e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended October 1, 2005


o		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 þ No o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of November 7, 2005 there were 27,329,238 shares of Enterasys common stock, $0.01 par value, outstanding.

PART I — FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

ENTERASYS NETWORKS, INC.

CONSOLIDATED BALANCE SHEETS


	October 1,			January 1,
	2005			2005
	(In thousands, except share and
	per share amounts)
	(unaudited)			(a)
Current assets:
Cash and cash equivalents	$	68,857		$	70,947
Marketable securities		35,931			48,472
Accounts receivable, net		29,215			29,088
Inventories		19,080			27,200
Income tax receivable		54,330			1,732
Insurance receivable		9,958			11,008
Asset held for sale		3,071			—
Prepaid expenses and other current assets		11,573			18,334

Total current assets		232,015			206,781
Restricted cash, cash equivalents and marketable securities		5,402			5,357
Long-term marketable securities		4,872			30,596
Investments		186			388
Property, plant and equipment, net		12,771			27,828
Goodwill		15,129			15,129
Intangible assets, net		1,445			4,234

Total assets	$	271,820		$	290,313


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	20,646		$	28,841
Accrued compensation and benefits		18,706			23,574
Accrued legal and litigation costs		11,803			12,945
Accrued restructuring charges		5,097			9,528
Other accrued expenses		13,778			19,001
Deferred revenue		31,505			33,136
Customer advances and billings in excess of revenues		6,233			11,341
Income taxes payable		5,588			32,427

Total current liabilities		113,356			170,793
Long-term deferred revenue		6,691			6,214
Long-term accrued restructuring charges		2,396			3,568

Total liabilities		122,443			180,575

Commitments and contingencies

Stockholders’ equity:
Series F preferred stock, $1.00 par value; 300,000 shares authorized; none outstanding		—			—
Undesignated preferred stock, $1.00 par value; 1,700,000 shares authorized; none outstanding		—			—
Common stock, $0.01 par value; 60,000,000 shares authorized; 27,331,940, and 26,543,808 shares issued and 27,331,940 and 26,325,200 shares outstanding at October 1, 2005 and January 1, 2005, respectively		273			265
Additional paid-in capital		1,163,459			1,192,885
Accumulated deficit		(1,022,765	)		(1,061,384	)
Treasury stock, at cost; none and 218,608 common shares at October 1, 2005 and January 1, 2005, respectively		—			(30,119	)
Accumulated other comprehensive income		8,410			8,091

Total stockholders’ equity		149,377			109,738

Total liabilities and stockholders’ equity	$	271,820		$	290,313


(a)		The balance sheet at January 1, 2005 has been derived from the audited consolidated financial statements at that date, but does not include all the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

See accompanying notes to consolidated financial statements.

ENTERASYS NETWORKS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS


	Three months ended						Nine months ended
	October 1,			October 2,			October 1,			October 2,
	2005			2004			2005			2004
	(In thousands, except per share amounts)
				(unaudited)
Net revenue:
Product	$	60,156		$	65,058		$	175,417		$	195,281
Services and other		21,678			22,352			65,134			71,057

Total net revenue		81,834			87,410			240,551			266,338

Cost of revenue:
Product		32,932			32,832			98,489			101,113
Services and other		6,060			7,864			23,587			27,656

Total cost of revenue		38,992			40,696			122,076			128,769

Gross margin		42,842			46,714			118,475			137,569
Operating expenses:
Research and development		10,892			17,685			41,376			57,829
Selling, general and administrative		31,820			34,030			99,976			122,006
Amortization of intangible assets		929			929			2,788			3,456
Restructuring charges, net		(189	)		5,418			9,585			11,311
Asset impairments and other charges		978			454			7,749			9,188

Total operating expenses		44,430			58,516			161,474			203,790

Loss from operations		(1,588	)		(11,802	)		(42,999	)		(66,221	)
Interest income, net		846			626			2,722			2,276
Other (expense) income, net		(69	)		2,980			(85	)		(6,236	)

Loss before income taxes		(811	)		(8,196	)		(40,362	)		(70,181	)
Income tax benefit		73,708			2,389			78,981			9,416

Net income (loss)	$	72,897		$	(5,807	)	$	38,619		$	(60,765	)


Basic net income (loss) per common share	$	2.67		$	(0.21	)	$	1.41		$	(2.24	)

Basic weighted average common shares outstanding		27,315			27,230			27,303			27,183


Diluted net income (loss) per common share	$	2.66		$	(0.21	)	$	1.41		$	(2.24	)

Diluted weighted average common shares outstanding		27,385			27,230			27,359			27,183

See accompanying notes to consolidated financial statements.

ENTERASYS NETWORKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Nine months ended
	October 1,			October 2,
	2005			2004
	(In thousands)
	(unaudited)
Cash flows from operating activities:
Net income (loss)	$	38,619		$	(60,765	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		12,775			17,329
Recoveries on accounts receivable		(617	)		(2,945	)
Provision for inventory write-downs		9,129			10,751
Asset impairment charges		6,236			9,188
(Gain) loss on minority investments		(77	)		9,446
Unrealized loss (gain) on foreign currency transactions		52			(1,775	)
Benefit from reduction in tax contingencies		(34,291	)		(9,913	)
Other, net		36			(1,026	)
Changes in current assets and liabilities:
Accounts receivable		685			10,071
Inventories		(459	)		(10,791	)
Prepaid expenses and other current assets		7,018			(8,483	)
Accounts payable and accrued expenses		(23,994	)		(14,317	)
Customer advances and billings in excess of revenues		(5,101	)		2,496
Deferred revenue		(1,286	)		(5,514	)
Income taxes, net		(45,360	)		(964	)

Net cash used in operating activities		(36,635	)		(57,212	)


Cash flows from investing activities:
Capital expenditures		(3,613	)		(8,104	)
Purchase of minority investments		—			(1,450	)
Proceeds from sales of minority investments		279			2,169
Purchase of marketable securities		(3,000	)		(34,360	)
Sales and maturities of marketable securities		41,052			22,777
Net release of restricted cash		(45	)		6,277

Net cash provided by (used in) investing activities		34,673			(12,691	)


Cash flows from financing activities:
Proceeds from exercise of stock options		224			1,789
Proceeds from common stock issued pursuant to employee stock purchase plans		477			1,713

Net cash provided by financing activities		701			3,502


Effect of exchange rate changes on cash		(829	)		(625	)


Net decrease in cash and cash equivalents		(2,090	)		(67,026	)
Cash and cash equivalents at beginning of period		70,947			136,801

Cash and cash equivalents at end of period	$	68,857		$	69,775


Supplemental disclosure of cash flow information:
Refunds received (cash paid) for income taxes, net	$	195		$	(1,251	)
Non-cash transactions:
Issuance of stock for shareholder litigation	$	28,068		$	—

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 accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (which include normal recurring adjustments except as disclosed herein) necessary for a fair presentation of the results of operations for the interim periods presented have been reflected herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. The accompanying financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, 2005.

2. Reverse Stock Split

In October 2005, the Company’s Board of Directors approved a 1-for-8 reverse stock split of the Company’s outstanding shares of common stock. Following shareholder approval, the reverse stock split became effective on October 28, 2005. All share and per share information included in these consolidated financial statements have been adjusted to reflect this reverse stock split. The authorized common stock was decreased from 450 million shares to 60 million shares and issued shares were reverse split on a 1 for 8 basis.

3. Accounting Policies

Principles of Consolidation

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

Use of Estimates

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

Stock-Based Compensation Plans

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


	Three months ended						Nine months ended
	October 1, 2005			October 2, 2004			October 1, 2005			October 2, 2004
				(In thousands)
Net income (loss), as reported	$	72,897		$	(5,807	)	$	38,619		$	(60,765	)
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for the employee stock option awards and the employee stock purchase plans		(1,037	)		(3,015	)		(3,586	)		(11,638	)

Pro forma net income (loss)	$	71,860		$	(8,822	)	$	35,033		$	(72,403	)

Basic net income (loss) per common share:
As reported	$	2.67		$	(0.21	)	$	1.41		$	(2.24	)

Pro forma	$	2.63		$	(0.32	)	$	1.28		$	(2.66	)

Diluted net income (loss) per common share:
As reported	$	2.66		$	(0.21	)	$	1.41		$	(2.24	)

Pro forma	$	2.62		$	(0.32	)	$	1.28		$	(2.66	)

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


	Three months ended						Nine months ended
	October 1, 2005			October 2, 2004			October 1, 2005			October 2, 2004
Employee stock options:

Risk-free interest rate		4.13	%		3.35	%		4.17	%		3.21	%
Expected option life	4.18		years	4.36		years	4.22		years	4.52		years
Expected volatility		107.36	%		112.00	%		107.03	%		112.09	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Fair value of options granted	$	6.47		$	10.64		$	7.47		$	16.96

Employee stock purchase plan shares:

Risk-free interest rate		3.76	%		1.95	%		3.25	%		1.73	%
Expected option life	6		months	6		months	6		months	6		months
Expected volatility		75.23	%		72.46	%		69.95	%		72.03	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Fair value of plan shares	$	2.08		$	6.96		$	2.16		$	8.16

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 September 2005, the Financial Accounting Standards Board (“FASB”) approved the consensus reached on the Emerging Issues Task Force Issue No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty (“EITF 04-13”). The Issue’s objective is to provide guidance for identifying and accounting for purchases and sales of inventory between entities in the same line of business that are deemed nonmonetary transactions within the scope of APB Opinion No. 29, Accounting for Nonmonetary Transactions. EITF 04-13 also provides new disclosure requirements for inventory exchanges accounted for under EITF 04-13. This statement is effective for transactions completed in reporting periods beginning after March 15, 2006. The adoption of EITF No. 04-13 is not expected to have a material effect on the Company’s results of operations or financial position.

In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections- a replacement of APB No. 20 and FASB Statement No. 3 (“SFAS No. 154”). This statement replaces APB Opinion No. 20, Accounting Changes, which required most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retroactive application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement is effective for fiscal periods beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material effect on the Company’s results of operations or financial position.

In March 2005, the FASB issued FASB interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (“FIN 47”). FIN 47 clarifies that the term Conditional Asset Retirement Obligation as used in FASB Statement No. 143, Accounting for Asset Retirement Obligation, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The Company is required to adopt the provisions of FIN 47 by May 2006, although earlier adoption is permitted. The adoption of FIN 47 is not expected to have a material effect on the Company’s results of operations or financial position.

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”). The Issue’s objective is to provide guidance for identifying other-than-temporarily impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued a FASB Staff Position (“FSP”) EITF 03-1-1 that delays the effective date of the measurement and recognition guidance in EITF 03-1 until further notice. The adoption of EITF 03-1 is not expected to have a material effect on the Company’s results of operations or financial position.

In December 2004, the FASB issued FSP No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act (“AJCA”) of 2004 (“FSP 109-2”). The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a US taxpayer (repatriation provision), provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. The Company does not currently plan to change its intention to permanently reinvest the undistributed earnings of its foreign subsidiaries. The Company does not expect the enactment of the AJCA to have a material effect on its consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”). This Statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123(R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. The requirements of FAS 123(R) are effective for the Company’s fiscal year beginning January 1, 2006, as a result of the SEC’s recent decision to delay the effective date of FAS 123(R) by six months. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 regarding the Staff’s interpretation of SFAS No. 123R. This interpretation provides the Staff’s views regarding interactions between SFAS No. 123R and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. The interpretive guidance is intended to assist companies in applying the provisions of SFAS No. 123R and investors and users of the financial statements in analyzing the information provided. The company will follow the guidance prescribed in SAB No. 107 in connection with its adoption of SFAS No. 123R. The Company is currently evaluating the requirements of SFAS 123(R) and has not yet fully determined the effect on its consolidated financial statements. The stock-based employee compensation expense presented in the Company’s pro forma financial results required to be disclosed under the current SFAS 123 was $1.0 million and $3.6 million for the three and nine months ended October 1, 2005, respectively, and $3.0 million and $11.6 million for the three and nine months ended October 2, 2004, respectively.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets (“SFAS No. 153”). This statement amends APB Opinion No. 29, Accounting of Nonmonetary Transactions, to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have a material effect on the Company’s results of operations or financial position.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs (“SFAS No. 151”). This statement amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This statement is effective for fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 is not expected to have a material effect on the Company’s results of operations or financial position.

Reclassifications

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

4. Accounts Receivable, net

Accounts receivable, net were as follows:


	October 1, 2005			January 1, 2005
	(In thousands)
Gross accounts receivable	$	29,488		$	29,641
Allowance for doubtful accounts		(273	)		(553	)

Accounts receivable, net	$	29,215		$	29,088

The Company defers revenue on product shipments to certain stocking distributors until those distributors have sold the product to their customer. At October 1, 2005 and January 1, 2005, $12.2 million and $19.7 million, respectively, of product shipments had been billed and revenue had not been recognized, of which $5.6 million and $10.0 million, respectively, was paid and included in customer advances and billings in excess of revenues. The balance of $6.6 million and $9.7 million, respectively, was unpaid and is recorded as a contra account to gross accounts receivable.

5. Inventories

Inventories consisted of the following:


	October 1, 2005		January 1, 2005
	(In thousands)
Raw materials	$	842	$	1,690
Service spares		1,576		2,520
Finished goods at stocking distributors		4,471		6,617
Finished goods		12,191		16,373

Inventories	$	19,080	$	27,200

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 its fiscal year as the date of the annual test. The Company completed its annual impairment test at October 1, 2005 and found no impairment of recorded goodwill. Goodwill at October 1, 2005 and January 1, 2005 was $15.1 million.

During the second quarter of fiscal year 2004, the Company recorded an impairment charge of $8.7 million relating to the write-down of patents and technology intangible assets recorded in connection with the Company’s fiscal year 2001 acquisition of Indus River Networks. In conjunction with a restructuring plan, the Company decided to curtail certain development efforts, which reduced forecasted demand on future products that would have used this technology. As a result, the intangible assets’ fair value was determined to be zero based on a discounted cash flows analysis.

The table below presents gross amortizable intangible assets and the related accumulated amortization at October 1, 2005:


						Net Carrying
	Gross					Value of
	Carrying		Accumulated			Intangible		Estimated
	Amount		Amortization			Assets		Useful Life
			(In thousands)
Customer relations	$	28,600	$	(27,531	)	$	1,069	8 years
Patents and technology		2,092		(1,716	)		376	3 years

Total	$	30,692	$	(29,247	)	$	1,445

All of the Company’s identifiable intangible assets are subject to amortization. Total amortization expense was $0.9 million and $2.8 million for the three and nine months ended October 1, 2005, respectively, and $0.9 million and $3.5 million for the three and nine months ended October 2, 2004, respectively. Based on the net carrying value of intangible assets at October 1, 2005, the estimated amortization expense is $0.9 million for the remainder of fiscal year 2005 and $0.5 million for fiscal year 2006.

7. Other Accrued Expenses

Other accrued expenses consisted of the following:


	October 1, 2005		January 1, 2005
	(In thousands)
Accrued audit and Sarbanes-Oxley Section 404 costs	$	2,920	$	3,194
Accrued marketing and selling costs		3,306		4,459
Accrued sales tax and VAT expense		445		1,760
Accrued royalties		1,038		684
Accrued IT and engineering		544		1,236
Accrued utilities		768		789
Other		4,757		6,879

Total other accrued expenses	$	13,778	$	19,001

8. Restructuring Charges, net

The following table summarizes accrued restructuring activity:


							Contract			Total
	Severance			Facility Exit			Cancellation			Accrued
	Benefits			Costs			Costs			Restructuring
				(In thousands)
Balance, January 3, 2004	$	3,842		$	6,683		$	—		$	10,525
Q1 restructuring charge		3,800			685			—			4,485
Q1 cash payments		(2,161	)		(777	)		—			(2,938	)

Balance, April 3, 2004		5,481			6,591			—			12,072
Q2 restructuring charge		1,173			235			—			1,408
Q2 cash payments		(2,518	)		(831	)		—			(3,349	)

Balance, July 3, 2004		4,136			5,995			—			10,131
Q3 restructuring charges		4,231			1,187			—			5,418
Q3 cash payments		(3,128	)		(976	)		—			(4,104	)

Balance, October 2, 2004		5,239			6,206			—			11,445
Q4 restructuring charge		4,870			—			—			4,870
Q4 cash payments		(2,361	)		(858	)		—			(3,219	)

Balance, January 1, 2005		7,748			5,348			—			13,096
Q1 restructuring charge		420			383			—			803
Prior year reversal		(820	)		—			—			(820	)
Q1 cash payments		(4,848	)		(872	)		—			(5,720	)

Balance, April 2, 2005		2,500			4,859			—			7,359
Q2 restructuring charge		8,138			701			952			9,791
Q2 cash payments		(2,639	)		(966	)		—			(3,605	)

Balance, July 2, 2005		7,999			4,594			952			13,545
Q3 restructuring charge		543			469			—			1,012
Prior quarter reversal		(1,201	)		—			—			(1,201	)
Q3 cash payments		(4,046	)		(865	)		(952	)		(5,863	)

Balance, October 1, 2005	$	3,295		$	4,198		$	—		$	7,493

In the second quarter of fiscal year 2005, the Company developed and began implementing a significant cost-reduction plan that is expected to reduce quarterly expenses by approximately $10 million to $13 million and achieve positive operating cash flow at quarterly revenues of approximately $80 million when completed. This plan includes reducing the Company’s workforce on the order of 30%, from the level at the end of the first quarter of fiscal year 2005, as well as the cancellation or curtailment of certain spending programs. The Company recorded restructuring charges, net of $10.8 million during the second and third quarters of fiscal year 2005, which included employee severance related costs of $8.7 million. In addition, the Company recorded facility exit costs of $1.1 million for closure of two regional sales offices and revisions to the estimated time required to sublet certain other vacant properties. Contract cancellation costs were $1.0 million for third-party engineering development activities. Offsetting this expense was a reversal of prior quarters’ severance expense of $1.2 million related to a change in estimated severance benefits as well as changes in the employee population expected to receive such benefits. Net headcount reductions related to the severance charges included approximately 182 individuals and involved most functions within the Company.

In the first quarter of fiscal year 2005, the Company recorded restructuring charges, net of $0.8 million related to workforce reductions and facility closings. In connection with the workforce reduction, the Company recorded employee severance related costs of $0.4 million for approximately 10 individuals. The reductions were a continuation of a previously announced plan. In addition, the Company recorded facility exit costs of $0.4 million for closure of one regional sales office and revisions to the estimated time required to sublet certain other vacant properties. Offsetting this expense was a reversal of prior year severance expense of $0.8 million related to a change in estimated severance benefits as well as changes in the employee population expected to receive such benefits.

The remaining accrued severance cost of $3.3 million as of October 1, 2005 is expected to be paid over the next twelve months and the remaining accrued exit costs of $4.2 million, which consists of long-term lease commitments less projected sublease income, will be paid as follows: $0.3 million for the remainder of fiscal year 2005, $2.0 million in fiscal year 2006, $0.9 million in fiscal year 2007, $0.4 million in fiscal year 2008, $0.4 million in fiscal year 2009 and $0.2 million thereafter.

In fiscal year 2004, the Company recorded restructuring charges, net of $16.2 million related to workforce reductions and facility closings, including $11.3 million for the nine months ended October 2, 2004. In connection with the workforce reductions, the Company recorded employee severance related costs of $14.1 million for approximately 400 individuals. The workforce reductions during fiscal year 2004 occurred in conjunction with a plan to align the cost structure of the Company’s business with its Secure Networks strategy and involved most functions within the Company. Additionally, the Company exited seven facilities,

which included two research facilities, and five regional sales offices and recorded facility exit costs of $2.1 million during fiscal year 2004.

9. Asset Impairments and Other Charges

The Company recorded asset impairment and other charges of $7.7 million in the first nine months of fiscal year 2005 which consisted of $6.2 million for asset impairments and $1.5 million for consulting costs associated with its initiative to improve sales force productivity. As a result of the Company’s plan to vacate and sell a facility in Rochester, NH and to relocate or outsource all employees and operations from Rochester by the end of the year, the Company performed a test for recoverability under SFAS No. 144 (“SFAS 144”), Accounting for the Impairment and Disposal of Long-lived Assets, at the end of the second quarter of fiscal year 2005. As a result, the Company recorded an impairment charge of $5.5 million associated with the write-down of the facility to its estimated fair value based on an independent appraisal. The estimated fair value of the facility less cost to sell was approximately $3.1 million as of October 1, 2005, and has been presented separately from the fixed assets reported in the consolidated balance sheets as an asset held for sale. The remaining asset impairment charge of $0.7 million consisted of various prepaid and fixed assets that have been impaired as a result of workforce reductions and project cancellations. During the nine months ended October 2, 2004, the Company recorded asset impairment charges of $9.2 million, which consisted of $8.7 million for a write-down of patents and technology intangible assets (see Note 6 for further information) and $0.5 million associated with the closure of certain facilities.

10. Other (Expense) Income, Net

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


	Three months ended						Nine months ended
	October 1, 2005			October 2, 2004			October 1, 2005			October 2, 2004
	(In thousands)
Gain (loss) on minority investments	$	—		$	552		$	77		$	(9,446	)
Net realized gain (loss) on sale of marketable securities		—			(130	)		(53	)		7
Foreign currency (loss) gain		(77	)		1,852			(87	)		1,729
Gain on legal settlement		—			1,048			—			1,048
Other, net		8			(342	)		(22	)		426

Total other (expense) income, net	$	(69	)	$	2,980		$	(85	)	$	(6,236	)

In the third quarter of fiscal year 2004, the Company recorded a non-recurring foreign currency benefit of $2.0 million to reflect the period end cumulative effect of foreign currency translation.

The Company recorded a gain of $1.0 million in the third quarter of fiscal year 2004 from a legal settlement related to claims pertaining to the sale of a former subsidiary in fiscal year 2002.

11. Income Taxes

The Company recorded a net income tax benefit of $79.0 million for the first nine months of fiscal year 2005. During the second quarter of fiscal year 2005, the Company was notified by the Internal Revenue Service (“IRS”) that it had completed its field audit of the Company’s federal tax returns for fiscal years 1999 through 2002, including certain amended tax return filings. The findings of this audit were accepted by the Company and were reviewed and approved in the third quarter by the Congressional Joint Committee on Taxation (“JCT”). As a result, the Company recorded in the third quarter of fiscal year 2005 a tax benefit of approximately $73.2 million which included a tax refund of $47.6 million, associated net interest income of $4.7 million, and a net reduction to previously accrued taxes of approximately $20.9 million. The Company subsequently received the cash refund of $52.3 million in October 2005. In addition, the Company recorded a benefit of $6.5 million in the first nine months of fiscal year 2005 which consisted of $5.0 million released from previously accrued federal and state tax reserves and a $1.5 million tax refund, resulting from the favorable settlement of an audit of certain foreign tax returns for the periods 1997 through 2003.

The Company recorded a net income tax benefit of $9.4 million for the first nine months of fiscal year 2004, primarily related to the release of previously accrued taxes. In the second quarter of fiscal year 2004, the Company filed documentation with the IRS based on then newly issued guidance that allowed the Company to recognize a reduction to accrued tax liabilities of $12.0 million in the fiscal year 2004. Approximately $9.9 million of the liability reduction was recognized as a tax benefit during the first nine months of fiscal year 2004.

During the first quarter of fiscal year 2005, the Company changed its method of accounting for reporting changes in interim periods to liabilities resulting from changes in judgments or settlements related to uncertain tax positions. The Company had previously accounted for such changes in judgments and settlements as adjustments to the estimated annual effective tax rate. The Company changed its method to account for such changes in judgments and settlements as discrete items in the interim period of

change. This discrete method recognizes the effect of any change in reserves only in the quarter of the change. The newly adopted accounting method is preferable in these circumstances because it better reflects the Company’s consolidated financial position and operations at the time of the change in its uncertain tax positions. As a result of the change in method, income tax benefit was increased by $4.8 million or $0.18 per common share for the three months ended April 2, 2005. If the Company had used the discrete method, the income tax benefit would have decreased by $2.2 million for the three months ended October 2, 2004, and increased $2.1 million for the nine months ended October 2, 2004, as compared to the amounts previously reported as income tax benefit. Additionally, the amounts previously reported for basic and diluted net loss per share would have increased by $0.08 per common share for the three months ended October 2, 2004 and decreased by $0.08 per common share for the nine months ended October 2, 2004.

12. Comprehensive Income (Loss)

The Company’s total comprehensive income (loss) was as follows:


	Three months ended					Nine months ended
	October 1, 2005		October 2, 2004			October 1, 2005		October 2, 2004
			(In thousands)
Net income (loss)	$	72,897	$	(5,807	)	$	38,619	$	(60,765	)
Other comprehensive income (loss):
Unrealized (loss) gain on marketable securities		—		(1	)		36		(882	)
Foreign currency gain (loss) on translation adjustment		746		(1,220	)		283		(1,595	)

Total comprehensive income (loss)	$	73,643	$	(7,028	)	$	38,938	$	(63,242	)

13. Segment Information

The Company operates its business as one segment, which is the business of designing, developing, marketing and supporting comprehensive network solutions architected to address the network communication, management and security requirements facing global enterprises.

Geographic revenue information is based on the location of the customer. Net revenue from external customers by geographic region was as follows:


	Three months ended										Nine months ended
	October 1, 2005					October 2, 2004					October 1, 2005					October 2, 2004
	Revenue		Percent			Revenue		Percent			Revenue		Percent			Revenue		Percent
								($ in thousands)
North America	$	39,783		48.6	%	$	45,156		51.6	%	$	117,241		48.7	%	$	129,873		48.8	%
Europe, Middle East and Africa		31,667		38.7	%		31,174		35.7	%		92,087		38.3	%		94,296		35.4	%
Asia Pacific		5,394		6.6	%		5,856		6.7	%		15,929		6.6	%		23,832		8.9	%
Latin America		4,990		6.1	%		5,224		6.0	%		15,294		6.4	%		18,337		6.9	%

Total net revenue	$	81,834		100.0	%	$	87,410		100.0	%	$	240,551		100.0	%	$	266,338		100.0	%

During the third quarter of fiscal year 2005, one stocking distributor accounted for approximately 29% of the Company’s net revenue and for the third quarter of fiscal year 2004, two stocking distributors accounted for approximately 29% and 16% of the Company’s net revenue, respectively. No single end-user accounted for more than 10% of the Company’s net revenue in any of the periods presented.

During the first nine months of fiscal year 2005, two stocking distributors accounted for approximately 26% and 10% of the Company’s net revenue, respectively and for the first nine months of fiscal year 2004, two stocking distributors accounted for approximately 28% and 15% of the Company’s net revenue, respectively.

Long-lived assets consist of the net book value of property, plant, and equipment, goodwill and intangible assets. Long-lived assets by location were as follows:


	October 1, 2005		January 1, 2005
	(In thousands)
U.S	$	28,033	$	45,089
All other countries		1,312		2,102

Total long-lived assets	$	29,345	$	47,191

14. Net Income (Loss) Per Share

The following table presents the calculation of basic and diluted common shares used to calculate net income (loss) per share:


	Three months ended				Nine months ended
	October 1, 2005		October 2, 2004		October 1, 2005		October 2, 2004
	(In thousands)
Basic weighted average common shares outstanding		27,315		27,230		27,303		27,183
Effect of dilutive potential common shares		70		—		56		—

Diluted weighted average common shares outstanding		27,385		27,230		27,359		27,183

Diluted weighted average common shares outstanding includes the dilutive effect of potential future issuances of common stock relating to employee stock option programs and other potentially dilutive securities. Employee stock options to purchase approximately 2.7 million shares were outstanding at October 1, 2005 but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the average share price of the common shares and therefore the effect would have been antidilutive. Employee stock options to purchase 3.9 million shares of the Company’s common stock were outstanding at October 2, 2004, but excluded from the calculation of diluted loss per common share since the effect would have been antidilutive.

For the three and nine months ended October 2, 2004, the Company included 927,939 shares of stock related to the settlement of the outstanding shareholder litigation in the Earnings Per Share calculation as shares outstanding. In accordance with SFAS No. 128, Earnings Per Share, the Company considered these shares to have no contingencies and accordingly included these shares of common stock in its calculation of weighted common stock outstanding.

15. Commitments and Contingencies

Legal Proceedings

In the normal course of its business, the Company 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 unresolved or threatened legal actions could adversely affect the Company’s relationships with existing customers and impair its ability to attract new customers. In addition, the defense of such actions may result in the diversion of management’s resources from the operation of the Company’s business, which could impede the Company’s ability to achieve its business objectives. The unfavorable resolution of any specific action could materially harm the Company’s business, operating results and financial condition, and could cause the price of its 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-JD (N.H.); No. 99-408-S (R.I.)). The case was referred to the District of Rhode Island. The complaint alleges that the Company and several of its officers and directors disseminated materially false and misleading information about the Company’s operations and acted in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder during the period between March 3, 1997 and December 2, 1997, and 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 February 2005, the Company entered into an agreement in principle to settle this litigation which is subject to approval by the Court and does not reflect any admission of wrongdoing. If finally approved, the settlement would result in the dismissal and release of all claims and, under the financial terms of the settlement, the Company would pay $10.5 million in cash in addition to ongoing defense costs of approximately $1.1 million in connection with the litigation, the majority of which will be offset by approximately $11.0 million in cash proceeds from certain of the Company’s insurers. During the first nine months of fiscal year 2005, the Company received $1.1 million of these insurance proceeds from one of its insurers. An additional sum of approximately $9.9 million has been deposited into an escrow by another insurer and will be used to fund the settlement if and when final court approval of the settlement is received.

Indemnification Claims. The Company’s certificate of incorporation provides for indemnification and advancement of certain litigation and other expenses to the Company’s directors and certain of its officers to the maximum extent permitted by Delaware

law. Accordingly, the Company, from time to time, may be required to indemnify directors and certain of its officers, including former directors and officers, in various litigation matters, claims or proceedings. The Company recorded operating expenses of approximately $1.2 million and $2.4 million for the three and nine months ended October 1, 2005, respectively, and $0.2 million and $2.4 million for the three and nine months ended October 2, 2004, respectively, in legal expenses relating to such matters. The Company is currently engaged in legal proceedings against certain insurers to recover these and other costs and expenses incurred by the Company in connection with indemnification claims and other litigation claims, proceedings, and investigative matters.

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

Other Commitments and Contingencies

The Company has guaranteed a portion of a former subsidiary’s lease obligations and related maintenance and management fees through 2012. At October 1, 2005, 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, 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 $4.0 million to secure this guarantee.

At October 1, 2005, the Company had non-cancelable purchase commitments of approximately $21.9 million primarily with its contract manufacturers. The majority of these purchase commitments are expected to be paid in fiscal year 2005.

At October 1, 2005, the Company had commitments of approximately $4.8 million related to various royalty and license agreements. The Company expects to make payments of $2.0 million for the remainder of fiscal year 2005, $2.7 million in fiscal year 2006 and $0.1 million in fiscal year 2007.

16. Related Party Transactions

Investments

The Company has minority investments in debt and equity securities of certain companies. The Company does not have a controlling interest in these entities or exert any managerial control. Revenues recognized from sales to investee companies were $1.9 million and $4.4 million for the three and nine months ended October 1, 2005 respectively, and $1.0 million and $5.3 million for the three and nine months ended October 2, 2004 respectively, and were related to transactions with normal terms and conditions.

17. Common Stock Issuance

During fiscal year 2003, the Company finalized its agreements to settle the outstanding shareholder litigation against the Company, and certain of its former directors and officers filed in connection with financial restatements for the 2001 fiscal and transition years. Under the financial terms of the settlements, the Company distributed 927,939 shares of its stock in the first quarter of fiscal year 2005, which included 218,608 shares of the Company’s treasury stock. In conjunction with the distribution of its treasury stock, the Company recorded a reduction in additional paid-in capital of approximately $30.1 million.

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 December 31, 2005 as “fiscal year 2005” and our prior fiscal year, the twelve-month period ended January 1, 2005 as “fiscal year 2004” throughout this Item.

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

Overview

We design, develop, market, and support comprehensive networking solutions architected to address the networking requirements of global enterprises. We believe our solutions offer customers the secure, high-capacity, cost-effective, network connectivity and infrastructure required to facilitate the exchange of information among employees, customers, vendors, partners and other network users. We are focused on delivering networking solutions that integrate security features within the network architecture. We believe our solutions enable customers to meet their requirements for network continuity, context, control, compliance and consolidation through an architecture and management interface designed for ease of use. Our installed base of customers consists of commercial enterprises; governmental entities; healthcare, financial, educational and non-profit institutions; and various other organizations.

Our product revenue consists primarily of sales of our network hardware, including switches, routers, wireless devices and other networking equipment. Product revenue also includes revenue from the sale of our software products, including our Dragon intrusion detection software and our NetSight network management software. Our services revenue is derived primarily from our contracts to provide on-going maintenance and support services around the world, 7 days a week, 24 hours a day. We also derive service revenue from network outsourcing contracts and professional services to install, develop and improve network performance and capabilities.

During the third quarter of fiscal year 2005, we achieved significant progress toward our goal of attaining operating profitability and cash-positive operations. We realized approximately $12.4 million of recurring cost benefits in the third quarter of fiscal year 2005 compared to the first quarter. Our operating loss was reduced to $1.6 million in the third quarter of fiscal year 2005 compared with a loss of $23.2 million in the prior quarter and a loss of $11.8 million in the third quarter of fiscal year 2004. For the nine months ended October 1, 2005, our operating loss was reduced to $43.0 million compared with a loss of $66.2 million in the prior year’s nine months. Net cash used in operating activities decreased to $2.5 million in the third quarter of fiscal year 2005 compared with a net cash use of $5.9 million in the prior quarter and a net cash use of $14.0 million in the third quarter of fiscal year 2004. For the first nine months of fiscal year 2005, our net cash used in operating activities declined to $36.6 million compared with a net cash use of $57.2 million in the prior year’s nine months.

We have incurred operating losses in recent years driven principally by revenue from older product lines and associated services declining faster than the growth in new, refreshed product lines. In response, we have undergone several restructuring initiatives to better align our cost structure with our anticipated revenues. A significant cost-reduction plan was developed and introduced in the second quarter of fiscal year 2005 which was expected to reduce quarterly expenses by approximately $10 million to $13 million and achieve positive operating cash flow at quarterly revenues of approximately $80 million when completed. This plan included reducing our workforce on the order of 30%, from the level at the end of the first quarter of fiscal year 2005, as well as the cancellation or curtailment of certain spending programs. As of October 1, 2005, we had approximately 845 full-time employees compared with 1,150 full-time employees as of January 1, 2005. The decrease in the number of employees was largely a result of the termination of employees in connection with our cost reduction initiatives.

Restructuring, asset impairment and other charges for the nine months ended October 1, 2005 and October 2, 2004 were $17.3 million and $20.5 million, respectively. These charges were incurred in connection with our cost reduction initiatives and included employee severance related costs, asset impairments, facility exit costs, contract cancellation costs, and certain consulting costs. For a further discussion of these items-see “Results of Operations.”

At the end of the second quarter of fiscal year 2005, we decided to vacate and sell our facility in Rochester, NH and to relocate or outsource all employees and operations from Rochester by the end of the year. As a result, we recorded an impairment charge of $5.5 million associated with the write-down of the facility to its estimated fair value based on an independent appraisal. The estimated fair value of the facility less cost to sell was approximately $3.1 million as of October 1, 2005, and has been presented separately from the fixed assets reported in the consolidated balance sheets as an asset held for sale.

Consistent with our goal of returning to operating profitability and cash-positive operations, we are also focused on growing revenue. Third quarter revenues for fiscal year 2005 increased by 4.7% to $81.8 million compared to the prior quarter’s $78.1 million but remained below the prior year’s third quarter revenue of $87.4 million. We are continuing to implement changes to further improve our competitive position and sales productivity. During fiscal year 2005:

	•		We released our Matrix X Series core router to production; introduced a new version of the Matrix X, the X4; introduced the Matrix N1 modular layer 3 switch; released a new stackable switch product line, including the SecureStack B2 and the SecureStack A2; as well as introduced a next generation appliance-based RoamAbout wireless switch;

	•		We focused our efforts on increasing sales opportunities through our global partners (Siemens, Lucent, Dell, IBM and EDS), which represented an aggregate of 17% of our total revenues in the third quarter and year to date;

	•		Revenue from products put into production since the introduction of the N Series in the second quarter of fiscal year 2003 (“refreshed product revenue”) increased to 82% of product sales for the third quarter of fiscal year 2005; and

	•		“New customer revenue” was 12.0% and 13.0% of our total revenues in the third quarter and year to date (a new customer is defined as a customer that has not purchased any Enterasys products within three years).

We were notified by the Internal Revenue Service (“IRS”) during the second quarter of fiscal year 2005 that they had completed their field audit of our federal tax returns for fiscal years 1999 through 2002, including certain amended tax return filings. The findings of this audit were accepted by us and were reviewed and approved in the third quarter by the congressional Joint Committee on Taxation (“JCT”). As a result, we recorded in the third quarter of fiscal year 2005 a tax benefit of approximately $73.2 million which included a refund of $47.6 million, associated net interest income of $4.7 million, and a net reduction to previously accrued federal and state taxes of approximately $20.9 million. We subsequently received the cash refund of $52.3 million in October 2005.

In October 2005, our Board of Directors approved a 1-for-8 reverse stock split of our outstanding shares of common stock. Following shareholder approval, the reverse stock split became effective on October 28, 2005. All share and per share information included in our consolidated financial statements has been adjusted to reflect this reverse stock split.

Results of Operations

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


	Three months ended						Nine months ended
	October 1, 2005			October 2, 2004			October 1, 2005			October 2, 2004
Net revenue:
Product		73.5	%		74.4	%		72.9	%		73.3	%
Services and other		26.5			25.6			27.1			26.7

Total net revenue		100.0			100.0			100.0			100.0

Cost of revenue:
Product		54.7			50.5			56.1			51.8
Services and other		28.0			35.2			36.2			38.9

Total cost of revenue		47.6			46.6			50.7			48.3

Gross margin:
Product		45.3			49.5			43.9			48.2
Services and other		72.0			64.8			63.8			61.1

Total gross margin		52.4			53.4			49.3			51.7


Research and development		13.3			20.2			17.2			21.7
Selling, general and administrative		38.9			38.9			41.6			45.8
Amortization of intangible assets		1.1			1.1			1.2			1.3
Restructuring charges, net		(0.2	)		6.2			4.0			4.3
Asset impairments and other charges		1.2			0.5			3.2			3.5

Total operating expenses		54.3			66.9			67.2			76.6

Loss from operations		(1.9	)%		(13.5	)%		(17.9	)%		(24.9	)%

Third Quarter of Fiscal Year 2005 Compared to the Third Quarter of Fiscal Year 2004

Net Revenue

Net revenue decreased by $5.6 million, or 6.4%, to $81.8 million in the third quarter of fiscal year 2005 from $87.4 million in the third quarter of fiscal year 2004. Geographically, net revenues decreased in the third quarter of fiscal year 2005 from the prior year’s third quarter by 11.9%, or $5.4 million in North America; by 7.9%, or $0.5 million in Asia Pacific; and by 4.5%, or $0.2

million in Latin America. Net revenues in Europe, the Middle East, and Africa increased from the prior year’s third quarter by 1.6% or $0.5 million.

Net product revenue in the third quarter of fiscal year 2005 decreased by $4.9 million, or 7.5%, to $60.2 million from the prior year’s third quarter. The quarterly decline from the prior year was primarily the result of lower sales of Layer 3 modular switching products, including older generation products, as well as decreases in our legacy core routing and legacy Layer 2 switching products. Increased sales of new products such as the Matrix C2 (Layer 3 fixed switching), the SecureStack B2 (Layer 2 switching), and the Matrix X Series (core routing) partially offset this decline.

In the third quarter of fiscal year 2005, net services and other revenue of $21.7 million declined by $0.7 million, or 3.0%, compared with $22.4 million in the third quarter of fiscal year 2004. Other revenue in the third quarter of the current year included $0.9 million of non-recurring license revenue associated with the sale of certain software to which we retained royalty-free usage rights. The decrease was primarily due to a declining maintenance revenue base in North America resulting from the expiration of higher priced maintenance contracts on older generation products, as well as lower professional services revenue. In the near term, we believe net services and other revenue in the fourth quarter could decline by approximately $1.0 million from the third quarter of fiscal year 2005.

Gross Margin

Total gross margin of $42.8 million in the third quarter of fiscal year 2005 decreased by $3.9 million compared with $46.7 million in the prior year’s quarter. As a percentage of net revenue, total gross margin was 52.4% in the third quarter of fiscal year 2005 compared with 53.4% in the third quarter of fiscal year 2004.

Product gross margin as a percentage of net revenue was 45.3% in the third quarter of fiscal year 2005 compared with 49.5% in the prior year. Product gross margin percentage declined from the prior year by 4.0 percentage points due to changes in product mix, greater discounting and price reductions on older legacy products. Provisions for inventory write-downs were $0.7 million or 1.2 percentage points in the third quarter of fiscal year 2005 compared with $1.1 million or 1.7 percentage points in the third quarter of fiscal year 2004.

Services and other gross margin percentage increased to 72.0% in the third quarter of fiscal year 2005 compared with 64.8% in the prior year’s third quarter, primarily due to approximately 7.8 percentage points of lower overhead expense from workforce reductions and other cost reduction initiatives. Service inventory write-downs were $0.4 million or 1.9% of service revenue for the third quarter of fiscal year 2005 compared with $0.3 million or 1.3% of service revenue in the prior year’s third quarter. The services gross margin percentage also increased by 1.2 percentage points in the current quarter due to the inclusion of $0.9 million of non-recurring license revenue associated with the sale of certain software. We currently expect service margins of above 65% for the fourth quarter based on our cost reduction savings.

Operating Expenses

For the third quarter of fiscal year 2005, research and development (“R&D”) expense decreased by $6.8 million to $10.9 million compared with $17.7 million in the third quarter of fiscal year 2004. The decline from the prior year was primarily due to lower labor-related costs of approximately $3.6 million from our cost reduction initiatives, a decrease in outside services of approximately $1.8 million related to the completion of various development projects and changes in development methodology, a decrease of approximately $0.9 million in facilities related costs due to facility closures, and lower depreciation expense of approximately $0.4 million from reduced capital expenditures. We currently expect research and development expense to increase to approximately $11.5 million in the fourth quarter, primarily as a result of the timing of new product initiatives.

Selling, general and administrative (“SG&A”) expense in the third quarter of fiscal year 2005 decreased by $2.2 million to $31.8 million compared with $34.0 million in the prior year. Significant components of the decline in SG&A expense were a decrease in labor-related costs of approximately $3.1 million from our cost reduction initiatives, a decrease in marketing and advertising expenses of approximately $2.1 million due to the launch of our Secure Networks campaign in the prior year, and a decrease of approximately $1.5 million in facilities related costs due to facility closures. The decrease in SG&A expense was partially offset by lower income from net recoveries of bad debts and lease guarantees of approximately $5.8 million, and higher litigation and other expenses from indemnification claims for former officers and directors of approximately $1.0 million. Last year’s third quarter included a benefit of $3.5 million for lease guarantee recoveries from a settlement with a former subsidiary and a benefit of $1.2 million for bad debt recoveries on the final distribution from a former customer’s bankruptcy liquidation.

In the second quarter of fiscal year 2005, we developed and began implementing a significant cost-reduction plan which includes prior cost-reduction initiatives. This plan is expected to reduce quarterly expenses by approximately $10 million to $13 million and achieve positive operating cash flow at quarterly revenues of approximately $80 million when completed. This plan includes reducing our workforce on the order of 30%, from the level at the end of the first quarter of fiscal year 2005, as well as the

cancellation or curtailment of certain spending programs. We realized approximately $12.4 million of recurring cost benefits in the third quarter of fiscal year 2005 compared to the prior quarter primarily as a result of this plan.

Restructuring Charges, net

We recorded a net restructuring benefit of $0.2 million in the third quarter of fiscal year 2005 which included employee severance related costs of $0.5 million for approximately 10 individuals. Offsetting these additional costs was a benefit of $1.2 million for a reversal of prior quarters’ employee severance related costs due to a change in estimated severance benefits as well as changes in the employee population expected to receive such benefits. We also recorded facility exit costs of $0.5 million for the closure of one regional sales office and revisions to the estimated time required to sublet certain other vacant properties. To the extent we identify additional cost savings opportunities, there could be additional restructuring charges in future periods.

In connection with a plan initiated during the first quarter of fiscal year 2004 to align the cost structure of our business with our Secure Networks strategy, we recorded employee severance related costs of $4.2 million during the third quarter of fiscal year 2004 which were principally due to planned reductions associated with changing our sales model in China and Japan. Additionally, we exited four facilities, which included a research facility and three regional sales offices, and recorded facility exit costs of $1.2 million.

Asset Impairments and Other Charges

We recorded other charges of $1.0 million in the third quarter of fiscal year 2005 which consisted of consulting costs associated with our initiative to improve sales force productivity. No further consulting costs are expected in the fourth quarter regarding this project. During the third quarter of fiscal year 2004, we recorded asset impairment charges of $0.5 million associated with the closure of certain facilities.

Other (Expense) Income, net

Net other expense was $0.1 million for the third quarter of fiscal year 2005 compared with net other income of $3.0 million for the third quarter of fiscal year 2004. In the third quarter of fiscal year 2004, we recorded a non-recurring foreign currency benefit of $2.0 million to reflect the period end cumulative effect of foreign currency translation and a gain of $1.0 million from a legal settlement related to claims pertaining to the sale of a former subsidiary in fiscal year 2002.

Income Tax Benefit

We recorded a net tax benefit of $73.7 million for the third quarter of fiscal year 2005 compared with a net tax benefit of $2.4 million for the third quarter of fiscal year 2004. We did not record an income tax benefit for losses generated in the U.S. for the third quarter of fiscal years 2005 and 2004 due to the uncertainty of realizing such benefits.

During the quarter ended July 2, 2005, we were notified by the Internal Revenue Service (“IRS”) that it had completed its field audit of our federal tax returns for fiscal years 1999 through 2002, including certain amended tax return filings. The findings of this audit were accepted by us and were reviewed and approved in the third quarter by the congressional Joint Committee on Taxation (“JCT”). As a result, we recorded in the third quarter of fiscal year 2005 a tax benefit of approximately $73.2 million which included a refund of $47.6 million, associated net interest income of $4.7 million, and a net reduction to previously accrued federal and state taxes of approximately $20.9 million. We subsequently received the cash refund of $52.3 million in October 2005.

Based on IRS guidance issued at the end of our first quarter of fiscal year 2004, we filed documentation with the IRS shortly following the end of the second quarter of fiscal year 2004 enabling us to recognize a reduction to accrued tax liabilities of $12.0 million for fiscal year 2004. Approximately $2.2 million of the liability reduction was recognized as a tax benefit during the third quarter of fiscal year 2004.

First Nine Months of Fiscal Year 2005 Compared to the First Nine Months of Fiscal Year 2004

Net Revenue

Net revenue decreased by $25.7 million, or 9.7%, to $240.6 million in the first nine months of fiscal year 2005 from $266.3 million in the first nine months of fiscal year 2004. Geographically, net revenues decreased in the first nine months of fiscal year 2005 from the first nine months of fiscal year 2004 by 33.2%, or $7.9 million in Asia Pacific; by 16.6%, or $3.0 million in Latin America; by 9.7%, or $12.6 million in North America; and by 2.3%, or $2.2 million in Europe, the Middle East, and Africa.

Net product revenue of $175.4 million in the first nine months of fiscal year 2005 decreased by $19.9 million, or 10.2%, compared with $195.3 million in the first nine months of the prior year. The decline from the prior year was primarily the result of

lower sales of Layer 3 modular switching products, including older generation products, as well as decreases in our legacy routing and Layer 2 switching products. Increased sales of new products such as the Matrix C2 (Layer 3 fixed switching), the SecureStack B2 (Layer 2 switching), and the Matrix X Series (core routing) partially offset this decline.

In the first nine months of fiscal year 2005, net services and other revenue of $65.1 million declined by $6.0 million, or 8.3%, compared with $71.1 million in the first nine months of fiscal year 2004. Other revenue during the first nine months of fiscal year 2005 included $0.9 million of non-recurring license revenue associated with the sale of certain software to which we retained royalty-free usage rights. The decrease was primarily due to a declining maintenance revenue base in North America resulting from the expiration of higher priced maintenance contracts on older generation products, as well as lower professional services revenue.

Gross Margin

Total gross margin of $118.5 million in the first nine months of fiscal year 2005 decreased by $19.1 million compared with $137.6 million in the prior year’s first nine months. As a percentage of net revenue, total gross margin decreased to 49.3% in the first nine months of fiscal year 2005 compared with 51.7% in the first nine months of fiscal year 2004.

Product gross margin as a percentage of net revenue was 43.9% for the nine months ended October 1, 2005 compared with 48.2% in the prior year. Product gross margin percentage for the nine months ended October 1, 2005 declined 4.4 percentage points due to changes in product mix, greater discounting and price reductions on older legacy products. Provisions for inventory write-downs were $4.7 million or 2.7 percentage points in the first nine months of fiscal year 2005 compared with $8.6 million or 4.4 percentage points in the first nine months of fiscal year 2004.

Services and other gross margin percentage increased to 63.8% in the first nine months of fiscal year 2005 compared with 61.1% in the prior year’s first nine months, primarily due to approximately 6.4 percentage points of lower overhead expense from workforce reductions and other cost reduction initiatives. Service inventory write-downs were $4.4 million or 6.8% of service revenue for the first nine months of fiscal year 2005 compared with $2.2 million or 3.1% of service revenue in the first nine months of the prior year. The services gross margin percentage also increased by 0.5 percentage points in the first nine months of fiscal year 2005 due to the inclusion of $0.9 million of non-recurring license revenue associated with the sale of certain software.

Operating Expenses

For the first nine months of fiscal year 2005, research and development expense decreased by $16.4 million to $41.4 million compared with $57.8 million in the first nine months of fiscal year 2004. The decline from the prior year was primarily due to lower labor-related costs of approximately $9.6 million from our cost reduction initiatives, a decrease of approximately $2.4 million in facilities related costs due to facility closures, a decrease in outside services and project related expense of approximately $3.0 million related to the completion of various development projects and changes in development methodology, and lower depreciation expense of approximately $1.2 million from reduced capital expenditures.

Selling, general and administrative (“SG&A”) expense in the first nine months of fiscal year 2005 decreased by $22.0 million to $100.0 million compared with $122.0 million in the prior year. Significant components of the decline in SG&A expense were a decrease in labor-related costs of approximately $9.5 million from our cost reduction initiatives, a decrease in marketing and advertising expenses of approximately $8.4 million due to the launch of our Secure Networks campaign in the prior year, a decrease in facilities related expense of $5.1 million as a result of facility closures, a decrease in sales-related recruiting, relocation, and training expense of approximately $1.5 million, a decrease in travel related expenses of $1.4 million due to headcount reductions and continued cost reduction initiatives, a decrease in professional services related to audit costs, and various litigation matters, claims and proceedings of approximately $1.1 million and a decrease in insurance expense of $0.8 million. Offsetting the decline in SG&A were lower income from net recoveries of bad debts and lease guarantees of approximately $7.2 million in the first nine months of fiscal year 2005 when compared to the prior year. Last year’s nine months included a benefit of $3.5 million for lease guarantee recoveries from a settlement with a former subsidiary and a benefit of $1.2 million for bad debt recoveries on the final distribution from a former customer’s bankruptcy liquidation.

Amortization of Intangible Assets

Amortization costs for intangible assets decreased by $0.7 million to $2.8 million in the first nine months of fiscal year 2005 compared with $3.5 million the prior year as a result of the impairment and related write-off of certain intangible assets during the first quarter of fiscal year 2004 and other intangibles becoming fully amortized.

Restructuring Charges, net

During the first nine months of fiscal year 2005, we recorded restructuring charges, net of $9.6 million which included employee severance related costs of $9.1 million. In addition, we recorded facility exit costs of $1.5 million for three regional sales offices and revised the estimated time required to sublet certain other vacant properties. Contract cancellation costs were $1.0 million for third-party engineering development activities. Offsetting this expense was a reversal of prior severance expense of $2.0 million related to a change in estimated severance benefits as well as changes in the employee population expected to receive such benefits. Net headcount reductions related to the severance charge included approximately 192 individuals and involved most functions within the Company.

During the first nine months of fiscal year 2004, we recorded restructuring charges, net of $11.3 million related to workforce reductions and facility closings. In connection with the workforce reductions, we recorded employee severance related costs of $9.2 million for approximately 300 individuals. Additionally, we exited seven facilities, which included two research facilities, and five regional sales offices and recorded facility exit costs of $2.1 million during fiscal year 2004.

Asset Impairment and Other Charges

During the first nine months of fiscal year 2005, we recorded asset impairment and other charges of $7.7 million which consisted of $6.2 million for asset impairments and $1.5 million for consulting costs associated with our initiative to improve sales force productivity. As a result of our plan to vacate and sell a facility in Rochester, NH and to relocate or outsource all employees and operations by the end of the year, we performed a test for recoverability under SFAS No. 144 (“SFAS 144”), Accounting for the Impairment and Disposal of Long-lived Assets, at the end of the second quarter of fiscal year 2005. As a result, we recorded an impairment charge of $5.5 million associated with the write-down of the facility to its estimated fair value based on an independent appraisal. The estimated fair value of the facility less cost to sell was approximately $3.1 million as of October 1, 2005, and has been presented separately from the fixed assets reported in the consolidated balance sheets as an asset held for sale. The remaining asset impairment charge of $0.7 million consisted of various prepaid and fixed assets that have been impaired as a result of workforce reductions and project cancellations.

During the nine months ended October 2, 2004, we recorded asset impairment and other charges of $9.2 million, which consisted of $8.7 million of an intangible asset impairment and $0.5 million associated with the closure of certain facilities. We recorded an impairment charge of $8.7 million relating to the write-down of patents and technology intangible assets recorded in connection with our fiscal year 2001 acquisition of Indus River Networks. In conjunction with our first quarter fiscal year 2004 restructuring plan, we decided to curtail certain development efforts which reduced forecasted demand on future products that would have used this technology. As a result, the intangible assets fair value was determined to be zero based on a discounted cash flows analysis.

Other Income (Expense), net

Net other expense was $0.1 million for the first nine months of fiscal year 2005 compared with $6.2 million for the first nine months of fiscal year 2004. Loss on minority investments for the first nine months of fiscal year 2004 was $9.4 million and related to reductions in carrying value due to event-specific impairments. We recorded a foreign currency benefit of $1.7 million in the first nine months of fiscal year 2004. A gain of $1.0 million was recorded in fiscal year 2004 related to a legal settlement pertaining to the sale of a former subsidiary in fiscal year 2002.

Income Tax Benefit

We recorded a net tax benefit of $79.0 million for the first nine months of fiscal year 2005 compared with a net tax benefit of $9.4 million for the first nine months of fiscal year 2004. We did not record an income tax benefit for losses generated in the U.S. for the first nine months of fiscal years 2005 and 2004 due to the uncertainty of realizing such benefits.

During the quarter ended July 2, 2005, we were notified by the Internal Revenue Service (“IRS”) that it had completed its field audit of our federal tax returns for fiscal years 1999 through 2002, including certain amended tax return filings. The findings of this audit were accepted by us and were reviewed and approved in the third quarter by the congressional Joint Committee on Taxation (“JCT”). As a result, we recorded in the third quarter of fiscal year 2005 a one-time tax benefit of approximately $73.2 million which included a refund of $47.6 million, associated net interest income of $4.7 million, and a net reduction to previously accrued federal and state taxes of approximately $20.9 million. We subsequently received the cash refund of $52.3 million in October 2005. In addition, we recorded a benefit of $6.5 million in the first nine months of fiscal year 2005 which consisted of $5.0 million released from previously accrued tax reserves and a $1.5 million tax refund, resulting from the favorable settlement of an audit of certain foreign tax returns for the periods 1997 through 2003.

million for fiscal year 2004. Approximately $9.9 million of the liability reduction was recognized as a tax benefit during the first nine months of fiscal year 2004.

Liquidity and Capital Resources

The sections below discuss the commitments on our liquidity and capital resources, and the effects of changes in our balance sheet and cash flows.

Commitments

The following is a summary of our significant contractual cash obligations and other commercial commitments as of October 1, 2005:

Contractual Cash Obligations


			Less than		1-3		4-5		Over 5
	Total		1 Year		Years		Years		Years
	(In millions)
Non-cancelable lease obligations	$	18.5	$	5.6	$	8.8	$	1.7	$	2.4
Non-cancelable purchase commitments, net		21.9		21.9		—		—		—
Obligations under restructuring plans (1)		7.5		5.1		1.7		0.5		0.2
Royalty and license obligations		4.8		4.7		0.1		—		—

Total contractual cash obligations	$	52.7	$	37.3	$	10.6	$	2.2	$	2.6


Other Commercial Commitments

Aprisma lease payment guarantees (2)	$	4.0	$	—	$	—	$	1.0	$	3.0


(1)		Includes lease obligations for exited facilities of $0.3 million for the remainder of 2005, $2.0 million in 2006, $0.9 million in 2007, $0.4 million in 2008, $0.4 million in 2009 and $0.2 million thereafter.

(2)		The Aprisma lease guarantee declines to $3.0 million in 2009, $2.0 million in 2010, $1.0 million in 2011 and terminates in 2012. We are indemnified for up to $3.5 million in losses.

Balance Sheet and Cash Flows

As of October 1, 2005, our liquid investments totaled $109.7 million, as compared to $150.0 million at January 1, 2005 and consisted of cash and cash equivalents of $68.9 million plus short and long-term marketable securities of $40.8 million. The decrease in liquid investments during the first nine months of fiscal year 2005 is the result of net uses from changes in current assets and liabilities, and capital expenditures, which offset income after adjustments for certain non-cash items. Based on our liquid investment position at October 1, 2005, we believe that we have sufficient liquid investments to fund our on-going operations and future obligations for at least the next twelve months. In October 2005, we received an IRS tax refund of $52.3 million.

In connection with the issuance of letters of credit, performance bonds and certain litigation matters, we have agreed to maintain specified amounts of cash, cash equivalents and marketable securities in collateral accounts. These assets totaled $5.4 million at October 1, 2005, and are classified as “Restricted cash, cash equivalents and marketable securities” on our balance sheet.

Net cash used in operating activities was $36.6 million for the nine months ended October 1, 2005 and consisted of $31.9 million of income after adjustments for certain non-cash items, primarily a result of the approved IRS tax audit, less net uses from changes in current assets and liabilities of $68.5 million. The change in working capital was primarily due to a decrease in trade payables as a result of a decrease in inventory purchases during fiscal year 2005 and lower operating expenses excluding restructuring charges due to our cost reduction initiatives. Also contributing to the net cash used from operations in the first nine months of fiscal year 2005 were employee-related severance and annual incentive payments. During the fourth quarter of fiscal year 2005, we currently expect to continue to progress toward our goal of attaining quarterly cash-positive operations. In October 2005, we received an IRS tax refund of $52.3 million.

Capital expenditures for the first nine months of fiscal year 2005 were $3.6 million. We expect capital spending of approximately $0.6 million to $1.0 million for the remainder of fiscal year 2005.

Net accounts receivable was $29.2 million at October 1, 2005 compared with $29.1 million at January 1, 2005. The number of days sales outstanding was 32 days at October 1, 2005 compared to 29 days at January 1, 2005.

Net property, plant and equipment was $12.8 million at October 1, 2005 compared with $27.8 million at January 1, 2005. The decrease in net property, plant and equipment was driven by lower capital expenditures as well as an impairment charge of $5.5 million to write-down the carrying value of our Rochester, New Hampshire facility, which we expect to close by the end of the year, to its estimated fair market value. The estimated fair value of the facility less cost to sell was approximately $3.1 million as of October 1, 2005, and has been presented separately from the fixed assets reported in the consolidated balance sheets as an asset held for sale.

Prepaid expenses and other current assets of $11.6 million at October 1, 2005 decreased by $6.8 million from year end primarily due to a decrease in prepaid taxes due to the receipt of various VAT receivables during the year.

Accounts payable of $20.6 million at October 1, 2005, decreased by $8.2 million from January 1, 2005 as a result of lower operating expenses and a decrease in inventory purchases during the first nine months of fiscal year 2005. Accrued expenses of $49.4 million decreased by $15.7 million from January 1, 2005 as a result of lower compensation and benefit accruals resulting from lower headcount, lower legal accruals, lower advertising and marketing related accruals, and various other accruals that have decreased as a result of lower operating expenses. Income taxes payable has declined by $26.8 million to $5.6 million at October 1, 2005 primarily due to a net reduction to previously accrued federal income taxes related to the IRS settlement.

Application of Critical Accounting Policies

Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our annual report on Form 10-K for the fiscal year ended January 1, 2005. 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, and services revenue, which includes maintenance, installation, system integration services and our Smart Source managed network offering. Our revenue recognition policy follows SEC Staff Accounting Bulletin (“SAB”) No. 104 Revenue Recognition, Statement of Position (“SOP”) 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 Emerging Issues Task Force (“EITF”) No. 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. 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. Revenue from installation and system integration services is recognized when the services have been performed. We recognize revenue from our Smart Source managed network offering based on actual port usage.

We recognize revenue from stocking distributors when the distributors ship our products to their customers. We record revenue from certain distributors and resellers located in Asia Pacific and Latin America upon cash receipt.

We provide for pricing allowances in the period when granted. We also provide an allowance for sales returns based on specific return rights granted to a customer.

Allowance for Doubtful Accounts. We estimate the collectibility of our accounts receivable and the related amount of bad debts that may be incurred in the future. The allowance for doubtful accounts results from an analysis of specific customer accounts, historical experience, customer concentrations, credit ratings and current economic trends. Based on this analysis, we provide allowances for specific accounts where collectibility is not reasonably assured. In addition, we provide a full allowance for any customer balances that are greater than 180 days past due.

Provision for Inventory Valuation. Inventory purchases and commitments are based upon future demand forecasts. Reserves for excess and obsolete inventory are established to account for the potential differences between our forecasted demand and the amount of purchased and committed inventory. We periodically experience variances between the amount of inventory purchased and contractually committed to and our demand forecasts, resulting in excess and obsolete inventory charges. In addition, we periodically adjust service spares inventory cost to net realizable value based upon a review of estimated service lives, as well as periodically adjust reserves for service parts in excess of 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 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. We have designated the end of the third quarter of its fiscal year as the date of the annual test. We completed our annual impairment test at October 1, 2005 and found no impairment of recorded goodwill. Goodwill at October 1, 2005 and January 1, 2005 was $15.1 million.

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

At October 1, 2005, the carrying value of long-lived assets, including fixed assets and intangible assets, was $14.2 million. We recorded asset impairment and other charges of $7.7 million during the first nine months of fiscal year 2005 which consisted of $6.2 million for asset impairments and $1.5 million for consulting costs associated with our initiative to improve sales force productivity. As a result of our plan to vacate and sell a facility in Rochester, NH and to relocate or outsource all employees and operations by the end of the year, we performed a test for recoverability under SFAS No. 144 (“SFAS 144”), Accounting for the Impairment and Disposal of Long-lived Asset, at the end of the second quarter of fiscal year 2005. As a result, we recorded an impairment charge of $5.5 million associated with the write-down of the facility to its estimated fair value based on an independent appraisal. The estimated fair value of the facility less cost to sell was approximately $3.1 million as of October 1, 2005, and has been presented separately from the fixed assets reported in the consolidated balance sheets as an asset held for sale. The remaining asset impairment charge of $0.7 million consisted of various prepaid and fixed assets that have been impaired as a result of workforce reductions and project cancellations.

Restructuring Reserves. We have periodically recorded restructuring charges in connection with our plans to reduce the cost structure of our business. These restructuring charges, which reflect management’s commitment to a termination or exit plan that will be completed within twelve months, require management’s judgment and may include severance benefits and costs for future lease commitments or excess facilities, net of estimated future sublease income. In determining the amount of the facility exit costs, we are required to estimate such factors as future vacancy rates, the time required to sublet properties and sublease rates. If the actual cost incurred exceeds the estimated cost, an additional charge to earnings will result. If the actual cost is less than the estimated cost, a reduction to restructuring charges will be recognized in the statement of operations. At October 1, 2005, we have estimated sublease income associated with vacated facilities of approximately $1.1 million. This estimate of sublease income is subject to change based on known real estate market conditions.

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

We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If our estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. Uncertainties are recorded in accordance with SFAS No. 5, Accounting for Contingencies.

During the quarter ended April 2, 2005, we changed our method of accounting for reporting changes in interim periods to liabilities resulting from changes in judgments or settlements related to uncertain tax positions. We had previously accounted for such changes in judgments and settlements as adjustments to the estimated annual effective rate. We changed our method to account for such changes in judgments and settlements as discrete items in the interim period of change. This discrete method recognizes the effect of any change in reserves only in the quarter of the change. The newly adopted accounting method is preferable in the circumstances because it better reflects our consolidated financial position and operations at the time of the change in our uncertain tax positions. As a result of the change in method, income tax benefit was increased by $4.8 million or $0.18 per common share for the three months ended April 2, 2005. If we had used the discrete method, income tax benefit would have decreased by $2.2 million for the three months ended October 2, 2004 and increased $2.1 million for the nine months ended October 2, 2004, as compared to the amounts previously reported as income tax benefit. Additionally, the amounts previously reported for basic and diluted net loss per share would have increased by $0.08 per common share for the three months ended October 2, 2004 and decreased by $0.08 per common share for the nine months ended October 2, 2004.

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


	Three months ended						Nine months ended
	October 1, 2005			October 2, 2004			October 1, 2005			October 2, 2004
	(In millions)
Provision for product inventory write-downs	$	0.7		$	1.2		$	4.7		$	8.6
Provision for service inventory valuations		0.4			0.3			4.4			2.2
Provision for tax contingencies		(28.7	)		(2.2	)		(34.3	)		(9.9	)
Net recoveries of doubtful accounts receivable		—			(1.9	)		(0.6	)		(2.9	)
Restructuring charges, net		(0.2	)		5.4			9.6			11.3
Asset impairment charges		—			0.5			6.2			9.2

Total net expense (income) from critical accounting estimates	$	(27.8	)	$	3.3		$	(10.0	)	$	18.5

New Accounting Pronouncements

In September 2005, the FASB approved the consensus reached on the Emerging Issues Task Force Issue No. 04-13, Accounting for Purchases and Sales of Inventory with the Same Counterparty (“EITF 04-13”). The Issue’s objective is to provide guidance for identifying and accounting for purchases and sales of inventory between entities in the same line of business that are deemed nonmonetary transactions within the scope of Accounting Practice Bulletin No. 29, Accounting for Nonmonetary Transactions (“APB No. 29”) . EITF 04-13 also provides new disclosure requirements for inventory exchanges accounted for under EITF 04-13. This statement is effective for transactions completed in reporting periods beginning after March 15, 2006. The adoption of EITF No. 04-13 is not expected to have a material effect on our results of operations or financial position.

In June 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, Accounting Changes and Error Corrections- a replacement of APB No. 20 and FASB Statement No. 3 (“SFAS No. 154”). This statement replaces APB Opinion No. 20 which required most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 requires retroactive application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement is effective for fiscal periods beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material effect on our results of operations or financial position.

In March 2005, the FASB issued FASB interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (“FIN 47”). FIN 47 clarifies that the term Conditional Asset Retirement Obligation as used in FASB Statement No. 143, Accounting for Asset Retirement Obligation, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. We are required to adopt the provisions of FIN 47 by May 2006, although earlier adoption is permitted. The adoption of FIN 47 is not expected to have a material effect on our results of operations or financial position.

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (“EITF”) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”). The Issue’s objective is to provide guidance for identifying other-than-temporarily impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued a FASB Staff

Position (“FSP”) EITF 03-1-1 that delays the effective date of the measurement and recognition guidance in EITF 03-1 until further notice. The adoption of EITF 03-1 is not expected to have a material effect on our results of operations or financial position.

In December 2004, the FASB issued FSP No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act (“AJCA”) of 2004 (“FSP 109-2”). The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a US taxpayer (repatriation provision), provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. We do not currently plan to change our intention to permanently reinvest the undistributed earnings of our foreign subsidiaries. We do not expect the enactment of the AJCA to have a material effect on our consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”). This Statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123(R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. The requirements of FAS 123(R) are effective for our fiscal year beginning January 1, 2006, as a result of the SEC’s recent decision to delay the effective date of FAS 123(R) by six months. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 regarding the Staff's interpretation of SFAS No. 123R. This interpretation provides the Staff’s views regarding interactions between SFAS No. 123R and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. The interpretive guidance is intended to assist companies in applying the provisions of SFAS No. 123R and investors and users of the financial statements in analyzing the information provided. We will follow the guidance prescribed in SAB No. 107 in connection with our adoption of SFAS No. 123R. We are currently evaluating the requirements of SFAS 123(R) and have not yet fully determined the effect on our consolidated financial statements. The stock-based employee compensation expense presented in our pro forma financial results required to be disclosed under the current SFAS 123 was $1.0 million and $3.6 million for the three and nine months ended October 1, 2005, respectively, and $3.0 million and $11.6 million for the three and nine months ended October 2, 2004, respectively.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets (“SFAS No. 153”). This statement amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for fiscal years beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have a material effect on our results of operations or financial position.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs (“SFAS No. 151”). This statement amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This statement is effective for fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 is not expected to have a material effect on our results of operations or financial position.

CAUTIONARY STATEMENTS

Risks Related to our Financial Results and Condition

Our quarterly operating results may 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;

	•		indemnity claims by eligible current or former directors and officers; and

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

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

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

We have derived and expect to continue to derive a substantial portion of our revenue in the last month of each quarter, with such revenue frequently concentrated in the last two weeks of the quarter, which reduces our ability to accurately predict our quarterly results and increases the risk that we may not achieve our financial and other goals. Due to this end-of-quarter buying pattern, we traditionally have not been able, and in the future may not be able to, predict our financial results for any quarter until very late in the quarter or at all. In addition, we may not achieve targeted revenue levels, either because expected sales do not occur in the anticipated quarter or because they occur at lower prices or on terms that are less favorable to us than anticipated. This end-of-quarter buying pattern also places pressure on our inventory, management and logistics systems. If predicted demand is substantially less than orders, there will be excess inventory, and if orders substantially exceed predicted demand, we may not be able to fulfill all orders received in the last few weeks of the quarter. In either case, our financial condition could be harmed.

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

We have experienced losses in recent years and may not achieve or sustain profitability in the future. We will need to either generate higher revenue or reduce our costs to achieve and maintain profitability. We may not be able to generate higher revenue or reduce our costs, and, if we do achieve profitability, we may not be able to achieve, sustain or increase our profitability over subsequent periods. Our revenue has been negatively affected by uncertain economic conditions worldwide, which has increased price and technological competition for most of our products, as well as resulted in longer selling cycles. If uncertain worldwide economic conditions continue for an extended period of time, our ability to maintain and increase our revenue may be significantly limited. In addition, while we continue to implement cost reduction plans designed to decrease our expenses, including reductions in the size of our workforce, we will continue to have large fixed expenses and expect to continue to incur significant sales and marketing, product development, customer support and service and other expenses. Our additional cost-cutting efforts may result in the recording of additional financial charges, such as workforce reduction costs, facilities reduction costs, asset write downs and contractual settlements. Further, our recently announced reduction of 30% of our total headcount at the end of the first quarter of fiscal year 2005 may impair our ability to realize our current or future business objectives. Costs incurred in connection with our cost-cutting efforts may be higher than the estimated costs of such actions and may not lead to anticipated cost savings. As a result, our cost-cutting efforts may not result in a return to profitability.

Worldwide and regional economic uncertainty may continue to negatively affect our business and revenue and continue to make forecasting more difficult

If economic or market conditions remain uncertain, fail to improve or worsen, our business, revenue, and forecasting ability will continue to be negatively affected, which could harm our results of operations and financial condition. Our business is subject to the effects of general worldwide economic conditions, particularly in the United States and Europe, and market conditions in the networking industry, which have been particularly uncertain. Recent political and social turmoil, such as terrorist and military actions, as well as the effects of hostilities involving the U.S. in the Middle East or anywhere else in the world, and any continuation or repercussions thereof or responses thereto, may put further pressure on uncertain worldwide economic conditions, particularly if they continue for an extended period of time. Challenging economic and market conditions have resulted in, and may in the future result in, decreased revenue and gross margin, restructuring charges associated with aligning the cost structure of the business with decreased revenue levels, write-offs arising from difficulty managing inventory levels and collecting customer receivables, and impairment of investments. Uncertain political, social, economic and market conditions also make it extremely difficult for us, our customers and our vendors to accurately forecast and plan future business activities. In particular, such conditions make it more difficult for us to develop and implement effective strategies, forecast demand for our products, and effectively manage contract manufacturing and supply chain relationships. This reduced predictability challenges our ability to operate profitably and to grow our business.

We continue to introduce new products, and if our customers delay product purchases or choose alternative solutions, our revenue could decline, we may incur excess and obsolete inventory charges, and our financial condition could be harmed

We have recently introduced new versions of our entire product portfolio, including introducing our new core router in the first quarter of fiscal year 2005. Among the risks associated with the introduction of new products are delays in development or manufacturing, failure to accurately predict customer demand, effective management of new and discontinued product inventory levels, and risks associated with customer qualification and evaluation of new products. Many of our customers may initially require additional time to evaluate our new products, extending the sales cycle, or may choose alternative solutions. In addition, sales of our existing products could decline as customers await the release of our new products and, as a result, we could be exposed to an increased risk of excess quantities of slow moving product or inventory obsolescence. If customers defer purchasing decisions or choose alternative solutions in connection with our new product introductions, our revenue could decline and our financial condition could be harmed.

We have experienced changes in our 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. Most recently, in April 2005, our Executive Vice President of Worldwide Sales and Service was terminated and we appointed a Vice President of Worldwide Sales and Service. Also, in February of 2005 our President assumed the position of Chief Executive Officer and our Chief Executive Officer assumed the position of Executive Chairman. Because of these changes, 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 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. 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 a reasonable cost. We have from time to time experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In addition, the significant downturn in our business environment has caused us to significantly reduce our workforce and implement other cost-containment activities. These actions, including our recently announced workforce reduction of 30% of our total headcount at the end of the first quarter of fiscal year 2005, 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.

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. Competition in the enterprise network communications market has increased over the past few years as enterprises more closely monitor their costs and investments in response to continued economic uncertainty. In recent quarters, our product revenue has declined as a result of increased competition and a lengthened sales cycle attributable in part to uncertain economic and market conditions as well as other factors. Competitive pressures, exacerbated by continued economic uncertainty, could further reduce demand for our products; result in price reductions, reduced margins or the loss of market share; or increase our risk of additional excess and obsolete inventory provisions and service spare inventory write-downs; any of which would materially harm our revenue, financial condition and business. In addition, if our pricing and other factors are not sufficiently competitive, or if there is an adverse reaction to our product introductions or discontinuations, we may lose market share in certain areas, which could harm our revenue, financial condition and business.

Our competitors may have greater resources than us, which could harm our competitive position and reduce our market share

Our principal competitors include Alcatel; Cisco Systems; Extreme Networks; Foundry Networks; Hewlett-Packard; Huawei; Juniper Networks; Nortel Networks; and 3Com. We also experience competition from a number of other smaller public and private companies. We may experience reluctance by our prospective customers to replace or expand their current infrastructure solutions, which may be supplied by one or more of these competitors, with our products, which could challenge our ability to increase our market share. Some of our competitors have significantly more established customer support and professional services organizations and substantially greater selling and marketing, technical, manufacturing, financial and other resources than we do. Some of our competitors also have larger installed customer bases, greater market recognition and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their products, pursue acquisitions and other opportunities more readily and adopt more aggressive pricing policies than us, which could harm our competitive position and reduce our market share.

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.

Additional capital, if required, may not be available on acceptable terms, or at all. If we are unable to obtain additional capital when needed or reduce our expenses, it is likely that our product development and marketing efforts will be restricted, which would harm our ability to develop new and enhanced products, expand our distribution relationships and customer base, and grow our business. This could adversely impact our competitive position and cause our revenue to decline. To the extent that we raise additional capital through the sale of equity or convertible debt securities, existing stockholders may suffer dilution. Also, these securities may provide the holders with rights, privileges and preferences senior to those of common stockholders. If we raise additional capital through the sale of debt securities, the terms of the debt could impose restrictions on our operations.

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

Our payment terms are typically 30 days in the United States, and sometimes longer internationally. We assess the payment ability of our customers in granting such terms and maintain reserves that we believe are adequate to cover doubtful accounts, however, some of our customers, are experiencing, or may experience, reduced revenue and cash flow problems, and may be unable to pay, or may delay payment of, amounts owed to us. Although we monitor the credit risk of our customers, we may not be

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

If we fail to maintain our listing on the New York Stock Exchange, or other public securities exchange, the price and liquidity of our common stock may decline

The New York Stock Exchange (“NYSE”) has several quantitative criteria for maintaining continued listing of common stock on the exchange, including a requirement that the price per share as well as the 30-day average closing price per share must be no less than $1.00. On May 9, 2005, we received a notice from the New York Stock Exchange that our continued listing was under review due to a failure to comply with the requirement. We had six months from receipt of the New York Stock Exchange notice to cure the deficiency, and we responded to the NYSE expressing our intent to do so and maintain our listing. Among the actions available to us was effecting a reverse stock split, which was contingent on stockholder approval at a special meeting called for this purpose. At a special meeting held on October 24, 2005, the stockholders approved an amendment to our Certificate of Incorporation that effected a one-for-eight reverse split of our common stock. This reverse stock split was effective as of the October 28, 2005. Our closing price per share on November 3, 2005 was above $10.00.

The New York Stock Exchange has additional criteria that we must meet in order to maintain our listing. Moreover, the exchange is not limited by this criteria, and it may make an appraisal of, and determine on an individual basis, the suitability for continued listing of an issue in light of all pertinent facts whenever it deems such an action is appropriate, even though a security meets or fails to meet any enumerated criteria.

If we fail to maintain the continued listing of our shares on a public stock exchange, our stock price would likely decline, the ability of our stockholders to buy and sell shares of our common stock may be materially impaired and the efficiency of the trading market for our common stock would be adversely affected. Delisting of our shares could harm our ability to recruit and retain directors and employees and diminish customer confidence in us, harming our revenues and our financial condition. In addition, our ability to raise capital in the public markets, should we desire to do so in the future, would be significantly impaired.

Risks Related To The Market For Our Products

We may be unable to effectively manage and increase the productivity of our indirect distribution channels, which may hinder our ability to grow our customer base and increase our revenue

Our sales and distribution strategy relies heavily on our indirect sales efforts, including sales through distributors and channel partners, such as value-added resellers, systems integrators and telecommunications service providers. We believe that our future success will depend in part upon our ability to effectively manage and increase the productivity of our existing channel partners, as well as maintain and establish successful new relationships. If we are unable to increase the productivity of our indirect distribution channels, we may be unable to increase or sustain market awareness or sales of our products and services, which may prevent us from maintaining or increasing our customer base and revenue. In addition, even if we are able to maintain our existing relationships and establish successful new relationships with channel partners, our revenue may not increase. Our partners are not prohibited from selling products and services that compete with ours and may not devote adequate resources to selling our products and services. Also, we may be unable to maintain our existing agreements or reach new agreements with these partners on a timely basis or at all.

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

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

If we do not anticipate and respond to technological developments and evolving customer requirements and introduce new products in a timely manner, we may not retain our current customers or attract new customers

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The introduction by us or our competitors of new products and the emergence of new industry standards and practices can render existing products obsolete and unmarketable, increasing our risk of excess and obsolete inventory charges and the risk that we may not achieve our revenue and profitability objectives. Our success will depend upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and functionality that keep pace with technological

developments and emerging standards. Any failure to introduce new products and enhancements on a timely basis will harm our future revenue and prospects.

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

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

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

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

In addition, a significant amount of our sales through our channel partners are to entities that rely in whole or in part on public sources of funding, such as federal, state and local government, education and healthcare. Entities relying in whole or in part on public funding often face significant budgetary pressure, which may cause these customers to delay, reduce or forego purchasing from us. If these customers are unable to make, reduce or delay planned purchases, our forecasting ability will be negatively affected and our business, revenue and results of operations could be harmed.

Risks Related To Our Products

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

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

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

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

The market for network communications equipment is characterized by the need to support industry standards as different standards emerge, evolve and achieve acceptance. In the past, we have had to delay the introduction of new products to comply with third party standards testing. We may be unable to address compatibility and interoperability problems that arise from technological changes and evolving industry standards. We also may devote significant resources developing products designed to meet standards that are not widely adopted. In the United States, our products must comply with various governmental regulations

and industry regulations and standards, including those defined by the Federal Communications Commission, Underwriters Laboratories and Networking Equipment Building Standards. Internationally, our products are required to comply with standards or obtain certifications established by telecommunications authorities in various countries and with recommendations of the International Telecommunications Union. If we do not comply with existing or evolving industry standards, fail to anticipate correctly which standards will be widely adopted or fail to obtain timely domestic or foreign regulatory approvals or certificates, we will be unable to sell our products where these standards or regulations apply, which may prevent us from sustaining our revenue or achieving profitability.

The United States government may impose unique requirements on network equipment providers before they are permitted to sell to the government, such as that supplied products qualify as made in the United States. Such requirements may be imposed on some or all government procurements. We may not always satisfy all such requirements. Other governments or industries may establish similar performance requirements or tests that we may be unable to satisfy. If we are unable to satisfy the performance or other requirements of the United States government or other industries that establish them, our revenue may be negatively impacted. Because several of our significant competitors maintain dominant positions in selling network equipment products to enterprises and others, they may have the ability to establish de facto standards within the industry. Any actions by these competitors or other industry leaders that diminish compliance by our products with industry or de facto standards or the ability of our products to interoperate with other network communication products would be damaging to our reputation and our ability to generate revenue.

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

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

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

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

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

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

products. If we are forced to enter into unacceptable royalty or licensing agreements or to redesign our products, our business and prospects would suffer.

Risks Related To Our Manufacturing and Components

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

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

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

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

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

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

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

In addition, because our contract manufacturers produce our products based on forward-looking demand projections that we supply to them, we may be unable to respond quickly to sudden changes in demand. With respect to sudden increases in demand, we may be unable to satisfy this demand with our products, thereby forfeiting revenue opportunities and damaging our customer relationships, and with respect to sudden decreases in demand, we may find ourselves with excess inventory, which could expose

us to high manufacturing costs compared to our revenue in a financial quarter and increased risks of inventory obsolescence. These factors contributed to provisions for inventory write-downs and valuations of $9.1 million and $10.8 million for the first nine months of fiscal year 2005 and fiscal year 2004, respectively.

We plan to continue introducing new and complex products, and if our contract manufacturers are unable to manufacture these products consistently and in required quantities, we could lose sales

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

Other Risks Related To Our Business

Our significant sales outside North America subject us to increasing foreign political and economic risks, including foreign currency fluctuations

Our sales to customers outside of North America accounted for approximately 51.3% and 51.2% of our revenue for the first nine months of fiscal year 2005 and fiscal year 2004, respectively. We are seeking to expand partners as well as through strategic relationships in international markets. Consequently, we anticipate that sales outside of North America will continue to account for a significant portion of our revenue in future periods.

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

Our international presence subjects us to risks, including:

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

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

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

	•		managing export licenses, tariffs and other regulatory issues pertaining to international trade, including those related to counter-terrorism and security;

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

	•		difficulties in hiring and managing employees in foreign countries.

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 certain previously disclosed and settled 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. During the first nine months of fiscal year 2005, we incurred $2.4 million in legal expenses as a result of our obligation to indemnify these officers and directors. During the first nine months of fiscal year 2004, we incurred a $2.4 million charge for these legal expenses. We are currently engaged in legal proceedings against certain of our insurers to recover these and other expenses and costs incurred by us in connection with related litigation matters, claims, and proceedings.

Our failure to maintain adequate systems, controls and procedures could harm our business

If we do not maintain adequate overall systems, controls and procedures, our ability to manage our business and implement our strategies may be impaired, irregularities may occur or fail to be identified, and our business could be harmed and our stock price could decline. We have implemented and continue to implement changes designed to improve our overall systems, controls and procedures, including organizational changes, new business systems, new management information systems, communication of revenue recognition and other accounting policies to all of our employees, an internal audit function, new approval procedures and various other initiatives, including extensive supervisory and management oversight along with process improvement programs. Some of these changes are complex and involve significant effort, and may also result in higher future operating expenses, capital expenditures, or both. We may not be able to successfully implement these changes or improvements, or they could prove inadequate, and our business could be disrupted, our financial condition could be harmed and our stock price could decline.

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

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

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

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

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

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

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

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

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

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

In April 2002, our Board of Directors adopted a stockholder rights plan pursuant to which we paid a dividend of one right for each share of common stock held by stockholders of record on June 11, 2002. As a result of the plan, our acquisition by a party not approved by our Board of Directors could be prohibitively expensive. This plan is designed to protect stockholders from attempts to acquire us while our stock price is inappropriately low or on terms or through tactics that could deny all stockholders the opportunity to realize the full value of their investment. Under the plan, each right initially represents the right, under certain circumstances, to purchase 1/1,000 of a share of a new series of our preferred stock at an exercise price of $160 per share. Initially the rights will not be exercisable and will trade with our common stock. If a person or group acquires beneficial ownership of 15% or more of the then outstanding shares of our common stock or announces a tender or exchange offer that would result in such person or group owning 15% or more of our then outstanding common stock, each right would entitle its holder (other than the holder or group which acquired 15% or more of our common stock) to purchase shares of our common stock having a market value of two times the exercise price of the right. Our Board of Directors may redeem the rights at the redemption price of $.01 per right, subject to adjustment, at any time prior to the earlier of June 11, 2012, the expiration date of the rights, or the date of distribution of the rights, as determined under the plan.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

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

Interest Rate Sensitivity. We maintain an investment portfolio consisting partly of debt securities of various issuers, types and maturities. The securities that we classify as held-to-maturity are recorded on the balance sheet at amortized cost, which approximates market value. Unrealized gains or losses associated with these securities are not material. The securities that we classify as available-for-sale are recorded on the balance sheet at fair market value with unrealized gains or losses reported as part of accumulated other comprehensive income, net of tax as a component of stockholders’ equity. A hypothetical 10 percent increase

in interest rates would not have a material impact on the fair market value of these securities due to their short maturity. We expect to be able to hold our fixed income investments until maturity, and therefore we do not expect our operating results or cash flows to be materially affected by the effect of a sudden change in market interest rates on our securities portfolio, unless we are required to liquidate these securities earlier to satisfy immediate cash flow requirements.

Foreign Currency Exchange Risk. Due to our global operating and financial activities, we are exposed to changes in foreign currency exchange rates. At October 1, 2005, we had net asset exposures to the Euro, Australian Dollar, Japanese Yen and Brazilian Real. These exposures may change over time as business practices evolve and could materially harm our financial results and cash flows.

To minimize the potential adverse impact of changes in foreign currency exchange rates, we, at times, have used foreign currency forward and option contracts to hedge the currency risk inherent in our global operations. We do not use financial instruments for trading or other speculative purposes, nor do we use leveraged financial instruments. Gains and losses on these contracts are largely offset by gains and losses on the underlying assets and liabilities. We had no foreign exchange forward or option contracts outstanding at October 1, 2005.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control over Financial Reporting

No significant changes were made to our internal controls during our most recent quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

Described below are the material legal proceedings in which we are involved:

In February 2005, we entered into an agreement in principle to settle this litigation which is subject to approval by the Court and does not reflect any admission of wrongdoing. If finally approved, the settlement would result in the dismissal and release of all claims and, under the financial terms of the settlement, we would pay $10.5 million in cash in addition to ongoing defense costs

of approximately $1.1 million in connection with the litigation, the majority of which will offset by approximately $11.0 million in cash proceeds from certain of our insurers. During the first nine months of fiscal year 2005, we received $1.1 million of these insurance proceeds from one of our insurers. An additional sum of approximately $9.9 million has been deposited into an escrow by another insurer and will be used to fund the settlement if and when the final court approval of the settlement is received.

Item 5. Other Information

On May 9, 2005, we received a notice from the New York Stock Exchange (the “NYSE”) indicating that we were below one criterion for the NYSE’s continued listing standard requiring the average closing price of a security be not less than $1.00 over a consecutive thirty-day trading period. In accordance with the rules of the exchange, we responded to the NYSE expressing our intent to cure this deficiency and maintain our listing. On October 28, 2005, we effected a one-for-eight reverse split of our common stock. This reverse stock split was effective as of October 28, 2005. Our closing price per share on November 3, 2005 was above $10.00.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

3.1		Amended and Restated Certificate of Incorporation

3.2		Certificate of Amendment to Certificate of Incorporation

3.3		Amended and Restated By-laws

10.1		Amendment to 2005 Enterasys Performance Incentive Plan

31.1		Certification of Mark Aslett 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 Mark Aslett 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 current report on Form 8-K on August 9, 2005 to announce the Board of Directors’ approval of an amendment to the 2005 Enterasys Performance Incentive Plan.

We filed a current report on Form 8-K on September 1, 2005 to announce that the Joint Committee on Taxation had approved a previously announced federal tax refund of $47,500,000.

We filed a current report on Form 8-K on September 13, 2005 to announce the Board of Directors’ approval of an amendment to our by-laws.


	Page
PART I. Financial Information

Item 1. Consolidated Financial Statements (unaudited)
Consolidated Balance Sheets at October 1, 2005 and January 1, 2005		3
Consolidated Statements of Operations for the three and nine months ended October 1, 2005 and October 2, 2004		4
Consolidated Statements of Cash Flows for the nine months ended October 1, 2005 and October 2, 2004		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		36
Item 5. Other Information		37
Item 6. Exhibits		37
Signatures		38
EX-3.1 AMENDED AND RESTATED CERTIFICATE OF INCORPORATION
EX-3.2 CERTIFICATE OF AMENDMENT TO CERTIFICATE OF INCORPORATION
EX-3.3 AMENDED AND RESTATED BY-LAWS
EX-10.1 AMENDMENT TO 2005 ENTERASYS PERFORMANCE INCENTIVE PLAN
EX-31.1 CERTIFICATION OF MARK ASLETT
EX-31.2 CERTIFICATION OF RICHARD S. HAAK
EX-32.1 CERTIFICATION OF MARK ASLETT
EX-32.2 CERTIFICATION OF RICHARD S. HAAK


		*ENTERASYS NETWORKS, INC.*
		/s/ Mark Aslett
Date: November 9, 2005	By:	Mark Aslett
		President & Chief Executive Officer

		*ENTERASYS NETWORKS, INC.*
	By:	/s/ Richard S. Haak, Jr.
Date: November 9, 2005		Richard S. Haak, Jr.
		Chief Financial Officer (Principal Financial and Accounting Officer)

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