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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 OCTOBER 2, 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 November 5, 2004 there were 210,516,744 shares of Enterasys common
stock, $0.01 par value, outstanding.
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets at October 2, 2004 and January 3, 2004................................................. 3
Consolidated Statements of Operations for the three and nine months ended October 2, 2004 and September 27, 2003... 4
Consolidated Statements of Cash Flows for the nine months ended October 2, 2004 and September 27, 2003............. 5
Notes to the Consolidated Financial Statements..................................................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................. 13
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 6. Exhibits........................................................................................................... 34
Signatures................................................................................................................. 35
2
PART I -- FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
OCTOBER 2, JANUARY 3,
2004 2004
----------- -------------
(unaudited) (a)
ASSETS
Current assets:
Cash and cash equivalents.................................................................... $ 69,775 $ 136,801
Marketable securities........................................................................ 38,955 29,851
Accounts receivable, net..................................................................... 30,126 37,541
Inventories.................................................................................. 29,076 29,049
Income tax receivable........................................................................ 1,768 595
Prepaid expenses and other current assets.................................................... 27,475 18,497
----------- -------------
Total current assets.................................................................. 197,175 252,334
Restricted cash, cash equivalents and marketable securities..................................... 12,416 18,693
Long-term marketable securities................................................................. 38,322 35,803
Investments..................................................................................... 987 11,417
Property, plant and equipment, net.............................................................. 31,607 37,881
Goodwill........................................................................................ 15,129 15,129
Intangible assets, net.......................................................................... 5,162 17,353
----------- -------------
Total assets.......................................................................... $ 300,798 $ 388,610
=========== =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................................. $ 34,960 $ 39,738
Accrued compensation and benefits............................................................ 20,950 26,832
Accrued legal and litigation costs........................................................... 8,017 8,338
Accrued restructuring charges................................................................ 7,425 6,407
Other accrued expenses....................................................................... 19,598 24,114
Deferred revenue............................................................................. 35,674 41,187
Customer advances and billings in excess of revenues......................................... 9,819 7,323
Income taxes payable......................................................................... 33,985 44,275
----------- -------------
Total current liabilities............................................................. 170,428 198,214
Long-term deferred revenue................................................................... 6,030 6,217
Long-term accrued restructuring charges...................................................... 4,020 4,118
----------- -------------
Total liabilities..................................................................... 180,478 208,549
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; 212,264,942 and
210,805,013 shares issued at October 2, 2004 and January 3, 2004, respectively........... 2,123 2,108
Additional paid-in capital................................................................... 1,190,935 1,187,449
Accumulated deficit.......................................................................... (1,051,015) (990,250)
Treasury stock, at cost; 1,748,861 common shares at October 2, 2004 and January 3, 2004...... (30,119) (30,119)
Accumulated other comprehensive income....................................................... 8,396 10,873
----------- -------------
Total stockholders' equity............................................................ 120,320 180,061
----------- -------------
Total liabilities and stockholders' equity............................................ $ 300,798 $ 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)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED
-------------------------- --------------------------
OCTOBER 2, SEPTEMBER 27, OCTOBER 2, SEPTEMBER 27,
2004 2003 2004 2003
---------- ------------- ---------- -------------
Net revenue:
Product ...................................................... $ 65,058 $ 70,792 $ 195,281 $ 225,226
Services ..................................................... 22,352 27,625 71,057 86,023
---------- ------------- ---------- -------------
Total net revenue .......................................... 87,410 98,417 266,338 311,249
---------- ------------- ---------- -------------
Cost of revenue:
Product ...................................................... 32,832 40,329 101,113 125,075
Services ..................................................... 7,864 15,052 27,656 35,650
---------- ------------- ---------- -------------
Total cost of revenue ...................................... 40,696 55,381 128,769 160,725
---------- ------------- ---------- -------------
Gross margin ............................................... 46,714 43,036 137,569 150,524
Operating expenses:
Research and development ..................................... 17,685 21,380 57,829 63,486
Selling, general and administrative .......................... 34,030 44,321 122,006 133,766
Amortization of intangible assets ............................ 929 1,597 3,456 4,905
Impairment of intangible assets .............................. -- -- 8,734 --
Shareholder litigation expense ............................... -- 15,900 -- 15,900
Restructuring and other charges .............................. 5,872 8,338 11,765 16,541
---------- ------------- ---------- -------------
Total operating expenses ................................... 58,516 91,536 203,790 234,598
---------- ------------- ---------- -------------
Loss from operations ....................................... (11,802) (48,500) (66,221) (84,074)
Interest income, net ............................................. 626 1,000 2,276 4,170
Other income (expense), net ...................................... 2,980 (8,550) (6,236) (23,063)
---------- ------------- ---------- -------------
Loss before income taxes ................................... (8,196) (56,050) (70,181) (102,967)
Income tax (benefit) expense ..................................... (2,389) -- (9,416) 749
---------- ------------- ---------- -------------
Net loss ................................................... (5,807) (56,050) (60,765) (103,716)
Accretive dividend and accretion of discount on preferred shares -- -- -- (2,192)
---------- ------------- ---------- -------------
Net loss available to common shareholders .................. $ (5,807) $ (56,050) $ (60,765) $ (105,908)
========== ============= ========== =============
Basic and diluted loss per common share:
Net loss available to common shareholders .................... $ (0.03) $ (0.27) $ (0.28) $ (0.52)
========== ============= ========== =============
Weighted average number of common shares
outstanding, basic and diluted ............................... 217,840 205,428 217,463 203,657
========== ============= ========== =============
See accompanying notes to consolidated financial statements.
4
ENTERASYS NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
NINE MONTHS ENDED
OCTOBER 2, SEPTEMBER 27,
2004 2003
------------ -------------
Cash flows from operating activities:
Net loss................................................................... $ (60,765) $ (103,716)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization......................................... 17,329 23,705
Recoveries on accounts receivable..................................... (2,945) (5,640)
Provision for inventory write-downs................................... 10,751 10,647
Impairment of intangible assets and property, plant and equipment..... 9,188 --
Recovery of notes receivable.......................................... -- (2,450)
Loss on minority investments.......................................... 9,446 24,485
(Gain) loss on foreign currency transactions.......................... (1,775) 3,486
Non-cash tax benefit.................................................. (9,913) --
Gain on legal settlement.............................................. (1,048) --
Other, net............................................................ 22 (805)
Changes in current assets and liabilities:
Accounts receivable........................................................ 10,071 8,715
Inventories................................................................ (10,791) 7,800
Prepaid expenses and other current assets.................................. (8,483) (29,611)
Accounts payable and accrued expenses...................................... (14,317) 18,954
Customer advances and billings in excess of revenues....................... 2,496 2,454
Deferred revenue........................................................... (5,514) (9,660)
Income taxes receivable, net............................................... (964) 28,998
------------- -------------
Net cash used in operating activities................................. (57,212) (22,638)
------------ --------------
Cash flows from investing activities:
Capital expenditures....................................................... (8,104) (13,210)
Proceeds from sale of building............................................. -- 1,250
Proceeds from sale of investments.......................................... 2,169 1,688
Purchase of investments.................................................... (1,450) (550)
Purchase of marketable securities.......................................... (34,360) (39,321)
Sales and maturities of marketable securities............................. 22,777 111,726
Release of restricted cash................................................. 6,277 --
------------ -----------
Net cash (used in) provided by investing activities................... (12,691) 61,583
------------- ------------
Cash flows from financing activities:
Proceeds from exercise of stock options.................................... 1,789 9,299
Proceeds from common stock issued pursuant to employee stock purchase plans 1,713 1,449
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................... 3,502 (81,116)
------------ -------------
Effect of exchange rate changes on cash......................................... (625) 991
------------ -------------
Net decrease in cash and cash equivalents....................................... (67,026) (41,180)
Cash and cash equivalents at beginning of period................................ 136,801 136,193
------------ -------------
Cash and cash equivalents at end of period...................................... $ 69,775 $ 95,013
============ =============
Supplemental disclosure of cash flow information:
Cash (paid) refunds received for income taxes, net........................ $ (1,251) $ 32,239
Non-cash investing and financing transactions:
Accretive dividend and accretion of discount on preferred shares...... $ -- $ 2,192
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 NINE MONTHS ENDED
------------------------- --------------------------
OCTOBER 2, SEPTEMBER 27, OCTOBER 2, SEPTEMBER 27,
2004 2003 2004 2003
---------- ------------- ---------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net loss available to common shareholders, as reported ........... $ (5,807) $ (56,050) $ (60,765) $ (105,908)
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 .......................... (3,015) (4,467) $ (11,638) (14,671)
---------- ---------- ---------- -----------
Pro forma net loss available to common shareholders .............. $ (8,822) $ (60,517) $ (72,403) $ (120,579)
========== ========== ========== ===========
Basic and diluted net loss per share:
As reported .................................................... $ (0.03) $ (0.27) $ (0.28) $ (0.52)
========== ========== ========== ===========
Pro forma ...................................................... $ (0.04) $ (0.29) $ (0.33) $ (0.59)
========== ========== ========== ===========
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 NINE MONTHS ENDED
OCTOBER 2, SEPTEMBER 27, OCTOBER 2, SEPTEMBER 27,
2004 2003 2004 2003
---------- ------------- ---------- -------------
Employee stock options:
Risk-free interest rate ....................... 3.35% 3.05% 3.21% 2.52%
Expected option life........................... 4.36 years 5.59 years 4.52 years 5.37 years
Expected volatility............................ 112.00% 113.02% 112.09% 111.71%
Expected dividend yield........................ 0.0% 0.0% 0.0% 0.0%
Fair value of options granted.................. $1.33 $4.13 $2.12 $2.99
Employee stock purchase plan shares:
Risk-free interest rate........................ 1.95% 1.02% 1.73% 98.0%
Expected option life........................... 6 months 6 months 6 months 6 months
Expected volatility............................ 72.46% 70.64% 72.03% 82.36%
Expected dividend yield........................ 0.0% 0.0% 0.0% 0.0%
Fair value of plan shares...................... $0.87 $1.51 $1.02 $1.04
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 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. On September 30, 2004, the
FASB approved the issuance of FASB Staff Position EITF No. 03-1-1, which delays
the effective date for the application of the recognition and measurement
provisions of EITF No. 03-1 to investments in securities that are impaired.
Certain disclosure provisions in EITF No. 03-1 were effective for fiscal years
ended after December 15, 2003 and other disclosure provisions are effective for
annual reporting periods ending after June 15, 2004. The adoption of this
statement is not expected to have a material effect on the Company's
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, NET
Accounts receivable were as follows:
OCTOBER 2, JANUARY 3,
2004 2004
---------- ----------
(IN THOUSANDS)
Gross accounts receivable.................... $ 31,334 $ 40,938
Allowance for doubtful accounts.............. (1,208) (3,397)
---------- ----------
Accounts receivable, net................... $ 30,126 $ 37,541
========== ==========
The Company defers revenue on product shipments to certain stocking
distributors until those distributors have sold the product to their customer.
At October 2, 2004 and January 3, 2004, $19.9 million and $19.1 million,
respectively, of product shipments had been billed and revenue has not been
recognized, of which $9.7 million and $6.2 million, respectively, was paid and
is included in customer advances and billings in excess of revenues. The balance
of $10.2 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:
OCTOBER 2, JANUARY 3,
2004 2004
---------- ----------
(IN THOUSANDS)
Raw materials.......................... $ 2,852 $ 4,170
Service spares......................... 2,400 2,184
Finished goods......................... 23,824 22,695
---------- ----------
Inventories.......................... $ 29,076 $ 29,049
========== ==========
5. GOODWILL AND INTANGIBLE ASSETS
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets,"
goodwill is subject to an annual impairment test using a fair-value-based
approach. All other intangible assets are amortized over their estimated useful
lives and assessed for impairment under SFAS No. 144, "Accounting for the
Impairment and Disposal of Long-lived Assets." The Company has designated the
end of the third quarter of the fiscal year as the date of the annual test. In
addition to the annual impairment test, SFAS No. 142 also requires the Company
to perform an impairment test if an event or circumstances indicate that it is
more likely than not that an impairment loss has occurred. The Company completed
its annual impairment test at October 2, 2004 and found no impairment of
recorded goodwill. Goodwill at October 2, 2004 and September 27, 2003 was
$15,129.
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 October 2, 2004:
NET CARRYING
GROSS VALUE OF
CARRYING ACCUMULATED INTANGIBLE
AMOUNT AMORTIZATION ASSETS
-------- ------------ ------------
(IN THOUSANDS)
Customer Relations........... $ 28,600 $ (24,511) $ 4,089
Patents and Technology....... 2,092 (1,019) 1,073
-------- ------------ ------------
Total...................... $ 30,692 $ (25,530) $ 5,162
======== ============ ============
All of the Company's identifiable intangible assets are subject to
amortization. Total amortization expense was $0.9 million and $3.5 million for
the three months and nine months ended October 2, 2004, respectively and $1.6
million and $4.9 million for the three and nine months ended September 27, 2003,
respectively. Based on the net carrying value of intangible assets at October 2,
2004, the estimated amortization expense is $1.0 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:
OCTOBER 2, JANUARY 3,
2004 2004
---------- ----------
(IN THOUSANDS)
Accrued audit and accounting expense................. $ 2,058 $ 2,285
Accrued marketing and selling costs.................. 5,459 7,180
Accrued royalties.................................... 1,715 337
Accrued IT and engineering 1,109 1,544
Accrued utilities.................................... 829 822
Accrued sales tax and VAT expense.................... 2,389 4,462
Other................................................ 6,039 7,484
---------- ----------
Total other accrued expenses $ 19,598 $ 24,114
========== ==========
7. RESTRUCTURING AND OTHER CHARGES
The following table summarizes accrued restructuring activity:
TOTAL
SEVERANCE FACILITY EXIT ACCRUED
BENEFITS COSTS RESTRUCTURING
--------- ------------- --------------
(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
Q3 restructuring charges (1) 4,231 1,187 5,418
Q3 cash payments ......... (3,128) (976) (4,104)
--------- ------- --------
Balance, October 2, 2004 ... $ 5,239 $ 6,206 $ 11,445
========= ======= ========
(1) Excludes asset impairment charges of $454.
During the first three 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 the plan was initially 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. The
targeted headcount reductions were achieved in the third quarter of fiscal year
2004. In connection with the targeted headcount reductions and additional
headcount reductions planned in the third quarter of fiscal year 2004, the
Company recorded employee severance related costs of $9.2 million during the
first nine months of fiscal year 2004 for approximately 300 individuals.
Additionally, the Company has exited seven facilities, which included two
research facilities and five regional sales offices, and recorded facility exit
costs of $2.1 million and asset impairment charges of $0.5 million during the
first nine months of fiscal year 2004.
The remaining accrued severance benefits of $5.2 million as of October 2,
2004 will be paid over the next twelve months; and the remaining accrued
facility exit costs of $6.2 million, which consists of long-term lease
commitments of $9.2 million less projected sublease income of $3.0 million, will
be paid as follows: $0.7 million for the remainder of fiscal year 2004, $1.8
million in fiscal year 2005, $1.4 million in fiscal year 2006, $0.6 million in
fiscal year 2007, $0.4 million in fiscal year 2008, and $1.3 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
9
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - - CONTINUED
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.
8. OTHER INCOME (EXPENSE), NET
The following schedule reflects the components of other income(expense),
net:
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------------ --------------------------------------
OCTOBER 2, 2004 SEPTEMBER 27, 2003 OCTOBER 2, 2004 SEPTEMBER 27, 2003
--------------- ------------------ --------------- -------------------
Gain (loss) on minority investments .............. $ 169 $(8,235) $(9,446) $(24,485)
Net realized gain on sale of marketable securities 7 - 7 776
Recovery of note receivable ...................... - - - 2,450
Foreign currency gain (loss) ..................... 1,844 (180) 1,729 (3,040)
Gain on legal settlement ......................... 1,048 - 1,048 -
Other, net ....................................... (88) (135) 426 1,236
------- ------- ------- --------
Total other income(expense), net ............... $ 2,980 $(8,550) $(6,236) $(23,063)
======= ======= ======= ========
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.
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 October 2, 2004, the remaining balance on the note receivable of $1.1 million
remains unpaid, and is fully offset by a valuation allowance.
In the third quarter of fiscal year 2004, the Company recorded a
non-recurring foreign currency benefit of $2.0 million to reflect the period end
cumulative effect of foreign currency translation.
The Company recorded a gain of $1.0 million in the third quarter of fiscal
year 2004 from a legal settlement related to claims pertaining to the sale of a
former subsidiary, Aprisma, in fiscal year 2002.
9. INCOME TAXES
The Company recorded a net income tax benefit of $9.4 million for the
first nine months of fiscal year 2004, compared with income tax expense of $0.7
million for the first nine 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 approximately $12.0 million
in fiscal year 2004. Approximately $9.9 million of the liability reduction was
recognized as a tax benefit during the first nine months of fiscal year 2004,
and the remaining $2.1 million will be recognized during the remainder of fiscal
year 2004.
10
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - - CONTINUED
10. COMPREHENSIVE LOSS
The Company's total comprehensive loss was as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------------- -------------------------------------
OCTOBER 2, 2004 SEPTEMBER 27, 2003 OCTOBER 2, 2004 SEPTEMBER 27, 2003
--------------- ------------------ --------------- ------------------
(IN THOUSANDS)
Net loss ................................. $(5,807) $(56,050) $(60,765) $(103,716)
Other comprehensive income (loss):
Unrealized loss on marketable securities (1) (678) (882) (1,765)
Foreign currency translation adjustment (1,220) (453) (1,595) 4,753
------- -------- -------- ---------
Total comprehensive loss ............. $(7,028) $(57,181) $(63,242) $(100,728)
======= ======== ======== =========
11. SEGMENT INFORMATION
The Company operates its business as one segment, which is the business of
designing, developing, marketing and supporting comprehensive networking
solutions.
Net revenue by geography is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
-------------------------------------- -----------------------------------------
OCTOBER 2, 2004 SEPTEMBER 27, 2003 OCTOBER 2, 2004 SEPTEMBER 27, 2003
------------------ ------------------ ------------------ -------------------
REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT
--------- ------- --------- ------- -------- ------- -------- -------
($ IN THOUSANDS)
North America ................ $ 45,156 51.6% $ 48,094 48.9% $129,873 48.8% $154,417 49.6%
Europe, Middle East and Africa 31,174 35.7 32,535 33.0 94,296 35.4 99,387 31.9
Asia Pacific ................. 5,856 6.7 13,094 13.3 23,832 8.9 38,578 12.4
Latin America ................ 5,224 6.0 4,694 4.8 18,337 6.9 18,867 6.1
-------- ------- --------- ------- -------- ------- -------- -------
Total net revenue ........ $ 87,410 100.0% $ 98,417 100.0% $266,338 100.0% $311,249 100.0%
======== ======= ========= ======= ======== ======= ======== =======
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 31.5 million
and 27.5 million shares of common stock were outstanding at October 2, 2004 and
September 27, 2003, respectively, and 0.5 million and 7.9 million warrants to
purchase shares of the Company's common stock were outstanding at October 2,
2004 and September 27, 2003, respectively, but were not included in the
computation of diluted net loss per share since the effect was anti-dilutive.
Warrants to purchase 7.4 million shares of common stock for an exercise price of
$6.20 per share expired on August 29, 2004.
During the fourth quarter of fiscal year 2003, the Company agreed to
distribute shares of its common stock with a value of $33.0 million to settle
outstanding shareholder litigation. The Company distributed 1,304,340 shares of
common stock during the fourth quarter of fiscal year 2003 and expects to
distribute the remaining 7,423,511 shares of its stock during fiscal year 2004.
In accordance with SFAS No. 128, "Earnings Per Share," the Company considers
these shares to have no contingencies, and accordingly, included these shares of
common stock in its calculation of weighted common stock outstanding at October
2, 2004.
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
11
ENTERASYS NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - - CONTINUED
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.
The Company maintains an accrual for various legal and litigation
expenses, which amounted to an aggregate of $8.0 million at October 2, 2004. The
Company could be obligated to pay up to approximately $3.8 million of the
accrued amounts as early as the fourth 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 $0.2 million and $2.4 million, for
the three and nine months ended October 2, 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. In fiscal
year 2003, the Company recorded the initial receipt of $2.0 million as a
reduction to selling, general and administrative expense, with the balance of
$3.5 million to be paid in 24 monthly installments. Payments received prior to
October 2, 2004 were recorded as a reduction to operating expense when received
due to the uncertainty regarding collectibility of the unpaid amounts. The
Company completed a settlement with Riverstone regarding reimbursement of
previously incurred losses from lease guarantee payments made by the Company. As
a part of the settlement, Riverstone agreed to guarantee the remaining payments
from this customer and the Company recorded a receivable for the remaining
unpaid balance of $1.5 million at October 2, 2004 because collectibility is now
deemed probable.
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 October 2, 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.
At October 2, 2004, the Company was committed to make up to $3.6 million
of future capital contributions to a venture capital fund in which it is a
limited partner. This commitment decreased by $4.6 million from the prior
quarter due to the partial sale of one partnership interest. For the nine months
ended October 2, 2004, the Company's commitment decreased by $8.4 million. In
the event
12
of future capital calls, the Company could be required to fund some or all of
this commitment. Based on recent communications from this fund, the Company
expects approximately $0.5 million of the commitment could be called by the fund
in the fourth quarter 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 remaining 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 $1.0 million and $5.3 million for the three and nine
months ended October 2, 2004, respectively, and $2.5 million and $5.9 million
for the three and nine months ended September 27, 2003, respectively, and was
related to transactions with normal terms and conditions.
In the third quarter of fiscal year 2004, the Company agreed to sell one
of its minority investments to the majority owner for approximately $0.5
million. We believe the transaction price represented the fair market value of
the investment.
15. SUBSEQUENT EVENTS
On October 11, 2004, the Company entered into a settlement agreement with
its former subsidiary, Riverstone, regarding reimbursement of previously
incurred losses from lease guarantee payments made by the Company. As part of
the agreement, Riverstone paid $2.0 million in cash and guaranteed a $1.5
million payable under a prior settlement agreement between the Company and a
Riverstone customer. The Company recorded a receivable for $3.5 million at
October 2, 2004 and a corresponding reduction to selling, general and
administrative expense for the three months ended October 2, 2004.
On October 28, 2004, the Company received $1.2 million in cash as
settlement for previously written off receivables for the final distribution
from a former customer's bankruptcy liquidation. The Company recorded the bad
debt recovery as a receivable at October 2, 2004 and a corresponding reduction
to selling, general and administrative expense for the three months ended
October 2, 2004.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion in conjunction with the section
below titled "Cautionary Statements," our consolidated financial statements and
related notes, and other financial information appearing elsewhere in this
report on Form 10-Q. We caution you that any statements contained in this report
which are not strictly historical statements constitute forward-looking
statements. Such statements include, but are not limited to, statements
reflecting management's expectations regarding our future financial performance;
strategic relationships and market opportunities; and our other business and
marketing strategies and objectives. These statements may be identified with
such words as "we expect," "we believe," "we anticipate," or similar indications
of future expectations. These statements are neither promises nor guarantees,
and involve risks and uncertainties that could cause actual results to differ
materially from such forward-looking statements. Such risks and uncertainties
include, among other things, the factors discussed below under "Cautionary
Statements" and elsewhere in this report. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as of the
date hereof. We expressly disclaim any obligation to publicly update or revise
any such statements to reflect any change in these forward-looking statements,
or in events, conditions, or circumstances on which any such statements may be
based, or that may affect the likelihood that actual results will differ from
those set forth in the forward-looking statements.
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 and infrastructure 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
13
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
primarily from our contracts to provide on-going maintenance and support
services around the world, 7 days a week, 24 hours a day, and also from network
outsourcing contracts and professional services to install, develop and improve
network performance and capabilities.
Net revenues were $266.3 million for the first nine months of fiscal year
2004, which represented a 14.4% decrease from the first nine months of fiscal
year 2003. Net revenues for the third quarter of fiscal year 2004 decreased by
4.7% from the second 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; and declining service revenue due to the expiration of
maintenance contracts on older generation products. The sequential decline in
quarterly net revenue is due primarily to lower product revenue in Asia Pacific
and Latin America and lower service revenue 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 nine
months of fiscal year 2004, we:
- - Continued the refresh of our entire product line including our Matrix C
Series switch product and eleven new modules for our Matrix N Series
switching products; 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;
and introducing a beta version of our Matrix X Series router;
- - 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;
- - Focused our efforts on increasing sales opportunities through our global
partners: EDS, IBM, Lucent, Siemens and Dell; and
- - Completed a cost reduction plan to 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.
While total product revenue declined in the third quarter of fiscal year
2004 from the prior quarter, we believe the successful introduction of our new
products and enhancements is essential to our goal of increasing product revenue
in future quarters. In the third quarter of fiscal year 2004, new product
shipments, defined as products introduced since mid-2003, increased by
approximately $4 million compared to the prior quarter and accounted for
approximately 60% of product shipments.
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 was initially targeted to reduce our global
workforce by approximately 200 individuals, or 14%, from our 2003 fiscal year
end headcount, as well as reduce our annual costs by an aggregate of
approximately $28 million, or $7 million per quarter compared to the first
quarter of fiscal year 2004. The targeted headcount reductions and annual cost
savings were achieved in the third quarter of fiscal year 2004. At the end of
the third quarter of fiscal year 2004, our full-time headcount stood at
approximately 1,180 compared with approximately 1,400 at the end of the prior
fiscal year. In connection with our targeted headcount reductions and additional
headcount reductions planned in the third quarter of fiscal year 2004, we
recorded employee severance related costs of $9.2 million during the first nine
months of fiscal year 2004 for approximately 300 individuals. Additionally, we
have exited seven facilities which included two research facilities and five
regional sales offices and recorded facility exit costs of $2.1 million and
asset impairment charges of $0.5 million during the first nine months of fiscal
year 2004. To the extent we identify additional costs savings opportunities, we
may incur 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 NINE MONTHS ENDED
OCTOBER 2, 2004 SEPTEMBER 27, 2003 OCTOBER 2, 2004 SEPTEMBER 27, 2003
--------------- ------------------ --------------- ------------------
Net revenue:
Product ....................... 74.4 % 71.9% 73.3% 72.4%
Services ...................... 25.6 28.1 26.7 27.6
---- ---- ---- ----
14
Total net revenue ....... 100.0 100.0 100.0 100.0
----- ----- ----- -----
Cost of revenue:
Product ...................... 50.5 57.0 51.8 55.5
Services ..................... 35.2 54.5 38.9 41.4
----- ----- ----- -----
Total cost of revenue .. 46.6 56.3 48.3 51.6
----- ----- ----- -----
Gross Margin:
Product gross margin ......... 49.5 43.0 48.2 44.5
Services gross margin ........ 64.8 45.5 61.1 58.6
----- ----- ----- -----
Total gross margin ..... 53.4 43.7 51.7 48.4
----- ----- ----- -----
Research and development .......... 20.2 21.7 21.7 20.4
Selling, general and administrative 38.9 45.0 45.8 43.0
Amortization of intangible assets . 1.1 1.6 1.3 1.6
Impairment of intangible assets ... -- -- 3.3 --
Shareholder litigation expense .... -- 16.2 -- 5.1
Restructuring charges ............. 6.7 8.5 4.4 5.3
----- ----- ----- -----
Total operating expenses 66.9 93.0 76.5 75.4
----- ----- ----- -----
Loss from operations ... (13.5)% (49.3)% (24.8)% (27.0)%
===== ===== ===== =====
THIRD QUARTER OF FISCAL YEAR 2004 COMPARED TO THE THIRD QUARTER OF FISCAL YEAR
2003
NET REVENUE
Net revenue decreased by $11.0 million or 11.2%, to $87.4 million in the
third quarter of fiscal year 2004 from $98.4 million in the third quarter of
fiscal year 2003 due to lower net product and services revenue. Geographically,
net revenue from Asia Pacific decreased in the third quarter of fiscal 2004 from
the prior year's third quarter by $7.2 million, or 55.3%, primarily due to China
and Japan. Net revenues from North America and Europe, the Middle East, and
Africa also declined by $2.9 million and $1.4 million, respectively. In North
America, a decline in service revenues of $5.0 million was partially offset by
an increase of $2.1 million in product revenues. Net revenue in Latin America
increased by $0.5 million.
Net product revenue of $65.1 million in the third quarter of fiscal year
2004 decreased by $5.7 million, or 8.1%, compared with $70.8 million in the
prior year's third quarter. The decline was 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. Sales of our older generation
core routing products declined to approximately 10% of product revenue for the
third quarter of fiscal year 2004, as compared to 17% for the third quarter of
fiscal year 2003. We are expecting to release our next generation core routing
product, the Matrix X Series, to production during the first quarter of fiscal
year 2005.
In the third quarter of fiscal year 2004, net services revenue of $22.4
million declined by $5.2 million, or 19.1%, compared with $27.6 million in the
third quarter of fiscal year 2003. The decrease was primarily due to a declining
maintenance revenue base in North America resulting from the expiration of
higher priced maintenance contracts on older generation products, as well as
lower professional services revenue. In the near term, we believe future net
services revenue could continue to decline by approximately $1 million to $2
million per quarter from the third quarter of fiscal year 2004 until growth in
new product sales and associated maintenance contracts are sufficient to replace
the expiration of higher-priced maintenance contracts on older generation
products.
GROSS MARGIN
Total gross margin of $46.7 million in the third quarter of fiscal year
2004 increased by $3.7 million compared with $43.0 million in the prior year's
third quarter. As a percentage of net revenue, total gross margin increased to
53.4% in the third quarter of fiscal year 2004 compared with 43.7% in the third
quarter of fiscal year 2003.
Product gross margin was 49.5% in the third quarter of fiscal year 2004
compared with 43.0% in the prior year. The improvement in the product gross
margin percentage was principally due to lower provisions for inventory
write-downs, higher profit margins on newer products, as well as reduced
overhead costs due to cost reduction initiatives. We recorded provisions of $1.1
million and $3.5 million for inventory write-downs in the third quarters of
fiscal years 2004 and 2003, respectively, due to lower projected sales of older
generation products.
Despite the lower service revenues, services gross margin percentage
improved to 64.8% in the third quarter of fiscal year 2004 compared with 45.5%
in the prior year's third quarter, primarily due to lower provisions for
inventory write-downs, and lower labor costs as a result of our workforce
reductions. Increased sales of newer products, as well as expirations of
maintenance contracts on
15
older generation products, resulted in an excess of certain service parts as of
the end of the third quarter of fiscal year 2003. Based on the revised usage
estimates, service spares inventory was written down by $4.4 million to net
realizable value. Services gross margin percentage is likely to be in the range
of 60% until the growth in new product sales and associated maintenance
contracts are sufficient to replace the expiration of legacy maintenance
contracts.
OPERATING EXPENSES
For the third quarter of fiscal year 2004, research and development
expense decreased by $3.7 million to $17.7 million compared with $21.4 million
in the third quarter of fiscal year 2003. The decline from the prior year was
primarily due to lower labor-related costs of $1.4 million from our cost
reduction initiatives, a decrease in outside services of $1.0 million related to
the timing of various projects, and lower depreciation expense of $0.6 million
from reduced capital expenditures.
Selling, general and administrative ("SG&A") expense in the third quarter
of fiscal year 2004 decreased by $10.3 million to $34.0 million compared with
$44.3 million in the prior year. Significant components of the decline in SG&A
expense were increased income of $4.0 million from recoveries of bad debts and
lease guarantees, $1.4 million from reduced professional services expenses, $1.2
million of lower legal expenses related to various litigation matters, claims
and proceedings, $1.1 million of lower depreciation expense from reduced capital
expenditures, and $0.8 million in lower labor-related costs from our cost
reduction initiatives. Included in the significant components described above
were $3.5 million for lease guarantee recoveries from a settlement with our
former subsidiary, Riverstone, and $1.2 million for bad debt recoveries on the
final distribution from a former customer's bankruptcy liquidation.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization costs for intangible assets decreased by $0.7 million to $0.9
million in the third quarter of fiscal year 2004 compared with the prior year 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.
SHAREHOLDER LITIGATION EXPENSE
In October 2003, we reached agreements to settle all outstanding shareholder
litigation against us, our directors and former officers filed in connection
with the financial restatements for the 2001 fiscal and transition years. Under
the financial terms of the settlement, we agreed to pay $17.4 million in cash
and to distribute shares of our stock with a value of $33.0 million. We also
received approximately $34.5 million in cash proceeds from certain of our
insurers in the fourth quarter which we recorded as insurance receivable on the
consolidated balance sheet at September 27, 2003. For the third quarter of
fiscal year 2003, we recorded a shareholder litigation charge of $15.9 million
which reflects the net result of the settlement.
RESTRUCTURING AND OTHER 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 the plan was initially targeted to reduce our global headcount
by approximately 200 individuals from our 2003 fiscal year end headcount, or 14%
of the global workforce. The targeted headcount reductions were achieved in the
third quarter of fiscal year 2004. During the third quarter of fiscal year 2004,
we recorded employee severance related costs of $4.2 million which were
principally due to planned reductions associated with changing our sales model
in China and Japan. Additionally, we exited four facilities, which included a
research facility and three regional sales offices, and recorded facility exit
costs of $1.2 million and asset impairment charges of $0.5 million during the
third quarter of fiscal year 2004. During the third quarter of fiscal year 2003,
we recorded a restructuring charge of $8.3 million which included $6.3 million
for employee severance related costs and $2.0 million of facility exit costs. To
the extent we identify additional cost savings opportunities, there could be
additional restructuring charges in future periods.
Our targeted savings from the fiscal year 2004 cost reduction plan were
achieved in the third quarter and have reduced our annual operating expenses by
approximately $24 million or approximately $6 million per quarter compared to
the first quarter of fiscal year 2004.
INTEREST INCOME, NET
Net interest income declined to $0.6 million in the third quarter of
fiscal year 2004 compared with $1.0 million in the third quarter of fiscal year
2003, principally due to lower average cash and investment balances available
for investing.
16
OTHER INCOME (EXPENSE), NET
Net other income (expense) was $3.0 million for the third quarter of
fiscal year 2004 compared with $(8.6) million for the third quarter of fiscal
year 2003. Gain (loss) on minority investments for the third quarters of fiscal
years 2004 and 2003 were $0.2 million and $(8.2) million, respectively. 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. At October 2, 2004, our
minority investments totaled $1.0 million.
In the third quarter of fiscal year 2004, we recorded a non-recurring
foreign currency benefit of $2.0 million to reflect the period end cumulative
effect of foreign currency translation and a gain of $1.0 million from a legal
settlement related to claims pertaining to the sale of a former subsidiary,
Aprisma, in fiscal year 2002.
INCOME TAX (BENEFIT) EXPENSE
We recorded a net income tax benefit of $2.4 million for the third quarter
of fiscal year 2004, as compared with no tax benefit or provision for the third
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 $12.0 million for fiscal year 2004. Approximately $2.2 million of the
liability reduction was recognized as a tax benefit during the third quarter of
fiscal year 2004, and the remaining $2.1 million will be recognized during the
fourth quarter.
FIRST NINE MONTHS OF FISCAL YEAR 2004 COMPARED TO THE FIRST NINE MONTHS OF
FISCAL YEAR 2003
NET REVENUE
Net revenue decreased by $44.9 million, or 14.4%, to $266.3 million in the
first nine months of fiscal year 2004 from $311.2 million in the first nine
months of fiscal year 2003 primarily due to lower net product and services
revenue. Geographically, net revenue decreased in all regions for the first nine
months of fiscal year 2004 compared to the prior year. The most significant
declines were in Asia Pacific and North America, which had revenue decreases of
$14.7 million, or 38.2%, and $24.5 million, or 15.9%, respectively.
Product revenue of $195.3 million in the first nine months of fiscal year
2004 decreased by $29.9 million, or 13.3%, compared with $225.2 million in the
prior year. The decline was 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. Sales of our older generation core
routing products declined to approximately 10% of product revenue for the first
nine months of fiscal year 2004 compared with approximately 20% for the first
nine months of fiscal year 2003.
In the first nine months of fiscal year 2004, services revenue of $71.1
million decreased by $14.9 million, or 17.4%, compared with $86.0 million in the
prior year. The decrease in net services revenue was primarily due to a
declining maintenance revenue base resulting from the expiration of higher-
priced maintenance contracts on older generation products, as well as lower
professional services revenue.
GROSS MARGIN
Total gross margin of $137.6 million in the first nine months of fiscal
year 2004 declined by $12.9 million compared with $150.5 million in the first
nine months of the prior year. However, total gross margin as a percentage of
net revenue increased to 51.7% compared with 48.4% in the prior year.
Product gross margin was 48.2% for the first nine months of fiscal year
2004 compared with 44.5% in the prior year. The improvement in the product gross
margin percentage was principally due to higher profit margins on newer
products, as well as reduced overhead costs due to cost reduction initiatives,
which was partially offset by a higher provision for inventory write-downs. We
recorded provisions of $8.6 million and $6.3 million for inventory write-downs
during the nine months ended October 2, 2004 and September 27, 2003,
respectively, due to lower projected sales of older generation products.
Despite the lower service revenues, services gross margin percentage
improved to 61.1% in the first nine months of fiscal year 2004 compared with
58.6% in the prior year, primarily due to lower provisions for inventory
write-downs, and lower labor costs as a result of our workforce reductions.
17
OPERATING EXPENSES
For the first nine months of fiscal year 2004, research and development
expense decreased by $5.7 million to $57.8 million compared with $63.5 million
in the prior year. The decline was primarily due to lower labor-related costs of
$1.8 million from our cost reduction initiatives, a decrease in outside services
of $1.3 million related to the timing of various projects, and lower
depreciation expense of $1.2 million from reduced capital expenditures.
SG&A expense of $122.0 million in the first nine months of fiscal year
2004 decreased by $11.8 million compared with $133.8 million in the prior year.
The decrease in SG&A expense was primarily the result of $8.2 million in lower
labor-related costs from our cost reduction initiatives, $2.8 million of lower
legal expenses related to various litigation matters, claims and proceedings,
$2.9 million from reduced professional services expenses, and lower depreciation
expense of $2.3 million from reduced capital expenditures. The decrease in SG&A
expense was partially offset by an increase of $3.9 million in advertising
expenses relating to the launch of our Secure Networks campaign in fiscal year
2004, and $1.6 million of lower income from net recoveries of bad debts and
lease guarantees.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets decreased by $1.4 million to $3.5
million in the first nine months of fiscal year 2004 compared with $4.9 million
in the first nine months of fiscal year 2003, 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 quarter 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.
SHAREHOLDER LITIGATION EXPENSE
In October 2003, we reached agreements to settle all outstanding shareholder
litigation against us, our directors and former officers filed in connection
with the financial restatements for the 2001 fiscal and transition years. Under
the financial terms of the settlement, we agreed to pay $17.4 million in cash
and to distribute shares of our stock with a value of $33.0 million. We also
received approximately $34.5 million in cash proceeds from certain of our
insurers in the fourth quarter which we recorded as insurance receivable on the
consolidated balance sheet at September 27, 2003. For the third quarter of
fiscal year 2003, we recorded a shareholder litigation charge of $15.9 million
which reflects the net result of the settlement.
RESTRUCTURING AND OTHER CHARGES
We recorded restructuring and other charges of $11.8 million related to
workforce reductions and facility closings during the first nine months of
fiscal year 2004. In connection with the workforce reductions, we recorded
employee severance related costs of $9.2 million for approximately 300
individuals. Additionally, we exited seven facilities which included two
research facilities and five regional sales offices and recorded facility exit
costs of $2.1 million and asset impairment charges of $0.5 million during the
first nine months of fiscal year 2004. During the first nine months of fiscal
year 2003, we recorded a restructuring charge of $16.5 million. These
restructuring costs consisted of $13.7 million in employee severance related
costs and $2.8 million of facility exit costs.
INTEREST INCOME, NET
Interest income, net declined to $2.3 million in the first nine months of
fiscal year 2004 compared with $4.2 million in the first nine months of fiscal
year 2003, principally due to lower average cash and investment balances
available for investing and lower interest rates.
OTHER INCOME (EXPENSE), NET
Net other income (expense) was $(6.2) million for the first nine months of
fiscal year 2004 compared with $(23.1) million in the prior year. Loss on
minority investments for the first nine months of fiscal years 2004 and 2003 was
$9.4 million and $24.5 million, respectively. Foreign currency gain (loss) was
$1.7 million for the current year to date compared with $(3.0) million in the
prior year. In fiscal year 2004, we recorded a non-recurring foreign currency
benefit of $2.0 million to reflect the period end cumulative effect of
18
foreign currency translation and a gain of $1.0 million from a legal settlement
related to claims pertaining to the sale of a former subsidiary, Aprisma, in
fiscal year 2002.
INCOME TAX (BENEFIT) EXPENSE
We recorded a net income tax benefit of $9.4 million for the first nine
months of fiscal year 2004 compared with income tax expense of $0.7 million for
the first nine 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 $12.0 million for
fiscal year 2004. Approximately $9.9 million of the liability reduction was
recognized as a tax benefit for the first nine months of fiscal year 2004, and
the remaining $2.1 million will be recognized during the fourth quarter.
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 October 2, 2004:
LESS THAN 1-3 4-5 OVER 5
CONTRACTUAL CASH OBLIGATIONS TOTAL 1 YEAR YEARS YEARS YEARS
- ---------------------------- ----- --------- ----- ----- -----
(IN MILLIONS)
Non-cancelable lease obligations .... $30.3 $ 8.6 $12.3 $ 5.2 $ 4.2
Non-cancelable purchase commitments . 20.3 20.3 -- -- --
Obligations under restructuring plans 11.4 7.4 2.3 0.9 0.8
Other ............................... 7.1 3.6 3.5 -- --
----- --------- ----- ----- -----
Total contractual cash obligations .. $69.1 $ 39.9 $18.1 $ 6.1 $ 5.0
===== ========= ===== ===== =====
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) .... 3.6 1.0 2.6 -- --
----- --------- ----- ----- ------
Total commercial commitments ....... $ 7.6 $ 1.0 $ 2.6 $ -- $ 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 $3.6 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. Based on recent communications from this fund, we
expect approximately $0.5 million of the commitment could be called by the
fund in the fourth quarter 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 remaining partnership interest in this fund to
minimize future capital call funding requirements.
OBLIGATIONS UNDER LEGAL PROCEEDINGS
We maintain an accrual for legal and litigation expenses, which amounted
to an aggregate of $8.0 million at October 2, 2004. We could be obligated to pay
up to approximately $3.8 million of the accrued amounts as early as the fourth
quarter of fiscal year 2004, as a result of final disposition of certain
litigation matters, of which $3.3 million is included in restricted cash. We are
also 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.
BALANCE SHEET AND CASH FLOWS
As of October 2, 2004, our liquid investments totaled $147.1 million, as
compared to $202.5 million at January 3, 2004, and consisted of cash and cash
equivalents of $69.8 million, and short and long-term marketable securities of
$77.3 million. 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 $12.4 million at October 2, 2004, and are
classified as "Restricted cash, cash equivalents and marketable securities" on
our balance sheet. The decrease in liquid
19
investments during the first nine months of fiscal year 2004 is the result of
the loss from operations, net working capital uses, and capital expenditures.
Based on our liquid investment position at October 2, 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 $57.2 million for the nine
months ended October 2, 2004 and consisted of a $29.7 million loss from
operations after adjustments for certain non-cash items, plus net working
capital uses of $27.5 million, primarily due to the timing of inventory
purchases as well as vendor and foreign value added tax payments and annual
incentive payments to employees which offset a reduction from accounts
receivable. Net cash used in operating activities was $14.0 million for the
three months ended October 2, 2004. We may continue to use cash for operating
activities during the fourth quarter of fiscal year 2004 due to an expected
operating loss, but at reduced levels from what we experienced during the third
quarter of fiscal year 2004.
Capital expenditures for the first nine months of fiscal year 2004 were
$8.1 million and consisted of information technology purchases and upgrades,
assets purchased to support outsourcing contracts, 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 $10
million to $12 million for the year. Restricted cash decreased by $6.3 million
during the first nine months of fiscal year 2004 as restrictions relating to
standby letters of credit were released.
Net accounts receivable was $30.1 million at October 2, 2004 compared with
$37.5 million at January 3, 2004. The decrease in accounts receivable is due
primarily to the decline in net revenues. The number of days sales outstanding
was 31 days at October 2, 2004, compared to 33 days at January 3, 2004.
Prepaid expenses and other current assets of $27.5 million at October 2,
2004 have increased by $9.0 million from year end primarily due to the timing of
various receipts expected in the fourth quarter. These receipts include $2.0
million from a settlement with Riverstone, $1.2 million from a settlement with
Aprisma, and $1.2 million for the final distribution from a former customer's
bankruptcy liquidation. Accounts payable at October 2, 2004 of $35.0 million
decreased from $39.7 million at January 3, 2004 due in part to the timing of
payments related to product purchases. Income taxes payable has declined by
$10.3 million to $34.0 million at October 2, 2004 primarily due to a non-cash
tax benefit recognized on updated IRS guidance.
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 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
20
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 October 2, 2004, our inventory valuation reserves were $35.1
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 October 2,
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 for
fiscal year 2004.
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 October 2, 2004, the carrying
value of long-lived assets, including fixed assets and intangible assets, was
$36.8 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. At October 2,
2004, the carrying value of these investments on our balance sheet was $1.0
million. We incurred net losses of $9.4 million relating to these investments
during the first nine months 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 reduction to restructuring charges will be recognized
in the statement of operations. During the first nine months of fiscal year
2004, we recorded restructuring and other charges of approximately $11.8 million
which consisted of $9.2 million for employee severance related costs, $2.1
million for facility exit costs, and asset impairment charges of $0.5 million.
At October 2, 2004, we have estimated sublease income associated with vacated
facilities of approximately $3.0 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
21
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 NINE MONTHS ENDED
-------------------------- --------------------------
OCTOBER 2, SEPTEMBER 27, OCTOBER 2, SEPTEMBER 27,
2004 2003 2004 2003
---------- ------------- ---------- -------------
(IN MILLIONS)
Net recoveries of doubtful accounts and notes receivable $(1.9) $(1.3) $(2.9) $(8.1)
Provision for product inventory write-downs ............ 1.1 3.5 8.6 6.3
Provision for service inventory valuations ............. 0.3 4.4 2.2 4.4
Gain (loss) on minority investments .................... (0.2) 8.2 9.4 24.5
Restructuring and other charges ........................ 5.9 8.3 11.8 16.5
Impairment of intangible assets ........................ -- -- 8.7 --
Deferred tax asset valuation provision ................. (0.3) 6.5 21.0 19.5
----- ----- ----- -----
Total net expense from critical accounting estimates . $ 4.9 $29.6 $58.8 $63.1
===== ===== ===== =====
NEW ACCOUNTING PRONOUNCEMENTS
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. On September 30, 2004, the FASB approved the
issuance of FASB Staff Position EITF No. 03-1-1, which delays the effective date
for the application of the recognition and measurement provisions of EITF No.
03-1 to investments in securities that are impaired. Certain disclosure
provisions in EITF No. 03-1 were effective for fiscal years ended after December
15, 2003 and other disclosure provisions are effective for annual reporting
periods ending after June 15, 2004. The adoption of this statement is not
expected to have a material effect on the Company's 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.
RISKS RELATED TO OUR FINANCIAL RESULTS AND CONDITION
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;
22
- 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;
- 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 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
23
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.
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 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.
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
24
identify, hire, train, assimilate and retain large numbers of highly qualified
engineering, sales, marketing, managerial and support personnel. If we cannot
successfully recruit and retain such persons, particularly in our engineering
and sales departments, our development and introduction of new products could be
delayed and our ability to compete successfully could be impaired.
Despite the current economic downturn, the competition for qualified
employees in our industry is particularly intense in the New England area, where
our principal operations are located, and it can be difficult to attract and
retain quality employees at reasonable cost. We have from time to time
experienced, and we expect to continue to experience in the future, difficulty
in hiring and retaining highly skilled employees with appropriate
qualifications. In addition, the significant downturn in our business
environment has caused us to significantly reduce our workforce and implement
other cost-containment activities. 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.
25
WE EXPECT THE AVERAGE SELLING PRICES OF OUR PRODUCTS TO DECREASE OVER TIME,
WHICH MAY REDUCE OUR REVENUE AND GROSS MARGINS
Our industry has experienced erosion of average selling prices in recent
years, particularly as products reach the end of their life cycles. We
anticipate that the average selling prices of our products will decrease in the
future in response to increased sales discounts and new product or technology
introductions by us and our competitors. Our prices will also likely be
adversely affected by downturns in regional or industry economies. 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
27
to enforce our intellectual property rights, to protect our trade secrets or to
determine the validity and scope of the proprietary rights of others. Litigation
of this type could result in substantial costs and diversion of resources and
could harm our business.
WE MAY BE SUBJECT TO CLAIMS THAT OUR INTELLECTUAL PROPERTY INFRINGES UPON THE
PROPRIETARY RIGHTS OF OTHERS, AND A SUCCESSFUL CLAIM COULD HARM OUR ABILITY TO
SELL AND DEVELOP OUR PRODUCTS
We license technology from third parties and are continuing to develop and
acquire additional intellectual property. Although we have not been involved in
any material litigation relating to our intellectual property, we expect that
participants in our markets will be increasingly subject to infringement claims.
Third parties may try to claim our products infringe their intellectual
property, in which case we would be forced to defend ourselves or our customers,
manufacturers and suppliers against those claims. Any claim, whether meritorious
or not, could be time consuming, result in costly litigation and/or require us
to enter into royalty or licensing agreements. Although we carry general
liability insurance, our insurance may not cover potential claims of this type
or may not be adequate to indemnify us for all liability that may be imposed. In
addition, any royalty or licensing agreements might not be available on terms
acceptable to us or at all, in which case we would have to cease selling,
incorporating or using the products that incorporate the challenged intellectual
property and expend substantial amounts of resources to redesign our products.
If we are forced to enter into unacceptable royalty or licensing agreements or
to redesign our products, our business and prospects would suffer.
RISKS RELATED TO OUR MANUFACTURING AND COMPONENTS
WE USE SEVERAL KEY COMPONENTS FOR OUR PRODUCTS THAT WE PURCHASE FROM SOLE,
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 $10.8 million provision for inventory
write-downs during the first nine months 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 48.4% and 51.2% of our revenue in the three and nine months ended
October 2, 2004, respectively, and 51.1% and 50.4% of our revenue in the three
and nine months ended September 27, 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 October 2, 2004,
these investments totaled approximately $1.0 million. During the first nine
months of fiscal year 2004, we recorded net losses of $9.4 million relating to
these investments.
We are committed to make up to $3.6 million of future 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. Based on recent communications from this fund, we expect
approximately $0.5 million of the commitment could be called by the fund in the
fourth quarter 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;
however, we may be unsuccessful in these efforts and our liquidity position
would be harmed.
OUR FAILURE TO MAINTAIN ADEQUATE SYSTEMS, CONTROLS AND PROCEDURES COULD HARM OUR
BUSINESS
Pursuant to new SEC rules promulgated under Section 404 of 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 over financial reporting. Beginning with our Form 10-K for fiscal year
2004, our independent auditors will be required to attest to the evaluation by
management. If our auditors are not able to attest to management's evaluation of
the effectiveness of our controls over financial reporting, or are unable to
issue an unqualified opinion based on their independent audit of the
effectiveness of such controls, our business could be harmed and our stock price
could decline.
Additionally, if we do not maintain adequate overall systems, controls and
procedures, our ability to manage our business and implement our strategies may
be impaired, irregularities may occur or fail to be identified, and our business
could be harmed and our stock price could decline. We have implemented and
continue to implement changes designed to improve our overall systems, controls
and procedures, including organizational changes, new business systems, new
management information systems, communication of revenue recognition and other
accounting policies to all of our employees, an internal audit function, new
approval procedures and various other initiatives, including extensive
supervisory and management oversight along with process improvement programs.
Some of these changes are complex and involve significant effort, and may also
result in higher future operating expenses, capital expenditures, or both. We
may not be able to successfully implement these changes or improvements, or they
could prove inadequate, and our business could be disrupted, our financial
condition could be harmed and our stock price could decline.
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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;
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- 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.
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
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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.
Foreign Currency Exchange Risk. Due to our global operating and financial
activities, we are exposed to changes in foreign currency exchange rates. At
October 2, 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 October 2,
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
No significant changes were made to our internal controls during our most
recent quarter that have materially affected, or are reasonably likely to
materially affect, our internal controls over financial reporting.
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 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
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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 $0.2 million and $2.4 million, for the three and nine
months ended October 2, 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 6. EXHIBITS
3.1 Amended and Restated Certificate of Incorporation of the Registrant.
3.2 Amended and Restated By-Laws of the Registrant.
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
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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: November 12, 2004 By: William K. O'Brien
Chief Executive Officer and Director
ENTERASYS NETWORKS, INC.
/s/Richard S. Haak, Jr.
--------------------------------------------
Date: November 12, 2004 By: Richard S. Haak, Jr.
Chief Financial Officer
(Principal Financial and Accounting Officer)
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EXHIBIT INDEX
3.1 Amended and Restated Certificate of Incorporation of Registrant.
3.2 Amended and Restated By-Laws of Registrant.
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
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