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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

Form 10-Q

(Mark One)

For the quarter ended March 28, 2004

OR

For the transition period from              to             

Commission file number 000-25711

EXTREME NETWORKS, INC.

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code: (408) 579-2800

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 of the Registrant’s Common Stock, $.001 par value, outstanding at April 26, 2004 was 119,962,046.

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EXTREME NETWORKS, INC.

FORM 10-Q

QUARTERLY PERIOD ENDED MARCH 28, 2004

INDEX

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Part I. Financial Information

Item 1. Financial Statements

EXTREME NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

See accompanying notes to the unaudited condensed consolidated financial statements.

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EXTREME NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements.

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EXTREME NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements.

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EXTREME NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Summary of Significant Accounting Policies

Basis of Presentation

The unaudited condensed consolidated financial statements of Extreme Networks, Inc. (referred to as “Extreme Networks” and as “we”, “us”, and “our”) included herein have been prepared 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 generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated balance sheet at June 29, 2003 was derived from audited financial statements as of that date but does not include all disclosures required by generally accepted accounting principles for complete financial statements. These interim financial statements and notes should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003.

The unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, that, in the opinion of management, are necessary for a fair presentation of the results of operations and cash flows for the interim periods presented and the financial condition of Extreme Networks at March 28, 2004. The results of operations for the three and nine months ended March 28, 2004 are not necessarily indicative of the results that may be expected for fiscal 2004 or any future periods.

Reclassifications

Certain items previously reported in specific financial statement captions have been reclassified to conform to the fiscal 2004 presentation. Such reclassifications have not impacted previously reported revenue, operating loss or net loss. During fiscal 2003, net revenue from service fees increased to greater than 10% of total net revenues, requiring us to separately report product and service revenues. In connection with the revised presentation of service revenue and cost of service revenue, we reclassified $4.8 million and $15.4 million, respectively, of service expenses for the three and nine months ended March 30, 2003 that had previously been included in operating expenses.

Revenue Recognition

We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated from service fees relating to the maintenance and training on our products. Our revenue recognition policy follows SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. We generally recognize product revenue from end-user and reseller customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the sales proceeds is reasonably assured. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period in accordance with FASB Technical Bulletin 90.1. Maintenance contracts typically range from one to five years. When sales arrangements contain multiple elements such as hardware, maintenance and other services, we allocate revenue to each element based on the guidance provided by Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), which is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. EITF 00-21 addresses certain aspects of accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. We adopted EITF 00-21 prospectively and the adoption of EITF 00-21 did not have a material impact on our results of operations or financial position.

We make certain sales to partners in two-tier distribution channels. The first tier consists of a limited number of independent distributors that sell primarily to resellers and, on occasion, to end-user customers. Under specified conditions, we grant these distributors the right to return a portion of unsold inventory to us for the purpose of stock rotation. We defer recognition of revenue on all sales to these distributors until the distributors sell the product, as evidenced by a monthly sales-out report that the distributors provide to us. The second tier of the distribution channel consists of a large number of third-party resellers that sell directly to end-users and are generally not granted return privileges, except for defective products during the warranty period. We reduce product revenue for certain price protection rights that may occur under contractual arrangements we have with our customers.

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Inventories

Inventories consist of (in thousands):

Product Warranties

Our standard hardware warranty period is typically 12 months from the date of shipment to end-users and 14 months from the date of shipment to channel partners, which include resellers and distributors. Upon shipment of products to our customers, including both end users and channel partners, we estimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability for this amount. The determination of warranty requirements is based on actual historical experience with the product or product family, estimates of repair and replacement costs and any product warranty problems that are identified after shipment. We estimate and adjust these accruals at each balance sheet date in accordance with changes in these factors. Changes in our warranty accrual are as follows (in thousands):

Deferred Support Revenue

We offer renewable support arrangements, including extended warranty contracts, to our customers that range generally from one to five years. The change in our deferred support revenue balance in relation to these arrangements was as follows (in thousands):

Stock Based Compensation

We issue stock options to our employees and outside directors and provide employees the right to purchase our stock pursuant to stockholder approved stock option and employee stock purchase programs. Currently we account for our stock-based compensation plans under the intrinsic value method of accounting as defined by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The following table depicts the effect on net loss and net loss per share if we had accounted for our stock option and stock purchase plans under the fair value method of accounting under SFAS No. 123, Accounting for Stock Based Compensation:

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We estimated the fair value of our options using the Black-Scholes option valuation model, which is one of the several methods that can be used to estimate options values. The Black-Scholes model requires the input of highly subjective assumptions, including the expected stock price volatility, and changes in the subjective input assumptions can materially affect the fair value estimates.

Recently Issued Accounting Standards

Consolidation of Variable Interest Entities

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). 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 (“VIE”) should be included in the consolidated financial statements of the entity. For arrangements entered into after January 31, 2003, FIN 46 was effective immediately. For arrangements entered into prior to February 1, 2003, FIN 46 was scheduled to be effective at the end of the period ending after December 15, 2003. In December 2003, FIN 46 was revised to require application in financial statements of public entities that have interests in special-purpose entities for periods ending after December 15, 2003. For all other types of variable interest entities, application is required for periods ending after March 15, 2004. The adoption of the remaining provisions of FIN 46, as revised, in our third quarter of fiscal 2004 did not have a material impact on our results of operations or financial condition.

2. Commitments, Contingencies and Leases

Line of Credit

We have a revolving line of credit for $10.0 million with Silicon Valley Bank. Borrowings under this line of credit bear interest at the bank’s prime rate. As of March 28, 2004, there were no outstanding borrowings under this line of credit. The line of credit contains a provision for the issuance of letters of credit not to exceed the unused balance of the line. As of March 28, 2004, we had letters of credit totaling $0.9 million. These letters of credit were primarily issued to satisfy requirements of certain of our customers for performance bonds. The line of credit requires us to maintain specified financial covenants related to tangible net worth and liquidity with which we were in compliance as of March 28, 2004. The line of credit expires on January 27, 2005.

Lease Liability

As part of our business relationship with MCMS, Inc. (“MCMS”), the predecessor-in-interest to Plexus Corp., we entered into a $9.0 million operating equipment lease for manufacturing equipment in September 2000 with a third-party financing company; we, in turn, subleased the equipment to MCMS. The equipment lease with the third-party financing company requires us to make monthly payments through September 2005 and to maintain certain specified financial covenants with which we were in compliance as of March 28, 2004. During the first quarter of fiscal 2002, due to the liquidity problems at MCMS and its voluntary filing for protection under Chapter 11, we recorded a charge of $9.0 million related to this lease. The liability, net of payments, related to this lease is included in lease liability on the condensed consolidated balance sheets.

Purchase Commitments

We currently have arrangements with one contract manufacturer and other suppliers for the manufacture of our products. Our arrangements allow them to procure long lead-time component inventory on our behalf based upon a rolling production forecast provided by us. We are obligated to the purchase of long lead-time component inventory that our contract manufacturer procures in accordance with our forecast, unless we give notice of order cancellation outside of applicable component lead-times. As of March 28, 2004, we were committed to purchase approximately $24.7 million of such inventory during the fourth quarter of fiscal 2004.

Legal Proceedings

On May 27, 2003, Lucent Technologies, Inc. (“Lucent”) filed suit against Extreme Networks and Foundry Networks, Inc. (“Foundry”) in the United States District Court for the District of Delaware, Civil Action No. 03-508. The complaint alleges willful infringement of U.S. Patent Nos. 4,769,810, 4,769,811, 4,914,650, 4,922,486 and 5,245,607 and seeks a judgment: (a) determining that we have willfully infringed each of the five patents; (b) determining that Foundry has willfully infringed four of the five patents; (c) permanently enjoining us from infringement, inducement of infringement and contributory

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infringement of each of the five patents; (d) permanently enjoining Foundry from infringement, inducement of infringement and contributory infringement of four of the five patents; and (e) awarding Lucent unspecified amounts of trebled damages, together with expenses, costs and attorneys’ fees.

We answered Lucent’s complaint on July 16, 2003, denying that we have infringed any of the five patents and also asserting various affirmative defenses and counterclaims that seek judgment: (a) that Lucent’s complaint be dismissed and Lucent be denied all requested relief; (b) declaring that we do not infringe, induce infringement or contribute to the infringement of any valid and enforceable claim of the five patents, (c) that each of the five patents be declared invalid; (d) finding the case exceptional within the definition of 35 U.S.C. § 285; and (e) that Lucent pay our attorneys’ fees and costs.

Discovery is proceeding. As set forth above, we have denied Lucent’s allegations and intend to defend the action vigorously. We cannot be certain, however, that we will prevail in this litigation, which could have a material, adverse effect on our financial position, results of operations and cash flows in the future.

Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District of New York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ. No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.).

The operative amended complaint is brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8, 1999 through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the “Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondary offering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings in exchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. The amended complaint also alleges that false analyst reports were issued. No specific damages are claimed.

Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied the motions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of the Securities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respective issuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims under Section 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, on the basis that the respective amended complaints alleged that the individuals sold stock.

We have decided to accept a settlement proposal presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against the Extreme Networks Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of the IPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will not be required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of the insurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured, after class members are given the opportunity to object to the settlement or opt out of the settlement. If the settlement is not approved, we cannot be certain that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on our consolidated financial position, results of operations and cash flows in the future.

We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters, including the specific matters discussed above, is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

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3. Comprehensive Loss

Comprehensive loss was as follows (in thousands):

4. Income Taxes

For the third quarter and first nine months of fiscal 2004, we recorded an income tax provision of $0.3 million and $1.1 million, respectively, as compared with an income tax benefit of $4.1 million and $19.3 million for the corresponding periods of fiscal 2003. For fiscal 2004, this income tax provision was recorded for taxes due on income generated in certain state and foreign tax jurisdictions. Income tax benefits have been recorded on the quarter and year-to-date fiscal 2004 pre-tax loss and we have provided a full valuation allowance against such benefits.

5. Net Loss Per Share

Basic earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period, less shares subject to repurchase, and excludes any dilutive effects of options, warrants and convertible subordinated notes. Dilutive earnings per share is calculated by dividing net income by the weighted average number of common shares used in the basic earnings (loss) per share calculation plus the dilutive effect, if any, of shares subject to repurchase, options, warrants and convertible subordinated notes. Diluted net loss per share was the same as basic net loss per share for the three and nine months ended March 28, 2004 and March 30, 2003 because we had net losses in those periods.

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

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The following table sets forth potential shares of common stock that are not included in the diluted net loss per share calculation above because to do so would be anti-dilutive for the periods (in thousands):

6. Restructuring Charge

During the first quarter of fiscal 2004, we recorded a restructuring charge of approximately $1.0 million, $0.9 million of which represented increases to the initial excess facilities charges recognized during fiscal 2003 and fiscal 2002 for domestic and international facilities discussed below. The commercial real estate market has continued to deteriorate since the previous charges were recorded in the third quarter of fiscal 2002 and in the second quarter of fiscal 2003 and current estimated sublease proceeds differ from our initial estimates.

During the nine months ended March 30, 2003, we recorded a restructuring charge of $14.2 million. The restructuring charge included excess facilities charges of $9.6 million, severance charges of $2.7 million and asset impairments of $1.9 million. The excess facilities charge represents an increase to the charge recognized during the third quarter of fiscal 2002. Because the commercial real estate market continued to deteriorate since we took the initial charge in the third quarter of fiscal 2002, we were required to increase our reserves to take into account the unfavorable difference between lease obligation payments and projected sublease receipts. The severance charges were related to a reduction in total staff of approximately 100 people, or 10% of the total workforce, across all departments. The asset impairment charge relates to the write-off of leasehold improvements and office furniture related to excess facilities. As a result of these charges, our expense levels will be lowered in future quarters.

The actual costs and sublease recoveries could differ from these estimates, and additional facilities charges could be incurred if we are unsuccessful in negotiating reasonable termination fees on certain facilities, if facility operating lease rental rates continue to decrease in the relevant real estate markets, if it takes longer than expected to find a suitable tenant to sublease these facilities, or if other estimates and assumptions change.

Restructuring liabilities consist of (in thousands):

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7. Stock Option Exchange Program

On March 25, 2003, we filed a Tender Offer Statement on Schedule TO with the Securities and Exchange Commission related to a voluntary stock option exchange program for our employees. Our executive officers, directors and sales executives who report directly to the Vice President, Worldwide Sales were not eligible to participate in this program. Under the program, eligible employees were given the opportunity to voluntarily cancel unexercised vested and unvested stock options previously granted to them that had an exercise price greater than $12.00. For each option for five shares tendered for cancellation, a new option for three shares was granted to employees who elected to participate in the option exchange program. In order to receive new stock options, an employee must have been employed by us or by one of our subsidiaries on October 23, 2003 when the replacement options were granted. Participants who elected to exchange any options were required to exchange all eligible options and were also required to exchange any other options granted to him or her in the previous six months. The replacement stock options vested 25% on October 23, 2003 and the remaining 75% of the replacement stock options vest monthly over 24 to 36 months based on the employee’s hire date. Options for approximately 11.0 million shares of common stock held by 570 employees were eligible for exchange under the program. Options for approximately 9.3 million shares of common stock held by 435 employees were accepted for exchange under this program and, accordingly, were canceled on April 22, 2003. Replacement options for approximately 5.1 million shares of common stock were issued on October 23,2003 at an exercise price of $7.07 per share, which was the fair market value of our common stock on October 23, 2003. The stock option exchange program did not result in any stock compensation expense or variable accounting for replacement awards.

8. Alliance with Avaya Inc.

On October 30, 2003, Extreme Networks and Avaya Inc. entered into a strategic alliance to jointly develop and market converged communications solutions, by executing a joint development agreement, and a distribution agreement under which Avaya is entitled to resell Extreme Networks products. Extreme issued to Avaya a warrant with a ten-year expiration period to purchase up to 2.6 million shares of Extreme Networks common stock at a price of $0.01 per share, with Avaya having the right to exercise the warrant with respect to one third of such shares 90 days after the date of the agreements, and the remaining shares become exercisable based upon the completion of certain milestones by Avaya. Even if the milestones are not completed, however, the warrant will become fully exercisable for all shares 90 days prior to the expiration of the warrant. Avaya exercised the warrant with respect to one third of the shares subject to the warrant on March 17, 2004 and, accordingly, approximately 859,000 shares of our common stock were issued to Avaya on that date.

Extreme Networks engaged an independent valuation firm to estimate the fair value of the warrant and to assist with the allocation of the fair value to the agreements entered into. The independent valuation firm estimated the fair value of the warrant at $22.7 million which has been allocated $17.9 million to the joint development agreement and $4.8 million to the distribution agreement based on the assumptions provided by management related to the projected revenue and expenses for the respective agreements.

The values assigned to the respective agreements will be amortized over a three-year period as the agreements span a three-year period. Management believes that it would not be prudent to assume there would be any benefit beyond the three-year period due to the nature of the industry it operates in. The amortization of the warrant cost related to the joint development agreement charged as research and development expense was $1.5 million and $2.5 million, respectively, in the three and nine month periods ending March 28, 2004. The amortization related to the distribution agreement included as contra-revenue in product net revenue was $0.4 million in the third quarter of fiscal 2004 and $0.7 million in the nine months ended March 28, 2004.

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

This quarterly report on Form 10-Q, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements relating to our expectations regarding results of operations, product demand and revenue, cash flows, product gross margins, our expectations to continue to develop new products and enhance existing products, our expectations regarding the amount of research and development expenses, and selling, general and administrative expenses, our efforts to achieve additional operating efficiencies and to review and improve our business systems and cost structure, our expectations to continue investing in technology, resources and infrastructure, our expectations concerning the availability of products from suppliers and contract manufacturers, anticipated product costs and sales prices, our expected effective income tax rate, our expectations that we have sufficient capital to meet our requirements for at least the next twelve months, our expectations regarding the rationalization of our workforce and facilities, and our expectations regarding materials and inventory management. These forward-looking statements involve risks and uncertainties, and the cautionary statements set forth below and those contained in the section entitled “Risk Factors” identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-Q and other filings we have made with the Securities and Exchange Commission.

Critical Accounting Policies and Estimates

Our significant accounting policies are more fully described in Note 1 of Notes to Consolidated Financial Statements included in our Form 10-K for the year ended June 29, 2003. The preparation of our consolidated financial statements in accordance with generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. We base our estimates and judgments on historical experience, market trends and other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the critical accounting policies stated below, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated from service fees relating to the maintenance and training on our products. Our revenue recognition policy follows SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. We generally recognize product revenue from our end-user and reseller customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the sales proceeds is reasonably assured. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period in accordance with FASB Technical Bulletin 90.1. Maintenance contracts typically range from one to five years. When sales arrangements contain multiple elements such as hardware, maintenance and other services, we allocate revenue to each element based on the guidance provided by Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), which is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. EITF 00-21 addresses certain aspects of accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. We adopted EITF 00-21 prospectively and the adoption of EITF 00-21 did not have a material impact on our results of operations or financial position.

We make certain sales to partners in two-tier distribution channels. The first tier consists of a limited number of independent distributors that sell primarily to resellers and, on occasion, to end-user customers. Under specified conditions, we grant these distributors the right to return a portion of unsold inventory to us for the purpose of stock rotation. We defer recognition of revenue on all sales to these distributors until the distributors sell the product, as evidenced by a monthly sales-out report that the distributors provide to us. The second tier of the distribution channel consists of a large number of third-party resellers that sell directly to end-users and are generally not granted return privileges, except for defective products during the warranty period. We reduce product revenue for certain price protection rights that may occur under contractual arrangements we have with our customers.

We provide an allowance for sales returns based on our historical returns, analysis of credit memo data and our return policies. The allowance is charged to net revenues in the accompanying condensed unaudited consolidated statements of operations. If the historical data we use to calculate the estimated sales returns and allowances does not properly reflect future levels of product returns, these estimates are revised, thus resulting in an impact on future net revenues. We estimate and adjust this allowance at each balance sheet date.

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Inventories

The networking industry is characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. We perform a detailed assessment of inventory at each balance sheet date, which includes a review of, among other factors, demand requirements, product lifecycle and product development plans and quality issues. Based on this analysis, we record adjustments, when appropriate, to reflect inventory at net realizable value. In fiscal 2003, demand for our products was adversely affected by the downturn in the global economy and reduced telecommunications and infrastructure capital spending, particularly in the United States. Although we make every effort to ensure the accuracy of our forecasts of product demand, any significant unanticipated changes in demand or technological developments would significantly impact the value of our inventory and our reported operating results. In the future, if we find that our estimates are too optimistic and we determine that our inventory needs to be written down, we will be required to recognize such costs in our cost of revenue at the time of such determination. Conversely, if we find our estimates are too pessimistic and we subsequently sell product that has previously been written down, our gross margin in that period will be favorably impacted.

Warranty Reserves

Networking products may contain undetected hardware or software errors when new products or new versions or updates of existing products are released to the marketplace. We have experienced such errors in connection with products and product upgrades. Our standard hardware warranty period is typically 12 months from the date of shipment to end-users and 14 months from the date of shipment to channel partners, which include resellers and distributors. Upon shipment of products to our customers, including both end-users and channel partners, we estimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability for this amount.

The determination of our warranty requirements is based on our actual historical experience with the product or product family, estimates of repair and replacement costs and any product warranty problems that are identified after shipment. We estimate and adjust these accruals at each balance sheet date in accordance with changes in these factors. While we believe that our warranty accrual is adequate and that the judgments applied in calculating this accrual are appropriate, the assumptions used are based on estimates and these estimated amounts could differ materially from our actual warranty expenses in the future.

Allowance for Doubtful Accounts

We continually monitor and evaluate the collectibility of our trade receivables based on a combination of factors. We record specific allowances for bad debts in general and administrative expense when we become aware of a specific customer’s inability to meet its financial obligation to us, such as in the case of bankruptcy filings or deterioration of financial position. Estimates are used in determining our allowances for all other customers based on factors such as current trends in the length of time the receivables are past due and historical collection experience. We mitigate some collection risk by requiring most of our customers in the Asia-Pacific region, excluding Japan, to pay cash in advance or secure letters of credit when placing an order with us.

Deferred Tax Asset Valuation Allowance

We calculate deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We make an assessment of the likelihood that our net deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not believed to be likely, a valuation allowance is established. During the fourth quarter of fiscal 2003, we established a full valuation allowance for our net deferred tax assets.

The valuation allowance was calculated in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“SFAS 109”), which requires an assessment of both negative and positive evidence when measuring the need for a valuation allowance. In accordance with SFAS 109, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain. Our net losses in recent periods represented sufficient negative evidence to require a full valuation allowance against our net deferred tax assets under SFAS 109. This valuation allowance will be evaluated periodically and can be reversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets.

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Legal Contingencies

We are currently involved in various claims and legal proceedings. Periodically, we review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals, if any, are based only on the most current and dependable information available at any given time. As additional information becomes available, we may reassess the potential liability from pending claims and litigation and the probability of claims being successfully asserted against us. As a result, we may revise our estimates related to these pending claims and litigation. Such revisions in the estimates of the potential liabilities could have a material impact on our consolidated results of operations, financial position and cash flows in the future. For further detail, see Note 2 of Notes to Condensed Consolidated Financial Statements for a description of legal proceedings.

Results of Operations

Net revenues. Our product revenue is derived primarily from sales of our Summit, BlackDiamond and Alpine product families. Service revenue comprises fees for services relating to the maintenance of our products and, to a lesser extent, from providing training services. Maintenance billings are deferred and recognized ratably over the service period obligations, which typically range from one to five years. During fiscal 2003, revenue from service fees increased to greater than 10% of total net revenues, requiring us to separately report product and service revenues.

Product revenue decreased to $76.1 million for the third quarter of fiscal 2004 from $76.4 million for the third quarter of fiscal 2003, a decrease of $0.3 million. This slight decrease was primarily due to decreases of $6.0 million in our revenue in international markets, offset by an increase of $5.7 million in our revenue in the United States. Product revenue decreased to $224.3 million for the first nine months of fiscal 2004 from $248.1 million for the first nine months of fiscal 2003, a decrease of $23.8 million. This decrease was primarily due to decreases of $11.3 million, $9.1 million and $3.6 million in our business in the United States, Japan and Asia, respectively. The decreases in our revenue in the United States for the nine months ended March 28, 2004 was primarily due to weakness in demand in the U.S. enterprise networking market in the first two quarters of the current fiscal year. We are experiencing some erosion of average selling prices of our products due to a number of factors, including competitive pricing pressures, promotional pricing and rapid technological change. The Avaya warrant amortization included as contra-revenue in product net revenue was $0.4 million in the third quarter of fiscal 2004 and $0.7 million in the nine months ended March 29, 2004.

Service revenue increased to $12.8 million for the third quarter of fiscal 2004 from $8.9 million for the third quarter of fiscal 2003, an increase of $3.9 million. Service revenue increased to $35.4 million for the first nine months of fiscal 2004 from $27.9 million for the first nine months of fiscal 2003, an increase of $7.5 million. These increases were primarily due to increases in our installed base of equipment and renewal of our service contracts outstanding.

Sales of products and services outside the United States accounted for approximately 60% of our business in the first nine months of fiscal 2004 and fiscal 2003. We expect that export sales will continue to represent a significant portion of net revenues, although export sales may fluctuate as a percentage of net revenues. Substantially all sales transactions are denominated in United States dollars.

The world economy in general, and the United States economy in particular have experienced a prolonged downturn for information technology products which we believe has adversely affected demand for our products and has made it increasingly difficult to accurately forecast future production requirements. While we are seeing indications that the economic outlook is no longer deteriorating, we cannot predict the extent, timing or duration of any improvement in the economies where we sell our products. Further, we expect that our net revenues during fiscal 2004 will be significantly affected by the timing and success of the introduction of new products during the fiscal year.

No customer accounted for greater than 10% of our net revenues for the three and nine months ended March 28, 2004. Two distributors, Westcon Corp and Tech Data Corporation, accounted for 13% and 11%, respectively, of our net revenues and one reseller, Hitachi Cable Ltd., accounted for 10% of our net revenues for the three months ended March 30, 2003. Tech Data Corporation accounted for 12% of our net revenues for the nine months ended March 30, 2003. The level of sales to any customer may vary from period to period; however, we expect that sales to a few key customers will represent a high percentage of revenue for the foreseeable future.

Gross margin. Cost of product revenues includes costs of raw materials, direct labor, manufacturing overhead, amounts paid to third-party contract manufacturers and costs related to warranty. Product gross margin increased to 54.7% for the third quarter of fiscal 2004 from 45.9% for the third quarter of fiscal 2003. Product gross margin increased to 54.5% for the first

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nine months of fiscal 2004 from 47.7% for the first nine months of fiscal 2003. The increase in product gross margin was primarily due to lower per-unit product costs and the effect of our cost reduction programs including lower warranty costs and lower overhead costs. The lower per-unit product cost was achieved as a result of our consolidation of all manufacturing to one contract manufacturer.

During the first nine months of fiscal 2003, we experienced a higher than normal rate of product warranty expense due to problems with various component parts within our products and our election, in some cases, to address those problems by replacing such products with new rather than refurbished replacements. The lower warranty expense in the first nine months of fiscal 2004 was attributable to operational changes we implemented to reduce these expenses. The lower overhead costs were due to cost reduction plans we put in place beginning in the first quarter of 2003.

We expect to realize lower per-unit product costs from our contract manufacturer as a result of volume and improved efficiencies as production matures. However, we do not know if or when such per unit cost reductions will occur. The failure to obtain these cost reductions could have a material adverse effect upon our gross margin and operating results. We anticipate some of these ongoing cost improvements will be offset by higher per unit costs of products we are currently introducing which are incurring higher costs during the pre-production phase of their manufacturing cycle.

Our cost of service consists primarily of labor, overhead, repair and freight costs and the cost of spares used in providing support under customer service contracts.

Service gross margin increased to 29.9% for the third quarter of fiscal 2004 from a negative 12.7% for the third quarter of fiscal 2003. Service gross margin increased to 23.9% for the first nine months of fiscal 2004 from a negative 2.1% for the first nine months of fiscal 2003. Service gross margin for the three and nine months ended March 30, 2003 was negatively impacted by a number of programs that we implemented to improve service delivery productivity and to enhance customer satisfaction. These programs included expenses incurred to increase service revenue and reduce service infrastructure, including outsourcing certain service functions. The service margins in the three and nine months ended March 28, 2004 reflect the benefits we achieved from these programs.

Our gross margin is variable and dependent on many factors, some of which are outside of our control. Some of the primary factors affecting gross margin include demand for our products, changes in our pricing policies and those of our competitors, and the mix of products sold. Our gross margin may be adversely affected by increases in material or labor costs, increases in warranty expense or the cost of providing services under extended service contracts, heightened price competition and obsolescence charges. In addition, our gross margin may fluctuate due to the mix of distribution channels through which our products are sold, including the effects of our two-tier distribution model. Any significant decline in sales to our resellers, distributors or end-user customers, or the loss of any of our key resellers, distributors or end-user customers could have a material adverse effect on our business, operating results and financial condition. In addition, an increase in distribution channels generally makes it more difficult to forecast the mix of products sold and the timing of orders from our customers. New product introductions may result in excess or obsolete inventories, which may also reduce our gross margin. Furthermore, if we are not able to reduce product or related warranty costs in future quarters, gross margin would be adversely affected.

Sales and marketing expenses. Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing and sales functions, as well as trade shows and promotional expenses. Sales and marketing expenses decreased to $23.3 million for the third quarter of fiscal 2004 from $25.0 million for the third quarter of fiscal 2003, a decrease of $1.7 million. This decrease was primarily due to reduced spending for advertising and marketing programs of $1.7 million, decreased depreciation expense of $0.3 million and decreased travel expenses of $0.3 million, offset by an increase of outside professional services of $0.5 million. Sales and marketing expenses decreased to $68.8 million for the first nine months of fiscal 2004 from $78.1 million for the first nine months of fiscal 2003, a decrease of $9.3 million. This decrease was primarily due to decreased payroll and related personnel expenses of $2.6 million, reduced spending for advertising and marketing programs of $3.4 million, decreased depreciation expense of $1.6 million, decreased travel expenses of $1.0 million and decreases in other expenses consistent with a lower level of sales, offset by an increase of outside professional services of $0.9 million. The decreases in payroll and related personnel expenses during the first nine months of fiscal 2004 resulted from the reductions in staff in the second and fourth quarters of fiscal 2003 and reductions in commissions earned due to reduced net revenues. The decrease in depreciation was due to the fixed asset write-offs recorded in the second quarter of fiscal 2003. The rate of future spending in our sales and marketing expenses will largely depend on the pace of recovery in the market for networking products.

Research and development expenses. Research and development expenses consist principally of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development, testing and enhancement of

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our products. Research and development expenses increased to $15.0 million for the third quarter of fiscal 2004 from $13.7 million for the third quarter of fiscal 2003, an increase of $1.3 million. This increase was primarily due to amortization expense of $1.5 million related to the $17.9 million of the fair value of the warrant allocated to the joint development agreement with Avaya. Research and development expenses increased to $42.9 million for the first nine months of fiscal 2004 from $41.7 million for the first nine months of fiscal 2003, an increase of $1.2 million. This result was due to increased amortization expense of $2.5 million related to the joint development agreement with Avaya and increased fees for outside professional services of $0.7 million, offset by decreased payroll and related personnel expenses of approximately $1.4 million and decreased depreciation expense of $0.6 million. The decreases in payroll and related personnel expenses resulted from the reductions in staff in the second and fourth quarters of fiscal 2003 and the decrease in depreciation is due to the fixed asset write-offs recorded in the second quarter of fiscal 2003. We expense all research and development costs as incurred. We believe that continued investment in research and development is critical to attaining our strategic objectives and as a result we expect these expenses will continue to be significant in future periods.

General and administrative expenses. General and administrative expenses consist principally of salaries and related expenses for executive, finance and administrative personnel, professional fees and other general corporate expenses. General and administrative expenses increased to $8.0 million for the third quarter of fiscal 2004 from $6.3 million for the third quarter of fiscal 2003, an increase of $1.7 million. General and administrative expenses increased to $22.9 million for the first nine months of fiscal 2004 from $20.0 million for the first nine months of fiscal 2003, an increase of $2.9 million. The increases in both periods were primarily due to increases in legal fees relating to litigation. The rate of future spending in our general and administrative expenses will largely depend on the pace of recovery in the market for networking products and upon the cost of outside services and professional fees, including legal fees relating to litigation.

Amortization of deferred stock compensation. Amortization of deferred stock compensation decreased to $0.2 million for the third quarter of fiscal 2004 from $1.0 million for the third quarter of fiscal 2003, a decrease of $0.8 million. Amortization of deferred stock compensation decreased to $0.9 million for the first nine months of fiscal 2004 from $3.3 million for the first nine months of fiscal 2003, a decrease of $2.4 million. Deferred stock compensation is amortized as charges to operations, using the graded vesting method, over the vesting periods of the individual stock options, generally four years. Upon termination of an employee, the amount of expense recognized under the graded vesting method that is in excess of the amount actually earned is reversed. We reversed $0.1 million and $0.6 million of excess compensation expense related to terminated employees for the third quarter of fiscal 2004 and fiscal 2003, respectively. We reversed $0.3 million and $2.0 million of excess compensation expense related to terminated employees for the first nine months of fiscal 2004 and fiscal 2003, respectively.

Restructuring charge. During the first quarter of fiscal 2004, we recorded a restructuring charge of approximately $1.0 million, $0.9 million of which represented increases to the initial excess facilities charges recognized during fiscal 2003 and fiscal 2002 for domestic and international facilities discussed below. The commercial real estate market has continued to deteriorate since the previous charges were recorded in the third quarter of fiscal 2002 and in the second quarter of fiscal 2003 and current estimated sublease proceeds differ from our initial estimates.

During the nine months ended March 30, 2003, we recorded a restructuring charge of $14.2 million. The restructuring charge included excess facilities charges of $9.6 million, severance charges of $2.7 million and asset impairments of $1.9 million. The excess facilities charge represents an increase to the charge recognized during the third quarter of fiscal 2002. Because the commercial real estate market continued to deteriorate since we took the initial charge in the third quarter of fiscal 2002, we were required to increase our reserves to take into account the unfavorable difference between lease obligation payments and projected sublease receipts. The severance charges were related to a reduction in total staff of approximately 100 people, or 10% of the total workforce, across all departments. The asset impairment charge relates to the write-off of leasehold improvements and office furniture related to excess facilities. As a result of these charges, our expense levels will be lowered in future quarters.

Property and equipment write-off. During the second quarter of fiscal 2003, we completed a property and equipment inventory in conjunction with the implementation of our new enterprise resource planning, or ERP, system. The property and equipment inventory resulted in the identification of $12.7 million of property and equipment that was written off during the second quarter of fiscal 2003. As a result of this charge, depreciation expense is lower in fiscal 2004 and is expected to continue to be lower in future quarters.

Other income, net. Other income, net decreased to $0.3 million for the third quarter of fiscal 2004 from $1.0 million for the third quarter of fiscal 2003, a decrease of $0.7 million. This decrease was primarily due to a decrease in interest income due to lower interest rates. Other income, net decreased to $2.7 million for the first nine months of fiscal 2004 from $2.9 million for the first nine months of fiscal 2003, a decrease of $0.2 million. This decrease was primarily due to a decrease in interest income of approximately $2.2 million due to lower interest rates offset by the settlement of litigation, net of related expenses, of $2.2 million.

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Income taxes. For the third quarter and first nine months of fiscal 2004, we recorded an income tax provision of $0.3 million and $1.1 million, respectively as compared with an income tax benefit of $4.1 million and $19.3 million for the corresponding periods of fiscal 2003. For fiscal 2004, this income tax provision was recorded for taxes due on income generated in certain state and foreign tax jurisdictions. Income tax benefits have been recorded on the quarter and year-to-date fiscal 2004 pre-tax loss and we have provided a full valuation allowance against such benefits.

We estimate our income taxes based on the various jurisdictions where we conduct business. Our tax provision for the remainder of fiscal 2004 and future years will be largely dependent on our profitability in specific jurisdictions and could fluctuate significantly. Tax benefits associated with operating losses and tax credits generated in the U.S. will be offset by full valuation allowances until such time as we are able to demonstrate a history of operating income in the U.S.

Liquidity and Capital Resources

Cash and cash equivalents, short-term investments and marketable securities increased to $416.9 million at March 28, 2004 from $402.2 million at June 29, 2003, an increase of $14.7 million. This increase was primarily due to cash provided by operating activities of $10.1 million and proceeds from issuance of common stock of $11.1 million, partially offset by capital expenditures of $5.6 million.

We generated $10.1 million in cash from operations in the first nine months of fiscal 2004. Accounts receivable increased to $30.7 million at March 28, 2004 from $26.8 million at June 29, 2003. Days sales outstanding (“DSO”) in receivables increased to 32 days at March 28, 2004 from 28 days at June 29, 2003. The increases in our accounts receivable balance, as well as the increase in DSO, was primarily due to shipment linearity, with more of our sales occurring at the end of the quarter. Inventory levels increased to $24.2 million at March 28, 2004 from $18.7 million at June 29, 2003. We increased our new product inventory levels in the current quarter after experiencing some modest product constraints in recent quarters. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times and avoid stock-outs with the risk of inventory excess or obsolescence caused by, among other things, declining demand, rapidly changing technology and customer requirements. Any significant increase in our inventory levels can be expected to reduce cash and cash equivalents, short-term investments and marketable securities.

We have a revolving line of credit for $10.0 million with Silicon Valley Bank. Borrowings under this line of credit bear interest at the bank’s prime rate. As of March 28, 2004, there were no outstanding borrowings under this line of credit. The line of credit contains a provision for the issuance of letters of credit not to exceed the unused balance of the line. As of March 28, 2004, we had letters of credit totaling $0.9 million. These letters of credit were primarily issued to satisfy requirements of certain of our customers for performance bonds. The line of credit requires us to maintain specified financial covenants related to tangible net worth and liquidity with which we were in compliance as of March 28, 2004. The line of credit expires on January 27, 2005. It is our intention to renew this line of credit when it expires.

As part of our business relationship with MCMS, Inc. (“MCMS”), the predecessor-in-interest to Plexus Corp., we entered into a $9.0 million operating equipment lease for manufacturing equipment in September 2000 with a third-party financing company; we, in turn, loaned the equipment to MCMS. The equipment lease with the third-party financing company requires us to make monthly payments through September 2005 and to maintain certain specified financial covenants with which we were in compliance as of March 28, 2004. During the first quarter of fiscal 2002, due to the liquidity problems at MCMS and its voluntary filing for protection under Chapter 11, we recorded a charge of $9.0 million related to this lease. The liability, net of payments, related to this lease is included in lease liability on the condensed consolidated balance sheet.

In December 2001, we completed a private placement of $200.0 million of convertible subordinated notes. The notes mature on December 1, 2006. Interest is payable semi-annually at 3.5% per annum. The notes are convertible at the option of the holders into our common stock at an initial conversion price of $20.96 per share, subject to adjustment. The notes are redeemable in cash at our option at an initial redemption price of 101.4% of the principal amount on or after December 2004 if not converted to common stock prior to the redemption date. Each holder of the notes has the right to cause us to repurchase all of such holder’s convertible notes at 100% of the principal amount plus accrued interest upon a change of control of ownership of Extreme Networks, as defined in the offering documents, however an acquisition of Extreme Networks for stock listed on U.S. exchanges would generally not qualify as a change of control.

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The following summarizes our contractual obligations, including interest payments, at March 28, 2004, and the effect such obligations are expected to have on our liquidity and cash flow in future periods, in thousands:

We did not have any material commitments for capital expenditures or other non-cancelable purchase commitments as of March 28, 2004. We did not have any off-balance sheet arrangements as of March 28, 2004.

We require substantial capital to fund our business, particularly to finance inventories and accounts receivable and for capital expenditures. As a result, we could be required to raise substantial additional capital at any time. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution to existing stockholders. If additional funds are raised through the issuance of debt securities, these securities may have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations. If we are unable to obtain such additional capital, we may be required to reduce the scope of our planned product development and marketing efforts, which would materially adversely affect our business, financial condition and operating results.

We believe that our current cash and cash equivalents, short-term investments, marketable securities and cash available from credit facilities and future operations will enable us to meet our working capital requirements for at least the next 12 months.

Risk Factors

We Are Not Profitable and We Cannot Assure You That We Will Be Profitable in the Future

Fiscal 2000 was the only year in which we achieved profitability for the full year. We reported losses for fiscal 2003, fiscal 2002 and fiscal 2001. We anticipate continuing to incur significant sales and marketing, product development and general and administrative expenses and, as a result, we will continue to need to rationalize expense levels and increase revenue levels to achieve profitability in future fiscal quarters.

A Number of Factors Could Cause Our Quarterly Financial Results to Be Worse Than Expected, Resulting in a Decline in Our Stock Price

Our ability to control our operating expenses at a level that is consistent with anticipated revenue is significant to our financial results. A high percentage of our expenses are fixed in the short term, so any delay in generating or recognizing revenue could cause our quarterly operating results to fall below the expectations of public market analysts or investors, which could cause the price of our stock to fall.

Orders in our backlog at the beginning of each quarter do not equal expected revenue for that quarter and are generally cancelable at any time. Accordingly, we are dependent upon obtaining orders during a quarter and shipping those orders in the same quarter to achieve our revenue objectives. In addition, the timing of product releases and purchase orders, and product availability, often results in a majority of our product shipments being scheduled near the end of a quarter. Failure to ship these products by the end of a quarter may adversely affect our operating results. Our customer agreements generally allow customers to delay scheduled delivery dates or to cancel orders within specified timeframes without significant charges to the customers. Furthermore, some of our customers require that we provide installation or inspection services that may delay the recognition of revenue for both products and services, and some of our customer agreements include acceptance provisions that prevent our ability to recognize revenue upon shipment.

We may experience a delay in generating or recognizing revenue for a number of reasons and our quarterly revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including, but not limited to, the following:

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