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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JANUARY 24, 2004

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 000-27273

SYCAMORE NETWORKS, INC.

(Exact name of registrant as specified in its charter)

220 Mill Road

Chelmsford, Massachusetts 01824

(Address of principal executive offices)

(Zip code)

(978) 250-2900

(Registrant’s telephone number, including area code)

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 of the Exchange Act).    Yes  x    No  ¨.

The number of shares outstanding of the Registrant’s Common Stock as of January 31, 2004 was 273,038,378.

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Sycamore Networks, Inc.

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Part I. Financial Information

Item 1. Financial Statements

Sycamore Networks, Inc.

Consolidated Balance Sheets

(in thousands, except par value)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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Sycamore Networks, Inc.

Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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Sycamore Networks, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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Sycamore Networks, Inc.

Notes To Consolidated Financial Statements

1. Description of Business

Sycamore Networks, Inc. (the “Company”) was incorporated in Delaware on February 17, 1998. The Company develops and markets intelligent optical networking products that are designed to enable telecommunications service providers to cost-effectively and easily transition their existing fiber optic network into an infrastructure that can provision, manage and deliver economic, high-bandwidth services to their customers.

2. Basis of Presentation

The accompanying financial data as of January 24, 2004 and for the three and six months ended January 24, 2004 and January 25, 2003 has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2003.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position as of January 24, 2004 and results of operations and cash flows for the periods ended January 24, 2004 and January 25, 2003 have been made. The results of operations and cash flows for the periods ended January 24, 2004 are not necessarily indicative of the operating results and cash flows for the full fiscal year or any future periods.

3. Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the intrinsic value provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”.

Under the intrinsic value method, when the exercise price of the Company’s employee stock awards equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Company’s Consolidated Statements of Operations. The Company currently recognizes compensation expense under APB 25 relating to certain stock options and restricted stock with exercise prices below fair market value on the date of grant.

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The Company is required under SFAS 123 to disclose pro forma information regarding the stock awards made to its employees based on specified valuation techniques that produce estimated compensation charges. The pro forma information is as follows (in thousands, except per share data):

The above pro forma disclosures are not necessarily representative of the effects on reported net income or loss for future periods. The fair value of the stock options at the date of grant was estimated using the Black-Scholes model.

4. Net Loss Per Share

Basic net loss per share is computed by dividing the net loss for the period by the weighted-average number of common shares outstanding during the period less unvested restricted stock. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted-average number of common and common equivalent shares outstanding during the period, if dilutive. Common equivalent shares are composed of unvested shares of restricted common stock and the incremental common shares issuable upon the exercise of stock options and warrants outstanding.

The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share data):

Options to purchase 28.8 million and 29.8 million shares of common stock, at respective average exercise prices of $7.43 and $7.98, have not been included in the computation of diluted net loss per share for the three and six months ended January 24, 2004 and January 25, 2003, respectively, as their effect would have been anti-dilutive. Warrants to purchase 150,000 shares of common stock at an exercise price of $11.69 have not been included in the computation of diluted net loss per share for the three and six months ended January 25, 2003, as their effect would have been anti-dilutive. These warrants expired unexercised during the fiscal year ended July 31, 2003.

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5. Inventories

Inventories consisted of the following (in thousands):

6. Comprehensive Loss

The components of comprehensive loss consisted of the following (in thousands):

7. Restructuring Charges and Related Asset Impairments

In fiscal 2001, the telecommunications industry began a severe decline which has impacted equipment suppliers, including the Company. In response to the telecommunications industry downturn, the Company enacted three separate restructuring programs: the first in the third quarter of fiscal 2001 (the “fiscal 2001 restructuring”), the second in the first quarter of fiscal 2002 (the “first quarter fiscal 2002 restructuring”), and the third in the fourth quarter of fiscal 2002 (the “fourth quarter fiscal 2002 restructuring”). As a part of the Company’s fourth quarter fiscal 2002 restructuring program, the Company discontinued the development of its standalone transport products and focused its business exclusively on optical switching products. During fiscal 2002, as a result of the combined activity under all of the restructuring programs, the Company recorded a total net charge of $241.5 million, which was classified in the statement of operations as follows: cost of revenue - $91.7 million, operating expenses - $125.0 million, and non-operating expenses - $24.8 million. The originally recorded restructuring charges were subsequently reduced by credits totaling $14.6 million (cost of revenue - $10.8 million and operating expenses - $3.8 million). During fiscal 2003, due to various changes in estimates relating to the prior restructuring programs, the Company recorded a credit of $0.5 million classified as cost of revenue, and a net credit of $4.4 million classified as operating expenses as described below.

During the third and fourth quarters of fiscal 2003, the Company recorded a net $4.4 million credit to operating expenses due to various changes in estimates relating to its restructuring programs. The changes in estimates consisted primarily of an $8.6 million reduction in the estimated legal matters associated with the restructuring programs, a $0.9 million credit relating to proceeds received from the disposal of certain equipment and a $0.8 million reduction in the costs associated with a workforce reduction, partially offset by $4.9 million of additional facility consolidation charges and a $1.0 million charge for the write-down of certain land. In addition, the Company recorded a $0.5 million credit to cost of revenue relating to a favorable settlement with a supplier. While the Company has reduced the accrual for potential legal matters based on its current estimate, given the inherent uncertainties involved in such matters, it is reasonably possible that the Company may incur a loss in addition to the amount accrued. In addition, in the event that other contingencies associated with the restructuring programs occur, or the estimates associated with the restructuring programs are revised, the Company may be required to record additional charges or credits against the reserves previously recorded for its restructuring programs.

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As of January 24, 2004, the Company had $15.6 million in accrued restructuring costs, consisting primarily of $15.1 million of accrued liabilities for facility consolidations. Details regarding each of the restructuring programs are described below.

Fiscal 2001 Restructuring:

The fiscal 2001 restructuring program included a workforce reduction of 131 employees, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products and overlapping feature sets. The Company recorded restructuring charges and related asset impairments of $81.9 million classified as operating expenses and an excess inventory charge of $84.0 million relating to discontinued product lines, which was classified as cost of revenue. The restructuring charges included amounts accrued for potential legal matters, administrative expenses and professional fees associated with the restructuring programs, including employment termination related claims. The Company substantially completed the fiscal 2001 restructuring program during the first half of fiscal 2002. In the fourth quarter of fiscal 2002, the Company recorded a net $2.1 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted primarily of $4.7 million of additional facility consolidation charges due to less favorable sublease assumptions, offset by a $6.7 million reduction in the potential legal matters associated with the restructuring programs. During the third and fourth quarters of fiscal 2003, the Company recorded a net $1.3 million charge to operating expenses due to various changes in estimates. The changes in estimates consisted of $3.6 million of additional facility consolidation charges due to less favorable sublease assumptions, partially offset by a $2.3 million reduction in potential legal matters associated with the restructuring programs. As of January 24, 2004, the projected future cash payments of $11.2 million consist of facility consolidation charges that will be paid over the respective lease terms through fiscal 2007, and potential legal matters associated with the restructuring programs.

The restructuring charges and related asset impairments recorded in the fiscal 2001 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):

First Quarter Fiscal 2002 Restructuring:

The first quarter fiscal 2002 restructuring program included a workforce reduction of 239 employees, consolidation of excess facilities and charges related to excess inventory and other asset impairments. As a result, the Company recorded restructuring charges and related asset impairments of $77.3 million classified as operating expenses and an excess inventory charge of $102.4 million classified as cost of revenue. In addition, the Company recorded charges totaling $22.7 million, classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. The restructuring charges included $7.1 million of costs relating to the workforce reduction, $11.2 million related to the write-down of certain land, lease terminations and non-cancelable lease costs and $6.0 million for potential legal matters, administrative expenses and professional fees associated with the restructuring programs, including employment termination related claims. The restructuring charges also included $102.4 million for inventory write-downs and non-cancelable purchase commitments for inventories due to a severe decline in the forecasted demand for the Company’s products and $53.1 million for asset impairments related to the Company’s vendor financing agreements and fixed assets that the Company abandoned.

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The first quarter fiscal 2002 restructuring program was substantially completed during the fourth quarter of fiscal 2002. During the third and fourth quarters of fiscal 2002, the Company recorded credits totaling $10.8 million to cost of revenue due to changes in estimates, the majority of which related to favorable settlements with contract manufacturers for non-cancelable inventory purchase commitments. In addition, during the fourth quarter of fiscal 2002, the Company recorded a net $1.7 million credit to operating expenses relating to various changes in estimates. The changes in estimates consisted of a $1.7 million reduction in potential legal matters associated with the restructuring programs and the reversal of an accrued liability of $0.8 million for workforce reductions, partially offset by $0.9 million of additional facility consolidation charges. During the third and fourth quarters of fiscal 2003, the Company recorded a net $1.4 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted of a $2.2 million reduction in potential legal matters associated with the restructuring programs, partially offset by $0.8 million of additional facility consolidation charges due to less favorable sublease assumptions. In addition, the Company recorded a $1.0 million non-cash charge to operating expenses for the write-down of certain land and a $0.5 million credit to cost of revenue relating to a favorable settlement with a supplier. As of January 24, 2004, the projected future cash payments of $1.0 million consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2005 and potential legal matters associated with the restructuring programs.

The restructuring charges and related asset impairments recorded in the first quarter fiscal 2002 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):

Fourth Quarter Fiscal 2002 Restructuring:

The fourth quarter fiscal 2002 restructuring program included a workforce reduction of 225 employees, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products. This included discontinuing the development of the Company’s standalone transport products, including the SN 8000 Intelligent Optical Transport Node and the SN 10000 Intelligent Optical Transport System. As a result, the Company recorded restructuring charges and related asset impairments of $51.5 million classified as operating expenses. In addition, the Company recorded a charge of $2.1 million, classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. The restructuring charges included $8.7 million of costs relating to the workforce reduction, $5.6 million for lease terminations and non-cancelable lease costs and $14.5 million relating to potential legal matters, contractual commitments, administrative expenses and professional fees related to the restructuring programs, including employment termination related claims. The restructuring charges also included $22.6 million of costs relating to asset impairments, which primarily included fixed assets that were disposed of, or abandoned, due to the rationalization of the Company’s product offerings and the consolidation of excess facilities. The fourth quarter fiscal 2002 restructuring program was substantially completed during the first half of fiscal 2003.

During the third and fourth quarters of fiscal 2003, the Company recorded a net $4.4 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted of a $4.1 million reduction in potential legal matters associated with the restructuring programs and a $0.8 million reduction in the costs associated with the workforce reduction, partially offset by $0.5 million of additional facility consolidation charges. In addition, the Company recorded a $0.9 million credit to operating expenses relating to proceeds received from the disposal of certain equipment. As of January 24, 2004, the projected future cash payments of $3.4 million consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2006 and potential legal matters and contractual commitments associated with the restructuring programs.

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The restructuring charges and related asset impairments recorded in the fourth quarter fiscal 2002 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):

8. Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides guidance on accounting for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 were applied to multiple element revenue arrangements entered into by the Company beginning in the first quarter of fiscal 2004. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position or results of operations.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 requires that its provisions are effective immediately for all arrangements entered into after January 31, 2003. The Company does not have any financial interests in variable interest entities created after January 31, 2003. For those arrangements entered into prior to January 31, 2003, FIN 46, as amended by FIN 46R, provisions are required to be adopted by the Company in the third quarter of fiscal 2004. The adoption of FIN 46R is not expected to have a material impact on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS 150, “Accounting For Certain Financial Instruments with Characteristics of Both Liabilities and Equity” which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on the Company’s financial position or results of operations.

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”), which supercedes SAB 101, Revenue Recognition in Financial Statements. The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s financial statements.

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9. Commitments and Contingencies

Litigation

Beginning on July 2, 2001, several purported class action complaints were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors (the “Individual Defendants”) and the underwriters for the Company’s initial public offering on October 21, 1999. Some of the complaints also include the underwriters for the Company’s follow-on offering on March 14, 2000. The complaints were consolidated into a single action and an amended complaint was filed on April 19, 2002. The amended complaint, which is the operative complaint, was filed on behalf of persons who purchased the Company’s common stock between October 21, 1999 and December 6, 2000. The amended complaint alleges violations of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, primarily based on the assertion that the Company’s lead underwriters, the Company and the other named defendants made material false and misleading statements in the Company’s Registration Statements and Prospectuses filed with the SEC in October 1999 and March 2000 because of the failure to disclose (a) the alleged solicitation and receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock to certain investors in the Company’s public offerings and (b) that certain of the underwriters allegedly had entered into agreements with investors whereby underwriters agreed to allocate the public offering shares in exchange for which the investors agreed to make additional purchases of stock in the aftermarket at pre-determined prices. The amended complaint alleges claims against the Company, several of the Company’s officers and directors and the underwriters under Sections 11 and 15 of the Securities Act. It also alleges claims against the Company, the individual defendants and the underwriters under Sections 10(b) and 20(a) of the Securities Exchange Act. The amended complaint seeks damages in an unspecified amount.

The action against the Company is being coordinated with approximately three hundred other nearly identical actions filed against other companies. The actions seek damages in an unspecified amount. On October 9, 2002, the court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. The Company has approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a proposed settlement between the Company and the plaintiff class. Among other provisions, the settlement contemplated by the MOU provides for a release of the Company and the individual defendants with respect to claims related to the conduct alleged in the action to be wrongful. Pursuant to the settlement contemplated by the MOU, the Company would agree to undertake certain responsibilities, including agreeing to assign to the plaintiffs, and not otherwise assert or release, certain potential claims the Company may have against its underwriters. It is anticipated that any potential financial obligation of the Company to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, the Company does not expect that the settlement will involve any payment by the Company. The MOU and related agreements are subject to a number of contingencies, including the negotiation of a settlement agreement and its approval by the Court. The Company is unable to determine whether or when a settlement will occur or be finalized. In the event that a settlement is not finalized, the Company is not currently able to estimate the possibility of loss or range of loss, if any, relating to these claims. Due to the large number of nearly identical actions, the Court has ordered the parties to select up to twenty “test” cases. To date, along with six other cases, the Company’s case has been selected as one such test case. As a result, among other things, the Company will be subject to discovery obligations and expenses in the litigation, whereas non-test case issuer defendants will not be subject to such obligations.

On April 1, 2003, a complaint was filed against the Company in the United States Bankruptcy Court for the Southern District of New York by the creditors’ committee (the “Committee”) of 360networks (USA), inc. and 360networks services inc. (the “Debtors”). The Debtors are the subject of a Chapter 11 bankruptcy proceeding but are not plaintiffs in the complaint filed by the Committee. The complaint seeks recovery of alleged preferential payments in the amount of approximately $16.1 million, plus interest. The Committee alleges that the Debtors made the preferential payments under Section 547(b) of the Bankruptcy Code to the Company during the 90-day period prior to the Debtors’ bankruptcy filings. The Company believes that the claims against it are without merit and intends to defend against the complaint vigorously. The Company is not currently able to estimate the possibility of loss or range of loss, if any, relating to these claims.

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The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s results of operations or financial position.

Guarantees

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation assumed under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002 only for those items that require disclosure. As of January 24, 2004 , the Company’s guarantees requiring disclosure consist of its accrued warranty obligations and indemnifications for intellectual property infringement claims.

In the normal course of business, the Company may also agree to indemnify other parties, including customers, lessors and parties to other transactions with the Company, with respect to certain matters. The Company has agreed to hold these other parties harmless against losses arising from a breach of representations or covenants, or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company, if any, under these agreements have not had a material impact on the Company’s operating results or financial position. Accordingly, the Company has not recorded a liability for these agreements as the Company believes the fair value is not material.

Warranty liability

The Company records a warranty liability for parts and labor on its products at the time revenue is recognized. Warranty periods are generally three years from installation date. The estimate of the warranty liability is based primarily on the Company’s historical experience in product failure rates and the expected material and labor costs to provide warranty services.

The following table summarizes the activity related to product warranty liability during the six months ended January 24, 2004 (in thousands):

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Except for the historical information contained herein, we wish to caution you that certain matters discussed in this report constitute forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including, without limitation, those risks and uncertainties discussed under the heading “Factors That May Affect Future Operating Results” contained in this Form 10-Q. The information discussed in this report should be read in conjunction with our Annual Report on Form 10-K and other reports we file from time to time with the Securities and Exchange Commission. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise. Forward-looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words.

Overview

Sycamore Networks, Inc. was incorporated in Delaware on February 17, 1998.

Sycamore develops and markets optical networking products for telecommunications service providers worldwide. Our current and prospective customers include domestic and international large, established telecommunications service providers (sometimes referred to as incumbent service providers), Internet service providers, non-traditional telecommunications service providers, newer start-up service providers (sometimes referred to as emerging service providers), systems integrators, governments and enterprise organizations with private fiber networks. We believe that our products enable service providers to cost-effectively and easily transition their existing fiber optic network into an infrastructure that can provision, manage and deliver economic, high-bandwidth services to their customers.

For the last several years, the market for our products in the United States was influenced by regulatory changes, in particular, the Telecommunications Act of 1996, and the entry of a substantial number of new companies into the communications service business both domestically and internationally. These new companies, commonly referred to as emerging service providers, raised significant amounts of capital, much of which they invested in capital expenditures to build out their networks. In order to compete with the new emerging service providers, incumbent service providers also increased their capital expenditures above their historical levels. These trends accelerated the growth of the telecommunications equipment industry, including the demand for our products.

Over the last three years, these trends began to reverse and the telecommunications industry began to decline. In addition, there has been a sharp contraction in the availability of capital to our industry. As a result, many emerging service providers were no longer able to finance the build-out of their networks and subsequently have failed or have significantly reduced the scope of their business operations. In addition, many incumbent service providers also had difficulty raising additional capital and have experienced significant financial difficulties. As a result of these developments service providers have reduced capital spending. At the same time, both the United States economy and the economies in substantially all of the countries in which we market our products have slowed significantly. As a result, our existing and prospective customers have become more conservative in their capital expenditures and more uncertain about their future purchases. As a consequence, we are facing a market that is both reduced in size and more difficult to predict and plan for.

These trends have had a number of significant effects on our business, including a decline in revenue of $309.6 million, or 83%, in fiscal 2002 compared to fiscal 2001 and a decline in revenue of $26.9 million, or 41%, in fiscal 2003 compared to fiscal 2002. In response to the telecommunications industry downturn, we enacted three separate restructuring programs through the fourth quarter of fiscal 2002. As a result of our restructuring programs we have incurred net charges totaling $402.4 million, comprised as follows: $175.1 million of net charges related to excess inventory, $202.5 million of net charges for restructuring and related asset impairments, and $24.8 million of losses on investments.

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Our restructuring programs have reduced our cost structure compared to historical levels, however, we maintain a significant cost structure, particularly within the research and development, sales and customer support organizations. We believe this cost structure is necessary to develop, market and sell our products to our current and prospective customers. We expect that our significant investment in our current cost structure will continue to have an adverse impact on our cost of revenue, gross margins and operating results. At this time, we cannot predict when, or if, the market conditions and the demand for our products will improve.

As a result of the downturn in the telecommunications industry, our restructuring programs and our decision to maintain a significant cost structure, we have incurred a cumulative net loss of $761.4 million at January 24, 2004.

During the second quarter of fiscal 2004, the Defense Information Systems Agency (DISA) selected our products to serve as the optical digital cross connect platform for the Global Information Grid Bandwidth Expansion (GIG-BE) project. The project was awarded as an indefinite-delivery and indefinite-quantity subcontract. As such, our visibility into the potential size of the project or the timing of shipments is limited. We did not recognize any revenue from the GIG-BE project in our second quarter.

While we believe that our success in the GIG-BE project validates our technology, we continue to face significant challenges including but not limited to the following: (i) we continue to compete against a number of larger more established incumbent telecom equipment suppliers, many of whom have long-standing relationships with our current and prospective customers; (ii) the incumbent competitors generally have more diverse product lines which allow them the flexibility to price their products more aggressively and absorb the large optical switching overhead expenses across their entire business; and (iii) in order to remain competitive, we continue to devote significant resources to research and development, sales and customer support which may cause us to generate operating losses and consume cash. In order to address these challenges, the Company continues to examine a variety of options to broaden our strategic direction including, but not limited to, alliances with larger networking companies, acquisitions of companies with either complementary technologies or of companies that participate in adjacent market segments or other strategic transactions.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. The preparation of these financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires us to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses and disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, including those relating to the allowance for doubtful accounts, inventory allowance, valuation of investments, warranty obligations, restructuring liabilities and asset impairments, litigation and other contingencies. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

We believe that the following critical accounting policies affect the most significant judgments, assumptions and estimates we use in preparing our consolidated financial statements. Changes in these estimates can affect materially the amount of our reported net income or loss.

When products are shipped to customers, we evaluate whether all of the fundamental criteria for revenue recognition have been met. The most significant revenue recognition judgments typically involve customer acceptance and whether collection is reasonably assured.

Some of our transactions involve the sale of products and services under multiple element arrangements. While each individual transaction varies according to the terms of the purchase order or sales agreement, a typical multiple element arrangement may include some or all of the following components: product shipments, installation services, maintenance and training. The total sales price is allocated based on the relative fair value of each component, which generally is the price charged for each component when sold separately. For the product portion, we recognize revenue upon shipment if there are no significant uncertainties regarding customer acceptance. If uncertainties regarding customer acceptance exist, we recognize revenue when the uncertainties are resolved.

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For installation services, typically we recognize revenue for services that have been performed upon acceptance in accordance with the contract. For maintenance and training services, we recognize revenue when the services are performed.

The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts. In the event that we become aware of deterioration in a particular customer’s financial condition, a review is performed to determine if additional provisions for doubtful accounts are required.

We accrue for warranty costs at the time revenue is recognized based on contractual rights and on the historical rate of claims and costs to provide warranty services. If we experience an increase in warranty claims above historical experience or our costs to provide warranty services increase, we may be required to increase our warranty accrual. An increase in the warranty accrual will have an adverse impact on our gross margins.

We continuously monitor inventory balances and record inventory allowances for any excess of the cost of the inventory over its estimated market value, based on assumptions about future demand and market conditions. While such assumptions may change from period to period, we measure the net realizable value of inventories using the best information available as of the balance sheet date. If actual market conditions are less favorable than those projected, or we experience a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, additional inventory allowances may be required, such as the $102.4 million charge we recorded in the first quarter of fiscal 2002.

Once we have written down inventory to its estimated net realizable value, we cannot increase its carrying value due to subsequent changes in demand forecasts. Accordingly, if inventory previously written down to its net realizable value is subsequently sold, we may realize improved gross profit margins on these transactions.

During the third quarter of fiscal 2001 and the first and fourth quarters of fiscal 2002, we recorded charges for restructuring and related asset impairments totaling $422.0 million, including inventory related charges of $186.4 million. These restructuring programs required us to make numerous assumptions and estimates such as future revenue levels and product mix, the timing of and the amounts received for subleases of excess facilities, the fair values of impaired assets, the amounts of other than temporary impairments of strategic investments, and the potential legal matters, administrative expenses and professional fees associated with the restructuring programs.

We continuously monitor the judgments, assumptions and estimates relating to the restructuring programs and, if these judgments, assumptions and estimates change, we may be required to record additional charges or credits against the reserves previously recorded for these restructuring programs. For example, during the third and fourth quarters of fiscal 2003, we recorded a net credit totaling $4.4 million to operating expenses, due to various changes in estimates relating to all of our restructuring programs. These credits included decreases in the accruals for potential legal matters associated with the restructuring programs and workforce reduction costs, partially offset by increases in the accrual for additional facility consolidation charges due to less favorable sublease assumptions. While we have reduced the accrual for potential legal matters based on our current estimate, given the inherent uncertainties involved in such matters, it is reasonably possible that we may incur a loss in addition to the amount accrued. In addition, in the event that other contingencies associated with the restructuring programs occur, or the estimates associated with the restructuring programs are revised, we may be required to record additional charges or credits against the reserves previously recorded for the restructuring programs. As of January 24, 2004, we had $15.1 million accrued as part of our restructuring liability relating to facility consolidations, based on our best estimate of the available sublease rates and terms at the present time. In the event that we are unsuccessful in subleasing any of the restructured facilities, we could incur additional restructuring charges and cash outflows in future periods totaling $1.2 million, which represents our current estimate of the assumed sublease recoveries.

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Results of Operations

Revenue

Total revenue was $6.9 million and $10.8 million for the second quarter of fiscal 2004 and the second quarter of fiscal 2003, respectively. Total revenue was $15.3 million and $16.8 million for the first six months of fiscal 2004 and the first six months of fiscal 2003, respectively. The decrease in revenue is primarily due to constrained service provider capital expenditures in optical switching and continued extended trial and evaluation periods by our prospective customers. Product revenue declined by 51% for the three months ended January 24, 2004 compared to the three months ended January 25, 2003. The demand for our products has been relatively flat, down 5%, in the first six months ended January 24, 2004, as compared to the first six months ended January 25, 2003. Service revenue decreased by 5% and 15%, respectively, for the three and six months ended January 24, 2004, compared to the three and six months ended January 25, 2003. The decrease in service revenue was primarily due to a lower level of installation services associated with our product deployments. For the second quarter of fiscal 2004, three international customers accounted for the majority of our revenue and international revenue represented 98% of our total revenue. For the second quarter of fiscal 2003, three international customers accounted for the majority of our revenue and international revenue represented more than 82% of our total revenue. For our current fiscal year ending July 31, 2004, we anticipate that revenue will continue to be highly concentrated in a relatively small number of customers and that international revenue may continue to represent a relatively high percentage of total revenue.

Gross profit (loss)

Gross profit (loss) for product and services, including non-cash stock-based compensation expense, was as follows (in thousands, except percentages):

Product gross profit (loss)

Product gross profit was 39.3% of product revenue for the second quarter of fiscal 2004 compared to 11.7% for the second quarter of fiscal 2003. Product gross profit was 39.8% for the six months ended January 24, 2004 compared to (7.3%) product gross loss for the six months ended January 25, 2003. The improvement in product gross profit was attributable to the expiration of preexisting warranty obligations, decreased manufacturing cost and reduced material cost.

We believe that product gross profit may decrease in the future due to pricing pressures resulting from intense competition as a result of limited optical switching opportunities worldwide. In addition, product gross profit may be affected in future periods by changes in the mix of products sold, channels of distribution, shipment volume, overhead absorption, sales discounts, increases in material or labor costs, excess inventory and obsolescence charges, loss of cost savings due to changes in component pricing, the introduction of new products or entering new markets with different pricing and cost structures.

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Service gross profit (loss)

Service gross profit was 31.5% of service revenue for the second quarter of fiscal 2004 compared to a service gross loss of (29.3%) of revenue for the second quarter of fiscal 2003. Service gross profit was 19.6% for the six months ended January 24, 2004 compared to a service gross loss of (14.4%) for the same period of fiscal 2003. Service gross margins increased in both the three months and six months ended January 24, 2004 as compared to the same periods ended January 25, 2003 due to a reduction in service delivery cost as a result of lower fixed support costs.

Service gross profit may be affected in future periods by various factors such as the change in mix between technical support services and advanced services, as well as the timing of technical support service contract initiations and renewals.

Research and Development Expenses

Research and development expenses for the second quarter of fiscal 2004 decreased $1.6 million, or 13%, to $11.8 million from $13.4 million for the second quarter of fiscal 2003. Research and development expenses decreased $4.4 million, or 16%, to $23.0 million for the six months ended January 24, 2004 compared to $27.4 million for the same period in fiscal 2003. The decrease in expenses for the three and six months ended January 24, 2004 was primarily due to reduced costs for project materials, a decrease in personnel-related expenses and reduced fixed overhead costs.

Sales and Marketing Expenses

Sales and marketing expenses for the second quarter of fiscal 2004 decreased $0.8 million, or 14%, to $4.3 million from $5.1 million for the second quarter of fiscal 2003. Sales and marketing expenses decreased $1.2 million, or 13%, to $8.8 million for the six months ended January 24, 2004 compared to $10.0 million for the same period of fiscal 2003. The decrease in expenses was primarily due to lower personnel-related expenses.

General and Administrative Expenses

General and administrative expenses for the second quarter of fiscal 2004 decreased $0.3 million, or 15%, to $1.5 million from $1.8 million for the second quarter of fiscal 2003. General and administrative expenses increased $0.1 million, or 1%, to $3.5 million for the six months ended January 24, 2004 compared to $3.4 million for the same period in fiscal 2003. The decrease in expenses for the three months ended January 24, 2004 was due to lower personnel related expenses. For the six months ended January 24, 2004 lower personnel costs were offset by increased expenses relating to new regulatory requirements including certain provisions of the Sarbanes-Oxley Act.

Stock-Based Compensation Expense

Total stock-based compensation expense for the second quarter of fiscal 2004 decreased $0.2 million, or 8%, to $1.9 million from $2.1 million for the second quarter of fiscal 2003. Total stock compensation decreased $1.1 million, or 23%, to $3.4 million for the six months ended January 24, 2004 compared to $4.5 million for the same period in fiscal 2003. For the three and six months ended January 24, 2004, $0.2 million and $0.4 million of stock compensation expense was classified as cost of revenue, respectively, and $1.7 million and $3.0 million was classified as operating expenses, respectively. Stock-based compensation expense primarily resulted from the granting of stock options and restricted shares with exercise or sale prices that were deemed to be below fair market value. The decrease was primarily due to headcount reductions from the second quarter of fiscal 2003 through the second quarter of fiscal 2004. Stock-based compensation expense is expected to impact our reported results of operations through the fourth quarter of fiscal 2005.

In fiscal 2001, the telecommunications industry began a severe decline which has impacted equipment suppliers, including Sycamore. In response to the telecommunications industry downturn, we enacted three separate restructuring programs: the first in the third quarter of fiscal 2001 (the “fiscal 2001 restructuring”), the second in the first quarter of fiscal 2002 (the “first quarter fiscal 2002 restructuring”), and the third in the fourth quarter of fiscal 2002 (the “fourth quarter fiscal 2002 restructuring”). As a part of our fourth quarter fiscal 2002 restructuring program, we discontinued the development of our standalone transport products and focused our

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business exclusively on optical switching products. During fiscal 2002, as a result of the combined activity under all of the restructuring programs, we recorded a total net charge of $241.5 million, which was classified in the statement of operations as follows: cost of revenue - $91.7 million, operating expenses - $125.0 million, and non-operating expenses - $24.8 million. The originally recorded restructuring charges were subsequently reduced by credits totaling $14.6 million (cost of revenue - $10.8 million and operating expenses - $3.8 million). During fiscal 2003, due to various changes in estimates relating to the prior restructuring programs, we recorded a credit of $0.5 million classified as cost of revenue, and a net credit of $4.4 million classified as operating expenses as described below.

During the third and fourth quarters of fiscal 2003, we recorded a net $4.4 million credit to operating expenses due to various changes in estimates relating to our restructuring programs. The changes in estimates consisted primarily of a $8.6 million reduction in the estimated legal matters associated with the restructuring programs, a $0.9 million credit relating to proceeds received from the disposal of certain equipment and a $0.8 million reduction in the costs associated with a workforce reduction, partially offset by $4.9 million of additional facility consolidation charges and a $1.0 million charge for the write-down of certain land. In addition, we recorded a $0.5 million credit to cost of revenue relating to a favorable settlement with a supplier. While we have reduced the accrual for potential legal matters based on our current estimate, given the inherent uncertainties involved in such matters, it is reasonably possible that we may incur a loss in addition to the amount accrued. In addition, in the event that other contingencies associated with the restructuring programs occur, or the estimates associated with the restructuring programs are revised, we may be required to record additional charges or credits against the reserves previously recorded for our restructuring programs.

As of January 24, 2004, we had $15.6 million in accrued restructuring costs, consisting primarily of $15.1 million of accrued liabilities for facility consolidations. Details regarding each of the restructuring programs are described below.

Fiscal 2001 Restructuring:

The fiscal 2001 restructuring program included a workforce reduction of 131 employees, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products and overlapping feature sets. We recorded restructuring charges and related asset impairments of $81.9 million classified as operating expenses and an excess inventory charge of $84.0 million relating to discontinued product lines, which was classified as cost of revenue. The restructuring charges included amounts accrued for potential legal matters, administrative expenses and professional fees associated with the restructuring programs, including employment termination related claims. We substantially completed the fiscal 2001 restructuring program during the first half of fiscal 2002. In the fourth quarter of fiscal 2002, we recorded a net $2.1 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted primarily of $4.7 million of additional facility consolidation charges due to less favorable sublease assumptions, offset by a $6.7 million reduction in the potential legal matters associated with the restructuring programs. During the third and fourth quarters of fiscal 2003, we recorded a net $1.3 million charge to operating expenses due to various changes in estimates. The changes in estimates consisted of $3.6 million of additional facility consolidation charges due to less favorable sublease assumptions, partially offset by a $2.3 million reduction in potential legal matters associated with the restructuring programs. As of January 24, 2004, the projected future cash payments of $11.2 million consist of facility consolidation charges that will be paid over the respective lease terms through fiscal 2007, and potential legal matters associated with the restructuring programs.

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The restructuring charges and related asset impairments recorded in the fiscal 2001 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):

First Quarter Fiscal 2002 Restructuring:

The first quarter fiscal 2002 restructuring program included a workforce reduction of 239 employees, consolidation of excess facilities and charges related to excess inventory and other asset impairments. As a result, we recorded restructuring charges and related asset impairments of $77.3 million classified as operating expenses and an excess inventory charge of $102.4 million classified as cost of revenue. In addition, we recorded charges totaling $22.7 million, classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. The restructuring charges included $7.1 million of costs relating to the workforce reduction, $11.2 million related to the write-down of certain land, lease terminations and non-cancelable lease costs and $6.0 million for potential legal matters, administrative expenses and professional fees associated with the restructuring programs, including employment termination related claims. The restructuring charges also included $102.4 million for inventory write-downs and non-cancelable purchase commitments for inventories due to a severe decline in the forecasted demand for our products and $53.1 million for asset impairments related to our vendor financing agreements and fixed assets that we abandoned.

The first quarter fiscal 2002 restructuring program was substantially completed during the fourth quarter of fiscal 2002. During the third and fourth quarters of fiscal 2002, we recorded credits totaling $10.8 million to cost of revenue due to changes in estimates, the majority of which related to favorable settlements with contract manufacturers for non-cancelable inventory purchase commitments. In addition, during the fourth quarter of fiscal 2002, we recorded a net $1.7 million credit to operating expenses relating to various changes in estimates. The changes in estimates consisted of a $1.7 million reduction in potential legal matters associated with the restructuring programs and the reversal of an accrued liability of $0.8 million for workforce reductions, partially offset by $0.9 million of additional facility consolidation charges. During the third and fourth quarters of fiscal 2003, we recorded a net $1.4 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted of a $2.2 million reduction in potential legal matters associated with the restructuring programs, partially offset by $0.8 million of additional facility consolidation charges due to less favorable sublease assumptions. In addition, we recorded a $1.0 million non-cash charge to operating expenses for the write-down of certain land and a $0.5 million credit to cost of revenue relating to a favorable settlement with a supplier. As of January 24, 2004, the projected future cash payments of $1.0 million consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2005 and potential legal matters associated with the restructuring programs.

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The restructuring charges and related asset impairments recorded in the first quarter fiscal 2002 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):

Fourth Quarter Fiscal 2002 Restructuring:

The fourth quarter fiscal 2002 restructuring program included a workforce reduction of 225 employees, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products. This included discontinuing the development of our standalone transport products, including the SN 8000 Intelligent Optical Transport Node and the SN 10000 Intelligent Optical Transport System. As a result, we recorded restructuring charges and related asset impairments of $51.5 million classified as operating expenses. In addition, we recorded a charge of $2.1 million, classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. The restructuring charges included $8.7 million of costs relating to the workforce reduction, $5.6 million for lease terminations and non-cancelable lease costs and $14.5 million relating to potential legal matters, contractual commitments, administrative expenses and professional fees related to the restructuring programs, including employment termination related claims. The restructuring charges also included $22.6 million of costs relating to asset impairments, which primarily included fixed assets that were disposed of, or abandoned, due to the rationalization of our product offerings and the consolidation of excess facilities. The fourth quarter fiscal 2002 restructuring program was substantially completed during the first half of fiscal 2003.

During the third and fourth quarters of fiscal 2003, we recorded a net $4.4 million credit to operating expenses due to various changes in estimates. The changes in estimates consisted of a $4.1 million reduction in potential legal matters associated with the restructuring programs and a $0.8 million reduction in the costs associated with the workforce reduction, partially offset by $0.5 million of additional facility consolidation charges. In addition, we recorded a $0.9 million credit to operating expenses relating to proceeds received from the disposal of certain equipment. As of January 24, 2004, the projected future cash payments of $3.4 million consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2006 and potential legal matters and contractual commitments associated with the restructuring programs.

The restructuring charges and related asset impairments recorded in the fourth quarter fiscal 2002 restructuring program, and the reserve activity since that time, are summarized as follows (in thousands):