --------- ---------
Total cost of revenue ....................................... 275,002 350,376 431,767
--------- --------- ---------
Gross margin .............................................. 209,795 44,169 342,600
Operating expenses:
Research and development (a) ................................. 85,019 76,471 81,723
Selling, general and administrative (a) ....................... 234,960 284,735 335,303
Amortization of intangible assets ............................. 8,708 32,366 23,176
Stock-based compensation ...................................... 2,644 30,572 1,442
Special charges ............................................... 31,978 47,168 63,187
Impairment of intangible assets ............................... -- 104,147 14,104
--------- --------- ---------
Total operating expenses .................................... 363,309 575,459 518,935
--------- --------- ---------
Loss from operations ..................................... (153,514) (531,290) (176,335)
Interest income, net ............................................ 8,347 17,672 29,981
Other income (expense), net ..................................... (42,625) (41,209) (557,355)
--------- --------- ---------
Loss from continuing operations before income taxes and
cumulative effect of a change in accounting principle ..... (187,792) (554,827) (703,709)
Income tax expense (benefit) .................................... (85,247) 60,242 (98,187)
--------- --------- ---------
Loss from continuing operations before cumulative effect of a
change in accounting principle ........................... (102,545) (615,069) (605,522)
Discontinued operations:
Operating loss (net of tax expense of $0, $346 and $224,
respectively) ........................................... -- (59,124) (76,306)
Loss on disposal (net of tax expense of $0) ................ (11,700) (42,782) --
--------- --------- ---------
Loss from discontinued operations ....................... (11,700) (101,906) (76,306)
Cumulative effect of a change in accounting principle (net of tax
expense of $0) ............................................... -- 12,691 --
--------- --------- ---------
Net loss ................................................. (114,245) (704,284) (681,828)
Dividend effect of beneficial conversion feature to preferred
stockholders ................................................. -- -- (16,854)
Accretive dividend and accretion of discount on preferred shares (12,963) (10,347) (6,044)
--------- --------- ---------
Net loss available to common shareholders ............... $(127,208) $(714,631) $(704,726)
========= ========= =========
Basic and diluted loss per common share:
Loss from continuing operations available to common
shareholders ............................................. $ (0.57) $ (3.24) $ (3.40)
Discontinued operations:
Operating loss ............................................ -- (0.31) (0.41)
Loss on disposal .......................................... (0.06) (0.22) --
Cumulative effect of a change in accounting principle ....... -- 0.06 --
--------- --------- ---------
Net loss available to common shareholders ................. $ (0.63) $ (3.71) $ (3.81)
========= ========= =========
Weighted average number of basic and diluted common shares
outstanding ................................................ 201,562 192,743 184,770
========= ========= =========
(a) Excludes non-cash, stock-based compensation expense as
follows:
Services cost of revenue ................................. $ -- $ 2,292 $ --
Research and development ................................. 2,644 13,356 1,442
Selling, general and administrative ...................... -- 14,924 --
--------- --------- ---------
Total stock-based compensation ........................ $ 2,644 $ 30,572 $ 1,442
========= ========= =========
See accompanying notes to consolidated financial statements.
F-3
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY
REDEEMABLE STOCKHOLDERS' EQUITY
CONVERTIBLE ----------------------------
PREFERRED STOCK COMMON STOCK
---------------------------- ---------------------------
CARRYING PAR
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES VALUE SHARES VALUE
----------- ----------- ----------- -----------
BALANCE AT FEBRUARY 29, 2000 .............................. -- $ -- 183,585,437 $ 1,836
Comprehensive loss:
Net loss ................................................. -- -- -- --
Other comprehensive loss:
Unrealized loss on available-for-sale securities (net
of tax benefit of $502,638) ............................ -- -- -- --
Effect of foreign currency translation ................. -- -- -- --
Reclassification adjustment for gains on available-
for-sale securities included in net income (net of
tax benefit of $158,327) ............................. -- -- -- --
Total comprehensive loss ............................ -- -- -- --
Exercise of options and warrants for shares of common stock -- -- 2,111,000 21
Issuance of subsidiary preferred stock .................... -- -- -- --
Issuance of common stock in connection with
purchased acquisitions ................................. -- -- 4,009,139 40
Tax adjustment for options exercised ...................... -- -- -- --
Issuance of shares under employee stock purchase plan ..... -- -- 906,000 9
Issuance of stock purchase rights ......................... -- -- -- --
Issuance of Class A and Class B warrants .................. -- -- -- --
Options issued in connection with purchased
acquisitions ........................................... -- -- -- --
Issuance of Series A and Series B preferred
stock and beneficial conversion .......................... 90,000 68,000 -- --
Accretion of Series A and Series B preferred stock
discount ................................................ -- 4,233 -- --
Accretive dividend of Series A and Series B preferred
stock .................................................. -- 1,811 -- --
Issuance of Series C preferred stock ...................... 45,471 31,875 -- --
Issuance of options and warrants to purchase Series
C preferred stock ...................................... -- 3,670 -- --
Purchase of treasury stock ................................ -- -- -- --
Premium from sale of put options .......................... -- -- -- --
Unearned stock-based compensation related to stock
option grants .......................................... -- -- -- --
Amortization of unearned stock-based compensation ......... -- -- -- --
Grants of options to consultants .......................... -- -- -- --
Issuance of Riverstone stock .............................. -- -- -- --
----------- ----------- ----------- -----------
BALANCE AT MARCH 3, 2001 .................................. 135,471 $ 109,589 190,611,576 $ 1,906
=========== =========== =========== ===========
STOCKHOLDERS' EQUITY
-------------------------------------------------
ADDITIONAL UNEARNED
PAID-IN RETAINED STOCK-BASED
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) CAPITAL EARNINGS COMPENSATION
----------- ----------- ------------
BALANCE AT FEBRUARY 29, 2000 .............................. $ 630,155 $ 1,000,758 $ --
Comprehensive loss:
Net loss ................................................. -- (681,828) --
Other comprehensive loss:
Unrealized loss on available-for-sale securities (net
of tax benefit of $502,638) ............................ -- -- --
Effect of foreign currency translation ................. -- -- --
Reclassification adjustment for gains on available-
for-sale securities included in net income (net of
tax benefit of $158,327) ............................. -- -- --
Total comprehensive loss ............................ -- -- --
Exercise of options and warrants for shares of common stock 19,982 -- --
Issuance of subsidiary preferred stock .................... 13,720 -- --
Issuance of common stock in connection with
purchased acquisitions ................................. 139,173 -- (5,519)
Tax adjustment for options exercised ...................... (13,954) -- --
Issuance of shares under employee stock purchase plan ..... 13,439 -- --
Issuance of stock purchase rights ......................... 7,173 -- --
Issuance of Class A and Class B warrants .................. 3,400 -- --
Options issued in connection with purchased
acquisitions ........................................... 13,824 -- (2,935)
Issuance of Series A and Series B preferred
stock and beneficial conversion .......................... 16,854 (16,854) --
Accretion of Series A and Series B preferred stock
discount ................................................ -- (4,233) --
Accretive dividend of Series A and Series B preferred
stock .................................................. -- (1,811) --
Issuance of Series C preferred stock ...................... -- -- --
Issuance of options and warrants to purchase Series
C preferred stock ...................................... -- -- --
Purchase of treasury stock ................................ -- -- --
Premium from sale of put options .......................... 4,934 -- --
Unearned stock-based compensation related to stock
option grants .......................................... 11,099 -- (11,099)
Amortization of unearned stock-based compensation ......... -- -- 2,880
Grants of options to consultants .......................... 2,100 -- --
Issuance of Riverstone stock .............................. 128,258 -- --
----------- ----------- -----------
BALANCE AT MARCH 3, 2001 .................................. $ 990,157 $ 296,032 $ (16,673)
=========== =========== ===========
STOCKHOLDERS' EQUITY
----------------------------------------------------------------
ACCUMULATED
TREASURY STOCK OTHER TOTAL
----------------------------- COMPREHENSIVE STOCKHOLDERS'
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES COST INCOME (LOSS) EQUITY
-------------- ----------- ------------- ------------
BALANCE AT FEBRUARY 29, 2000 .............................. -- $ -- $ 514,690 $ 2,147,439
Comprehensive loss:
Net loss ................................................. -- -- -- (681,828)
Other comprehensive loss:
Unrealized loss on available-for-sale securities (net
of tax benefit of $502,638) ............................ -- -- (752,232) (752,232)
Effect of foreign currency translation ................. -- -- 762 762
Reclassification adjustment for gains on available-
for-sale securities included in net income (net of
tax benefit of $158,327) ............................. -- -- 236,156 236,156
-----------
Total comprehensive loss ............................ -- -- -- (1,197,142)
Exercise of options and warrants for shares of common stock -- -- -- 20,003
Issuance of subsidiary preferred stock .................... -- -- -- 13,720
Issuance of common stock in connection with
purchased acquisitions ................................. -- -- -- 133,694
Tax adjustment for options exercised ...................... -- -- -- (13,954)
Issuance of shares under employee stock purchase plan ..... -- -- -- 13,448
Issuance of stock purchase rights ......................... -- -- -- 7,173
Issuance of Class A and Class B warrants .................. -- -- -- 3,400
Options issued in connection with purchased
acquisitions ........................................... -- -- -- 10,889
Issuance of Series A and Series B preferred
stock and beneficial conversion .......................... -- -- -- --
Accretion of Series A and Series B preferred stock
discount ................................................ -- -- -- (4,233)
Accretive dividend of Series A and Series B preferred
stock .................................................. -- -- -- (1,811)
Issuance of Series C preferred stock ...................... -- -- -- --
Issuance of options and warrants to purchase Series
C preferred stock ...................................... -- -- -- --
Purchase of treasury stock ................................ (2,100,000) (56,479) -- (56,479)
Premium from sale of put options .......................... -- -- -- 4,934
Unearned stock-based compensation related to stock
option grants .......................................... -- -- -- --
Amortization of unearned stock-based compensation ......... -- -- -- 2,880
Grants of options to consultants .......................... -- -- -- 2,100
Issuance of Riverstone stock .............................. -- -- -- 128,258
----------- ----------- ----------- -----------
BALANCE AT MARCH 3, 2001 .................................. (2,100,000) $ (56,479) $ (624) $ 1,214,319
=========== =========== =========== ===========
See accompanying notes to consolidated financial statements.
F-4
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY -- (CONTINUED)
REDEEMABLE STOCKHOLDERS' EQUITY
CONVERTIBLE ---------------------------
PREFERRED STOCK COMMON STOCK
---------------------------- ---------------------------
CARRYING PAR
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES VALUE SHARES VALUE
----------- ----------- ----------- -----------
BALANCE AT MARCH 3, 2001 .................................. 135,471 $ 109,589 190,611,576 $ 1,906
Comprehensive loss:
Net loss ................................................. -- -- -- --
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $1,490) ...................... -- -- -- --
Effect of foreign currency translation ................ -- -- -- --
Total comprehensive loss ............................. -- -- -- --
Riverstone spin-off ....................................... -- -- -- --
Exercise of options and warrants for shares of
common stock ............................................ -- -- 10,477,337 105
Acceleration of stock options ............................. -- -- -- --
Proceeds from sale of put options ......................... -- -- -- --
Issuance of shares under employee share purchase plan ..... -- -- 778,752 7
Issuance of Riverstone stock at spin-off .................. -- (18,582) -- --
Adjustment to Riverstone stock derivative ................. -- (4,020) -- --
Accretive dividend of Series A and B preferred stock ...... -- 1,443 -- --
Accretion of Series D and E preferred stock discount (a) .. -- 7,251 -- --
Accretive dividend of Series D and E preferred stock (a) .. -- 1,653 -- --
Conversion of Series C preferred stock .................... (45,471) (31,875) 955,253 9
Conversion of options and warrants on Series C
preferred stock ....................................... -- (3,670) -- --
Contingent redemption value of common stock put
options ................................................ -- -- -- --
Purchase of treasury stock ................................ -- -- -- --
Exercise of warrants ...................................... -- -- 118,626 2
Amortization of unearned stock-based compensation ......... -- -- -- --
Effect of minority interests .............................. -- -- -- --
----------- ----------- ----------- -----------
BALANCE AT DECEMBER 29, 2001 .............................. 90,000 $ 61,789 202,941,544 $ 2,029
=========== =========== =========== ===========
STOCKHOLDERS' EQUITY
------------------------------------------------
RETAINED
ADDITIONAL EARNINGS UNEARNED
PAID-IN (ACCUMULATED STOCK-BASED
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) CAPITAL DEFICIT) COMPENSATION
----------- ----------- ------------
BALANCE AT MARCH 3, 2001 .................................. $ 990,157 $ 296,032 $ (16,673)
Comprehensive loss:
Net loss ................................................. -- (704,284) --
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $1,490) ...................... -- -- --
Effect of foreign currency translation ................ -- -- --
Total comprehensive loss ............................. -- -- --
Riverstone spin-off ....................................... -- (329,600) 9,022
Exercise of options and warrants for shares of
common stock ............................................ 48,296 -- --
Acceleration of stock options ............................. 42,274 -- --
Proceeds from sale of put options ......................... 135 -- --
Issuance of shares under employee share purchase plan ..... 7,561 -- --
Issuance of Riverstone stock at spin-off .................. 18,582 -- --
Adjustment to Riverstone stock derivative ................. -- -- --
Accretive dividend of Series A and B preferred stock ...... -- (1,443) --
Accretion of Series D and E preferred stock discount (a) .. -- (7,251) --
Accretive dividend of Series D and E preferred stock (a) .. -- (1,653) --
Conversion of Series C preferred stock .................... 31,866 -- --
Conversion of options and warrants on Series C
preferred stock ....................................... 3,670 -- --
Contingent redemption value of common stock put
options ................................................ (842) -- --
Purchase of treasury stock ................................ -- -- --
Exercise of warrants ...................................... (2) -- --
Amortization of unearned stock-based compensation ......... -- -- 4,849
Effect of minority interests .............................. (608) -- --
----------- ----------- -----------
BALANCE AT DECEMBER 29, 2001 .............................. $ 1,141,089 $ (748,199) $ (2,802)
=========== =========== ===========
STOCKHOLDERS' EQUITY
----------------------------------------------------------------
ACCUMULATED
TREASURY STOCK OTHER TOTAL
----------------------------- COMPREHENSIVE STOCKHOLDERS'
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES COST INCOME (LOSS) EQUITY
-------------- ----------- ------------- ------------
BALANCE AT MARCH 3, 2001 .................................. (2,100,000) $ (56,479) $ (624) $ 1,214,319
Comprehensive loss:
Net loss ................................................. -- -- -- (704,284)
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $1,490) ...................... -- -- 2,235 2,235
Effect of foreign currency translation ................ -- -- 866 866
-----------
Total comprehensive loss ............................. -- -- -- (701,183)
Riverstone spin-off ....................................... -- -- -- (320,578)
Exercise of options and warrants for shares of
common stock ............................................ -- -- -- 48,401
Acceleration of stock options ............................. -- -- -- 42,274
Proceeds from sale of put options ......................... -- -- -- 135
Issuance of shares under employee share purchase plan ..... -- -- -- 7,568
Issuance of Riverstone stock at spin-off .................. -- -- -- 18,582
Adjustment to Riverstone stock derivative ................. -- -- -- --
Accretive dividend of Series A and B preferred stock ...... -- -- -- (1,443)
Accretion of Series D and E preferred stock discount (a) .. -- -- -- (7,251)
Accretive dividend of Series D and E preferred stock (a) .. -- -- -- (1,653)
Conversion of Series C preferred stock .................... -- -- -- 31,875
Conversion of options and warrants on Series C
preferred stock ....................................... -- -- -- 3,670
Contingent redemption value of common stock put
options ................................................ -- -- -- (842)
Purchase of treasury stock ................................ (953,201) (8,411) -- (8,411)
Exercise of warrants ...................................... -- -- -- --
Amortization of unearned stock-based compensation ......... -- -- -- 4,849
Effect of minority interests .............................. -- -- -- (608)
----------- ----------- ----------- -----------
BALANCE AT DECEMBER 29, 2001 .............................. (3,053,201) $ (64,890) $ 2,477 $ 329,704
=========== =========== =========== ===========
(a) Series A and Series B redeemable preferred stock were exchanged for Series
D and Series E redeemable preferred stock in July 2001 (see Note 19).
See accompanying notes to consolidated financial statements.
F-5
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY-- (CONTINUED)
REDEEMABLE STOCKHOLDERS' EQUITY
CONVERTIBLE ---------------------------
PREFERRED STOCK COMMON STOCK
---------------------------- ---------------------------
CARRYING PAR
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES VALUE SHARES VALUE
----------- ----------- ----------- -----------
BALANCE AT DECEMBER 29, 2001 .............................. 90,000 $ 61,789 202,941,544 $ 2,029
Comprehensive loss:
Net loss ................................................. -- -- -- --
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $0) ............................ -- -- -- --
Effect of foreign currency translation ................. -- -- -- --
Total comprehensive loss ............................. -- -- -- --
Exercise of options and warrants for shares of common
stock .................................................. -- -- 1,333,995 13
Tax adjustment for options exercised ...................... -- -- -- --
Issuance of shares under employee share purchase
plan .................................................... -- -- 665,189 7
Adjustment to Riverstone stock derivative ................. -- 20,048 -- --
Expiration of put options ................................. -- -- -- --
Accretion of Series D and E preferred stock discount ...... -- 9,019 -- --
Accretive dividend of Series D and E preferred stock ...... -- 3,944 -- --
Amortization of unearned stock-based compensation ........ -- -- -- --
----------- ----------- ----------- -----------
BALANCE AT DECEMBER 28, 2002 .............................. 90,000 $ 94,800 204,940,728 $ 2,049
=========== =========== =========== ===========
STOCKHOLDERS' EQUITY
-----------------------------------------------
ADDITIONAL UNEARNED
PAID-IN ACCUMULATED STOCK-BASED
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) CAPITAL DEFICIT COMPENSATION
----------- ----------- ------------
BALANCE AT DECEMBER 29, 2001 .............................. $ 1,141,089 $ (748,199) $ (2,802)
Comprehensive loss:
Net loss ................................................. -- (114,245) --
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $0) ............................ -- -- --
Effect of foreign currency translation ................. -- -- --
Total comprehensive loss ............................. -- -- --
Exercise of options and warrants for shares of common
stock .................................................. 3,833 -- --
Tax adjustment for options exercised ...................... 30,266 -- --
Issuance of shares under employee share purchase
plan .................................................... 813 -- --
Adjustment to Riverstone stock derivative ................. -- -- --
Expiration of put options ................................. 842 -- --
Accretion of Series D and E preferred stock discount ...... -- (9,019) --
Accretive dividend of Series D and E preferred stock ...... -- (3,944) --
Amortization of unearned stock-based compensation ........ -- -- 2,644
----------- ----------- -----------
BALANCE AT DECEMBER 28, 2002 .............................. $ 1,176,843 $ (875,407) $ (158)
=========== =========== ===========
STOCKHOLDERS' EQUITY
-----------------------------------------------------------------
ACCUMULATED
TREASURY STOCK OTHER TOTAL
----------------------------- COMPREHENSIVE STOCKHOLDERS'
(IN THOUSANDS, EXCEPT NUMBER OF SHARES) SHARES COST INCOME (LOSS) EQUITY
-------------- ----------- ------------- ------------
BALANCE AT DECEMBER 29, 2001 .............................. (3,053,201) $ (64,890) $ 2,477 $ 329,704
Comprehensive loss:
Net loss ................................................. -- -- -- (114,245)
Other comprehensive income (loss):
Unrealized gain on available-for-sale securities
(net of tax expense of $0) ............................ -- -- 930 930
Effect of foreign currency translation ................. -- -- 4,106 4,106
-----------
Total comprehensive loss ............................. -- -- -- (109,209)
Exercise of options and warrants for shares of common
stock .................................................. -- -- -- 3,846
Tax adjustment for options exercised ...................... -- -- -- 30,266
Issuance of shares under employee share purchase
plan .................................................... -- -- -- 820
Adjustment to Riverstone stock derivative ................. -- -- -- --
Expiration of put options ................................. -- -- -- 842
Accretion of Series D and E preferred stock discount ...... -- -- -- (9,019)
Accretive dividend of Series D and E preferred stock ...... -- -- -- (3,944)
Amortization of unearned stock-based compensation ........ -- -- -- 2,644
----------- ----------- ----------- -----------
BALANCE AT DECEMBER 28, 2002 .............................. (3,053,201) $ (64,890) $ 7,513 $ 245,950
=========== =========== =========== ===========
See accompanying notes to consolidated financial statements
F-6
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED TEN MONTHS ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
Cash flows from operating activities:
Net loss ........................................................................... $ (114,245) $ (704,284)
Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:
Loss from discontinued operations ................................................ 11,700 101,906
Depreciation and amortization .................................................... 42,833 59,106
Provision for losses on accounts receivable ...................................... 1,630 12,523
Provision for excess and obsolete inventory ...................................... 17,885 72,888
Valuation allowance for notes receivable ......................................... (2,500) 6,125
Deferred income taxes ............................................................ -- 82,275
Impairment of intangible assets .................................................. -- 104,147
Loss on disposals and impairment of property, plant and equipment ................ -- 4,671
Stock-based compensation ......................................................... 2,644 30,572
Purchased research and development from acquisitions ............................. -- --
Net realized (gain) loss on sale of securities ................................... (1,121) (61,819)
Loss on sale of division ......................................................... -- --
Loss on investment write-downs ................................................... 22,119 65,901
Unrealized loss (gain) on Riverstone stock derivative ............................ 20,048 (4,020)
Changes in current assets and liabilities (net of effects of business acquisitions):
Accounts receivable .............................................................. 24,385 57,494
Inventories ...................................................................... 55,777 (106,067)
Prepaid expenses and other assets ................................................ 4,676 35,565
Accounts payable and accrued expenses ............................................ (34,422) 3,128
Customer advances and billings in excess of revenues ............................. (48,717) 56,115
Deferred revenue ................................................................. (21,394) (11,066)
Income taxes payable ............................................................. 7,458 (13,424)
----------- -----------
Net cash used in operating activities ............................................. (11,244) (208,264)
----------- -----------
Cash flows from investing activities:
Capital expenditures ............................................................... (24,608) (21,115)
Cash paid for business acquisitions, net ........................................... -- --
Cash paid for minority investments ................................................. (1,677) (20,538)
Proceeds from sales of minority investments ........................................ 4,107 427
Proceeds from sale of fixed assets ................................................. -- 2,000
Purchase of available-for-sale securities .......................................... (142,151) (259,193)
Purchase of held-to-maturity securities ............................................ -- --
Sales and maturities of marketable securities ...................................... 143,685 689,336
----------- -----------
Net cash (used in) provided by investing activities ................................ (20,644) 390,917
----------- -----------
Cash flows from financing activities:
Common stock issued pursuant to employee stock purchase plans ...................... 820 7,568
Proceeds from sale of common stock put options ..................................... -- 135
Proceeds from issuance of preferred stock, warrants and stock purchase rights ...... -- --
Proceeds from issuance of subsidiary shares and exercise of stock purchase
rights ........................................................................... -- --
Payments from notes receivable ..................................................... 15,000 1,875
Issuance of notes receivable ....................................................... -- (13,000)
Repurchase of common stock ......................................................... -- (8,411)
Proceeds from exercise of stock options ............................................ 3,846 48,401
----------- -----------
Net cash provided by financing activities .......................................... 19,666 36,568
----------- -----------
Effect of exchange rate changes on cash .............................................. 4,106 866
----------- -----------
Cash flows related to discontinued operations ........................................ 29,509 (169,665)
----------- -----------
Net increase (decrease) in cash and cash equivalents ................................. 21,393 50,422
Cash and cash equivalents at beginning of year ....................................... 114,800 64,378
----------- -----------
Cash and cash equivalents at end of year ............................................. $ 136,193 $ 114,800
=========== ===========
YEAR ENDED
(IN THOUSANDS) MARCH 3, 2001
-------------
Cash flows from operating activities:
Net loss ........................................................................... $ (681,828)
Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:
Loss from discontinued operations ................................................ 76,306
Depreciation and amortization .................................................... 60,176
Provision for losses on accounts receivable ...................................... 17,788
Provision for excess and obsolete inventory ...................................... 44,686
Valuation allowance for notes receivable ......................................... --
Deferred income taxes ............................................................ (103,480)
Impairment of intangible assets .................................................. 14,104
Loss on disposals and impairment of property, plant and equipment ................ 22,292
Stock-based compensation ......................................................... 1,442
Purchased research and development from acquisitions ............................. 25,600
Net realized (gain) loss on sale of securities ................................... 385,552
Loss on sale of division ......................................................... 143,108
Loss on investment write-downs ................................................... 17,178
Unrealized loss (gain) on Riverstone stock derivative ............................ --
Changes in current assets and liabilities (net of effects of business acquisitions):
Accounts receivable .............................................................. 46,147
Inventories ...................................................................... (154,253)
Prepaid expenses and other assets ................................................ (27,832)
Accounts payable and accrued expenses ............................................ (69,754)
Customer advances and billings in excess of revenues ............................. --
Deferred revenue ................................................................. 7,113
Income taxes payable ............................................................. (2,272)
-----------
Net cash used in operating activities ............................................. (177,927)
-----------
Cash flows from investing activities:
Capital expenditures ............................................................... (16,897)
Cash paid for business acquisitions, net ........................................... (11,964)
Cash paid for minority investments ................................................. (75,904)
Proceeds from sales of minority investments ........................................ --
Proceeds from sale of fixed assets ................................................. --
Purchase of available-for-sale securities .......................................... (1,004,936)
Purchase of held-to-maturity securities ............................................ (113,785)
Sales and maturities of marketable securities ...................................... 1,278,955
-----------
Net cash (used in) provided by investing activities ................................ 55,469
-----------
Cash flows from financing activities:
Common stock issued pursuant to employee stock purchase plans ...................... 13,448
Proceeds from sale of common stock put options ..................................... 4,934
Proceeds from issuance of preferred stock, warrants and stock purchase rights ...... 78,573
Proceeds from issuance of subsidiary shares and exercise of stock purchase
rights ........................................................................... 13,720
Payments from notes receivable ..................................................... --
Issuance of notes receivable ....................................................... (10,000)
Repurchase of common stock ......................................................... (56,479)
Proceeds from exercise of stock options ............................................ 20,003
-----------
Net cash provided by (used in) financing activities ................................ 64,199
-----------
Effect of exchange rate changes on cash .............................................. 762
-----------
Cash flows related to discontinued operations ........................................ (229,105)
-----------
Net increase (decrease) in cash and cash equivalents ................................. (286,602)
Cash and cash equivalents at beginning of year ....................................... 350,980
-----------
Cash and cash equivalents at end of year ............................................. $ 64,378
===========
Supplemental disclosures of cash flow information (see Note 18).
See accompanying notes to consolidated financial statements.
F-7
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS OPERATIONS
Enterasys Networks, Inc. and its subsidiaries (the "Company") design,
develop, market and support comprehensive networking solutions to address the
networking challenges facing global enterprises. The Company's solutions empower
customers to use their internal networks and the Internet to facilitate the
exchange of information, increase productivity and reduce operating costs, while
maintaining security. Using the Company's 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. The
Company's significant installed base of customers consists of commercial
enterprises; governmental entities; health care, financial, educational and
non-profit institutions; and other various organizations.
The Company does not have internal manufacturing capabilities. It
outsources substantially all of its manufacturing to two companies, Flextronics
International USA, Inc. ("Flextronics") and Accton Technology Corporation
("Accton"), which procure material on the Company's behalf and provide
comprehensive manufacturing services, including assembly, test and quality
control. Flextronics, which accounted for approximately 55 percent of the
Company's production during fiscal year 2002, manufactures the Company's
products in Portsmouth, New Hampshire, and Cork, Ireland. Accton, which
accounted for 29 percent of the Company's production during fiscal year 2002,
manufactures the Company's products in Taiwan.
2. SUMMARY OF SIGNIFICANT 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.
FISCAL YEAR-END CHANGE
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. References to fiscal year 2001 represent the fiscal year
ended March 3, 2001. The ten-month transition period ended December 29, 2001 is
noted as such or as "transition year 2001" and the twelve-month period ended
December 28, 2002, is noted as such or as "fiscal year 2002." The Company has
not included comparable twelve-month financial information for the period from
December 31, 2000 to December 29, 2001 because it was impracticable to do so due
to certain inherent limitations in the Company's interim monthly closing
process.
RECLASSIFICATIONS
On 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." EITF No. 00-25, as further defined by EITF No. 01-9,
"Accounting for Consideration Given by a Vendor to a Customer (Including a
Reseller of the Vendor's Products)," requires that payments made to resellers by
the Company for cooperative advertising, buy-downs and similar arrangements be
classified as a reduction to net sales or an increase in selling expenses,
depending upon the application of the funds by the customer. As a result,
certain amounts for transition year 2001 and fiscal year 2001 have been
reclassified to comply with the guidelines of EITF No. 00-25. The
reclassification for transition year 2001 and fiscal year 2001 resulted in a
reduction of net revenue of $20.7 million and $9.3 million, respectively; a
reduction of cost of revenue of $28.1 million and $14.7 million, respectively;
and an increase in selling, general and administrative expense of $7.4 million
and $5.4 million, respectively. The above reclassification had no impact on net
loss or loss per share.
In addition to the reclassifications noted above, certain prior period
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
F-8
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 investments,
the use and recoverability of inventory and tangible and intangible assets, the
amounts of incentive compensation liabilities, accrued restructuring charges,
and 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, any of
which could affect the future realizability of the Company's assets. Estimates
and assumptions are reviewed on an ongoing 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.
REVENUE RECOGNITION
The Company's revenue is comprised of product revenue, which includes
revenue from sales of the Company's switches, routers, and other network
equipment and software, and services revenue, which includes maintenance,
installation, and system integration services. The Company's revenue recognition
policy follows SEC Staff Accounting Bulletin No. 101,"Revenue Recognition in
Financial Statements," and Statement of Position ("SOP") No. 97-2, "Software
Revenue Recognition," as amended by SOP No. 98-9, "Modification of SOP No. 97-2,
Software Recognition, With Respect to Certain Transactions." The Company
generally recognizes product revenue from its 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 for system integration or customer acceptance, revenue and
related costs are deferred until such obligations are fulfilled. Software
revenue is deferred in instances when vendor specific objective evidence
("VSOE") of fair value of undelivered elements is not determinable. VSOE of fair
value is the price charged when the element is sold separately. Revenue from
service obligations under maintenance contracts is deferred and recognized on a
straight-line basis over the contractual period, which is typically twelve
months.
Beginning in September 2001, the Company determined that it could no
longer estimate the amount of future product returns from certain stocking
distributors located in the United States and Europe. The Company now recognizes
revenue from these distributors when they ship the Company's products to their
customers. The Company records payments from these distributors as customer
advances and billings in excess of revenues when they pay for the Company's
products in advance of shipments to their customers. Beginning in fiscal year
2001, the Company began recording revenue from certain distributors and
resellers located in Asia Pacific and Latin America when they paid the Company,
due to existing practices related to the distributor/reseller relationships.
Prior to fiscal year 2002, the Company periodically sold products and
services to customers in exchange for minority investments in the form of debt
or equity securities in the customers. In some instances, the Company issued
product credits, or the right to purchase the Company's products, which, when
used, were exchanged for debt or equity securities of the customer. In other
cases, the Company invested cash that was then used by the investee company to
purchase the Company's products. The amount of revenue recorded by the Company
was 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.
The Company provides an allowance for sales returns based on return
policies and return rights granted to its customers and historical returns. The
Company also provides for pricing allowances in the period when granted. These
allowances have been recorded as a reduction of net revenue in the accompanying
consolidated statements of operations.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of all highly liquid investments with an
original or remaining maturity of 90 days or less. Cash and cash equivalents are
carried at cost, which approximates fair value.
MARKETABLE SECURITIES
Held-to-maturity securities are those financial instruments that the
Company has the ability and intent to hold until maturity. Held-to-maturity
securities are recorded at amortized cost, adjusted for amortization and
accretion of premiums and discounts. Due to the
F-9
nature of the Company's marketable securities and the resulting low volatility,
the difference between fair value and amortized cost is not material.
Available-for-sale securities are recorded at fair value. Unrealized gains
and losses net of the related tax effect on available-for-sale securities are
reported in accumulated other comprehensive income, a component of stockholders'
equity, until realized. The estimated market values of investments are based on
quoted market prices as of the end of the reporting period.
Investments described below under the heading "Investments" are not
included in marketable securities.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company estimates the collectibility of its accounts receivable and
the related amount of bad debts that may be incurred in the future. The
allowance for doubtful accounts results from an analysis of specific customer
accounts, historical experience, customer concentrations, credit ratings and
current economic trends.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to a
concentration of credit risk principally consist of cash equivalents, marketable
securities, long-term investments, notes and accounts receivable. The Company
seeks to reduce credit risk on financial instruments by investing in high credit
quality issuers and, by policy, limiting the amount of credit exposure to any
one issuer or fund. Exposure to customer credit risk is controlled through
credit approvals, credit limits, continuous monitoring procedures and
establishment of an allowance for doubtful accounts when deemed necessary.
The carrying amounts of cash, cash equivalents, trade receivables,
accounts payable and accrued expenses approximate the fair value because of the
short maturity of these financial instruments.
Several major international financial institutions are counterparties to
the Company's financial instruments. It is Company practice to monitor the
financial standing of these counterparties and limit the amount of exposure with
any one institution. The Company may be exposed to credit loss in the event of
nonperformance by the counterparties to these contracts, but believes any such
loss is unlikely and would not be material to its financial position and results
of operations.
During fiscal year 2002, two distributors accounted for approximately 17%
and 12%, respectively, of net revenue; for transition year 2001, two
distributors accounted for approximately 14% and 10%, respectively, of net
revenue; and for fiscal year 2001, no distributor accounted for greater than 10%
of the Company's revenue. No single direct sales customer accounted for more
than 10% of the Company's net revenue in fiscal year 2002, transition year 2001,
or fiscal year 2001.
During fiscal year 2002, transition year 2001 and fiscal year 2001, the
U.S. federal government accounted for approximately 11%, 13% and 10% of total
net revenue, respectively. The Company's sales to the U.S. federal government
are distributed across a wide variety of government agencies; therefore, the
Company does not believe its revenue would be materially impacted by
fluctuations in federal government spending by any one agency.
INVENTORIES
Inventories are reported at the lower of cost or market. Costs are
determined at standard, which approximates actual cost on a first-in, first-out
("FIFO") method. The Company provides for excess and obsolete inventory using a
reserve methodology based primarily on forecasts of future demand. Finished
goods inventory includes spare parts inventory and customer evaluation units as
well as products shipped to stocking distributors where revenue is not
recognized until the products are shipped to their customers.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are reported at cost. Depreciation is
provided on a straight-line method over the estimated useful lives of the
assets. Leasehold improvements are amortized over the shorter of the lives of
the related assets or the term of the lease. Repairs and maintenance costs are
expensed as incurred.
GOODWILL AND OTHER INTANGIBLE ASSETS
F-10
Goodwill is the excess of the purchase price over the fair value of
identifiable net assets acquired in business combinations accounted for as
purchases. Intangible assets consist of customer relations, patents, and
technology acquired in business combinations and are reported at cost less
accumulated amortization. Prior to fiscal year 2002, amortization of goodwill
and other intangible assets was provided on a straight-line basis over the
respective useful lives that ranged from three to ten years. On December 30,
2001, the Company adopted FASB Statement of Financial Standards ("SFAS") No.
142, "Goodwill and Other Intangible Assets," and discontinued amortizing
goodwill. Existing and future acquired goodwill will be subject to an annual
impairment test using a fair- value-based approach. The Company has designated
the end of the third quarter of the fiscal year as the date of the annual
impairment test for goodwill. All other intangible assets with definite lives
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."
During the second quarter of fiscal year 2002, in conjunction with the
implementation of SFAS No. 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.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets are comprised of property, plant and equipment and
intangible assets with definite lives. The Company assesses the impairment of
long-lived assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable through projected undiscounted cash flows
expected to be generated by the asset. When the Company determines that the
carrying value of intangible assets and fixed assets may not be recoverable, the
Company measures impairment by the amount by which the carrying value of the
long-lived asset exceeds the related fair value. Estimated fair value is
generally based on a projected discounted cash flow method using a discount rate
determined by management to be commensurate with the risk inherent in the
business underlying the asset in question.
Effective December 30, 2001, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets" which requires long-lived
assets to be 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 and 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 ("APB") 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 Transaction," 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
15 for a discussion of the Company's discontinued operations. The adoption of
SFAS No. 144 did not have any impact on the carrying amount of the Company's
long-lived assets.
DERIVATIVES
The Company accounts for derivatives in accordance with SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," and recognizes
derivatives on the balance sheet at fair value. The accounting for changes in
the fair value of a derivative depends on the intended use of the derivative and
the resulting designation.
Upon adoption of SFAS No. 133 in the first quarter of transition year
2001, the Company recorded a transition adjustment, which resulted in an
after-tax increase in net income of $12.7 million related to the Company's
written call options on Efficient Networks, Inc. ("Efficient") common stock held
as of March 4, 2001. The call options expired, in accordance with their terms
during the quarter ended June 2, 2001, as part of the acquisition of Efficient
by Siemens A.G. This transition adjustment is reflected in the Company's results
of operations for transition year 2001 as the cumulative effect of a change in
accounting principle.
The Company periodically uses derivative financial instruments,
principally forward exchange contracts and options, to reduce
F-11
foreign currency exposures arising from its international operations. The
Company had no foreign exchange or option contracts outstanding at December 28,
2002 and December 29, 2001.
During July 2001, the Company amended its securities purchase agreement
with an investor group led by Silver Lake Partners, L.P. ("Silver Lake")
(collectively the "Strategic Investors") as discussed in Note 19. As a result,
the Riverstone shares received by the Strategic Investors in an August 2001
spin-off distribution due to their ownership of Series D and E preferred stock
are subject to certain restrictions on transfer; and the proceeds from any
permitted sale of such shares reduce the liquidation preference and redemption
price of the Series D and E preferred stock. Since the Company's potential
redemption liability is indexed to the value of securities of an unrelated
entity, Riverstone, a financial derivative instrument was established by this
transaction.
COMPREHENSIVE INCOME
The Company presents comprehensive income in its consolidated statement of
stockholders' equity. Accumulated other comprehensive income, net of tax, as of
December 28, 2002 consisted of unrealized gains on available-for-sale securities
of $3.4 million and foreign currency translation adjustments of $4.1 million.
Accumulated other comprehensive income, net of tax, as of December 29, 2001
consisted of unrealized gains on available-for-sale securities of $2.5 million.
INVESTMENTS
The Company has certain minority investments in debt and equity securities
of companies that were acquired for cash and in non-monetary transactions
whereby the Company exchanged cash, inventory or product credits for preferred
or common stock or convertible notes. The Company records cash investments at
cost and non-monetary transactions generally at the fair value of the instrument
received, using the most objectively determinable basis from among a variety of
methods and data sources. Methods and data sources used to value non-monetary
transactions include quoted market prices for publicly traded securities, cash
financing rounds with outside investors completed near the date of the Company's
investment, and third party valuations or appraisals. These investments are
accounted for under the cost method and are included in investments on the
Company's balance sheet. The carrying value of investments approximates fair
value.
The Company reviews investments for potential impairment whenever events
or changes in circumstances indicate that the carrying value may not be
recoverable. Such events include declines in the investees' stock price in new
rounds of financing, market capitalization relative to book value, bankruptcy or
insolvency, and deterioration in the financial position or results of
operations. Appropriate reductions in carrying value are recognized in other
income (expense), net, in the consolidated statements of operations.
Prior to fiscal year 2002, the Company has also invested in
technology-focused venture capital funds that are accounted for under the equity
method of accounting.
RESEARCH AND DEVELOPMENT COSTS AND SOFTWARE COSTS
Expenditures related to the development of new products, including
significant improvements and refinements to existing products and the
development of software, are expensed as incurred, unless they are required to
be capitalized. Software development costs are required to be capitalized
beginning when the technological feasibility of a product has been established
and ending when a product is available for general release to customers. The
Company's current process for developing software is essentially completed
concurrent with the establishment of technological feasibility; accordingly, no
costs have been capitalized to date.
With respect to acquisitions, at the date of acquisition or investment,
the Company evaluates the components of the purchase price of each acquisition
or investment to identify amounts allocable to in-process research and
development. Upon completion of acquisition accounting and valuation, the
Company charges such amounts to expense if technological feasibility had not
been reached at the acquisition date and the technology has no alternative
future use.
STOCK-BASED COMPENSATION PLANS
At December 28, 2002, the Company had seven stock-based employee
compensation plans, which are described more fully in Note 20. The Company
accounts for those plans using the intrinsic method under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. The following table illustrates the
effect on net loss and net loss per share if the Company had applied the fair
value recognition provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based
Compensation--Disclosure," to stock-
F-12
based employee compensation:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Net loss available to common shareholders, as reported $(127,208) $(714,631) $(704,726)
Add: Total stock-based employee compensation
expense determined under fair-value-based method
for the employee stock option awards and the
employee stock purchase plans, net of related
tax benefits ...................................... (25,704) (32,137) (62,177)
--------- --------- ---------
Pro forma net loss available to common shareholders .. $(152,912) $(746,768) $(766,903)
========= ========= =========
Basic and diluted loss per share:
As reported ....................................... $ (0.63) $ (3.71) $ (3.81)
Pro forma ......................................... $ (0.76) $ (3.87) $ (4.15)
Equity instruments issued to non-employees are accounted for in accordance
with the provisions of SFAS No. 123 and EITF No. 96-18, "Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring or in
Conjunction with Selling Goods or Services."
INCOME TAXES
The Company accounts for income taxes under the asset and liability
method. Under this method, deferred tax assets and liabilities are recognized
for the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and operating loss and tax credit carryforwards.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income during
the period that includes the enactment date. The Company recognizes a valuation
allowance if it anticipates that it may not realize some or all of a deferred
tax asset.
The Company has permanently reinvested earnings of its foreign
subsidiaries and therefore, has not provided for United States ("U.S.") income
taxes that could result from the remittance of such earnings. The unremitted
earnings at December 28, 2002 and December 29, 2001 amounted to approximately
$207.4 million and $206.7 million, respectively. Furthermore, any taxes paid to
foreign governments on those earnings may be used, in whole or in part, as
credits against U.S. tax on any dividends distributed from such earnings. It is
not practicable to estimate the amount of unrecognized deferred U.S. taxes on
these undistributed earnings.
NET INCOME (LOSS) PER SHARE
The Company computes basic net income (loss) per common share by dividing
net income (loss) available to common stockholders by the weighted average
number of common shares outstanding for the period. The Company computes diluted
net income per common share by dividing net income to common shareholders by the
weighted average number of common shares and all potentially dilutive
securities. In periods where the Company reports a net loss and inclusion of
dilutive securities would therefore be anti-dilutive, the Company excludes
dilutive securities from the diluted net loss per common share calculation.
FOREIGN CURRENCY TRANSLATION AND TRANSACTION GAINS AND LOSSES
The Company's international revenues are denominated in either U.S.
dollars or local currencies. For those international subsidiaries that use their
local currency as their functional currency, assets and liabilities are
translated at period-end exchange rates in effect at the balance sheet date, and
income and expense items are translated at the average exchange rate for the
period. Resulting translation adjustments are reported in accumulated other
comprehensive income, a component of stockholders' equity.
Where the U.S. dollar is the functional currency, non-monetary assets are
translated at historical exchange rates, and all other assets and liabilities
are translated at exchange rates in effect at the end of the period. Cost of
sales and depreciation are translated at historical exchange rates, and all
other income and expense items are translated at the average exchange rate for
the period. Gains and losses that result from translation are included in other
income (expense), net, in the consolidated statement of operations.
F-13
RESTRUCTURING RESERVES
The Company has periodically recorded restructuring charges in connection
with its plans to reduce the cost structure of its business. These restructuring
charges, which reflect management's commitment to a termination or exit plan
that will be completed within twelve months, require management's judgement and
may include severance benefits and costs for future lease commitments on excess
facilities, net of estimated future sublease income. In determining the amount
of the facility exit costs, the Company is required to estimate such factors as
future vacancy rates, the time required to sublet properties and sublease rates.
These estimates are reviewed and potentially revised on a quarterly basis based
on known real estate market conditions and the credit worthiness of subtenants,
resulting in revisions to established facility reserves. 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.
NEW ACCOUNTING PRONOUNCEMENTS
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 an asset
retirement obligation as a liability rather than a contra-asset. SFAS No. 143 is
effective for the Company's fiscal year beginning December 29, 2002. The Company
does not expect the adoption of this statement will have a material impact on
its consolidated financial statements.
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 extraordinary items, 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 the Company's fiscal year beginning December 29,
2002. The Company does not expect the adoption of this statement will have a
material 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 exit or disposal activities that are initiated
after December 31, 2002.
In November 2002, the FASB issued interpretation No. 45 ("FIN No. 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness to Others." FIN No. 45 requires that a
liability be recorded in the guarantor's balance sheet upon issuance of a
guarantee. In addition, FIN No. 45 requires disclosures about the guarantees
that an entity has issued, including a roll-forward of the entity's product
warranty liabilities. The Company's warranty experience has not been
significant. The Company adopted the annual disclosure provisions of FIN No. 45
at December 28, 2002. The Company will adopt the provisions for initial
recognition and measurement and interim disclosures during the first quarter of
2003. The Company is currently evaluating the impact the adoption will have on
its consolidated financial statements.
In November 2002, the FASB issued EITF No. 00-21, "Revenue Arrangements
with Multiple Deliverables," which provides guidance on how to account for
revenue arrangements that involve the delivery or performance of multiple
products, services and/or rights to use assets. The provisions of this EITF are
effective for revenue arrangements entered into beginning in the Company's third
quarter of fiscal year 2003. The Company is currently evaluating the impact the
adoption will have on its consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation, Transition and Disclosure," which provides alternative
methods of transition for a voluntary change to the fair-value-based method of
accounting for stock-based employee compensation. SFAS No. 148 also requires
disclosures of the pro forma effect of using the fair value method of accounting
for stock-based employee compensation be displayed more prominently and in a
tabular format in annual and interim financial statements. The Company adopted
the disclosure requirements at December 28, 2002. The transition requirements
are effective for the Company's fiscal year 2003. The Company is currently
evaluating the impact the adoption will have on its consolidated financial
statements.
In January 2003, the FASB issued Interpretation No. 46 ("FIN No. 46"),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51."
FIN No. 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient
F-14
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN No. 46 is effective for
all new variable interest entities created or acquired after January 31, 2003.
For variable interest entities created or acquired prior to February 1, 2003,
the provisions of FIN No. 46 must be applied for the first interim or annual
period beginning after June 25, 2003. The Company has no variable interest
entities at this time and as such, the adoption of FIN No. 46 will not have an
effect on the consolidated financial statements.
3. MARKETABLE SECURITIES
Marketable securities are summarized as follows at December 28, 2002 and
December 29, 2001:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
(IN THOUSANDS) COST GAINS LOSSES VALUE
--------- ---------- ---------- --------
DECEMBER 28, 2002
U.S. government and agency obligations ...... $131,192 $ 1,945 $ (3) $133,134
U.S. corporate obligations .................. 25,029 465 -- 25,494
Asset-backed securities ..................... 14,047 57 -- 14,104
State, municipal and county government notes
and bonds ................................ 18,914 441 -- 19,355
Corporate equity securities ................. 403 -- (365) 38
-------- -------- -------- --------
Total marketable securities .............. $189,585 $ 2,908 $ (368) $192,125
======== ======== ======== ========
Amounts included in cash and cash equivalents $ 22,810 $ 47 $ -- $ 22,857
Amounts included in short-term marketable
Securities ............................... 81,740 1,113 -- 82,853
Amounts included in long-term marketable
Securities ............................... 68,574 1,560 (368) 69,766
Amounts included in restricted cash, cash
equivalents and marketable securities .... 16,461 188 -- 16,649
-------- -------- -------- --------
Total marketable securities .............. $189,585 $ 2,908 $ (368) $192,125
======== ======== ======== ========
DECEMBER 29, 2001
U.S. government and agency obligations ...... $113,139 $ 1,205 $ (63) $114,281
U.S. corporate obligations .................. 25,724 891 (4) 26,611
Asset-backed securities ..................... 9,642 190 (6) 9,826
State, municipal and county government notes
and bonds ................................ 16,268 382 -- 16,650
Corporate equity securities ................. 403 -- (29) 374
Foreign deposits ............................ 35 -- -- 35
-------- -------- -------- --------
Total marketable securities .............. $165,211 $ 2,668 $ (102) $167,777
======== ======== ======== ========
Amounts included in cash and cash equivalents $ 33,552 $ -- $ -- $ 33,552
Amounts included in short-term marketable
Securities ............................... 47,519 22 (9) 47,532
Amounts included in long-term marketable
Securities ............................... 62,094 1,918 (92) 63,920
Amounts included in restricted cash, cash
equivalents and marketable securities .... 22,046 728 (1) 22,773
-------- -------- -------- --------
Total marketable securities ............. $165,211 $ 2,668 $ (102) $167,777
======== ======== ======== ========
The contractual maturities of debt securities at December 28, 2002 were as
follows. Actual maturities may differ from contractual maturities because some
borrowers have the right to call or prepay obligations.
(IN THOUSANDS) AMORTIZED FAIR
COST VALUE
--------- --------
Less than one year ................................. $104,147 $105,672
Due in 1-2 years ................................... 50,149 50,720
Due in 2-3 years ................................... 34,886 35,695
-------- --------
Total .......................................... $189,182 $192,087
======== ========
F-15
The fair value of marketable securities categorized by purpose of investment was
as follows:
(IN THOUSANDS) CURRENT LONG-TERM TOTAL
------- --------- -----
DECEMBER 28, 2002
Available-for-sale ................ $105,710 $ 86,415 $192,125
======== ======== ========
DECEMBER 29, 2001
Held-to-maturity .................. $ 9,999 $ -- $ 9,999
Available-for-sale ................ 71,085 86,693 157,778
-------- -------- --------
Total marketable securities ..... $ 81,084 $ 86,693 $167,777
======== ======== ========
4. RESTRICTED CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES
At December 28, 2002 the Company had restricted cash of $24.5 million,
which included marketable securities of $16.6 million. Pledged assets at
December 28, 2002, included $4.4 million to secure letters of credit for
equipment leases associated with sales by discontinued operations. The
underlying obligations decrease over time and terminate in 2004. In addition,
the Company had $4.4 million pledged to secure a real estate lease associated
with the sale of a discontinued operation. The underlying obligation decreases
$1.0 million each year beginning in 2009 and terminates in 2012. See Note 21 for
further discussion of the underlying obligations. The remaining balance of
restricted cash is primarily collateral for operations-related performance
obligations that were required by various parties, mainly due to the lack of
timely financial reporting by the Company during fiscal year 2002.
At December 29, 2001, the Company had restricted cash of $27.9 million,
which included $22.8 million of marketable securities pledged primarily to
secure letters of credit.
5. ACCOUNTS RECEIVABLE
Accounts receivable were as follows:
DECEMBER 28, DECEMBER 29,
(IN THOUSANDS) 2002 2001
---------- ----------
Gross accounts receivable ................ $ 60,933 $ 100,267
Allowance for doubtful accounts .......... (19,250) (32,569)
--------- ---------
Accounts receivable, net ................. $ 41,683 $ 67,698
========= =========
Beginning in September 2001, the Company defers revenue on product
shipments to certain stocking distributors until those distributors have sold
the product to their customer. At December 28, 2002 and December 29, 2001, $21.4
million and $68.9 million, respectively, of product shipments had been billed
and revenue has not been recognized, of which $3.8 million and $43.5 million,
respectively, was paid and is included in customer advances and billings in
excess of revenues. The balance of $17.6 million and $25.4 million,
respectively, was unpaid and is recorded as an offset to accounts receivable.
6. NOTES RECEIVABLE
Notes receivable consisted of the following:
DECEMBER 28, DECEMBER 29,
(IN THOUSANDS) 2002 2001
------------ ------------
Note receivable from distributor ......... $ -- $ 13,000
Note receivable .......................... 30,000 30,000
Credit agreement ......................... 6,125 8,125
Less: valuation allowance .............. (33,625) (36,125)
-------- --------
Notes receivable, net .................... $ 2,500 $ 15,000
======== ========
NOTE RECEIVABLE FROM DISTRIBUTOR
During transition year 2001, the Company entered into a promissory note
with a distributor in which the Company loaned the distributor $13.0 million.
Principal and interest were due in full on March 9, 2002. In the second quarter
of fiscal year 2002, the Company reached a settlement in which the note was
extinguished in connection with product returns by the distributor.
F-16
NOTE RECEIVABLE AND CREDIT AGREEMENT
A note receivable and credit agreement were entered into in connection
with the sale of the Company's DNPG division. Commencing on May 31, 2002 through
February 28, 2006, principal amounts of the note receivable are due in quarterly
installments of approximately $1.9 million. The buyer has the ability under
certain circumstances to defer principal payments when due, potentially
extending the final maturity of the note to February 28, 2010. All scheduled
payments to date have been deferred. Interest accrues and is due quarterly at a
rate of 4.0% per annum. At December 28, 2002 and December 29, 2001, the Company
had a valuation allowance for the total amount of the note receivable of $30.0
million due to significant uncertainty regarding the likelihood that the Company
would receive payments under the note.
In addition, as part of the sale, the Company entered into a credit
agreement for up to $10.0 million with the buyer. Interest under the credit
agreement accrues at a rate of 6.50% per annum. Borrowings are subject to a
borrowing base, on any date equal to the sum of 80% of eligible accounts
receivable and 50% of eligible inventory. The remaining principal payments of
$6.1 million on the credit agreement are due in fiscal year 2003. During the
fourth quarter of transition year 2001, the Company recorded a valuation
allowance of $6.1 million on the balance of the credit agreement due to
significant uncertainty regarding the likelihood that the Company would receive
the balance due. During the fourth quarter of fiscal year 2002, the Company
reduced the valuation allowance to $3.6 million due to a subsequent receipt of a
principal payment of $2.5 million on December 31, 2002.
Given the significant uncertainty regarding collection of these notes
receivable, no interest income has been accrued. Instead, the Company records
interest income on these obligations when the Company is paid.
7. INVENTORIES, NET
Inventories, net, consisted of the following:
DECEMBER 28, DECEMBER 29,
(IN THOUSANDS) 2002 2001
------------ ------------
Raw materials ........................ $ 2,454 $ 8,130
Finished goods ....................... 42,098 110,084
-------- --------
Inventories, net ................... $ 44,552 $118,214
======== ========
8. PROPERTY, PLANT AND EQUIPMENT, NET
Property, plant and equipment, net, consisted of the following:
ESTIMATED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 USEFUL LIFE
----------------- ----------------- -----------
Land and improvements .................... $ 1,045 $ 1,704 15 years
Buildings and improvements ............... 15,752 17,551 15-40 years
Equipment ................................ 143,206 205,840 1.5-7 years
Furniture and fixtures ................... 6,400 11,395 5 years
Software ................................. 14,066 9,676 3-7 years
Leasehold improvements ................... 7,781 15,475 5 years
--------- ---------
Total property, plant and equipment .... 188,250 261,641
Less accumulated depreciation and
amortization ........................... (140,843) (204,717)
--------- ---------
Total property, plant and equipment, net $ 47,407 $ 56,924
========= =========
For fiscal year 2002, transition year 2001 and fiscal year 2001
depreciation and amortization expense was $34.1 million, $26.7 million and $37.0
million, respectively. Buildings and improvements at December 28, 2002 included
$1.3 million associated with a building held for sale. In March 2003, the
Company completed the sale of the building to a third party for cash and notes
receivable of $1.3 million.
9. GOODWILL AND OTHER INTANGIBLE ASSETS
The changes in the carrying value of goodwill were as follows:
F-17
YEAR ENDED TEN MONTHS ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
Goodwill beginning balance ........ $ 15,129 $ 144,102
Impairment loss ................... -- (104,147)
Amortization ...................... -- (24,826)
--------- ---------
Goodwill ending balance ........... $ 15,129 $ 15,129
========= =========
The Company recorded a charge of $104.1 million in the fourth quarter of
transition year 2001 relating to the impairment of goodwill recorded in
connection with the acquisition of Indus River Networks. This impairment was
primarily due to the complex, proprietary nature of the Indus River VPN
architecture, which had to be substantially redesigned in order to conform with
emerging industry standards; the introduction of new, low cost VPN products and
technologies by a leading provider of network security products who captured a
market leadership position in 2001; and abandonment of the Company's development
efforts in conjunction with a significant reduction in the acquired workforce in
the fourth quarter of transition year 2001. These factors led to significantly
lower projections for future sales of products using the Indus River VPN
architecture.
A reconciliation of net loss and loss per share adjusted for the
discontinuation of the amortization of goodwill, net of the related income tax
effect, was as follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Net loss available to common shareholders ........ $ (127,208) $ (714,631) $ (704,726)
Add back: Goodwill amortization expense .......... -- 24,826 4,973
----------- ----------- -----------
Adjusted net loss available to common shareholders $ (127,208) $ (689,805) $ (699,753)
=========== =========== ===========
Basic and diluted loss per share:
Net loss available to common shareholders ........ $ (0.63) $ (3.71) $ (3.81)
Add back: Goodwill amortization expense .......... -- 0.13 0.02
----------- ----------- -----------
Adjusted net loss available to common shareholders $ (0.63) $ (3.58) $ (3.79)
=========== =========== ===========
Identifiable intangible assets at December 28, 2002 consisted of the
following:
GROSS NET CARRYING
CARRYING ACCUMULATED VALUE OF ESTIMATED
(IN THOUSANDS) AMOUNT AMORTIZATION INTANGIBLE ASSETS USEFUL LIFE
-------- ------------ ----------------- -----------
Customer relations .................... $28,600 $19,226 $ 9,374 8 years
Patents and technology ................ 32,200 19,810 12,390 3-10 years
------- ------- ----------
Total identifiable intangible assets $60,800 $39,036 $ 21,764
======= ======= ==========
Identifiable intangible assets at December 29, 2001 consisted of the
following:
GROSS NET CARRYING
CARRYING ACCUMULATED VALUE OF ESTIMATED
(IN THOUSANDS) AMOUNT AMORTIZATION INTANGIBLE ASSETS USEFUL LIFE
-------- ------------ ----------------- -----------
Customer relations .................... $28,600 $16,207 $ 12,393 8 years
Patents and technology ................ 32,200 14,121 18,079 3-10 years
------- ------- ----------
Total identifiable intangible assets $60,800 $30,328 $ 30,472
======= ======= ==========
All of the Company's identifiable intangible assets are subject to
amortization. Total amortization was $8.7 million and $7.5 million for fiscal
year 2002 and transition year 2001, respectively. Based on intangible assets
recorded at December 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 $0.5 million for fiscal year 2007.
10. OTHER ACCRUED EXPENSES
Other accrued expenses consisted of the following:
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
Accrued restructuring ................... $ 7,682 $ 6,182
Accrued legal and audit costs ........... 14,970 7,134
Accrued marketing development obligations 7,845 15,073
Accrued liability on lease guarantees ... 4,324 7,100
Accrued loss on disposal of Aprisma ..... -- 1,281
Other ................................... 15,656 9,867
------- -------
Total accrued expenses ................ $50,477 $46,637
======= =======
F-18
11. INCOME TAXES
Loss from continuing operations before income taxes consisted of the
following:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Total US domestic loss .............. $(152,686) $(508,217) $(680,180)
Total foreign subsidiaries loss ..... (35,106) (46,610) (23,529)
--------- --------- ---------
Total loss from continuing operations
before income taxes .............. $(187,792) $(554,827) $(703,709)
========= ========= =========
The provision (benefit) for income taxes attributable to loss from
continuing operations consisted of the following items:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Current:
Federal ........................ $ (90,127) $ (30,251) $ 1,785
State .......................... 650 4,935 (641)
Foreign ........................ 4,230 3,283 4,149
--------- --------- ---------
Total current .................... (85,247) (22,033) 5,293
--------- --------- ---------
Deferred:
Federal ........................ (237) 82,227 (96,354)
State .......................... -- -- (6,565)
Foreign ........................ 237 48 (561)
--------- --------- ---------
Total deferred ................... -- 82,275 (103,480)
--------- --------- ---------
Total income tax expense (benefit) $ (85,247) $ 60,242 $ (98,187)
========= ========= =========
The differences between the U.S. statutory federal tax rate and the
Company's effective tax (benefit) rate for continuing operations were as
follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Statutory federal income tax (benefit) rate .... (35.0)% (35.0)% (35.0)%
State income tax, net of federal tax benefit . 0.2 0.6 (0.7)
Research and experimentation credit .......... (1.7) (0.5) (0.3)
Municipal income ............................. -- -- (0.4)
Rate differential on foreign operations ...... 6.8 2.8 1.1
Nondeductible goodwill and intangibles ....... -- 8.9 1.4
Unbenefited losses/change in valuation
allowance ................................. (31.0) 39.6 20.0
Change in estimate for tax contingencies ..... 10.9 (5.5) --
Other ........................................ 4.2 -- (0.1)
----- ----- -----
Effective tax (benefit) rate .............. (45.6)% 10.9% (14.0)%
===== ===== =====
The Company has recorded a valuation allowance against its remaining
foreign, federal and state deferred tax assets at December 28, 2002 and December
29, 2001 since management believes that, after considering all the available
objective evidence, both positive and negative, historical and prospective, with
greater weight given to historical evidence, it is more likely than not that
these assets will not be realized.
During 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.
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities were as follows:
F-19
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
Deferred tax assets:
Accounts receivable ...................... $ 3,432 $ 10,162
Inventories .............................. 9,724 21,208
Deferred revenue ......................... 11,696 22,555
Property, plant and equipment ............ 6,906 6,261
Other reserves and accruals .............. 28,942 35,424
Acquired research and development ........ 167,116 170,447
Domestic net operating loss and tax credit
carryforwards ........................ 93,141 152,552
Foreign net operating loss carryforwards . 37,522 33,443
--------- ---------
Gross deferred tax assets ............. 358,479 452,052
Valuation allowance ...................... (358,479) (452,052)
--------- ---------
Total deferred tax assets ............. $ -- $ --
========= =========
On March 9, 2002, the President signed into law the Job Creation and
Worker Assistance Act of 2002, which extended the net operating loss carryback
period from two to five years for losses generated in tax years ending in 2001
and 2002. As a result, the Company was able to utilize the benefit of $201.8
million and $116.8 million in net operating losses from transition year 2001 and
fiscal year 2001, respectively. The Company received net refunds of $102.2
million during fiscal year 2002, which consisted of a tax benefit of $71.9
million for the net operating losses and $30.3 million attributable to the
exercise of employee stock options which was recorded as an increase to
additional paid-in capital. Also, the Company was able to utilize its remaining
net operating loss carryback benefit of $110.7 million for fiscal year 2002 and
has recorded an income tax receivable of $31.9 million at December 28, 2002. The
Company expects to receive this refund during the first half of fiscal year
2003.
At December 28, 2002, the Company had domestic net operating loss ("NOL")
carryforwards for tax purposes of $192.1 million expiring in fiscal years 2005
through 2022. Approximately $53.3 million of this NOL is attributable to the
pre-acquisition periods of acquired subsidiaries. The utilization of these
acquired NOLs are limited pursuant to Internal Revenue Code ("IRC") Section 382
as a result of these prior ownership changes. In addition, the Company has $19.6
million of U.S. income tax credit carryforwards as of December 28, 2002, which
expire in fiscal years 2019 through 2022. The future utilization of the losses
and credits may be limited in the event of an ownership change under IRC Section
382.
The net change in the total valuation allowance for fiscal year 2002 and
transition year 2001 was a decrease of $93.6 million and an increase of $221.3
million, respectively. The decrease in fiscal year 2002 related primarily to the
ability to carry back the net operating losses as a result of the 2002 tax
legislation. Subsequently recognized tax benefits relating to valuation
allowances for deferred tax assets (if any) will be allocated as follows: $17.3
million to additional paid-in capital which is attributable to the exercise of
employee stock options, $5.2 million to goodwill, and $336.0 million to the
consolidated statement of operations.
12. SPECIAL CHARGES
The components of special charges were as follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
In-process research and development
related to an acquisition ....... $ -- $ -- $ 25,600
Transformation charges ............ -- 24,461 13,258
Restructuring charges:
Fixed assets .................... 129 2,170 13,512
Severance benefits .............. 25,974 17,874 10,650
Facility exit costs ............. 6,079 2,663 1,667
Reversal of prior year charge ... (204) -- (1,500)
-------- -------- --------
Total restructuring charges .. 31,978 22,707 24,329
-------- -------- --------
Total special charges ...... $ 31,978 $ 47,168 $ 63,187
======== ======== ========
During the fourth quarter of fiscal year 2002, the Company recorded a
restructuring charge of $1.2 million primarily for facilities
F-20
exit costs related to the closure of two facilities. 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.
In transition year 2001, the Company recorded special charges of $24.5
million related to the transformation of Cabletron's business. The
transformation-related charges include investment banking, legal and accounting
fees related to the establishment of the Enterasys Subsidiary, Riverstone,
Aprisma and GNTS as stand-alone entities and the Riverstone spin-off. Also,
during the fourth quarter of transition year 2001, the Company recorded a
restructuring charge of $12.4 million for 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. In addition, during the second
quarter of transition year 2001, the Company recorded restructuring charges of
$10.3 million to reduce the expense structure of the Company. These charges
reflected a write-down of $2.2 million for a vacant office building in
Rochester, New Hampshire, to its estimated fair value, exit costs of $2.6
million associated with the planned closure of eight sales offices worldwide and
executive severance costs of $5.5 million.
During the first quarter of fiscal year 2001, the Company recorded
restructuring charges of $25.8 million. These charges reflected the expected
sale of an office building in Rochester, New Hampshire, exit costs associated
with the planned closure of 20 sales offices worldwide, the write-off of certain
assets that were not required subsequent to the transformation of the Company
and the planned reduction of approximately 570 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. On January 31, 2001, the
Company acquired Indus River Networks ("Indus River"), a designer and marketer
of virtual private networks for enterprise-class customers. In connection with
the acquisition, approximately $25.6 million of the purchase price was allocated
to in-process research development and recorded in special charges in fiscal
year 2001. In addition, in fiscal year 2001, the Company recorded special
charges of $13.3 million for professional fees associated with the
transformation of Cabletron's business.
The activity for accrued restructuring costs for the three years ended
December 28, 2002 was as follows:
ACCRUED RESTRUCTURING CHARGES
--------------------------------------------------------
SEVERANCE FACILITY EXIT
(IN THOUSANDS) BENEFITS COSTS TOTAL
-------- ------------- --------
Balance, February 29, 2000 ..... $ 2,084 $ 3,269 $ 5,353
Charges ...................... 10,650 1,667 12,317
Cash payments ................ (10,294) (4,797) (15,091)
Reversal of prior year charge (1,500) -- (1,500)
-------- -------- --------
Balance, March 3, 2001 ......... 940 139 1,079
Second quarter charges ....... 5,471 2,663 8,134
Fourth quarter charges ....... 12,403 -- 12,403
Cash payments ................ (14,862) (572) (15,434)
-------- -------- --------
Balance, December 29, 2001 ..... 3,952 2,230 6,182
Reclassification ............ (572) 572 --
Second quarter charges ...... 20,239 -- 20,239
Third quarter charges ....... 5,646 5,089 10,735
Fourth quarter charges ...... 89 1,120 1,209
Cash payments ............... (27,534) (2,945) (30,479)
Reversal of prior year charge (204) -- (204)
-------- -------- --------
Balance, December 28, 2002 ..... $ 1,616 $ 6,066 $ 7,682
======== ======== ========
The remaining accrued severance costs of $1.6 million as of December 28,
2002 will be paid out during fiscal year 2003; and the remaining accrued exit
costs of $6.1 million, which consisted of long-term lease commitments, will be
paid out over the next several years.
13. OTHER INCOME (EXPENSE), NET
F-21
The components of other income (expense), net, were as follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Impairment of investments ................... $ (22,119) $ (65,901) $ (17,178)
Loss on exchange of products for
investments ............................... -- (17,086) (13,018)
Transactions related to Efficient:
Recognition of deferred gain on
Efficient investment ................. -- 46,778 30,384
Other than temporary decline of
Efficient investment ................. -- -- (376,456)
Other than temporary decline in available
for sale securities, excluding Efficient
investment ............................... -- (1,712) (18,100)
Unrealized (loss) gain on Riverstone stock
Derivative ................................ (20,048) 4,020 --
Loss on sale of DNPG division ............... -- -- (143,108)
Net gain (loss) on sale of available for sale
Securities ................................ 1,121 4,062 (21,380)
Recovery (write-down) of note receivable .... 2,500 (6,125) --
Foreign currency gain (loss) ................ (2,711) (4,850) 542
Other ....................................... (1,368) (395) 959
--------- --------- ---------
Total other income (expense), net ...... $ (42,625) $ (41,209) $(557,355)
========= ========= =========
The Company recorded impairments of investments of $22.1 million for
fiscal year 2002, $65.9 million for transition year 2001 and $17.2 million in
fiscal year 2001. These impairments of value were 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 and fiscal 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 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 losses of $17.1 million for transition
year 2001 and $13.0 million in fiscal year 2001.
In December 1999, the Company sold its Flow Point, Inc. subsidiary to
Efficient. On the transaction date, the Company held a portion of the
outstanding common stock of Efficient on an as-converted basis. Accordingly, the
Company deferred $235.9 million of its pre-tax gain, since through its ownership
percentage of Efficient, it effectively still had an ownership interest in Flow
Point. As the Company sold the Efficient shares, this deferred gain was
recognized into income in proportion to the Company's reduction in its
percentage ownership of Efficient. During the ten months ended December 29, 2001
and the fiscal year ended March 3, 2001, the Company sold its remaining shares
of Efficient for net proceeds of approximately $242.7 million and $46.6 million,
respectively, and recognized approximately $46.8 million and $30.4 million,
respectively, of deferred gain to other income. In addition, the Company
determined at March 3, 2001 that the Efficient shares had experienced an
other-than-temporary decline in value of $487.9 million with an associated
reduction in the deferred gain of $111.4 million and a charge to other expense
of $376.5 million.
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 $20.0
million during fiscal year 2002 and increased by $4.0 million during transition
year 2001, and the changes in the redemption liability were recorded in other
income (expense), net.
During fiscal year 2001, the Company completed the sale of its Digital
Network Products Group ("DNPG") and recorded a loss on the sale of $143.1
million.
14. NET LOSS PER SHARE
The reconciliation of the numerator for basic and diluted loss per common
share computations for the Company's reported net loss was as follows:
F-22
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Loss from continuing operations ........... $(102,545) $(615,069) $(605,522)
Effect of preferred shares ................. (12,963) (10,347) (22,898)
--------- --------- ---------
Loss from continuing operations available to
common shareholders ...................... (115,508) (625,416) (628,420)
Discontinued operations:
Operating loss ........................... -- (59,124) (76,306)
Loss on disposal ......................... (11,700) (42,782) --
Cumulative effect of a change in accounting
principle ................................ -- 12,691 --
--------- --------- ---------
Net loss available to common shareholders $(127,208) $(714,631) $(704,726)
========= ========= =========
In fiscal year 2002, transition year 2001, and fiscal year 2001, options
to purchase 29.8 million, 36.4 million and 12.6 million, respectively, shares of
the Company's common stock were outstanding but excluded from the calculation of
diluted loss per common share since the effect would have been anti-dilutive.
Additionally, in fiscal year 2002 and transition year 2001, diluted loss per
common share excluded warrants to purchase 7.4 million of shares held by the
Strategic Investors because the effect would have been anti-dilutive.
15. DISCONTINUED OPERATIONS
On July 17, 2001, the Company's Board of Directors declared a special
dividend of its shares of Riverstone common stock to the Company's shareholders
of record on July 27, 2001, payable on August 6, 2001; and on August 6, 2001,
the Company distributed its shares of Riverstone common stock to its
shareholders. The distribution ratio was 0.5131 shares of Riverstone common
stock for each outstanding share of its common stock. The Company did not
recognize any gain or loss as a result of this transaction. As a result of the
distribution of the Company's Riverstone shares, the Company recorded a non-cash
charge to retained earnings of approximately $329.6 million, which reflected the
distribution of the net assets and liabilities of Riverstone to its
shareholders.
The Company finalized the sale of a portion of GNTS to a third party
during September 2001. The remainder of GNTS was either absorbed into the
Company or Aprisma or discontinued. During transition year 2001, the Company
recognized a loss on disposal of GNTS of approximately $41.5 million primarily
related to severance, office closings and asset write-offs associated with the
discontinuation and sale of GNTS. Approximately $23.1 million of these expenses
were non-cash charges.
In August 2001, the Company's Board of Directors made a determination to
distribute Aprisma's shares to its stockholders or to otherwise dispose of
Aprisma. The Company recorded in discontinued operations a provision for the
loss on sale of Aprisma of $1.3 million for transition year 2001. This included
Aprisma's estimated loss from operations of $14.8 million from December 29, 2001
to the disposal date. 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 and received approximately $62.0 million of cash
and marketable securities from 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.
As a result of the above dispositions, the Company has presented Aprisma
as discontinued operations for all periods presented and GNTS and Riverstone as
discontinued operations for transition year 2001 and fiscal year 2001.
The Company's discontinued operations included sales to customers in which
it had investments in debt and equity securities accounted for under the cost
method of accounting. This revenue is disclosed separately in the following
table as "Revenue from related parties -- minority investees." See Note 23 for
further discussion of these transactions. The following revenue was recorded in
the consolidated statements of operations in loss from discontinued operations:
TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 29, 2001 MARCH 3, 2001
----------------- -------------
Revenue (trade) from discontinued operations ................ $ 91,888 $ 188,705
Intercompany revenue--Enterasys, Aprisma, GNTS and Riverstone 11,836 11,119
Revenue from related parties--minority investees ............ 22,940 15,590
--------- ---------
Subtotal ................................................. 126,664 215,414
Eliminations ................................................ (11,836) (11,119)
--------- ---------
Total discontinued operations revenue .................... $ 114,828 $ 204,295
========= =========
F-23
16. BUSINESS ACQUISITIONS
All business acquisitions for the periods presented have been accounted
for using the purchase method. The Company's consolidated results of operations
include the operating results of the acquired companies from their acquisition
dates. Acquired assets and liabilities were recorded at their estimated fair
values at the acquisition date and the aggregate purchase price plus costs
directly attributable to the completion of acquisitions has been allocated to
the assets and liabilities acquired.
On January 31, 2001, the Company acquired Indus River Networks ("Indus
River") and issued 3,641,139 shares of common stock and 45,471 shares of Series
C preferred stock to the shareholders of Indus River in exchange for all of the
outstanding shares of stock of Indus River. The Series C shares were
subsequently converted into common shares of the Company. In addition, the
Company assumed outstanding options to purchase Indus River stock, which were
converted into options to purchase 406,898 shares of the Company's common stock
and 5,000 shares of the Company's Series C preferred stock. The Company also
assumed outstanding warrants to purchase Indus River stock, which were converted
into warrants to purchase 23,472 shares of the Company's common stock and 293
shares of the Company's Series C preferred stock. In connection with the
acquisition of Indus River, the Company issued stock options to employees in
respect of unvested stock options.
The Company recorded the cost of the acquisition at approximately $187.3
million, including direct costs of $3.2 million. Approximately $25.6 million of
the purchase price was allocated to in-process research development and recorded
in special charges for fiscal year 2001. The excess of cost over the estimated
fair value of net assets acquired of $156.4 million was allocated to goodwill
and other intangible assets which were being amortized on a straight-line basis
over three to ten years. On December 30, 2001, the Company adopted SFAS No. 142
and discontinued amortizing goodwill.
On September 7, 2000, the Company acquired Network Security Wizards, Inc.
("NSW"). In exchange for all of the issued and outstanding capital stock of NSW,
the Company (i) issued 210,286 shares of its common stock to the two
stockholders of NSW, (ii) issued 157,714 shares of its common stock to be held
in escrow on behalf of the two stockholders of NSW, subject to forfeiture upon
the occurrence of certain events, and (iii) granted 32,000 options to purchase
the Company's common stock. In connection with the Company's acquisition of NSW,
the Company agreed to issue 157,714 additional shares of common stock contingent
upon future services to be rendered to the Company by certain employees of NSW.
The Company recorded the cost of the acquisition at approximately $8.3 million,
including direct costs of $0.3 million. The cost represents 210,286 shares of
common stock at $35.00 per share and 32,000 options, valued at approximately
$0.6 million. The excess of cost over the estimated fair value of the net assets
acquired of $8.1 million was allocated to goodwill which was being amortized on
a straight-line basis over a period of four years prior to the adoption of SFAS
No. 142.
The following table represents the unaudited pro forma results of
operations of the Company for fiscal year 2001 as if acquisitions completed
during that year had occurred at the beginning of the fiscal year. These pro
forma results include adjustments for the amortization of goodwill and other
intangibles and deferred compensation and the elimination of amounts expensed
for in-process research and development. They have been prepared for comparative
purposes only and do not purport to be indicative of what would have occurred
had the acquisitions been made at the beginning of the period noted or of the
results that may occur in the future.
YEAR ENDED
MARCH 3, 2001
-------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
Net revenue ........................ $ 789,136
Loss from operations ............... $(246,900)
Net loss ........................... $(710,736)
Basic and diluted net loss per share $ (3.85)
The purchase price for the acquisitions completed during fiscal year 2001
was allocated to assets acquired and liabilities assumed based on fair value at
the date of the acquisition. The following table summarizes the cash paid, value
of equity instruments issued and acquisition costs:
(IN THOUSANDS) MARCH 3, 2001
-------------
Cash paid for acquisitions ................ $ 11,964
Common stock issued ....................... 133,694
Preferred stock issued .................... 31,875
Preferred stock options and warrants issued 3,670
Common stock options issued ............... 10,889
Acquisition costs ......................... 3,516
--------
Purchase price ....................... $195,608
========
F-24
The allocation of purchase price including intangible assets is as
follows:
(IN THOUSANDS) MARCH 3, 2001
-------------
Goodwill .................................. $146,583
Assembled work force ...................... 700
Patents and developed technology .......... 17,200
In-process research and development........ 25,600
Other assets, net ......................... 5,525
--------
Purchase price .......................... $195,608
========
17. SEGMENT AND GEOGRAPHICAL INFORMATION
Operating segments are identified as components of an enterprise about
which separate discrete financial information is available for evaluation by the
chief operating decision maker ("CODM") in making decisions concerning how to
allocate resources and assess performance. The Company's CODM is its Chief
Executive Officer. As a result of the Company's decision to discontinue or
dispose of the operations of Riverstone, GNTS and Aprisma, the Company now
operates its business as one segment, which is the business of designing,
developing, marketing and supporting comprehensive standards-based networking
solutions.
In years prior to transition year 2001, the Company also developed and
sold non-standards-based solutions. In fiscal year 2001, the Company operated in
two segments, Enterasys and Other. The Other segment included the revenue and
cost of goods sold relating to non-standards-based products. For fiscal year
2001, net revenue and income from operations for the Enterasys segment was
$704.7 million and $14.2 million, respectively, and net revenue and loss from
operations for the Other segment was $69.7 million and $62.2 million,
respectively.
Geographic revenue information for the three years ended December 28,
2002, was based on the location of the selling entity. Net revenue from
unaffiliated customers by geographic region was as follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
--------------------- ---------------------- --------------------
(IN THOUSANDS) REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT
-------- ------- -------- ------- -------- -------
North America ................ $276,853 57.1% $196,616 49.9% $412,007 53.2%
Europe, Middle East and Africa 142,834 29.5% 132,218 33.5% 209,535 27.1%
Asia Pacific ................. 36,268 7.5% 44,336 11.2% 86,447 11.1%
Latin America ................ 28,842 5.9% 21,375 5.4% 66,378 8.6%
-------- ----- -------- ----- -------- -----
Total net revenue ...... $484,797 100.0% $394,545 100.0% $774,367 100.0%
======== ===== ======== ===== ======== =====
In fiscal year 2002, the U.S. accounted for 56% of net revenues and the
United Kingdom ("U.K.") accounted for 16%; in transition year 2001, the U.S.
accounted for 50% of net revenues and the U.K. accounted for 19%; and in fiscal
year 2001, the U.S. accounted for 53% of net revenues and the U.K. accounted for
10% of net revenues.
Long-lived assets consist of the net book value of property, plant, and
equipment, goodwill and intangible assets. Long-lived assets by location were as
follows:
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
U.S ..................... $ 77,551 $ 91,998
All other countries ..... 6,749 10,527
-------- --------
Total long-lived assets $ 84,300 $102,525
======== ========
18. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental disclosure of cash flow information was as follows:
F-25
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Cash paid (refunds received) for income taxes, net ........................ $(96,656) $ (7,188) $ 3,502
Non-cash transactions:
Dividend effect of beneficial conversion feature to preferred stockholders $ -- $ -- $ 16,854
Accretive dividend and accretion of discount on preferred shares ......... $ 12,963 $ 10,347 $ 6,044
Common stock issued for businesses acquired .............................. $ -- $ -- $133,694
Preferred stock, options and warrants issued for business acquired ....... $ -- $ -- $103,545
Conversion of Series C preferred stock, options and warrants to common
stock ................................................................. $ -- $ 35,545 $ --
Product and services exchanged for investments ........................... $ -- $ 12,771 $ 26,596
19. STOCKHOLDERS' EQUITY
STOCK REPURCHASE AND PUT OPTION PROGRAM
On April 24, 2000, the Company's Board of Directors authorized the Company
to repurchase up to $400.0 million of the Company's outstanding shares of common
stock. During fiscal year 2002, the Company did not make any repurchases. During
transition year 2001, the Company repurchased 953,201 shares for approximately
$8.4 million. During fiscal year 2001, the Company repurchased approximately 2.1
million shares for approximately $56.5 million. Approximately $335.1 million of
the original repurchase authorization had not been used as of December 28, 2002.
The Company has no current plans to make additional repurchases of common
shares.
The Company has sold equity put options as an enhancement to its share
repurchase program. Each put option entitled its holder to sell one share of the
Company's common stock to the Company at a specified price. The Company has
accounted for these options in accordance with EITF No. 96-13, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock" and EITF No. 00-19, "Accounting for Derivative Financial
Instruments Determination of Whether Share Settlement Is Within the Control of
the Issuer for the Purposes of Applying Issue No. 96-13."
During fiscal year 2001, the Company received $4.9 million in premiums
from the sale of put options covering 1.2 million shares of the Company's stock.
These options expired unexercised, and the Company recorded this amount as
additional paid-in capital. At March 3, 2001, no put options remained
outstanding. During transition year 2001, the Company received $0.1 million in
premiums from the sale of put options covering 150,000 shares of the Company's
common stock and recorded this amount as additional paid-in capital. The put
options outstanding at December 29, 2001 had an average exercise price of $5.61
per share and a total contingent redemption amount of approximately $0.8 million
which was recorded as temporary equity and a reduction to additional paid-in
capital. These options expired unexercised in January 2002, and the Company
recorded an increase of $0.8 million to additional paid-in capital and an offset
to the contingent redemption liability. At December 28, 2002, no put options
remained outstanding.
STOCKHOLDER RIGHTS PLAN
In April 2002, the Company's Board of Directors adopted a stockholder
rights plan pursuant to which the Company paid a dividend of one right for each
share of common stock held by stockholders of record on June 11, 2002. Under the
plan, each right initially represents the right, under certain circumstances, to
purchase 1/1,000 of a share of the Company's Series F Preferred Stock, par value
$1.00 per share (the "Series F Preferred Stock"), at an exercise price of $20
per share. Initially the rights will not be exercisable and will trade with the
shares of the Company's common stock. Generally, if a person or group acquires
beneficial ownership of 15 percent or more of the then outstanding shares of the
Company's common stock or announces a tender or exchange offer that would result
in such person or group owning 15 percent or more of the Company's then
outstanding common stock, each right would entitle its holder (other than the
holder or group which acquired 15 percent or more of our common stock) to
purchase shares of the Company's common stock having a market value of two times
the exercise price of the right. The Company's Board of Directors may redeem the
rights at the redemption price of $.01 per right, subject to adjustment, at any
time prior to the earlier of June 11, 2012, which is the expiration date of the
rights, or the date of distribution of the rights, as determined under the plan.
PREFERRED STOCK, WARRANTS AND SUBSIDIARY STOCK PURCHASE RIGHTS
SECURITIES ISSUED TO THE STRATEGIC INVESTORS
F-26
On August 29, 2000, the Company and its operating subsidiaries Riverstone,
Enterasys Subsidiary, Aprisma and GNTS (collectively, the "Operating
Subsidiaries") issued securities and granted rights for the purchase of
additional securities to the Strategic Investors. The Company and its Operating
Subsidiaries received approximately $87.8 million in cash from the Strategic
Investors. The Company issued to the Strategic Investors 4% Series A
Participating Convertible Preferred Stock, par value $1.00 per share, and 4%
Series B Participating Convertible Preferred Stock, par value $1.00 per share,
(the "A&B Preferred Stock") as well as Class A and Class B warrants to purchase
the Company's common stock. The Company also agreed to issue to the Strategic
Investors additional warrants to purchase its common stock upon the occurrence
of certain events, including the merger of an Operating Subsidiary into the
Company, the sale of the Company or the failure of an Operating Subsidiary to
consummate an initial public offering ("IPO"). In addition, each of the
Operating Subsidiaries issued to the Strategic Investors rights to purchase
shares of its common stock, and each of the Operating Subsidiaries agreed to
issue rights to purchase additional shares of its common stock to the Strategic
Investors upon the occurrence of certain events. The exercise prices and the
number of shares issuable upon exercise of the subsidiary stock purchase rights
were dependent upon certain events.
The Company accounted for the transaction with the Strategic Investors in
accordance with the following pronouncements: APB No. 14, "Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants," EITF No. 00-27,
EITF No. 98-5, "Accounting for Convertible Securities with Beneficial Conversion
Features or Contingently Adjustable Conversion Ratios," EITF No. 96-13,
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in a Company's Own Stock," and EITF No. 00-19, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock," In accordance with these pronouncements, the Company
allocated the proceeds to the various equity instruments issued by the Company
and its Operating Subsidiaries as set forth below:
- $5.2 million to the Class A and Class B warrants, recorded as $3.4
million to additional paid-in capital of the Company and $1.8
million to minority interest in the Operating Subsidiaries.
- $14.6 million to the Operating Subsidiary stock purchase rights,
recorded as approximately $7.2 million to additional paid-in capital
of the Company and approximately $7.4 million to minority interest
in the Operating Subsidiaries.
- $68.0 million to the A&B Preferred Stock. The Company recognized a
beneficial conversion dividend at the time of the issuance of the
A&B Preferred Stock of $16.9 million, which represents the excess of
aggregate fair value of the common stock that the Strategic
Investors would receive at the earliest conversion date over the
proceeds ascribed to the A&B Preferred Stock. In addition, the
Company is recording an accretive dividend of $22.0 million through
February 23, 2003, using the interest method, as a result of the
difference between the $90.0 million redemption value of the A&B
Preferred Stock and the $68.0 million ascribed value.
SERIES A, B, D, AND E PREFERRED STOCK
On August 29, 2000, the Company issued 65,000 shares of 4% Series A
Participating Convertible Preferred Stock ("A Preferred Stock") and 25,000
shares of 4% Series B Participating Convertible Preferred Stock ("B Preferred
Stock"). On July 12, 2001, the Company amended its securities purchase agreement
("the SPA Amendment") with the Strategic Investors and entered into an exchange
agreement with the Strategic Investors whereby the Strategic Investors exchanged
their shares of A Preferred Stock for an equal number of shares of the Company's
4% Series D Participating Convertible Preferred Stock ("D Preferred Stock") and
exchanged their shares of B Preferred Stock for an equal number of shares of the
Company's 4% Series E Participating Convertible Preferred Stock ("E Preferred
Stock" and together with the D Preferred Stock, "D&E Preferred Stock"). The
terms of the D&E Preferred Stock are described below.
Voting
Shares of the D&E Preferred Stock vote together with the common stock as a
single class on an as-converted basis.
Seniority
With respect to liquidations, the D&E Preferred Stock ranks senior to the
common stock and on par with or senior to all other series of preferred stock
that may be outstanding.
Liquidation Preference
F-27
The D&E Preferred Stock has a liquidation preference equal to the sum of
$1,036.14 per share (adjusted for stock dividends, splits, combinations or
similar events) plus all accrued and unpaid dividends (such sum being the
"Liquidation Preference") net of the fair value of the Strategic Investors
1,300,000 shares of common stock received in connection with the Riverstone
spin-off. This liquidation preference represents the original $1,000 per share
liquidation preference of the A&B Preferred Stock, increased by accrued
dividends from the issuance of the A&B Preferred Stock to the issuance of the
D&E Preferred Stock. The Liquidation Preference may be reduced as provided below
under the heading "Participation in Distributions" and may be increased upon the
liquidation of the Company to an amount equal to the liquidation proceeds
payable with respect to the common stock into which the D&E Preferred Stock is
convertible, if such liquidation proceeds are greater.
Dividends
Dividends on the D&E Preferred Stock accrue daily from the date of issue
at a rate equal to the greater of 4.00% per annum on its Liquidation Preference
or the aggregate ordinary cash dividends payable with respect to the common
stock into which the D&E Preferred Stock is convertible and compound at the end
of each of the Company's fiscal quarters. Cash dividends on the D&E Preferred
Stock are not payable without the consent of a majority of holders of the D&E
Preferred Stock. As of December 28, 2002, approximately $5.6 million of
dividends have been accreted and are included in the carrying value of the D and
E preferred stock.
Conversion
Each share of D Preferred Stock is convertible at any time at the option
of the holder into a number of shares of common stock of the Company equal to
the Liquidation Preference of the share of D Preferred Stock at that time
divided by $40.00, adjusted for stock dividends, splits, combinations or similar
events (the "Series D Conversion Price"). Each share of E Preferred Stock is
convertible at any time at the option of the holder into that number of shares
of common stock of the Company equal to the Liquidation Preference of the share
of E Preferred Stock at that time divided by $30.00, adjusted for stock
dividends, splits, combinations or similar events (the "Series E Conversion
Price," together with the Series D Conversion Price, the "Conversion Price").
On the conversion of D&E Preferred Stock, any transfer restrictions on
stock received in a spin-off distribution (as described below under the heading
"Participation in Distributions") with respect to the converted shares of D&E
Preferred Stock lapse.
If certain restrictions prevent the holders of the D&E Preferred Stock
from exercising their redemption rights (as described below under the heading
"Shareholder Redemption Rights"), then the Conversion Price will be adjusted to
equal 90 percent of the market price of the Company's common stock on the date
specified for such redemption.
Participation in Distributions and Related Derivatives
If the Company makes a distribution of property (including shares of the
Company's stock) with respect to the Company's common stock prior to the
conversion of a holder's D&E Preferred Stock, the holder will participate in
such distribution as described in this paragraph. If the distribution is of
stock of any of the Company's Operating Subsidiaries in a spin-off distribution
("Spin Shares"), the holder will participate in such distribution immediately on
an as-converted basis; however, in conjunction with the SPA amendment, any Spin
Shares received by the holders of D&E Preferred Stock are subject to certain
restrictions on transfer, and the net proceeds from any permitted sale of such
shares reduce the liquidation preference and redemption price of the D&E
Preferred Stock.
In connection with the Riverstone spin-off on August 6, 2001, the Company
distributed approximately 1,300,000 Spin Shares of Riverstone common stock to
the Strategic Investors which resulted in a net increase to the Company's equity
of $18.6 million. These shares are restricted from transfer and any permitted
sales of these shares reduce the liquidation preference and redemption value of
the D&E Preferred Stock as described above. As of December 28, 2002 the value of
the Riverstone common stock Spin Shares was $2.5 million.
Shareholder Redemption Rights
At any time on or after February 23, 2003, a holder of D&E Preferred Stock
may require the Company to redeem for cash all (but not less than all) of the
holder's D&E Preferred Stock at the Liquidation Preference then in effect. This
right was exercised in 2003, and the D and E Preferred Stock was redeemed on
March 3, 2003 for approximately $98.6 million in cash.
CLASS A WARRANTS
F-28
The Company issued to the Strategic Investors warrants to purchase 250,000
shares of common stock at an initial exercise price of $45.00 per share,
adjusted for stock dividends, splits, combinations or similar events (the "Class
A Warrants"). In connection with the Riverstone spin-off, the exercise price of
these warrants was adjusted to $28.424 per share. The Class A Warrants are
exercisable until August 2007 and otherwise contain customary terms and
conditions (including provisions with respect to "cashless" exercise and
customary anti-dilutive provisions).
CLASS B WARRANTS
The Company issued to the Strategic Investors warrants to purchase 200,000
shares of common stock at an initial exercise price of $35.00 per share,
adjusted for stock dividends, splits, combinations or similar events (the "Class
B Warrants"). In connection with the Riverstone spin-off, the exercise price of
these warrants was adjusted to $22.108 per share. The Class B Warrants are
exercisable until August 2007 and otherwise contain customary terms and
conditions (including provisions with respect to "cashless" exercise and
customary anti-dilutive provisions).
REPLACEMENT WARRANTS
In connection with the SPA Amendment, the Company and the Strategic
Investors agreed that the distribution of the Company's shares of Riverstone
common stock would be deemed to have occurred prior to the merger of Enterasys
Subsidiary into the Company and, pursuant to the terms of the SPA Amendment and
as a consequence of the merger of Enterasys Subsidiary into the Company, that
the Company would issue warrants to purchase an additional 7,400,000 shares of
its common stock for an exercise price of $6.20 per share in replacement of all
of the Strategic Investors' rights to purchase common stock of Enterasys
Subsidiary. Other than the number of shares subject to the warrants and the
exercise price of the warrants, the terms of these additional warrants are
substantially the same as the terms of the Class A Warrants and Class B
Warrants.
SERIES C PREFERRED STOCK
As part of the acquisition of Indus River, completed on January 31, 2001,
the Company issued 45,471 shares of Series C Preferred Stock ("C Preferred
Stock") and options and warrants to purchase 5,293 shares of C Preferred Stock.
The merger of Enterasys Subsidiary into the Company on August 6, 2001
represented an "Enterasys Spin-off" for purposes of the C Preferred Stock. In
accordance with the C Preferred Stock conversion provisions, upon the merger all
outstanding shares of the C Preferred Stock and related options and warrants
converted into approximately 955,000 shares of the Company's common stock.
SERIES F PREFERRED STOCK
In connection with the stockholder rights plan, the Company is authorized
to issue up to 300,000 shares of Series F Preferred Stock. The number of shares
of Series F Preferred Stock may be increased or decreased by the Company's Board
of Directors by a duly adopted resolution of the Board. As of December 28, 2002,
no shares of Series F Preferred Stock were outstanding.
The terms of the Series F Preferred Stock are as follows:
Voting
Each share of Series F Preferred Stock entitles the holder to 1,000 votes
on all matters submitted to a vote of the stockholders of the Company. The
holders of the shares of Series F Preferred Stock and the holders of the common
stock shall vote together on all matters submitted to a vote of stockholders,
except as required by applicable law.
Seniority
The Series F Preferred Stock shall rank equal to all other series of
preferred stock of the Company as to dividends and/or preference upon
liquidation, dissolution or winding up, unless otherwise resolved by the Board
of Directors in any vote establishing any other series of preferred stock.
Notwithstanding the foregoing, the Series F Preferred Stock ranks junior to the
Series D&E Preferred Stock.
Dividends
Beginning on the last day of the first March, June, September or December
after the issuance of shares of Series F Preferred Stock, the holders of shares
of Series F Preferred Stock shall be entitled to receive a quarterly dividend
equal to the greater of (a) $1.00 per
F-29
share or (b) 1,000 times the aggregate per share amount of all cash dividends
and all non-cash dividends or other distributions other than a dividend payable
in shares of common stock. In the event no dividend or distribution shall have
been declared on the common stock during any quarterly period in which shares of
Series F Preferred Stock are outstanding, a dividend of $1.00 per share shall
accrue and be cumulative. Accrued but unpaid dividends do not bear interest.
Whenever quarterly dividends or other dividends or distributions payable
on the Series F Preferred Stock are in arrears, the Company may not, in addition
to certain other similar restrictions, declare or pay dividends on, make any
other distributions on, or redeem any shares of common stock or any other series
of preferred stock ranking junior to the Series F Preferred Stock.
Liquidation Preference
The Series F Preferred Stock has a liquidation preference equal to the sum
of $1,000 per share plus an amount equal to all accrued and unpaid dividends and
distributions thereon, whether or not declared.
Redemption
Outstanding shares of Series F Preferred Stock may be purchased by the
Company at such times and on such terms as the redeeming stockholder and the
Company may agree, subject to any limitations imposed by law or the Company's
charter. Promptly after such shares are reacquired by the Company they shall be
retired and canceled and shall become authorized but unissued shares of the
Company's Undesignated Preferred Stock (defined below).
UNDESIGNATED PREFERRED STOCK
At December 28, 2002, the Company was authorized to issue up to 1,610,000
shares of preferred stock (the "Undesignated Preferred Stock"). Issuances of the
Undesignated Preferred Stock may be made at the discretion of the Board of
Directors of the Company (without stockholder approval) with designations,
rights and preferences as the Board of Directors may determine from time to
time, which may be more expansive than the rights of the current holders of the
Company's preferred stock and common stock.
20. STOCK PLANS
EQUITY INCENTIVE PLANS
The Company's 1998 Equity Incentive Plan, as amended, was approved by the
stockholders of the Company on July 9, 1998 and provides for the availability of
19,500,000 shares of common stock for the granting of various incentive awards
to eligible employees. Options granted under the plan are granted with exercise
prices equal to the fair market value on the date of grant, generally expire ten
years from the date of grant and vest as to 25 percent of the shares one year
from the date of grant with monthly vesting of the remainder ratably over the
following three years. As of December 28, 2002, 9,473,590 shares remained
available for issuance under the 1998 Equity Incentive Plan and options to
purchase 7,453,928 shares were outstanding under the plan.
The Company's 2001 Equity Incentive Plan was adopted by the Board of
Directors of the Company on July 30, 2001 and provided for the availability of
50,000,000 shares of common stock solely for the purpose of granting options to
purchase shares of the Company's common stock ("Replacement Options") to replace
options to purchase shares of the Enterasys Subsidiary ("Prior Options") in
connection with the merger of the Enterasys Subsidiary into the Company on
August 6, 2001. Replacement Options were granted to replace Prior Options held
on the basis of 1.39105 shares of the Company's common stock for each share of
common stock subject to the original Enterasys Subsidiary options. The exercise
price of each Replacement Option is equal to the exercise price of the Prior
Option divided by 1.39105 to reflect the effect of the merger. The 2001 Equity
Incentive Plan was not required to be, and has not been, approved by the
Company's stockholders. No additional options may be granted under the 2001
Equity Incentive Plan and as of December 28, 2002, options to purchase
20,619,984 shares were outstanding under the plan.
Prior to February 28, 1999, the Company maintained a Directors Option Plan
which provided for 1,250,000 shares of common stock for purchase by non-employee
directors of the Company. The Directors Option Plan provided for issuance of
options with exercise prices equal to the underlying stock price on the date of
grant. The options vested over a period of three years and expire six years from
the date of grant. Options to purchase a total of 50,000 shares were outstanding
under the Directors Option Plan at December 28, 2002. After March 1, 1999, the
nonemployee directors of the Company are eligible to receive options to purchase
shares of the Company's common stock under the 1998 Equity Incentive Plan.
F-30
The Company's 2002 Stock Option Plan for Eligible Executives was adopted
by the Board of Directors on April 5, 2002 and provides for the availability of
900,000 shares of common stock solely for the purpose of granting options in
connection with the acceptance by certain executives of offers of employment
with the Company. The options vest over a period of twelve months, or sooner if
certain performance targets outlined in the plan are met, and expire ten years
from the date of grant. Options to purchase all 900,000 shares were outstanding
under the 2002 Stock Option Plan for Eligible Executives at December 28, 2002.
A summary of option transactions under the Company's Equity Incentive
Plans for the three years ended December 28, 2002 is as follows:
WEIGHTED-
NUMBER OF AVERAGE
OPTIONS EXERCISE PRICE
------- --------------
Options outstanding at February 29, 2000 15,998,256 $ 11.16
Granted .............................. 1,101,614 17.55
Exercised ............................ (1,958,935) 8.94
Cancelled ............................ (3,373,355) 12.73
-----------
Options outstanding at March 3, 2001 ... 11,767,580 11.66
Granted .............................. 1,042,299 13.86
Converted subsidiary options ......... 41,568,878 3.47
Exercised ............................ (10,477,337) 4.62
Cancelled ............................ (8,173,832) 9.83
-----------
Options outstanding at December 29, 2001 35,727,588 3.91
Granted .............................. 8,075,121 1.21
Exercised ............................ (1,333,995) 2.88
Cancelled ............................ (13,444,802) 3.98
-----------
Options outstanding at December 28, 2002 29,023,912 $ 3.18
===========
DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Options exercisable ........... 13,245,695 11,867,978 4,340,530
Weighted average exercise price $ 3.60 $ 3.34 $ 11.51
The following table summarizes information concerning outstanding and
exercisable options as of December 28, 2002:
WEIGHTED-AVERAGE
REMAINING WEIGHTED
RANGE OF OPTIONS CONTRACTUAL LIFE WEIGHTED-AVERAGE OPTIONS AVERAGE
EXERCISE PRICES OUTSTANDING (YEARS) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
----------------- ----------- ----------------- ------------------ ----------- --------------
$ 0.90-$ 1.12 5,952,612 9.48 $ 1.03 16,270 $ 1.09
$ 1.13-$ 1.78 1,349,425 9.45 $ 1.44 74,970 $ 1.34
$ 1.79-$ 2.52 14,610,925 7.38 $ 2.52 9,854,362 $ 2.52
$ 2.53-$12.58 6,591,488 8.11 $ 5.74 3,016,256 $ 5.75
$12.59-$49.40 519,462 5.86 $ 18.66 283,837 $ 19.04
---------- ----------
29,023,912 8.05 $ 3.18 13,245,695 $ 3.60
========== ==========
EMPLOYEE STOCK PURCHASE PLANS
In October 2002 the Board approved the Employee Stock Purchase Plan (the
"2002 ESPP") which was approved by the stockholders in December 2002. It
provides for the availability of 5,000,000 shares of common stock to be
purchased by employees. Under this plan, eligible employees, twice yearly
through the accumulation of employee payroll deductions from 2 to 10 percent of
employee compensation as defined in the plan (up to a maximum of $12,500 per
six-month plan period), may purchase stock at 85 percent of the fair market
value of the common stock at the beginning or end of the applicable six-month
period, whichever amount is lower. The maximum number of shares that an employee
may purchase during a six-month plan period is limited to 1,200 shares. At
December 28, 2002, no options were outstanding, and no shares had been issued
under the plan.
Prior to the adoption of the 2002 ESPP, the Company had two Employee Stock
Purchase Plans, the "1989 ESPP" and the "1995
F-31
ESPP" which provided for the combined availability of up to 6,000,000 shares of
common stock to be purchased by employees. Under these plans, eligible employees
twice yearly through the accumulation of employee payroll deductions from 2 to
10 percent of employee compensation as defined in the plan, up to a maximum of
$25,000 annually (measured by reference to share values at the dates of grant of
the Purchase rights), were able to purchase stock at 85 percent of the fair
market value of the common stock at the beginning or end of the applicable
six-month period, whichever amount was lower. In fiscal year 2002, 665,189
shares were purchased at a price of $1.23 per share. The Company's employees
purchased 778,752 shares at a weighted-average purchase price of $9.71 during
transition year 2001; and 906,000 shares at a weighted-average purchase price of
$14.85 during fiscal year 2001. The remaining number of shares available for
purchase by employees under these plans at December 28, 2002 was 747,238 shares.
These shares were purchased by employees in February 2003. After that date, no
further shares remained available for purchase under the 1989 ESPP and the 1995
ESPP.
ASSUMPTIONS USED IN PRO FORMA DISCLOSURE
The Company has elected to follow APB Opinion No. 25, "Accounting for
Stock Issued to Employees," in accounting for its employee stock options. Pro
forma information is required by SFAS No. 123, "Accounting for Stock Based
Compensation," as amended by SFAS No. 148, "Accounting for Stock-based
Compensation--Transition and Disclosure," as if the Company had accounted for
its employee stock options (including shares issued under the Employee Stock
Purchase Plan) granted subsequent to December 31, 1994 under the fair value
method of that statement. (See Note 2 for pro forma disclosure.) The fair value
of each Company option grant was estimated on the date of grant using the
Black-Scholes option pricing model, with the following weighted- average
assumptions used for grants in fiscal year 2002, transition year 2001 and fiscal
year 2001:
DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Employee stock options:
Risk-free interest rate ............ 2.79% 3.86% 4.51%
Expected option life ............... 5.4 years 2.7 years 3.8 years
Expected volatility ................ 113.28% 92.11% 83.18%
Expected dividend yield ............ 0.0% 0.0% 0.0%
Employee stock purchase plan shares:
Risk-free interest rate ............ 1.23% 1.83% 4.69%
Expected option life ............... 11 months 6 months 6 months
Expected volatility ................ 98.11% 92.11% 83.18%
Expected dividend yield ............ 0.0% 0.0% 0.0%
The weighted average estimated fair values of stock options granted during
fiscal year 2002, transition year 2001 and fiscal year 2001 were $0.97, $8.68
and $17.24 per share, respectively. The weighted average estimated fair values
of employee stock purchase plan options grants during fiscal year 2002,
transition year 2001, and fiscal year 2001 were $1.05, $7.32, and $8.38.
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions, including the expected stock price
volatility. Because the Company options held by employees and directors have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in the opinion of management the existing models do not
necessarily provide a reliable single measure of the fair value of these
options.
STOCK-BASED COMPENSATION
As of the end of the third quarter of fiscal year 2001, each of the
Operating Subsidiaries had granted options to purchase its common stock to their
respective employees and to certain non-employees. Of these options, an
aggregate total of approximately 8.0 million options were granted primarily to
three officers and certain other employees of the Company, who were not
employees of the Operating Subsidiaries. These individuals were generally
restricted from transferring these options and the underlying shares were
subject to restrictions lapsing over a period of time approximating the standard
vesting period of options granted by the Company, subject to partial
acceleration in certain circumstances. At the Operating Subsidiary level, these
options generated variable stock-based compensation over the vesting period at
fair value using the Black-Scholes option pricing model as the individuals were
considered non-employees of the Operating Subsidiaries. By approval of each
Operating Subsidiary's board of directors and the Company's Board of Directors,
these options were accelerated to become fully vested in November 2000. At that
time, these options to purchase shares of an Operating Subsidiary were scheduled
to become exercisable at the first to occur of: the Company's distribution to
its
F-32
shareholders its shares of that Operating Subsidiary's common stock, April 1,
2004, or the sale of the Operating Subsidiary. As a result of the acceleration,
each Operating Subsidiary recorded compensation expense during the third quarter
of fiscal year 2001, which was eliminated in consolidation for the Company's
consolidated reporting; and the options were accounted for in accordance with
APB 25. Accordingly, the Company had measured the intrinsic value at the date of
the acceleration. During the second quarter ended September 1, 2001, the Company
recorded stock-based compensation of $1.9 million and $15.9 million in
continuing operations and discontinued operations, respectively, as certain
employees left the Company and benefited from the acceleration of vesting
discussed above. This amount was based on the intrinsic value as of the
modification date.
In connection with the acquisition of Indus River, the Company issued
stock options to employees in respect of unvested stock options. The Company
calculated the fair value of these unvested stock options using the
Black-Scholes option pricing model. The Company recorded approximately $2.9
million of unearned stock-based compensation expense for the value of the
options, of which it recognized $0.8 million, $1.9 million and $0.1 million of
compensation expense during fiscal year 2002, transition year 2001 and fiscal
year 2001, respectively.
In connection with the Company's acquisition of NSW, the Company agreed to
issue 157,714 additional shares of common stock contingent upon future services
to be rendered to the Company by certain employees of NSW. The Company recorded
approximately $5.5 million of unearned stock-based compensation for the value of
these shares at the date of the acquisition. This compensation expense has been
recognized over the required service period of two years. The Company recorded a
stock-based compensation expense of approximately $1.8 million, $2.3 million and
$1.4 million during fiscal year 2002, transition year 2001 and fiscal year 2001,
respectively.
In connection with certain Riverstone subsidiary stock option grants to
employees, the Company recorded approximately $11.1 million of unearned
stock-based compensation for the excess of the deemed fair market value over the
exercise price at date of grant during fiscal year 2001. Prior to the Riverstone
distribution, the compensation expense had been recognized over the options'
vesting period of four years. As a result of these grants, the Company recorded
stock-based compensation expense in discontinued operations of $0.7 million and
$1.4 million for transition year 2001 and fiscal year 2001, respectively.
Stock-based compensation expense related to stock options granted to
consultants is recognized in accordance with EITF No. 96-18. The fair value of
the stock options granted is calculated at each reporting date using the
Black-Scholes option pricing model. The Company believes that the fair value of
the stock options are more reliably measurable than the fair value of the
services rendered. As a result of these grants, the Company recorded stock-based
compensation expense in discontinued operations of $2.1 million during fiscal
year 2001 related to stock options granted to consultants.
In connection with the transformation events of August 6, 2001, the
portion of each option (an "Applicable Cabletron Option") to purchase common
stock of Cabletron that was held by an employee (other than the employees of
Aprisma and certain other individuals) that would have vested after February 28,
2002 was cancelled and the portion of the option that was scheduled to vest
prior to that date (assuming a quarterly vesting schedule for those options
scheduled to vest yearly) was accelerated. The Applicable Cabletron Options
expired on November 6, 2001. The Company recorded a net $24.5 million non-cash
stock-based compensation charge related to the acceleration of these options.
On August 6, 2001, each employee who held options, taking into account the
acceleration described above, to purchase Cabletron's common stock received an
option to purchase 0.5131 shares of Riverstone common stock (the "Rainbow
Awards") for each share of Cabletron common stock subject to their options. The
exercise price of the options to purchase the Company's stock were adjusted, and
the exercise price of the Rainbow Awards established, to preserve as closely as
possible, without increasing, the intrinsic value and without decreasing the
ratio of the exercise price to market value that existed in the Cabletron option
prior to the distribution.
The Replacement Options and the Rainbow Awards described previously were
granted, and the options adjusted, in accordance with the guidance set forth in
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation, an Interpretation of APB Opinion No. 25," regarding equity
restructuring.
21. COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
Described below are material legal proceedings in which the Company is
involved:
F-33
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 assigned to a
judge of the District of Rhode Island sitting by designation in the District of
New Hampshire. 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 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 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
plaintiffs prevail on the merits of the case, the Company 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 the Company,
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, defendants issued materially
false and misleading financial statements and press releases that overstated the
Company's revenues, income, and cash, and understated the Company's net losses,
because the Company 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 its 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 in the Court of Chancery of the State of
Delaware in and for New Castle County on behalf of the Company. 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 responsive brief with respect to this motion.
The Company cannot predict the outcome of these lawsuits at this time, and
there can be no assurance that the litigation will not have a material adverse
impact on its financial condition or results of operations.
F-34
Other. In addition, the Company is involved in various other legal
proceedings and claims arising in the ordinary course of business. The Company's
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 Company's financial condition or results of operations.
OTHER COMMITMENTS AND CONTINGENCIES
The Company leases office facilities under non-cancelable operating leases
expiring through the year 2018. Some of the leases provide for rent increases
based on the consumer price index and increases in real estate taxes. Rent
expense associated with operating leases was $14.5 million, $12.7 million, and
$11.8 million for fiscal year 2002, transition year 2001 and fiscal year 2001,
respectively. Total future minimum lease payments under all non-cancelable
operating leases that the Company has initial or remaining noncancelable lease
terms in excess of one year at December 28, 2002 were $12.9 million, $11.1
million, $9.4 million, $6.8 million, $5.2 million, and $8.2 million for fiscal
years 2003, 2004, 2005, 2006, 2007, and for all years thereafter, respectively.
In addition, the Company has guaranteed a portion of Aprisma's lease
obligations and related maintenance and management fees through 2012. This
guarantee currently is in the amount of $4.0 million and automatically reduces
to $3.0 million on February 1, 2009, to $2.0 million on February 1, 2010 and to
$1.0 million on February 1, 2011 and terminates on February 1, 2012. The Company
estimates the fair value of the guarantee to be between $2.0 million and $4.0
million based on current market rates for similar property. The Company is
indemnified for up to $3.5 million in losses it may incur in connection with
this guarantee. The Company has pledged $4.4 million to secure this lease. See
Note 4 for further discussion.
In some instances prior to fiscal year 2002, customers of the Company
received financing for the purchase of equipment from third party leasing
organizations; and the Company guaranteed the payments of those customers. Most
of these guarantees related to the sale of Riverstone equipment. During fiscal
year 2002, transition year 2001, and fiscal year 2001, the Company made payments
of $5.1 million, $28.8 million, and $0.8 million, respectively, related to these
guarantees. As of December 28, 2002, the Company had remaining guarantees
associated with these lease obligations of approximately $4.3 million for which
the Company has fully reserved in accrued expenses. The estimated fair value of
this guarantee approximates the face value of the guarantee. The Company has
$4.4 million pledged to secure letters of credit for some of these leases. See
Note 4 for further discussion.
At December 28, 2002, the Company had non-cancelable purchase commitments
of approximately $20.1 million with its contract manufacturers. Approximately
$11.7 million of the non-cancelable purchase commitments were with Flextronics
and $5.2 million with Accton.
During fiscal year 2002, the Company incurred legal and forensic
accounting fees of approximately $21.0 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 being expensed as they are incurred.
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 $2.2 million at
December 28, 2002 would be significantly diluted. The fund has not indicated
that it expects to issue a material capital call in the near future.
22. 401(K) PLAN
The Company's eligible employees may participate in the Enterasys
Networks, Inc. 401(k) Plan (the "401(k) Plan") which provides retirement
benefits to the eligible employees of participating employers. As allowed under
Section 401(k) of the Internal Revenue Code, the 401(k) Plan provides
tax-deferred salary deductions for eligible employees. Participants may elect to
contribute from 1% to 18% of their annual compensation to the 401(k) Plan each
year, limited to a maximum annual amount as set periodically by the Internal
Revenue Service. In addition, unless determined otherwise by the Company's Board
of Directors, the 401(k) Plan provides for a basic matching contribution
F-35
each quarter on behalf of each eligible participant equal to the lesser of $250
or 50% of the participant's elective contributions for the quarter. The 401(k)
Plan also provides for a quarterly supplemental matching contribution equal to
the lesser of $250 or 5% of the participant's elective contributions if the
Company's performance meets a specified threshold. The 401(k) Plan also provides
for make-up matching contributions to address specified circumstances where
fluctuations in a participant's level of deferrals result in lower basic or
supplemental matching contributions than would be the case with a level rate of
deferrals. Employees become vested in the matching contributions according to a
one-year vesting schedule based on initial date of hire. The Company's expenses
related to matching contributions to the 401(k) Plan for fiscal year 2002,
transition year 2001 and fiscal year 2001 were approximately $0.8 million, $0.9
million, and $0.9 million, respectively.
23. 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 transition year 2001 and fiscal year 2001,
the Company recognized revenue in connection with investments where it received
equity instruments in exchange for products sold. Revenue recognized from sales
to investee companies were cash transactions with normal terms and conditions.
Revenue recognized from investee transactions was as follows:
YEAR ENDED TEN MONTHS ENDED YEAR ENDED
(IN THOUSANDS) DECEMBER 28, 2002 DECEMBER 29, 2001 MARCH 3, 2001
----------------- ----------------- -------------
Revenue recognized in connection
with investments ............. $ -- $ 6,988 $ 1,435
Revenue recognized from sales to
investee companies ........... 9,217 40,196 38,619
------- ------- -------
Total revenue recognized from
investee transactions ..... $ 9,217 $47,184 $40,054
======= ======= =======
SEVERANCE
In connection with the merger of the Enterasys Subsidiary into the Company
on August 6, 2001, senior Cabletron management resigned their executive
positions, and the Company made lump-sum severance payments to them of
approximately $2.4 million.
In connection with the resignations of senior Enterasys management in
April 2002, the Company agreed to make $1.0 million of severance payments over
the twelve-month period beginning in April 2002. In addition, one senior
executive received a lump sum payment of $0.2 million during fiscal year 2002.
In connection with the resignation of a senior Enterasys executive in November
2002, the Company agreed to make $0.3 million of severance payments over the
twelve-month period beginning in November 2002.
CONSULTING ARRANGEMENTS
In connection with the senior management resignations in September 2001,
the Company entered into consulting arrangements with two former members of
senior Cabletron management to provide strategic advice and assistance to the
Company for a period of one year. The Company paid consulting fees of $0.2
million in both fiscal year 2002 and transition year 2001. These arrangements
ended in September 2002.
INDEBTEDNESS
On April 12, 2000, the Company entered into a promissory note with Mr.
Romulus Pereira, the President and Chief Executive Officer of Riverstone in the
amount of $0.4 million to be applied to the payment of certain taxes owed by Mr.
Pereira with respect to the Company's shares that he received in connection with
the Company's acquisition of Yago Systems, Inc. The note with interest at the
rate of 6.46% per annum was forgiven in April 2002.
On August 23, 1999, the Company entered into an interest-free promissory
note with Mr. Enrique Fiallo, former Chief Executive Officer of the Company, in
the amount of $0.1 million. The outstanding principal balance on the note of
$0.1 million was forgiven by the Company in connection with Mr. Fiallo's
resignation and termination of employment in April 2002.
On January 1, 2000, the Company entered into interest-free promissory
notes with each of Messrs. Fiallo and Eric Jaeger, former Executive
Vice-President of the Company, each for the principal amount of $0.1 million.
The Company entered into a similar
F-36
promissory note with Mr. David Kirkpatrick, former Chief Financial Officer and
Chief Operating Officer of the Company, on June 15, 2000. Pursuant to the terms
of the notes, the Company forgave 25% of the original principal balance of the
notes on January 1, 2001 for Messrs. Fiallo and Jaeger and on February 28, 2001
for Mr. Kirkpatrick. In connection with the merger of the Enterasys Subsidiary
into the Company, on August 6, 2001, the Company forgave the remaining original
principal balance of the notes of $0.1 million issued by each of Messrs. Fiallo,
Jaeger and Kirkpatrick.
On April 12, 2000, the Company entered into a promissory note with Mr.
Piyush Patel, former Chief Executive Officer and President of the Company, in
the principal amount of $0.4 million bearing interest at a rate of 6.46% per
year. The proceeds of the note were to be applied to the payment of taxes owed
by Mr. Patel relating to the shares of the Company he received in connection
with the Company's acquisition of Yago Systems in 1998. On August 6, 2001, the
Company forgave the outstanding principal and all accrued interest on the note
of $0.4 million.
On June 1, 2000, the Company entered into a promissory note with Mr.
Kirkpatrick for the principal amount of $0.2 million bearing interest at a rate
of 8% per year. The outstanding principal balance and all accrued interest on
the note of $0.2 million was forgiven by the Company in connection with Mr.
Kirkpatrick's resignation and termination of employment in April 2002.
On September 6, 2001, the Company entered into an interest-free promissory
note with Mr. James Riddle, former Executive Vice-President of the Company, for
the principal amount of $0.1 million. The outstanding principal balance on the
note of $0.1 million was forgiven by the Company in connection with Mr. Riddle's
resignation and termination of employment in April 2002.
TRANSACTIONS WITH RIVERSTONE
On February 16, 2001, Riverstone completed the initial public offering of
10.0 million shares of its common stock at $12 per share, which was in excess of
its book value; and the Company's net investment in Riverstone increased. Prior
to the offering, Riverstone was a wholly owned subsidiary of the Company. The
increase was recorded as additional paid-in capital. The Company did not
recognize gains on issuance of Riverstone stock because the planned spin-off was
not expected to result in the realization of a gain by the Company. Net proceeds
from the offering totaled $108.8 million and were raised for general working
capital purposes. After Riverstone's registration statement relating to the
initial public offering had been declared effective, the Strategic Investors
exercised stock purchase rights requiring Riverstone to issue 5.4 million shares
of its common stock. Riverstone received net proceeds of approximately $46.6
million from the purchase rights exercise. The Company continued to own
approximately 85 percent of Riverstone subsequent to the initial public offering
and the exercise of the stock purchase rights by the Strategic Investors until
August 6, 2001, when the Company distributed its shares of Riverstone common
stock to its stockholders.
The Company and Riverstone are parties to a tax sharing agreement, whereby
each entity, for the period of their parent-subsidiary ownership, will reimburse
or seek reimbursement from the other for the tax consequences for incremental
income or expenses resulting from the filing of amended tax returns.
Additionally, the Company and Riverstone are parties to an Asset Contribution
Agreement pursuant to which Riverstone is obligated to assume and satisfy
liabilities of the Company relating primarily to the business or assets of
Riverstone, to the extent that such obligations were not previously assumed by
Riverstone. As of August 6, 2001, Riverstone discontinued the use of corporate
and other infrastructure services that the Company had previously provided in
accordance with a transitional services agreement.
In accordance with the terms of a commercial agreement with Riverstone,
during fiscal year 2001 the Company paid referral fees to Riverstone of $2.9
million. This amount reflects Riverstone's commission for sales of Company
products to Riverstone customers and has been recorded in selling, general and
administrative expenses. There were no referral fees paid to Riverstone during
fiscal year 2002 and transition year 2001. Upon completion of the August 6, 2001
tax-free spin-off transaction, the Company no longer sells product through
Riverstone.
24. SUBSEQUENT EVENTS
REDEMPTION OF SERIES D AND E PREFERRED STOCK
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. On March 3, 2003, the
Company redeemed all of these shares for approximately $98.6 million in cash.
SETTLEMENT OF SEC INVESTIGATION
F-37
After the close of business on January 31, 2002, the SEC notified the
Company that it had issued a "Formal Order of Private Investigation" relating to
the Company's financial accounting and reporting practices. The Company
cooperated fully with the SEC during the investigation, and in February 2003,
the Company reached a settlement of the SEC investigation. Without admitting or
denying any allegations, the Company consented to 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 changes to the Company's historical financial statements which were
restated in the Company's Form 10-K for the transition period ended December 29,
2001 filed with the SEC on November 26, 2002.
25. QUARTERLY FINANCIAL DATA (UNAUDITED)
YEAR ENDED DECEMBER 28, 2002
------------------------------------------------------------------------------
FIRST QUARTER SECOND QUARTER THIRD QUARTER FOURTH QUARTER
ENDED ENDED ENDED ENDED
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) MARCH 30, 2002 JUNE 29, 2002 SEPTEMBER 28, 2002 DECEMBER 28, 2002 (1)
-------------- ------------- ------------------ ---------------------
Net revenue ................................. $ 120,766 $ 120,062 $ 122,731 $ 121,238
Gross margin ................................ $ 48,320 $ 60,121 $ 59,059 $ 42,295
Loss from continuing operations available to
common shareholders ...................... $ (1,996) $ (51,437) $ (31,464) $ (30,611)
Loss from discontinued operations ........... $ (11,700) $ -- $ -- $ --
Net loss available to common shareholders ... $ (13,696) $ (51,437) $ (31,464) $ (30,611)
Basic and diluted loss per common share:
Loss from continuing operations available to
common shareholders ....................... $ (0.01) $ (0.25) $ (0.16) $ (0.15)
Discontinued operations ..................... $ (0.06) $ -- $ -- $ --
Net loss available to common shareholders ... $ (0.07) $ (0.25) $ (0.16) $ (0.15)
TEN MONTHS ENDED DECEMBER 29, 2001
-------------------------------------------------------------------------------
THIRD QUARTER FOURTH QUARTER
FIRST QUARTER SECOND QUARTER ENDED ENDED
ENDED ENDED SEPTEMBER 29, DECEMBER 29,
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) JUNE 2, 2001(6) SEPTEMBER 1, 2001(6) 2001(2)(3)(6) 2001(4)(6)
--------------- -------------------- ------------- --------------
Net revenue ................................. $ 181,650 $ 150,816 $ 65,268 $ 139,253
Gross margin ................................ $ 87,913 $ 50,983 $ (39,271) $ 7,305
Loss from continuing operations available to
common shareholders ...................... $ 473 $(157,438) $(255,911) $(319,280)
Loss from discontinued operations ........... $ (11,112) $ (84,560) $ (76,058) $ (4,004)
Net loss available to common shareholders (5) $ (2,898) $(241,998) $(331,969) $(318,334)
Basic and diluted loss per common share:
Loss from continuing operations available to
common shareholders ...................... $ -- $ (0.83) $ (1.33) $ (1.65)
Discontinued operations ..................... $ (0.06) $ (0.44) $ (0.40) $ (0.02)
Net loss available to common shareholders (5) $ (0.02) $ (1.27) $ (1.73) $ (1.65)
(1) The fourth quarter of fiscal year 2002 included a provision for excess and
obsolete inventory of $17.6 million that principally related to customer
returns, increased reserves for customer evaluation units and service
inventory and a reserve for the carrying value of inventory held by
certain cash-basis partners in Asia Pacific.
(2) The results of operations for the three months ended September 29, 2001
above differ from the 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 year ended December 29, 2001. The
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-end
as described in Note 2. 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.
(3) Both of the quarters ended September 1, 2001 and September 29, 2001
include the months of July 2001 and August 2001 as a result of the
Company's change in fiscal year-end from the Saturday closest to the last
day in February to the Saturday closest to the last day in December. The
consolidated results of operations for July and August 2001 are summarized
as follows: net revenue
F-38
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.
(4) Significant items during the fourth quarter ended December 29, 2001
included the following: provisions for excess and obsolete inventory of
$30.5 million; valuation provision for deferred taxes of $82.3 million;
and impairment of intangible assets of $104.1 million.
(5) Included in the net loss available to common shareholders is the
cumulative effect of an accounting change. In the first quarter the effect
totaled $7.7 million, or $0.04 per share. In the fourth quarter, the tax
effect of the change was reversed due to a net loss for the ten months
ended December 29, 2001. This reversal lowered the net loss $4.9 million,
or $0.03 per share.
(6) Certain marketing development costs paid to resellers have been
reclassified for transition year 2001 to comply with EITF No. 00-25, as
further defined in EITF 01-9, which the Company adopted in the first
quarter of fiscal year 2002. Net revenue was reduced by $3.4 million, $6.1
million, $13.3 million and $4.5 million, and gross margin was reduced by
$1.6 million, $2.9 million, $3.6 million and $1.6 million for the quarters
ended June 2, 2001, September 1, 2001, September 29, 2001 and December 29,
2001, respectively. This reclassification had no impact on loss from
continuing operations available to common shareholders and net loss
available to common shareholders in total or on a per-share basis.
F-39
ENTERASYS NETWORKS, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE THREE YEARS ENDED DECEMBER 28, 2002
ADDITIONS
BALANCE AT ADDITIONS CHARGED TO AMOUNTS BALANCE AT
BEGINNING CHARGED TO OTHER WRITTEN THE END OF
(IN THOUSANDS) OF PERIOD EXPENSE ACCOUNTS OFF PERIOD
--------- ------- ---------- ---------- -----------
Allowance for doubtful accounts
December 28, 2002 ............. $ 32,569 $ 1,630 $ 154 $ (15,103) $ 19,250
December 29, 2001 ............. $ 24,784 $ 12,523 $ -- $ (4,738) $ 32,569
March 3, 2001 ................. $ 18,311 $ 17,788 $ -- $ (11,315) $ 24,784
Inventory reserves
December 28, 2002 ............. $ 82,278 $ 17,885 $ (1,112) $ (61,362) $ 37,689
December 29, 2001 ............. $ 42,257 $ 72,888 $ -- $ (32,867) $ 82,278
March 3, 2001 ................. $ 79,894 $ 44,686 $ -- $ (82,323) $ 42,257
Notes receivable valuation
allowance
December 28, 2002 ............. $ 36,125 $ (2,500) $ -- $ -- $ 33,625
December 29, 2001 ............. $ 30,000 $ 6,125 $ -- $ -- $ 36,125
March 3, 2001 ................. $ -- $ 30,000 $ -- $ -- $ 30,000
Deferred tax valuation
allowance
December 28, 2002 ............. $ 452,052 $ 19,828 $ -- $(113,401)(a) $ 358,479
December 29, 2001 ............. $ 230,717 $ 259,963 $ 19,771(b) $ (58,399)(c) $ 452,052
March 3, 2001 ................. $ 26,672 $ 173,215 $ 30,830(d) $ -- $ 230,717
- ----------
(a) Realization of deferred tax assets for which a valuation allowance had
previously been provided.
(b) Represents amounts for unbenefited stock compensation.
(c) Represents amounts attributable to the distribution of shares of a former
subsidiary.
(d) Represents amounts for unbenefited stock compensation and acquired
losses.
S-1
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of Enterasys Networks, Inc.:
Under date of March 25, 2003, we reported on the consolidated balance sheets of
Enterasys Networks, Inc. and subsidiaries as of December 28, 2002 and December
29, 2001, and the related consolidated statements of operations, redeemable
convertible preferred stock and stockholders' equity, and cash flows for the
year ended December 28, 2002, for the ten-month period ended December 29, 2001,
and for the year ended March 3, 2001. In connection with our audits of the
aforementioned consolidated financial statements, we also have audited the
related consolidated financial statement schedule as listed in Item 14(a)2 of
this Form 10-K. This consolidated financial statement schedule is the
responsibility of the Company's management. Our responsibility is to express an
opinion on this consolidated financial statement schedule based on our audits.
In our opinion, the consolidated financial statement schedule, when considered
in relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
Our audit report on the Company's consolidated financial statements referred to
above indicates that, effective December 30, 2001, the Company changed its
method of accounting for goodwill and other intangibles. Our audit report also
indicates that, effective March 4, 2001, the Company changed its method of
accounting for derivative financial instruments and hedging activities.
/s/ KPMG LLP
Boston, Massachusetts
March 25, 2003
S-2