ENTERASYS NETWORKS INC /DE/ - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


[X]		QUARTERLY REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended September 27, 2003


[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-10228

Enterasys Networks, Inc.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		04-2797263 (I.R.S. Employer Identification No.)

50 Minuteman Road

Andover, Massachusetts 01810

(978) 684-1000

(Address, including zip code, and telephone number, including area code, of
registrant’s principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

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

As of November 3, 2003 there were 207,278,437 shares of the Enterasys common stock, $0.01 par value, outstanding.

TABLE OF CONTENTS


PART I — FINANCIAL INFORMATION
	Item 1. Consolidated Financial Statements
		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF OPERATIONS
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
Ex-31.1 Section 302 Certification of CEO
Ex-31.2 Section 302 Certification of CFO
Ex-32.1 Section 906 Certification of CEO
Ex-32.2 Section 906 Certification of CFO

TABLE OF CONTENTS


			Page

PART I. Financial Information
	Item 1. Consolidated Financial Statements
		Consolidated Balance Sheets at September 27, 2003 and December 28, 2002		3
		Consolidated Statements of Operations for the three and nine months ended September 27, 2003 and September 28, 2002		4
		Consolidated Statements of Cash Flows for the nine months ended September 27, 2003 and September 28, 2002		5
		Notes to the Consolidated Financial Statements		6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
	Item 3. Quantitative and Qualitative Disclosures About Market Risk			35
	Item 4. Controls and Procedures			36
PART II. Other Information
	Item 1. Legal Proceedings			37
	Item 6. Exhibits and Reports on Form 8-K			39
	Signatures			40

PART I — FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

ENTERASYS NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS


			September 27,			December 28,
			2003			2002

			(In thousands, except share
			and per share amounts)
			(unaudited)			(a)
ASSETS
Current assets:
	Cash and cash equivalents		$	95,013		$	136,193
	Marketable securities			44,043			82,853
	Accounts receivable, net			40,005			41,683
	Inventories			27,541			44,552
	Income tax receivable			763			38,695
	Insurance proceeds receivable			34,500			—
	Note receivable			—			2,500
	Prepaid expenses and other current assets			16,571			17,220

		Total current assets		258,436			363,696
Restricted cash, cash equivalents and marketable securities				18,740			24,450
Long-term marketable securities				40,894			69,766
Investments				13,512			39,135
Property, plant and equipment, net				38,473			47,407
Goodwill				15,129			15,129
Intangible assets, net				18,950			21,764

		Total assets	$	404,134		$	581,347

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	30,406		$	47,589
	Accrued compensation and benefits			24,938			31,138
	Accrued legal and litigation costs			58,970			10,297
	Accrued restructuring charges			13,210			7,682
	Other accrued expenses			22,742			32,269
	Deferred revenue			47,246			55,982
	Customer advances and billings in excess of revenues			9,852			7,398
	Income taxes payable			42,843			48,242
	Current portion of redeemable convertible preferred stock			—			94,800

		Total current liabilities		250,207			335,397
	Commitments and contingencies
	Stockholders’ equity:
	Series F preferred stock, $1.00 par value; 300,000 shares designated; none outstanding			—			—
	Undesignated preferred stock, $1.00 par value; 1,700,000 shares authorized; none outstanding			—			—
	Common stock, $0.01 par value; 450,000,000 shares authorized; 210,066,476 and 204,940,728 shares issued at September 27, 2003 and December 28, 2002, respectively			2,101			2,049
	Additional paid-in capital			1,187,539			1,176,843
	Accumulated deficit			(981,315	)		(875,407	)
	Unearned stock-based compensation			(9	)		(158	)
	Treasury stock, at cost; 3,053,201 common shares at September 27, 2003 and December 28, 2002			(64,890	)		(64,890	)
	Accumulated other comprehensive income			10,501			7,513

		Total stockholders’ equity		153,927			245,950

		Total liabilities and stockholders’ equity	$	404,134		$	581,347

(a) The balance sheet at December 28, 2002 has been derived from the audited consolidated financial statements at that date, but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements.

See accompanying notes to consolidated financial statements.

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


				Three months ended						Nine months ended

				September 27,			September 28,			September 27,			September 28,
				2003			2002			2003			2002

				(In thousands, except per share amounts)
Net revenue:
		Product		$	70,792		$	89,812		$	225,226		$	259,883
		Services			27,625			32,919			86,023			103,676

			Total revenue		98,417			122,731			311,249			363,559

Cost of revenue:
		Product			40,329			52,059			125,075			162,506
		Services			15,052			11,613			35,650			33,553

			Total cost of revenue		55,381			63,672			160,725			196,059

			Gross margin		43,036			59,059			150,524			167,500
Operating expenses:
		Research and development (a)			21,352			19,696			63,337			64,988
		Selling, general and administrative			44,321			60,400			133,766			182,196
		Amortization of intangible assets			1,597			2,177			4,905			6,531
		Stock-based compensation			28			585			149			2,538
		Shareholder litigation expense			15,900			—			15,900			—
		Restructuring charges			8,338			10,735			16,541			30,974

			Total operating expenses		91,536			93,593			234,598			287,227

			Loss from operations		(48,500	)		(34,534	)		(84,074	)		(119,727	)
Interest income, net					1,000			2,144			4,170			6,201
Other expense, net					(8,550	)		(6,113	)		(23,063	)		(37,774	)

			Loss from continuing operations before income taxes		(56,050	)		(38,503	)		(102,967	)		(151,300	)
Income tax (benefit) expense					—			(10,364	)		749			(76,100	)

Loss from continuing operations					(56,050	)		(28,139	)		(103,716	)		(75,200	)
Discontinued operations:
	Loss on disposal (net of tax benefit of $0)				—			—			—			(11,700	)

			Loss from discontinued operations		—			—			—			(11,700	)
			Net loss		(56,050	)		(28,139	)		(103,716	)		(86,900	)
Accretive dividend and accretion of discount on preferred shares					—			(3,325	)		(2,192	)		(9,697	)

			Net loss available to common shareholders	$	(56,050	)	$	(31,464	)	$	(105,908	)	$	(96,597	)

Basic and diluted loss per common share:
		Loss from continuing operations available to common shareholders		$	(0.27	)	$	(0.16	)	$	(0.52	)	$	(0.42	)

		Loss from discontinued operations		$	—		$	—		$	—		$	(0.06	)

		Net loss available to common shareholders		$	(0.27	)	$	(0.16	)	$	(0.52	)	$	(0.48	)

Weighted average number of common shares outstanding, basic and diluted					205,428			201,888			203,657			201,452

(a) Excludes non-cash, stock-based compensation expense.

See accompanying notes to consolidated financial statements.

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


			Nine months ended

			September 27, 2003			September 28, 2002

			(In thousands)
Cash flows from operating activities:
	Net loss		$	(103,716	)	$	(86,900	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Loss from discontinued operations		—			11,700
		Depreciation and amortization		23,705			32,364
		Provision for losses (recoveries) on accounts receivable		(5,640	)		816
		Provision for inventory write-downs		10,647			322
		Recovery of notes receivable		(2,450	)		—
		Stock-based compensation		149			2,538
		Net realized gain on sale of marketable securities		(776	)		(935	)
		Loss on investment write-downs		24,485			15,175
		Unrealized (gain) loss on Riverstone stock derivative		(178	)		21,829
		Unrealized loss on foreign currency transactions		3,486			604
		Other		—			(842	)
Changes in current assets and liabilities:
	Accounts receivable			8,715			19,409
	Inventories			7,800			38,085
	Prepaid expenses and other assets			(29,287	)		(4,082	)
	Accounts payable and accrued expenses			18,954			(42,569	)
	Customer advances and billings in excess of revenues			2,454			(48,738	)
	Deferred revenue			(9,660	)		(16,233	)
	Income taxes receivable, net			28,998			12,336

		Net cash used in operating activities		(22,314	)		(45,121	)

Cash flows from investing activities:
	Capital expenditures and purchases of intangible assets			(13,210	)		(17,240	)
	Proceeds from sale of building			1,250			—
	Proceeds from sale of investments			1,688			3,907
	Cash paid for investments			(550	)		(1,677	)
	Purchase of marketable securities			(39,321	)		(99,151	)
	Sales and maturities of marketable securities			111,726			113,518
	Net proceeds from sale of discontinued operations			—			7,568

		Net cash provided by investing activities		61,583			6,925

Cash flows from financing activities:
	Proceeds from exercise of stock options			9,299			3,846
	Proceeds from common stock issued pursuant to employee stock purchase plans			1,449			820
	Proceeds from notes receivable			4,950			14,000
	Net payments for redemption of Series D and E Preferred Stock			(97,138	)		—
	Cash flows from discontinued operations			—			21,941

		Net cash (used in) provided by financing activities		(81,440	)		40,607

Effect of exchange rate changes on cash				991			(928	)

Net (decrease) increase in cash and cash equivalents				(41,180	)		1,483
Cash and cash equivalents at beginning of period				136,193			114,800

Cash and cash equivalents at end of period			$	95,013		$	116,283

Supplemental disclosure of cash flow information:
	Cash refunds received for income taxes, net		$	32,239		$	93,841
	Non-cash investing and financing transactions:
		Accretive dividend and accretion of discount on preferred shares	$	2,192		$	9,697

See accompanying notes to consolidated financial statements.

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

1. Basis of Presentation

The accompanying unaudited consolidated financial statements of Enterasys Networks, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 3 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments except as disclosed herein) necessary for a fair presentation of the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. The accompanying financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 28, 2002.

2. Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Enterasys Networks, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

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

Stock-Based Compensation Plans

The Company accounts for its stock-based employee compensation plans using the intrinsic method under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” to stock-based employee compensation:


		Three months ended						Nine months ended

		September 27,			September 28,			September 27,			September 28,
		2003			2002			2003			2002

		(In thousands, except per share amounts)
Net loss available to common shareholders, as reported		$	(56,050	)	$	(31,464	)	$	(105,908	)	$	(96,597	)
Add: Total stock-based employee compensation expense determined under fair-value-based method for the employee stock option awards and the employee stock purchase plans, net of related tax benefits			(4,467	)		(5,501	)		(14,671	)		(19,993	)

Pro forma net loss available to common shareholders		$	(60,517	)	$	(36,695	)	$	(120,579	)	$	(116,590	)

Basic and diluted net loss per share:
	As reported	$	(0.27	)	$	(0.16	)	$	(0.52	)	$	(0.48	)

	Pro forma	$	(0.29	)	$	(0.18	)	$	(0.59	)	$	(0.58	)

The pro forma information above has been prepared as if the Company had accounted for its employee stock options (including shares issued under the Employee Stock Purchase Plan) under the fair value method of that statement. The fair value of each Company option grant was estimated on the date of grant using the Black-Scholes option pricing model, with the following weighted-average assumptions used for grants:


	Three months ended						Nine months ended

	September 27,			September 28,			September 27,			September 28,
	2003			2002			2003			2002

Employee stock options:
Risk-free interest rate		3.05	%		2.79	%		2.52%-3.05	%		2.79	%
Expected option life	5.59 years			5.40 years			5.37-5.59 years			5.40 years
Expected volatility		113.02	%		113.28	%		111.17-113.02	%		113.28	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%

Employee stock purchase plan shares:
Risk-free interest rate		0.95	%		1.23	%		0.95%-1.15	%		1.23	%
Expected option life	6 months			11 months			6 months			11 months
Expected volatility		91.01	%		98.11	%		91.01-112.23	%		98.11	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company options held by employees and directors have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management the existing models do not necessarily provide a reliable single measure of the fair value of these options.

New Accounting Pronouncements

In November 2002, the FASB issued EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on how to account for revenue arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of this Pronouncement are effective for revenue arrangements entered into beginning in the Company’s third quarter of fiscal year 2003. The adoption of EITF 00-21 did not have a material effect on the Company’s consolidated financial statements.

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after June 25, 2003. The Company is not the primary beneficiary of any minority investment that would be considered a variable interest entity and, as such, the adoption of FIN No. 46 did not have an effect on the consolidated financial statements.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003 and is to be applied prospectively. The Company has no derivatives imbedded in other contracts and no hedging relationships at this time and, as such, the adoption of SFAS No. 149 did not have an effect on the consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). 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 No. 150 did not have a material impact on the Company’s consolidated financial statements.

In May 2003, the FASB issued EITF No. 03-5, “Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software,” which provides guidance on how to account for non-software deliverables included in an arrangement that contains software that is more than incidental to the products or services as a whole. The provisions of this Pronouncement are effective for revenue arrangements entered into beginning in the Company’s third quarter of fiscal year 2003. The adoption of EITF No. 03-5 did not have a material effect on the Company’s consolidated financial statements.

Reclassifications

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

3. Accounts Receivable

Accounts receivable were as follows:


		September 27, 2003			December 28, 2002

		(In thousands)
Gross accounts receivable		$	45,902		$	60,933
Allowance for doubtful accounts			(5,897	)		(19,250	)

	Accounts receivable, net	$	40,005		$	41,683

The Company defers revenue on product shipments to certain stocking distributors until those distributors have sold the product to their customer. At September 27, 2003 and December 28, 2002, $18.7 million and $21.4 million, respectively, of product shipments to distributors had been billed and revenue had not been recognized, of which $7.0 million and $3.8 million, respectively, were paid and are included in customer advances and billings in excess of revenues. The balance of $11.7 million and $17.6 million, respectively, was unpaid and is recorded as an offset to gross accounts receivable.

4. Inventories

Inventories consisted of the following:


		September 27, 2003		December 28, 2002

		(In thousands)
Raw materials		$	2,141	$	2,454
Service spares			3,166		7,522
Finished goods			22,234		34,576

	Inventories	$	27,541	$	44,552

5. Income Taxes

Effective for fiscal year 2003, the Company no longer records an income tax benefit for losses generated in the U.S. due to the uncertainty of realizing such benefits and the fact that the Company has fully utilized its tax loss carryback benefits. Due to the net loss incurred, and the favorable resolution in the second quarter of fiscal year 2003 of certain US Federal tax audit matters, net tax expense for the three months ended September 27, 2003 was zero. For the nine months ended September 27, 2003, the Company incurred net tax expense of $0.7 million due to certain foreign and state taxes. For the three and nine months ended September 28, 2002, the Company recorded net income tax benefits of $10.4 and $76.1 million, respectively, due primarily to the tax loss carry back benefits associated with the passage of the Job Creation and Workers Assistance Act of 2002, whereby the allowable period to carry back net operating losses was increased from two to five years. The Company received net tax refunds of $32.2 million during the nine months ended September 27, 2003, primarily related to the Job Creation and Workers Assistance Act of 2002 and certain foreign taxes.

6. Goodwill and Intangible Assets

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is subject to an annual impairment test using a fair-value-based approach. All other intangible assets are amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment and Disposal of Long-lived Assets.” The Company has designated the end of the third quarter of the fiscal year as the date of the annual test. In addition to the annual impairment test, SFAS No. 142 also requires the Company to perform an impairment test if an event or circumstances indicate that it is more likely than not that an impairment loss has occurred. The Company completed its annual impairment test and found no impairment of recorded goodwill at

September 27, 2003. Goodwill at September 27, 2003 and December 28, 2002 was $15,129.

The Company acquired certain fixed assets and intellectual property from Tenor Networks in April of 2003. The Company allocated the purchase price between the fixed assets and intellectual property acquired. The amount allocated to the Patents and Technology intangibles was $2.1 million, and this amount will be amortized over the estimated useful life of the intangibles, or 36 months.

The table below presents gross amortizable intangible assets and the related accumulated amortization at September 27, 2003:


		Gross					Net Carrying
		Carrying		Accumulated			Value of
		Amount		Amortization			Intangible Assets

		(In thousands)
Customer Relations		$	28,600	$	(21,491	)	$	7,109
Patents and Technology			34,292		(22,451	)		11,841

	Total	$	62,892	$	(43,942	)	$	18,950

All of the Company’s identifiable intangible assets are subject to amortization. Total amortization expense was $1.6 million and $4.9 million for the three and nine months ended September 27, 2003, respectively, and $2.2 million and $6.5 million for the three and nine months ended September 28, 2002, respectively. Based on intangible assets recorded at September 27, 2003, the estimated amortization expense is $1.6 million for the remainder of fiscal year 2003; $6.4 million for each of the fiscal years 2004 and 2005; $3.2 million for fiscal year 2006; $0.5 million for fiscal year 2007 and $0.8 million thereafter.

7. Other Accrued Expenses

Other accrued expenses consisted of the following:


		September 27, 2003		December 28, 2002

		(In thousands)
Accrued marketing and selling costs		$	7,450	$	11,663
Accrued liability on lease guarantees			96		4,324
Accrued audit expense			2,497		4,729
Other			12,699		11,553

	Total other accrued expenses	$	22,742	$	32,269

8. Restructuring Charges

The following table summarizes accrued restructuring activity:


		Severance			Facility Exit
		Benefits			Costs			Total

		(In thousands)
Balance, June 29, 2002		$	5,364		$	1,871		$	7,235
	Q3 restructuring charge		5,646			5,089			10,735
	Q3 cash payments		(4,536	)		(1,307	)		(5,843	)

Balance, September 28, 2002			6,474			5,653			12,127
	Q4 reversal of prior year charge		(204	)		—			(204	)
	Q4 restructuring charge		89			1,120			1,209
	Q4 cash payments		(4,743	)		(707	)		(5,450	)

Balance, December 28, 2002			1,616			6,066			7,682
	Q1 cash payments		(791	)		(544	)		(1,335	)

Balance, March 29, 2003			825			5,522			6,347
	Q2 restructuring charge		7,431			772			8,203
	Q2 cash payments		(1,908	)		(282	)		(2,190	)

Balance, June 28, 2003			6,348			6,012			12,360
	Q3 restructuring charge		6,282			2,056			8,338
	Q3 cash payments		(6,416	)		(1,072	)		(7,488	)

Balance, September 27, 2003		$	6,214		$	6,996		$	13,210

Throughout fiscal years 2002 and 2003, the Company has implemented cost reduction programs to improve gross margins and reduce fixed operating costs. During fiscal year 2003, the Company further evaluated the workforce and skill levels necessary to satisfy the expected future requirements of the business. As a result, the Company has implemented plans to eliminate additional

positions, and realigned and modified certain roles based on skill assessments. The Company has recorded restructuring charges of $16.5 million in fiscal year 2003, which included $13.7 million in employee severance related costs for approximately 385 individuals. Net of new hires, the Company expects to decrease its workforce of 1,650 employees at March 29, 2003 by 17%, or approximately 275 employees, once all the planned actions are completed. The fiscal year 2003 reductions in the global workforce involved most functions within the Company. Since the beginning of fiscal year 2002, cumulative annualized labor cost reductions realized exceeded $60.0 million. The additional anticipated quarterly decrease to operating expense is expected to be in excess of $2.6 million once all the remaining workforce reductions of approximately 160 individuals have occurred. The Company has also recorded $2.8 million of facility exit costs in fiscal year 2003 primarily as a result of consolidation of its North American distribution center into an owned facility with excess space and a decrease in estimated future sublease income anticipated from a vacated facility.

The remaining accrued severance cost of $6.2 million as of September 27, 2003 will be paid over the next several quarters; and the remaining accrued facility exit costs of $7.0 million, which consist of long-term lease commitments, will be paid out primarily over the next several years.

During the fourth quarter of fiscal year 2002, the Company recorded a restructuring charge of $1.2 million primarily for facilities exit costs related to the closure of two facilities. During the third quarter of fiscal year 2002, the Company recorded a restructuring charge of $10.7 million, which consisted of exit costs of $5.1 million related to the closure or reduction in size of seven facilities and employee severance costs of $5.6 million. The employee severance costs were associated with the reduction of approximately 130 individuals or 8% of the Company’s global workforce. During the second quarter of fiscal year 2002, the Company recorded a restructuring charge of $20.2 million. These restructuring costs consisted of employee severance costs associated with the reduction of approximately 600 individuals or 26% of the Company’s global workforce. The fiscal year 2002 reductions in the global workforce involved most functions within the Company.

9. Other Expense, Net

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


		Three months ended						Nine months ended

		September 27, 2003			September 28, 2002			September 27, 2003			September 28, 2002

		(In thousands)
Impairment of investments		$	(8,235	)	$	(2,619	)	$	(24,485	)	$	(15,175	)
Unrealized (loss) gain on Riverstone stock derivative			—			(3,365	)		178			(21,829	)
Net realized gain on sale of marketable securities			—			117			776			935
Recovery of note receivable			—			—			2,450			—
Foreign currency (loss) gain			(180	)		80			(3,040	)		(80	)
Other, net			(135	)		(326	)		1,058			(1,625	)

	Total other expense, net	$	(8,550	)	$	(6,113	)	$	(23,063	)	$	(37,774	)

The Company reviews its minority investments in debt and equity securities of primarily privately held companies for potential impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Many factors are considered for assessing potential impairments. Such events or factors include declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations, and bankruptcy or insolvency. From time to time, the Company may also engage third party experts to estimate the recoverable value of investments management may consider selling. The Company is currently considering selling its interests in several private venture funds.

A portion of the Company’s Series D and E convertible preferred stock redemption liability was offset by the value of 1.3 million shares of Riverstone stock received by the holders of the Series D and E redeemable convertible preferred stock in connection with the Company’s spin-off of its Riverstone subsidiary in August 2001. This offset created a derivative instrument as the Company’s liability was related to the Riverstone stock price. The value of the Riverstone shares increased by $0.2 million during the first quarter of the fiscal year 2003 and decreased by $3.4 million and $21.8 million for the three and nine months ended September 28, 2002, respectively. The changes in the redemption liability were recorded in other expense, net. The Company redeemed all of the Series D and E convertible preferred stock in the first quarter of fiscal year 2003.

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

10. Comprehensive Loss

The Company’s total comprehensive loss was as follows:


			Three months ended						Nine months ended

			September 27, 2003			September 28, 2002			September 27, 2003			September 28, 2002

			(In thousands)
Net loss			$	(56,050	)	$	(28,139	)	$	(103,716	)	$	(86,900	)
Other comprehensive income (loss):
	Unrealized (loss) gain on marketable securities			(678	)		18			(1,765	)		1,798
	Foreign currency translation adjustment			(453	)		(1,394	)		4,753			(324	)

		Total comprehensive loss	$	(57,181	)	$	(29,515	)	$	(100,728	)	$	(85,426	)

11. Segment Information

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

Net revenue by geography is as follows:


		Three months ended										Nine months ended

		September 27, 2003					September 28, 2002					September 27, 2003					September 28, 2002

		Revenue		Percent			Revenue		Percent			Revenue		Percent			Revenue		Percent

		($ In thousands)
North America		$	48,094		48.9	%	$	68,465		55.8	%	$	154,417		49.6	%	$	211,560		58.2	%
Europe, Middle East and Africa			32,535		33.0			35,067		28.6			99,387		31.9			104,963		28.9
Asia Pacific			13,094		13.3			11,228		9.1			38,578		12.4			22,916		6.3
Latin America			4,694		4.8			7,971		6.5			18,867		6.1			24,120		6.6

	Total net revenue	$	98,417		100.0	%	$	122,731		100.0	%	$	311,249		100.0	%	$	363,559		100.0	%

12. Loss Per Share

Basic and diluted net loss per common share is computed using the weighted average number of common shares outstanding. Options to purchase 27.5 million and 30.5 million shares of common stock were outstanding at September 27, 2003 and September 28, 2002, respectively, and 7.9 million warrants to purchase shares of the Company’s common stock were outstanding at September 27, 2003 and September 28, 2002 but were not included in the computation of diluted net loss per share since the effect was anti-dilutive.

13. Commitments and Contingencies

Legal Proceedings

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

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

Securities Class Action in the District of Rhode Island. Between October 24, 1997 and March 2, 1998, nine shareholder class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the District of New Hampshire. By order dated March 3, 1998, these lawsuits, which are similar in material respects, were consolidated into one class action lawsuit, captioned In re Cabletron Systems, Inc. Securities Litigation (C.A. No. 97-542-SD). The complaint alleges that the Company and several of its officers and directors disseminated materially false and misleading information about the Company’s operations and acted in violation of Section 10(b) and Rule 10b-5 of the Exchange Act during the period between March 3, 1997 and December 2, 1997. The complaint further alleges that certain officers and directors profited from the dissemination of such misleading information by selling shares of the Company’s common stock during this period. The complaint does not specify the amount of damages sought on behalf of the class. In a ruling dated May 23, 2001, the District Court dismissed this complaint with

prejudice. The plaintiffs appealed that ruling to the First Circuit Court of Appeals, and, in a ruling issued on November 12, 2002, the Court of Appeals reversed and remanded the case to the District Court for further proceedings. On January 17, 2003, the defendants filed an answer denying all material allegations of the complaint. By order of the Court dated March 18, 2003, the parties are now engaged in limited discovery. On July 16, 2003, the defendants renewed their motion to dismiss the complaint. At a status conference on August 11, 2003, the Court instructed the parties to continue limited discovery and, without ruling on the merits of defendants’ motion to dismiss, indicated that defendants would be allowed to renew their motion to dismiss upon the completion of limited discovery. If the plaintiffs prevail on the merits of this case, the Company could be required to pay substantial damages.

Securities Class Action in the District of New Hampshire. Between February 7, 2002 and April 9, 2002, six class action lawsuits were filed in the United States District Court for the District of New Hampshire. Defendants are the Company, former chairman and chief executive officer Enrique Fiallo and former chief financial officer Robert Gagalis. By orders dated August 2, 2002 and September 25, 2002, these lawsuits, which are similar in material respects were consolidated into one class action lawsuit, captioned In re Enterasys Networks, Inc. Securities Litigation (C.A. No. 02-CV-71). On December 9, 2002, the plaintiffs filed an amended consolidated complaint, adding two additional defendants, Piyush Patel, former chief executive officer of Cabletron Systems, Inc. (“Cabletron”) and David Kirkpatrick, former chief financial officer of Cabletron. The amended complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 there under. Specifically, plaintiffs allege that during periods spanning from June 28, 2000 and August 3, 2001 and in the period between August 6, 2001 and February 1, 2002 (together the “Class Period”), defendants issued materially false and misleading financial statements and press releases that overstated the Company’s revenues, income, and cash, and understated the Company’s net losses, because the Company purportedly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”) and the Company’s own accounting policies in connection with various sales and/or investment transactions. The complaints seek unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all of the defendants, jointly and severally as well as fees, costs and interest and unspecified equitable relief. On October 17, 2003, a stipulation of settlement signed by all parties to the litigation was filed in the District of New Hampshire. Although it continues to deny any liability, the Company has agreed to pay approximately $17.0 million in cash and to distribute shares of common stock with a value of $33.0 million, and to adopt corporate governance changes in full settlement of all claims against it and its former officers. On October 20, 2003, the Court gave preliminary approval for the settlement. A hearing for final approval of the settlement has been set for December 19, 2003 in the District of New Hampshire. Once final approval of the settlement is received, the New Hampshire derivative action will be dismissed.

Shareholder Derivative Action in State of New Hampshire. On February 22, 2002, a shareholder derivative action was filed on the Company’s behalf in the Superior Court of Rockingham County, State of New Hampshire. The suit is captioned Nemes v. Fiallo, et al. Individual defendants are former chairman and chief executive officer Enrique Fiallo and certain members of the Company’s Board of Directors. Plaintiffs allege that the individual defendants breached their fiduciary duty to shareholders by causing or allowing the Company to conduct its business in an unsafe, imprudent, and unlawful manner and failing to implement and maintain an adequate internal accounting control system. Plaintiffs allege that this breach caused the Company to improperly recognize revenue in violation of GAAP and the Company’s own accounting policies in connection with transactions in the Company’s Asia Pacific region, and that this alleged wrongdoing resulted in damages to the Company. Plaintiffs seek unspecified compensatory damages. On October 7, 2002, the Superior Court approved the parties’ joint stipulation to stay proceedings. On October 20, 2003, the parties filed a stipulation of settlement in the Superior Court of Rockingham County, State of New Hampshire. Although it continues to deny any liability, the Company has agreed to adopt corporate governance changes and pay attorneys’ fees up to $0.4 million in full settlement of all claims against it and its former officers and directors. At this time, parties are awaiting preliminary approval of the settlement from the Court. Once preliminary and final approval of the settlement is received, the New Hampshire derivative action will be dismissed.

Shareholder Derivative Action in State of Delaware. On April 16, 2002, a shareholder derivative action was filed on the Company’s behalf in the Court of Chancery of the State of Delaware in and for New Castle County. It is captioned; Meisner v. Enterasys Networks, Inc., et al. Individual defendants are former chairman and chief executive officer Enrique Fiallo and members of the Company’s Board of Directors. Plaintiffs allege that the individual defendants permitted wrongful business practices to occur which had the effect of manipulating revenues and earnings, inadequately supervised the Company’s employees and managers, and failed to institute legal actions against those officers, directors and employees responsible for the alleged conduct. The complaint alleges counts for breach of fiduciary duty, misappropriation of confidential information for personal profit, and contribution and indemnification. Plaintiffs seek judgment directing defendants to account to the Company for all damages sustained by the Company by reason of the alleged conduct, return all compensation of whatever kind paid to them by the Company, pay interest on the damages as well as costs of the action. The settlement and dismissal of this Delaware derivative action is covered in the Stipulation of Settlement filed in the Superior Court of Rockingham County, State of New Hampshire. Once the settlement of the New Hampshire derivative action receives final approval by the New Hampshire Court, the parties will file the necessary papers in the Court of Chancery of the State of Delaware to effectuate settlement and dismissal of the Delaware action.

Other. In addition, the Company is involved in various other legal proceedings and claims arising in the ordinary course of business. Management believes that the disposition of these additional matters, individually or in the aggregate, is not expected to have a materially adverse effect on the financial condition of the Company. However, depending on the amount and timing of such

disposition, an unfavorable resolution of some or all of these matters could materially affect the Company’s future results of operations or cash flows in a particular period. The Company believes it has adequately accrued for these matters at September 27, 2003.

Other

In some instances prior to fiscal year 2002, customers of the Company received financing for the purchase of equipment from third party leasing organizations and the Company guaranteed the payments of those customers. Most of these guarantees related to the sale of Riverstone equipment. During the first nine months of fiscal year 2003 and fiscal year 2002, the Company made payments of $3.7 million and $3.4 million, respectively, related to these guarantees. During July 2003, the Company entered into a $5.5 million settlement agreement with a Riverstone customer for reimbursement of lease guarantee payments made by the Company related to default guarantees of the customer’s equipment lease obligations provided in prior years. The Company recorded the initial receipt of $2.0 million, in July 2003, as a reduction to selling, general and administrative expense in the second quarter of fiscal year 2003, and the balance of $3.5 million will be paid in 24 installments and recorded as a reduction to operating expense when received.

In addition, the Company has guaranteed a portion of a former subsidiary’s (Aprisma), lease obligations and related maintenance and management fees through 2012. At September 27, 2003, the amount of the guarantee was $4.0 million and automatically reduces to $3.0 million on February 1, 2009, to $2.0 million on February 1, 2010 and to $1.0 million on February 1, 2011 and terminates on February 1, 2012. The Company estimates the fair value of the guarantee to be between $2.0 million and $4.0 million based on current market rates for similar property. The Company is indemnified for up to $3.5 million in losses it may incur in connection with this guarantee. The Company has pledged $4.8 million to secure this guarantee.

The Company could be required to make up to $13.2 million of additional capital contributions to private venture funds in which it is already an investor, which includes $1.2 million of capital contributions made by the Company in October 2003. If the Company fails to make a required contribution its remaining capital contribution obligations could be accelerated. The Company is currently considering selling its interests in several private venture funds, which would eliminate future capital call obligations.

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

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

15. Related Party Transactions

Investments

The Company has minority investments in debt and equity securities of certain companies. The Company does not have a controlling interest in these entities. Revenue recognized from sales to investee companies was $2.5 million and $5.9 million for the three and nine months ended September 27, 2003, respectively, and $2.8 million and $8.2 million for the three and nine months ended September 28, 2002, respectively, and was related to cash transactions with normal terms and conditions.

Consulting Arrangements

In connection with senior management resignations in September 2001, the Company entered into consulting arrangements with two former members of senior management to provide strategic advice and assistance to the Company for a period of one year. The Company paid consulting fees under these arrangements of approximately $0.04 million and $0.16 million in the three and nine months ended September 28, 2002, respectively. These arrangements ended in September 2002.

16. Shareholder Litigation Settlement

In October 2003, the Company reached agreements to settle the outstanding shareholder litigation against the Company, its directors and former officers filed in connection with the financial restatements for the 2001 fiscal and transition years (See Note 13). Under the financial terms of the settlements, the Company has agreed to pay $17.4 million in cash and to distribute shares of its stock with a value of $33.0 million. As a result, the Company has recorded a liability for these costs on the consolidated balance sheet under accrued legal and litigation costs at September 27, 2003. The Company expects to receive approximately $34.5 million in cash proceeds from certain of its insurers in the fourth quarter which has been recorded as insurance proceeds receivable on the consolidated balance sheet at September 27, 2003. For the third quarter of fiscal year 2003, the Company recorded a shareholder litigation charge of $15.9 million which reflects the net result of the settlements. The Company is currently engaged in legal

proceedings against certain other insurers to recover a portion of the remaining expenses incurred by it in connection with the shareholder litigation and other related matters.

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

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

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

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

Overview

We are a global provider of Business Driven Networks™, enterprise networks designed and developed to enhance the security, productivity and adaptability of enterprises. With a strong focus on secure networks, open convergence and on-demand networking solutions, we believe our solutions meet the specific business requirements of our customers while delivering a high return on investment and low total cost of ownership. Our global customer base includes commercial enterprises; government entities; health care, financial, manufacturing, educational and non-profit institutions; and other organizations.

Net revenue declined for the first nine months of fiscal year 2003 as compared to the level attained in the first nine months of fiscal year 2002. The decline in net revenue is primarily a result of weak customer demand, particularly in North America, Central Europe and Latin America. We believe the weak customer demand is a result of the lingering effects of a weaker market for enterprise networking products, reduced revenue from sales of older products as we continue a significant upgrade to our product portfolio, a longer sales cycle on our new products as some customers delay purchases while they evaluate our new products, and certain customers’ budgetary constraints. Additionally, service revenues have declined due to the expiration of legacy contracts, which in some cases have been replaced by lower priced contracts on new products. The decrease in net revenue has been partially offset by increased sales of our new Matrix N Series switching products which increased 104% from the second quarter of fiscal 2003 to the third quarter of fiscal 2003, and accounted for 20% of net product revenue during the third quarter of fiscal 2003.

We are focused on improving our sales execution through new sales and marketing initiatives designed to expand our reach beyond our current customer base. We have implemented a new sales force automation tool, continued the consolidation and standardization of our customer database, developed new training programs, and focused on further development of our relationships with channel partners. On October 1, 2003, we also announced the appointment of Cosmo Santullo as Executive Vice President of Worldwide Sales and Service. Mr. Santullo has over 20 years of senior sales management experience, primarily with IBM.

In April 2003, we acquired certain intellectual property from a core router start-up venture, Tenor Networks, Inc. We hired approximately 20 engineers from Tenor, including co-founders Leon Woo and Robert Ryan. Mr. Woo was named our Executive Vice President of Engineering, and is in charge of our worldwide research and development activities.

We intend to continue making appropriate investments in research and development as we upgrade our product portfolio. We have introduced significant enhancements to our product portfolio during the first nine months of fiscal 2003. During the second quarter of fiscal 2003, we introduced our new modular switching product, the Matrix N-Series. The initial release of the N-Series included both a 3 and 7 slot chassis, as well as our line of high-end Platinum modules. Other product introductions during the first nine months of fiscal 2003 include our Matrix V2 stackable switch, a high performance Matrix E1 edge switch, XSR-3000 and XSR-4000 regional security routers, the RoamAbout R2 wireless access point along with our 802.11a and 802.11 a/b/g wireless cards, and

release 6.1 of our Dragon intrusion detection software. During the fourth quarter of fiscal 2003, we announced plans to expand the N-Series offering to include a 5 slot chassis and introduce the lower cost Gold series modules. In 2004, we anticipate continuing to enhance our X-pedition router products and to introduce next generation core routing technologies.

Throughout fiscal years 2002 and 2003, we have implemented cost reduction programs to improve gross margins and reduce fixed operating costs. During fiscal year 2003, we further evaluated the workforce and skill levels necessary to satisfy the expected future requirements of the business. As a result, we implemented plans to eliminate additional positions, and realigned and modified certain roles based on skill assessments. We have recorded restructuring charges of $16.5 million in fiscal year 2003, which included $13.7 million in employee severance related costs for approximately 385 individuals. Net of new hires, we expect to decrease our workforce of 1,650 employees at March 29, 2003 by 17%, or approximately 275 employees, once all the planned actions are completed. The fiscal year 2003 reductions in the global workforce involved most functions within the business. Since the beginning of fiscal year 2002, cumulative annualized labor cost reductions realized exceeded $60.0 million. The anticipated additional quarterly decrease to operating expense is expected to be in excess of $2.6 million once all the remaining workforce reductions of approximately 160 individuals have occurred. We also recorded $2.8 million of facility exit costs in fiscal year 2003 primarily as a result of consolidation of our North American distribution center into an owned facility with excess space and a decrease in estimated future sublease income anticipated from a vacated facility.

In October 2003, we reached agreements to settle the outstanding shareholder litigation against us, our directors and former officers filed in connection with the financial restatements for the 2001 fiscal and transition years. Under the financial terms of the settlements, we have agreed to pay $17.4 million in cash and to distribute shares of our stock with a value of $33.0 million. We expect to receive approximately $34.5 million in cash proceeds from certain of our insurers in the fourth quarter which will result in a net cash inflow of approximately $17.1 million. For the third quarter of fiscal year 2003, we recorded a shareholder litigation charge of $15.9 million which reflects the net result of the settlements. We are currently engaged in legal proceedings against certain other insurers to recover a portion of the remaining expenses incurred by us in connection with the shareholder litigation and other related matters.

Results of Operations

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


			Three months ended						Nine months ended

			September 27, 2003			September 28, 2002			September 27, 2003			September 28, 2002

Net revenue:
	Product			71.9	%		73.2	%		72.4	%		71.5	%
	Services			28.1			26.8			27.6			28.5

		Total net revenue		100.0			100.0			100.0			100.0

Cost of revenue:
	Product			57.0			58.0			55.5			62.5
	Services			54.5			35.3			41.4			32.4

		Total cost of revenue		56.3			51.9			51.6			53.9

Gross Margin:
	Product gross margin			43.0			42.0			44.5			37.5
	Services gross margin			45.5			64.7			58.6			67.6

		Total gross margin		43.7			48.1			48.4			46.1

Research and development				21.7			16.0			20.3			17.9
Selling, general and administrative				45.0			49.2			43.0			50.1
Amortization of intangible assets				1.6			1.8			1.6			1.8
Stock-based compensation				—			0.5			0.1			0.7
Shareholder litigation expense				16.2			—			5.1			—
Restructuring charges				8.5			8.7			5.3			8.5

		Total operating expenses		93.0			76.2			75.4			79.0

		Loss from operations		(49.3	)%		(28.1	)%		(27.0	)%		(32.9	)%

Third Quarter of Fiscal Year 2003 Compared to the Third Quarter of Fiscal Year 2002

Net Revenue

Net revenue decreased by $24.3 million, or 19.8%, from $122.7 million in the third quarter of fiscal year 2002 to $98.4 million in the third quarter of fiscal year 2003 primarily due to lower unit sales volume, as well as lower revenue from maintenance contracts. Geographically, net revenue decreased from the third quarter of fiscal 2002 to the third quarter of fiscal 2003 in all regions except for Asia Pacific, which increased $1.9 million or 16.6%. Net revenue to customers in North America decreased from $68.5 million in the third quarter of fiscal year 2002 to $48.1 million in the third quarter of fiscal year 2003, or 29.8%.

Product revenue decreased by $19.0 million, or 21.2%, from $89.8 million in the third quarter of fiscal year 2002 to $70.8 million in the third quarter of fiscal year 2003. The decline in net product revenue is primarily a result of weak customer demand, particularly in North America, Central Europe and Latin America. We believe the weak customer demand is a result of the lingering effects of a weaker market for enterprise networking products, reduced revenue on older products as we continue a significant upgrade to our product portfolio, a longer sales cycle on our new products as some customers delay purchases while they evaluate our new products, and certain customers’ budgetary constraints. Our Matrix E Series switches have been upgraded by our Matrix N Series, and our stackable Vertical Horizon switches have been upgraded by our stackable Matrix V2 switch. Sales of the predecessor switching products declined from the third quarter of fiscal 2002 to the third quarter of fiscal 2003. This decline was partially offset by an increase in the Matrix N Series switches, and the initial shipment of the Matrix V2 switch. Net revenue from sales of the Matrix N Series switching products increased 104% from the second quarter of fiscal 2003 to the third quarter of fiscal 2003, and accounted for 20% of net product revenue during the third quarter of fiscal 2003. We are continuing to upgrade our portfolio of products to improve our competitive position including enhancements to our current routing products and the introduction of next generation core routing technologies in fiscal 2004. We believe future product revenue will generally fluctuate with overall changes in the markets we serve and will be affected by the nature and timing of new product introductions by our competitors and us, as well as other competitive factors.

Services revenue decreased by $5.3 million, or 16.1%, from $32.9 million in the third quarter of fiscal year 2002 to $27.6 million in the third quarter of fiscal year 2003. The decrease in services revenue is primarily due to a declining maintenance revenue base resulting from the expiration of higher priced maintenance contracts on legacy products, which in some cases have been replaced by lower priced contracts for new products. Sales of new product maintenance contracts were not sufficient to offset the decline in our maintenance revenue base. We believe that the negative trend in services revenue may continue until growth in new product sales and associated maintenance contracts are sufficient to replace the expiration of higher-priced legacy maintenance contracts.

Gross Margin

Total gross margin decreased by $16.1 million, from $59.1 million in the third quarter of fiscal year 2002 to $43.0 million in the third quarter of fiscal year 2003. Total gross margin as a percentage of net revenue decreased to 43.7% in the third quarter of fiscal year 2003, as compared to 48.1% in the third quarter of fiscal year 2002.

Product gross margin increased to 43.0% compared to 42.0% in the third quarter of fiscal year 2002. The product gross margin percentage improvement was primarily due to initiatives designed to lower supply costs from our contract manufacturers and to higher margins on new products as well as to reductions in fixed costs due to our cost reduction activities and supply chain process improvement initiatives. This improvement was partially offset by a provision for excess and obsolete inventory in the third quarter of fiscal year 2003 of $3.5 million. The charge for excess and obsolete inventory relates primarily to our introduction of new switching products, which caused inventory levels of predecessor products to exceed foreseeable requirements. Excess and obsolete inventory charges were $0.2 million and $0.9 million for the third quarter of fiscal year 2002 and the second quarter of fiscal year 2003, respectively. Pro forma product gross margin, excluding excess and obsolete inventory charges, was 47.9% for the third quarter of fiscal year 2003 compared to 42.2 % for the third quarter of fiscal year 2002, and was 47.0% for the second quarter of fiscal year 2003. The pro forma product gross margin is provided to give an indication of what comparable product gross margins would have been without the inventory charges, as we believe this is a better indicator of underlying trends in product gross margin. Since our new products generally have higher margins than the products they replace, we believe that an increasing proportion of new product sales should result in improved product margins, excluding charges for excess and obsolete inventory, in the future. Our product gross margin percentage varies depending on unit volumes and product mix sold as well as other factors such as competitors’ pricing. In addition, the nature and timing of our new product introductions, as well as our competitors’ new products entering the markets we serve, could adversely affect our inventory levels in the future and may result in additional excess and obsolete inventory provisions.

Services gross margin percentage decreased from 64.7% in the third quarter of fiscal year 2002 to 45.5% in the third quarter of fiscal year 2003, primarily due to a write-down of service spares inventory. Increased sales of newer products, as well as recent and anticipated expirations of legacy maintenance contracts, resulted in an excess of certain service parts as of the end of the third quarter of fiscal year 2003. Based on the revised usage estimates, service spares inventory was written down by $4.4 million to net realizable

value. Also, fixed service costs were reduced by $2.2 million from the prior year’s third quarter primarily due to workforce reductions as part of our on-going restructuring programs. We believe that services gross margin, excluding the impact of service spares inventory write downs, is not expected to improve significantly until growth in new product sales and associated maintenance contracts are sufficient to replace the expiration of legacy maintenance contracts.

Operating Expenses

Research and development expense increased by $1.7 million from $19.7 million in the third quarter of fiscal year 2002, to $21.4 million in the third quarter of fiscal year 2003. The increase in research and development expenses from the prior year was primarily due to an increase in the cost of pilot and prototype units related to new product introductions and an increase in costs related to the addition of Tenor personnel. We expect research and development expense in the fourth quarter of fiscal year 2003 to approximate the level of spending in the third quarter of fiscal year 2003.

Selling, general and administrative (“S,G&A”) expense decreased by $16.1 million from $60.4 million in the third quarter of fiscal year 2002 to $44.3 million in the third quarter of fiscal year 2003. The decrease in SG&A expense was primarily the result of a $10.0 million decrease in costs associated with the settled SEC investigation and the various pending shareholder lawsuits discussed in this quarterly report and related audit fees; a $3.3 million decrease in provisions for bad debts and customers lease guarantee obligations; a $2.5 million decrease in general legal fees; a decrease of $2.0 million in labor related costs primarily as a result of workforce reductions and a $1.2 million decrease in facility costs as a result of cost reduction activities. The decrease in SG&A expense was partially offset by an increase in marketing and advertising expenditures of $1.7 million primarily relating to the development of channel relationships. Excluding the impact of bad debt and lease guarantee recoveries, as well as ongoing shareholder litigation, future SG&A expenses are expected to decline as a result of our cost reduction activities.

Amortization of Intangible Assets

Amortization of intangibles decreased by $0.6 million from $2.2 million in the third quarter of fiscal year 2002 to $1.6 million in the third quarter of fiscal year 2003, primarily as a result of some intangibles becoming fully amortized.

Stock-based Compensation

Stock-based compensation decreased by $0.6 million as a result of some underlying stock options becoming fully vested.

Shareholder Litigation Expense

In October 2003, we reached agreements to settle all outstanding shareholder litigation against us, our directors and former officers filed in connection with the financial restatements for the 2001 fiscal and transition years. Under the financial terms of the settlement, we have agreed to pay $17.4 million in cash and to distribute shares of our stock with a value of $33.0 million and as a result, we have recorded a liability for these costs on the consolidated balance sheet at September 27, 2003 under accrued legal and litigation costs. We expect to receive approximately $34.5 million in cash proceeds from certain of our insurers in the fourth quarter which we have recorded as insurance receivable on the consolidated balance sheet at September 27, 2003. The shareholder settlement will result in a net cash inflow of approximately $17.1 million during the fourth quarter of fiscal year 2003. For the third quarter of fiscal year 2003, we recorded a shareholder litigation charge of $15.9 million which reflects the net result of the settlement. We are currently engaged in legal proceedings against certain other insurers to recover a portion of the remaining expenses incurred by us in connection with the shareholder litigation and other related matters.

Restructuring Charges

We recorded a restructuring charge of $8.3 million during the third quarter of fiscal year 2003, which included $6.3 million in employee severance related costs for approximately 169 individuals. In addition, we recorded $2.0 million of facility exit costs primarily as a result of the consolidation of our North American distribution center into an owned facility with excess space. During the third quarter of fiscal year 2002, we recorded a restructuring charge of $10.7 million, which consisted of exit costs of $5.1 million related to the closure or reduction in size of seven facilities and employee severance costs of $5.6 million. The employee severance costs were associated with the reduction of approximately 130 individuals or 8% of our global workforce. The reductions in the global workforce involved most functions within the business.

Interest Income, net

Interest income, net declined from $2.1 million in the third quarter of fiscal year 2002 to $1.0 million in the third quarter of fiscal year 2003, primarily due to lower interest rates and lower average cash and investment balances available for investing.

Other Expense, net

Other expense, net increased to $8.6 million for the third quarter of fiscal 2003 from $6.1 million for the third quarter of fiscal year 2002. Other expense, net includes investment impairments of $8.2 million for the third quarter of fiscal year 2003 and $2.6 million for the third quarter of fiscal year 2002. We review our minority investments in debt and equity securities of primarily privately held companies for potential impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Many factors are considered in assessing potential impairments. Such events or factors include declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations, and bankruptcy or insolvency. From time to time, we may engage third party experts to estimate the recoverable value of investments management may consider selling. We are currently considering selling our interests in several private venture funds. At September 27, 2003, our minority investments totaled $13.5 million. The concentration of our investments in privately-held companies, many of which are in the start-up or development stage, expose our investments to increased risk. If these companies are not successful, we could incur additional impairment charges and lose our entire investment. Other expense, net for the third quarter of fiscal 2002 also included a $3.4 million unrealized loss on the Riverstone stock derivative. The Riverstone stock derivative offset the convertible preferred stock redemption liability, which was paid during the first quarter of fiscal 2003.

Income Tax Expense (Benefit)

Effective for fiscal year 2003, we no longer record an income tax benefit for losses generated in the U.S. due to the uncertainty of realizing such benefits and the fact that we have fully utilized our tax loss carryback benefits. Due to the net loss incurred, and the favorable resolution in the second quarter of fiscal year 2003 of certain U.S. Federal tax audit matters, net tax expense for the third quarter of fiscal year 2003 was zero and is expected to be zero for the remainder of fiscal year 2003. For the third quarter of fiscal year 2002, we incurred net income tax benefits of $10.4 million due primarily to the tax loss carryback benefits associated with the passage of the Job Creation and Worker Assistance Act of 2002, whereby the allowable period to carry back net operating losses was increased from two to five years.

First Nine Months of Fiscal Year 2003 Compared to the First Nine Months of Fiscal Year 2002

Net Revenue

Net revenue decreased by $52.4 million, or 14.4%, from $363.6 million in the first nine months of fiscal year 2002 to $311.2 million in the first nine months of fiscal year 2003 primarily due to lower unit sales volume, as well as lower revenue from maintenance contracts. Geographically, net revenue decreased in the first nine months of fiscal 2002 compared to the first nine months of fiscal 2003 in all regions except for Asia Pacific, which increased $15.7 million or 68.3%. Net revenue to customers in North America decreased from $211.6 million in the first nine months of fiscal year 2002 to $154.4 million in the first nine months of fiscal year 2003, or 27.0%.

Product revenue decreased by $34.7 million, or 13.4%, from $259.9 million in the first nine months of fiscal year 2002 to $225.2 million in the first nine months of fiscal year 2003. The decline in net product revenue is primarily a result of weak customer demand, particularly in North America, Central Europe and Latin America. We believe the weak customer demand is a result of the lingering effects of a weaker market for enterprise networking products, reduced revenue on older products as we continue a significant upgrade to our product portfolio, a longer sales cycle on our new products as certain customers delay purchases while they evaluate our the new products, and certain customers’ budgetary constraints. Our Matrix E Series switches have been upgraded by our Matrix N Series, and our stackable Vertical Horizon switches have been upgraded by our stackable Matrix V2 switch. Sales of the predecessor switching products declined from the third quarter of fiscal 2002 to the third quarter of fiscal 2003. This decline was partially offset by an increase in the Matrix N Series switches, and the initial shipment of the Matrix V2 switch.

Services revenue decreased by $17.7 million, or 17.1%, from $103.7 million in the first nine months of fiscal year 2002 to $86.0 million in the first nine months of fiscal year 2003. The decrease in services revenue is primarily due to a declining maintenance revenue base resulting from the expiration of higher priced maintenance contracts on legacy products which in some cases have been replaced by lower priced maintenance contracts for new products. Sales of new product maintenance contracts were not sufficient to offset the decline in our maintenance revenue base.

Gross Margin

Total gross margin decreased by $17.0 million, from $167.5 million in the first nine months of fiscal year 2002 to $150.5 million in the first nine months of fiscal year 2003. Total gross margin as a percentage of net revenue was 48.4% in the first nine months of fiscal year 2003, compared with 46.1% in the first nine months of fiscal year 2002.

The margin percentage improvement was principally due to increased product gross margin, which was 44.5% compared to 37.5% in the first nine months of fiscal year 2002. The product gross margin percentage improvement was primarily due to initiatives designed to lower supply costs from our contract manufacturers and higher margins on new products as well as reductions in fixed costs due to cost reduction activities and supply chain process improvement initiatives implemented by us, which were partially offset by a $6.3 million provision for excess and obsolete inventory in the first nine months of fiscal year 2003. The charge for excess and obsolete inventory relates primarily to introductions of new switching products, which caused current inventory levels of predecessor products to be in excess of foreseeable requirements.

Services gross margin percentage decreased from 67.6% in the first nine months of fiscal year 2002 to 58.6% in the first nine months of fiscal year 2003, primarily due to the cost of services revenue not decreasing in proportion to the decrease in services net revenue and a write-down of service spares inventory. Increased sales of newer products, and recent and anticipated expirations of legacy maintenance contracts, resulted in an excess of certain service parts as of the end of the third quarter of fiscal year 2003. Based on the revised usage estimates, service spares inventory was written down by $4.4 million to net realizable value. Also, year-to-date fixed service costs were reduced by $6.1 million compared to the prior year primarily due to workforce reductions as part of our on-going restructuring programs.

Operating Expenses

Research and development expense decreased by $1.7 million from $65.0 million in the first nine months of fiscal year 2002 to $63.3 million in the first nine months of fiscal year 2003. The decline in research and development expenses from the prior year was primarily due to workforce reductions.

Selling, general and administrative expense decreased by $48.4 million from $182.2 million in the first nine months of fiscal year 2002 to $133.8 million in the first nine months of fiscal year 2003. The decrease in SG&A expense was primarily the result of a decrease of $17.7 million in costs associated with the settled SEC investigation and the various pending shareholder lawsuits discussed in this quarterly report and related audit costs; a decrease of $10.6 million in labor costs due to workforce reductions; a decrease of $6.7 million in bad debt expense primarily due to bad debt recoveries; a $6.4 million decrease in provisions for lease guarantees including payments in a bankruptcy settlement; a decrease of $6.3 million in various marketing and advertising expenses; a $2.4 million decrease in facility costs as a result of cost reduction activities and a reduction of $2.0 million in general legal fees. The decrease in SG&A expense was partially offset by a $3.8 million increase in expenses primarily relating to the development of channel relationships.

Amortization of Intangible Assets

Amortization of intangibles decreased by $1.6 million from $6.5 million in the first nine months of fiscal year 2002 to $4.9 million in the first nine months of fiscal year 2003, primarily as a result of some intangibles becoming fully amortized.

Stock-based Compensation

Stock-based compensation decreased by $2.4 million as a result of some underlying stock options becoming fully vested.

Shareholder Litigation Expense

In October 2003, we reached agreements to settle the outstanding shareholder litigation against us, our directors and former officers filed in connection with the financial restatements for the 2001 fiscal and transition years. Under the financial terms of the settlement, we have agreed to pay $17.4 million in cash and to distribute shares of our stock with a value of $33.0 million and as a result, we have recorded a liability for these costs on the consolidated balance sheet at September 27, 2003 under accrued legal and litigation costs. We expect to receive approximately $34.5 million in cash proceeds from certain of our insurers in the fourth quarter which we have recorded as insurance proceeds receivable on the consolidated balance sheet at September 27, 2003. This settlement will result in a net cash inflow of approximately $17.1 million during the fourth quarter of fiscal year 2003. For the third quarter of fiscal year 2003, we recorded a shareholder litigation charge of $15.9 million which reflects the net result of the settlement. We are currently engaged in legal proceedings against certain other insurers to recover a portion of the remaining expenses incurred by us in connection with the shareholder litigation and other related matters.

Restructuring Charges

We recorded restructuring charges of $16.5 million during the first nine months of fiscal year 2003, which included $13.7 million in employee severance related costs for approximately 385 individuals. In addition, we recorded $2.8 million of facility exit costs in fiscal year 2003 primarily as a result of consolidation of our North American distribution center into an owned facility with excess space and a decrease in estimated future sublease income anticipated from a vacated facility. The fiscal year 2003 reductions involved most functions within the business. During the second quarter of fiscal year 2002, we recorded a restructuring charge of

$20.2 million. These restructuring costs consisted of employee severance costs associated with the reduction of approximately 600 individuals and involved most functions within the business.

Interest Income, net

Interest income, net declined from $6.2 million in the first nine months of fiscal year 2002 to $4.2 million in the first nine months of fiscal year 2003, primarily due to lower interest rates and lower average cash and investment balances available for investing.

Other Expense, net

Other expense, net decreased to $23.1 million for the first nine months of fiscal 2003 as compared to other expense, net of $37.8 million in the third quarter of fiscal year 2002 primarily due to a $21.8 million loss incurred on the Riverstone stock derivative in fiscal year 2002. In addition to the loss on the Riverstone stock derivative, other expense consisted primarily of investment impairments of $24.5 million for the nine months ended September 27, 2003 and $15.2 million for the nine months ended September 28, 2002.

Income Tax Expense (Benefit)

Effective for fiscal year 2003, we no longer record an income tax benefit for losses generated in the U.S. due to the uncertainty of realizing such benefits and the fact that we have fully utilized our tax loss carryback benefits. For the first nine months of fiscal year 2003, we incurred net tax expense of $0.7 million due to certain foreign and state taxes. For the first nine months of fiscal year 2002, we recorded net income tax benefits of $76.1 million due primarily to the tax loss carryback benefits associated with the passage of the Job Creation and Worker Assistance Act of 2002, whereby the allowable period to carry back net operating losses was increased from two to five years.

Loss from Discontinued Operations

During the first nine months of fiscal year 2002, we recorded an additional charge of $11.7 million due to a change in estimate of the loss on disposal of Aprisma which was sold in August of 2002.

Liquidity and Capital Resources

Net cash used in operating activities was $22.3 million for the nine months ended September 27, 2003 and consisted of a $50.3 million net loss from operations after adjustments for certain non-cash items, which was partially offset by $28.0 million in net cash inflows from changes in working capital. Net cash inflows from working capital included the receipt of $32.2 million in net income tax refunds. We do not expect any significant tax refunds in the near future.

Capital expenditures for the first nine months of fiscal year 2003 were $13.2 million and consisted of assets purchased to support outsourcing contracts, equipment and software used in research and development activities and internal information technology purchases and upgrades in addition to equipment and certain fixed assets and intellectual property purchased from Tenor Networks. We expect capital spending to approximate $6.0 million for the remainder of fiscal year 2003 as we continue our investment in information technology systems and research and development.

On February 21, 2003, the holders of our Series D and E Preferred Stock notified us of their intention to exercise their right to redeem these shares effective as of February 23, 2003. We redeemed these shares during the first quarter of fiscal year 2003 for $97.1 million, which is net of the value of the Riverstone shares sold by these holders which partially offset our redemption liability.

Our significant contractual cash obligations and commercial commitments associated with future periods are disclosed in our Form 10-K for the year ended December 28, 2002. Changes to our commitments from that date include an increase in our non-cancelable purchase commitments for inventory from $20.1 million at December 28, 2002 to $22.7 million at September 27, 2003, the redemption of the Series D&E preferred stock during the first quarter of fiscal year 2003 and payments of $3.7 million related to equipment lease guarantees. All other obligations have not changed materially since December 28, 2002.

We could be required to make up to $13.2 million of additional capital contributions to private venture funds in which we are already an investor, which includes $1.2 million of capital contributions made by us in October 2003. If we fail to make a required contribution, our remaining capital contribution obligations could be accelerated. We are currently considering selling our interests in several private venture funds, which would eliminate future capital call obligations.

Accounts receivable, net of allowance for doubtful accounts, were $40.0 million at September 27, 2003 compared with $41.7 million at December 28, 2002. The decrease in accounts receivable is due primarily to the decline in net revenue. The number of days sales outstanding was 37 days at September 27, 2003, compared to 31 days at December 28, 2002. The increase in the number of days sales outstanding is primarily due to the increase in the percentage of sales outside of North America, to customers with longer payment terms and the conversion of one of our larger distributors in Asia Pacific from revenue recognition upon cash receipt to revenue recognition when the distributor ships our products to their customers.

Inventories were $27.5 million at September 27, 2003 or 6.6 turns per annum, compared with $44.6 million at December 28, 2002 or 5.2 turns per annum. Inventories have decreased during the first nine months of fiscal year 2003 primarily as a result of $10.7 million in inventory write downs, and $6.4 million primarily due to improved channel inventory management resulting in lower inventory requirements. We expect future cash commitments related to inventory purchases to vary based on sales order demand. In addition, the nature and timing of our new product introductions as well as our competitors’ new products entering the markets we serve could have an adverse affect on our inventory levels in the future and may result in additional excess and obsolete inventory provisions.

Accounts payable at September 27, 2003 of $30.4 million declined by $17.2 million from $47.6 million at December 28, 2002 due in part to decreased expenses for professional fees and the timing of payments related to product purchases.

In October 2003, we reached agreements to settle the outstanding shareholder litigation against us, our directors and former officers filed in connection with the financial restatements for the 2001 fiscal and transition years. Under the terms of the settlement, we have agreed to pay $17.4 million in cash and to distribute shares of our stock with a value of $33.0 million and as a result we have recorded a liability for these costs on our consolidated balance sheet at September 27, 2003 under accrued legal and litigation costs. In addition, we expect to receive approximately $34.5 million in cash proceeds from certain of our insurers in the fourth quarter which we have recorded as insurance proceeds receivable on the consolidated balance sheet at September 27, 2003. The settlements will result in a net cash inflow of approximately $17.1 million during the fourth quarter of fiscal year 2003.

As of September 27, 2003, our liquid investments totaled $180.0 million, as compared to $288.8 million at December 28, 2002, and consisted of $95.0 million of cash and cash equivalents, $44.1 million of marketable securities and $40.9 million of long-term marketable securities. In connection with the issuance of letters of credit by several banking institutions, we have agreed to maintain specified amounts of cash, cash equivalents and marketable securities in collateral accounts controlled by those institutions. These assets totaled $18.7 million at September 27, 2003, and are classified as “Restricted cash, cash equivalents and marketable securities” on our balance sheet. The decrease in liquid investments during the first nine months of fiscal year 2003 is primarily the result of the redemption of the Series D&E preferred stock, and the loss from operations, which were partially offset by the receipt of income tax refunds. Based on our liquid investment position at September 27, 2003, we believe that we have sufficient liquid investments to fund our on-going operations and future obligations for at least the next twelve months.

Application of Critical Accounting Policies

Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our annual report on Form 10-K for the fiscal year ended December 28, 2002. The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience, current conditions and various other assumptions that are believed to be reasonable under the circumstances. The markets for our products are characterized by rapid technological development, intense competition and frequent new product introductions, any of which could affect the future realizability of our assets. Estimates and assumptions are reviewed on an ongoing basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results could differ from those estimates under different assumptions or conditions. We believe the following critical accounting policies impact our judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. Our revenue is comprised of product revenue, which includes revenue from sales of our switches, routers, and other network equipment and software, services revenue, which includes maintenance, installation, and system integration services. Our revenue recognition policy follows SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,”, Statement of Position No. 97-2, “Software Revenue Recognition,” as amended by SOP No. 98-9, “Modification of SOP No. 97-2, Software Recognition, With Respect to Certain Transactions.” And EITF 00-21 “Revenue Arrangements with Multiple Deliverables.” 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, the price is fixed or determinable and collectibility of sales proceeds is reasonably assured. When significant obligations remain after products are delivered, such as for system integration or customer acceptance, revenue and related costs are deferred until such obligations are fulfilled. Software and equipment revenue is deferred in instances when vendor specific objective evidence, or VSOE, of fair value of undelivered elements is not determinable. VSOE of fair value is

the price charged when the element is sold separately. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically twelve months.

We recognize revenue from stocking distributors when they ship our products to their customers. We also record revenue from certain distributors and resellers located in Asia Pacific and Latin America upon our cash receipt. During the third quarter of fiscal year 2003, we converted one of our larger distributors in Asia Pacific from revenue recognition upon cash receipt to revenue recognition when the distributor ships our products to their customers. This change is a result of improved distributor practices including consistent timely payment, standard contract terms, and other independent vendor relationships. This conversion did not have a material impact on our consolidated results of operations.

We provide an allowance for sales returns based on return policies and return rights granted to our customers and historical returns. We also provide for pricing allowances in the period when granted. These allowances have been recorded as a reduction of net revenue in the accompanying consolidated statements of operations.

Allowance for Doubtful Accounts and Notes Receivable. We estimate the collectibility of our accounts receivable and notes receivable and the related amount of bad debts that may be incurred in the future. The allowance for doubtful accounts results from an analysis of specific customer accounts, historical experience, customer concentrations, credit ratings and current economic trends. The allowance for notes receivable is based on specific customer accounts.

Provision for Inventory Write-downs. Inventory purchases and commitments are based upon future demand forecasts. Reserves for excess and obsolete inventory are established to account for the potential differences between our forecasted demand and the amount of purchased and committed inventory. We have periodically experienced significant variances between the amount of inventory purchased and contractually committed to and our demand forecasts, resulting in material excess and obsolete inventory charges. In addition, the net realizable value of our services spares inventory is based upon future usage estimates. We write-down service spares inventory to net realizable value due to revised usage estimates.

Valuation of Goodwill. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. In accordance with Financial Accounting Standards Board or FASB Statement of Financial Standards or SFAS No. 142, goodwill is subject to an annual impairment test using a fair-value-based approach. In assessing the fair value of goodwill, we make projections regarding future cash flow and other estimates. If these projections or other estimates change in the future, we may be required to record an impairment charge.

Valuation of Long-lived Assets. Long-lived assets are comprised of property, plant and equipment and intangible assets with finite lives. We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable through projected undiscounted cash flows expected to be generated by the asset. When we determine that the carrying value of intangible assets and fixed assets may not be recoverable, we measure impairment by the amount by which the carrying value of the asset exceeds the related fair value. Estimated fair value is generally based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in the business underlying the asset in question.

Valuation of Investments. We maintain certain minority investments in debt and equity securities of companies that were acquired for cash and in non-monetary transactions whereby we exchanged inventory or product credits for preferred or common stock or convertible notes. We review investments for potential impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Many factors are considered in assessing potential impairments. Such events or factors include declines in the investees’ stock price in new rounds of financing, market capitalization relative to book value, deteriorating financial condition or results of operations and bankruptcy or insolvency. From time to time we may engage third party experts to estimate the recoverable value of investments management may consider selling. Appropriate reductions in carrying value are recognized in other expense, net in the consolidated statements of operations. We are currently considering selling our interests in several private venture funds, which would eliminate future capital call obligations.

Restructuring Reserves. We have periodically recorded restructuring charges in connection with our plans to reduce the cost structure of our business. These restructuring charges, which reflect management’s commitment to a termination or exit plan that will be completed within twelve months, require management’s judgment and may include severance benefits and costs for future lease commitments or excess facilities, net of estimated future sublease income. In determining the amount of the facility exit costs, we are required to estimate such factors as future vacancy rates, the time required to sublet properties and sublease rates. These estimates are reviewed and potentially revised on a quarterly basis based on known real estate market conditions and the credit worthiness of subtenants, resulting in revisions to established facility reserves. If the actual cost incurred exceeds the estimated cost, an additional charge to earnings will result. If the actual cost is less than the estimated cost, a reduction to special charges will be recognized in the statement of operations.

Deferred Tax Valuation Allowance. We estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we increase or decrease our income tax provision in our statement of operations. If any of our estimates of our prior period taxable income or loss prove to be incorrect, material differences could impact the amount and timing of income tax benefits or payments for any period.

Summary of Critical Estimates Included in Our Consolidated Results of Operations. The following table summarizes the (income) expense impact on our results of operations arising from our critical accounting estimates:


		Three months ended					Nine months ended

		September 27,			September 28,		September 27,			September 28,
		2003			2002		2003			2002

		(In millions)
Net recoveries of doubtful accounts and notes receivable		$	(1.3	)	$	1.3	$	(8.1	)	$	0.8
Provision for inventory write-downs			7.9			0.2		10.7			0.3
Impairment of investments			8.2			2.6		24.5			15.2
Restructuring charges			8.3			10.7		16.5			31.0
Deferred tax asset valuation provision			6.5			11.9		19.5			2.2

	Total expense from critical accounting estimates	$	29.6		$	26.7	$	63.1		$	49.5

New Accounting Pronouncements

In November 2002, the FASB issued EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on how to account for revenue arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of this Pronouncement are effective for revenue arrangements entered into beginning in our third quarter of fiscal year 2003. The adoption of EITF No. 00-21 did not have a material effect on our consolidated financial statements.

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after June 25, 2003. We are not the primary beneficiary of any minority investment that would be considered a variable interest entity and, as such, the adoption of FIN No. 46 did not have an effect on the consolidated financial statements.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003 and is to be applied prospectively. We have no derivatives imbedded in other contracts and no hedging relationships at this time and, as such, the adoption of SFAS No. 149 did not have an effect on our consolidated financial statements.

In May 2003, the FASB issued EITF No. 03-5, “Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software,” which provides guidance on how to account for non-software deliverables included in an arrangement that contains software that is more than incidental to the products or services as a whole. The provisions of this Pronouncement are effective for revenue arrangements entered into beginning of our third quarter of fiscal year 2003. The adoption of EITF No. 03-05 did not have a material effect on our consolidated financial statements.

CAUTIONARY STATEMENTS

We may occasionally make forward-looking statements and estimates such as forecasts and projections of our future performance or statements of our plans and objectives. These forward-looking statements may be contained in, among other things, SEC filings, including this quarterly report on Form 10-Q, press releases made by us, and in oral statements made by our officers. Actual results could differ materially from those contained in such forward-looking statements. Important factors that could cause our actual results to differ from those contained in such forward-looking statement include, among other things, the risks described below and in our annual report on Form 10-K for the fiscal year ended December 28, 2002.

Risks Related to our Financial Results and Condition

Worldwide economic weakness, deteriorating market conditions and recent political and social turmoil may continue to negatively affect our business and revenues and continue to make forecasting more difficult

Our business is subject to the effects of general worldwide economic conditions, particularly in the United States and Europe, the Middle East and Africa, and market conditions in the networking industry, which have been particularly unfavorable. Recent political and social turmoil, such as terrorist and military actions, as well as the effects of hostilities involving the U.S. in the Middle East, North Korea or anywhere else in the world, and any continuation or repercussions thereof or responses thereto, may put further pressure on worldwide economic conditions, particularly if they continue for an extended period of time. If economic or market conditions fail to improve or worsen, our business, revenues, and forecasting ability will continue to be negatively affected, which could harm our results of operations and financial condition.

Market conditions in the networking industry have been particularly unfavorable over the past two years, as companies have been reluctant to invest in their network infrastructures in light of continued economic uncertainty. In recent quarters, our product revenues have declined as a result of reduced capital spending and a lengthened sales cycle attributable to unfavorable economic and market conditions as well as other factors. Continued economic weakness could result in increased price competition in our industry, could further reduce demand for our products and could increase our risk of additional excess and obsolete inventory provisions and service spare inventory write-downs, any of which could harm our revenues and reduce our gross margin.

These unfavorable political, social and economic conditions and uncertainties also make it extremely difficult for us, our customers and our vendors to accurately forecast and plan future business activities. In particular, it is difficult for us to develop and implement strategies, forecast demand for our products, and effectively manage contract manufacturing and supply chain relationships. This reduced predictability challenges our ability to operate profitably and to grow our business.

The effects of hostilities involving the U.S. in the Middle East, North Korea or anywhere else in the world, and any continuation or repercussions thereof or responses thereto, particularly if they continue for an extended period of time, could disrupt our operations or those of our suppliers and contract manufacturers, which could harm our business and negatively affect our revenues. Our disaster recovery plans and those of our suppliers and contract manufacturers may not adequately protect us or them in the event hostilities involving the U.S. disrupt our operations or those of our suppliers and contract manufacturers. In addition, our business interruption insurance may not adequately protect us in the event these hostilities disrupt our operations, and a significant disruption may make this insurance difficult to obtain at a reasonable cost.

We have a history of losses in recent years and may not operate profitably in the future

We have experienced losses in recent years and may not achieve or sustain profitability in the future. We will need to generate higher revenues and reduce our costs to achieve and maintain consistent profitability. We may not be able to generate higher revenues or reduce our costs, and if we do achieve profitability, we may not be able to sustain or increase our profitability over subsequent periods. Our revenues have been negatively affected by weaker economic conditions worldwide, which have reduced demand and increased price competition for most of our products, as well as resulted in longer selling cycles. If weaker worldwide economic conditions continue for an extended period of time, our ability to maintain and increase our revenues may be significantly limited. In addition, while we continue to implement cost reduction plans designed to decrease our expenses, including reductions in the size of our workforce, we will continue to have large fixed expenses and expect to continue to incur significant sales and marketing, product development, customer support and service and other expenses. We continue to assess whether additional cost-cutting efforts may be required. Additional cost-cutting efforts may result in the recording of additional financial charges, such as workforce reduction costs, facilities reduction costs, asset write downs and contractual settlements. Further, our workforce reductions may impair our ability to realize our current or future business objectives. Costs incurred in connection with our cost-cutting efforts may be higher than the estimated costs of such actions and may not lead to anticipated cost savings. As a result, our cost-cutting efforts may not result in a return to profitability.

Our quarterly operating results are likely to fluctuate, which could cause us to fail to meet quarterly operating targets and result in a decline in our stock price

Our operating expenses are largely based on anticipated organizational size and revenue trends, and a high percentage of these expenses are, and will continue to be, fixed in the short term. As a result, if our revenue for a particular quarter is below our expectations, we will be unable to proportionately reduce our operating expenses for that quarter. Any revenue shortfall in a quarter may thus cause our financial results for that quarter to fall below the expectations of public market analysts or investors, which could cause the price of our common stock to fall. Any increase in our fixed expenses will increase the magnitude of this risk. In addition, the unpredictability of our operating results from quarter to quarter could cause our stock to trade at lower prices than it would if our results were consistent from quarter to quarter.

Our quarterly operating results may vary significantly from quarter to quarter in the future due to a number of factors, including:

• fluctuations in the demand for our products and services;

• the timing and size of sales of our products or the cancellation or rescheduling of significant orders;

• the length and variability of the sales cycle for our products;

• the timing of implementation and product acceptance by our customers and by customers of our distribution partners;

• the timing and success of new product introductions;

• increases in the prices or decreases in the availability of the components we purchase;

• price and product competition in the networking industry;

• our ability to source and receive from third party sources appropriate product volumes and quality;

• our ability to execute on our operating plan and strategy;

• manufacturing lead times and our ability to maintain appropriate inventory levels;

• the timing and level of research, development and prototype expenses;

• the mix of products and services sold;

• changes in the distribution channels through which we sell our products and the loss of distribution partners;

• the uncertainties inherent in our accounting estimates and assumptions and the impact of changes in accounting principles;

• our ability to achieve targeted cost reductions;

• the outcome of pending securities litigation; and

• general economic conditions as well as those specific to the networking industry.

Due to these and other factors, you should not rely on quarter-to-quarter comparisons of our operating results as an indicator of our future performance.

We earn a substantial portion of our revenue for each quarter in the last month of each quarter, which reduces our ability to accurately forecast our quarterly results and increases the risk that we will be unable to achieve previously forecasted results

We have derived and expect to continue to derive a substantial portion of our revenues in the last month of each quarter, with such revenues frequently concentrated in the last two weeks of the quarter. Because we rely on the generation of a large portion of revenues at the end of the quarter, we traditionally have not been able, and in the future do not expect to be able, to predict our financial results for any quarter until very late in the quarter. Due to this end-of-quarter buying pattern, we may not achieve our financial forecasts,

either because expected sales do not occur in the anticipated quarter or because they occur at lower prices or on terms that are less favorable to us than anticipated.

We may need additional capital to fund our future operations, commitments and contingencies and, if it is not available when needed, our business and financial condition may be harmed

We believe our existing working capital and cash available from operations will enable us to meet our working capital requirements for at least the next twelve months. Our working capital requirements and cash flows historically have been, and are expected to continue to be, subject to quarterly and yearly fluctuations, depending on such factors as capital expenditures, sales levels, collection of receivables, inventory levels, supplier terms and obligations, and other factors impacting our financial performance and condition. Our inability to manage cash flow fluctuations resulting from these and other factors could impair our ability to fund our working capital requirements from operating cash flows and other sources of liquidity or to achieve our business objectives in a timely manner. We have not established any borrowing relationships with financial institutions and are primarily reliant on cash generated from operations to meet our cash requirements. If cash from future operations is insufficient, or if cash must be used for currently unanticipated uses, we may need to raise additional capital or reduce our expenses.

We cannot assure you that additional capital, if required, will be available on acceptable terms, or at all. As a result of the current unfavorable capital market environment, as well as the pending securities litigation against us, our ability to access the capital markets and establish borrowing relationships with financial institutions has been impaired and may continue to be impaired for the foreseeable future. If we are unable to obtain additional capital when needed or must reduce our expenses, it is likely that our product development and marketing efforts will be restricted, which would harm our ability to develop new and enhanced products, expand our distribution relationships and customer base, and grow our business. This could adversely impact our competitive position and cause our revenues to decline. To the extent that we raise additional capital through the sale of equity or convertible debt securities, existing stockholders may suffer dilution. Also, these securities may provide the holders with certain rights, privileges and preferences senior to those of common stockholders. If we raise additional capital through the sale of debt securities, the terms of such debt could impose restrictions on our operations.

Our failure to improve and successfully implement our management information systems and internal controls could harm our business

We currently use three disparate information systems in our domestic and international operations, resulting in delays in obtaining consistent and timely information on a worldwide basis and the use of extensive manual procedures to generate and review our consolidated financial results. Further, our systems do not provide all of the information that we believe is necessary to successfully operate our business, and we have identified weaknesses in our internal controls and accounting procedures. Pursuant to new SEC rules under the Sarbanes-Oxley Act of 2002, we will be required to include in our future Form 10-K filings a report by our management as to the effectiveness of our internal controls and procedures for financial reporting. Beginning with our Form 10-K for fiscal year 2004, our independent auditors will be required to attest to and report on the evaluation by management. Although we have implemented a number of changes designed to improve our systems and controls, including organizational changes, communication of revenue recognition and other accounting policies to all of our employees, implementation of an internal audit function, new approval procedures and various other initiatives, including extensive supervisory and management oversight along with systems and process improvement programs, we anticipate making additional changes to improve our systems controls and procedures, some of which may result in higher future operating expenses and capital expenditures. In addition, we are making significant upgrades to our management information systems. The implementation of these upgrades involves significant effort and is complex. If we are unable to successfully and/or timely implement these upgrades, our business could be disrupted and our financial condition harmed.

If we fail to strengthen our management information systems and internal controls, our ability to manage our business and implement our strategies may be impaired, irregularities may occur or fail to be identified, and our financial condition could be harmed. In addition, even if we are successful in strengthening these systems and controls, they may not sufficiently improve our ability to manage our business and implement our strategies, or be adequate to prevent or identify irregularities and ensure the effectiveness of our system of controls and procedures.

We plan to introduce new products over the next several fiscal quarters, and if our customers delay product purchases or choose alternative solutions, our revenues could decline, we may incur excess and obsolete inventory charges, and our financial condition could be harmed.

We are in the process of refreshing our entire product portfolio; however, many of our customers may initially require additional time to evaluate our new products, extending the sales cycle, or may choose alternative solutions. In addition, sales of our existing products could decline as customers await the release of our new products and, as a result, we could be exposed to an increased risk of inventory write downs. If customers defer purchasing decisions or choose alternative solutions in connection with our new product introductions, our revenues could decline and our financial condition could be harmed.

The lingering effects of the recently settled SEC investigation and our financial statement restatements could materially harm our business, operating results and financial condition

On January 31, 2002, we learned that the SEC had opened a formal order of investigation into the financial accounting and reporting practices of us and our affiliates. In February 2003, we settled the SEC investigation. Without admitting or denying any allegations, we consented to an administrative order pursuant to which we agreed to cease and desist from future violations of the Securities Exchange Act of 1934. In addition, we agreed to appoint, and did appoint in October 2002, an internal auditor reporting directly to the Audit Committee of our Board of Directors. No fines or civil penalties were imposed in connection with the settlement, and the settlement did not require any changes to our historical financial statements which were restated in our Form 10-K for the transition period ended December 29, 2001 filed with the SEC on November 26, 2002. Despite the resolution of the investigation of us, the lingering effects of the SEC investigation and the restatement of our financial statements could materially harm our business, financial condition and reputation. In particular, lingering concerns of potential and existing customers could impair our ability to attract new customers or maintain relationships with existing customers. We believe that due in part to the SEC investigation, purchasing decisions by potential and existing customers have been and may continue to be postponed. If potential and existing customers lose confidence in us, our competitive position in the networking industry may be seriously harmed and our revenues could decline.

Pending and future litigation could materially harm our business, operating results and financial condition

Several lawsuits have been filed against us and our directors in recent years, including nine shareholder class action lawsuits filed between October 24, 1997 and March 2, 1998, and, more recently, six shareholder class action lawsuits filed between February 7, 2002 and April 9, 2002, as well as shareholder derivative actions filed in the State of New Hampshire on February 22, 2002 and in the State of Delaware on April 16, 2002. See “Part II, Item 1 - Legal Proceedings” of this quarterly report for a more detailed discussion of pending securities and derivative litigation. The unfavorable resolution of any specific lawsuit could materially harm our business, operating results and financial condition, and could cause the price of our common stock to decline significantly.

Although we recently announced we reached agreements to settle the six shareholder class action lawsuits filed between February 7, 2002 and April 9, 2002, agreeing to pay approximately $17.4 million in cash and to distribute shares of common stock with a value of $33.0 million, and to adopt corporate governance changes, the settlement remains subject to final court approval. If the settlement does not receive final court approval, the terms of the settlement may require renegotiation which could result in less favorable terms or no settlement, resulting in additional costs to us and further proceedings on the subject matter of the litigation. Further, we may be required to pay significant damages in connection with the 1997 and 1998 lawsuits which remain pending.

The uncertainty associated with these lawsuits could seriously harm our business, financial condition and reputation by, among other things, harming our relationships with existing customers and impairing our ability to attract new customers. In addition, the continued defense of the 1997 and 1998 lawsuits will continue to result in significant expense and the continued diversion of our management’s time and attention from the operation of our business, which could impede our ability to achieve our business objectives. Although we have insurance designed to cover claims under these lawsuits, this insurance may not be adequate to cover expenses and certain liabilities relating to these lawsuits, and we may need to litigate with our insurance carriers to obtain coverage under our insurance policies. For example, with respect to the 2002 class action litigation, although we expect to receive cash proceeds of approximately $34.5 million from certain of our insurers and have engaged in legal proceedings against certain other insurers to recover a portion of the remaining expenses incurred, we do not expect these proceeds will fully cover all of our costs and expenses incurred in connection with this and other related matters and we may be unsuccessful in our litigation against the other insurers.

The limitations of our director and officer liability insurance may materially harm our financial condition

Our director and officer liability insurance for the period during which events related to securities class action lawsuits against us and certain of our current and former officers and directors are alleged to have occurred, provides only limited liability protection. If these policies do not adequately cover expenses and certain liabilities relating to these lawsuits, our financial condition could be materially harmed. Our certificate of incorporation provides that we will indemnify and advance expenses to our directors and officers to the maximum extent permitted by Delaware law. The indemnification covers any expenses and liabilities reasonably incurred by a person, by reason of the fact that such person is or was or has agreed to be a director or officer, in connection with the investigation, defense and settlement of any threatened, pending or completed action, suit, proceeding or claim.

The facts underlying the SEC investigation and shareholder lawsuits has increased the premiums we must pay for director and officer liability insurance, and may make this insurance coverage prohibitively expensive or unavailable in the future. Increased premiums for this insurance could materially harm our financial results in future periods. The inability to obtain this coverage due to its unavailability or prohibitively expensive premiums would make it significantly more difficult for us to retain and attract officers and directors.

We have experienced significant turnover of senior management and our current management team has been together for only a limited time, which could harm our business and operations

Since August 2001 there have been numerous changes in our senior management team. In August 2001, our management team was restructured to include several senior executives of one of our operating subsidiaries. Then in April 2002, we announced the departure of several of these senior executives, including our President and Chief Executive Officer. We appointed a new Chief Executive Officer and a new President in April 2002, and, in the period from March 2002 to March 2003, we appointed a number of other senior officers, including promoting our Vice President of Finance to the position of Chief Financial Officer, appointing a new Executive Vice President of Sales, Executive Vice President of Worldwide Marketing and Product Management and Vice President of Human Resources, and adding a Director of Internal Audit and Executive Vice President of Supply Chain Management. In December 2002, our President resigned upon the completion of his employment agreement with us, and, in April 2003, we appointed a new President. In May 2003 we appointed a new EVP of Engineering and in October 2003 we appointed a new EVP of Worldwide Sales and Service. Because of these recent changes and their recent recruitment, our current management team has not worked together for a significant length of time and may not be able to work together effectively to successfully develop and implement business strategies. In addition, as a result of these management changes, management will need to devote significant attention and resources to preserve and strengthen relationships with employees and customers. If our new management team is unable to develop successful business strategies, achieve our business objectives, or maintain positive relationships with employees and customers, our ability to grow our business and successfully meet operational challenges could be impaired.

Retaining key management and employees is critical to our success

Our future success depends to a significant extent on the continued services of our key employees, many of whom have significant experience with the network communications market, as well as relationships with many of our existing and potential enterprise customers and business partners. The loss of several of our key employees or any significant portion of them could have a significant detrimental effect on our ability to execute our business strategy. Our future success also depends on our continuing ability to identify, hire, train, assimilate and retain large numbers of highly qualified engineering, sales, marketing, managerial and support personnel. If we cannot successfully recruit and retain such persons, particularly in our engineering and sales departments, our development and introduction of new products could be delayed and our ability to compete successfully could be impaired.

Despite the current economic downturn, the competition for qualified employees in our industry is particularly intense in the New England area, where our principal operations are located, and it can be difficult to attract and retain quality employees at reasonable cost. We have from time to time experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In addition, the significant downturn in our business environment has caused us to significantly reduce our workforce and implement other cost-containment activities, including consolidating our operating locations and relocating some of our personnel to Rochester, New Hampshire and Andover, Massachusetts. These actions, as well as the pending securities litigation, may lead to disruptions in our business, reduced employee morale and productivity, increased attrition and difficulty retaining existing employees and recruiting future employees, any of which could harm our business and operating results.

We maintain investments in early stage, privately held technology companies and value-added resellers to establish relationships that we believe may benefit us as we execute our business strategy, but these relationships may not prove helpful to us, and we could lose our entire investment in these companies

We have made investments in privately-held technology companies and value-added resellers, many of which are in the start-up or development stage. The benefits we expected to achieve by investing in these companies may not be realized. Moreover, investments in these companies are inherently risky as the technologies or products they have under development, or the services they propose to provide, are often in early stages of development and may never materialize. We may never realize any benefits or financial returns from these investments, and, if these companies are not successful, we could lose our entire investment. The concentration of our investments in a small number of related industries, primarily telecommunications, exposes our investments to increased risk, particularly if these industries continue to be adversely affected by the worldwide economic slowdown. At September 27, 2003, these investments totaled approximately $13.5 million. During the quarter ended September 27, 2003, we recorded impairment losses of $8.2 million relating to these investments.

We are exposed to the credit risk of some of our customers

Our payment terms are typically 30 days in the United States, and sometimes longer internationally. We assess the payment ability of our customers in granting such terms and maintain reserves that we believe are adequate to cover doubtful accounts, however, as a result of the current economic slowdown, our exposure to the credit risk of our customers has increased. Some of our customers are experiencing, or may experience, reduced revenues and cash flow problems, and may be unable to pay, or may delay payment for, amounts owed to us. Although we monitor the credit risk of our customers, we may not be effective in managing our exposure. If our

customers are unable to pay amounts owed to us or cancel outstanding orders, our forecasting ability, cash flow and revenues could be harmed and our business and results of operations may be adversely affected.

Risks Related to the Markets for our Products

There is intense competition in the market for enterprise network equipment, which could prevent us from increasing our revenue and achieving profitability

The network communications market is dominated by a small number of competitors, some of which, Cisco Systems in particular, have substantially greater resources and market share than other participants in that market, including us. In addition, this market is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and other market activities of industry participants. Competitive pressures could result in price reductions, reduced margins or loss of market share, which would materially harm our ability to increase revenues and profitability.

Our principal competitors include Alcatel; Avaya, formerly part of Lucent; Cisco Systems; Extreme Networks; Foundry Networks; Hewlett-Packard; Nortel Networks; and 3Com. We also experience competition from a number of other smaller public and private companies. We may experience reluctance by our prospective customers to replace or expand their current infrastructure solutions, which may be supplied by one or more of these competitors, with our products. There has also been a trend toward consolidation in our industry for several years, and we expect this trend will continue as companies attempt to strengthen or maintain their market share positions. Consolidation among our competitors and potential competitors may result in stronger competitors with expanded product offerings and a greater ability to accelerate their development of new technologies.

Some of our competitors have significantly more established customer support and professional services organizations and substantially greater selling and marketing, technical, manufacturing, financial and other resources than we do. Many of our competitors also have more customers, greater market recognition and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their products, pursue acquisitions and other opportunities more readily and adopt more aggressive pricing policies. Additional competitors with significant market presence and financial resources may enter our rapidly evolving market, thereby further intensifying competition.

We may be unable to upgrade our indirect distribution channels, which may hinder our ability to grow our customer base and increase our revenues

Our sales and distribution strategy relies heavily on our indirect sales efforts, including sales through distributors and channel partners, such as value-added resellers, systems integrators and telecommunications service providers. We believe that our future success will depend in part upon our ability to maintain and upgrade existing relationships, as well as establish successful new relationships, with a variety of these partners. If we are unable to upgrade our indirect distribution channels, we may be unable to increase or sustain market awareness or sales of our products and services, which may prevent us from maintaining or increasing our customer base and revenues.

Even if we are able to upgrade our indirect distribution channels, our revenues may not increase. Our distribution partners are not prohibited from selling products and services that compete with ours and may not devote adequate resources to selling our products and services. In addition, we may be unable to maintain our existing agreements or reach new agreements with distribution partners on a timely basis or at all.

We expect the average selling prices of our products to decrease over time, which may reduce our revenue and gross margins

Our industry has experienced erosion of average selling prices in recent years, particularly as products reach the end of their life cycles. We anticipate that the average selling prices of our products will decrease in the future in response to increased sales discounts and new product or technology introductions by us and our competitors. Our prices will also likely be adversely affected by downturns in regional or industry economies, such as the recent downturn in the United States economy. We also expect our gross margins may be adversely affected by increases in material or labor costs and an increasing reliance on third party distribution channels. If we are unable to achieve commensurate cost reductions and increases in sales volumes, any decline in average selling prices will reduce our revenues and gross margins.

If we do not anticipate and respond to technological developments and evolving customer requirements, we may not retain our current customers or attract new customers

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The introduction by us or our competitors of new products and the emergence of new industry standards and practices can render existing

products obsolete and unmarketable, increasing our risk of excess and obsolete inventory charges. Our success will depend upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and functionality that keep pace with technological developments and emerging standards. Any failure to introduce new products and enhancements on a timely basis will harm our future revenue and prospects.

Our future success will also depend upon our ability to develop and manage customer relationships and to introduce a variety of new products and product enhancements that address the increasingly sophisticated needs of our customers. Our current and prospective customers may require product features and capabilities that our products do not have. We must anticipate and adapt to customer requirements and offer products that meet those demands in a timely manner. Our failure to develop products that satisfy evolving customer requirements could seriously harm our ability to achieve or maintain market acceptance for our products and prevent us from recovering our product development investments.

Our focus on sales to enterprise customers subjects us to risks that may be greater than those for providers with a more diverse customer base

We focus principally on sales of products and services to enterprises, such as large corporations and government agencies that rely on network communications for many important aspects of their operations. This focus subjects us to risks that are particular to this customer segment. For example, many of our current and potential customers are health care, education and governmental agencies, all of whom are generally slower to incorporate information technology into their business practices due to the regulatory and privacy issues that must be addressed with respect to the sharing of their information. In addition, the use and growth of the Internet is critical to enterprises, which often have electronic networks, applications and other mission-critical functions that use the Internet. To the extent that there is any decline in use of the Internet for electronic commerce or communications, for whatever reason, including performance, reliability or security concerns, we may experience decreased demand for our products and lower than expected revenue growth.

Many of our competitors sell their products to both enterprises and service providers, which are companies who provide Internet-based services to businesses and individuals. In the future, the demand for network communications products from enterprises may not grow as rapidly as the demand from service providers. Enterprises may turn to service providers to supply them with services that obviate the need for enterprises to implement many of our solutions. Because we sell our products primarily to enterprises, our exposure to these risks is greater than that of vendors that sell to a more diversified customer base.

Risks Related to our Products

Our products are very complex, and undetected defects may increase our costs, harm our reputation with our customers and lead to costly litigation

Our network communications products are extremely complex and must operate successfully with complex products of other vendors. Our products may contain undetected errors when first introduced or as we introduce product upgrades. The pressures we face to be the first to market new products or functionality increases the possibility that we will offer products in which we or our customers later discover problems. We have experienced new product and product upgrade errors in the past and expect similar problems in the future. These problems may cause us to incur significant warranty and other costs and divert the attention of our engineering personnel from our product development efforts. If we are unable to repair these problems in a timely manner, we may experience a loss of or delay in revenues and significant damage to our reputation and business prospects.

Many of our customers rely upon our products for business-critical applications. Because of this reliance, errors, defects or other performance problems in our products could result in significant financial and other damage to our customers. Our customers could attempt to recover these losses by pursuing product liability claims against us, which, even if unsuccessful, would likely be time-consuming and costly to defend and could adversely affect our reputation.

If our products do not comply with complex governmental regulations and evolving industry standards, our products may not be widely accepted, which may prevent us from sustaining our revenues or achieving profitability

The market for network communications equipment is characterized by the need to support industry standards as different standards emerge, evolve and achieve acceptance. In the past, we have had to delay the introduction of new products to comply with third party standards testing. We may be unable to address compatibility and interoperability problems that arise from technological changes and evolving industry standards. We also may devote significant resources developing products designed to meet standards that are not widely adopted. In the United States, our products must comply with various governmental regulations and industry regulations and standards, including those defined by the Federal Communications Commission, Underwriters Laboratories and Networking Equipment Building Standards. Internationally, our products are required to comply with standards or obtain certifications established by telecommunications authorities in various countries and with recommendations of the International

Telecommunications Union. If we do not comply with existing or evolving industry standards, fail to anticipate correctly which standards will be widely adopted or fail to obtain timely domestic or foreign regulatory approvals or certificates, we will be unable to sell our products where these standards or regulations apply, which may prevent us from sustaining our revenues or achieving profitability.

The United States government may impose unique requirements on network equipment providers before they are permitted to sell to the government, such as that supplied products qualify as made in the United States. Such requirements may be imposed on some or all government procurements. We may not always satisfy all such requirements. Other governments or industries may establish similar performance requirements or tests that we may be unable to satisfy. If we are unable to satisfy the performance or other requirements of the United States government or other industries that establish them, our revenues growth may be lower than expected.

Because several of our significant competitors maintain dominant positions in selling network equipment products to enterprises and others, they may have the ability to establish de facto standards within the industry. Any actions by these competitors or other industry leaders that diminish compliance by our products with industry or de facto standards or the ability of our products to interoperate with other network communication products would be damaging to our reputation and our ability to generate revenue.

We may periodically establish relationships with other companies to develop, manufacture and sell products, which could increase our reliance on others for development or supply capabilities or generation of revenues and may lead to disputes about ownership of intellectual property

We may periodically establish relationships with other companies to incorporate our technology into products and solutions sold by these organizations as well as to jointly develop, manufacture and/or sell new products and solutions with these organizations. We may be unable to enter into agreements of this type on favorable terms, if at all. If we are unable to enter into these agreements on favorable terms, or if our partners do not devote sufficient resources to developing, manufacturing and/or selling the products that incorporate our technology or the new products we have jointly developed, our revenue growth could be lower than expected. If we are able to enter into these agreements, we will likely be unable to control the amount and timing of resources our partners devote to developing products incorporating our technology or to jointly developing new products and solutions. Further, although we intend to retain all rights in our technology in these arrangements, we may be unable to negotiate the retention of these rights and disputes may arise over the ownership of technology developed as a result of these arrangements. These and other potential disagreements between us and these organizations could lead to delays in the research, development or sale of products we are jointly developing or more serious disputes, which may be costly to resolve. Disputes with organizations that also serve as indirect distribution channels for our products could also reduce our revenues from sales of our products.

Our limited ability to protect our intellectual property may hinder our ability to compete

We regard our products and technology as proprietary. We attempt to protect them through a combination of patents, copyrights, trademarks, trade secret laws, contractual restrictions on disclosure and other methods. These methods may not be sufficient to protect our proprietary rights. We also generally enter into confidentiality agreements with our employees, consultants and customers, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise misappropriate and use our products or technology without authorization, particularly in foreign countries where the laws may not protect our proprietary rights to the same extent as do the laws of the United States, or to develop similar technology independently. We have resorted to litigation in the past and may need to resort to litigation in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation of this type could result in substantial costs and diversion of resources and could harm our business.

We may be subject to claims that our intellectual property infringes upon the proprietary rights of others, and a successful claim could harm our ability to sell and develop our products

We license technology from third parties and are continuing to develop and acquire additional intellectual property. Although we have not been involved in any material litigation relating to our intellectual property, we expect that participants in our markets will be increasingly subject to infringement claims. Third parties may try to claim our products infringe their intellectual property, in which case we would be forced to defend ourselves or our customers, manufacturers and suppliers against those claims. Any claim, whether meritorious or not, could be time consuming, result in costly litigation and/or require us to enter into royalty or licensing agreements. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. In addition, any royalty or licensing agreements might not be available on terms acceptable to us or at all, in which case we would have to cease selling, incorporating or using the products that incorporate the challenged intellectual property and expend substantial amounts of resources to redesign our products. If we are forced to enter into unacceptable royalty or licensing agreements or to redesign our products, our business and prospects would suffer.

Risks Related to our Manufacturing and Components

We use several key components for our products that we purchase from single or limited sources, and we could lose sales if these sources fail to fulfill our needs

We currently work with third parties to manufacture our key proprietary application-specific integrated circuits, which are custom designed circuits built to perform a specific function more rapidly than a general purpose microprocessor. These proprietary circuits are very complex, and these third parties are our sole source suppliers for the specific types of application specific integrated circuits that they supply to us. We also have limited sources for semiconductor chips that we use in some of our products, as well as several other key components used in the manufacture of our products. We do not carry significant inventories of these components, and we do not have a long-term, fixed price or minimum volume agreements with these suppliers. If we encounter future problems with these vendors, we likely would not be able to develop an alternate source in a timely manner. We have encountered shortages and delays in obtaining these components in the past and may experience similar shortages and delays in the future. If we are unable to purchase our critical components, particularly our application-specific integrated circuits, at such times and in such volumes as our business requires, we may not be able to deliver our products to our customers in accordance with schedule requirements. In addition, any delay in obtaining key components for new products under development could cause a significant delay in the initial launch of these products. Any delay in the launch of new products could harm our reputation and operating results.

Even if we are able to obtain these components in sufficient volumes and on schedules that permit us to satisfy our delivery requirements, we have little control over their cost. Accordingly, the lack of alternative sources for these components may force us to pay higher prices for them. If we are unable to obtain these components from our current suppliers or others at economical prices, our margins could be adversely impacted unless we raise the prices of our products in a commensurate manner. The existing competitive conditions may not permit us to do so, in which case our operating results may suffer.

We depend upon a limited number of contract manufacturers for substantially all of our manufacturing requirements, and the loss of any of our primary contract manufacturers would impair our ability to meet the demands of our customers

We do not have internal manufacturing capabilities. We outsource most of our manufacturing to two companies, Flextronics International, Ltd. and Accton Technology Corporation, which procure material on our behalf and provide comprehensive manufacturing services, including assembly, test, control and shipment to our customers. Our agreement with Flextronics expired in February 2002 and, since that time, we have been operating under an informal extension of the expired contract while negotiating a new agreement with Flextronics. If we experience increased demand for our products, we will need to increase our manufacturing capacity with Flextronics and Accton or add additional contract manufacturers. Flextronics and Accton also build products for other companies, and we cannot be certain that they will always have sufficient quantities of inventory and capacity available or that they will allocate their internal resources to fulfill our requirements. Further, qualifying a new contract manufacturer and commencing volume production is expensive and time consuming. The loss of our existing contract manufacturers, the failure of our existing contract manufacturers to satisfy their contractual obligations to us or our failure to timely qualify a new contract manufacturer to meet anticipated demand increases could result in a significant interruption in the supply of our products. In this event, we could lose revenue and damage our customer relationships. In addition, our business interruption insurance has certain standard limitations and, as a result of these limitations, may not adequately cover damages we incur in the event of a supply interruption.

If we fail to accurately predict our manufacturing requirements, we could incur additional costs or experience manufacturing delays

We use a forward-looking forecast of anticipated product orders to determine our product requirements for our contract manufacturer. The lead times for materials and components we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. For example, some of our application-specific integrated circuits have a lead time of up to eight months. If we overestimate our requirements, our contract manufacturers may have excess inventory, which we may be obligated to pay for. If we underestimate our requirements, our contract manufacturers may have inadequate inventory, which could result in delays in delivery to our customers and our recognition of revenue.

In addition, because our contract manufacturers produce our products based on forward-looking demand projections that we supply to them, we may be unable to respond quickly to sudden changes in demand. With respect to sudden increases in demand, we may be unable to satisfy this demand with our products, thereby forfeiting revenue opportunities and damaging our customer relationships, and with respect to sudden decreases in demand, we may find ourselves with excess finished goods inventory, which could expose us to high manufacturing costs compared to our revenue in a financial quarter and increased risks of inventory obsolescence. These factors contributed to a total $6.3 million provision for excess and obsolete inventory, and a $4.4 million inventory write-down of services spares inventory to net realizable value during the first nine months of fiscal year 2003, a $17.9 million charge in fiscal year 2002, and a $72.9 million charge in transition year 2001.

We plan to introduce new and complex products over the next several fiscal quarters, and if our contract manufacturers are unable to manufacture these products consistently and in required quantities, we could lose sales

Due to the complexity of our new products, the manufacturing process for these new products and/or the new products themselves may require adjustments and refinements during the first several months of initial manufacture. In addition, it may be difficult for our contract manufacturers to produce these complex products consistently with the level of quality we require. We depend on the highly trained and knowledgeable employees of our contract manufacturers to assemble and test our products. Given the significant training required to manufacture our products, the loss of a number of these employees could also impair the ability of our contract manufacturers to produce sufficient quantities of our products in a timely manner with the quality we require.

Other Risks Related to our Business

Our significant sales outside the United States subject us to increasing foreign political and economic risks, including foreign currency fluctuations

Our sales to customers outside of the United States accounted for approximately 51.1% and 50.4% of our revenue in the three and nine months ended September 27, 2003, respectively, and 44.2% and 41.8% of our revenue in the three and nine months ended September 28, 2002, respectively. We are seeking to expand our international presence by establishing arrangements with distribution partners as well as through strategic relationships in international markets. Consequently, we anticipate that sales outside of the United States will continue to account for a significant portion of our revenues in future periods.

The sales of our products are denominated primarily in United States dollars. As a result, increases in the value of the United States dollar relative to foreign currencies could cause our products to become less competitive in international markets and could result in reductions in sales and profitability. To the extent our prices or expenses are denominated in foreign currencies, we will be exposed to increased risks of currency fluctuations.

Our international presence subjects us to risks, including:

• political and economic instability and changing regulatory environments in foreign countries;

• increased time to deliver solutions to customers due to the complexities associated with managing an international distribution system;

• increased time to collect receivables caused by slower payment practices in many international markets;

• managing export licenses, tariffs and other regulatory issues pertaining to international trade;

• increased effort and costs associated with the protection of our intellectual property in foreign countries; and

• difficulties in hiring and managing employees in foreign countries.

We have made and may make future acquisitions or dispositions, which involve numerous risks

We periodically evaluate our business and our technology needs, and evaluate alternatives for acquisitions, dispositions and other transfers of businesses, assets, technologies and product lines, and we have made, and may in the future make, acquisitions and dispositions. Any future acquisitions and/or dispositions would expose us to various risks associated with such transactions and could harm our results of operations and financial condition.

Although we may seek to make acquisitions, we may be unable to identify and acquire suitable businesses, assets, technology or product lines on reasonable terms, if at all. Our financial condition or stock price may make it difficult for us to complete acquisitions and we may compete for acquisitions with other companies that have substantially greater financial, management and other resources than we do. This competition may increase the prices we pay to make acquisitions, which are often high when compared to the assets and sales of acquisition candidates. Also, our acquisitions may not generate sufficient revenues to offset increased expenses associated with the acquisition in the short term or at all. We may also consider discontinuing or disposing of businesses, assets, technologies or product lines; however, any decision to limit our investment in or dispose of businesses, assets, technologies or product lines may result in the recording of charges to our income statement, such as inventory and technology related write-downs, workforce reduction costs, contract termination costs, fixed asset write-downs or claims from third party resellers or users of the discontinued products. In addition, to the extent we are required to sell

intellectual property rights in disposing of these businesses, assets, technologies or product lines, we may need to re-license the right to use this intellectual property for a fee.

Acquisitions and dispositions, particularly multiple transactions over a short period of time, involve transaction costs and a number of risks that may result in our failure to achieve the desired benefits of the transaction. These risks include, among others, the following:

• difficulties and unanticipated costs incurred in assimilating the operations of the acquired business, technologies or product lines or of segregating, marketing and disposing of a business, technology or product line;

• potential disruption of our existing operations;

• an inability to successfully integrate, train and retain key personnel, or transfer or eliminate positions or key personnel;

• diversion of management attention and employees from day-to-day operations;

• an inability to incorporate, develop or market acquired businesses, technologies or product lines, or realize value from technologies, products or businesses;

• operating inefficiencies associated with managing companies in different locations, or separating integrated operations; and

• impairment of relationships with employees, customers, suppliers and strategic partners.

We may finance acquisitions by issuing shares of our common stock, which could dilute our existing stockholders. We may also use cash or incur debt to pay for these acquisitions. In addition, we may be required to expend substantial funds to develop acquired technologies in connection with future acquisitions, which could adversely affect our financial condition or results of operations. We have made acquisitions and may make future acquisitions that result in in-process research and development expenses being charged in a particular quarter, which could adversely affect our operating results for that quarter.

The market price of our common stock has historically been volatile, and declines in the market price of our common stock may negatively impact our ability to make future strategic acquisitions, raise capital, issue debt, and retain employees

Shares of our common stock may continue to experience substantial price volatility, including significant decreases, as a result of potential variations between our actual or anticipated financial results and the published expectations of analysts, announcements by our competitors and us, and pending class action lawsuits against us. In addition, the stock markets have experienced extreme price fluctuations that have affected the market price of many technology companies. These price fluctuations have, in some cases, been unrelated to the operating performance of these companies. A major decline in capital markets generally, or in the market price of our shares of common stock, may negatively impact our ability to make future strategic acquisitions, raise capital, issue debt, or retain employees. These factors, as well as general economic and political conditions and the outcome of the pending class action lawsuits, may in turn materially adversely affect the market price of our shares of common stock.

We have not established a comprehensive disaster recovery plan and if we are unable to quickly and successfully restore our operations our revenues and our business could be harmed

We have not established and tested a comprehensive disaster recovery plan for our business operations or for recovering or otherwise operating our information technology systems in the event of a catastrophic systems failure or a natural or other disaster. If there is a natural or other disaster which impacts our operations or a failure or extended inoperability of our information technology systems, our ability to service customers, ship products, process transactions, test and develop products, and communicate internally and externally could be materially impaired and our revenues and business could be harmed. We are in the process of developing a disaster recovery plan which we expect will conform to industry standards and is intended to limit our business and financial exposure in the event of a disaster or catastrophic systems failure. Nevertheless, in the event of a disaster or catastrophic systems failure, we may be unable to successfully implement any plan we develop and restore, or operate at an alternate location, our business or our information technology systems and, to the extent it is implemented, any plan we develop may not adequately prevent or limit the adverse effects on our business of such a disaster or catastrophic systems failure. Additionally, our business interruption insurance has certain limitations and, as a result of these limitations, may not adequately cover damages we incur in the event our business is interrupted by such a disaster or catastrophic systems failure.

The tax implications of Riverstone spin-off may place restrictions on us and subject us to risks

We have received a ruling from the Internal Revenue Service that the distribution of Riverstone qualifies as a tax-free spin-off under Section 355 of the Internal Revenue Code of 1986, as amended. Rulings and opinions of this nature are subject to various

representations and limitations, and in any event, are not binding upon the Internal Revenue Service or any court. If the distribution of Riverstone’s shares fails to qualify as a tax-free spin-off under Section 355 of the Internal Revenue Code, we will recognize a taxable gain equal to the difference between the fair market value of Riverstone on the date of the distribution and our adjusted tax basis in Riverstone’s stock on the date of the distribution. In addition, each of our stockholders will be treated as having received a taxable corporate distribution in an amount equal to the fair market value of Riverstone’s stock received by the stockholder on the date of distribution. Any taxable gain recognized by us or our stockholders as a result of a failure of the Riverstone distribution to qualify as tax-free under Section 355 is likely to be substantial.

Provisions of our articles of incorporation and bylaws and our investor rights plan could delay or prevent a change in control, which could reduce our stock price

Pursuant to our certificate of incorporation, our Board of Directors has the authority to issue preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any vote or action by our stockholders. The issuance of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. Our certificate of incorporation requires the affirmative vote of the holders of not less than 85% of the outstanding shares of our capital stock for the approval or authorization of certain business combinations as described in our certificate of incorporation. In addition, our staggered Board of Directors and certain advance notification requirements for submitting nominations for election to our Board of Directors contained in our bylaws, as well as other provisions of Delaware law and our certificate of incorporation and bylaws, could delay or make a change in control more difficult to accomplish.

In April 2002, our Board of Directors adopted a stockholder rights plan pursuant to which we paid a dividend of one right for each share of common stock held by stockholders of record on June 11, 2002. As a result of the plan, our acquisition by a party not approved by our Board of Directors could be prohibitively expensive. This plan is designed to protect stockholders from attempts to acquire us while our stock price is inappropriately low or on terms or through tactics that could deny all stockholders the opportunity to realize the full value of their investment. Under the plan, each right initially represents the right, under certain circumstances, to purchase 1/1,000 of a share of a new series of our preferred stock at an exercise price of $20 per share. Initially the rights will not be exercisable and will trade with our common stock. If a person or group acquires beneficial ownership of 15% or more of the then outstanding shares of our common stock or announces a tender or exchange offer that would result in such person or group owning 15% or more of our then outstanding common stock, each right would entitle its holder (other than the holder or group which acquired 15% or more of our common stock) to purchase shares of our common stock having a market value of two times the exercise price of the right. Our Board of Directors may redeem the rights at the redemption price of $.01 per right, subject to adjustment, at any time prior to the earlier of June 11, 2012, the expiration date of the rights, or the date of distribution of the rights, as determined under the plan.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk primarily related to changes in interest rates and foreign currency exchange rates. Our hedging activity is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities.

Interest Rate Sensitivity. We maintain an investment portfolio consisting partly of debt securities of various issuers, types and maturities. The securities that we classify as held-to-maturity are recorded on the balance sheet at amortized cost, which approximates market value. Unrealized gains or losses associated with these securities are not material. The securities that we classify as available-for-sale are recorded on the balance sheet at fair market value with unrealized gains or losses reported as part of accumulated other comprehensive income, net of tax as a component of stockholders’ equity. A hypothetical 10 percent increase in interest rates would not have a material impact on the fair market value of these securities due to their short maturity. We are able to hold our fixed income investments until maturity, and therefore we do not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio, unless we are required to liquidate these securities earlier to satisfy immediate cash flow requirements.

Foreign Currency Exchange Risk. Due to our global operating and financial activities, we are exposed to changes in foreign currency exchange rates. At September 27, 2003, we had net asset exposures to the Australian Dollar, Eurodollar, Japanese Yen and Brazilian Real. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results and cash flows.

To minimize the potential adverse impact of changes in foreign currency exchange rates, we, at times, have used foreign currency forward and option contracts to hedge the currency risk inherent in our global operations. We do not use financial instruments for trading or other speculative purposes, nor do we use leveraged financial instruments. Gains and losses on these contracts are largely

offset by gains and losses on the underlying assets and liabilities. We had no foreign exchange forward or option contracts outstanding at September 27, 2003.

Equity Price Risk. We maintain a small amount of investments in marketable equity securities of publicly-traded companies. At September 27, 2003, these investments were considered available-for-sale with any unrealized gains or losses deferred as a component of stockholders’ equity. It is not customary for us to make investments in equity securities of publicly traded companies as part of our investment strategy. In the past, we have also made strategic equity and convertible debt investments in privately-held technology companies, many of which are in the start-up or development stage. Investments in these companies are highly illiquid and inherently risky as the technologies or products they have under development, or the services they propose to provide, are typically in early stages of development and may never materialize. If these companies are not successful, we could lose our entire investment. The concentration of our investments in a small number of related industries, primarily telecommunications, exposes our investments to increased risk, particularly if these industries continue to be adversely affected by the worldwide economic slowdown. At September 27, 2003, these investments totaled $13.5 million. During the first nine months of fiscal year 2003, we recorded impairment losses of $24.5 million relating to these investments. While our financial results may be materially adversely affected by fluctuations in the value of these investments, we do not expect any material adverse impact in our cash flows.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the fiscal quarter covered by this quarterly report on Form 10-Q, an evaluation of the effectiveness of our disclosure controls and procedures was carried out under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer. Based on and as of the date of that evaluation, the CEO and CFO concluded that our disclosure controls and procedures are sufficient to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

Notwithstanding management’s conclusions, the effectiveness of a system of disclosure controls and procedures is subject to certain inherent limitations, including cost limitations, judgments used in decision making, assumptions regarding the likelihood of future events, soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud, or in making all material information known in a timely manner to the appropriate levels of management. As described below under “Changes in Internal Controls,” we have identified certain deficiencies in our internal controls. We believe the corrective actions we have taken and the additional procedures we have performed, as described in more detail below, provide us with reasonable assurance that the identified internal control weaknesses have not limited the effectiveness of our disclosure controls and procedures.

Changes in Internal Controls

Our management has assessed our internal controls in each of the regions in which we operate as of the end of the fiscal quarter covered by this quarterly report on Form 10-Q. In connection with this assessment, management determined that, although progress has been made, previously identified significant deficiencies remain in our internal controls relating to accounting policies and procedures, systems integration and data reconciliation, and personnel and their roles and responsibilities. We have performed additional procedures designed to ensure that these internal control deficiencies do not lead to material misstatements in our consolidated financial statements.

Management has assigned the highest priority to the short-term and long-term correction of these internal control deficiencies, and we have implemented and continue to implement changes to our accounting policies, procedures, systems and personnel to address these issues. Specifically, since June 28, 2003, we have implemented the following corrective actions as well as additional procedures:

1. Development and implementation of additional financial, accounting and other policies and procedures and publication of these policies on our internal website;

2. Continued increased supervisory and management reviews of procedures, including review and approval of demand forecasts by senior management;

3. Implementation of software tools to improve supply chain management, implementation of e-commerce tools, the development of a data warehouse tool and the implementation of a sales opportunity management system;

4. Continued enhancement to system controls and reporting; and

5. Continued expansion of internal audit processes and procedures, including regional financial statement reviews.

Longer term corrective actions, some of which we have already begun to implement, include:

1. Improved financial and management reporting systems, including the consolidation of disparate information systems in certain international locations and the implementation of a financial planning and budgeting system;

2. Continued development of additional financial, accounting and other policies and procedures;

3. Additional training of our personnel;

4. Expanded certification by employees of their familiarity, and obligation to comply, with our policies and procedures; and

5. Periodic re-certification by employees of their continued compliance with our policies and procedures.

We continue to evaluate the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In the normal course of our business, we are subject to proceedings, litigation and other claims. Litigation in general, and securities and intellectual property litigation in particular, can be expensive and disruptive to our normal business operations. Moreover, the results of litigation are difficult to predict. Described below are material legal proceedings in which we are involved. The uncertainty associated with these and other unresolved or threatened legal actions could adversely affect our relationships with existing customers and impair our ability to attract new customers. In addition, the defense of these actions may result in the diversion of management’s resources from the operation of our business, which could impede our ability to achieve our business objectives. The unfavorable resolution of any specific action could materially harm our business, operating results and financial condition, and could cause the price of our common stock to decline significantly. See also “Cautionary Statements – The lingering effects of the recently settled SEC investigation and our accounting restatements could materially harm our business, operating results and financial condition” and “Cautionary Statements - - Pending and future litigation could materially harm our business, operating results and financial condition.”

Securities Class Action in the District of Rhode Island. Between October 24, 1997 and March 2, 1998, nine shareholder class action lawsuits were filed against us and certain of our officers and directors in the United States District Court for the District of New Hampshire. By order dated March 3, 1998 these lawsuits, which are similar in material respects, were consolidated into one class action lawsuit, captioned In re Cabletron Systems, Inc. Securities Litigation (C.A. No. 97-542-SD). The complaint alleges that we and several of our officers and directors disseminated materially false and misleading information about our operations and acted in violation of Section 10(b) and Rule 10b-5 of the Exchange Act during the period between March 3, 1997 and December 2, 1997. The complaint further alleges that certain officers and directors profited from the dissemination of such misleading information by selling shares of our common stock during this period. The complaint does not specify the amount of damages sought on behalf of the class. In a ruling dated May 23, 2001, the district court dismissed this complaint with prejudice. The plaintiffs appealed that ruling to the First Circuit Court of Appeals, and, in a ruling issued on November 12, 2002, the Court of Appeals reversed and remanded the case to the District Court for further proceedings. On January 17, 2003, the defendants filed an answer denying all material allegations of the complaint. By Order of the Court dated March 18, 2003, the parties are now engaged in limited discovery. On July 16, 2003, the defendants renewed their motion to dismiss the complaint. At a status conference on August 11, 2003, the Court instructed the parties to continue limited discovery and, without ruling on the merits of defendants’ motion to dismiss, indicated that defendants would be allowed to renew their motion to dismiss upon the completion of limited discovery. If plaintiffs prevail on the merits of the case, we could be required to pay substantial damages.

and August 3, 2001 and in the period between August 6, 2001 and February 1, 2002 (together the “Class Period”), defendants issued materially false and misleading financial statements and press releases that overstated the our revenues, income, and cash, and understated our net losses, because we purportedly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”) and the our own accounting policies in connection with various sales and/or investment transactions. The complaints seek unspecified compensatory damages in favor of the plaintiffs and the other members of the purported class against all of the defendants, jointly and severally as well as fees, costs and interest and unspecified equitable relief. On October 17, 2003, a stipulation of settlement signed by all parties to the litigation was filed in the District of New Hampshire. Although we continue to deny any liability, we have agreed to pay approximately $17.0 million in cash and to distribute shares of common stock with a value of $33.0 million, and to adopt corporate governance changes in full settlement of all claims against us and our former officers. On October 20, 2003, the Court gave preliminary approval for the settlement. A hearing for final approval of the settlement has been set for December 19, 2003 in the District of New Hampshire. Once final approval of the settlement is received, the New Hampshire derivative action will be dismissed.

Shareholder Derivative Action in State of New Hampshire. On February 22, 2002, a shareholder derivative action was filed on our behalf in the Superior Court of Rockingham County, State of New Hampshire. The suit is captioned Nemes v. Fiallo, et al. Individual defendants are former chairman and chief executive officer Enrique Fiallo and certain members of our Board of Directors. Plaintiffs allege that the individual defendants breached their fiduciary duty to shareholders by causing or allowing us to conduct our business in an unsafe, imprudent, and unlawful manner and failing to implement and maintain an adequate internal accounting control system. Plaintiffs allege that this breach caused us to improperly recognize revenue in violation of GAAP and our own accounting policies in connection with transactions in our Asia Pacific region, and that this alleged wrongdoing resulted in damages to us. Plaintiffs seek unspecified compensatory damages. On October 7, 2002, the Superior Court approved the parties’ joint stipulation to stay proceedings. On October 20, 2003, the parties filed a stipulation of settlement in the Superior Court of Rockingham County, State of New Hampshire. Although we continue to deny any liability, we have agreed to adopt corporate governance changes and pay attorneys’ fees up to $0.4 million in full settlement of all claims against us and our former officers and directors. At this time, parties are awaiting preliminary approval of the settlement from the Court. Once preliminary and final approval of the settlement is received, the New Hampshire derivative action will be dismissed.

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

Other. In addition, we are involved in various other legal proceedings and claims arising in the ordinary course of business. Our management believes that the disposition of these additional matters, individually or in the aggregate, is not expected to have a materially adverse effect on our financial condition. However, depending on the amount and timing of such disposition, an unfavorable resolution of some or all of these matters could materially affect our future results of operations or cash flows in a particular period.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

31.1 Certification of William K. O’Brien under Section 302 of the Sarbanes-Oxley Act.

31.2 Certification of Richard S. Haak, Jr. under Section 302 of the Sarbanes-Oxley Act.

32.1 Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.*

32.2 Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.*

* The certifications under section 906 are being “furnished” hereunder and shall not be deemed “filed” for purposes of section 18 of the Securities Exchange Act of 1934

(b) Reports on Form 8-K:

We filed a Form 8-K on, July 24, 2003 to announce our second quarter results for the quarter ended June 28, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		*ENTERASYS NETWORKS, INC.*

		/S/ William K. O’Brien

Date: November 10, 2003	By:	William K. O’Brien
		Chief Executive Officer and Director

		*ENTERASYS NETWORKS, INC*

		/S/ Richard S. Haak, Jr.

Date: November 10, 2003	By:	Richard S. Haak, Jr.
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

EXHIBIT INDEX


31.1		Certification of William K. O’Brien under Section 302 of the Sarbanes-Oxley Act.

31.2		Certification of Richard S. Haak, Jr. under Section 302 of the Sarbanes-Oxley Act.

32.1		Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.*

32.2		Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.*

*		The certifications under section 906 are being “furnished” hereunder and shall not be deemed “filed” for purposes of section 18 of the Securities Exchange Act of 1934

	•		fluctuations in the demand for our products and services;

	•		the timing and size of sales of our products or the cancellation or rescheduling of significant orders;

	•		the length and variability of the sales cycle for our products;

	•		the timing of implementation and product acceptance by our customers and by customers of our distribution partners;

	•		the timing and success of new product introductions;

	•		increases in the prices or decreases in the availability of the components we purchase;

	•		price and product competition in the networking industry;

	•		our ability to source and receive from third party sources appropriate product volumes and quality;

	•		our ability to execute on our operating plan and strategy;

	•		manufacturing lead times and our ability to maintain appropriate inventory levels;

	•		the timing and level of research, development and prototype expenses;

	•		the mix of products and services sold;

	•		changes in the distribution channels through which we sell our products and the loss of distribution partners;

	•		the uncertainties inherent in our accounting estimates and assumptions and the impact of changes in accounting principles;

	•		our ability to achieve targeted cost reductions;

	•		the outcome of pending securities litigation; and

	•		general economic conditions as well as those specific to the networking industry.

	•		political and economic instability and changing regulatory environments in foreign countries;

	•		increased time to deliver solutions to customers due to the complexities associated with managing an international distribution system;

	•		increased time to collect receivables caused by slower payment practices in many international markets;

	•		managing export licenses, tariffs and other regulatory issues pertaining to international trade;

	•		increased effort and costs associated with the protection of our intellectual property in foreign countries; and

	•		difficulties in hiring and managing employees in foreign countries.

	•		difficulties and unanticipated costs incurred in assimilating the operations of the acquired business, technologies or product lines or of segregating, marketing and disposing of a business, technology or product line;

	•		potential disruption of our existing operations;

	•		an inability to successfully integrate, train and retain key personnel, or transfer or eliminate positions or key personnel;

	•		diversion of management attention and employees from day-to-day operations;

	•		an inability to incorporate, develop or market acquired businesses, technologies or product lines, or realize value from technologies, products or businesses;

	•		operating inefficiencies associated with managing companies in different locations, or separating integrated operations; and

	•		impairment of relationships with employees, customers, suppliers and strategic partners.

	1.		Development and implementation of additional financial, accounting and other policies and procedures and publication of these policies on our internal website;

	2.		Continued increased supervisory and management reviews of procedures, including review and approval of demand forecasts by senior management;

	3.		Implementation of software tools to improve supply chain management, implementation of e-commerce tools, the development of a data warehouse tool and the implementation of a sales opportunity management system;

	4.		Continued enhancement to system controls and reporting; and

	1.		Improved financial and management reporting systems, including the consolidation of disparate information systems in certain international locations and the implementation of a financial planning and budgeting system;

	2.		Continued development of additional financial, accounting and other policies and procedures;

	3.		Additional training of our personnel;

	4.		Expanded certification by employees of their familiarity, and obligation to comply, with our policies and procedures; and

	5.		Periodic re-certification by employees of their continued compliance with our policies and procedures.

(a)		Exhibits:

31.1		Certification of William K. O’Brien under Section 302 of the Sarbanes-Oxley Act.

31.2		Certification of Richard S. Haak, Jr. under Section 302 of the Sarbanes-Oxley Act.

32.1		Certification of William K. O’Brien under Section 906 of the Sarbanes-Oxley Act.*

32.2		Certification of Richard S. Haak, Jr. under Section 906 of the Sarbanes-Oxley Act.*

*		The certifications under section 906 are being “furnished” hereunder and shall not be deemed “filed” for purposes of section 18 of the Securities Exchange Act of 1934

(b)		Reports on Form 8-K:

		We filed a Form 8-K on, July 24, 2003 to announce our second quarter results for the quarter ended June 28, 2003.