Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the Quarter Ended March 29, 2003

OR

Commission File Number 1-10228

Enterasys Networks, Inc.

50 Minuteman Road

Andover, Massachusetts 01810

(978) 684-1000

     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 o

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

     As of May 6, 2003, there were 203,127,394 shares of the Enterasys common stock, $0.01 par value, outstanding.

Table of Contents

TABLE OF CONTENTS

2

Table of Contents

PART I — FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(unaudited)

See accompanying notes to consolidated financial statements.

3

Table of Contents

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

See accompanying notes to consolidated financial statements.

4

Table of Contents

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

See accompanying notes to consolidated financial statements.

5

Table of Contents

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

1. Basis of Presentation

     The accompanying unaudited consolidated financial statements of Enterasys Networks, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 2 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments except as disclosed herein) necessary for a fair presentation of the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. The accompanying financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 28, 2002.

2. 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.

Use of Estimates

     The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates include assessing the fair value of acquired assets, the amount and timing of revenue recognition, the collectibility of accounts and notes receivable, the valuation of fair value investments, the use and recoverability of inventory and tangible and intangible assets, and the amounts of incentive compensation liabilities and certain accrued employee benefits, accrued restructuring charges, litigation liabilities and contingencies, among others. The Company bases its estimates on historical experience, current conditions and various other assumptions that are believed to be reasonable under the circumstances. The markets for the Company’s products are characterized by rapid technological development, intense competition and frequent new product introductions, all of which could affect the future realizability of the Company’s assets. Estimates and assumptions are reviewed on an on-going basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from those estimates under different assumptions or conditions.

Stock-Based Compensation Plans

     The Company accounts for its stock-based employee compensation 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—Transition and Disclosure,” to stock-based employee compensation:

6

Table of Contents

     The pro forma information above is required by SFAS No. 123, as amended by SFAS No. 148, and has been prepared 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. 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:

     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.

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 which began December 29, 2002. The adoption of SFAS No. 143 did not have a material impact on the Company’s 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 which began December 29, 2002. The adoption of SFAS No. 145 did not have a material impact on the Company’s 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 initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material impact on the Company’s consolidated financial statements.

     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 adopted the provisions for initial recognition and measurement and interim disclosures during the first quarter of fiscal year 2003. The adoption of FIN No. 45 did not have a material impact on the Company’s 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

7

Table of Contents

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 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. 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.

Reclassifications

     Certain prior period balances have been reclassified to conform to the current period presentation.

3. Accounts Receivable

     Accounts receivable were as follows:

     The Company defers revenue on product shipments to certain stocking distributors until those distributors have sold the product to their customer. At March 29, 2003 and December 28, 2002, $24.1 million and $21.4 million, respectively, of product shipments to distributors had been billed and revenue had not been recognized, of which $7.2 million and $3.8 million, respectively, was paid and is included in customer advances and billings in excess of revenues. The balance of $16.9 million and $17.6 million, respectively, was unpaid and is recorded as an offset to gross accounts receivable.

4. Inventories, net

     Inventories, net, consisted of the following:

5. Income Taxes

     For the first quarter of fiscal year 2003, the Company incurred net tax expense of $0.7 million due to certain foreign and state activities. For the first quarter of fiscal year 2002, the Company recorded net income tax benefits of $61.0 million due primarily to the tax loss carry back benefits associated with the passage of the Job Creation and Worker Assistance Act of 2002, whereby the allowable period to carry back net operating losses was increased from two to five years. The Company established an income tax receivable during fiscal year 2002 to reflect the refunds anticipated as a result of the Job Creation and Workers Assistance Act of 2002. The Company received net tax refunds during the first quarter of fiscal year 2003 of approximately $25.8 million, of which $25.5 million related to the Job Creation and Workers Assistance Act of 2002. As of March 29, 2003, the Company had an income tax receivable of approximately $6.4 million.

6. Goodwill and Intangible Assets

     In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is subject to an annual impairment test using a fair-value-based approach. All other intangible assets are amortized over their estimated useful lives and assessed for

8

Table of Contents

impairment under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-lived Assets.” The Company has designated the end of the third quarter of the fiscal year as the date of the annual test. 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. Goodwill at March 29, 2003 and December 28, 2002 was $15,129.

     The table below presents gross amortizable intangible assets and the related accumulated amortization at March 29, 2003:

     All of the Company’s identifiable intangible assets are subject to amortization. Total amortization expense was $1.7 million and $2.2 million for the three months ended March 29, 2003 and March 30, 2002, respectively. Based on intangible assets recorded at March 29, 2003, the estimated amortization expense is $4.3 million for the remainder of fiscal year 2003; $5.7 million for each of the fiscal years 2004 and 2005; $3.0 million for fiscal year 2006; $0.5 million for fiscal year 2007 and $0.8 million thereafter.

7. Other Accrued Expenses

     Other accrued expenses consisted of the following:

8. Special Charges

     The following table summarizes accrued restructuring activity:

     The majority of remaining accrued severance costs of $0.8 million as of March 29, 2003 will be paid out during fiscal year 2003; and the remaining accrued exit costs of $5.5 million, which consist of long-term lease commitments, will be paid out primarily over the next several years.

9

Table of Contents

     During the fourth quarter of fiscal year 2002, the Company recorded a restructuring charge of $1.2 million primarily for facilities 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.

9. Other Income (Expense), Net

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

     The Company reviews its minority investments in debt and equity securities of primarily privately held companies for potential impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Impairments in carrying value are based on investee-specific events including declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations and bankruptcy or insolvency. The Company recorded impairments of investments of $0.2 million and $0.4 million for the three months ended March 29, 2003 and March 30, 2002, respectively, in other income (expense), net.

     A portion of the Company’s Series D and E convertible preferred stock redemption liability was offset by the value of 1.3 million shares of Riverstone stock received by the holders of the Series D and E redeemable convertible preferred stock in connection with the Riverstone spin off in August 2001. This offset created a derivative instrument as the Company’s liability was related to the Riverstone stock price. The value of the Riverstone shares increased by $0.2 million during the three months ended March 29, 2003 and decreased by $14.7 million during the three months ended March 30, 2002, and the changes in the redemption liability were recorded in other income (expense), net. The Company redeemed all of the Series D and E convertible preferred stock in the first quarter of fiscal year 2003 (See Note 14).

     At December 28, 2002, the Company had a valuation allowance of $3.6 million on the balance of a note receivable, under a credit agreement related to the Company’s earlier sale of its Digital Networks Product Group, due to significant uncertainty regarding the likelihood that the Company would receive the balance due. During the first quarter of fiscal year 2003, the Company reduced the valuation allowance to $1.1 million due to a subsequent receipt of a principal payment of approximately $2.5 million on March 31, 2003.

10. Comprehensive Loss

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

10

Table of Contents

11. Segment Information

     The Company operates its business as one segment, which is the business of designing, developing, marketing and supporting comprehensive networking solutions.

     Net revenue by geography is as follows:

12. Loss Per Share

     Basic and diluted net loss per common share is computed using the weighted average number of common shares outstanding. Options to purchase 27.2 million and 33.7 million shares of common stock were outstanding at March 29, 2003 and March 30, 2002, respectively, and 7.9 million warrants to purchase shares of the Company’s common stock were outstanding at March 29, 2003 and March 30, 2002, but were not included in the computation of diluted net loss per share since the effect was anti-dilutive.

13. Commitments and Contingencies

Legal Proceedings

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

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

     Securities Class Action in the District of Rhode Island. Between October 24, 1997 and March 2, 1998, nine shareholder class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the District of New Hampshire. By order dated March 3, 1998, these lawsuits, which are similar in material respects, were consolidated into one class action lawsuit, captioned In re Cabletron Systems, Inc. Securities Litigation (C.A. No. 97-542-SD). The 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. By order of the Court dated March 18, 2003, the parties are now engaged in limited discovery. If the plaintiffs prevail on the merits of this case, we could be required to pay substantial damages.

     Securities Class Action in the District of New Hampshire. Between February 7, 2002 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

11

Table of Contents

In re Enterasys Networks, Inc. Securities Litigation (C.A. No. 02-CV-71). On December 9, 2002, the plaintiffs filed an amended consolidated complaint, adding two additional defendants, Piyush Patel, former chief executive officer of Cabletron Systems, Inc. (“Cabletron”) and David Kirkpatrick, former chief financial officer of Cabletron. The amended complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 there under. Specifically, plaintiffs allege that during periods spanning from June 28, 2000 and August 3, 2001 and in the period between August 6, 2001 and February 1, 2002 (together the “Class Period”), defendants issued materially false and misleading financial statements and press releases that overstated the Company’s revenues, income, and cash, and understated 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. A hearing on this motion has been scheduled to convene during the second quarter of fiscal year 2003. 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 Enrique Fiallo and certain members of the Company’s Board of Directors. Plaintiffs allege that the individual defendants breached their fiduciary duty to shareholders by causing or allowing the Company to conduct its business in an unsafe, imprudent, and unlawful manner and failing to implement and maintain an adequate internal accounting control system. Plaintiffs allege that this breach caused the Company to improperly recognize revenue in violation of GAAP and the Company’s own accounting policies in connection with transactions in the Company’s Asia Pacific region, and that this alleged wrongdoing resulted in damages to the Company. Plaintiffs seek unspecified compensatory damages. On October 7, 2002, the Superior Court approved the parties’ joint stipulation to stay proceedings.

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

     Other. In addition, the Company is involved in various other legal proceedings and claims arising in the ordinary course of business. Management believes that the disposition of these additional matters, individually or in the aggregate, is not expected to have a materially adverse effect on the financial condition of the Company. The Company believes it has adequately accrued for these matters at March 29, 2003.

Other

     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 the first quarter of fiscal year 2002, the Company made payments of $3.4 million related to these guarantees. As of March 29, 2003, the Company had remaining guarantees associated with these lease obligations of approximately $4.1 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 guarantees.

     In addition, the Company has guaranteed a portion of Aprisma’s lease obligations and related maintenance and management fees through 2012. At March 29, 2003, the amount of the guarantee was $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 $4.8 million to secure this guarantee.

     Through March 29, 2003, the Company has incurred legal and forensic accounting fees of approximately $22.5 million for

12

Table of Contents

services rendered in connection with the SEC investigation into the Company’s financial accounting and reporting practices, the subsequent restatement of the Company’s fiscal year 2001 and transition year 2001 financial statements, and the various shareholder lawsuits discussed above. The Company has not received a determination as to whether and to what extent costs incurred to date are reimbursable under its insurance coverage. These costs are expensed to operating expenses as they are incurred. Costs incurred during the three months ended March 29, 2003 and March 30, 2002 were $1.5 million and $3.5 million, respectively.

     The Company could be required 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 March 29, 2003 could be significantly diluted. The fund has not indicated that it expects to issue a material capital call in the near future.

14. Redemption of Series D and E Redeemable Convertible Preferred Stock

     On February 21, 2003, the holders of the Company’s Series D and E Preferred Stock (“Strategic Investors”) notified the Company of their intention to exercise their right to request redemption of these shares effective as of February 23, 2003. The Company redeemed these shares during the first quarter of fiscal year 2003 for $97.1 million, which is net of the value of the Riverstone shares sold by the Strategic Investors which partially offset the redemption liability.

15. 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. Revenue recognized from sales to investee companies was $0.3 million and $2.4 million for the three months ended March 29, 2003 and March 30, 2002, respectively and was related to cash transactions with normal terms and conditions.

Consulting Arrangements

     In connection with senior management resignations in September 2001, the Company entered into consulting arrangements with two former members of senior management to provide strategic advice and assistance to the Company for a period of one year. The Company paid consulting fees under these arrangements of approximately $60,000 in the three months ended March 30, 2002. These arrangements ended in September 2002.

16. Subsequent Event

     On April 16, 2003 the Company acquired the advanced routing intellectual property and certain equipment from Tenor Networks, Inc. in a cash transaction that did not have a material impact on the Company’s liquidity. In addition, the Company hired approximately 20 engineers from Tenor, including co-founders Leon K. Woo and Robert P. Ryan. Mr. Woo was named as the Executive Vice President of Engineering of the Company, and will lead the Company’s worldwide research and development activities.

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

     You should read the following discussion in conjunction with the section below titled “Cautionary Statements,” our consolidated financial statements and related notes, and other financial information appearing elsewhere in this report on Form 10-Q. We caution you that any statements contained in this report which are not strictly historical statements constitute forward-looking statements. Such statements include, but are not limited to, statements reflecting management’s expectations regarding our future financial performance; strategic relationships and market opportunities; and our other business and marketing strategies and objectives. These statements may be identified with such words as “we expect,” “we believe,” “we anticipate,” or similar indications of future expectations. These statements are neither promises nor guarantees, and involve risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Such risks and uncertainties include, among other things, the factors discussed below under “Cautionary Statements” and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward looking statements, which speak only as of the date hereof. We expressly disclaim any obligation to publicly update or revise any such statements to reflect any change in these forward-looking statements, or in events, conditions, or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements.

13

Table of Contents

     We refer to our current fiscal year, the twelve-month period ended January 3, 2004, as “fiscal year 2003” and our prior fiscal year, the twelve-month period ended December 28, 2002 as “fiscal year 2002” throughout this Item. We refer to the ten-month transition period from March 4, 2001 through December 29, 2001 as “transition year 2001” and the twelve-month period ended March 3, 2001 as “fiscal year 2001” throughout this Item.

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

Overview

     We are a global provider of Business Driven Networks™- enterprise networks that are optimized to support the specific business requirements of customers. We design, develop, market and support network infrastructure solutions that enhance the security, productivity and business agility of enterprise customers. Our global customer base includes commercial enterprises; governmental entities; health care, financial, educational and non-profit institutions; and other organizations.

     Net revenue declined in the first quarter of fiscal year 2003 as compared to the quarterly levels attained throughout fiscal year 2002 primarily due to the weak enterprise networking solutions market, particularly in North America, as well as the nature and timing of new product introductions.

     Throughout fiscal year 2002, we implemented cost reduction programs to improve gross margins and reduce fixed overhead costs. We intend to continue implementing cost reduction initiatives designed to further lower our fixed overhead cost structure. However, in the near term, we expect our cost reduction initiatives will be partially offset by additional efforts to accelerate system and process improvement initiatives, including costs to replace disparate management information systems in various international locations, and incremental marketing costs related to new product introductions.

     We intend to continue making appropriate investments in research and development. In April 2003, we introduced our new Matrix N Series of switching products which provide enterprises with a distributed switching architecture that scales up to 1.68 terabits of capacity, along with providing enhanced reliability and functionality. In tandem with the Matrix N Series release, we announced the new Distributed Forwarding Engine (“DFE”) modules which utilize our proprietary nTera family of application specific integrated circuits. The new DFE modules are compatible with our existing E Series switching products, which are designed to protect the investment of current Matrix series switch customers.

     Also in April 2003, we announced the acquisition of certain intellectual property of Tenor Networks. The acquisition of this intellectual property is intended to advance our core router development path which includes adding high performance Internet Protocol IP and Multiprotocol Label Switching capabilities to our current routing products. We have hired approximately 20 engineers from Tenor, including co-founders Mr. Leon Woo and Robert P. Ryan. Mr. Woo was named our Executive Vice President of Engineering, and will lead our worldwide research and development activities. The Tenor acquisition was a cash transaction that did not have a material impact on our liquidity or financial position.

14

Table of Contents

Results of Operations

     The table below sets forth the principal line items from our consolidated statement of operations. Product and services revenue, total cost of revenue, total gross margin, operating expenses and loss from operations are each expressed as a percentage of net revenue. Product and services cost of revenue and gross margin are expressed as a percentage of the respective product or services revenue.