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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE QUARTER ENDED JULY 3, 2004
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 01810
(978) 684-1000
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 in the Exchange Act) Yes [X] No[ ]
As of August 5, 2004 there were 210,485,577 shares of Enterasys common
stock, $0.01 par value, outstanding.
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TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets at July 3, 2004 and January 3, 2004......................................... 3
Consolidated Statements of Operations for the three and six months ended July 3, 2004 and June 28,...... 4
2003..................................................................................................
Consolidated Statements of Cash Flows for the six months ended July 3, 2004 and June 28, 2003........... 5
Notes to the Consolidated Financial Statements.......................................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................... 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................................ 32
Item 4. Controls and Procedures................................................................................... 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................... 33
Item 4. Submission of Matters to a Vote of Security Holders....................................................... 34
Item 6. Exhibits and Reports on Form 8-K.......................................................................... 34
Signatures........................................................................................................ 36
2
PART I-- FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
JULY 3, JANUARY 3,
2004 2004
----------- -----------
(IN THOUSANDS, EXCEPT SHARE
AND PER SHARE AMOUNTS)
(unaudited) (a)
ASSETS
Current assets:
Cash and cash equivalents .................................................................. $ 79,683 $ 136,801
Marketable securities ...................................................................... 28,393 29,851
Accounts receivable, net ................................................................... 36,970 37,541
Inventories ................................................................................ 28,111 29,049
Income tax receivable ...................................................................... 1,525 595
Prepaid expenses and other current assets .................................................. 20,159 18,497
----------- -----------
Total current assets ................................................................ 194,841 252,334
Restricted cash, cash equivalents and marketable securities ................................... 10,613 18,693
Long-term marketable securities ............................................................... 54,685 35,803
Investments ................................................................................... 1,896 11,417
Property, plant and equipment, net ............................................................ 34,540 37,881
Goodwill ...................................................................................... 15,129 15,129
Intangible assets, net ........................................................................ 6,091 17,353
----------- -----------
Total assets ........................................................................ $ 317,795 $ 388,610
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................................... $ 42,093 $ 39,738
Accrued compensation and benefits .......................................................... 23,842 26,832
Accrued legal and litigation costs ......................................................... 8,684 8,338
Accrued restructuring charges .............................................................. 6,245 6,407
Other accrued expenses ..................................................................... 18,910 24,114
Deferred revenue ........................................................................... 40,215 41,187
Customer advances and billings in excess of revenues ....................................... 5,644 7,323
Income taxes payable ....................................................................... 37,652 44,275
----------- -----------
Total current liabilities ........................................................... 183,285 198,214
Long-term deferred revenue ................................................................. 3,818 6,217
Long-term accrued restructuring charges .................................................... 3,886 4,118
----------- -----------
Total liabilities ................................................................... 190,989 208,549
Commitments and contingencies
Stockholders' equity:
Series F preferred stock, $1.00 par value; 300,000 shares authorized; none outstanding ..... -- --
Undesignated preferred stock, $1.00 par value; 1,700,000 shares authorized; none
outstanding............................................................................. -- --
Common stock, $0.01 par value; 450,000,000 shares authorized; 211,844,575 and
210,805,013 shares issued at July 3, 2004 and January 3, 2004, respectively ............ 2,118 2,108
Additional paid-in capital ................................................................. 1,190,398 1,187,449
Accumulated deficit ........................................................................ (1,045,208) (990,250)
Treasury stock, at cost; 1,748,861 common shares at July 3, 2004 and January 3, 2004 ....... (30,119) (30,119)
Accumulated other comprehensive income ..................................................... 9,617 10,873
----------- -----------
Total stockholders' equity .......................................................... 126,806 180,061
----------- -----------
Total liabilities and stockholders' equity .......................................... $ 317,795 $ 388,610
=========== ===========
(a) The balance sheet at January 3, 2004 has been derived from the audited
consolidated financial statements at that date, but does not include all
the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements.
See accompanying notes to consolidated financial statements.
3
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
---------------------- ----------------------
JULY 3, JUNE 28, JULY 3, JUNE 28,
2004 2003 2004 2003
--------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net revenue:
Product .................................................. $ 67,424 $ 79,973 $ 130,223 $ 154,434
Services ................................................. 24,310 28,402 48,705 58,398
--------- --------- --------- ---------
Total net revenue ..................................... 91,734 108,375 178,928 212,832
--------- --------- --------- ---------
Cost of revenue:
Product .................................................. 34,879 43,209 68,281 84,746
Services ................................................. 9,768 10,628 19,792 20,598
--------- --------- --------- ---------
Total cost of revenue ................................. 44,647 53,837 88,073 105,344
--------- --------- --------- ---------
Gross margin .......................................... 47,087 54,538 90,855 107,488
Operating expenses:
Research and development ................................. 19,670 22,065 40,144 42,106
Selling, general and administrative ...................... 45,534 44,777 87,976 89,445
Amortization of intangible assets ........................ 929 1,571 2,527 3,308
Impairment of intangible assets .......................... -- -- 8,734 --
Restructuring charges .................................... 1,408 8,203 5,893 8,203
--------- --------- --------- ---------
Total operating expenses .............................. 67,541 76,616 145,274 143,062
--------- --------- --------- ---------
Loss from operations .................................. (20,454) (22,078) (54,419) (35,574)
Interest income, net ........................................... 800 1,509 1,650 3,170
Other expense, net ............................................. (6,349) (14,804) (9,216) (14,513)
--------- --------- --------- ---------
Loss before income taxes............................... (26,003) (35,373) (61,985) (46,917)
Income tax (benefit) expense ................................... (6,744) -- (7,027) 749
--------- --------- --------- ---------
Net loss .............................................. (19,259) (35,373) (54,958) (47,666)
Accretive dividend and accretion of discount on preferred
shares................................................... -- -- -- (2,192)
--------- --------- --------- ---------
Net loss available to common shareholders ............. $ (19,259) $ (35,373) $ (54,958) $ (49,858)
========= ========= ========= =========
Basic and diluted loss per common share:
Net loss available to common shareholders ................ $ (0.09) $ (0.17) $ (0.25) $ (0.25)
========= ========= ========= =========
Weighted average number of common shares
outstanding, basic and diluted ........................... 217,497 203,344 217,274 202,771
========= ========= ========= =========
See accompanying notes to consolidated financial statements.
4
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
---------------------------
JULY 3, 2004 JUNE 28,2003
------------ ------------
(IN THOUSANDS)
Cash flows from operating activities: .
Net loss .................................................................. $ (54,958) $ (47,666)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization ........................................ 11,922 14,900
Provision for recoveries on accounts receivable ...................... (1,000) (4,320)
Provision for inventory write-downs .................................. 7,590 2,790
Impairment of intangibles ............................................ 8,734 --
Recovery of notes receivable ......................................... -- (2,450)
Loss on investment write-downs ....................................... 9,998 16,250
Unrealized loss on foreign currency transactions ..................... 181 3,627
Non-cash tax benefit ................................................. (7,746) --
Other, net ........................................................... (337) (833)
Changes in current assets and liabilities:
Accounts receivable ....................................................... 1,130 9,266
Inventories ............................................................... (6,841) 2,822
Prepaid expenses and other current assets ................................. (2,271) 2,665
Accounts payable and accrued expenses ..................................... (5,524) (26,437)
Customer advances and billings in excess of revenues ...................... (1,679) 3,599
Deferred revenue .......................................................... (3,204) (6,652)
Income taxes receivable, net .............................................. 803 29,058
----------- -----------
Net cash used in operating activities ................................ (43,202) (3,381)
----------- -----------
Cash flows from investing activities:
Capital expenditures ...................................................... (6,132) (8,231)
Proceeds from sale of building ............................................ -- 625
Proceeds from sale of investments ......................................... 1,171 1,103
Purchase of investments ................................................... (1,450) --
Purchase of marketable securities ......................................... (34,360) (39,022)
Sales and maturities of marketable securities ............................. 16,241 105,956
Release of restricted cash ................................................ 8,031 --
----------- -----------
Net cash (used in) provided by investing activities .................. (16,499) 60,431
----------- -----------
Cash flows from financing activities:
Proceeds from exercise of stock options ................................... 1,753 2,597
Proceeds from common stock issued pursuant to employee stock
purchase plans ......................................................... 1,209 826
Proceeds from notes receivable ............................................ -- 4,950
Net payments for redemption of Series D and E Preferred Stock ............. -- (96,814)
----------- -----------
Net cash provided by (used in) financing activities .................. 2,962 (88,441)
----------- -----------
Effect of exchange rate changes on cash ........................................ (379) 871
----------- -----------
Net decrease in cash and cash equivalents ...................................... (57,118) (30,520)
Cash and cash equivalents at beginning of period ............................... 136,801 136,193
----------- -----------
Cash and cash equivalents at end of period ..................................... $ 79,683 $ 105,673
=========== ===========
Supplemental disclosure of cash flow information:
Cash (paid) refunds received for income taxes, net ....................... $ (200) $ 31,159
Non-cash investing and financing transactions:
Accretive dividend and accretion of discount on preferred shares ..... $ -- $ 2,192
Note receivable from sale of building ................................ $ -- $ 625
See accompanying notes to consolidated financial statements.
5
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 3 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the United States 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 January 3, 2004.
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
accounting principles generally accepted in the United States of America
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.
STOCK-BASED COMPENSATION PLANS
The Company accounts for stock-based compensation plans using the
intrinsic method under the recognition and measurement principles of Accounting
Principles Board ("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 Statement of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS
No. 148, "Accounting for Stock-Based Compensation -- Disclosure," to stock-based
employee compensation:
THREE MONTHS ENDED SIX MONTHS ENDED
------------------------ ------------------------
JULY 3, JUNE 28, JULY 3, JUNE 28,
2004 2003 2004 2003
---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net loss available to common shareholders, as reported $ (19,259) $ (35,373) $ (54,958) $ (49,858)
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 (3,439) (5,013) (8,622) (10,204)
---------- ---------- ---------- ----------
Pro forma net loss available to common shareholders ................. $ (22,698) $ (40,386) $ (63,580) $ (60,062)
========== ========== ========== ==========
Basic and diluted net loss per share:
As reported ...................................................... $ (0.09) $ (0.17) $ (0.25) $ (0.25)
========== ========== ========== ==========
Pro forma ........................................................ $ (0.10) $ (0.20) $ (0.29) $ (0.30)
========== ========== ========== ==========
6
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - CONTINUED
The pro forma information above has been prepared as if the Company had
accounted for its employee stock options (including shares issued under the
Employee Stock Purchase Plan) 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:
THREE MONTHS ENDED SIX MONTHS ENDED
---------------------------- --------------------------
JULY 3, JUNE 28, JULY 3, JUNE 28,
2004 2003 2004 2003
------------ ----------- ----------- -----------
Employee stock options:
Risk-free interest rate.......................... 3.62% 2.52% 3.08% 2.58%
Expected option life............................. 4.47.years 5.37 years 4.51 years 5.38 years
Expected volatility.............................. 111.46% 111.71% 112.18% 111.61%
Expected dividend yield.......................... 0.0% 0.0% 0.0% 0.0%
Fair value of options granted.................... $ 1.50 $ 1.83 $ 2.89 $ 1.78
Employee stock purchase plan shares:
Risk-free interest rate.......................... 1.02% 1.83% 1.02% 1.83%
Expected option life............................. 6.months 6 months 6 months 6 months
Expected volatility.............................. 75.41% 111.97% 72.9% 111.97%
Expected dividend yield.......................... 0.0% 0.0% 0.0% 0.0%
Fair value of plan shares........................ $ 1.85 $ 0.80 $ 1.67 $ 0.80
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 December 2003, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 104 ("SAB No. 104"), "Revenue Recognition" which revises
or rescinds portions of the interpretative guidance included in Topic 13 of the
codification of staff accounting bulletins in order to provide consistent
guidance with respect to selected revenue recognition issues. The adoption of
SAB No. 104 did not have a material effect on the Company's consolidated
financial statements.
In March 2004, the FASB issued Emerging Issues Task Force ("EITF") No.
03-1, "The Meaning of Other-than-Temporary Impairment and Its Application to
Certain Investments" which provides additional guidance on how companies,
carrying debt and equity securities at amounts higher than the securities fair
values, evaluate whether to record a loss on impairment. In addition, EITF No.
03-1 provides guidance on additional disclosures required about unrealized
losses. The impairment accounting guidance is effective for reporting periods
beginning after June 15, 2004 and the disclosure requirements are effective for
annual reporting periods ending after June 15, 2004. The Company does not expect
the adoption of this statement will have a material impact on its consolidated
financial statements.
RECLASSIFICATIONS
Certain prior period balances have been reclassified to conform to the
current period presentation.
7
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- CONTINUED
3. ACCOUNTS RECEIVABLE
Accounts receivable were as follows:
JULY 3, 2004 JANUARY 3, 2004
------------ ---------------
(IN THOUSANDS)
Gross accounts receivable ......... $ 38,771 $ 40,938
Allowance for doubtful accounts ... (1,801) (3,397)
---------- ----------
Accounts receivable, net ........ $ 36,970 $ 37,541
========== ==========
The Company defers revenue on product shipments to certain stocking
distributors until those distributors have sold the product to their customer.
At July 3, 2004 and January 3, 2004 $15.6 million and $19.1 million,
respectively, of product shipments had been billed and revenue has not been
recognized, of which $4.9 million and $6.2 million, respectively, was paid and
is included in customer advances and billings in excess of revenues. The balance
of $10.7 million and $12.9 million, respectively, was unpaid and is recorded as
a contra account to gross accounts receivable.
4. INVENTORIES
Inventories consisted of the following:
JULY 3, 2004 JANUARY 3, 2004
------------ ---------------
(IN THOUSANDS)
Raw materials..................... $ 2,591 $ 4,170
Service spares.................... 1,973 2,184
Finished goods.................... 23,547 22,695
------- -------
Inventories..................... $28,111 $29,049
======= =======
5. INTANGIBLE ASSETS
During the first quarter of fiscal year 2004, the Company recorded an
impairment charge of $8.7 million relating to the write-down of patents and
technology intangible assets recorded in connection with the Company's fiscal
year 2001 acquisition of Indus River Networks. In conjunction with the Company's
first quarter restructuring plan, the Company decided to curtail certain
development efforts which reduced forecasted demand on future products that
would have used this technology. As a result, the intangible assets' fair value
was determined to be zero based on a discounted cash flows analysis.
The table below presents gross amortizable intangible assets and the related
accumulated amortization at July 3, 2004:
GROSS NET CARRYING
CARRYING ACCUMULATED VALUE OF
AMOUNT AMORTIZATION INTANGIBLE ASSETS
---------- ------------ -----------------
(IN THOUSANDS)
Customer Relations....... $ 28,600 $ (23,756) $ 4,844
Patents and Technology... 17,092 (15,845) 1,247
---------- ---------- ----------
Total ................. $ 45,692 $ (39,601) $ 6,091
========== ========== ==========
All of the Company's identifiable intangible assets are subject to
amortization. Total amortization expense was $0.9 million and $2.5 million for
the three months and six months ended July 3, 2004, respectively and $1.6
million and $3.3 million for the three and six months ended June 28, 2003,
respectively. Based on the net carrying value of intangible assets at July 3,
2004, the estimated amortization expense is $1.9 million for the remainder of
fiscal year 2004; $3.7 million for fiscal year 2005 and $0.5 million for fiscal
year 2006.
8
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - CONTINUED
6. OTHER ACCRUED EXPENSES
Other accrued expenses consisted of the following:
JULY 3, 2004 JANUARY 3, 2004
------------ ---------------
(IN THOUSANDS)
Accrued audit and accounting expense.. $ 1,795 $ 2,285
Accrued marketing and selling costs... 6,374 7,180
Accrued royalties .................... 1,109 337
Accrued IT and engineering ........... 1,394 1,544
Accrued utilities .................... 1,249 822
Accrued sales tax and VAT expense..... 566 4,462
Other ................................ 6,423 7,484
---------- ------------
Total other accrued expenses ...... $ 18,910 $ 24,114
========== ============
7. RESTRUCTURING CHARGES
The following table summarizes accrued restructuring activity:
SEVERANCE FACILITY EXIT
BENEFITS COSTS TOTAL
-------- ----- -----
(IN THOUSANDS)
Balance, March 29, 2003 ............. $ 825 $ 5,522 $ 6,347
Q2 restructuring charge ......... 7,431 772 8,203
Q2 cash payments ................ (1,908) (282) (2,190)
------- ------- --------
Balance, June 28, 2003 .............. 6,348 6,012 12,360
Q3 restructuring charge ......... 6,282 2,056 8,338
Q3 cash payments ................ (6,416) (1,072) (7,488)
------- ------- --------
Balance, September 27, 2003 ......... 6,214 6,996 13,210
Q4 restructuring charge ......... 990 -- 990
Q4 cash payments ................ (3,362) (313) (3,675)
------- ------- --------
Balance, January 3, 2004 ............ 3,842 6,683 10,525
Q1 restructuring charge ......... 3,800 685 4,485
Q1 cash payments ................ (2,161) (777) (2,938)
------- ------- --------
Balance, April 3, 2004 ............. 5,481 6,591 12,072
Q2 restructuring charge ......... 1,173 235 1,408
Q2 cash payments ................ (2,518) (831) (3,349)
------- ------- --------
Balance, July 3, 2004 .............. $ 4,136 $ 5,995 $ 10,131
======= ======= ========
During the first six months of fiscal year 2004, the Company developed a
plan to align the cost structure of the Company's business with its Secure
Networks strategy. The implementation of this plan is targeted to reduce the
Company's global headcount by approximately 200 individuals from the Company's
2003 fiscal year end headcount, or 14% of the global workforce. Additionally,
the Company has exited three facilities during the first six months of fiscal
year 2004. In connection with this workforce reduction plan, the Company has
recorded restructuring charges of $5.9 million during the first six months of
fiscal year 2004 which included severance charges of $5.0 million, and facility
exit costs of $0.9 million to exit a research facility and two regional sales
offices.
The remaining accrued severance cost of $4.1 million as of July 3, 2004
will be paid over the next twelve months; and the remaining accrued facility
exit costs of $6.0 million, which consists of long-term lease commitments less
projected sublease income, will be paid as follows: $1.5 million for the
remainder of fiscal year 2004, $1.2 million in fiscal year 2005, $1.3 million in
fiscal year 2006, $0.4 million in fiscal year 2007 and fiscal year 2008, and
$1.2 million thereafter.
During fiscal year 2003, the Company evaluated the workforce and skill
levels necessary to satisfy the expected future requirements of the business. As
a result, the Company implemented plans to eliminate positions, and realigned
and modified certain roles based on skill assessments. The Company recorded
restructuring charges of $17.5 million in fiscal year 2003, which included $14.7
million in employee severance related costs for approximately 405 individuals.
The fiscal year 2003 reductions in the global workforce involved most functions
within the Company. The Company also recorded $2.8 million of facility exit
costs in fiscal year 2003 primarily as a result of consolidation of its North
American distribution center into an owned facility with excess space and a
decrease in estimated future sublease income anticipated from a vacated
facility.
9
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - CONTINUED
8. OTHER EXPENSE, NET
The following schedule reflects the components of other expense, net:
THREE MONTHS ENDED SIX MONTHS ENDED
------------------ ----------------
JULY 3, 2004 JUNE 28, 2003 JULY 3, 2004 JUNE 28, 2003
------------ ------------- ------------ -------------
(IN THOUSANDS)
Impairment of minority investments ......................... $(6,578) $(16,068) $(9,998) $(16,250)
Unrealized gain on Riverstone stock derivative ............. - - - 178
Net realized gain on sale of marketable securities ......... 75 650 137 776
Recovery of note receivable ................................ - - - 2,450
Foreign currency gain (loss) ............................... 135 (333) (123) (2,860)
Other, net ................................................. 19 947 768 1,193
------- -------- ------- --------
Total other expense, net ................................ $(6,349) $(14,804) $(9,216) $(14,513)
======= ======== ======= ========
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. Many factors are considered for assessing potential impairments.
Such events or factors include 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. From
time to time, the Company may also engage third party experts to estimate the
recoverable value of investments management may consider selling. The Company is
currently considering selling its interest in one private venture fund.
At December 28, 2002, the Company had a valuation allowance of $3.6
million on the balance of a note receivable, issued as part of 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 the 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.
At July 3, 2004, the remaining balance on the note receivable of $1.1 million
remains unpaid, and is fully offset by a valuation allowance.
9. INCOME TAXES
The Company recorded a net income tax benefit of $7.0 million for the
first six months of fiscal year 2004, compared with income tax expense of $0.7
million for the first six months of fiscal year 2003. Based on Internal Revenue
Service ("IRS") guidance issued at the end of the Company's first quarter of
fiscal year 2004, the Company filed documentation with the IRS shortly following
the end of the second quarter of fiscal year 2004 enabling the Company to
recognize a reduction to accrued tax liabilities of $11.9 million in fiscal year
2004. Approximately $7.7 million of the liability reduction was recognized as a
tax benefit during the second quarter of fiscal year 2004, and the remaining
$4.2 million will be recognized during the remainder of fiscal year 2004.
10. COMPREHENSIVE LOSS
The Company's total comprehensive loss was as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
------------------------------ -----------------------------
JULY 3, 2004 JUNE 28, 2003 JULY 3, 2004 JUNE 28, 2003
------------ ------------- ------------ -------------
(IN THOUSANDS)
Net loss .................................... $(19,259) $(35,373) $(54,958) $(47,666)
Other comprehensive income (loss):
Unrealized loss on marketable securities.. (858) (746) (881) (1,087)
Foreign currency translation adjustment... (494) 2,819 (375) 5,206
-------- -------- -------- --------
Total comprehensive loss ............... $(20,611) $(33,300) $(56,214) $(43,547)
======== ======== ======== ========
10
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - CONTINUED
11. SEGMENT INFORMATION
The Company operates its business as one segment, which is the business of
designing, developing, marketing and supporting comprehensive networking
solutions.
Net revenue by geography is as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
------------------------------------- -------------------------------------
JULY 3, 2004 JUNE 28, 2003 JULY 3, 2004 JUNE 28, 2003
---------------- ------------------ ----------------- -----------------
REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT
------- ------- ------- ------- ------- ------- ------- -------
($ IN THOUSANDS)
North America ...................................... $45,193 49.3% $ 54,946 50.7% $ 84,717 47.4% $106,323 50.0%
Europe, Middle East and Africa ..................... 31,202 34.0 31,477 29.0 63,122 35.3 66,852 31.4
Asia Pacific ....................................... 8,731 9.5 15,348 14.2 17,976 10.0 25,484 12.0
Latin America ...................................... 6,608 7.2 6,604 6.1 13,113 7.3 14,173 6.6
------- ----- -------- ----- -------- ----- -------- -----
Total net revenue ............................. $91,734 100.0% $108,375 100.0% $178,928 100.0% $212,832 100.0%
======= ===== ======== ===== ======== ===== ======== =====
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 28.6 million
and 27.8 million shares of common stock were outstanding at July 3, 2004 and
June 28, 2003, respectively, and 7.9 million warrants to purchase shares of the
Company's common stock were outstanding at July 3, 2004 and June 28, 2003 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 its 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 the material legal proceedings in which we are
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-JD (N.H.); No. 99-408-S (R.I.)). The case
was referred to the District of Rhode Island. The complaint alleges that the
Company and several of its officers and directors disseminated materially false
and misleading information about its operations and acted in violation of
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder 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 its common stock during this period.
The complaint does not specify the amount of damages sought on behalf of the
class. The defendants have filed an answer denying the allegations in all
material respects, and the parties are engaged in limited discovery. If the
plaintiffs prevail on the merits of this case, the Company could be required to
pay substantial damages.
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. However, depending on the amount
and timing of such disposition, an unfavorable resolution of some or all of
these matters could materially affect the Company's future results of operations
or cash flows in a particular period.
11
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - CONTINUED
The Company maintains an accrual for various legal and litigation
expenses, which amounted to an aggregate of $8.7 million at July 3, 2004. The
Company could be obligated to pay up to approximately $3.8 million of the
accrued amounts as early as the third quarter of fiscal year 2004, as a result
of final disposition of certain litigation matters.
INDEMNIFICATION CLAIMS
The Company's certificate of incorporation provides for indemnification
and advancement of certain litigation and other expenses to the Company's
directors and certain of its officers to the maximum extent permitted by
Delaware law. Accordingly, the Company, from time to time, may be required to
indemnify directors and certain of its officers, including former directors and
officers, in various litigation matters, claims or proceedings. The Company
recorded operating expenses of approximately $1.1 million and $2.2 million, for
the three and six months ended July 3, 2004, respectively, in legal expenses
relating to such matters. The Company is currently engaged in legal proceedings
against certain insurers to recover these and other expenses and costs incurred
by the Company in connection with the related litigation matters, claims and
proceedings.
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 equipment sales of Riverstone, an entity which
was spun off in 2001. During fiscal year 2003, the Company entered into a $5.5
million settlement agreement with a Riverstone customer for reimbursement of
lease guarantee payments made by the Company related to default guarantees of
the customer's equipment lease obligations provided in prior years. The Company
recorded the initial receipt of $2.0 million, in fiscal year 2003, as a
reduction to selling, general and administrative expense in fiscal year 2003,
and the balance of $3.5 million will be paid in 24 installments and recorded as
a reduction to operating expense when received due to the uncertainty regarding
collectibility of the unpaid amounts. At July 3, 2004, the balance remaining to
be received is $1.9 million.
In addition, the Company has guaranteed a portion of a former subsidiary's
(Aprisma) lease obligations and related maintenance and management fees through
2012. At July 3, 2004, 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 by the acquirer of Aprisma 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.
The Company is committed to make up to $8.2 million of additional capital
contributions to a venture capital fund in which it is a limited partner. This
commitment decreased by $3.8 million from the prior quarter due to the sale of
one partnership interest and an additional capital call. 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, it may be
obligated to immediately pay aggregate capital contributions of $18.2 million
based on the original commitment. Based on recent communications from this fund,
the Company expects approximately $1.0 million to $2.0 million of the remaining
commitment could be called by the fund during the remainder of fiscal year 2004.
The Company cannot predict the likelihood or timing of capital calls for the
remaining commitment. The Company is pursuing the sale of its partnership
interest in this fund to minimize future capital call funding requirements.
14. 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 or exert any managerial control. Revenue recognized from sales to
investee companies was $2.3 million and $4.4 million for the three and six
months ended July 3, 2004, respectively, and $3.2 million and $3.5 million for
the three and six months ended June 28, 2003, respectively, and was related to
transactions with normal terms and conditions.
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
12
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.
We refer to our current fiscal year, the twelve-month period ending
January 1, 2005 as "fiscal year 2004" and our prior fiscal year, the
twelve-month period ended January 3, 2004 as "fiscal year 2003" throughout this
Item. We refer to the twelve-month period ended December 28, 2002 as "fiscal
year 2002" and the ten-month transition period from March 4, 2001 through
December 29, 2001 as "transition year 2001" throughout this Item.
All references in this quarterly report to "Enterasys Networks," "we,"
"our," or "us" mean Enterasys Networks, Inc.
OVERVIEW
We design, develop, market, and support comprehensive networking solutions
architected to address the networking requirements of global enterprises. We
believe our solutions offer customers the secure, high-capacity, cost-effective,
network connectivity required to facilitate the exchange of information among
employees, customers, vendors, partners and other network users. We are focused
on delivering networking solutions that include security features within the
network architecture. We believe our solutions enable customers to meet their
requirements for network continuity, context, control, compliance and
consolidation through an architecture and management interface designed for ease
of use. Our installed base of customers consists of commercial enterprises;
governmental entities; healthcare, financial, educational and non-profit
institutions; and various other organizations. Our product revenue consists
primarily of sales of our network hardware, including switches, routers,
wireless devices and other networking equipment. Product revenue also includes
revenue from the sale of our software products, including our Dragon intrusion
detection software and our NetSight Atlas network management software. Our
services revenue is derived from our contracts to provide on-going maintenance
and support services around the world, 7 days a week, 24 hours a day, network
outsourcing contracts and also to provide installation and professional services
to install, develop and improve network performance and capabilities.
Net revenues were $178.9 million for the first half of fiscal year 2004,
which represents a 15.9% decrease from the first half of fiscal year 2003. Net
revenues for the second quarter of fiscal year 2004 increased 5.2% from the
first quarter of fiscal year 2004. The year over year decline in net revenue is
the result of lower sales from older generation products, primarily our core
routing products, that were only partially offset by sales of new switching
products; declining service revenue due to the expiration of maintenance
contracts on older generation products; and sales productivity issues, mainly in
North America. We believe the sequential increase in quarterly net revenue is
due primarily to new product sales and improving sales productivity,
particularly in North America.
We are focused on implementing changes to further improve our competitive
position and sales productivity as well as continuing our product refresh,
consistent with our goal of increasing net revenues. During the first half of
fiscal year 2004, we:
- Appointed a new Executive Vice President of Worldwide Sales
and Service, and appointed several new senior sales leaders in
North America;
- Launched an advertising campaign focusing on our Secure
Networks(TM) solutions;
- Formed a new alliance with Lucent Technologies aimed at
broadening our market reach through the Lucent professional
services organization;
- Began implementing enhancements to our two-tier partner
programs designed to further leverage the capabilities of our
value added resellers;
- Focused our efforts on increasing sales opportunities through
our global partners: EDS, IBM, Lucent, Siemens and Dell;
- Initiated a cost reduction plan intended to ultimately reduce
our annual costs by an aggregate of approximately $28 million,
consisting of approximately $24 million in reduced annual
operating expenses and $4 million in reduced cost of revenue
from the first quarter 2004 levels.
- Continued the refresh of our entire product line including
introducing eleven new modules for our Matrix N Series
switching products, and releasing enhancements to our Secure
Networks offering with our Trusted End Systems (TES) admission
control functionality and our Dynamic Intrusion Response
(DIR) detection and intervention capability.
The successful introduction of our new products is essential to our goal
of increasing revenue from the levels attained during the second quarter of
fiscal year 2004. New product revenue, defined as revenue realized from products
introduced during the prior
13
twelve months, accounted for approximately 50% of product shipments during the
second quarter of fiscal year 2004. Our new Matrix N Series switching products,
which were introduced midway through the second quarter of fiscal year 2003
accounted for approximately 36% of product shipments during the second quarter
of fiscal year 2004, up from 33% of product shipments during the first quarter
of fiscal year 2004.
During the first quarter of fiscal year 2004, we developed and began
implementing a plan to align the cost structure of our business with our Secure
Networks strategy. The implementation of this plan is targeted to reduce our
global headcount by approximately 200 individuals from our 2003 fiscal year end
headcount, or 14% of the global workforce. At the end of the second quarter of
fiscal year 2004, our headcount stood at 1,276 compared with 1,564 at the end of
the second quarter of fiscal year 2003. Additionally, we have exited three
facilities during the first half of fiscal year 2004, and we may close
additional offices as we consolidate our excess space. In connection with this
workforce reduction plan, we recorded a severance charge of $5.0 million, and we
recorded facility exit costs of $0.9 million to exit a research facility and two
regional sales offices. The implementation of this plan, which should be
completed by the end of fiscal year 2004, is intended to reduce our annual costs
by approximately an aggregate of $28 million, or approximately $7 million per
quarter compared to the first quarter of fiscal year 2004. The workforce
reductions involve all functions of our business. To the extent we identify
additional costs savings opportunities, there could be additional restructuring
charges in future periods.
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 total net revenue. Product and services cost of
revenue and gross margin are expressed as a percentage of the respective product
or services revenue.
THREE MONTHS ENDED SIX MONTHS ENDED
---------------------------- ---------------------------
JULY 3, 2004 JUNE 28, 2003 JULY 3, 2004 JUNE 28, 2003
------------ ------------- ------------ -------------
Net revenue:
Product ......................... 73.5% 73.8% 72.8% 72.6%
Services ........................ 26.5 26.2 27.2 27.4
----- ----- ----- -----
Total net revenue ......... 100.0 100.0 100.0 100.0
----- ----- ----- -----
Cost of revenue:
Product ........................ 51.7 54.0 52.4 54.9
Services ....................... 40.2 37.4 40.6 35.3
----- ----- ----- -----
Total cost of revenue .... 48.7 49.7 49.2 49.5
----- ----- ----- -----
Gross Margin:
Product gross margin ........... 48.3 46.0 47.6 45.1
Services gross margin .......... 59.8 62.6 59.4 64.7
----- ----- ----- -----
Total gross margin ....... 51.3 50.3 50.8 50.5
----- ----- ----- -----
Research and development ............ 21.5 20.3 22.4 19.7
Selling, general and administrative.. 49.6 41.3 49.2 42.0
Amortization of intangible assets ... 1.0 1.5 1.4 1.6
Impairment of intangible assets ..... -- -- 4.9 --
Restructuring charges ............... 1.5 7.6 3.3 3.9
----- ----- ----- -----
Total operating expenses.. 73.6 70.7 81.2 67.2
----- ----- ----- -----
Loss from operations ..... (22.3)% (20.4)% (30.4)% (16.7)%
===== ===== ===== =====
SECOND QUARTER OF FISCAL YEAR 2004 COMPARED TO THE SECOND QUARTER OF FISCAL YEAR
2003
NET REVENUE
Net revenue decreased by $16.7 million, or 15.4%, from $108.4 million in
the second quarter of fiscal year 2003 to $91.7 million in the second quarter of
fiscal year 2004 due to lower product sales as well as lower revenue from
maintenance contracts. Geographically, net revenue decreased from the second
quarter of fiscal 2003 to the second quarter of fiscal 2004 by 17.8%, or $9.8
14
million in North America, and by 43.1%, or $6.6 million in Asia Pacific,
primarily due to weakness in China. Revenue in EMEA and Latin America was
relatively flat for the second quarter of fiscal year 2004 as compared to the
second quarter of fiscal year 2003.
Net product revenue decreased by $12.6 million, or 15.8%, from $80.0
million in the second quarter of fiscal year 2003 to $67.4 million in the second
quarter of fiscal year 2004. The decline in net product revenue is primarily a
result of lower sales from older generation products, such as our core routing
products, that were only partially offset by sales of new products. Sales of our
older generation core routing products declined to 5.8% of product revenue for
the second quarter of fiscal year 2004, as compared to 13.2% for the second
quarter of fiscal year 2003. We are targeting to release our next generation
core routing product, the Matrix X Series, during the first quarter of fiscal
year 2005.
Net services revenue decreased by $4.1 million, or 14.4%, from $28.4
million in the second quarter of fiscal year 2003 to $24.3 million in the second
quarter of fiscal year 2004. The decrease in net services revenue is primarily
due to a declining maintenance revenue base resulting from the expiration of
higher priced maintenance contracts on older generation products, as well as a
reduction in volume and price on outsourcing contracts. In the near term, we
expect approximately a 5% decline in net services revenue from the levels
attained for the second quarter of fiscal year 2004.
GROSS MARGIN
Total gross margin decreased by $7.4 million, from $54.5 million in the
second quarter of fiscal year 2003 to $47.1 million in the second quarter of
fiscal year 2004. Total gross margin as a percentage of net revenue increased to
51.3% in the second quarter of fiscal year 2004, as compared to 50.3% in the
second quarter of fiscal year 2003.
Product gross margin increased to 48.3% compared to 46.0% in the second
quarter of fiscal year 2003. The product gross margin percentage improvement was
principally due to higher profit margins on newer products, as well as reduced
overhead costs due to cost reduction initiatives. This cost improvement was
partially offset by an increase in provisions for excess and obsolete
inventories. We recorded a $3.4 million charge for excess and obsolete inventory
during the second quarter of fiscal year 2004 due to lower projected sales of
older generation products. During the second quarter of fiscal year 2003, we
recorded a charge for excess and obsolete inventory of $0.9 million.
Despite lowering service related overhead, services gross margin
percentage decreased from 62.6% in the second quarter of fiscal year 2003 to
59.8% in the second quarter of fiscal year 2004, primarily due to the 14.4%
decline in net services revenue. We expect that services gross margin percentage
will not increase much above 60% until the growth in new product sales and
associated maintenance contracts are sufficient to replace the expiration of
legacy maintenance contracts.
OPERATING EXPENSES
Research and development expense decreased by $2.4 million from $22.1
million in the second quarter of fiscal year 2003, to $19.7 million in the
second quarter of fiscal year 2004. The decrease in research and development
expenses from the prior year was primarily due to a decrease in labor costs of
$1.5 million as a result of the implementation of cost reduction initiatives.
Selling, general and administrative ("SG&A") expense increased by $0.7
million from $44.8 million in the second quarter of fiscal year 2003 to $45.5
million in the second quarter of fiscal year 2004. The increase in SG&A expense
was primarily the result of reduced recoveries of bad debts and lease guarantees
of $5.1 million and an increase of $1.9 million in marketing and advertising
expenditures relating to the launch of our Secure Networks campaign. These
increases were partially offset by a decrease in labor costs of $3.5 million, a
decrease in outside service costs of $1.1 million and a decrease in facilities
costs of $0.4 million, all related to our cost reduction plans. During the
second quarter of fiscal year 2004, we recorded as SG&A expense approximately
$1.1 million in legal expenses related to indemnification of individuals in
connection with various litigation matters, claims and proceedings. We could
continue to incur such costs over the next several quarters.
The implementation of our cost reduction plan, which should be completed
by the end of fiscal year 2004, is intended to reduce our annual operating
expenses by approximately $24 million or approximately $6 million per quarter
compared to the first quarter of fiscal year 2004.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets decreased by $0.7 million from $1.6
million in the second quarter of fiscal year 2003 to $0.9 million in the second
quarter of fiscal year 2004 as a result of the impairment and related write off
of certain intangible assets during the first quarter of fiscal year 2004 and
other intangibles becoming fully amortized.
15
RESTRUCTURING CHARGES
During the first quarter of fiscal year 2004, we developed a plan to align
the cost structure of our business with our Secure Networks strategy. The
implementation of this plan is targeted to reduce our global headcount by
approximately 200 individuals from our year end fiscal year 2003 headcount, or
14% of the global workforce. In connection with this workforce reduction plan,
we recorded during the second quarter of fiscal year 2004 a severance charge of
$1.2 million and facility exit costs of $0.2 million to exit a regional sales
office. During the second quarter of fiscal year 2003, we recorded a
restructuring charge of $8.2 million which included $7.4 million in employee
severance related costs and $0.8 million of facility exit costs. To the extent
we identify additional cost savings opportunities there could be additional
restructuring charges in future periods. We currently expect to exit one or more
additional excess facilities during the second half of fiscal year 2004, which
will result in anticipated exit costs of approximately $2.0 million.
INTEREST INCOME, NET
Interest income, net declined from $1.5 million in the second quarter of
fiscal year 2003 to $0.8 million in the second quarter of fiscal year 2004,
principally due to lower average cash and investment balances available for
investing.
OTHER EXPENSE, NET
Other expense, net decreased to $6.3 million for the second quarter of
fiscal 2004 from $14.8 million for the second quarter of fiscal year 2003 mainly
due to a decrease in impairments of minority investments. Other expense
consisted primarily of investment impairments of $6.6 million for the second
quarter of fiscal year 2004 and $16.1 million for the quarter ended June 28,
2003. We review our minority investments in debt and equity securities of
privately held companies for potential impairment whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Many
factors are considered in assessing potential impairments. Such events or
factors include 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. From time to
time we may engage third party experts to estimate the recoverable value of
investments management may consider selling. At July 3, 2004, our minority
investments totaled $1.9 million. The concentration of our investments in
privately-held companies, many of which are in the start-up or development
stage, expose our investments to increased risk. If these companies are not
successful, we could incur additional impairment charges and lose our entire
investment.
INCOME TAX (BENEFIT) EXPENSE
We recorded a net income tax benefit of $6.7 million for the second
quarter of fiscal year 2004, as compared with no tax benefit or provision for
the second quarter of fiscal year 2003. Based on Internal Revenue Service
("IRS"), guidance issued at the end of our first quarter of fiscal year 2004, we
filed documentation with the IRS shortly following the end of the second quarter
of fiscal year 2004 enabling us to recognize a reduction to accrued tax
liabilities of $11.9 million in fiscal year 2004. Approximately $7.7 million of
the liability reduction was recognized as a tax benefit during the second
quarter of fiscal year 2004, and the remaining $4.2 million will be recognized
during the remainder of fiscal year 2004.
FIRST SIX MONTHS OF FISCAL YEAR 2004 COMPARED TO THE FIRST SIX MONTHS OF FISCAL
YEAR 2003
NET REVENUE
Net revenue decreased by $33.9 million, or 15.9%, from $212.8 million in
the first six months of fiscal year 2003 to $178.9 million in the first six
months of fiscal year 2004 primarily due to lower product sales volume, as well
as lower revenue from maintenance contracts. Geographically, net revenue
decreased in the first six months of fiscal 2003 compared to the first six
months of fiscal 2004 in all regions. Net revenue to customers in North America
decreased 20.3% from $106.3 million in the first six months of fiscal year 2003
to $84.7 million in the first six months of fiscal year 2004, and net revenue in
Asia Pacific decreased 29.4% from $25.5 million in the first six months of
fiscal year 2003 to $18.0 million in the first six months of fiscal year 2004
primarily due to weakness in China.
Product revenue decreased by $24.2 million, or 15.7%, from $154.4 million
in the first six months of fiscal year 2003 to $130.2 million in the first six
months of fiscal year 2004. The decline in net product revenue is primarily a
result of lower sales from older generation products, such as our core routing
products, which were only partially offset by sales of new products, and sales
productivity issues. Sales of our older generation core routing products
declined to 7.1% of product revenue for the first six months of fiscal year
2004, as compared to 12.6% for the first six months of fiscal year 2003.
Services revenue decreased by $9.7 million, or 16.6%, from $58.4 million
in the first six months of fiscal year 2003 to $48.7 million in the first six
months of fiscal year 2004. The decrease in net services revenue is primarily
due to a declining maintenance
16
revenue base resulting from the expiration of higher priced maintenance
contracts on older generation products, as well as a reduction in volume and
price on outsourcing contracts.
GROSS MARGIN
Total gross margin decreased by $16.6 million, from $107.5 million in the
first six months of fiscal year 2003 to $90.9 million in the first six months of
fiscal year 2004. Total gross margin as a percentage of net revenue was 50.8% in
the first six months of fiscal year 2004, compared with 50.5% in the first six
months of fiscal year 2003.
The margin percentage improvement was principally due to increased product
gross margin, which was 47.6% compared to 45.1% in the first six months of
fiscal year 2003. The product gross margin percentage improvement was primarily
due to higher profit margins on newer products as well as reduced overhead costs
due to cost reduction initiatives. The increase in product gross margin was
partially offset by a $3.8 million increase in provisions for excess and
obsolete inventory due to lower projected sales of older generation products.
Services gross margin percentage decreased from 64.7% in the first six
months of fiscal year 2003 to 59.4% in the first six months of fiscal year 2004,
primarily due to the cost of services revenue not decreasing in proportion to
the decrease in services net revenue.
OPERATING EXPENSES
Research and development expense decreased by $2.0 million from $42.1
million in the first six months of fiscal year 2003 to $40.1 million in the
first six months of fiscal year 2004. The decline in research and development
expenses from the prior year was primarily due to a $0.6 million decrease in
depreciation expense due to reduced capital spending, a decline of $0.4 million
in labor costs due to workforce reductions and a reduction of $0.2 million in
facility costs due to facility closures.
Selling, general and administrative expense decreased by $1.4 million from
$89.4 million in the first six months of fiscal year 2003 to $88.0 million in
the first six months of fiscal year 2004. The decrease in SG&A expense was
primarily the result of a decrease of $6.2 million in labor costs due to
workforce reductions, a decrease of $2.3 million in costs associated with the
settled SEC investigation and the related shareholder lawsuits discussed in this
quarterly report; a decrease of $1.0 million in depreciation expense due to
lower capital spending; a $0.8 million reduction in audit fees and a reduction
of $0.2 million in facility costs due to facility closures. The decrease in SG&A
expense was partially offset by a $4.0 million increase in advertising expenses
relating to the launch of our Secure Networks campaign, and reduced recoveries
of bad debts and lease guarantees of $5.6 million.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangibles decreased by $0.8 million from $3.3 million in
the first six months of fiscal year 2003 to $2.5 million in the first six months
of fiscal year 2004, primarily as a result of the impairment and related write
off of certain intangible assets during the first quarter of fiscal year 2004,
and other intangibles becoming fully amortized.
IMPAIRMENT OF INTANGIBLE ASSETS
During the first six months of fiscal year 2004, we recorded an impairment
charge of $8.7 million relating to the write-down of patents and technology
intangible assets recorded in connection with our fiscal year 2001 acquisition
of Indus River Networks. In conjunction with our first quarter restructuring
plan, we decided to curtail certain development efforts which reduced forecasted
demand on future products that would have used this technology. As a result, the
intangible assets' fair value was determined to be zero based on a discounted
cash flows analysis.
RESTRUCTURING CHARGES
We recorded restructuring charges of $5.9 million during the first six
months of fiscal year 2004, which included $5.0 million in employee severance
related costs and $0.9 million of facility exit costs in fiscal year 2004
primarily as a result of exiting three facilities during the first six months of
fiscal year 2004. The fiscal year 2004 reductions involved most functions within
the business. During the first six months of fiscal year 2003, we recorded a
restructuring charge of $8.2 million. These restructuring costs consisted of
$7.4 million in employee severance costs and $0.8 million of facility exit
costs.
INTEREST INCOME, NET
Interest income, net declined from $3.2 million in the first six months of
fiscal year 2003 to $1.7 million in the first six months of fiscal year 2004,
primarily due to lower interest rates and lower average cash and investment
balances available for investing.
17
OTHER EXPENSE, NET
Other expense, net decreased to $9.2 million for the first six months of
fiscal year 2004, as compared to other expense, net of $14.5 million in the
first six months of fiscal year 2003. Other expense consisted primarily of
investment impairments of $10.0 million for the six months ended July 3, 2004
and $16.3 million for the six months ended June 28, 2003.
INCOME TAX (BENEFIT) EXPENSE
We recorded a net income tax benefit of $7.0 million for the first six
months of fiscal year 2004, compared with income tax expense of $0.7 million for
the first six months of fiscal year 2003. Based on IRS guidance issued at the
end of our first quarter of fiscal year 2004, we filed documentation with the
IRS shortly following the end of the second quarter of fiscal year 2004 enabling
us to recognize a reduction to accrued tax liabilities of $11.9 million in
fiscal year 2004. Approximately $7.7 million of the liability reduction was
recognized as a tax benefit during the second quarter of fiscal year 2004, and
the remaining $4.2 million will be recognized during the remainder of fiscal
year 2004.
LIQUIDITY AND CAPITAL RESOURCES
The sections below discuss the commitments on our liquidity and capital
resources, and the effects of changes in our balance sheet and cash flows.
COMMITMENTS
The following is a summary of our significant contractual cash obligations
and other commercial commitments as of July 3, 2004:
LESS THAN 1-3 4-5 OVER 5
CONTRACTUAL CASH OBLIGATIONS TOTAL 1 YEAR YEARS YEARS YEARS
- ---------------------------- ----- ------ ----- ----- -----
(IN MILLIONS)
Non-cancelable lease obligations ......... $39.3 $11.1 $15.5 $ 7.0 $ 5.7
Non-cancelable purchase commitments ...... 33.2 33.2 -- -- --
----- ----- ----- ----- -----
Total contractual cash obligations ....... $72.5 $44.3 $15.5 $ 7.0 $ 5.7
===== ===== ===== ===== =====
LESS THAN 1-3 4-5 OVER 5
OTHER COMMERCIAL COMMITMENTS TOTAL 1 YEAR YEARS YEARS YEARS
- ---------------------------- ----- ------ ----- ----- -----
(IN MILLIONS)
Aprisma lease payment guarantees (1) ..... $ 4.0 $ -- $ -- $ -- $ 4.0
Venture capital commitments (2) .......... 8.2 2.0 6.2 -- --
----- ----- ----- ----- -----
Total commercial commitments ............. $12.2 $ 2.0 $ 6.2 $ -- $ 4.0
===== ===== ===== ===== =====
(1) The Aprisma lease guarantee reduces to $3.0 million in 2009, $2.0 million
in 2010, $1.0 million in 2011 and terminates in 2012. We are indemnified
for up to $3.5 million in losses.
(2) We are committed to make up to $8.2 million of additional capital
contributions to a venture capital fund in which we are a limited partner.
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, we may
be obligated to immediately pay aggregate capital contributions of $18.2
million based on the original commitment. Based on recent communications
from this fund, we expect approximately $1.0 million to $2.0 million of
the remaining commitment could be called by the fund during the remainder
of fiscal year 2004. We cannot predict the likelihood or timing of capital
calls for the remaining commitment. We are pursuing the sale of our
interest in this fund to minimize future capital call funding
requirements.
Accrued severance costs of $4.1 million as of July 3, 2004 will be paid
out over the next twelve months; and the remaining accrued exit costs of $6.0
million, which consisted of long-term lease commitments less projected sublease
income, will be paid as follows: $1.5 million for the remainder of fiscal year
2004, $1.2 million in fiscal year 2005, $1.3 million in fiscal year 2006, $0.4
million in fiscal year 2007 and fiscal year 2008, and $1.2 million thereafter.
We maintain an accrual for legal and litigation expenses, which amounted
to $8.7 million at July 3, 2004. We could be obligated to pay up to
approximately $3.8 million of the accrued amounts during the third quarter of
fiscal year 2004 as a result of final settlements on certain litigation matters.
We are currently engaged in legal proceedings against certain insurers to
recover expenses incurred by us in connection with various litigation matters
and other claims and proceedings.
18
BALANCE SHEET AND CASH FLOWS
As of July 3, 2004, our liquid investments totaled $162.8 million, as
compared to $202.5 million at January 3, 2004, and consisted of $79.7 million of
cash and cash equivalents, $28.4 million of marketable securities and $54.7
million of long-term marketable securities. In connection with the issuance of
letters of credit, performance bonds and certain litigation matters, we have
agreed to maintain specified amounts of cash, cash equivalents and marketable
securities in collateral accounts. These assets totaled $10.6 million at July 3,
2004, and are classified as "Restricted cash, cash equivalents and marketable
securities" on our balance sheet. The decrease in liquid investments during the
first six months of fiscal year 2004 is the result of the loss from operations,
the payment of certain accrued expenses, and investments in our information
technology infrastructure as well as tooling and test equipment for new
products. Based on our liquid investment position at July 3, 2004, we believe
that we have sufficient liquid investments to fund our on-going operations and
future obligations for at least the next twelve months.
Net cash used in operating activities was $43.2 million for the six months
ended July 3, 2004 and consisted of a $25.6 million loss from operations after
adjustments for certain non-cash items, plus working capital uses of $17.6
million, primarily due to annual incentive payments to employees, the timing of
receipts from accounts receivable, and the timing of value added tax payments in
our EMEA region. We expect to use cash for operating activities during the third
quarter of fiscal year 2004 due to an expected operating loss, albeit at reduced
levels from what we have experienced during the first six months of fiscal year
2004. We have initiated cost reduction plans aimed at eliminating our operating
losses, and may be required to make further cost reductions to eliminate our
operating losses.
Capital expenditures for the first half of fiscal year 2004 were $6.1
million and consisted of information technology purchases and upgrades, assets
purchased to support outsourcing contracts and equipment and software used in
research and development activities as well as tooling and test equipment for
new products. We expect capital spending of approximately $4.0 million to $6.0
million for the remainder of fiscal year 2004. Restricted cash decreased by $8.1
million during the first half of fiscal year 2004 as restrictions relating to
standby letters of credit were released. Restricted cash may increase
temporarily as funds are placed in escrow pending appeals of certain litigation
matters.
Accounts receivable, net of allowance for doubtful accounts, were $37.0
million at July 3, 2004 compared with $37.5 million at January 3, 2004. The
number of days sales outstanding was 37 days at July 3, 2004, compared to 33
days at January 3, 2004. The increase in the number of days sales outstanding is
due to the timing of shipments to customers at the end of the second quarter of
fiscal year 2004.
Inventories were $28.1 million at July 3, 2004 or 6.4 turns per annum,
compared with $29.0 million at January 3, 2004 or 5.6 turns per annum.
Inventories have decreased during fiscal year 2004 primarily as a result of $7.6
million in inventory write-downs and a decrease in inventories at distributors.
We expect future cash commitments related to inventory purchases to vary 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.
Accounts payable at July 3, 2004 of $42.1 million increased from $39.7
million at January 3, 2004 due in part to the timing of payments related to
product purchases.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are described in Note 2 to the
consolidated financial statements included in Item 8 of our annual report on
Form 10-K for the fiscal year ended January 3, 2004. 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. We recognize revenue on arrangements where products
and services were bundled in accordance with Emerging Issues Task Force ("EITF")
00-21, "Revenue Arrangements with Multiple Deliverables." In accordance with
EITF 00-21, we determine whether the deliverables are separable into multiple
units of accounting. We allocate the total fee on such arrangements to the
individual deliverables based on their relative fair values or using the
residual method. The application of EITF 00-21 includes
19
judgments as to whether the delivered item has value to the customer on a
standalone basis and whether we have established objective and reliable evidence
of fair value for the undelivered items. Our ability to recognize revenue in the
future may be affected if actual selling prices are significantly less than the
fair values.
We recognize revenue on arrangements where software and services were
bundled in accordance with SOP 97-2 "Software Revenue Recognition," as amended
by SOP 98-9, "Modification of SOP 97-2, Software Recognition, With Respect to
Certain Transactions." We allocate the total fee on such arrangements based on
the relative fair values of each element. Our ability to recognize revenue in
the future may be affected if actual selling prices are significantly less than
the fair values.
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. Based on this analysis, we provide allowances for specific
accounts where collectibility is not reasonably assured. In addition, we provide
a full allowance for any customer balances that are greater than 180 days past
due. The allowance for notes receivable is based on specific customer accounts.
Inventory Valuation Reserves. Inventory purchases and commitments are
based upon future demand forecasts. Reserves for excess and obsolete inventory
are established to account for the potential differences between our forecasted
demand and the amount of purchased and committed inventory. We periodically
experience variances between the amount of inventory purchased or contractually
committed to and our demand forecasts, resulting in excess and obsolete
inventory charges. In addition, we periodically adjust service spares inventory
to net realizable value, as well as reserve for service parts in excess of usage
estimates. At July 3, 2004, our inventory valuation reserves were $37.8 million.
Valuation of Goodwill. Goodwill is the excess of the purchase price over
the fair value of identifiable net assets acquired in business combinations. In
accordance with Financial Accounting Standards Board, or FASB, Statement of
Financial Standards, or SFAS, No. 142, goodwill is subject to an annual
impairment test using a fair-value-based approach. We have designated the end of
the third quarter of each fiscal year as the date of the annual impairment test.
In assessing the fair value of goodwill, we make 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. At July 3, 2004,
the carrying value of goodwill on our balance sheet was $15.1 million. Based on
our annual impairment test, we did not record an impairment charge during fiscal
year 2003.
Valuation of Long-lived Assets. Long-lived assets are comprised of
property, plant and equipment and intangible assets with finite 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. At July 3, 2004, the carrying value
of long-lived assets, including fixed assets and intangible assets, was $40.6
million. During the first quarter of fiscal year 2004, we recorded impairment
charges of $8.7 million relating to certain technology related intangibles due
to the decision not to utilize this technology in future products, and the
reduction of development efforts for products that currently utilize this
technology.
Valuation of Investments. We maintain 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. Many factors are considered in
assessing potential impairments. Such events or factors include 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. From time to time we may engage third
party experts to estimate the recoverable value of investments management may
consider selling. Appropriate reductions in carrying value are recognized in
other expense, net in the consolidated statements of operations. We are
currently considering selling our interests in a private venture fund, which
would eliminate future capital call obligations. At July 3, 2004, the carrying
value of these investments on our balance sheet was $1.9 million. We incurred
impairment charges of $10.0 million relating to these investments during the
first half of fiscal year 2004.
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 judgment 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. 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
20
reduction to special charges will be recognized in the statement of operations.
During the first half of fiscal year 2004, we recorded restructuring charges of
approximately $5.9 million of which $5.0 million consisted of severance costs
and $0.9 million for facility exit costs. At July 3, 2004, we have estimated
sublease income associated with vacated facilities of approximately $1.8
million. This estimate of sublease income is subject to change based on known
real estate market conditions.
Income Taxes. 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. In
addition, the calculation of our tax liabilities involves dealing with
uncertainties in the application of complex tax regulations in a multitude of
jurisdictions. We recognize potential liabilities for anticipated tax audit
issues in the U.S and other tax jurisdictions based on our estimate of whether,
and the extent to which, additional taxes will be due. If payment of these
amounts ultimately proves to be unnecessary, the reversal of the liabilities
would result in tax benefits being recognized in the period when we determine
the liabilities are no longer necessary. If our estimate of tax liabilities
proves to be less than the ultimate assessment, a further charge to expense
would result.
Summary of Critical Estimates Included in Our Consolidated Results of
Operations. The following table summarizes the (income) expense impact on our
results of operations arising from our critical accounting estimates:
THREE MONTHS ENDED SIX MONTHS ENDED
------------------ -------------------
JULY 3, JUNE 28, JULY 3, JUNE 28,
------- -------- ------- --------
2004 2003 2004 2003
---- ---- ---- ----
(IN MILLIONS)
Net recoveries of doubtful accounts and notes receivable.. $(0.4) $(3.0) $(1.0) $(6.8)
Provision for product inventory write-downs .............. 3.4 0.9 6.6 2.8
Provision for service inventory valuations ............... 0.5 -- 1.0 --
Impairment of minority investments ....................... 6.6 16.1 10.0 16.3
Restructuring charges ................................... 1.4 8.2 5.9 8.2
Impairment of intangible assets ......................... -- -- 8.7 --
Deferred tax asset valuation provision .................. 11.1 9.1 21.3 13.0
----- ----- ----- -----
Total expense from critical accounting estimates ....... $22.6 $31.3 $52.5 $33.5
===== ===== ===== =====
NEW ACCOUNTING PRONOUNCEMENTS
In December 2003, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 104, or SAB No. 104, "Revenue Recognition" which revises
or rescinds portions of the interpretative guidance included in Topic 13 of the
codification of staff accounting bulletins in order to provide consistent
guidance with respect to selected revenue recognition issues. The adoption of
SAB No. 104 did not have a material effect on our consolidated financial
statements.
In March 2004, the FASB issued EITF No. 03-1, "The Meaning of
Other-than-Temporary Impairment and Its Application to Certain Investments"
which provides additional guidance on how companies, carrying debt and equity
securities at amounts higher than the securities fair values, evaluate whether
to record a loss on impairment. In addition, EITF No. 03-1 provides guidance on
additional disclosures required about unrealized losses. The impairment
accounting guidance is effective for reporting periods beginning after June 15,
2004 and the disclosure requirements are effective for annual reporting periods
ending after June 15, 2004. We do not expect the adoption of this statement will
have a material impact on our consolidated financial statements.
CAUTIONARY STATEMENTS
We may occasionally make forward-looking statements and estimates such as
forecasts and projections of our future performance or statements of our plans
and objectives. These forward-looking statements may be contained in, among
other things, SEC filings, including this quarterly report on Form 10-Q, 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.
21
RISKS RELATED TO OUR FINANCIAL RESULTS AND CONDITION
WORLDWIDE AND REGIONAL ECONOMIC UNCERTAINTY MAY CONTINUE TO NEGATIVELY AFFECT
OUR BUSINESS AND REVENUE AND CONTINUE TO MAKE FORECASTING MORE DIFFICULT
If economic or market conditions remain uncertain, fail to improve or
worsen, our business, revenue, and forecasting ability will continue to be
negatively affected, which could harm our results of operations and financial
condition. Our business is subject to the effects of general worldwide economic
conditions, particularly in the United States and Europe, and market conditions
in the networking industry, which have been particularly uncertain. 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 or anywhere
else in the world, and any continuation or repercussions thereof or responses
thereto, may put further pressure on uncertain worldwide economic conditions,
particularly if they continue for an extended period of time. Challenging
economic and market conditions have resulted in, and may in the future result
in, decreased revenue and gross margin, restructuring charges associated with
aligning the cost structure of the business with decreased revenue levels,
write-offs arising from difficulty managing inventory levels and collecting
customer receivables, and impairment of investments. Uncertain political,
social, economic and market conditions also make it extremely difficult for us,
our customers and our vendors to accurately forecast and plan future business
activities. In particular, such conditions make it more difficult for us to
develop and implement effective strategies, forecast demand for our products,
and effectively manage contract manufacturing and supply chain relationships.
This reduced predictability challenges our ability to operate profitably and to
grow our business.
WE HAVE A HISTORY OF LOSSES IN RECENT YEARS AND MAY NOT OPERATE PROFITABLY IN
THE FUTURE
We have experienced losses in recent years and may not achieve or sustain
profitability in the future. We will need to either generate higher revenue or
reduce our costs to achieve and maintain profitability. We may not be able to
generate higher revenue or reduce our costs, and if we do achieve profitability,
we may not be able to achieve, sustain or increase our profitability over
subsequent periods. Our revenue has been negatively affected by uncertain
economic conditions worldwide, which has increased price and technological
competition for most of our products, as well as resulted in longer selling
cycles. If uncertain worldwide economic conditions continue for an extended
period of time, our ability to maintain and increase our revenue may be
significantly limited. In addition, while we continue to implement cost
reduction plans designed to decrease our expenses, including reductions in the
size of our workforce, 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. Our 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:
- fluctuations in the demand for our products and services;
- the timing and size of sales of our products or the
cancellation or rescheduling of significant orders;
- the length and variability of the sales cycle for our
products;
- the timing of implementation and product acceptance by our
customers and by customers of our distribution partners;
- the timing and success of new product introductions;
- increases in the prices or decreases in the availability of
the components we purchase;
22
- price and product competition in the networking industry;
- our ability to source and receive from third party sources
appropriate product volumes and quality;
- our ability to execute on our operating plan and strategy;
- manufacturing lead times and our ability to maintain appropriate
inventory levels;
- the timing and level of research, development and prototype
expenses;
- the mix of products and services sold;
- changes in the distribution channels through which we sell our
products and the loss of distribution partners;
- the uncertainties inherent in our accounting estimates and
assumptions and the impact of changes in accounting principles;
- our ability to achieve targeted cost reductions;
- the pending securities litigation;
- indemnity claims by current or former directors and eligible
officers; and
- general economic conditions as well as those specific to the
networking industry.
Due to these and other factors, you should not rely on quarter-to-quarter
comparisons of our operating results as an indicator of our future performance.
WE EARN A SUBSTANTIAL PORTION OF OUR REVENUE FOR EACH QUARTER IN THE LAST MONTH
OF EACH QUARTER, WHICH REDUCES OUR ABILITY TO ACCURATELY PREDICT OUR QUARTERLY
RESULTS AND INCREASES THE RISK THAT WE WILL BE UNABLE TO ACHIEVE OUR GOALS AND
OUR FINANCIAL CONDITION COULD BE HARMED
We have derived and expect to continue to derive a substantial portion of
our revenue in the last month of each quarter, with such revenue frequently
concentrated in the last two weeks of the quarter, which reduces our ability to
accurately predict our quarterly results and increases the risk that we may not
achieve our financial and other goals. Due to this end-of-quarter buying
pattern, we traditionally have not been able, and in the future may not be able
to predict our financial results for any quarter until very late in the quarter.
In addition, we may not achieve targeted revenue levels, 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. This
end-of-quarter buying pattern also places pressure on our inventory management
and logistics systems. If predicted demand is substantially less than orders,
there will be excess inventory and if orders substantially exceed predicted
demand, we may not be able to fulfill all orders received in the last few weeks
of the quarter. In either case, our financial condition could be harmed.
WE CONTINUE TO INTRODUCE NEW PRODUCTS, AND IF OUR CUSTOMERS DELAY PRODUCT
PURCHASES OR CHOOSE ALTERNATIVE SOLUTIONS, OUR REVENUE COULD DECLINE, WE MAY
INCUR EXCESS AND OBSOLETE INVENTORY CHARGES, AND OUR FINANCIAL CONDITION COULD
BE HARMED
We are in the process of introducing new versions of our entire product
portfolio, including a new core router. Among the risks associated with the
introduction of new products are delays in development or manufacturing, failure
to accurately predict customer demand, effective management of new and
discontinued product inventory levels, and risks associated with customer
qualification and evaluation of new products. Many of our customers may
initially require additional time to evaluate our new products, extending the
sales cycle, or may choose alternative solutions. In addition, sales of our
existing products could decline as customers await the release of our new
products and, as a result, we could be exposed to an increased risk of excess
quantities of slow moving product or inventory obsolescence. If customers defer
purchasing decisions or choose alternative solutions in connection with our new
product introductions, our revenue could decline and our financial condition
could be harmed.
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
23
intensely competitive, subject to rapid technological change and significantly
affected by new product introductions and other market activities of industry
participants. Competition in the enterprise network communications market has
increased over the past few years as enterprises more closely monitor their
costs and investments in response to continued economic uncertainty. In recent
quarters, our product revenue has declined as a result of increased competition
and a lengthened sales cycle attributable in part to uncertain economic and
market conditions as well as other factors. Competitive pressures, exacerbated
by continued economic uncertainty, could further reduce demand for our products;
result in price reductions, reduced margins or the loss of market share; or
increase our risk of additional excess and obsolete inventory provisions and
service spare inventory write-downs; any of which would materially harm our
revenue, financial condition and business. In addition, if our pricing and other
factors are not sufficiently competitive, or if there is an adverse reaction to
our product introductions or discontinuations, we may lose market share in
certain areas, which could harm our revenue, financial condition and business.
We intend to compete by investing in product development, focusing on our
Secure Networks solutions, expanding our customer base, developing our name
recognition and branding, and focusing on operating efficiencies. If our
products, services, branding campaign and cost structure do not enable us to
compete successfully in these areas, our business could be harmed.
OUR COMPETITORS MAY HAVE GREATER RESOURCES THAN US, WHICH COULD HARM OUR
COMPETITIVE POSITION AND REDUCE OUR MARKET SHARE
Our principal competitors include Alcatel; Cisco Systems; Extreme
Networks; Foundry Networks; Hewlett-Packard; Huawei; 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, which could challenge our
ability to increase our market share. 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. Some of our competitors also have larger
installed customer bases, 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 than us, which could harm our competitive position
and reduce our market share.
Additional competitors with significant market presence and financial
resources may enter our rapidly evolving market, thereby further intensifying
competition. 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, which could harm our competitive position and reduce our
market share.
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
Since August 2001 there have been numerous changes in our senior
management team. In August 2001, our management team was restructured to include
several senior executives of one of our operating subsidiaries. Then in April
2002, we announced the departure of several of these senior executives,
including our President and Chief Executive Officer. We appointed a new Chief
Executive Officer and a new President in April 2002, and, in the period from
March 2002 to March 2004, we appointed a number of other senior officers,
including promoting our Vice President of Finance to the position of Chief
Financial Officer, appointing a new Executive Vice President of Sales, Executive
Vice President of Worldwide Marketing and Product Management and Vice President
of Human Resources, and adding an Executive Vice President of Supply Chain
Management. In December 2002, our President resigned upon the completion of his
employment agreement with us, and, in April 2003, we appointed a new President.
In May 2003 we appointed a new Executive Vice President of Engineering and in
March 2004 we appointed a new Executive Vice President of Worldwide Sales and
Service. Because of these recent changes and their recent recruitment, our
current management team has not worked together for a significant length of time
and may not be able to work together effectively to successfully develop and
implement business strategies. In addition, as a result of these management
changes, management will need to devote significant attention and resources to
preserve and strengthen relationships with employees and customers. If our new
management team is unable to develop successful business strategies, achieve our
business objectives, or maintain positive relationships with employees and
customers, our ability to grow our business and successfully meet operational
challenges could be impaired.
RETAINING KEY MANAGEMENT AND EMPLOYEES IS CRITICAL TO OUR SUCCESS
Our future success depends to a significant extent on the continued
services of our key employees, many of whom have significant experience with the
network communications market, as well as relationships with many of our
existing and potential enterprise customers and business partners. The loss of
several of our key employees or any significant portion of them could have a
significant detrimental effect on our ability to execute our business strategy.
Our future success also depends on our continuing ability to identify, hire,
train, assimilate and retain large numbers of highly qualified engineering,
sales, marketing, managerial and support personnel. If
24
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. These actions 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 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, some of our customers, particularly in Latin
America and China, are experiencing, or may experience, reduced revenue and cash
flow problems, and may be unable to pay, or may delay payment of, 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
revenue could be harmed and our business and results of operations may be
adversely affected.
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 and cash available from operations
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 capital
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 revenue 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 rights, privileges and preferences senior to those of common
stockholders. If we raise additional capital through the sale of debt
securities, the terms of the debt could impose restrictions on our operations.
RISKS RELATED TO THE MARKETS FOR OUR PRODUCTS
WE MAY BE UNABLE TO EFFECTIVELY MANAGE AND INCREASE THE PRODUCTIVITY OF OUR
INDIRECT DISTRIBUTION CHANNELS, WHICH MAY HINDER OUR ABILITY TO GROW OUR
CUSTOMER BASE AND INCREASE OUR REVENUE
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 effectively manage and increase the productivity of our existing
channel partners, as well as maintain and establish successful new
relationships. If we are unable to increase the productivity of 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 revenue. In addition, even if we are able to
maintain our existing relationships and establish successful new relationships
with channel partners, our revenue may not increase. Our 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. Also, we may be
unable to maintain our existing agreements or reach new agreements with these
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
25
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. 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 revenue and gross
margins.
IF WE DO NOT ANTICIPATE AND RESPOND TO TECHNOLOGICAL DEVELOPMENTS AND EVOLVING
CUSTOMER REQUIREMENTS AND INTRODUCE NEW PRODUCTS IN A TIMELY MANNER, 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, increasing our
risk of excess and obsolete inventory charges and the risk that we may not
achieve our revenue and profitability objectives. Our success will depend upon
our ability to enhance our existing products and to develop and introduce, on a
timely and cost-effective basis, new products and functionality that keep pace
with technological developments and emerging standards. Any failure to introduce
new products and enhancements on a timely basis will harm our future revenue and
prospects.
Our future success will also depend upon our ability to develop and manage
customer relationships and to introduce a variety of new products and product
enhancements that address the increasingly sophisticated needs of our customers.
Our current and prospective customers may require product features and
capabilities that our products do not have. We must anticipate and adapt to
customer requirements and offer products that meet those demands in a timely
manner. Our failure to develop products that satisfy evolving customer
requirements could seriously harm our ability to achieve or maintain market
acceptance for our products and prevent us from recovering our product
development investments.
OUR FOCUS ON SALES TO ENTERPRISE CUSTOMERS SUBJECTS US TO RISKS THAT MAY BE
GREATER THAN THOSE FOR PROVIDERS WITH A MORE DIVERSE CUSTOMER BASE
We focus principally on sales of products and services to enterprises,
such as large corporations and government agencies that rely on network
communications for many important aspects of their operations. This focus
subjects us to risks that are particular to this customer segment. For example,
many of our current and potential customers are health care, education and
governmental agencies, all of whom are generally slower to incorporate
information technology into their business practices due to the regulatory and
privacy issues that must be addressed with respect to the sharing of their
information. In addition, the use and growth of the Internet is critical to
enterprises, which often have electronic networks, applications and other
mission-critical functions that use the Internet. To the extent that there is
any decline in use of the Internet for electronic commerce or communications,
for whatever reason, including performance, reliability or security concerns, we
may experience decreased demand for our products and lower than expected revenue
growth.
Many of our competitors sell their products to both enterprises and service
providers, which are companies who provide Internet-based services to businesses
and individuals. In the future, the demand for network communications products
from enterprises may not grow as rapidly as the demand from service providers.
Enterprises may turn to service providers to supply them with services that
obviate the need for enterprises to implement many of our solutions. Because we
sell our products primarily to enterprises, our exposure to these risks is
greater than that of vendors that sell to a more diversified customer base.
In addition, a significant amount of our sales through our channel partners
are to entities that rely in whole or in part on public sources of funding, such
as federal, state and local government, education and healthcare. Entities
relying in whole or in part on public funding often face significant budgetary
pressure, which may cause these customers to delay, reduce or forego purchasing
from us. If these customers are unable to make, reduce or delay planned
purchases, our forecasting ability will be negatively affected and our business,
revenue and results of operations could be harmed.
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 costs to support our service
contracts and other costs and
26
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 revenue 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 REVENUE OR ACHIEVING PROFITABILITY
The market for network communications equipment is characterized by the
need to support industry standards as different standards emerge, evolve and
achieve acceptance. In the past, we have had to delay the introduction of new
products to comply with third party standards testing. We may be unable to
address compatibility and interoperability problems that arise from
technological changes and evolving industry standards. We also may devote
significant resources developing products designed to meet standards that are
not widely adopted. In the United States, our products must comply with various
governmental regulations and industry regulations and standards, including those
defined by the Federal Communications Commission, Underwriters Laboratories and
Networking Equipment Building Standards. Internationally, our products are
required to comply with standards or obtain certifications established by
telecommunications authorities in various countries and with recommendations of
the International Telecommunications Union. If we do not comply with existing or
evolving industry standards, fail to anticipate correctly which standards will
be widely adopted or fail to obtain timely domestic or foreign regulatory
approvals or certificates, we will be unable to sell our products where these
standards or regulations apply, which may prevent us from sustaining our revenue
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 revenue 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 MAY PERIODICALLY ESTABLISH RELATIONSHIPS WITH OTHER COMPANIES TO DEVELOP,
MANUFACTURE AND SELL PRODUCTS, WHICH COULD INCREASE OUR RELIANCE ON OTHERS FOR
DEVELOPMENT OR SUPPLY CAPABILITIES OR GENERATION OF REVENUE AND MAY LEAD TO
DISPUTES ABOUT OWNERSHIP OF INTELLECTUAL PROPERTY
We may periodically establish relationships with other companies to
incorporate our technology into products and solutions sold by these
organizations as well as to jointly develop, manufacture and/or sell new
products and solutions with these organizations. We may be unable to enter into
agreements of this type on favorable terms, if at all. If we are unable to enter
into these agreements on favorable terms, or if our partners do not devote
sufficient resources to developing, manufacturing and/or selling the products
that incorporate our technology or the new products we have jointly developed,
our revenue growth could be lower than expected. 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 incorporating our
technology or to jointly developing new products and solutions. Further,
although we intend to retain all rights in our technology in these arrangements,
we may be unable to negotiate the retention of these rights and disputes may
arise over the ownership of technology developed as a result of these
arrangements. These and other potential disagreements between us and these
organizations could lead to delays in the research, development or sale of
products we are jointly developing or more serious disputes, which may be costly
to resolve. Disputes with organizations that also serve as indirect distribution
channels for our products could also reduce our revenue 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
27
enforce our intellectual property rights, to protect our trade secrets or to
determine the validity and scope of the proprietary rights of others. Litigation
of this type could result in substantial costs and diversion of resources and
could harm our business.
WE MAY BE SUBJECT TO CLAIMS THAT OUR INTELLECTUAL PROPERTY INFRINGES UPON THE
PROPRIETARY RIGHTS OF OTHERS, AND A SUCCESSFUL CLAIM COULD HARM OUR ABILITY TO
SELL AND DEVELOP OUR PRODUCTS
We license technology from third parties and are continuing to develop and
acquire additional intellectual property. Although we have not been involved in
any material litigation relating to our intellectual property, we expect that
participants in our markets will be increasingly subject to infringement claims.
Third parties may try to claim our products infringe their intellectual
property, in which case we would be forced to defend ourselves or our customers,
manufacturers and suppliers against those claims. Any claim, whether meritorious
or not, could be time consuming, result in costly litigation and/or require us
to enter into royalty or licensing agreements. Although we carry general
liability insurance, our insurance may not cover potential claims of this type
or may not be adequate to indemnify us for all liability that may be imposed. In
addition, any royalty or licensing agreements might not be available on terms
acceptable to us or at all, in which case we would have to cease selling,
incorporating or using the products that incorporate the challenged intellectual
property and expend substantial amounts of resources to redesign our products.
If we are forced to enter into unacceptable royalty or licensing agreements or
to redesign our products, our business and prospects would suffer.
RISKS RELATED TO OUR MANUFACTURING AND COMPONENTS
WE USE SEVERAL KEY COMPONENTS FOR OUR PRODUCTS THAT WE PURCHASE FROM SINGLE OR
LIMITED SOURCES, AND WE COULD LOSE SALES IF THESE SOURCES FAIL TO FULFILL OUR
NEEDS
We currently work with third parties to manufacture our key proprietary
application-specific integrated circuits, which are custom designed circuits
built to perform a specific function more rapidly than a general purpose
microprocessor. These proprietary circuits are very complex, and these third
parties are our sole source suppliers for the specific types of application
specific integrated circuits that they supply to us. We also have limited
sources for semiconductor chips that we use in some of our products, 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 EITHER 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. In addition, our business interruption insurance contains
standard limitations and, as a result of these limitations, may not adequately
cover damages we incur in the event of a supply interruption.
IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD INCUR
ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS
28
We use a forward-looking forecast of anticipated product orders to
determine our product requirements for our contract manufacturers. 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 six 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. 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
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 total of $7.6 million provision for inventory
write-downs during the first half of fiscal year 2004, a $12.2 million charge in
fiscal year 2003 and a $17.9 million charge in fiscal year 2002.
WE PLAN TO CONTINUE INTRODUCING NEW AND COMPLEX PRODUCTS, AND IF OUR CONTRACT
MANUFACTURERS ARE UNABLE TO MANUFACTURE THESE PRODUCTS CONSISTENTLY AND IN
REQUIRED QUANTITIES, WE COULD LOSE SALES
Due to the complexity of our new products, the manufacturing process for
these new products and/or the new products themselves may require adjustments
and refinements during the first several months of initial manufacture. In
addition, it may be difficult for our contract manufacturers to produce these
complex products consistently with the level of quality we require. We depend on
the highly trained and knowledgeable employees of our contract manufacturers to
assemble and test our products. Given the significant training required to
manufacture our products, the loss of a number of these employees could also
impair the ability of our contract manufacturers to produce sufficient
quantities of our products in a timely manner with the quality we require.
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 50.7% and 52.6% of our revenue in the three and six months ended
July 3, 2004, respectively, and 49.3% and 50.0% of our revenue in the three and
six months ended June 28, 2003, respectively. We are seeking to expand our
international presence by establishing arrangements with distribution partners
as well as through strategic relationships in international markets.
Consequently, we anticipate that sales outside of the United States will
continue to account for a significant portion of our revenue 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, including those related to
counter-terrorism and security;
- 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.
PENDING AND FUTURE LITIGATION COULD MATERIALLY HARM OUR BUSINESS, OPERATING
RESULTS AND FINANCIAL CONDITION
29
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. See "Part II, Item 1 - Legal Proceedings" of this
quarterly report for a more detailed discussion of pending litigation. 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 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, and we may be required to pay significant damages in connection with
the 1997 and 1998 securities lawsuits which remain pending. In addition, the
defense of the 1997 and 1998 lawsuits will continue to 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. Although we have insurance designed to cover claims under
these lawsuits, this insurance may not be adequate to cover expenses and certain
liabilities relating to these lawsuits, and we may need to litigate with our
insurance carriers to obtain coverage under our insurance policies. For example,
with respect to our recently settled 2002 class action litigation, although we
received cash proceeds of approximately $34.5 million from our insurers and have
engaged in legal proceedings against other insurers to recover a portion of the
remaining expenses incurred, we do not expect these proceeds will fully cover
all of our costs and expenses incurred in connection with this and other related
matters and we may be unsuccessful in our litigation against the other insurers.
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.
WE MAINTAIN INVESTMENTS IN EARLY STAGE, PRIVATELY HELD TECHNOLOGY COMPANIES,
VALUE-ADDED RESELLERS, AND VENTURE CAPITAL FUNDS 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,
and venture capital funds that invest in similar start-up companies. 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. At July 3, 2004, these
investments totaled approximately $1.9 million. During the first half of fiscal
year 2004, we recorded impairment losses of $10.0 million relating to these
investments.
We are committed to make up to $8.2 million of additional capital
contributions to a venture capital fund in which we are a limited partner. 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, we may be obligated
to immediately pay all remaining capital contributions of $18.2 million based on
the original commitment. Based on recent communications from this fund, we
expect approximately $1.0 million to $2.0 million of the remaining commitment
could be called by the fund during fiscal year 2004. We cannot predict the
likelihood or timing of capital calls for the remaining commitment. We are
pursuing the sale of our interest in this fund to minimize future capital call
funding requirements; however, we may be unsuccessful in these efforts and our
liquidity position would be harmed
OUR FAILURE TO IMPROVE AND SUCCESSFULLY IMPLEMENT OUR MANAGEMENT INFORMATION
SYSTEMS AND INTERNAL CONTROLS COULD HARM OUR BUSINESS
We have reviewed our systems controls and operating procedures and
identified improvements which could be made. Pursuant to new SEC rules under the
Sarbanes-Oxley Act of 2002, we are required to include in our future Form 10-K
filings a report by our management as to the effectiveness of our internal
controls and procedures for financial reporting. Beginning with our Form 10-K
for fiscal year 2004, our independent auditors will be required to attest to and
report on the evaluation by management. Although we have implemented a number of
changes designed to improve our systems and controls, including organizational
changes, implementation of new business systems, 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 process improvement programs, we anticipate making
additional changes to improve our systems controls and procedures, some of which
may result in higher future operating expenses and capital expenditures. In
addition, we plan to make continued upgrades to our management information
systems. The implementation of these upgrades involves significant effort and is
complex. If we are unable to successfully and/or timely implement these
upgrades, our business could be disrupted and our financial condition harmed.
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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 HAVE NOT ESTABLISHED A COMPREHENSIVE DISASTER RECOVERY PLAN AND IF WE ARE
UNABLE TO QUICKLY AND SUCCESSFULLY RESTORE OUR OPERATIONS OUR REVENUE AND OUR
BUSINESS COULD BE HARMED
We have not established and tested a comprehensive disaster recovery plan
for our business operations or 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 natural or other disaster which
impacts our operations or a 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 revenue and business could be
harmed. We are in the process of developing a disaster recovery plan which we
expect will conform to industry standards and is intended to limit our business
and financial exposure in the event of a disaster or catastrophic systems
failure. Nevertheless, in the event of a disaster or catastrophic systems
failure, we may be unable to successfully implement any plan we develop and
restore, or operate at an alternate location, our business or our information
technology systems and, to the extent it is implemented, any plan we develop may
not adequately prevent or limit the adverse effects on our business of such a
disaster or catastrophic systems failure. Additionally, our business
interruption insurance has certain limitations and, as a result of these
limitations, may not adequately cover damages we incur in the event our business
is interrupted by such a disaster or catastrophic systems failure.
WE HAVE MADE AND MAY MAKE FUTURE ACQUISITIONS OR DISPOSITIONS, WHICH INVOLVE
NUMEROUS RISKS
We periodically evaluate our business and our technology needs, and
evaluate alternatives for acquisitions, dispositions and other transfers of
businesses, assets, technologies and product lines, and we have made, and may in
the future make, acquisitions and dispositions. Any future acquisitions and/or
dispositions would expose us to various risks associated with such transactions
and could harm our results of operations and financial condition.
Although we may seek to make acquisitions, we may be unable to identify
and acquire suitable businesses, assets, technology or product lines on
reasonable terms, if at all. Our financial condition or stock price may make it
difficult for us to complete acquisitions and we may compete for acquisitions
with other companies that have substantially greater financial, management and
other resources than we do. This competition may increase the prices we pay to
make acquisitions, which are often high when compared to the assets and sales of
acquisition candidates. Also, our acquisitions may not generate sufficient
revenue to offset increased expenses associated with the acquisition in the
short term or at all. We may also consider discontinuing or disposing of
businesses, assets, technologies or product lines; however, any decision to
limit our investment in or dispose of businesses, assets, technologies or
product lines may result in the recording of charges to our statement of
operations, such as inventory and technology related impairments, workforce
reduction costs, contract termination costs, fixed asset impairments or claims
from third party resellers or users of the discontinued products. In addition,
to the extent we are required to sell intellectual property rights in disposing
of these businesses, assets, technologies or product lines, we may need to
re-license the right to use this intellectual property for a fee.
Acquisitions and dispositions, particularly multiple transactions over a
short period of time, involve transaction costs and 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 business, technologies or product lines
or of segregating, marketing and disposing of a business, technology
or product line;
- potential disruption of our existing operations;
- an inability to successfully integrate, train and retain key
personnel, or transfer or eliminate positions or key personnel;
- diversion of management attention and employees from day-to-day
operations;
- an inability to incorporate, develop or market acquired businesses,
technologies or product lines, or realize value from technologies,
products or businesses;
- operating inefficiencies associated with managing companies in
different locations, or separating integrated operations; and
- impairment of relationships with employees, customers, suppliers and
strategic partners.
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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 in connection with future
acquisitions, which could adversely affect our financial condition or results of
operations. 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.
THE MARKET PRICE OF OUR COMMON STOCK HAS HISTORICALLY BEEN VOLATILE, AND
DECLINES 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 may continue to experience substantial price
volatility, including significant decreases, as a result of variations between
our actual or anticipated financial results and the published expectations of
analysts, announcements by our competitors and us, 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.
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, 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 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about our market risk involves forward-looking
statements. Actual results could differ materially from those projected in the
forward-looking statements. We are exposed to market risk primarily related to
changes in interest rates and foreign currency exchange rates. Our hedging
activity is intended to offset the impact of currency fluctuations on certain
nonfunctional currency assets and liabilities.
Interest Rate Sensitivity. We maintain an investment portfolio consisting
partly of debt securities of various issuers, types and maturities. The
securities that we classify as held-to-maturity are recorded on the balance
sheet at amortized cost, which approximates market value. Unrealized gains or
losses associated with these securities are not material. The securities that we
classify as available-for-sale are recorded on the balance sheet at fair market
value with unrealized gains or losses reported as part of accumulated other
comprehensive income, net of tax as a component of stockholders' equity. A
hypothetical 10 percent increase in interest rates would not have a material
impact on the fair market value of these securities due to their short maturity.
We expect to be able to hold our fixed income investments until maturity, and
therefore we do not expect our operating results or cash flows to be materially
affected 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.
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Foreign Currency Exchange Risk. Due to our global operating and financial
activities, we are exposed to changes in foreign currency exchange rates. At
July 3, 2004, we had net asset exposures to the Australian Dollar, Eurodollar,
Japanese Yen and Brazilian Real. These exposures may change over time as
business practices evolve and could materially harm our financial results and
cash flows.
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 July 3, 2004.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
An evaluation of the effectiveness of our disclosure controls and
procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934)
as of the end of the fiscal quarter covered by this quarterly report on Form
10-Q was carried out under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer.
Based on and as of the date of that evaluation, our 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.
CHANGES IN INTERNAL CONTROLS
Our management has assessed our internal controls in each of the regions
in which we operate as of the end of the fiscal quarter covered by this
quarterly report on Form 10-Q. Management continues to seek opportunities to
improve our internal controls and has assigned the highest priority to
implementing improvements to our internal controls. Specifically, since April 3,
2004, we have implemented the following improvements and additional procedures:
1. Assessed and identified potential system access control
deficiencies with our Enterprise Resource Planning (ERP) system,
and initiated actions to remediate these deficiencies;
2. Performed various tests and evaluations in preparation for our
Sarbanes-Oxley section 404 compliance; and
3. Developed and implemented additional financial, accounting and
other policies and procedures and publication of these policies
on our internal website.
We continue to evaluate the effectiveness of our internal controls and
procedures on an ongoing basis and will take further action as appropriate.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In the normal course of our business, we are subject to proceedings,
litigation and other claims. Litigation in general, and securities and
intellectual property litigation in particular, can be expensive and disruptive
to 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 our relationships with existing
customers and impair our ability to attract new customers. In addition, the
defense of these actions may result in the diversion of management's resources
from the operation of our business, which could impede our ability to achieve
our business objectives. The unfavorable resolution of any specific action could
materially harm our business, operating results and financial condition, and
could cause the price of our common stock to decline significantly.
Described below are the material legal proceedings in which we are
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 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-JD (N.H.); No. 99-408-S (R.I.)). The
33
case was referred to the District of Rhode Island. The complaint alleges that we
and several of our officers and directors disseminated materially false and
misleading information about our operations and acted in violation of Section
10(b) of the Exchange Act and Rule 10b-5 thereunder 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.
The defendants have filed an answer denying the allegations in all material
respects, and the parties are engaged in limited discovery. If the plaintiffs
prevail on the merits of this case, we could be required to pay substantial
damages.
Indemnification Claims. Our certificate of incorporation provides for
indemnification and advancement of certain litigation and other expenses to our
directors and certain of our officers to the maximum extent permitted by
Delaware law. Accordingly, we, from time to time, may be required to indemnify
directors and certain of our officers, including former directors and officers,
in various litigation matters, claims or proceedings. We recorded operating
expenses of approximately $1.1 million and $2.2 million, for the three and six
months ended July 3, 2004, respectively, in legal expenses relating to such
matters. We are currently engaged in legal proceedings against certain insurers
to recover these and other expenses and costs incurred by us in connection with
the related litigation matters, claims and proceedings.
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.
However, depending on the amount and timing of such disposition, an unfavorable
resolution of some or all of these matters could materially affect our future
results of operations or cash flows in a particular period.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We held our annual meeting of shareholders on June 9, 2004. At that meeting,
shareholders elected William K. O'Brien and Michael Gallagher as directors.
Directors Paul R. Duncan, Edwin A. Huston and Ronald T. Maheu continued their
respective terms of office. As a result of the approval of the shareholder
proposal to approve the adoption of the amended and restated certification of
incorporation to declassify our Board of Directors, the terms of our Class I and
Class III directors will expire at the 2005 annual meeting of shareholders, and
the term of our Class II directors will expire in 2006. All directors will
henceforth be elected for terms of one year. The persons elected and the results
of the voting are as follows:
Votes For Votes Withheld
----------- --------------
William K. O'Brien 188,913,047 2,907,609
Michael Gallagher 186,477,736 5,342,920
Broker Non-
Votes For Votes Against Abstain Vote
----------- ------------- ------- -----------
Company proposal to approve the
adoption of the 2004 Equity Incentive Plan 116,304,157 12,207,631 351,689 62,957,179
Shareholder proposal to approve the adoption
of the amended and restated certificate of
incorporation to declassify the Board of Directors 190,302,621 1,147,550 370,485
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
31.1 Certification of William K. O'Brien under Section 302 of the Sarbanes-Oxley
Act.
31.2 Certification of Richard S. Haak, Jr. under Section 302 of the
Sarbanes-Oxley Act.
32.1 Certification of William K. O'Brien under Section 906 of the Sarbanes-Oxley
Act.*
32.2 Certification of Richard S. Haak, Jr. under Section 906 of the
Sarbanes-Oxley Act.*
* The certifications under section 906 are being "furnished" hereunder and
shall not be deemed "filed"
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for purposes of section 18 of the Securities Exchange Act of 1934
(b) Reports on Form 8-K:
We furnished a current report on Form 8-K on April 27, 2004 to report our
financial results for the quarter ended April 3, 2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ENTERASYS NETWORKS, INC.
/s/ William K. O'Brien
------------------------------------------
Date: August 12, 2004 By: William K. O'Brien
Chief Executive Officer and Director
ENTERASYS NETWORKS, INC.
/s/ Richard S. Haak, Jr.
------------------------------------------
Date: August 12, 2004 By: Richard S. Haak, Jr.
Chief Financial Officer
(Principal Financial and
Accounting Officer)
36
EXHIBIT INDEX
31.1 Certification of William K. O'Brien under Section 302 of the
Sarbanes-Oxley Act.
31.2 Certification of Richard S. Haak, Jr. under Section 302 of the
Sarbanes-Oxley Act.
32.1 Certification of William K. O'Brien under Section 906 of the
Sarbanes-Oxley Act.*
32.2 Certification of Richard S. Haak, Jr. under Section 906 of the
Sarbanes-Oxley Act.*
* The certifications under section 906 are being "furnished" hereunder and
shall not be deemed "filed" for purposes of section 18 of the Securities
Exchange Act of 1934
37