Annual Report — Form 10-K Filing Table of Contents
Document/ExhibitDescriptionPagesSize 1: 10-K Annual Report HTML 915K
2: EX-21.1 Subsidiaries of the Registrant HTML 10K
3: EX-23.1 Consent of Experts or Counsel HTML 7K
4: EX-23.2 Consent of Experts or Counsel HTML 9K
5: EX-31.1 Certification per Sarbanes-Oxley Act (Section 302) HTML 13K
6: EX-31.2 Certification per Sarbanes-Oxley Act (Section 302) HTML 13K
7: EX-32.1 Certification per Sarbanes-Oxley Act (Section 906) HTML 7K
8: EX-32.2 Certification per Sarbanes-Oxley Act (Section 906) HTML 7K
Registrant’s telephone number, including area code:
(408)
586-1700
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock,
$0.0001 par value
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 than the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent
filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
[ ]
Indicate by check mark whether the registrant is an
accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the registrant’s
voting stock, $0.0001 par value per share, held by non-affiliates of the registrant on June 30, 2003, the last business day of the registrant’s
most recently completed second quarter, was approximately $1,552,169,505, based upon the closing sale price on the Nasdaq National Market reported for
such date. Shares of common stock held by each officer and director and by each person who owns 5% of more of the outstanding common stock have been
excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for
other purposes.
There were 134,483,114 shares of the
registrant’s common stock issued and outstanding as of March 8, 2004.
Part III (Items 10-14) incorporates information by
reference from the definitive proxy statement for the 2004 Annual Meeting of Stockholders to be filed hereafter.
In addition to historical information, this Annual
Report on Form 10-K contains forward-looking statements. These forward-looking statements involve risks, uncertainties and assumptions. Actual results
may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those
discussed in the sections entitled “Business—Research and Development,”“Business—Competition,”“Business—Intellectual Property,” and “Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Risk Factors That May Affect Future Results and the Market Price of Our Stock.” Readers are cautioned not to place undue reliance
on these forward-looking statements, which reflect management’s opinions only as of the date hereof. Foundry Networks, Inc., together with its
consolidated subsidiaries (collectively “we” or “us”), undertakes no obligation to revise or publicly release the
results of any revision to these forward-looking statements. Readers should carefully review the risk factors described in this document and in other
documents we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q to be filed by the
Company in fiscal year 2004. All public reports filed by us with the Securities and Exchange Commission (the “SEC”) are available free of
charge on our website at www.foundrynetworks.com or from the SEC at www.sec.gov as soon as practicable after we electronically file such reports
with the SEC.
Item 1. Business
Overview
Foundry Networks, founded in 1996, is a leading
provider of next-generation networking products. We design, develop, manufacture and market solutions to meet the needs of high-performance network
infrastructures for Layer 2-7 switching and routing and wired and wireless local area networks (LANs), metropolitan area networks (MANs), wide area
networks (WANs), and the web. We sell a wide variety of both fixed configuration switches, typically referred to as stackables, and modular platforms,
referred to as chassis. Our combined product breadth allows us to offer global end-to-end solutions within and throughout a customer’s networking
infrastructure, regardless of the geographically dispersed nature of the entire organization. Our products can be found from the wireless access points
and wiring closets connecting the desktops together within an enterprise, to the mission critical LAN backbone and data center. We provide robust and
high-performance routing solutions from the Internet core to the edge of the Internet data centers and a customer’s network of web and application
servers. Our Metro routers deliver the capabilities and performance needed to provide efficient and reliable core routing services to Internet data
centers around the world. Our Layer 2 and Layer 3 switches provide the intelligence, speed and cost effectiveness required to support the increasing
use of bandwidth-intensive and Internet-based applications. Our high-performance Internet traffic management systems with network intelligence
capabilities allow enterprises and service providers to build highly available network infrastructures that direct traffic flow
efficiently.
Our networking products have been deployed in key
enterprise markets that include automotive, energy, retail, healthcare, banking, trading, insurance, aerospace, government agencies, technology, motion
pictures, video and animation, transportation, e-commerce, and universities. Our service provider markets include Metro service providers, Internet
service providers, web hosting and Internet data centers, application service providers, and Internet exchanges. For enterprises, we provide a complete
end-to-end solution with our FastIron®, FastIron Edge®, IronPointTM, BigIron®, ServerIron®, and EdgeIronTM
product lines. Our enterprise portfolio of products, combined with our network management and security, meets the needs for wireless access, wiring
closet, data center, and campus solutions. For service providers, we offer our high-performance BigIron switches, NetIron® Metro routers, and
ServerIron web switches. Our switching and routing products can be managed with our IronView® Network Manager products. Our products support a
wide array of interfaces such as wireless, 10/100 Ethernet, 1 Gigabit Ethernet (copper and fiber), 10 Gigabit Ethernet, Packet over SONET and ATM so
that our customers can leverage their existing infrastructures. We sell our products through a direct sales force, resellers, and OEM partners. By
providing high levels of performance and intelligence capabilities at competitive price points, we provide comprehensive solutions to address the
growing enterprise, government, and service provider markets.
Next Generation Needs
Two trends continue to drive the network
infrastructure market. First, as businesses seek to accommodate network user needs, adding bandwidth alone is not an adequate solution. Due to the
increased use of multiple traffic
types for many applications, enterprises and service providers have an acute need
for solutions that provide network intelligence to distinguish among and prioritize network traffic based on types of traffic, content being requested,
and the applications deployed. Network intelligence allows anyone supporting electronic business on the web to maintain network reliability and offer
differentiated, fee-based quality of service.
Second, as the Internet has evolved, traffic
crossing the WANs has shifted from primarily voice traffic to primarily data traffic. Historically, the basic technology used to move traffic within
WANs has been SONET, which was primarily designed to carry voice traffic. As the majority of wide area traffic has migrated to data, service providers
are looking for a technology that is better suited to handle data traffic. Gigabit Ethernet, which has emerged as the ubiquitous LAN technology, is
gaining momentum as the solution for MANs. This momentum has been propelled in part by the low cost and availability of off-the-shelf Ethernet
networking equipment and the large pool of qualified networking specialists that are proficient in Ethernet technology. 10 Gigabit Ethernet is a key
factor in this momentum for MANs because providers can quickly build out high-speed networks. The general acceptance and large volume of Ethernet
installations in LANs have, over time, led to improved performance and significantly lower prices.
As bandwidth demand increases and
bandwidth-intensive applications are being made available to enterprise and private users, a new class of service provider is beginning to emerge, the
Metro service provider (Metro SP). We have had significant success in providing our Ethernet solutions for MANs across the globe. Metro SPs provide the
critical intermediary network between enterprises and long-haul regional networks. Using long-haul Gigabit Ethernet as the enabling technology, these
service providers deliver new services such as broadband Internet access, bandwidth-on-demand and virtual LANs across the Metro and regional areas to
business and private users. In this application, Gigabit Ethernet provides high-bandwidth, high-reliability, and high-density solutions that enable
multi-services such as voice-over-IP and virtual private networks to be delivered over a common backbone.
Strategy
Our objective is to be a leading provider of
next-generation, high-performance network solutions. We intend to achieve this objective by providing a broad suite of the most cost-effective,
highest-performing network switching products. Key elements of our strategy include:
Continue to Deliver
Products that Meet the Needs of the High-End Switching Segment. Our high-performance Ethernet switches have achieved both commercial success and
high levels of customer satisfaction. We will continue to broaden our product offerings to meet customer business needs with a full range of networking
products. We will continue to broaden our high-end enterprise and service provider switch portfolio to meet the needs for greater bandwidth, more
flexible interfaces, advances in Internet networking protocols, and enhanced security. This commitment has been demonstrated by our introduction of
TerathonTM ASICs, JetCoreTM ASICs, Gigabit-over-Copper, and second-generation 10 Gigabit Ethernet products. We intend to continue
to offer value-added feature sets that provide for redundancy and ease of use and management of the network, yielding a higher return on investment and
with a lower total cost of ownership.
We have successfully introduced products that
implement solutions in five strategic areas, and we intend to continue to enhance our product portfolio in these areas:
•
10 Gigabit Ethernet—Our 10GbE solutions have achieved
commercial success in the marketplace and we remain a leader in 10 Gigabit Ethernet. Our 10GbE customers include healthcare, government, research,
university, and media organizations. As the boundaries of LANs, MANs and WANs continue to blur, companies will want to unify networks at a lower cost,
with fewer management and operational requirements. 10GbE is the logical evolution of Ethernet that delivers the reliability of optical networks.
10GigE addresses the key concerns facing businesses today—the continued need for additional bandwidth while building a reliable network. In 2003,
we announced and delivered our Terathon class of products that provide exceptional 10GbE port density. We also delivered 1GbE modules in 2003 to meet
the demands of our customers for connectivity options. Our first two products with the new Terabit-capacity switching fabric were the BigIron MG8
enterprise switch and the NetIron 40G Metro router. We intend to sustain our leadership in 10GbE with additional products and modules.
•
Wireless Networking—We introduced our first wireless
product offering, the IronPoint 200 wireless access point, in conjunction with the ratification of key industry standards in the third quarter of 2003.
Our wireless
product offering delivers strong security, seamless mobility, enhanced user
policies, centralized management, ease of use, and seamless integration with our wired networks. The IronPoint 200 offers enterprises maximum
flexibility with optimal controls for increased productivity and secure deployments. Effective and efficient management of networking resources is key
to cost containment and reliability. Therefore, we also developed an IronPoint edition of the IronView Network Manager system. This software provides
centralized wireless access point management. Our high-performance FastIron Edge Layer 2/3 switches can be software upgraded to enable integrated
wireless LAN capability. Our wireless-enabled switches will provide seamless wireless LAN support, including Layer 2/3 mobility, enhanced monitoring
and reporting with sFlow, secure web guest authentication, IPsec/VPN pass-through for existing VPN support, enhanced authentication, security and user
policy control, and enhanced AP management. As a result, we offer one of the most complete suites of integrated infrastructure management applications
for wired and wireless networks. We intend to further develop and support new wireless networking products and upgrades.
•
Voice-over-IP (VoIP)—An increasing number of enterprises
are migrating to converged environments in which voice, video, and data are carried by the same network to take advantage of valuable business benefits
such as reduced costs and increased productivity. A converged network needs more than just new devices such as IP telephones or IP video cameras. A
converged environment needs a network foundation that provides superior performance and high availability. We deliver both the high-performance
networking products in our FastIron Layer 2/3 Enterprise Switches and the tools necessary to configure and optimize a converged environment with our
IronView Network Manager system. Our adherence to industry and international standards has been validated by our customers who have successfully used a
wide variety of IP phones and cameras from different suppliers, including those of our competitors. In 2003, we delivered new FastIron Edge switches
with power-over-Ethernet. This provides customers with the technology needed to power new devices such as IP phones, realize optimal network
performance, and manage network resources. We intend to further develop and expand our networking and management offerings for converged environments
so that customers will have more options for efficiencies and productivity.
•
Security—As networking has become an essential part of
nearly all businesses, agencies, and organizations, security has become an integral part of designing and deploying today’s networks and data
centers. As networks and data centers become more complex with greater openness and interoperability, the challenge to securing them similarly
increases. Threats are myriad, changing, and imposed from both external and internal sources. Responses to them can be no less dynamic. Our IronShield
security encompasses network level features that we have deployed in our full range of Layer 2-7 switches, routers, and intelligent traffic management
devices to implement secure networks. Our focus is on using networking devices as policy enforcement points that do not compromise performance. Since
our inception, we have delivered innovative, effective, and efficient functions and features into our products to provide network security. In 2003, we
published a comprehensive white paper on networking security and provided it free of charge to the public in the interest of contributing to the
further development of best practices for networking security. We intend to continue our investment in security and best practices, and to build them
into all of our products. We remain committed to a strategy of standard-based implementations and product offerings so that our customers will benefit
from ease of use and interoperability.
•
Internet Protocol version 6 (IPv6)—The U.S. federal
government has joined the growing list of customers requiring IPv6 adoption. Previously, these customers were in international markets. The widespread
adoption of IPv6 in the U.S. commercial sector is likely to take several years. In 2003, we delivered the NetIron 4802 stand-alone router with support
for IPv6 and the existing IPv4. This device has been deployed by customers with a need to deploy dual-IPv4-IPv6 networks. We also began a phased
implementation of IPv6 support in our BigIron and NetIron products. We intend to further develop and deliver IPv6 solutions including software upgrades
and new management modules.
Continue to Expand our
Metro Router Capabilities to Address this Growing Market and Deliver a New Level of Price/Performance. We will continue to bring new features and
functionality to our Metro router platform and add to our product offering by incorporating leading-edge features. These new enhancements include
features such as MPLS (Multi-Protocol Label Switching), and VPLS (Virtual Private LAN Services).
We provide a wide range of features for both MPLS and Layer 2 Metro architectures
with industry-leading scalability and reliability. We were the first to deliver Layer 3 10 Gigabit Ethernet and we intend to pursue further innovation
that will expand our leadership.
Continue to Leverage our
Product Capabilities to Address Emerging Markets. This includes metropolitan area networking (MAN), Gigabit Ethernet storage area networking (SAN),
voice-over-IP (VoIP), and content distribution networks. As noted above, the key advantages of Gigabit Ethernet, such as price, simplicity, ease of
use, will allow this technology to migrate into many new adjacent markets over time. Our strategy is to position ourself to benefit from acceptance of
Gigabit Ethernet in such environments as MAN, SAN, VoIP, and content distribution. To accomplish this, we have added the necessary features and
enhancements to our products to provide an ideal solution for these customers. We work with select partners when additional non-networking hardware or
software is needed for solutions such as VoIP and SAN. This permits us to remain entirely focused on network infrastructure and provide complete
solutions to our customers.
Continue our Market
Leadership Position in Internet Traffic Management Systems. We believe demand for Internet traffic management intelligence capabilities will be a
very important growth area for web-based businesses and Internet service providers and an area of increasing importance to traditional enterprise
networks. We intend to maintain our leadership position in this market by continually improving the performance and functionality of our Internet
traffic management products. Designed to provide the highest level of performance and network intelligence capabilities, our products enable web-based
businesses and Internet service providers to rapidly deliver new revenue-generating applications and services to end-user customers, while providing a
high degree of service reliability.
Expand Global Sales
Organization. We intend to continue the global expansion of our sales organization utilizing a direct sales organization in the United States and
abroad, strategic channel partners outside the United States and select original equipment manufacturers. We intend to increase our worldwide sales
force and establish additional channel partner relationships to build greater worldwide sales presence.
Deliver World Class Service
and Support. We intend to expand our service and support infrastructure to meet the needs of our growing customer base. Our goal is to minimize our
customers’ network downtime by offering a wide range of service and support programs to meet individual customer needs, including prompt on-site
hardware repair and replacement, twenty-four hour, seven days-a-week web and telephone support, parts depots in strategic global locations,
implementation support, pre-sales service, system software and network management software upgrades, and technical documentation
updates.
Sales and Marketing
Our sales strategy includes domestic and
international field sales organizations, domestic and international resellers, OEM relationships, and marketing programs.
Domestic field sales. Our domestic field
sales organization establishes and maintains direct relationships with key accounts and strategic customers. To a lesser extent, our field organization
also works with resellers to assist in communicating product benefits to end-user customers and proposing networking solutions. As of December 31,2003, our domestic sales organization consisted of 146 sales representatives and systems engineers.
Domestic resellers. Our domestic resellers
include regional networking system resellers and vertical resellers who focus on specific markets, such as small Internet service providers. We provide
sales and marketing assistance and training to our resellers, who in turn provide first level support to end-user customers. We intend to leverage our
relationship with key resellers to penetrate select vertical markets.
International sales. Internationally, product
fulfillment and first level support is provided by resellers and integrators. Our international resellers include Mitsui & Co., Inc., in Japan,
Samsung Electronics in Korea, Shanghai Gentek Corp. Ltd. and Global Technology Integrator Ltd. in China, Spot Distribution in the United Kingdom, and
Pan Dacom Networking AG and GE CompuNet in Germany. As of December 31, 2003, our international field organization consisted of 94 sales representatives
and system engineers who conduct sales, marketing, and support activities. Our international sales organization establishes and maintains direct
relationships with resellers, integrators and end-users. Our export sales represented 35%, 38%, and 35% of net revenues in 2003, 2002, and 2001,
respectively.
OEM/Co-Branding. We have OEM/Co-Branding
relationships established with Hewlett-Packard Company, Hitachi, Ltd., Lucent Technologies, Digital China Holdings Ltd. and NEC Corporation. Our OEMs
market and sell our products on a private label basis through their worldwide sales forces and also purchase our products for use in their own internal
networks. Our agreements with OEMs provide that the OEMs may postpone, cancel, increase or decrease any order prior to shipment without
penalty.
Marketing programs. We have numerous
marketing programs designed to inform existing and potential customers, the press, industry standard analyst groups, and resellers and OEMs, about
the capabilities and benefits of us and our products. Our marketing efforts also support the sale and distribution of our products through our field
organizations and channels. Our marketing efforts include advertising, public relations, participation in industry trade shows and conferences, public
seminars and Webcasts, participation in independent third-party product tests, presentations, and our maintenance of our web site.
Customer Service and Support
Our service and support organization maintains and
supports products sold by our field organization to end-users. Our service and support organization provides 24-hour assistance, including telephone,
Internet and worldwide web support. Our customer service offerings also include parts depots in strategic locations globally, implementation support,
and pre-sales service. Our resellers and OEMs are responsible for installation, maintenance and support services to their customers.
We provide all customers with our standard, limited
one-year hardware and 90-day software warranty. We also have four levels of customer service offerings to meet specific support needs. Our Titanium
service program provides the most comprehensive support and includes advance hardware replacement within four hours delivered by a trained technician
for on-site support. Our Gold service program is targeted towards customers who have trained internal resources to maintain their network 24x7. Our
Gold program is designed to provide all the tools needed by these trained resources to maximize the uptime of their network. Our Silver service program
is tailored for customers who typically purchase spares inventory as part of their overall contingency plan. Our Bronze service program is targeted
towards budget conscious customers who are looking for basic telephone and web-based support and run a 9 to 5 operation.
We have regional Centers-of-Excellence in San Jose,
Boston, New York, Chicago, Denver, Herndon, Irvine, London, Hong Kong, Toronto and Tokyo. These Centers-of-Excellence include executive briefing
centers and serve as major customer demonstration centers, regional technical support centers, and equipment depot centers. The Centers-of-Excellence
are fully equipped to demonstrate our award-winning, high-performance product lines including NetIron Metro routers, BigIron Layer 3 switches, FastIron
Enterprise switches, and ServerIron Layer 4-7 traffic management switches. They also support interoperability testing, provide hands-on training for
customers, and showcase our end-to-end LAN, MAN and WAN solutions. These Centers-of-Excellence allow us to deliver superior customer service and expand
service offerings to our rapidly growing worldwide installed base.
Quality Assurance
In 2003, we demonstrated our commitment to quality
assurance and testing by expanding and adding dedicated quality assurance test labs and facilities. Our software quality assurance test processes have
been enhanced and deepened. In particular, we have focused heavily on test automation so that testing is both comprehensive and expandable. In order to
continue to provide the highest level of customer service, our internal resolution labs were expanded in 2003 to approximately twice their previous
size. Because quality is a priority in all of our operating units, we have a quality council consisting of interdepartmental leaders that meet weekly
to monitor quality and to drive continuous improvement. The results of our enhancements are measured by several metrics, including the number of events
reported to customer support in relation to systems shipped.
Manufacturing
We operate under a modified “turn-key”
process, utilizing strategic manufacturing partners that are ISO 9000 certified and have global manufacturing capabilities. We maintain control and
procurement responsibility for all proprietary components. All designs, documentation, selection of approved suppliers, quality control, and
configuration are performed at our facilities. Our manufacturing operations consist of quality assurance for
subassemblies and final assembly and test. Our manufacturing process also includes
the configuration of hardware and software in unique combinations to meet a wide variety of individual customer requirements. We use automated testing
equipment and “burn-in” procedures, as well as comprehensive inspection and testing, to ensure the quality and reliability of our products.
Our approach to manufacturing provides the flexibility of outsourcing while maintaining quality control of products delivered to customers. We have
selected this approach to ensure our ability to respond to rapid growth and sudden market shifts.
We currently have four manufacturing partners.
Celestica, Inc., located in San Jose, California, Flash Electronics, Inc., in Fremont, California, and Proworks Inc, located in San Jose, California,
assemble and test printed circuit boards. Sanmina-SCI Corp., located in San Jose, assembles and tests printed circuit boards and our backplane
products. Celestica, Inc., Sanmina-SCI Corp., and Flash Electronics, Inc. have global manufacturing facilities providing full back-up capability and
local content for foreign sales if required. We perform all prototype and pre-production procurement and component qualification with support from our
manufacturing partners. Our agreements with our contract manufacturers allow them to procure long lead-time component inventory on our behalf based on
a rolling production forecast provided by us. We are contractually obligated to purchase long lead-time component inventory procured by our contract
manufacturers in accordance with our forecast, unless we give notice of order cancellation at least 90 days prior to the scheduled delivery
date.
We design all ASICs, printed circuit boards and
sheet metal, and work closely with semiconductor partners on future component selection and design support. All materials used in our products are
subject to a full qualification cycle and controlled by use of an “approved vendor listing” that must be followed by our sources. We perform
extensive testing of all of our products, including in-circuit testing of all printed circuit board assemblies, full functional testing, elevated
temperature burn-in and power cycling at maximum and minimum configuration levels. Please see “Risk Factors—Our reliance on third-party
manufacturing vendors to manufacture our products may cause a delay in our ability to fill orders” for a review of certain risks associated with
our manufacturing operations.
We currently purchase components from several
sources, including certain integrated circuits, power supplies and long-range optics, which we believe are readily-available from other suppliers. Our
proprietary ASICs, which provide key functionality in our products, are fabricated in foundries operated by, or subcontracted by, Texas Instruments
Inc., Fujitsu Ltd., and Broadcom Corp. An alternative supply for these ASICs would require an extensive development period. Please see “Risk
Factors—We purchase several key components for our products from several sources; if these components are not available, our revenues may be
harmed.”
Backlog
Our backlog represents orders for which a purchase
order has been received for product to be shipped generally within 90 days to customers with approved credit status. Orders are subject to
cancellation, rescheduling or product specification changes by the customers. Although we believe that our backlog is firm, orders may be cancelled by
the customer without penalty. For this reason, we believe our backlog at any given date is not a reliable indicator of future
revenues.
Research and Development
Our future success depends on our ability to enhance
existing products and develop new products that incorporate the latest technological developments. We work with customers and prospects, as well as
partners and industry research organizations, to identify and implement new solutions that meet the current and future needs of businesses. Whenever
possible, our products are based on industry standards to ensure interoperability. We intend to continue to support emerging industry standards
integral to our product strategy.
Our research and development operations involve
development activities that utilize both custom and commercial silicon, which enables us to quickly bring new products and features to market. We are
currently developing new switching solutions that provide new levels of performance, scalability and functionality We had 159 engineers at the end of
2003, compared to 153 engineers at the end of 2002 and 135 engineers in 2001. Our research and development expenses were $40.5 million in 2003, $34.9
million in 2002 and $33.9 million in 2001, or 10%, 12% and 11% of net revenues, respectively.
We believe we perform favorably with respect to key
competitive factors that affect our markets, including technical expertise, pricing, new product innovation, product features, service and support,
brand awareness and distribution. Our products have won numerous awards. We intend to remain competitive through ongoing investment in research and
development efforts to enhance existing products and introduce new products. We will seek to expand our market presence through aggressive marketing
and sales efforts and through the continued implementation of cost reduction efforts. However, our market is still evolving and we may not be able to
compete successfully against current and future competitors.
The market in which we operate is highly
competitive. Cisco Systems, Inc. (“Cisco”) maintains a dominant position in our market and several of its products compete directly with
ours. Cisco’s substantial resources and market dominance have enabled it to reduce prices on its products within a short period of time following
introduction, which reduces the profitability of its competitors. Purchasers of networking solutions may choose Cisco’s products because of its
longer operating history, broader product line and strong reputation in the networking market. In addition, Cisco may have developed or could in the
future develop new technologies that directly compete with our products or render our products obsolete. We believe our technology and the
purpose-built features of our products make them unique and allow us to compete effectively against Cisco and other competitors. Although we believe
that we are currently among the top providers of networking solutions, there can be no assurance that we will be able to compete successfully against
Cisco, currently the market leader in network infrastructure solutions.
In addition to Cisco, we compete against other
companies, such as Extreme Networks, Inc., Juniper Networks, Inc., Nortel Networks Ltd., Enterasys Networks Inc., 3Com Corp., Huawei Technologies Co.,
Ltd., and Alcatel. Some of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales,
marketing and other resources, as well as greater name recognition and larger installed customer bases than we do. Furthermore, companies that do not
offer a directly competitive product to our products could develop new products or enter into agreements with other networking companies to provide a
product that competes with our products or provides a more complete solution than we can offer. Additionally, we may face competition from unknown
companies and emerging technologies that may offer new LAN, MAN, and WAN solutions. Please see “Risk Factors—Intense competition in the
market for network solutions could prevent us from maintaining or increasing revenue and sustaining profitability. ”
Intellectual Property
Our success and ability to compete are heavily
dependent on our internally developed technology and know-how. Our proprietary technology includes our ASICs, our IronCore and JetCore hardware
architecture, our IronWare software, our IronView network management software, and certain mechanical designs. Different variations and combinations of
these proprietary technologies are implemented across our product offerings. We rely on a combination of patent, copyright, trademark and trade secret
laws and contractual restrictions on disclosure to protect our intellectual property rights in these proprietary technologies.
We provide software to customers under license
agreements included in the packaged software. These agreements are not negotiated with or signed by the licensee, and thus may not be enforceable in
some jurisdictions. Despite our efforts to protect our proprietary rights through confidentiality and license agreements, unauthorized parties may
attempt to copy, imitate, or otherwise obtain and use our products or technology. These precautions may not prevent misappropriation or infringement of
our intellectual property. Monitoring unauthorized use of our products is difficult and the steps we have taken may not prevent misappropriation of our
technology, particularly in some foreign countries where the laws may not protect our proprietary rights as fully as in the United
States.
The networking industry is increasingly
characterized by the existence of a large number of patents, frequent claims of infringement, and related litigation regarding patent and other
intellectual property rights. In addition, leading companies in the networking market may have extensive patent portfolios. As a result of the
existence of a large number of patents and rapid rate of issuance of new patents in the networking industry, it is not economically practical for a
company of our size to determine in advance whether a product or any of its components may infringe intellectual property rights claimed by others. See
Item 3 “Legal Proceedings” below for pending litigation related to intellectual property matters and “Risk Factors—We may be
subject to intellectual property infringement claims that are costly to defend and could limit our ability to use certain technologies in the
future.”
As of December 31, 2003, we had 588 employees,
consisting of 308 in sales and marketing, 159 in engineering, 67 in manufacturing and 54 in general and administrative. None of our employees is
represented by a labor union, with the exception of several foreign employees who are required by local country employment laws to have labor union
representation. We have never experienced a work stoppage and believe our employee relations are good.
We are committed to our responsibility to maintain
employment practices that promote affirmative action and equal opportunity in hiring, promotions, compensation and employee development without regard
to race, color, religion, sex, national origin, age, disability, sexual orientation, marital status or veteran status.
Item 2. Properties
Our headquarters for corporate administration,
research and development, sales and marketing, and manufacturing occupy approximately 110,000 square feet of space in San Jose, California. We also
lease space in various other geographic locations, domestically and internationally, for sales and service personnel. In addition to smaller sales
offices, we have regional offices in the following locations:
AMERICAS
EMEA
APAC
San Jose,
California
London, England
Tokyo, Japan
Irvine,
California
Munich, Germany
Singapore
Salt Lake City,
Utah
Paris, France
Hong Kong
Chicago,
Illinois
Amsterdam, Netherlands
Sydney, Australia
Fort Lauderdale,
Florida
Milan, Italy
Beijing, China
New York City,
New York
Herndon,
Virginia
Toronto,
Canada
We believe our existing facilities are adequate to
meet current requirements, and that suitable additional or substitute space will be available as needed to accommodate any further physical expansion
of corporate operations and for any additional sales offices. Our principal web server equipment and operations are maintained in our corporate
headquarters in San Jose, California.
Item 3. Legal Proceedings
In December 2000, several similar shareholder class
action lawsuits were filed against us and certain of our officers in the United States District Court for the Northern District of California,
following our announcement of our anticipated financial results for the fourth quarter ended December 31, 2000. The lawsuits were subsequently
consolidated as a class action by the District Court, under the caption In re Foundry Networks, Inc. Securities Litigation, Master File No.
C-00-4823-MMC, lead plaintiffs were selected and filed a consolidated amended complaint which alleged violations of federal securities laws and
purported to seek damages on behalf of a class of shareholders who purchased our common stock during the period from September 7, 2000 to December 19,2000. We then brought four successful motions to dismiss the complaint. Although the District Court granted each of the four dismissal motions, it also
provided plaintiffs leave to amend the complaint. On August 29, 2003, following the dismissal of the four amended complaints, the District Court
granted our motion to dismiss the case with prejudice and without leave to amend and, on September 2, 2003, entered judgment in our favor, dismissing
the plaintiff’s fifth amended complaint. On September 29, 2003, plaintiff filed a Notice of Appeal with the United States Court of Appeals for the
Ninth Circuit (“Court of Appeals”). On January 15, 2004, the plaintiff/appellants filed their opening brief with the Court of Appeals. We
have reviewed the appeal and are in the process of preparing our response. We believe the District Court’s judgment validates our conviction that
the lawsuit is without merit and we will defend the District Court’s judgment vigorously.
A class action lawsuit was filed on November 27,2001 in the United States District Court for the Southern District of New York on behalf of purchasers of our common stock alleging violations of
federal securities laws. The case was designated as In re Foundry Networks, Inc. Initial Public Offering Securities Litigation, No. 01-CV-10640
(SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS) (S.D.N.Y.). The case is brought purportedly
on behalf of all persons who purchased our common stock from September 27, 1999 through December 6, 2000. The operative amended complaint names as
defendants us and
three of our officers (the “Foundry Defendants”), including our Chief
Executive Officer and Chief Financial Officer; and investment banking firms that served as underwriters for our initial public offering in September
1999. The amended complaint alleged violations of Sections 11 and 15 of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of
1934, on the grounds that the registration statement for the initial public offering (“IPO”) failed to disclose that (i) the underwriters
agreed to allow certain customers to purchase shares in the IPO in exchange for excess commissions to be paid to the underwriters, and (ii) the
underwriters arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. The amended complaint also
appears to allege that false or misleading analyst reports were issued. Similar allegations were made in lawsuits challenging over 300 other initial
public offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all
defendants’ motions to dismiss. In ruling on motions to dismiss, the Court must treat the allegations in the complaint as if they were true solely
for purposes of deciding the motions. The motion was denied as to claims under the Securities Act of 1933 in the case involving us. The same ruling was
made in all but 10 of the other cases. The Court dismissed the claims under Section 10(b) of the Securities Exchange Act of 1934, against us and one of
the individual defendants and dismissed all of the Section 20(a) “control person” claims. The Court denied the motion to dismiss the Section
10(b) claims against our remaining individual defendants on the basis that those defendants allegedly sold our stock following the IPO, allegations
found sufficient purely for pleading purposes to allow those claims to move forward. A similar ruling was made with respect to 62 of the individual
defendants in the other cases. We have accepted a settlement proposal presented to all issuer defendants. Under the terms of this settlement,
plaintiffs will dismiss and release all claims against the Foundry Defendants in exchange for a contingent payment by the insurance companies
collectively responsible for insuring the issuers in all of the IPO cases and for the assignment or surrender of control of certain claims we may have
against the underwriters. The settlement, which is still being finalized, will require approval of the Court, which cannot be assured, after class
members are given the opportunity to object to the settlement or opt out of the settlement.
In March 2001, Nortel Networks Corp.
(“Nortel”) filed a lawsuit against us in the United States District Court for the District of Massachusetts alleging that certain of our
products infringe several of Nortel’s patents and seeking injunctive relief and unspecified damages. Nortel has also brought suit, on the same or
similar patents, against a number of other networking companies. We have analyzed the validity of Nortel’s claims and believe that Nortel’s
suit is without merit. We are committed to vigorously defending ourself against these claims. On October 9, 2002, we filed a lawsuit against Nortel in
the United States District Court, Northern District of California alleging that certain of Nortel’s products infringe one of our patents and
alleging breach of contract by Nortel. We are seeking injunctive relief and damages.
In May 2003, Lucent Technologies Inc.
(“Lucent”) filed a lawsuit against us in the United States District Court for the District of Delaware alleging that certain of our products
infringe several of Lucent’s patents, and seeking injunctive relief, as well as unspecified damages. Lucent also brought suit on the same patents
(and one additional patent) against one of our competitors. On August 12, 2003, we filed a motion to sever the cases, and on February 6, 2004, the
District Court granted the motion. The parties are in the process of rescheduling the court dates in view of the District Court’s order to sever
the cases. We have analyzed the validity of Lucent’s claims and believe that Lucent’s suit is without merit. We are committed to vigorously
defending ourself against Lucent’s claims.
On February 13, 2004, we filed a lawsuit against
Lucent in the United States District Court, Eastern District of Texas, Marshall Division. The lawsuit alleges that certain of Lucent’s products
infringe one of our patents. We are seeking injunctive relief and damages.
From time to time, we are subject to other legal
proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents and other
intellectual property rights. In addition, from time to time, third parties assert patent infringement claims against us in the form of letters,
lawsuits and other forms of communication. Regardless of the merits of our position, litigation is always an expensive and uncertain proposition. In
accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”), we record a liability when it is both probable that a
liability has been incurred and the amount of the loss can be reasonably estimated. Any such provision would be adjusted on a quarterly basis to
reflect the effect of ongoing negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular
case. To date, we have not recorded any such provisions in accordance with SFAS 5. We believe we have valid defenses
with respect to the legal matters pending against us. In the event of a
determination adverse to us, we could incur substantial monetary liability, or be required to change our business practices. Any unfavorable
determination could have a material adverse effect on our financial position, results of operations, or cash flows.
Item 4. Submission Of Matters to a Vote of Security Holders
No matters were submitted to a vote of security
holders during the fourth quarter of fiscal 2003.
Item 5. Market For Registrant’s Common Equity and Related Stockholder
Matters
Price Range of Common Stock
Foundry’s common stock commenced trading on the
Nasdaq National Market on September 28, 1999 and is traded under the symbol “FDRY”. As of December 31, 2003, there were approximately 380
holders of record of the common stock. The following table sets forth the high and low closing sale prices for our common stock as reported on the
Nasdaq National Market.
High
Low
2003
Fourth
quarter
$
27.68
$
21.88
Third
quarter
$
23.77
$
15.25
Second
quarter
$
16.00
$
7.92
First
quarter
$
10.13
$
7.39
2002
Fourth
quarter
$
10.23
$
4.44
Third
quarter
$
9.50
$
5.48
Second
quarter
$
7.44
$
4.86
First
quarter
$
9.30
$
5.62
Dividend Policy
We have never paid cash dividends on our capital
stock. We currently anticipate that we will retain our future earnings, if any, to fund the development and growth of our business and, therefore, do
not anticipate paying cash dividends in the foreseeable future.
Unregistered Securities Sold in 2003
We did not sell any unregistered shares of our
common stock during 2003.
The selected consolidated financial data set forth
below should be read together with the consolidated financial statements and related notes, “Management’s Discussion and Analysis of
Financial Condition and Results of Operations,” and the other information contained in this Form 10-K.
Item 7. Management’s Discussion and Analysis of Financial Condition and
Results Of Operations
The following discussion and analysis of our
financial condition and results of operations should be read together with our consolidated financial statements and related notes appearing elsewhere
in this Form 10-K. This discussion and analysis contain forward-looking statements that involve risks, uncertainties and assumptions. Our actual
results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to,
those discussed in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk
Factors That May Affect Future Results and the Market Price of Our Stock.” Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or publicly
release the results of any revision to these forward-looking statements. Readers should carefully review the risk factors described in this document as
well as in other documents we file from time to time with the SEC. All public reports filed by us with the SEC are available free of charge on our
website at www.foundrynetworks.com or from the SEC at www.sec.gov as soon as practicable after we electronically file such reports with
the SEC.
Overview
Founded in 1996, Foundry designs, develops,
manufactures and markets a comprehensive, end-to-end suite of high performance data networking solutions, including Ethernet Layer 2 and Layer 3
switches, Metro routers, and Internet traffic management products. Our customers include Internet and Metro service providers, and enterprises such as
e-commerce sites, entertainment, health and wellness, financial and manufacturing companies, universities, and government agencies. Our product suite
includes the FastIron® family of Layer 2/3 enterprise switches, the IronPointTM family of wireless access points, the BigIron®
family of Layer 3 backbone switches, the EdgeIron® family of Layer 2 wiring closet switches, the NetIron® family of Metro routers, the
ServerIron® family of Layer 4-7 traffic management switches, and the IronViewTM Network Management software system.
At the end of 2000, the data networking industry
entered a period of market contraction as global economies entered a recessionary period and the global IT environment experienced excess network
capacity from the large volume of networking equipment deployed during the previous two years in anticipation of high network traffic growth. This was
particularly evident with telecom carriers and service providers who significantly reduced their IT budgets in response to excess capacity when network
traffic did not increase as expected. According to an independent research group, after two years of significant growth in excess of 25% in 1999 and
2000, the market for Ethernet-based products decreased 13% in 2001 and 3% in 2002, before stabilizing and showing a slight 1% growth rate in
2003.
In response to this economic environment, we shifted
our sales focus from telecom carriers and service providers to enterprises and government agencies. We also evolved our core strategy from one of
‘performance’, to one of ‘features and performance.’ Since many of our enterprise customers had not only reduced their IT
budgets, but also the size of their IT staffs, we focused our development efforts on product enhancements that would reduce total cost of ownership and
allow enterprise customers to manage their networks with fewer resources.
Although the data networking industry experienced
slight growth in 2003, many of our customers remain cautious about their capital spending and many of our competitors continue to struggle financially.
We believe economic conditions have improved, but are uncertain as to the duration and strength of the economic recovery.
2003 Financial Performance
•
2003 marks our fifth consecutive year of profitability since we
went public in September 1999.
•
Our revenues for 2003 were $399.6 million, a 33% increase over
2002. Sales to the U.S. government represented 31% of our revenues in 2003, compared to 15% in 2002. Revenues per employee increased to an
industry-high of $680,000 in 2003, compared to $515,000 in 2002.
•
Our gross margins improved from 53% in 2002 to 65% in 2003. This
improvement was achieved primarily as a result of economies of scale associated with our year-over-year revenue growth of 33%, significant cost
reduction for both components and assemblies, and, to a lesser extent, increased sales of higher-end, higher gross margin products.
•
Net income in 2003 was $75.1 million, or 19% of revenues,
compared to $22.5 million, or 7% of revenues, in 2002. In 2003, we grew our revenues and improved our gross margins, while carefully controlling
expenses to achieve bottom line growth.
•
Our balance sheet remains debt-free, with cash and investments
of $505.7 million, an increase of $179.2 million from 2002. In 2003, we generated $115.4 million of cash from operations and received $70.6 million of
cash from employee stock option exercises.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of
financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with generally
accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the
reported amounts of revenue and expenses during the period reported. By their nature, these estimates and judgments are subject to an inherent degree
of uncertainty. Management bases their estimates and judgments on historical experience, market trends, and other factors that are believed to be
reasonable under the circumstances. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities that
are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management
believes the following critical accounting policies, among others, reflect the more significant judgments and estimates that can have a significant
effect on our results of operations and the value of certain assets and liabilities on our consolidated financial statements. Management has discussed
the development, selection, and disclosure of these estimates with the Audit Committee of our Board of Directors. These and other significant
accounting policies are more fully described in Note 1 to the consolidated financial statements included in this Form 10-K.
We generate the majority of our revenue from sales
of stackable and chassis-based networking equipment, with the remainder of our revenue coming from customer support fees, training and installation
services. We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or
determinable and collectibility is reasonably assured. When sales arrangements contain multiple elements (i.e., hardware, training, and installation),
judgment is applied to determine the appropriate accounting, including how we allocate revenue to each element and when we recognize revenue for each
element.
Product revenue is generally recognized at the time
of shipment, unless an acceptance period or other contingency exists, in which case revenue is recognized upon the earlier of customer acceptance or
expiration of the acceptance period, or upon satisfaction of the contingency.
At the time product revenue is recognized, we
estimate the amount of warranty costs to be incurred and record the amount as a cost of revenue. Our standard warranty period extends 12 months from
the date of sale, and our estimate of the amount necessary to settle warranty claims is based primarily on our past experience with repair costs
related to warranty claims. Although we believe our estimate is adequate and that the judgment we apply is appropriate, actual warranty costs could
differ materially from our estimate. If actual warranty costs are greater than initially estimated, our cost of revenues could increase in the future.
We also provide a provision for estimated customer returns at the time product revenue is recognized. Our provision is based primarily on actual
historical sales returns and our return policies. Our resellers generally do not have a right of return, and our contracts with original equipment
manufacturers only provide for rights of return in the event our products do not meet specifications or there is an epidemic failure, as defined in the
contracts. If historical data used by us to calculate estimated sales returns does not reasonably approximate future returns, revenue in future periods
could be affected.
Allowance for Doubtful
Accounts
Customers are subject to a credit review process,
which evaluates the customer’s financial condition and ability to pay, and are generally assigned a credit limit that may be increased only after
a successful collection history with the customer has been established. We continually monitor and evaluate the collectibility of our trade receivables
and actively manage our accounts receivable to minimize bad debt. We record specific allowances for doubtful accounts when we become aware of a
specific customer’s inability to meet its financial obligation to us, such as in the case of bankruptcy filings or significant deterioration in
financial condition. We estimate allowances for doubtful accounts for all other customers based on factors such as current economic and industry
trends, the extent to which receivables are past due and historical collection experience. If circumstances change, estimates regarding the
collectibility of receivables would be adjusted. We mitigate some collection risk by requiring certain international customers to provide letters of
credit or bank guarantees prior to placing an order with us. Although we believe our allowance for doubtful accounts is adequate and that the judgment
we applied is appropriate, our actual amount of bad debt could differ materially from our estimate.
Inventories
The networking industry is characterized by rapid
technological change, frequent new product introductions, changes in customer requirements, and evolving industry standards. Our inventory purchases
and commitments are made based on anticipated demand for our products. We perform a detailed assessment of our inventory each period, which includes a
review of, among other factors, demand requirements, manufacturing lead-times, technological changes, product life cycles and development plans,
component cost trends, product pricing and quality issues. Based on this analysis, we estimate the amount of excess, obsolete and impaired inventory,
and provide reserves to record inventory at the lower of cost or estimated net realizable value. Once inventory has been written down to the lower or
cost or estimated net realizable value, it is reflected on our balance sheet at its new carrying cost until it is sold or otherwise disposed of.
Revisions to our inventory reserves may be required if actual factors differ from our estimates.
We subcontract substantially all of our
manufacturing to companies that assemble and test our products. Our agreements with some of these companies allow them to procure long lead-time
component inventory on our behalf based on a rolling production forecast provided by us. We may be contractually obligated to purchase long lead-time
component inventory procured by certain contract manufacturers in accordance with our forecast, unless we give
notice of order cancellation at least 90 days prior to the delivery date. As of
December 31, 2003, we were potentially committed to purchase approximately $50.1 million of such inventory. If actual demand for our products is below
the level in our production forecasts, we may have excess inventory or a liability as a result of our purchase commitments with our contract
manufacturers.
Deferred Tax Asset Valuation
Allowance
We recognize deferred tax assets based on
differences between the financial statement carrying amounts and the tax bases of assets. We record a valuation allowance to reduce our deferred tax
assets to the amount that is more likely than not to be realized. Significant management judgment is required in determining whether valuation
allowances should be recorded against our deferred tax assets. Management assesses the likelihood that our deferred tax assets will be realized against
projected future taxable income, and to the extent that realization is not believed to be more likely than not, a valuation allowance is established.
In the event we determine that we are unable to realize some or all of our deferred tax assets in the future, an adjustment to our deferred tax assets
would be necessary, resulting in a charge to income in the period such determination is made. Likewise, if we later determine that it is more likely
than not that our deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Our deferred tax assets as of
December 31, 2003 and 2002 were $33.3 million and $28.6 million, respectively.
Loss Contingencies
We are subject to the possibility of loss
contingencies in the normal course of our business, including those related to intellectual property and securities litigation. A loss contingency is
accrued when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. We continually reassess the
likelihood of any adverse judgments or outcomes to our contingencies, as well as potential ranges of probable losses, and will recognize a liability,
if any, for these contingencies based on a careful analysis of each issue with the assistance of outside legal counsel and other
experts.
Results of Operations
Net Revenues
The following table presents net product and service
revenues for the years ended December 31, 2003, 2002, and 2001 (dollars in thousands):
Net product revenues were $351.3 million, $265.0
million, and $281.4 million in 2003, 2002, and 2001, respectively, representing an increase of 33% in 2003 and a decrease of 6% in 2002. The 33%
increase in 2003 can be attributed to an increase in overall IT spending, increased market share and expanded sales coverage. During 2003, we focused
our sales efforts on broadening our customer base, particularly in non-cyclical customer verticals such as healthcare, research enterprises, government
agencies, and universities, that typically demonstrate continued capital spending during slow economic cycles. Sales to the U.S. government were
particularly strong in 2003, accounting for 31% of our total revenues, compared to 15% in 2002, due to the government’s effort to both expand and
upgrade their networks. In late 2002, the federal government certified many of our JetCore-based products for sale to the Department of Defense
(“DOD”). Once certified, we generated significant revenue from sales of these products to the DOD. Our success within the global enterprise
market and the U.S. federal government can be attributed to our ability to offer a compelling value proposition, our product architecture, which
provides an easy migration path to new technologies with minimal disruption, and our financial strength relative to other data networking vendors. We
also experienced significant revenue growth in Japan in 2003, due to the establishment
of a direct sales force in 2002 to complement our reseller relationship with
Mitsui, one of our largest resellers. In 2003, our expanded sales coverage in Japan resulted in sales growth of 57% in that country.
Product revenues decreased 6% in 2002 from 2001, due
to lower average selling prices caused by weak economic conditions, competitive pressures, and reduced IT spending. Although our product revenues grew
from $54.7 million in the first quarter of 2002 to $76.6 million in the fourth quarter of 2002, as a result of market acceptance of our new products
introduced in early 2002, we were unable to achieve product revenue growth year-over-year due to difficult economic and IT spending
conditions.
The following table presents net chassis and
stackable product revenues for the years ended December 31, 2003, 2002, and 2001 (dollars in thousands):
We offer products in two configuration platforms, a
fixed configuration stackable or a flexible configuration chassis. A stackable has a fixed configuration that cannot be altered. Chassis use a modular
platform that can be populated and reconfigured with various management and line card modules as frequently as desired by the customer. For example,
customers can use our chassis products at the edge of their network and then reconfigure the chassis to be used in the backbone or core of their
network. Our selling prices and gross margins on chassis-based products are generally higher than our stackable products because of the flexible
configuration offered by chassis-based products. Our chassis products accounted for 80%, 78%, and 77% of our net product revenues in 2003, 2002, and
2001, respectively. We do not expect sales of our chassis and stackable products to fluctuate significantly as a percentage of total product revenues
in the future.
Service revenues consist primarily of revenue from
customer support contracts, and to a lesser extent, from providing training and installation services. Net service revenues were $48.3 million, $35.7
million, and $29.8 million in 2003, 2002, and 2001, respectively, and accounted for 12% of total revenues in 2003 and 2002, and 10% in 2001. The
revenue increases in absolute dollars were due to a larger installed base of our networking equipment each year as customers purchased new support
contracts with their new equipment purchases and renewed maintenance contracts on existing equipment. Our customer base grew from 3,700 customers at
the end of 2001, to 5,200 customers in 2002, and to 6,500 customers at the end of 2003.
For the year ended December 31, 2003, two customers
accounted for greater than 10% of our total revenues. Mitsui, a reseller in Japan, accounted for 12% of our total revenues, and a U.S. government
integrator accounted for 11% of our total revenues. In 2002, Mitsui accounted for 11% of our revenues. No individual customer accounted for more than
10% of our total revenues in 2001. Sales to the U.S. government represented approximately 31% and 15% of our total revenues in 2003 and 2002,
respectively, and less than 10% of our total revenues in 2001.
International sales represented 35%, 38%, and 35% of
our total revenues for the years ended December 31, 2003, 2002, and 2001, respectively. One individual country outside of the United States, Japan,
accounted for 13% and 11% of our total revenues in 2003 and 2002, respectively. No individual country outside of the United States accounted for
greater than 10% of our total revenues in 2001. Sales to customers located in Japan increased in 2003 as a result of our expanded sales presence in
Japan.
The following table presents gross margins and gross
margin percentages for product and service revenues for the years ended December 31, 2003, 2002, and 2001 (dollars in thousands):
Our cost of product revenues consists primarily of
materials, labor, manufacturing overhead, warranty costs, and provisions for excess and obsolete inventory. Product gross margins were $218.2 million,
$130.4 million, and $131.2 million in 2003, 2002, and 2001, or 62%, 49%, and 47% of product revenues, respectively. The increase in product gross
margin as a percentage of product revenues in 2003 was due primarily to cost efficiencies associated with increased business volume in 2003 and
significant reductions of our component and sub-assembly costs. Product margins improved to a lesser extent as a result of increased sales of our
high-end, high-margin products in 2003 and lower provisions for excess and obsolete inventory. During 2003, our total port shipments of all products
increased by 32% from 2002, but our shipments of Gigabit Ethernet ports, a higher gross margin product, grew by 67%. This shift in product mix was due
to our customers’ increasing preference for Gigabit Ethernet, a Layer 4-7 switching technology and higher gross margin product, instead of 10/100
Ethernet, a Layer 2/3 technology and lower gross margin product. This product mix shift contributed to our gross margin improvement in 2003. During the
first nine months of 2003, our component and assembly costs were reduced significantly, which dramatically improved our gross margins. In the fourth
quarter of 2003, our component and assembly costs stabilized. Lead-times for various components have lengthened recently as a result of IT spending and
the general economic recovery. As component demand increases and lead-times become longer, our suppliers are less inclined to reduce component costs.
If we are unable to further reduce component costs, or our selling prices decline, our gross margins may also decline. See “Risk Factors—Our
gross margins may decline over time and the average selling prices of our products may decrease as a result of competitive pressures and other
factors.”
The 2% increase in product gross margins from 47% in
2001 to 49% in 2002 was due to significantly lower inventory provisions in 2002, offset by increased manufacturing overhead expenses due to the
expansion of our manufacturing facility. Inventory provisions were $12.0 million in 2003, $16.4 million in 2002, and $24.9 million in 2001. Significant
inventory reserves were provided in 2001 in connection with our transition from IronCore ASIC-based products to products incorporating our
next-generation JetCore ASICs.
Our cost of service revenues consists primarily of
costs of providing services under customer support contracts. These costs include material costs, labor, and overhead. Service gross margins were 84%
in 2003 and 2002, and 73% in 2001. Despite significantly higher service revenues in 2003, our service gross margin percentage remained unchanged from
2002, due primarily to increased service inventory and labor costs associated with supporting a larger customer base. As noted above, our customer base
grew considerably between 2001 and 2003. Service gross margin as a percentage of service revenue increased in 2002, compared to 2001, due to a
write-off of service inventory at customer sites in 2001. Many of our customers ceased operations during 2001 due to the economic recession and, as a
result, we were unable to recover our service inventory. We expect service gross margins to experience variability over time due to the timing of
technical support initiations and renewals and additional investments in our customer support infrastructure.
Research and Development, Sales and Marketing,
and General and Administrative Expenses
The following table presents research and
development, sales and marketing, and general and administrative expenses for the years ended December 31, 2003, 2002, and 2001 (dollars in
thousands):
Research and development expenses consist primarily
of salaries and related personnel expenses, prototype materials and expenses related to the development of our ASICs, software development and testing
costs, and the depreciation of property and equipment used in research and development activities. Research and development expenses were $40.5
million, $34.9 million, and $33.9 million in 2003, 2002, and 2001, or 10%, 12%, and 11% of revenue, respectively. The increase in research and
development expenses in 2003 was due primarily to prototype expenses incurred in connection with development of our terabit-capacity Ethernet switching
products, and, to a lesser extent, an increase in our average headcount from 147 engineers in 2002 to 159 engineers in 2003. Research and development
expenses increased $1.0 million in 2002 due to an increase in headcount from an average of 118 engineers in 2001 to 147 engineers in 2002, offset by
reduced prototype expenses in 2002 as a result of the completion of our next-generation JetCore ASICS in 2001. We believe continued investment in
product enhancements and new product development is critical to achieving our strategic objectives, and, as a result, we expect research and
development expenses to continue to increase in absolute dollars.
Sales and marketing expenses consist primarily of
salaries, commissions and related expenses for personnel engaged in marketing, sales and customer support activities, costs associated with trade
shows, advertising, and promotions, and the cost of facilities. Sales and marketing expenses were $88.4 million, $82.9 million, and $90.8 million in
2003, 2002, and 2001, or 22%, 28%, and 29% of revenues, respectively. The increase in absolute dollars from 2002 to 2003 was primarily due to higher
sales commissions as a result of increased revenues in 2003, higher travel costs associated with expanding our sales coverage, and to a lesser extent,
increased marketing expenses associated with the launch of new products in 2003. The decrease in absolute dollars from 2001 to 2002 was primarily due
to a 5% reduction in our domestic sales force in 2002. We believe that continued investment in sales and marketing activities is critical to our
success, and expect these expenses to increase slightly in absolute dollars in 2004 as we initiate additional sales and marketing programs to support
our products.
General and administrative expenses consist
primarily of salaries and related expenses for executive, finance and administrative personnel, costs of facilities, bad debt, legal fees, and other
general corporate expenses. General and administrative expenses were $17.6 million, $14.5 million, and $27.2 million in 2003, 2002, and 2001, or 4%,
5%, and 9% of revenue, respectively. The $3.1 million increase in 2003 was primarily due to an increase of $3.0 million in legal expenses related to
litigation matters discussed in Part I Item 3 “Legal Proceedings,” and an increase of $0.9 million in executive bonuses, offset by a $1.2
million decrease in bad debt expense as a result of the effect of improved economic conditions on the financial condition of our customer base. The
decrease of $12.7 million from 2001 to 2002 was primarily due to the effect of the economic recession in 2001. In 2001, we recorded a provision for
doubtful accounts receivable of $9.1 million, a charge of $2.8 million in 2001 for the write-down of a note receivable from a stockholder, and $1.1
million of costs related to consolidation of facilities. In 2002, we recorded only $0.3 million for doubtful accounts, and did not incur any expenses
for write-downs of notes receivable or consolidation of facilities. We expect general and administrative expenses to increase slightly in 2004,
compared to 2003.
Amortization of deferred stock compensation.
In connection with the granting of stock options to employees and a director, we recorded deferred stock compensation in the aggregate amount of $17.3
million in 1999 and $0.3 million in 2000, representing the difference between the exercise price and the deemed fair market value of our common stock
on the date stock options were granted. We recorded no additional deferred stock compensation after 2000. Deferred stock compensation was amortized to
operations over the respective vesting periods of the
options. We recorded amortization of deferred stock compensation expense of
approximately $231,000, $1.1 million, and $2.7 million for fiscal 2003, 2002, and 2001, respectively. We have no remaining deferred stock compensation
at December 31, 2003.
Interest income. We earn interest income on
funds maintained in interest-bearing money market and investment accounts. We recorded interest income of $5.2 million, $5.0 million, and $8.7 million
in 2003, 2002, and 2001, respectively. Despite higher levels of cash and investments throughout 2003, interest income remained nearly unchanged from
2002 due to lower average interest rates in 2003. Interest income decreased from 2001 to 2002, primarily due to lower average interest rates on our
portfolio of fixed income securities in 2002. See Item 7A “Quantitative and Qualitative Disclosures about Market Risk” for a description of
our investment policy.
Write-down of minority investment. In
February 2001, we made a $2.5 million minority investment in a privately-held development stage company, who was also a customer. Total sales to this
customer were insignificant. In December 2001, we determined that the investment’s decline in fair market value was other than temporary based on
certain factors such as the value of the investee’s most recent round of financing, market and industry conditions, and the financial condition
of, and business outlook for, the investee. Accordingly, we wrote-down our entire minority investment during the year ended December 31,2001.
Income taxes. The effective tax rate for the
years ended December 31, 2003, 2002, and 2001 was 36%, 30%, and 38%, respectively. These rates reflect applicable federal and state tax rates, offset
by research and development tax credits, foreign sales corporation tax benefits, and tax-exempt interest income. Since tax-exempt interest income and
research and development credits as a percentage of net income were significantly higher in 2002 than in 2003, our effective tax rate was higher in
2003. In addition, we recorded a valuation allowance of $1.0 million in 2003 against a deferred tax asset associated with a capital loss carryover, as
we do not believe we can generate significant capital gains from our investment portfolio to utilize the capital loss carryover before its statutory
expiration in 2007.
Our income taxes payable for federal and state
purposes have been reduced, and stockholders’ equity increased, by the tax benefits associated with taxable dispositions of employee stock
options. When an employee exercises a stock option issued under a nonqualified plan, or has a disqualifying disposition related to a qualified plan, we
receive an income tax benefit for the difference between the fair market value of the stock issued at the time of the exercise and the employee’s
option price, tax effected. These benefits are credited directly to stockholders’ equity and amounted to $46.5 million, $4.8 million, and $10.5
million for the years ended December 31, 2003, 2002, and 2001, respectively.
Liquidity and Capital Resources
At December 31, 2003, we had cash and investments
totaling $505.7 million, an increase of $179.2 million from $326.5 million at December 31, 2002. The increase was primarily the result of increased
profitability in 2003 and proceeds from the exercise of employee stock options. Due to significant tax deductions in 2003 and 2002 resulting from
disqualifying dispositions of employee stock options, we paid relatively insignificant amounts of taxes in those years in relation to our income before
taxes. In 2003, we generated $117.2 million of income before taxes, we received $70.6 million of cash from employee stock option exercises and stock
purchases, and our deferred support revenue increased by $14.9 million as a result of our larger installed product base. These factors were the primary
contributors to our increase in cash and investments in 2003.
Accounts receivable, net of allowances, increased
$25.2 million, or 49%, to $77.1 million as of December 31, 2003, from $51.9 million as of December 31, 2002. Our accounts receivable and days sales
outstanding (“DSO”) are primarily affected by shipment linearity and collections performance. Shipment linearity is a measure of the level of
shipments throughout a particular period. A steady level of shipments throughout a period will result in lower DSO, than a period in which there is a
higher level of shipments toward the end of the period, due to less time available to collect accounts receivable prior to period end. DSO, calculated
based on annualized revenues for the most recent quarter and net accounts receivable as of the balance sheet date, increased to 63 days as of December31, 2003, from 54 days as of December 31, 2002. The increase in DSO was due to less linear shipments during the fourth quarter of fiscal 2003, in which
more than 50% of our revenue shipped during the last month of the quarter.
Disclosures about Contractual Obligations and
Commercial Commitments
The following table aggregates our contractual
obligations and commercial commitments at December 31, 2003, and the effect such obligations are expected to have on our liquidity and cash flow in
future periods (in thousands):
For purposes of the above table, contractual
obligations for the purchase of goods or services are defined as agreements that are enforceable, legally binding on us, and subject us to penalties if
we cancel the agreement. Our purchase commitments are based on our short-term manufacturing needs and are fulfilled by our vendors within short time
horizons.
Although it is difficult for us to predict future
liquidity requirements with certainty, we believe our existing cash balances and anticipated funds from operations will satisfy our cash requirements
for at least the next 12 months. Key factors affecting our cash flows include our ability to effectively manage our working capital, in particular
inventories and accounts receivable, and future demand for our products and related pricing. We may incur higher capital expenditures in the near
future if market conditions improve and we expand our operations. Although we do not have any current plans or commitments to do so, we may from
time-to-time consider the acquisition of products or businesses complementary to our business. Any acquisition or investment may require additional
capital.
Off-Balance Sheet
Arrangements
We do not maintain any off-balance sheet
transactions, arrangements, or obligations that are reasonably likely to have a material current or future effect on our financial condition, results
of operations, liquidity, or capital resources.
Recently Issued Accounting Standards
More-Than Incidental
Software
On July 31, 2003, the Emerging Issues Task Force
(“EITF”) of the Financial Accounting Standards Board (“FASB”) reached a consensus on its tentative conclusions on Issue No. 03-5,
“Applicability of AICPA Statement of Position 97-2, ”Software Revenue Recognition,“ to Non-Software Deliverables in an Arrangement
Containing More-Than Incidental Software ”(“EITF 03-5”). EITF 03-5 discusses that software deliverables are within the scope of SOP 97-2
as are non-software deliverables for which the related software is essential to the functionality of the non-software deliverables. EITF 03-5 was
effective for fiscal periods beginning after August 2003. The adoption of EITF 03-5 did not have a material effect on our financial position, results
of operations or liquidity.
Consolidation of Variable Interest
Entities
In January 2003, the FASB issued Financial
Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). FIN 46 addresses
consolidation by business enterprises of variable interest entities (“VIEs”) that do not have sufficient equity investment at risk to permit
the entity to finance its activities without additional subordinated financial support, or in which the equity investors lack an essential
characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46
(“Revised Interpretation”), resulting in multiple effective dates based on the nature and the creation date of the VIE. VIEs created after
January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretation.
However, the Revised Interpretation must be applied no later than our first quarter of fiscal 2004. VIEs created after January 1, 2004 must be
accounted for under the Revised Interpretation. Special Purpose Entities (“SPEs”) created prior to February 1, 2003 may be accounted for
under the original or Revised Interpretation’s provisions no later than December 31, 2003. Non-SPEs
created prior to February 1, 2003, should be accounted for under the Revised
Interpretation’s provisions no later than our first quarter of fiscal 2004. We do not currently have any arrangements with variable interest or
special purpose entities that will require consolidation in our financial statements.
Risk Factors That May Affect Future Results and the Market Price of Our
Stock
Weak economic and market conditions or geopolitical turmoil may adversely affect
our revenues, gross margins and expenses.
Our quarterly revenues and operating results may
continue to fluctuate, due to the effects of general economic conditions in the United States and globally, and, in particular, market conditions in
the communications and networking industries. Additionally, current political turmoil in many parts of the world, including terrorist and military
actions, may weaken the global economy. If economic conditions in the United States and globally do not improve, or if they worsen, we may experience
material negative effects on our business, operating results and financial condition. Although we experienced improved sales, gross margins, and
profitability on a quarter-over-quarter basis throughout 2003 as a result of improving economic and market conditions, there can be no assurance that
we will be able to maintain or further improve our financial results or that economic and market conditions will continue to improve and will not
deteriorate.
Because our financial results are difficult to predict, we may not meet
quarterly financial expectations, which could cause our stock price to decline.
Our quarterly revenues and operating results are
difficult to predict and may fluctuate significantly from quarter to quarter. Delays in generating or recognizing forecasted revenues could cause our
quarterly operating results to be below the expectations of public market analysts or investors, which could cause the price of our common stock to
fall.
We may experience a delay in generating or
recognizing revenue for a number of reasons. Unfulfilled orders at the beginning of each quarter typically do not equal expected revenue for that
quarter and are generally cancelable at any time prior to shipment. Therefore, we depend on obtaining orders in a quarter for shipment in that quarter
to achieve our revenue objectives. In addition, our reseller agreements typically allow the reseller to delay scheduled delivery dates without penalty.
Moreover, demand for our products may fluctuate as a result of seasonality.
In addition, we may incur increased costs and
expenses related to sales and marketing, including expansion of our direct sales operations and distribution channels, product development, customer
support, expansion of our corporate infrastructure, legal matters, and facilities expansion. We base our operating expenses on anticipated revenue
levels, and a high percentage of our expenses are fixed in the short-term. As a result, any significant shortfall in revenue relative to our
expectations could cause a significant decline in our quarterly operating results.
Because of the uncertain nature of the economic
environment and rapidly changing market we serve, period-to-period comparisons of operating results may not be meaningful. In addition, you may not be
able to rely on the results for any period as an indication of future performance. In the future, our revenue may remain flat, decrease or increase,
and we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. As a consequence, operating results for a
particular quarter are extremely difficult to predict.
Although our customer base has increased, we still depend on large, recurring
purchases from certain customers, and a loss, cancellation or delay in purchases by these customers could negatively affect our revenue.
Sales to our ten largest customers accounted for 44%
and 37% of total revenues in 2003 and 2002, respectively. The loss of continued orders from any of our more significant customers, such as the U.S.
government or individual agencies within the U.S. government, Mitsui, America Online, or Hewlett Packard, could cause our revenue and profitability to
suffer. Our ability to attract new customers will depend on a variety of factors, including the cost-effectiveness, reliability, scalability, breadth
and depth of our products.
Although our financial performance may depend on
large, recurring orders from certain customers and resellers, we do not generally have binding commitments from them. For example:
•
our reseller agreements generally do not require minimum
purchases;
our customers can stop purchasing and our resellers can stop
marketing our products at any time; and
•
our reseller agreements generally are not exclusive and are for
one-year terms, with no obligation of the resellers to renew the agreements.
Because our expenses are based on our revenue
forecasts, a substantial reduction or delay in sales of our products to, or unexpected returns from, customers and resellers, or the loss of any
significant customer or reseller, could harm our business. Although our largest customers may vary from period to period, we anticipate that our
operating results for any given period will continue to depend on large orders from a small number of customers.
The United States government is a significant customer and has been one key to
our financial success. However, government demand is unpredictable and there is no guarantee of future contract awards.
As part of the changing economic environment, the
United States government has become an important customer for the networking industry, and for us in particular. The process of becoming a qualified
government vendor takes considerable time and effort, and the timing of contract awards and deployment of our products are hard to predict. Typically,
six to twelve months may elapse between the initial evaluation of our systems by governmental agencies and the execution of a contract. The revenue
stream from these contracts is hard to predict and may be materially uneven between quarters. Government agency contracts are frequently awarded only
after formal competitive bidding processes, which are often protracted and may contain provisions that permit cancellation in the event funds are
unavailable to the government agency. Even if we are awarded contracts, substantial delays or cancellations of purchases could result from protests
initiated by losing bidders. In addition, government agencies are subject to budgetary processes and expenditure constraints that could lead to delays
or decreased capital expenditures in certain areas. If we fail to win any significant government contract award, if the government or individual
agencies within the government terminate or reduce the scope and value of our existing contracts, or if the government fails to reduce the budget
deficit, our financial results may be harmed.
Intense competition in the market for network solutions could prevent us from
maintaining or increasing revenue and sustaining profitability.
The market for network solutions is intensely
competitive. In particular, Cisco Systems, Inc. maintains a dominant position in this market and several of its products compete directly with our
products. Cisco’s substantial resources and market dominance have enabled it to reduce prices on its products within a short period of time
following the introduction of these products, which reduces margins and, therefore, the profitability of its competitors. Purchasers of networking
solutions may choose Cisco’s products because of its longer operating history, broader product line and strong reputation in the networking
market. In addition, Cisco may have developed, or could in the future develop, new technologies that directly compete with our products or render our
products obsolete. Although we are currently among the top providers of network infrastructure solutions, we cannot assure you that we will be able to
compete successfully against Cisco, currently the leading provider in the networking market.
We also compete with other companies, such as
Extreme Networks, Juniper Networks, Nortel Networks, Enterasys Networks, 3Com, Huawei, and Alcatel. Some of our current and potential competitors have
greater market leverage, longer operating histories, greater financial, technical, sales, marketing and other resources, more name recognition and
larger installed customer bases. Additionally, we may face competition from unknown companies and emerging technologies that may offer new LAN, MAN and
LAN/WAN solutions. Furthermore, a number of these competitors may merge or form strategic relationships that would enable them to apply greater
resources and sales coverage than we can, and to offer, or bring to market earlier, products that are superior to ours in terms of features, quality,
pricing or other factors.
In order to remain competitive, we must, among other
things, invest significant resources in developing new products with superior performance at lower prices than our competitors, enhance our current
products and maintain customer satisfaction. In addition, we must make certain our sales and marketing capabilities allow us to effectively compete
against our competitors. If we fail to do so, our products may not compete favorably with those of our competitors and our revenues and profitability
could suffer.
We must continue to introduce new products with superior performance and
features in a timely manner in order to sustain and increase our revenue.
The networking industry is characterized by rapid
technological change, frequent new product introductions, changes in customer requirements, and evolving industry standards. Therefore, in order to
remain competitive, we must introduce new products in a timely manner that offer substantially greater performance and support a greater number of
users per device, all at lower price points. The process of developing new technology is complex and uncertain, and if we fail to develop or obtain
important intellectual property and accurately predict customers’ changing needs and emerging technological trends, our business could be harmed.
We must commit significant resources to develop new products before knowing whether our investments will eventually result in products that the market
will accept. After a product is developed, we must be able to forecast sales volumes and quickly manufacture a sufficient volume of products and mix of
configurations that meet customer requirements, all at low costs.
The current life cycle of our products is typically
18 to 24 months. The introduction of new products or product enhancements may shorten the life cycle of our existing products or replace sales of some
of our current products, thereby offsetting the benefit of even a successful product introduction, and may cause customers to defer purchasing our
existing products in anticipation of the new products. This could harm our operating results by decreasing sales, increasing our inventory levels of
older products and exposing us to greater risk of product obsolescence. In addition, we have experienced, and may in the future experience, delays in
developing and releasing new products and product enhancements. This has led to, and may in the future lead to, delayed sales, increased expenses and
lower quarterly revenues than anticipated. During the development of our products, we have also experienced delays in the prototyping of our ASICs,
which in turn has led to delays in product introductions.
Our ability to increase our revenues depends on expanding our direct sales
operations and reseller distribution channels and continuing to provide excellent customer support.
If we are unable to effectively develop and retain
our sales and support staff, or establish and cultivate relationships with our indirect distribution channels, our ability to grow and increase revenue
could be harmed. Additionally, if our resellers are not successful in their sales efforts, sales of our products may decrease and our operating results
could suffer. Some of our resellers also sell products that compete with our products. As a result, we cannot assure you that our resellers will market
our products effectively or continue to devote the resources necessary to provide us with adequate sales, marketing and technical
support.
In an effort to gain market share and support our
customers, we may need to expand our direct sales operations and customer service staff to support new and existing customers. The timing and extent of
any such expansion are uncertain in light of the current economic environment. Expansion of our direct sales operations and reseller distribution
channels may not be successfully implemented and the cost of any expansion may exceed the revenues generated.
Our gross margins may decline over time and the average selling prices of our
products may decrease as a result of competitive pressures and other factors.
Our industry has experienced erosion of average
product selling prices due to a number of factors, particularly competitive and macroeconomic pressures and rapid technological change. The average
selling prices of our products has decreased in the past and may continue to decrease in response to competitive pressures, increased sales discounts,
new product introductions by our competitors or other factors. Both we and our competitors occasionally lower sales prices in order to gain market
share or create more demand. Furthermore, as a result of the recent disruption in the technology sector, coupled with more broad macro-economic
factors, both we and our competitors may pursue more aggressive pricing strategies in an effort to maintain sales levels. Such intense pricing
competition could cause our gross margins to decline and may adversely affect our business, operating results or financial condition.
Our gross margins may be adversely affected if we
are unable to reduce manufacturing costs and effectively manage our inventory levels. Although management continues to closely monitor inventory
levels, declines in demand for our products could result in additional provisions for excess inventory. Additionally, our gross margins may be
negatively affected by fluctuations in manufacturing volumes, component costs, the mix of product
configurations sold and the mix of distribution channels through which our products
are sold. For example, we generally realize higher gross margins on direct sales to an end user than on sales through resellers or to our OEMs. As a
result, any significant shift in revenues through resellers or to our OEMs could harm our gross margins. If product or related warranty costs
associated with our products are greater than we have experienced, our gross margins may also be adversely affected.
We need additional qualified personnel to maintain and expand our business. If
we are unable to promptly attract and retain qualified personnel, our business may be harmed.
We believe our future success will depend in large
part on our ability to identify, attract and retain highly-skilled managerial, engineering, sales and marketing, finance and manufacturing personnel.
Despite the economic downturn, competition for these personnel can be intense, especially in the San Francisco Bay Area, and we may experience some
difficulty hiring employees in the timeframe we desire, particularly engineers. Volatility or lack of positive performance in our stock price may also
adversely affect our ability to retain key employees, all of whom have been granted stock options. In order to improve productivity, we have
historically used stock options to motivate and retain our employees. Some of the proposals currently under consideration by the accounting profession
regarding the accounting treatment of stock options could limit our ability to continue to use stock options as an incentive and retention tool. We may
not succeed in identifying, attracting and retaining personnel. The loss of the services of any of our key personnel, the inability to identify,
attract or retain qualified personnel in the future, or delays in hiring required personnel, particularly engineers and sales personnel, could make it
difficult for us to manage our business and meet key objectives, such as timely product introductions.
Our success also depends to a significant degree on
the continued contributions of our key management, engineering, sales and marketing, finance and manufacturing personnel, many of whom would be
difficult to replace. In particular, we believe that our future success depends on Bobby R. Johnson, Jr., President, Chief Executive Officer and
Chairman of the Board. We do not have employment contracts or key person life insurance for any of our personnel.
Our presence in international markets involves inherent risks that we may not be
able to control. As a result, our business may be harmed if we are unable to successfully address these risks.
Our success will depend, in part, on increasing
international sales and expanding our international operations. Our international sales primarily depend on our resellers, including Pervasive Networks
and Spot Distribution Ltd. in Europe, Mitsui in Japan, Shanghai Gentek and GTI in China, and Samsung in Korea. For example, our largest reseller,
Mitsui, accounted for 12% and 11% of our total net revenues in 2003 and 2002, respectively. The failure of our international resellers to sell our
products would limit our ability to sustain and grow our revenue. In particular, our revenue from Japan depends primarily on Mitsui’s ability to
sell our products and on the strength of the Japanese economy, which has been weak in recent years. There are a number of risks arising from our
international business, including:
• potential recessions in economies
outside the United States;
• longer accounts receivable
collection cycles;
• seasonal reductions in business
activity;
• higher costs of doing business in
foreign countries;
• difficulties in managing operations across disparate geographic
areas;
• difficulties associated with enforcing agreements through
foreign legal systems;
One or more of such factors may have a material
adverse effect on our future international operations and, consequently, on our business, operating results and financial condition.
Generally, our international sales are denominated
in U.S. dollars. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive on a
price basis in international markets. In the future, we may elect to invoice some of our international customers in local currency, which could subject
us to fluctuations in exchange rates between the U.S. dollar and the local currency.
We purchase several key components for our products from several sources; if
these components are not available, our revenues may be harmed.
We purchase several key components used in our
products from several sources and depend on supply from these sources to meet our needs. The inability of any supplier to provide us with an adequate
supply of key components, or the loss of any of our suppliers, may cause a delay in our ability to fulfill orders and may have a material adverse
effect on our business and financial condition. Lead-times for various components have lengthened recently as a result of limits on IT spending and the
economic uncertainty, which has made certain components scarce. As component demand increases and lead-times become longer, our suppliers may increase
component costs. If component costs increase, our gross margins may also decline.
Our principal limited-sourced components include
dynamic and static random access memories, commonly known as DRAMs and SRAMs, ASICs, printed circuit boards, optical components, microprocessors and
power supplies. We acquire these components through purchase orders and have no long-term commitments regarding supply or price from these suppliers.
From time-to-time, we have experienced shortages in allocations of components, resulting in delays in filling orders. We may encounter shortages and
delays in obtaining components in the future which could impede our ability to meet customer orders.
We depend on anticipated product orders to determine
our material requirements. Lead-times for limited-sourced materials and components can be as long as six months, vary significantly and depend on
factors such as the specific supplier, contract terms and demand for a component at a given time. Inventory management remains an area of focus as we
balance the need to maintain strategic inventory levels to ensure competitive lead-times with the risk of inventory obsolescence due to rapidly
changing technology and customer requirements. If orders do not match forecasts, or if we do not manage inventory effectively, we may have either
excess or insufficient inventory of materials and components, which could negatively affect our operating results and financial
condition.
Our reliance on third-party manufacturing vendors to manufacture our products
may cause a delay in our ability to fill orders.
We subcontract substantially all of our
manufacturing to companies that assemble and test our products. Our agreements with some of these companies allow them to procure long lead-time
component inventory on our behalf based on a rolling production forecast provided by us. We may be contractually obligated to purchase long lead-time
component inventory procured by our contract manufacturers in accordance with our forecast, unless we give notice of order cancellation at least 90
days prior to the delivery date. If actual demand for our products is below our projections, we may have excess inventory as a result of our purchase
commitments with our contract manufacturers. We do not have long-term contracts with these manufacturers.
We have experienced delays in product shipments from
our contract manufacturers, which in turn delayed product shipments to our customers. We may in the future experience similar delays or other problems,
such as inferior quality and insufficient quantity of product, any of which could harm our business and operating results. We intend to regularly
introduce new products and product enhancements, which will require us to rapidly achieve volume production by coordinating our efforts with our
suppliers and contract manufacturers. We attempt to increase our material purchases, contract manufacturing capacity and internal test and quality
functions to meet anticipated demand. The inability of our contract manufacturers to provide us with adequate supplies of high-quality products, the
loss of any of our contract manufacturers, or the inability to obtain raw materials, could cause a delay in our ability to fulfill
orders.
Due to the lengthy sales cycles of some of our products, the timing of our
revenue is difficult to predict and may cause us to fail to meet our revenue expectations.
Some of our products have a relatively high sales
price, and often represent a significant and strategic decision by a customer. The decision by customers to purchase our products is often based on
their internal budgets and procedures involving rigorous evaluation, testing, implementation and acceptance of new technologies. As a result, our sales
cycle in these situations can be as long as 12 months and may vary substantially from customer to customer. While our customers are evaluating our
products and before they may place an order with us, we may incur substantial sales and marketing expenses and expend significant management effort.
Consequently, if sales forecasted from a specific customer for a particular quarter are not realized in that quarter, we may not meet our revenue
expectations.
If we fail to protect our intellectual property, our business and ability to
compete could suffer.
Our success and ability to compete are substantially
dependent on our internally developed technology and know-how. Our proprietary technology includes our ASICs, our IronCore, JetCore, and Terathon
hardware architecture, our IronWare software, our IronView network management software, and certain mechanical designs. We rely on a combination of
patent, copyright, trademark and trade secret laws and contractual restrictions on disclosure to protect our intellectual property rights in these
proprietary technologies. Although we have patent applications pending, there can be no assurance that patents will be issued from pending
applications, or that claims allowed on any future patents will be sufficiently broad to protect our technology.
We provide software to customers under license
agreements included in the packaged software. These agreements are not negotiated with or signed by the licensee, and thus may not be enforceable in
some jurisdictions. Despite our efforts to protect our proprietary rights through confidentiality and license agreements, unauthorized parties may
attempt to copy or otherwise obtain and use our products or technology. These precautions may not prevent misappropriation or infringement of our
intellectual property. Monitoring unauthorized use of our products is difficult and the steps we have taken may not prevent misappropriation of our
technology, particularly in some foreign countries in which the laws may not protect our proprietary rights as fully as in the United
States.
We may be subject to intellectual property infringement claims that are costly
to defend and could limit our ability to use certain technologies in the future.
The networking industry is increasingly
characterized by the existence of a large number of patent claims and related litigation regarding patent and other intellectual property rights. In
particular, some companies in the networking industry claim extensive patent portfolios. As a result of the existence of a large number of patents and
rapid rate of issuance of new patents in the networking industry, it is not economically practical for a company of our size to determine in advance
whether a product or any of its components may infringe intellectual property rights claimed by others. From time-to-time third parties have asserted
exclusive patent, copyright and trademark rights to technologies and related standards that are important to us. Such third parties may assert claims
or initiate litigation against us or our manufacturers, suppliers or customers alleging infringement of their intellectual property rights with respect
to our existing or future products.
In March 2001, Nortel filed a lawsuit against us in
the United States District Court for the District of Massachusetts, alleging that certain of our products infringe several of Nortel’s patents and
seeking injunctive relief and unspecified damages. Nortel has also brought suit, on the same or similar patents, against a number of other networking
companies. We have analyzed the validity of Nortel’s claims and believe that Nortel’s suit is without merit. We are committed to vigorously
defending ourself against these claims. On October 9, 2002, we filed a lawsuit against Nortel in the United States District Court, Northern District of
California, alleging that certain of Nortel’s products infringe one of our patents, and alleging breach of contract by Nortel. We are seeking
injunctive relief and damages.
In May 2003, Lucent filed a lawsuit against us in
the United States District Court for the District of Delaware, alleging that certain of our products infringe several of Lucent’s patents, and
seeking injunctive relief and unspecified damages. Lucent also brought suit on the same patents (and one other patent) against one of our competitors.
On August 12, 2003, we filed a motion to sever the cases, and on February 6, 2004, the District Court granted the motion. The parties are in the
process of rescheduling the court dates in view of the District Court’s
order to sever the cases. We have analyzed the validity of Lucent’s claims and
believe Lucent’s suit is without merit. We are committed to vigorously defending ourself against Lucent’s claims. Regardless of the merits of
our position, we may incur substantial expenses in defending against third party claims. In the event of a determination adverse to us, we could incur
substantial monetary liability, and be required to change our business practices. Either of these could have a material adverse effect on our financial
position, results of operations, or cash flows.
In difficult economic times, some companies have
attempted to realize revenues from their patent portfolios by using licensing programs. Some of these companies have contacted us regarding a license.
We carefully review all license requests, but are unwilling to license technology not required for our product portfolio. However, any asserted license
demand can require considerable effort to review and respond. Moreover, a refusal by us to a license request could result in threats of litigation or
actual litigation, which, if initiated, could harm our business.
We face litigation risks.
We are a party to lawsuits in the normal course of
our business. Litigation in general, and intellectual property and securities litigation in particular, can be expensive, lengthy and disruptive to
normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. We believe that we have defenses in the
lawsuits pending against us as indicated in Part I, Item 3 “Legal Proceedings,” and we are vigorously contesting these allegations.
Responding to the allegations has been, and probably will continue to be, expensive and time-consuming for us. An unfavorable resolution of the
lawsuits could adversely affect our business, results of operations, or financial condition.
The timing of the adoption of industry standards may negatively affect
widespread market acceptance of our products.
Our success depends in part on both the adoption of
industry standards for new technologies in our market and our products’ compliance with industry standards. Many technological developments occur
prior to the adoption of the related industry standard. The absence or delay of an industry standard related to a specific technology may prevent
market acceptance of products using the technology. We intend to develop products using new technological advancements, such as MPLS Draft-Martini, and
may develop these products prior to the adoption of industry standards related to these technologies. As a result, we may incur significant expenses
and losses due to lack of customer demand, unusable purchased components for these products and the diversion of our engineers from future product
development efforts. Further, if the adoption of industry standards moves too quickly, we may develop products that do not comply with a later-adopted
industry standard, which could hurt our ability to sell these products. If the industry evolves to new standards, we may not be able to successfully
design and manufacture new products in a timely fashion that meet these new standards. Even after industry standards are adopted, the future success of
our products depends on widespread market acceptance of their underlying technologies. At least one networking equipment standards body has reportedly
stopped all work on a standard in response to assertions by Nortel that it controls the patent rights to certain industry standards. Attempts by third
parties to impose licensing fees on industry standards could undermine the adoption of such standards and lessen industry
opportunities.
If our products contain undetected software or hardware errors, we could incur
significant unexpected expenses and lost sales and be subject to product liability claims.
Our products are complex and may contain undetected
defects or errors, particularly when first introduced or as new enhancements and versions are released. Despite our testing procedures, these defects
and errors may be found after commencement of commercial shipments. Any defects or errors in our products discovered in the future or failures of our
customers’ networks, whether caused by our products or another vendors’ products, could result in:
• negative customer
reactions;
• product liability
claims;
• negative publicity regarding us
and our products;
• delays in or loss of market
acceptance of our products;
If we do not adequately manage and evolve our financial reporting and managerial
systems and processes, our ability to manage and grow our business may be harmed.
Our ability to successfully implement our business
plan and comply with regulations requires an effective planning and management process. We expect that we will need to continue to improve existing,
and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the
implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast
sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.
Our products may not meet the standards required for their sale, which may harm
our business.
In the United States, our products must comply with
various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, products that we
develop may be required to comply with standards established by telecommunications authorities in various countries, as well as those of certain
international bodies. Although we believe our products are currently in compliance with domestic and international standards and regulations in
countries in which we currently sell, there can be no assurance that our existing and future product offerings will continue to comply with evolving
standards and regulations. If we fail to obtain timely domestic or foreign regulatory approvals or certification, we may not be able to sell our
products where these standards or regulations apply, which may prevent us from sustaining our revenues or maintaining profitability.
We may engage in acquisitions that could result in the dilution of our
stockholders, cause us to incur substantial expenses and harm our business if we cannot successfully integrate the acquired business, products,
technologies or personnel.
Although Foundry focuses on internal product
development and growth, we may learn of acquisition prospects that would complement our existing business or enhance our technological capabilities.
Any acquisition by us could result in large and immediate write-offs, the incurrence of debt and contingent liabilities, or amortization expenses
related to amortizable intangible assets, any of which could negatively affect our results of operations. Furthermore, acquisitions involve numerous
risks and uncertainties, including:
•
difficulties in the assimilation of products, operations,
personnel and technologies of the acquired companies;
•
diversion of management’s attention from other business
concerns;
•
risks of entering geographic and business markets in which we
have no or limited prior experience; and
•
potential loss of key employees of acquired
organizations.
Although we do not currently have any agreements or
plans with respect to any material acquisitions, we may make acquisitions of complementary businesses, products or technologies in the future. We may
not be able to successfully integrate any businesses, products, technologies or personnel that might be acquired, and our failure to do so could harm
our business.
Our stock price has been volatile historically, which may make it more difficult
to sell shares when needed at attractive prices.
The trading price of our common stock has been, and
may continue to be, subject to wide fluctuations. Our stock price may fluctuate in response to a number of events and factors, such as quarterly
variations in operating results, announcements of technological innovations or new products by us or our competitors, changes in financial estimates
and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable, and news
reports relating to trends in our markets. In addition, the stock market in general, and technology companies in particular, have experienced extreme
volatility that often
has been unrelated to the operating performance of such companies. These broad
market and industry fluctuations may adversely affect the price of our stock, regardless of our operating performance. Additionally, volatility or lack
of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock
options.
If we are required to record compensation expense in connection with stock
option grants, our profitability may be reduced significantly.
The Financial Accounting Standards Board has
recently indicated that they will require stock-based employee compensation to be recorded as a charge to earnings. The various methods for expensing
stock options are based on, among other things, the volatility of the underlying stock. As noted above, our stock price has historically been volatile.
Therefore, the adoption of an accounting standard requiring companies to expense stock options could negatively affect our profitability and may
adversely affect our stock price. Such adoption could also limit our ability to continue to use stock options as an incentive and retention tool, which
could, in turn, hurt our ability to recruit employees and retain existing employees. FASB is expected to issue final rules on stock option expensing in
the second half of 2004. We will continue to monitor FASB’s progress on the issuance of this standard.
Management beneficially owns approximately 10.9% of our stock; their interests
could conflict with other shareholders; significant sales of stock held by them and other employees could have a negative effect on our stock
price.
Our directors and executive officers beneficially
own approximately 10.9% of our outstanding common stock as of December 31, 2003. As a result of their ownership and positions, our directors and
executive officers collectively are able to significantly influence all matters requiring stockholder approval, including the election of directors and
approval of significant corporate transactions. Our employees who own Foundry common stock are also collectively able to significantly influence such
matters. Such concentration of ownership may have the effect of delaying or preventing a change in control of Foundry. In addition, sales of
significant amounts of shares held by Foundry’s employees, directors and executive officers, or the prospect of these sales, could adversely
affect the market price of Foundry’s common stock.
Anti-takeover provisions could make it more difficult for a third party to
acquire us.
Our board of directors has the authority to issue up
to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those
shares without any further vote or action by the stockholders. The rights of the holders of common stock may be subject to, and may be adversely
affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock may have the effect of
delaying, deferring or preventing a change of control of Foundry without further action by the stockholders and may adversely affect the voting and
other rights of the holders of common stock. We have no present plans to issue shares of preferred stock. Further, certain provisions of our charter
documents, including provisions eliminating the ability of stockholders to take action by written consent and limiting the ability of stockholders to
raise matters at a meeting of stockholders without giving advance notice, may have the effect of delaying or preventing changes in control or
management of Foundry, which could have an adverse effect on the market price of our stock. In addition, our charter documents do not permit cumulative
voting, which may make it more difficult for a third party to gain control of our board of directors.
Our operations could be significantly hindered by the occurrence of a natural
disaster, terrorist acts or other catastrophic event.
Our operations are susceptible to outages due to
fire, floods, power loss, power shortages, telecommunications failures, break-ins and similar events. In addition, certain of our local and foreign
offices and contract manufacturers are located in areas susceptible to earthquakes and acts of terrorism, which could cause a material disruption in
our operations. The prospect of such unscheduled interruptions may continue for the foreseeable future and we are unable to predict either their
occurrence, duration or cessation. We do not have multiple site capacity for all of our services in the event of any such occurrence. Despite our
implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized
tampering with our
computer systems. We may not carry sufficient insurance to compensate us for losses
that may occur as a result of any of these events. Any such event could have a material adverse effect on our business, operating results, and
financial condition.
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk.
Our investments are made in accordance with an
investment policy approved by our Board of Directors. The primary objective of our investment activities is to preserve capital while maximizing yields
without significantly increasing risk. Our exposure to interest rate risk relates to our investment portfolio. We do not use interest rate swaps in our
investment portfolio. We place our investments with high-credit quality issuers and, by policy, limit the amount of credit exposure with any one issuer
or fund. For liquidity purposes, our investment policy requires that we maintain a minimum of $75 million in money market accounts of suitable credit
quality. We have performed a hypothetical sensitivity analysis assuming an immediate parallel shift in the yield curve of plus or minus 50 basis
points, while all other variables remain constant. A hypothetical 50 basis point decline in interest rates would reduce our annualized interest income
by approximately $1.9 million at December 31, 2003.
Our investment portfolio is classified as
held-to-maturity and is recorded at amortized cost, and includes only securities with original maturities of less than two years and with secondary or
resale markets to ensure portfolio liquidity. Since we hold our investments to maturity, we are exposed to risk in the event an issuer is not able to
meet its obligations at maturity. To mitigate this risk, our investment policy does not allow us to invest more than $15 million with any one issuer.
We do not have any investments denominated in foreign country currencies, and therefore are not subject to foreign currency risk on such
investments.
Currently, the majority of our sales and expenses
are denominated in U.S. dollars and, as a result, we have not experienced significant foreign exchange gains and losses to date. We do not currently
enter into forward exchange contracts to hedge exposures denominated in foreign currencies or any other derivative financial instruments for trading or
speculative purposes. However, in the event our exposure to foreign currency risk increases, we may choose to hedge those exposures. For most
currencies, we are a net payer of foreign currencies and, therefore, benefit from a stronger U.S. dollar and are adversely affected by a weaker U.S.
dollar relative to those foreign currencies. We have performed a sensitivity analysis as of December 31, 2003 using a modeling technique that measures
the change in fair values arising from a hypothetical 10% adverse movement in foreign currency exchange rates relative to the U.S. dollar, with all
other variables held constant. Foreign currency exchange rates used were based on market rates in effect at December 31, 2003. The sensitivity analysis
indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would not result in a material loss in the fair values of foreign
currency denominated assets and liabilities at December 31, 2003.
To the Board of Directors and Stockholders of
Foundry Networks,
Inc.:
We have audited the accompanying consolidated
balance sheets of Foundry Networks, Inc. as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders’
equity, and cash flows for each of the two years in the period ended December 31, 2003. Our audits also included the financial statement schedule
listed in the Index at Item 15(a)(2) for the years ended December 31, 2003 and 2002. These financial statements and schedule are the responsibility of
the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. The
consolidated financial statements of Foundry Networks, Inc. for the year ended December 31, 2001, prior to the adjustments discussed in Note 1, were
audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report
dated January 21, 2002.
We conducted our audits in accordance with auditing
standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to
above present fairly, in all material respects, the consolidated financial position of Foundry Networks, Inc. at December 31, 2003 and 2002, and the
consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2003, in conformity with
accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule for the years ended
December 31, 2003 and 2002, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
As discussed above, the consolidated financial
statements of Foundry Networks, Inc. for the year ended December 31, 2001 were audited by other auditors who have ceased operations. As disclosed in
Note 1, the Company changed the presentation of revenues and cost of revenues for the year ended December 31, 2001 to conform to the presentation
required in 2002 and 2003 in accordance with Rule 5.03 of Regulation S-X as service revenues exceeded 10% of total revenues for the years ended
December 31, 2003 and 2002. We audited the reclassification adjustments that impacted product revenues, cost of product revenues, service revenues, and
cost of service revenues. In our opinion, all such adjustments and disclosures are appropriate and the adjustments have been properly applied. However,
we were not engaged to audit, review, or apply any procedures to the consolidated financial statements of the Company for the year ended December 31,2001 other than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the consolidated
financial statements for the year ended December 31, 2001 taken as a whole.
This is a copy of the audit report previously issued by Arthur Andersen LLP in
connection with Foundry Networks Inc.’s filing on Form 10-K for the year ended December 31, 2001. This audit report has not been reissued by
Arthur Andersen LLP in connection with this filing on Form 10-K. See Exhibit 23.2 for further discussion.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Foundry Networks, Inc.:
We have audited the accompanying consolidated
balance sheets of Foundry Networks, Inc. (a Delaware corporation) and subsidiaries as of December 31, 2000 and 2001, and the related consolidated
statements of income, redeemable convertible preferred stock and stockholders’ equity and cash flows for each of the three years in the period
ended December 31, 2001. These financial statements and the schedule referred to below are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing
standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to
above present fairly, in all material respects, the financial position of Foundry Networks, Inc. and subsidiaries as of December 31, 2000 and 2001, and
the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting
principles generally accepted in the United States of America.
Our audit was made for the purpose of forming an
opinion on the basic financial statements taken as a whole. The schedule listed in Item 15(a)(2) is presented for purposes of complying with the
Securities and Exchange Commission’s rules and is not part of the basic financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data
required to be set forth therein in relation to the basic financial statements taken as a whole.
Accounts
receivable, net of allowances for doubtful accounts of $4,151 and $5,833 and sales returns of $2,020 and $1,584 at December 31, 2003 and 2002,
respectively
Foundry Networks, Inc. (together with its
subsidiaries, collectively “Foundry” or “we”) designs, develops, manufactures, and markets a comprehensive, end-to-end suite of
high performance data networking solutions, including Ethernet Layer 2 and Layer 3 switches, Metro routers and Internet traffic management products.
Our customers include Internet and Metro service providers, and enterprises such as e-commerce sites, entertainment, health and wellness, financial and
manufacturing companies, universities and government agencies.
Principles of Consolidation and Foreign Currency Translation
Foundry’s consolidated financial statements
reflect the operations of Foundry and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated.
Assets and liabilities of foreign operations are translated to U.S. dollars at the exchange rate in effect at the applicable balance sheet date, and
revenues and expenses are translated using average exchange rates prevailing during that period. Translation adjustments have not been material to date
and are included as a component of stockholders’ equity.
Reclassifications
Certain prior period items have been reclassified to
conform to the December 31, 2003 presentation. The Company changed the presentation of revenues and cost of revenues for the year ended December 31,2001 as service revenues exceeded 10% of total revenues for the years ended December 31, 2003 and 2002.
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in
conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying footnotes. Actual results could differ from those estimates. Estimates are used in
accounting for, but are not limited to, allowances for doubtful accounts and sales returns, inventory provisions, product warranty, income taxes and
contingencies. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements
in the period in which they are determined.
Cash Equivalents and Marketable Investments
We consider all investments with original maturities
of 90 days or less to be cash equivalents. Cash and cash equivalents consist of commercial paper, corporate and government debt securities, and cash
deposited in checking and money market accounts. Our investment portfolio includes only marketable securities with original maturities of less than two
years and with secondary or resale markets to ensure portfolio liquidity.
Investments in financial instruments with original
maturities greater than 90 days but less than one year are classified as short-term investments. Investments with maturities greater than one year from
the balance sheet date are classified as long-term investments. All of our investments are stated at amortized cost and classified as
held-to-maturity.
We recognize an allowance for doubtful accounts to
ensure trade receivables are not overstated due to uncollectibility. Accounts receivable are not sold or factored. Exposure to credit risk is
controlled through credit approvals, credit limits, and continuous monitoring procedures. Customers are subject to a credit review process which
evaluates their financial position and ability to pay. Specific allowances for bad debts are recorded when we become aware of a customer’s
inability to meet its financial obligation to us, such as in the case of bankruptcy filings or a significant deterioration in financial position.
Estimates are used in determining allowances for all other customers based on factors such as current economic and industry trends, the extent to which
receivables are past due and historical collection experience. Accounts are deemed past due once they exceed the due date on the invoice. We mitigate
collection risk by requiring certain international customers to secure letters of credit or bank guarantees prior to placing an order with us. If
circumstances change, estimates regarding the collectibility of receivables would be adjusted.
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Inventories
Inventories are stated on a first-in, first-out
basis at the lower of cost or estimated net realizable value, and include purchased parts, labor and manufacturing overhead. Inventories consist of the
following (in thousands):
The networking industry is characterized by rapid
technological change, frequent new product introductions, changes in customer requirements, and evolving industry standards. Our inventory purchases
and commitments are made based on anticipated demand for our products. We perform a detailed assessment of our inventory each period, which includes a
review of, among other factors, demand requirements, manufacturing lead-times, product life cycles and development plans, component cost trends,
product pricing and quality issues. Based on this analysis, we estimate the amount of excess, obsolete and impaired inventory, and provide reserves to
record inventory at its lower of cost or estimated net realizable value. Once inventory has been written down to the lower of cost or estimated net
realizable value, it is reflected on our balance sheet at its new carrying value until it is sold or otherwise disposed of. Revisions to our inventory
reserves may be required if actual factors differ from our estimates.
Inventory provisions of $12.0 million, $16.4
million, and $24.9 million were recorded for the years ended December 31, 2003, 2002, and 2001, respectively. Approximately $4.5 million and $6.1
million of our purchased parts and work-in-process inventories were consigned to contract manufacturers’ sites as of December 31, 2003 and 2002,
respectively.
Concentrations
Financial instruments that potentially subject us to
a concentration of credit risk consist principally of cash equivalents, short and long-term investments and accounts receivable. We seek to reduce
credit risk on financial instruments by investing in high-quality debt issuances and, by policy, limit the amount of credit exposure with any one
issuer or fund. For certain of our financial instruments, including cash, cash equivalents, investments and accounts receivable, accounts payable, and
other accrued liabilities, the carrying amounts approximate fair value due to their short maturities. We estimate fair value based on quoted market
prices using current market rates. Our estimate of fair value may not be representative of values that could have been realized as year end or that
will be realized in the future. As of December 31, 2003, ten customers accounted for 55% of our outstanding trade receivables.
We purchase several key components used in the
manufacture of our products from several sources and depend on supply from these sources to meet our needs. In addition, we depend on several contract
manufacturers for major portions of our manufacturing requirements. The inability of our suppliers or contract manufacturers to fulfill our production
requirements could negatively affect our future results.
Property and Equipment
Property and equipment are stated at cost.
Depreciation expense is computed using the straight-line method over estimated useful lives of the assets. Estimated useful lives of two years are used
for computers and equipment. Estimated useful lives of three years are used for furniture and fixtures. Leasehold improvements are amortized over the
shorter of their estimated useful life or the lease term.
General. We generate the majority of our
revenue from sales of stackable and chassis-based networking equipment, with the remainder of our revenue coming from customer support fees, training
and installation services. We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales
price is fixed or determinable and collectibility is reasonably assured. When sales arrangements contain multiple elements (i.e., hardware, training
and installation), we allocate revenue to each element based on its relative fair value, generally the price charged when the item is sold separately,
and recognize revenue for each element when revenue recognition criteria have been met for that element. This is in accordance with Emerging Issues
Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”), which was effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003. EITF 00-21 addresses certain aspects of accounting by a vendor for
arrangements under which the vendor will perform multiple revenue generating activities. We adopted EITF 00-21 prospectively in the third quarter of
2003, and its adoption did not have a material effect on our results of operations or financial position.
Product. Product revenue is generally
recognized at the time of shipment, unless an acceptance period or other contingency exists, in which case revenue is recognized upon the earlier of
customer acceptance or expiration of the acceptance period, or upon satisfaction of the contingency. Shipping charges billed to customers are included
in product revenue, and the related shipping costs are included in cost of product revenues.
At the time product revenue is recognized, we
estimate the amount of warranty costs to be incurred and record the amount as a cost of revenue. Our standard warranty period extends 12 months from
the date of sale, and our estimate of the amount necessary to settle warranty claims is based primarily on our past experience. We also provide a
provision for estimated customer returns at the time product revenue is recognized. Our provision is based primarily on actual historical sales returns
and our return policies. Our resellers generally do not have a right of return, and our contracts with original equipment manufacturers only provide
for rights of return in the event our products do not meet specifications or there is an epidemic failure, as defined in the
contracts.
Services. Service revenues consist
primarily of revenue from customer support services and, to a lesser extent, training and installation services. Our suite of customer support programs
provides customers with access to technical assistance, software updates and upgrades, hardware repair and replacement parts.
Support services are offered under renewable, annual
fee-based contracts or as part of multiple-element arrangements. Revenue from customer support contracts is deferred and recognized ratably over the
contractual support period, which is generally one to five years.
Revenue from training and installation services is
recognized when services have been performed, and accounted for less than 1% of total revenues for each of the years ended December 31, 2003, 2002, and
2001.
Segment Reporting
Operating segments are defined as components of an
enterprise for which separate financial information is available and is evaluated regularly by the chief operating decision maker, or decision making
group, in deciding
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
how to allocate resources and in assessing performance. We are organized as, and operate in, one reportable segment: the design, development,
manufacturing and marketing of a comprehensive, end-to-end suite of high-performance data networking solutions, including Ethernet Layer 2 and Layer 3
switches, Metro routers and Internet traffic management products.
We sell to customers located in various countries in
North and South America, Europe, Asia, and Australia. Our foreign offices conduct sales, marketing and support activities. We determine revenues by
geographic location based on the physical destination of our product shipments. Our international sales represented 35%, 38%, and 35% of revenues for
the years ended December 31, 2003, 2002, and 2001, respectively. One individual country outside of the United States, Japan, accounted for 13% and 11%
of revenues in 2003 and 2002, respectively. No individual country outside of the United States accounted for greater than 10% of revenues in 2001.
Substantially all of our long-lived assets are located in the United States.
For the year ended December 31, 2003, two customers
accounted for greater than 10% of our revenues. Mitsui, a reseller in Japan, accounted for 12% of revenues in 2003, and a U.S. government integrator
accounted for 11% of revenues in 2003. In 2002, Mitsui accounted for 11% of our revenues. No individual customer accounted for more than 10% of our
revenues in 2001. Sales to the U.S. government represented approximately 31% and 15% of our revenues in 2003 and 2002, respectively, and accounted for
less than 10% of our revenues in 2001.
Advertising Costs
We expense all advertising costs as incurred.
Advertising expenses for the years ended December 31, 2003, 2002 and 2001 were $3.5 million, $3.8 million and $8.3 million,
respectively.
Software Development Costs
We account for internally-generated software
development costs in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed.”
Capitalization of eligible product development costs begins upon the establishment of technological feasibility, which we have defined as completion of
a working model. Internally-generated costs that were eligible for capitalization, after consideration of factors such as realizable value, were not
material and were charged to research and development expense for the years ended December 31, 2003, 2002 and 2001.
Computation of Per Share Amounts
Basic earnings per share (“EPS”) has been
calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted EPS
has been calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase, and
potentially dilutive common stock equivalents. Weighted-average dilutive common stock equivalents include the potentially dilutive effect of
in-the-money stock options, determined based on the average share price for each period using the treasury stock method. Under the treasury stock
method, the tax-effected proceeds that would be received assuming the exercise of all in-the-money stock options are assumed to be used to repurchase
shares in the open market. Certain common stock equivalents were excluded from the calculation of diluted EPS because the exercise price of these
common stock equivalents was greater than the average market price of the common stock for the respective period and, therefore, their inclusion would
have been anti-dilutive. Anti-dilutive common stock equivalents for the years ended December 31, 2003, 2002, and 2001, were 1.9 million, 15.7 million,
and 10.4 million, respectively.
Less:
Weighted average shares subject to repurchase
—
(379
)
(1,971
)
Weighted
average shares used in computing basic EPS
$
125,133
$
119,482
$
117,360
Basic
EPS
$
0.60
$
0.19
$
0.02
Diluted:
Weighted
average shares outstanding
$
125,133
$
119,861
$
119,331
Add: Weighted
average dilutive potential shares
10,498
3,919
6,190
Weighted
average shares used in computing diluted EPS
$
135,631
$
123,780
$
125,521
Diluted
EPS
$
0.55
$
0.18
$
0.02
Accounting for Stock-Based Compensation
As permitted by Statement of Financial Accounting
Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), we have elected to follow the intrinsic value method of
accounting for employee stock options as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
Employees.” Accordingly, we only recognize compensation expense when options are granted with an exercise price below fair market value at the
date of grant. Any resulting compensation expense is recognized ratably over the vesting period.
We currently grant stock options under several stock
option plans that allow for the granting of non-qualified and incentive stock options to our employees, directors and consultants. Stock options
generally vest ratably over three to five years from the date of grant and have a term of ten years. We also have an employee stock purchase plan that
allows eligible employees to purchase shares of our common stock at 85% of the lower of the fair market value of the common stock at the beginning of
each offering period or at the end of each purchase period through payroll deductions that may not exceed 20% of an employee’s
compensation.
The following table illustrates the effect on
reported net income and earnings per share as if we had accounted for our employee stock options and employee stock purchase plan under the fair value
method prescribed by SFAS 123.
The weighted average fair value of stock options
granted under all plans during 2003, 2002, and 2001 was $6.15, $3.41, and $8.61 per share, respectively. We estimate the fair value of our stock
options using the Black-Scholes option valuation model, which is the most commonly used model for purposes of disclosure pursuant to SFAS 123, as
amended by SFAS 148. However, the Black-Scholes model was developed for use in estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. The Black-Scholes model requires the input of highly-subjective assumptions, including expected stock price
volatility. Because our employee stock options have characteristics significantly different than those of traded shares, and because the changes in the
assumptions can materially affect fair value estimates, in management’s opinion, the Black-Scholes model does not provide a reliable measure of
the fair value of our options. The following weighted-average assumptions were used to estimate the fair value of employee stock options
granted:
Stock Option Plan
Employee Stock Purchase Plan
2003
2002
2001
2003
2002
2001
Average risk
free interest rate
2.16
%
3.15
%
3.84
%
1.88
%
2.23
%
3.36
%
Average
expected life of the options
3.8
years
3.6
years
4
years
2.0
years
0.5
years
1.3
years
Dividend
yield
0
%
0
%
0
%
0
%
0
%
0
%
Volatility of
common stock
75.0
%
75.0
%
111.0
%
73.7
%
81.1
%
111.0
%
Recent Accounting Pronouncements
More-Than Incidental
Software
On July 31, 2003, the EITF reached a consensus on
its tentative conclusions on Issue No. 03-5, “Applicability of AICPA Statement of Position 97-2, ”Software Revenue Recognition,“ to
Non-Software Deliverables in an Arrangement Containing More-Than Incidental Software”. EITF 03-5 discusses that software deliverables are within
the scope of SOP 97-2 as are non-software deliverables for which the related software is essential to the functionality of the non-software
deliverables. EITF 03-5 is effective for fiscal periods beginning after August 2003. The adoption of EITF 03-5 did not have a material effect on our
financial position, results of operations or liquidity.
Consolidation of Variable Interest
Entities
In January 2003, the FASB issued Financial
Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). FIN 46 addresses
consolidation by business enterprises of variable interest entities (“VIEs”) that do not have sufficient equity investment at risk to permit
the entity to finance its activities without additional subordinated financial support, or in which the equity investors lack an essential
characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46
(“Revised Interpretation”) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created
after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation or the Revised Interpretation.
However, the Revised Interpretation must be applied no later than December 31, 2003. VIEs created after January 1, 2004 must be accounted for under the
Revised Interpretation. Special Purpose Entities (“SPEs”) created prior to February 1, 2003 may be accounted for under the original or
revised interpretation’s provisions no later than our first quarter of fiscal 2004. Non-SPEs created prior to February 1, 2003, should be
accounted for under the revised interpretation’s provisions no later than our first quarter of fiscal 2004. We do not currently have any
arrangements with variable interest entities that will require consolidation of their financial information in our financial
statements.
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
2. COMMITMENTS AND CONTINGENCIES:
Guarantees and Product Warranties
FASB Interpretation No. 45, “Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), requires
that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that
guarantee. The initial recognition and measurement provisions of FIN 45 apply on a prospective basis to guarantees issued or modified after December31, 2002 and are applicable to our product warranty liability and to indemnification obligations contained in commercial agreements, including
customary intellectual property indemnifications for our products contained in agreements with our resellers and end-users. Our adoption of FIN 45 did
not have a material effect on our results of operations or financial position.
We provide all customers with a standard one-year
hardware and 90-day software warranty. Customers can upgrade the standard warranty and extend the warranty for one-to-five years by purchasing one of
our customer support programs. At the time product revenue is recognized, we establish an accrual for estimated warranty expenses and record the amount
as a component of cost of revenues. Our warranty accrual represents our best estimate of the amount necessary to settle future and existing claims as
of the balance sheet date. We periodically assess the adequacy of our warranty accrual and adjust the amount as considered necessary.
Changes in our product warranty liability for the
year ended December 31, 2003 were as follows:
We offer our customers renewable support
arrangements, including extended warranties, that generally range from one to five years. We do not separate extended warranty revenues from routine
support service revenues, as it is not practical to do so. The change in our deferred support revenue balance was as follows for the year ended
December 31, 2003:
In the ordinary course of business, we enter into
contractual arrangements under which we may agree to indemnify the counter-party to such an arrangement from any losses relating to a breach of
representations and warranties, a failure to perform certain covenants, or claims and losses arising from certain external events as outlined within
the particular contract, which may include, for example, losses arising from litigation or claims relating to past performance. Such indemnification
clauses may not be subject to maximum loss clauses. No amounts are reflected in our financial statements as of December 31, 2003 related to these
indemnifications as, historically, payments made related to these indemnifications have not been material to our financial position or results of
operations.
Leases
We lease our facilities and office buildings under
operating leases that expire at various dates through April 2011. Most of our leases contain renewal options. Rent expense under operating leases was
$5.3 million, $5.3 million, and $7.6 million for the years ended December 31, 2003, 2002, and 2001, respectively. At December 31,
We use contract manufacturers to assemble and test
our products. In order to reduce manufacturing lead-times and ensure adequate inventories, our agreements with some of these contract manufacturers
allow them to procure long lead-time component inventory on our behalf based on a rolling production forecast provided by us. We may be contractually
obligated to purchase long lead-time component inventory procured by certain contract manufacturers in accordance with our forecast, unless we give
notice of order cancellation at least 90 days prior to the delivery date. As of December 31, 2003, we were committed to purchase approximately $50.1
million of such inventory.
Litigation
In December 2000, several similar shareholder class
action lawsuits were filed against us and certain of our officers in the United States District Court for the Northern District of California,
following our announcement of our anticipated financial results for the fourth quarter ended December 31, 2000. The lawsuits were subsequently
consolidated as a class action by the District Court, under the caption In re Foundry Networks, Inc. Securities Litigation, Master File No.
C-00-4823-MMC, lead plaintiffs were selected and filed a consolidated amended complaint which alleged violations of federal securities laws and
purported to seek damages on behalf of a class of shareholders who purchased our common stock during the period from September 7, 2000 to December 19,2000. We then brought four successful motions to dismiss the complaint. Although the District Court granted each of the four dismissal motions, it also
provided plaintiffs leave to amend the complaint. On August 29, 2003, following the dismissal of the four amended complaints, the District Court
granted our motion to dismiss the case with prejudice and without leave to amend and, on September 2, 2003, entered judgment in our favor, dismissing
the plaintiff’s fifth amended complaint. On September 29, 2003, plaintiff filed a Notice of Appeal with the United States Court of Appeals for the
Ninth Circuit (“Court of Appeals”). On January 15, 2004, the plaintiff/appellants filed their opening brief with the Court of Appeals. We
have reviewed the appeal and are in the process of preparing our response. We believe the District Court’s judgment validates our conviction that
the lawsuit is without merit and we will defend the District Court’s judgment vigorously.
A class action lawsuit was filed on November 27,2001 in the United States District Court for the Southern District of New York on behalf of purchasers of our common stock alleging violations of
federal securities laws. The case was designated as In re Foundry Networks, Inc. Initial Public Offering Securities Litigation, No. 01-CV-10640
(SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, No. 21 MC 92 (SAS) (S.D.N.Y.). The case is brought purportedly
on behalf of all persons who purchased our common stock from September 27, 1999 through December 6, 2000. The operative amended complaint names as
defendants us and three of our officers (the “Foundry Defendants”), including our Chief Executive Officer and Chief Financial Officer; and
investment banking firms that served as underwriters for our initial public offering in September 1999. The amended complaint alleged violations of
Sections 11 and 15 of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934, on the grounds that the registration
statement for the initial public offering
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
(“ IPO”) failed to disclose that (i) the underwriters agreed to allow certain customers to purchase shares in the IPO in exchange for excess
commissions to be paid to the underwriters, and (ii) the underwriters arranged for certain customers to purchase additional shares in the aftermarket
at predetermined prices. The amended complaint also appears to allege that false or misleading analyst reports were issued. Similar allegations were
made in lawsuits challenging over 300 other initial public offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes. On
February 19, 2003, the Court ruled on all defendants’ motions to dismiss. In ruling on motions to dismiss, the Court must treat the allegations in
the complaint as if they were true solely for purposes of deciding the motions. The motion was denied as to claims under the Securities Act of 1933 in
the case involving us. The same ruling was made in all but 10 of the other cases. The Court dismissed the claims under Section 10(b) of the Securities
Exchange Act of 1934, against us and one of the individual defendants and dismissed all of the Section 20(a) “control person” claims. The
Court denied the motion to dismiss the Section 10(b) claims against our remaining individual defendants on the basis that those defendants allegedly
sold our stock following the IPO, allegations found sufficient purely for pleading purposes to allow those claims to move forward. A similar ruling was
made with respect to 62 of the individual defendants in the other cases. We have accepted a settlement proposal presented to all issuer defendants.
Under the terms of this settlement, plaintiffs will dismiss and release all claims against the Foundry Defendants in exchange for a contingent payment
by the insurance companies collectively responsible for insuring the issuers in all of the IPO cases and for the assignment or surrender of control of
certain claims we may have against the underwriters. The settlement, which is still being finalized, will require approval of the Court, which cannot
be assured, after class members are given the opportunity to object to the settlement or opt out of the settlement.
In March 2001, Nortel Networks Corp.
(“Nortel”) filed a lawsuit against us in the United States District Court for the District of Massachusetts alleging that certain of our
products infringe several of Nortel’s patents and seeking injunctive relief and unspecified damages. Nortel has also brought suit, on the same or
similar patents, against a number of other networking companies. We have analyzed the validity of Nortel’s claims and believe that Nortel’s
suit is without merit. We are committed to vigorously defending ourself against these claims. On October 9, 2002, we filed a lawsuit against Nortel in
the United States District Court, Northern District of California alleging that certain of Nortel’s products infringe one of our patents and
alleging breach of contract by Nortel. We are seeking injunctive relief and damages.
In May 2003, Lucent Technologies Inc.
(“Lucent”) filed a lawsuit against us in the United States District Court for the District of Delaware alleging that certain of our products
infringe several of Lucent’s patents, and seeking injunctive relief, as well as unspecified damages. Lucent also brought suit on the same patents
(and one additional patent) against one of our competitors. On August 12, 2003, we filed a motion to sever the cases, and on February 6, 2004, the
District Court granted the motion. The parties are in the process of rescheduling the court dates in view the District Court’s order to sever the
cases. We have analyzed the validity of Lucent’s claims and believe that Lucent’s suit is without merit. We are committed to vigorously
defending ourself against Lucent’s claims.
On February 13, 2004, we filed a lawsuit against
Lucent in the United States District Court, Eastern District of Texas, Marshall Division. The lawsuit alleges that certain of Lucent’s products
infringe one of our patents. We are seeking injunctive relief and damages.
From time to time, we are subject to other legal
proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks, copyrights, patents and other
intellectual property rights. In addition, from time to time, third parties assert patent infringement claims against us in the form of letters,
lawsuits and other forms of communication. Regardless of the merits of our position, litigation is always an expensive and uncertain proposition. In
accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”), we record a liability when it is both probable that a
liability has been incurred and the amount of the loss can be reasonably estimated. Any such provision would be adjusted on a quarterly basis to
reflect the effect of ongoing negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular
case. To date, we have not recorded any such provisions in accordance with SFAS 5. We believe we have valid defenses
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
with respect to
the legal matters pending against us. In the event of a determination adverse to us, we
could incur substantial monetary liability, and be required to change our business
practices. Any unfavorable determination could have a material adverse effect on our
financial position, results of operations, or cash flows.
3. INCOME TAXES:
We account for income taxes pursuant to SFAS No.
109, “Accounting for Income Taxes” (SFAS 109). SFAS 109 provides for an asset and liability approach to accounting for income taxes, under
which deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their respective tax bases, and to tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled.
Components of our deferred tax assets were as follows (in thousands):
We believe that we will likely generate sufficient
taxable income in future periods to realize the tax benefits arising from our existing deferred tax assets. In 2003, we recorded a valuation allowance
of approximately $1.0 million against a deferred tax asset associated with a capital loss carryover, as we do not believe we can generate significant
capital gains from our investments to utilize the capital loss carryover before its statutory expiration in 2007.
As of December 31, 2003, we had a federal research
and development tax credit carryforward of approximately $5.7 million, which will expire beginning in 2021. We also had state research and development
tax credit carryforwards of approximately $5.9 million. Of this amount, $5.5 million can be carried forward indefinitely and $0.4 million will expire
beginning in 2009.
Our provision for income taxes and the corresponding
rate differs from the statutory U.S. federal income tax rate as follows for the years ended December 31 (in thousands):
2003
2002
2001
Provision at
U.S. statutory rate 35%
$
41,029
35.0
%
$
11,269
35.0
%
$
1,629
35.0
%
State income
taxes, net of federal benefit
6,044
5.2
%
1,657
5.1
%
(211
)
(4.5
)%
Research and
development credits
(2,118
)
(1.8
)%
(1,895
)
(5.9
)%
(1,254
)
(26.9
)%
Nondeductible
deferred stock compensation
92
0.0
%
424
1.3
%
1,176
25.3
%
Export sales
incentive
(1,884
)
(1.6
)%
(620
)
(1.9
)%
(241
)
(5.2
)%
Tax-exempt
interest
(616
)
(0.5
)%
(1,126
)
(3.5
)%
(1,235
)
(26.5
)%
Valuation
allowance
1,003
0.9
%
—
—
—
—
Other
(1,407
)
(1.2
)%
(50
)
(0.1
%)
1,905
40.8
%
Total
$
42,143
36.0
%
$
9,659
30.0
%
$
1,769
38.0
%
Our income taxes payable for federal and state
purposes have been reduced by the tax benefits associated with taxable dispositions of employee stock options. When an employee exercises a stock
option issued under a nonqualified plan, or has a disqualifying disposition related to a qualified plan, we receive an income tax benefit for the
difference between the fair market value of the stock issued at the time of the exercise and the employee’s option price, tax effected. These
benefits are credited directly to stockholders’ equity and amounted to $46.5 million, $4.8 million, and $10.5 million for the years ended December31, 2003, 2002, and 2001, respectively.
4. STOCKHOLDERS’ EQUITY:
Preferred Stock
We are authorized to issue up to 5,000,000 shares of
preferred stock, with a par value of $0.0001 per share. Preferred stock may be issued from time-to-time in one or more series. Our board of directors
is authorized to determine the rights, preferences, privileges and restrictions on these shares. As of December 31, 2003 and 2002, no shares of
preferred stock were outstanding.
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
Stock Option Exchange Program
On August 21, 2002, we filed a Tender Offer
Statement on Schedule TO with the Securities and Exchange Commission related to a voluntary stock option exchange program for our employees. Our
executive officers and directors were not eligible to participate in this program. Under the exchange program, employees were given the opportunity to
voluntarily cancel unexercised vested and unvested stock options previously granted to them in exchange for a stock option grant on or about March 21,2003 equal to one-half the number of tendered options. However, participants who elected to exchange options were also required to exchange other
options granted to them in the previous six months. On September 20, 2002, we accepted for exchange options to purchase 5,744,500 shares of our common
stock. The cancelled options were exchanged for 2,757,100 replacement stock options on March 24, 2003 at an exercise price of $7.76 per share, which
was the fair value of the shares on the grant date. In order to receive the replacement stock option grant, an employee was required to remain employed
with us or one of our subsidiaries until March 24, 2003. The replacement options vest on a three-year schedule with a six month cliff, meaning 1/6th of
the new option shares vest six months from March 24, 2003, and the remaining shares vest 1/36th per month for the remaining 30 months. The stock option
exchange program did not result in stock compensation expense or variable accounting for replacement awards.
Note Receivable from Stockholder
In May 2000, we allowed an employee to exercise
stock options in exchange for a secured promissory note of $3.3 million. In December 2001, we wrote down the note by $2.8 million to reflect the
adverse effect of the significant decline in our stock price on the employee’s ability to sell the vested stock options at a price at or above the
exercise price, as well as general concerns over the collectibility of the note. We determined the fair value of the note to be $480,000 based on the
fair market value of our stock in December 2001. Accordingly, we recorded compensation expense of $2.8 million associated with the write-down. At
December 31, 2003, this note was past due, but we expect to collect $480,000 in the near future and forgive the remainder of the note, which was
written down in 2001. The note is classified as a reduction of stockholders’ equity.
Common Stock
We had 131,622,730 and 121,328,862 shares of common
stock issued and outstanding at December 31, 2003 and 2002, respectively.
The following shares of common stock have been
reserved for future issuance as of December 31, 2003:
1996 Stock
Plan
25,509,700
1999
Directors’ Stock Option Plan
3,280,000
1999 Employee
Stock Purchase Plan
5,312,918
2000
Non-Executive Stock Option Plan
2,872,873
36,975,491
1996 Stock Plan
Under our 1996 Stock Plan (the Plan), the board of
directors authorized the issuance of 68,235,683 shares of common stock to employees and consultants as of December 31, 2003, of which 25,509,700 shares
are available for future issuance. Nonstatutory options granted under the Plan must be issued at a price equal to at least 85% of the fair market value
of our common stock on the date of grant. Incentive stock options granted under the Plan must be issued at a price at least equal to the fair market
value of our common stock on the date of grant. In 2003 and 2002, all option grants under the Plan were granted at a price equal to the fair market
value of our common stock on the date of grant. Options under the Plan have a term of ten years and vest over a vesting schedule determined by the
board of directors, generally three to five years. The number of shares available for issuance under the Plan will be increased on the first day of
each fiscal year through 2006 by the lesser of (i) 5,000,000
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
shares; (ii)
five percent (5%) of the shares outstanding on the last day of the immediately preceding
fiscal year; or (iii) such lesser amount of shares as determined by the Board of
Directors.
1999 Directors’ Stock Option Plan
Under the Directors’ Plan, each non-employee
director who becomes a non-employee director after the effective date of the plan will receive an automatic initial grant of an option to purchase
225,000 shares of common stock upon appointment or election, and annual grants to purchase 60,000 shares of common stock. Options granted under the
plan will vest at the rate of 1/4th of the total number of shares subject to the options twelve months after the date of grant and 1/48th of the total
number of shares subject to the options each month thereafter. The exercise price of all stock options granted under the Directors’ Plan shall be
equal to the fair market value of a share of common stock on the date of grant of the option. Options granted under this plan have a term of ten years.
In June 2003, our four non-employee directors received annual grants totaling 240,000 stock options at an exercise price of $14.67 per share. As of
December 31, 2003, 1,610,000 options were outstanding with a weighted-average exercise price of $39.90 per share.
2000 Non-Executive Stock Option Plan
Under the Non-Executive Plan, we may issue
non-qualified options to purchase common stock to employees and external consultants other than officers and directors. As of December 31, 2003,
1,503,287 shares were outstanding with a weighted average exercise price of $11.10 per share.
The following table summarizes stock option activity
under all stock option plans during the three years ended December 31, 2003:
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
The following table presents information about stock
options outstanding and exercisable at December 31, 2003:
Stock Options Outstanding
Stock Options Exercisable
Range of Exercise Prices
Shares
Outstanding
Weighted-
Average
Remaining
Contractual
Life (years)
Weighted-
Average
Exercise
Price $
Shares
Exercisable
Weighted-
Average
Exercise
Price $
$0.03–$6.14
7,235,678
7.16
4.80
4,306,986
4.14
$6.30–$7.76
7,194,323
8.70
7.35
2,218,688
7.28
$7.94–$13.35
6,134,330
7.94
9.87
3,341,024
10.94
$14.27–$27.33
4,064,928
9.32
17.35
362,732
19.23
$36.88–$128.00
1,887,300
6.59
66.20
1,652,803
66.11
Total
26,516,559
8.05
12.96
11,882,233
15.72
As of December 31, 2002, there were 14,436,869
options exercisable at a weighted average exercise price of $13.39 per share.
1999 Employee Stock Purchase Plan
Under the 1999 Employee Stock Purchase Plan (the
Purchase Plan), a total of 5,312,918 shares of common stock were reserved for issuance as of December 31, 2003. The number of shares reserved for
issuance under the Purchase Plan will be increased on the first day of each fiscal year through 2009 by the lesser of (i) 1,500,000 shares, (ii) 2% of
our outstanding common stock on the last day of the immediately preceding fiscal year or (iii) the number of shares determined by the board of
directors.
The Purchase Plan allows eligible employees to
purchase common stock through payroll deductions, which cannot exceed 20% of an employee’s compensation, at a price equal to the lower of 85% of
the fair market value of our common stock at the beginning of each offering period or at the end of each purchase period. During the two purchase
periods in 2003, a total of 817,921 shares were issued under the Purchase Plan at an average price of $6.18 per share.
Deferred Stock Compensation
In connection with the grant of stock options to
employees and a director, we recorded deferred stock compensation in the aggregate amount of $17.3 million in 1999, and $0.3 million in 2000,
representing the difference between the exercise price of the option and the deemed fair market value of our common stock on the date these stock
options were granted. We have not recorded additional deferred stock compensation since 2000. Deferred stock compensation was reflected within
stockholders’ equity and was amortized to expense over the respective vesting periods of the options. For the years ended December 31, 2003, 2002
and 2001, amortization expense was approximately $231,000, $1.1 million and $2.7 million, respectively. Amortization expense relates to options granted
to employees in all operating expense categories, but has not been separately allocated to these categories. Approximately $1.6 million of deferred
stock compensation expense was reversed in 2001 as a result of employee terminations. No such reversals were recorded during 2003 and 2002. We have no
remaining deferred stock compensation at December 31, 2003.
5. MINORITY INVESTMENT:
In February 2001, we made a $2.5 million minority
investment in a privately-held development stage company, who was also a customer. We made no sales to this customer in 2003 or 2002, and sales to this
customer in 2001 were insignificant. Our interest in the investee is significantly less than 20% and, as such, we do not have the ability to exercise
significant influence. In December 2001, we determined that our investment’s decline in fair value was other than temporary based on a number of
factors, including the value of the investee’s most recent round of
FOUNDRY NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
financing,
general market and industry conditions and the financial condition of and business
outlook for the investee. Accordingly, we wrote off the entire minority investment and
recorded an expense of $2.5 million in 2001.
6. 401(k) PLAN:
We provide a tax-qualified employee savings and
retirement plan that entitles eligible employees to make tax-deferred contributions. Under the 401(k) Plan (“the Plan”), employees may elect
to reduce their current annual compensation up to the lesser of 20% or the statutorily prescribed limit, which was $12,000 in calendar year 2003.
Employees age 50 or over may elect to contribute an additional $1,000. The Plan provides for discretionary contributions as determined by our board of
directors each year. In January 2003, the board of directors approved a matching contribution program whereby we will match dollar for dollar
contributed by each employee up to $1,250 per year for each employee. Our matching contributions to the Plan totaled $474,000 in 2003.
The following tables set forth our consolidated
statement of operations data for each of the eight quarters ended December 31, 2003, including such amounts expressed as a percentage of net revenues.
This unaudited quarterly information has been prepared on the same basis as our audited financial statements and, in the opinion of management,
reflects all adjustments, consisting only of normal recurring entries, necessary for a fair presentation of the information for the periods presented.
The operating results for any quarter are not necessarily indicative of results for any future period.
Deductions for allowance for doubtful accounts refer to
write-offs and deductions for allowance for sales returns refer to actual returns.
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
On June 24, 2002, the Company’s Board of
Directors, upon the recommendation of the audit committee, authorized the termination of Arthur Andersen LLP (“AA”) and the engagement of
Ernst & Young LLP.
During the years ended December 31, 2001 and 2000
and the subsequent interim period through June 24, 2002, there were no disagreements between the Company and AA on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to AA’s satisfaction, would
have caused AA to make reference to the subject matter of the disagreement in connection with its reports; and there were no reportable events
described under Item 304(a)(1)(v) of Regulation S-K.
The audit reports of AA on the consolidated
financial statements of the Company as of and for the years ended December 31, 2001 and 2000 did not contain any adverse opinion or disclaimer or
opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.
During the years ended December 31, 2001 and 2000
and the subsequent interim period through June 24, 2002, the Company did not consult with Ernst &Young LLP with respect to the application of
accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our consolidated
financial statements, or any other matter or reportable events as set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.
The Company provided a copy of the above disclosures
to AA. Exhibit 16.1 is a copy of AA’s letter dated June 25, 2002, stating its agreement with the above statements.
Item 9A. Controls and Procedures
We evaluated the design and operation of our
disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is made in
accordance with the Exchange Act and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision, and
with the participation of, management, including our principal executive officer and principal financial officer, as of the end of the period covered
by this Annual Report on Form 10-K. Our principal executive officer and principal financial officer have concluded, based on their review, that our
disclosure controls and procedures, including those of our consolidated subsidiaries, are effective to ensure that information required to be disclosed
by us in reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities
and Exchange Commission rules and forms. 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.
Item 10. Directors and Executive Officers of the Registrant
Certain information concerning our directors and
executive officers required by this Item is incorporated by reference from the information contained under the caption “Executive Officers and
Directors,” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Proxy Statement for its 2004 Annual
Meeting of Stockholders.
Certain information concerning our Audit Committee,
Audit Committee Financial Expert(s) and Code of Ethics is incorporated by reference from information contained in the Company’s Proxy Statement
for its 2004 Annual Meeting of Stockholders.
Item 11. Executive Compensation
Incorporated by reference from the information under
the captions “Proposal No. 1—Election of Directors,”“Compensation of Executive Officers,”“Option Grants in Last Fiscal
Year,”“Aggregated Option Exercise in Last Fiscal Year and Fiscal Year-End Option Values,”“Change of Control Agreements with Named
Executive Officers,”“Compensation Committee Report on Executive Compensation,” and “Transactions with Management,” and
“Performance Graph” in the Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
Incorporated by reference from the information under
the captions “Record Date; Voting Securities,”“Common Stock Ownership of Certain Beneficial Owners and Management,”“Change
of Control Agreements with Named Executive Officers,” and “Equity Compensation Plan Information” in the Proxy
Statement.
Item 13. Certain Relationships and Related Transactions
Incorporated by reference from the information under
the caption “Transactions with Management” in the Proxy Statement.
Item 14. Principal Auditor Fees and Services
Incorporated by reference from the information under
the caption “Principal Auditor Fees and Services” in the Proxy Statement.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form
8-K
(a)
The following documents are filed as part of this Form
10-K:
(1)
Consolidated Financial Statements and Report of Independent
Auditors and Public Accountants
(2)
Financial Statement Schedules
See “Item 8. Financial Statements, Quarterly
Summary, and Schedule II—Valuation and Qualifying Accounts.” Other schedules are omitted because they are not applicable, or because the
information is included in the Financial Statements or the Notes thereto.
(3)
Exhibits (numbered in accordance with Item 601 of Regulation
S-K)
OEM
Purchase Agreement dated January 6, 1999 between Foundry Networks, Inc. and Hewlett-Packard Company, Workgroup Networks Division. (4)
10.6
Reseller Agreement dated July 1, 1997 between Foundry Networks, Inc. and Mitsui & Co., Ltd. (4)
10.7
2000
Non-Executive Stock Option Plan. (5)
10.11
Lease agreement dated September 28, 1999, between Foundry Networks, Inc., and Legacy Partners Commercial Inc., for offices located at 2100
Gold Street, San Jose, CA95002. (6)
Copy of original 1996 Stock Plan incorporated herein by
reference to the exhibit filed with the Company’s Registration Statement on Form S-1 (Commission File No. 333-82577). Copy of 1996 Stock Plan
reflecting the amendments approved at the 2000 Annual Meeting of Stockholders incorporated by reference to the Company’s Definitive Proxy
Statement for such meeting (Commission File No. 000-26689). Copy of 1996 Stock Plan reflecting the amendments for approval at the 2002 Annual Meeting
of Stockholders incorporated by reference to the Company’s Definitive Proxy Statement for such meeting (Commission File No.
000-26689).
Incorporated herein by reference to the exhibit filed with the
Company’s Registration Statement on Form S-1 (Commission File No. 333-82577). Copy of Directors’ Plan reflecting the amendment for approval
at the 2002 Annual Meeting of Stockholders incorporated by reference to the Company’s Definitive Proxy Statement for such meeting (Commission File
No. 000-26689).
(4)
Incorporated herein by reference to the exhibit filed with the
Company’s Registration Statement on Form S-1 (Commission File No. 333-82577); Confidential treatment has been granted by the Securities and
Exchange Commission with respect to this exhibit.
The Registrant furnished a Current Report on Form
8-K dated October 22, 2003 to report the announcement of our financial results for the three month period ended September 30, 2003, pursuant to Item 12
of Form 8-K.
SIGNATURES
Pursuant to the requirements of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.
FOUNDRY NETWORKS,
INC. (Registrant)
By:
/s/ TIMOTHY D.
HEFFNER Timothy D. Heffner
Vice President, Finance
& Administration, Chief Financial Officer (Principal Financial and Accounting Officer)
KNOW ALL PERSONS BY THESE PRESENTS, that each person
whose signature appears below constitutes and appoints Bobby R. Johnson Jr. and Timothy D. Heffner, jointly and severally, his attorneys-in-fact, each
with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same,
with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact, or his substitute or substitutes may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates
indicated.
Signature
Title
Date
/s/
BOBBY R. JOHNSON, JR.(Bobby R. Johnson,
Jr.)
President, Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)
