-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HFb+fFR+qTYTSbkT3uAUz2/ukbGcbstIqHM08z4YzWNJhSyyqbjQG7rglmhicTOI cfdL2KHFGOpAbbqaJOtK5A== 0000927016-02-003167.txt : 20020610 0000927016-02-003167.hdr.sgml : 20020610 20020607122521 ACCESSION NUMBER: 0000927016-02-003167 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20020427 FILED AS OF DATE: 20020607 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SYCAMORE NETWORKS INC CENTRAL INDEX KEY: 0001092367 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661] IRS NUMBER: 043410558 STATE OF INCORPORATION: DE FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27273 FILM NUMBER: 02673251 BUSINESS ADDRESS: STREET 1: 150 APOLLO DRIVE CITY: CHELMSFORD STATE: MA ZIP: 01824 BUSINESS PHONE: 9782502900 MAIL ADDRESS: STREET 1: 150 APOLLO DRIVE CITY: CHELMSORD STATE: MA ZIP: 01824 10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED APRIL 27, 2002 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____ COMMISSION FILE NUMBER 000-27273 SYCAMORE NETWORKS, INC. (Exact name of registrant as specified in its charter) Delaware 04-3410558 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 150 Apollo Drive Chelmsford, MA 01824 (Address of principal executive offices) (Zip code) (978) 250-2900 (Registrant's telephone number, including area code) NONE (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) Yes X No ___, and (2) has been subject to such filing requirements for the past 90 days. Yes X No___ . The number of shares outstanding of the Registrant's Common Stock as of May 31, 2002 was 273,680,683. 1 Sycamore Networks, Inc.
Index - ----- Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheets as of April 27, 2002 and July 31, 2001 3 Consolidated Statements of Operations for the three and nine months ended April 27, 2002 and April 28, 2001 4 Consolidated Statements of Cash Flows for the nine months ended April 27, 2002 and April 28, 2001 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Item 3. Quantitative and Qualitative Disclosure About Market Risk 31 Part II. Other Information Item 1. Legal Proceedings 31 Item 6. Exhibits and Reports on Form 8-K 32 Signature 33 Exhibit Index 34
2 Part I. Financial Information ITEM 1. FINANCIAL STATEMENTS SYCAMORE NETWORKS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PAR VALUE)
April 27, July 31, 2002 2001 ---- ---- Assets Current assets: Cash and cash equivalents $ 262,318 $ 492,500 Short-term investments 588,755 332,471 Accounts receivable, net of allowance for doubtful accounts of $5,185 and $4,773 at April 27, 2002 and July 31, 2001, respectively 24,649 41,477 Inventories 15,077 66,939 Prepaids and other current assets 8,632 13,739 ----------- ----------- Total current assets 899,431 947,126 ----------- ----------- Property and equipment, net 59,266 106,625 Long-term investments 206,097 423,578 Other assets 13,380 73,992 ----------- ----------- Total assets $ 1,178,174 $ 1,551,321 =========== =========== Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 12,849 $ 62,513 Accrued expenses 19,779 25,199 Accrued restructuring costs 31,649 61,003 Deferred revenue 7,041 6,607 Other current liabilities 5,186 8,139 ----------- ----------- Total current liabilities 76,504 163,461 ----------- ----------- Stockholders' equity: Preferred stock, $.01 par value, 5,000 shares authorized; none issued or outstanding -- -- Common stock, $.001 par value; 2,500,000 shares authorized; 273,681 shares issued and outstanding at April 27, 2002 and July 31, 2001, respectively 274 274 Additional paid-in capital 1,736,084 1,738,505 Accumulated deficit (607,556) (301,429) Deferred compensation (29,195) (54,110) Treasury stock, at cost, 2,077 and 680 shares held at April 27, 2002 and July 31, 2001, respectively (219) (126) Accumulated other comprehensive income 2,282 4,746 ----------- ----------- Total stockholders' equity 1,101,670 1,387,860 ----------- ----------- Total liabilities and stockholders' equity $ 1,178,174 $ 1,551,321 =========== ===========
The accompanying notes are an integral part of the consolidated financial statements. 3 SYCAMORE NETWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months Ended Nine Months Ended ------------------ ----------------- April 27, April 28, April 27, April 28, 2002 2001 2002 2001 ---- ---- ---- ---- Revenue ................................................................. $ 13,582 $ 54,203 $ 56,625 $ 323,894 Cost of revenue (exclusive of non-cash stock compensation expense of $440, $480, $1,393 and $2,611) ............................... 3,052 132,254 145,069 275,504 --------- --------- --------- --------- Gross profit (loss) ..................................................... 10,530 (78,051) (88,444) 48,390 Operating expenses: Research and development (exclusive of non-cash stock compensation expense of $2,395, $2,894, $7,460 and $31,186) ...................................................... 25,541 44,407 88,041 122,400 Sales and marketing (exclusive of non-cash stock compensation expense of $2,205, $2,495, $8,771 and $19,732) ...................................................... 8,870 22,213 33,953 61,483 General and administrative (exclusive of non-cash stock compensation expense of $501, $1,461, $1,778 and $3,014) ....................................................... 2,186 4,419 7,990 13,038 Amortization of stock compensation ................................... 5,541 7,330 19,402 56,543 Restructuring charges and related asset impairments .................. -- 81,926 77,306 81,926 Acquisition costs .................................................... -- -- -- 4,948 --------- --------- --------- --------- Total operating expenses ........................................ 42,138 160,295 226,692 340,338 --------- --------- --------- --------- Loss from operations ................................................... (31,608) (238,346) (315,136) (291,948) Losses on investments .................................................. -- -- (22,737) -- Interest and other income, net ......................................... 8,765 18,940 31,746 67,564 --------- --------- --------- --------- Loss before income taxes ............................................... (22,843) (219,406) (306,127) (224,384) Provision for income taxes ............................................. -- 5,703 -- 13,132 --------- --------- --------- --------- Net loss ............................................................... $ (22,843) $(225,109) $(306,127) $(237,516) ========= ========= ========= ========= Basic and diluted net loss per share .................................... $ (0.09) $ (0.94) $ (1.21) $ (1.01) Shares used in per share calculation - basic and diluted ................ 256,468 240,492 252,877 235,483
The accompanying notes are an integral part of the consolidated financial statements. 4 SYCAMORE NETWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Nine months ended ----------------- April 27, April 28, 2002 2001 ---- ---- Cash flows from operating activities: Net loss $(306,127) $(237,516) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 32,440 24,715 Restructuring charges and related asset impairments 134,022 52,476 Amortization of stock compensation 19,402 56,543 Changes in operating assets and liabilities: Accounts receivable 16,828 (2,732) Inventories 1,344 (40,589) Prepaids and other current assets 5,107 10,299 Deferred revenue 434 (13,583) Accounts payable (49,664) 23,603 Accrued expenses and other liabilities (8,373) 12,682 Accrued restructuring costs (29,354) 78,166 --------- --------- Net cash used in operating activities (183,941) (35,936) --------- --------- Cash flows from investing activities: Purchases of property and equipment (13,036) (101,108) Purchases of investments (781,671) (472,768) Maturities of investments 740,404 517,638 Decrease (increase) in other assets 5,286 (46,798) --------- --------- Net cash used in investing activities (49,017) (103,036) --------- --------- Cash flows from financing activities: Proceeds from issuance of common stock 3,056 5,803 Purchase of treasury stock (280) (279) Payments received for notes receivable -- 262 Payments on notes payable -- (1,780) --------- --------- Net cash provided by financing activities 2,776 4,006 --------- --------- Net decrease in cash and cash equivalents (230,182) (134,966) Cash and cash equivalents, beginning of period 492,500 429,965 --------- --------- Cash and cash equivalents, end of period $ 262,318 $ 294,999 ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 5 SYCAMORE NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF THE BUSINESS Sycamore Networks, Inc. (the "Company") was incorporated in Delaware on February 17, 1998. The Company is a leading provider of intelligent optical networking products that enable telecommunications service providers to quickly and cost-effectively transform the capacity created by their fiber optic networks into usable bandwidth for the deployment of new high-speed data services. The Company is subject to risks common to technology-based companies including, but not limited to, the development of new technology, development of markets and distribution channels, dependence on key personnel, and the ability to obtain additional capital as needed to meet its product plans. The Company's ultimate success is dependent upon its ability to successfully develop and market its products. 2. BASIS OF PRESENTATION The accompanying financial data as of April 27, 2002 and for the three and nine months ended April 27, 2002 and April 28, 2001 has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended July 31, 2001. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position as of April 27, 2002, and results of operations and cash flows for the periods ended April 27, 2002 and April 28, 2001 have been made. The results of operations for the three and nine months ended April 27, 2002 are not necessarily indicative of the operating results for the full fiscal year or any future periods. 3. REVENUE DETAIL Components of revenue and cost of revenue included in the consolidated statements of operations are as follows (in thousands):
Three Months Ended Nine Months Ended ------------------ ----------------- April 27, April 28, April 27, April 28, 2002 2001 2002 2001 ---- ---- ---- ---- Revenue Product $ 6,929 $ 48,195 $ 39,826 $ 312,436 Service 6,653 6,008 16,799 11,458 ----------- ----------- ----------- ----------- $ 13,582 $ 54,203 $ 56,625 $ 323,894 ----------- ----------- ----------- ----------- Cost of Revenue Product $ (2,587) $ 120,379 $ 124,221 $ 247,811 Service 5,639 11,875 20,848 27,693 ----------- ----------- ----------- ----------- $ 3,052 $ 132,254 $ 145,069 $ 275,504 ----------- ----------- ----------- -----------
For the nine months ended April 27, 2002, two international customers represented the majority of the Company's revenue. For the full fiscal year ending July 31, 2002, the Company anticipates that revenue will continue to be highly concentrated in a relatively small number of customers, and that international revenue will represent a relatively high percentage of total revenue. At April 27, 2002, more than 90% of the Company's accounts receivable balance was attributable to two international customers. 6 4. NET LOSS PER SHARE Basic net loss per share is computed by dividing the net loss for the period by the weighted-average number of common shares outstanding during the period less unvested restricted stock. Diluted net loss per share is computed by dividing the net loss for the period by the weighted-average number of common and common equivalent shares outstanding during the period, if dilutive. Common equivalent shares are composed of unvested shares of restricted common stock and the incremental common shares issuable upon the exercise of stock options and warrants outstanding. The following table sets forth the computation of basic and diluted net loss per share, (in thousands, except per share data):
Three Months Ended Nine Months Ended ------------------ ----------------- April 27, April 28, April 27, April 28, 2002 2001 2002 2001 --------- --------- --------- --------- Numerator Net loss $ (22,843) $(225,109) $(306,127) $(237,516) ========= ========= ========= ========= Denominator Weighted-average shares of common stock outstanding 271,657 273,359 272,252 272,894 Weighted-average shares subject to repurchase (15,189) (32,867) (19,375) (37,411) --------- --------- --------- --------- Shares used in per-share calculation - basic and diluted 256,468 240,492 252,877 235,483 ========= ========= ========= ========= Net loss per share: Basic and diluted $ (0.09) $ (0.94) $ (1.21) $ (1.01) ========= ========= ========= =========
Options to purchase 29.7 million and 38.5 million shares of common stock at a weighted-average exercise price of $10.16 and $44.19 have not been included in the computation of diluted net loss per share for the three and nine months ended April 27, 2002 and April 28, 2001, respectively, as their effect would have been anti-dilutive. Warrants to purchase 150,000 shares of common stock at an exercise price of $11.69 have not been included in the computation of diluted net loss per share for each period presented, as their effect would have been anti-dilutive. 5. STOCK OPTION EXCHANGE OFFER In May 2001 the Company announced an offer to exchange outstanding employee stock options having an exercise price of $7.25 or more per share in return for restricted stock and new stock options to be granted by the Company (the "Exchange Offer"). Pursuant to the Exchange Offer, in exchange for eligible options, an option holder generally received a number of shares of restricted stock equal to one-tenth (1/10) of the total number of shares subject to the options tendered by the option holder and accepted for exchange, and commitment for new options to be issued exercisable for a number of shares of common stock equal to nine-tenths (9/10) of the total number of shares subject to the options tendered by the option holder and accepted for exchange. In order to address potential adverse tax consequences for employees of certain international countries, these employees were allowed to forego the restricted stock grants and receive all stock options. A total of 17.6 million options were accepted for exchange under the Exchange Offer and accordingly, were canceled in June 2001. A total of 1.7 million shares of restricted stock were issued in June 2001 and the Company recorded deferred compensation of $12.6 million related to these grants at that time. Due to cancellations of restricted stock relating to employee terminations, which were primarily due to the Company's fiscal 2002 restructuring program as described in Note 8, the number of outstanding shares of restricted stock related to the Exchange Offer was subsequently reduced to 1.3 million shares and the total deferred compensation relating to the Exchange Offer was reduced to approximately $10.1 million. The deferred compensation costs will be amortized ratably over the vesting periods of the restricted stock, generally over a four year period, with 25% of the shares vesting one year after the date of grant and the remaining 75% vesting quarterly thereafter. Until the restricted stock vests, such shares are subject to forfeiture in the event the employee leaves the Company. Upon the completion of the Exchange Offer, options to purchase approximately 15.9 million shares were expected to be granted in the second quarter of fiscal 2002, no sooner than six months and one day from June 20, 2001. However, due to the effect of employee terminations, which were primarily due to the Company's fiscal 2002 restructuring program as described in Note 8, the number of options which were granted in the second quarter of fiscal 2002 related to the Exchange Offer was approximately 12.6 million shares. The new options will generally vest over three years, with 8.34% of the options vesting on the date of grant and the remaining 91.66% vesting quarterly thereafter subject to forfeiture in the event the employee leaves the Company. The new options were granted with an exercise price of $4.89 per share, equal to the fair market value of the Company's common stock on the date of the grant. 7 6. INVENTORIES Inventories consisted of the following (in thousands): April 27, July 31, 2002 2001 -------- -------- Raw materials $ 3,449 $ 25,299 Work in process 754 18,849 Finished goods 10,874 22,791 -------- -------- $ 15,077 $ 66,939 ======== ======== 7. COMPREHENSIVE LOSS The Company reports comprehensive loss in accordance with Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130). The components of comprehensive loss are as follows (in thousands):
Three Months Ended Nine Months Ended ------------------ ----------------- April 27, April 28, April 27, April 28, 2002 2001 2002 2001 --------- --------- --------- --------- Net loss $ (22,843) $(225,109) $(306,127) $(237,516) Other comprehensive income: Unrealized gain (loss) on investments (2,428) 433 (2,464) 936 --------- --------- --------- --------- Comprehensive loss $ (25,271) $(224,676) $(308,591) $(236,580) ========= ========= ========= =========
8. RESTRUCTURING AND RELATED ASSET IMPAIRMENTS Beginning in the third quarter of fiscal 2001, unfavorable economic conditions and reduced capital spending by telecommunications service providers negatively impacted the Company's operating results in a progressive and increasing manner. As a result, the Company has enacted two separate business restructuring programs, the first in the third quarter of fiscal 2001 (the "fiscal 2001 restructuring"), and the second in the first quarter of fiscal 2002 (the "fiscal 2002 restructuring"). Details regarding each of these restructuring actions are as follows: Fiscal 2001 Restructuring: - -------------------------- As a result of the unfavorable conditions referred to above, the Company implemented a restructuring program in the third quarter of fiscal 2001, designed to reduce expenses in order to align resources with long-term growth opportunities. The restructuring program included a workforce reduction, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products and overlapping feature sets. This included the discontinuance of the SN 6000 Intelligent Optical Transport product and the bi-directional capabilities of the SN 8000 Intelligent Optical Network Node. As a result of the restructuring program, the Company recorded restructuring charges and related asset impairments of $81.9 million classified as operating expenses and an excess inventory charge of $84.0 million relating to the discontinued product lines, which was classified as cost of revenue. The restructuring charges and related asset impairments recorded in the third quarter of fiscal 2001, and the reserve activity since that time, are summarized as follows (in thousands):
Accrual Accrual Total Fiscal 2001 Balance at Fiscal 2002 Balance at Restructuring Non-cash Cash July 31, Cash April 27, Charge Charges Payments 2001 Payments 2002 ------ ------- -------- ---- -------- ---- Workforce reductions $ 4,174 $ 829 $ 2,823 $ 522 $ 380 $ 142 Facility consolidations and certain other costs 24,437 1,214 1,132 22,091 3,409 18,682 Inventory and asset write-downs 137,285 84,972 13,923 38,390 38,390 -- -------- -------- --------- --------- --------- --------- Total $165,896 $ 87,015 $ 17,878 $ 61,003 $ 42,179 $ 18,824 ======== ======== ========= ========= ========= =========
8 The fiscal 2001 restructuring program was substantially completed during the first half of fiscal 2002. The remaining cash payments consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2007 and administrative expenses associated with the restructuring activities. Fiscal 2002 Restructuring: - ------------------------- As a result of a continued decline in overall economic conditions and further reductions in capital spending by telecommunications service providers, the Company implemented a second restructuring program in the first quarter of fiscal 2002, designed to further reduce expenses to align resources with long-term growth opportunities. The restructuring program included a workforce reduction, consolidation of excess facilities, and charges related to excess inventory and other asset impairments. As a result of the restructuring program, the Company recorded restructuring charges and related asset impairments of $77.3 million classified as operating expenses and an excess inventory charge of $102.4 million classified as cost of revenue. In addition, the Company recorded charges totaling $22.7 million classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. The following paragraphs provide detailed information relating to the restructuring charges and related asset impairments which were recorded during the first quarter of fiscal 2002. Workforce reduction The restructuring program resulted in the reduction of 239 regular employees across all business functions and geographic regions. The workforce reductions were substantially completed in the first quarter of fiscal 2002. The Company recorded a workforce reduction charge of approximately $7.1 million relating primarily to severance and fringe benefits. In addition the number of temporary and contract workers employed by the Company was also reduced. Consolidation of facilities and certain other costs The Company recorded a charge of $17.2 million relating to the consolidation of excess facilities and certain other costs. The total charge includes $11.2 million related to the write-down of certain land, as well as lease terminations and non-cancelable lease costs. The Company also recorded other restructuring costs of $6.0 million relating primarily to administrative expenses and professional fees in connection with the restructuring activities. Inventory and asset write-downs The Company recorded a charge of $155.5 million relating to the write-down of inventory to its net realizable value and the impairment of certain other assets. The total charge includes $102.4 million of inventory write-downs and purchase commitments for inventory which was recorded as part of cost of revenue. This excess inventory charge was due to a severe decline in the demand for the Company's products. The Company also recorded charges totaling $53.1 million for asset impairments, including the assets related to the Company's vendor financing agreements and fixed assets that were abandoned by the Company. Since revenue had been recognized under the vendor financing agreements on a cash basis, the amount of the impairment loss was limited to the cost of the systems shipped to the vendor financing customers, which had been recorded in other long-term assets. Losses on investments The Company recorded charges totaling $22.7 million for impairments of investments in non-publicly traded companies that were determined to be other than temporary. The impairment charges were classified as a non-operating expense. 9 The restructuring charges and related asset impairments recorded in the first quarter of fiscal 2002, and the reserve activity since that time, are summarized as follows (in thousands):
Accrual Original Balance at Restructuring Non-cash Cash April 27, Charge Charges Payments Adjustments 2002 ------ ------- -------- ----------- ---- Workforce reduction $ 7,106 $ 173 $ 6,088 $ -- $ 845 Facility consolidations and certain other costs 17,181 8,572 1,195 -- 7,414 Inventory and asset write-downs 155,451 102,540 39,306 9,039 4,566 Losses on investments 22,737 22,737 -- -- -- -------- ---------- --------- ----------- --------- Total $202,475 $ 134,022 $ 46,589 $ 9,039 $ 12,825 ======== ========== ========= =========== =========
During the third quarter of fiscal 2002, the Company recorded a $9.0 million credit to cost of revenue due to changes in estimates, the majority of which related to favorable settlements with contract manufacturers. The remaining cash expenditures relating to workforce reductions will be substantially paid by the fourth quarter of fiscal 2002. Facility consolidation charges will be paid over the respective lease terms through fiscal 2005. The Company expects to substantially complete the fiscal 2002 restructuring program by the first quarter of fiscal 2003. 9. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which addresses the recognition and measurement of goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 also addresses the initial recognition and measurement of intangible assets acquired outside of a business combination whether acquired individually or with a group of other assets. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that intangible assets with indefinite lives and goodwill will not be amortized, but will rather be tested at least annually for impairment. Although SFAS No. 142 is not required to be adopted by the Company until fiscal 2003, its provisions must be applied to goodwill and other intangible assets acquired after June 30, 2001. As of April 27, 2002, the Company does not have any goodwill or other intangible assets relating to business combinations that were accounted for under APB Opinion No. 16. Accordingly, the adoption of SFAS No. 142 will not have a material impact on the Company's financial position or results of operations. In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses the financial accounting and reporting for the disposal of long-lived assets. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. Accordingly, the Company will be required to adopt SFAS No. 144 in the first quarter of fiscal 2003. The adoption of SFAS No. 144 is not expected to have a material impact on the Company's financial position or results of operations. 10. LITIGATION Beginning on July 2, 2001, several purported class action complaints were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors and the underwriters for the Company's initial public offering on October 21, 1999. Some of the complaints also include the underwriters for the Company's follow-on offering on March 14, 2000. The complaints were consolidated into a single action and an amended complaint was filed on April 19, 2002. The amended complaint was filed on behalf of persons who purchased the Company's common stock between October 21, 1999 and December 6, 2000. The amended complaint alleges violations of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, primarily based on the assertion that the Company's lead underwriters, the Company and the other named defendants made material false and misleading statements in the Company's Registration Statements and Prospectuses filed with the SEC in October 1999 and March 2000 because of the failure to disclose (a) the alleged solicitation and receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock to certain investors in the Company's public offerings and (b) that certain of the underwriters allegedly had entered into agreements with investors whereby underwriters agreed to allocate the public offering shares in exchange for which the investors agreed to make additional purchases of stock in the aftermarket at pre-determined prices. The amended complaint alleges claims against the Company, several of the Company's officers and directors and the underwriters under Sections 11 and 15 of the Securities Act. It also alleges claims against the Company, the individual defendants and the underwriters under Sections 10(b) and 20(a) of the Securities Exchange Act. The action against the Company is being coordinated with over three hundred other nearly identical actions filed against other companies. No date has been set for a response to the amended complaint. The actions seek damages in an unspecified amount. The Company believes that the claims against it are 10 without merit and intends to defend against the complaints vigorously. The Company is not currently able to estimate the possibility of loss or range of loss, if any, relating to these claims. The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company's results of operations or financial position. 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, we wish to caution you that certain matters discussed in this report constitute forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including, without limitation, those risks and uncertainties discussed under the heading "Factors That May Affect Future Operating Results" contained in our Annual Report on Form 10-K and other reports we file from time to time with the SEC and the risks and uncertainties discussed under the captions "Risks Related To Our Business" and "Risks Related to the Securities Market." Forward-looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may, " "should," "will," and "would" or similar words. OVERVIEW We are a leading provider of intelligent optical networking products that enable telecommunications service providers to quickly and cost-effectively transform the capacity created by their fiber optic networks into usable bandwidth for the deployment of new high-speed data services. Since our inception in February 1998, our revenue has increased from $11.3 million for the fiscal year ended July 31, 1999 to $374.7 million for the fiscal year ended July 31, 2001. Our rapid growth in revenue during the majority of this period reflected a strong economic environment for telecommunications service providers, driven by strong capital markets and by changes in the regulatory environment, in particular those brought about by the Telecommunications Act of 1996. These factors enabled the entry of a significant number of new companies, typically referred to as emerging service providers or emerging carriers, into the telecommunications services industry. Beginning in the third quarter of fiscal 2001, our revenue declined significantly due to unfavorable economic conditions caused by a rapid and significant decrease in capital spending by telecommunications service providers. Emerging service providers, which had been the early adopters of our technology, were no longer able to continue to fund aggressive deployments of equipment within their networks due to their inability to access the capital markets. Since then, many emerging service providers have experienced severe financial difficulties, and in many cases, have filed for bankruptcy protection, or have liquidated their assets and are no longer in business. This trend was compounded by decisions by incumbent service providers to slow their capital expenditures significantly, in part due to reduced competitive pressure from emerging carriers. In addition, many incumbent service providers have found their prospects for raising additional capital through the issuance of debt or equity securities to be greatly reduced, causing them to decrease capital expenditures to the minimum amount required to support their existing customer commitments. These conditions are currently impacting many of our current and prospective customers, and make any recovery in capital spending extremely difficult to forecast. Our revenue has been, and continues to be, negatively impacted by these unfavorable economic conditions. We currently anticipate that the cost of revenue and the resulting gross margin will continue to be adversely affected by several factors, including reduced demand for our products, the effects of new product introductions including volumes and manufacturing efficiencies, component limitations, the mix of products and services sold, competitive pricing, and possible increases in inventory levels which could increase our exposure to excess and obsolete inventory charges. While we have taken actions to reduce our cost structure, we anticipate that we will continue to incur operating losses unless our revenue increases significantly compared to current levels. During the last half of fiscal 2001 and the first three quarters of fiscal 2002, we incurred substantial operating losses totaling $613.5 million, which includes net restructuring and asset impairment charges totaling $336.6 million. We expect to incur operating losses until the overall economic environment and the demand for our products improve. At this time, we have limited visibility into future revenue and cannot predict when, or if, the economic environment and the demand for our products will improve. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's discussion and analysis of its financial condition and results of operations are based upon our interim consolidated financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. We evaluate these estimates on an ongoing basis, including those relating to bad debts, inventories, valuation of investments, warranty obligations, restructuring reserves, litigation and other contingencies. Estimates are based on our historical experience and other assumptions that are considered reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these 12 estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements. When products are shipped to customers, we evaluate whether all of the fundamental criteria for revenue recognition have been met. The most significant judgments for revenue recognition typically involve whether there are any significant uncertainties regarding customer acceptance and whether collectibility can be considered reasonably assured. In addition, the Company's transactions often consist of multiple element arrangements which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized. After customers have been invoiced, management evaluates the outstanding accounts receivable balances until they are collected, to determine whether an allowance for doubtful accounts should be recorded. In the event of a sudden deterioration in a particular customer's financial condition, additional provisions for doubtful accounts may be required, such as the specific provision that we recorded in the fourth quarter of fiscal 2001. We accrue for the estimated cost of product warranties at the time revenue is recognized, based primarily on our historical experience. If actual warranty claims exceed the amounts accrued, additional warranty charges would be required which would reduce gross margins in future periods. We continuously monitor our inventory balances and provisions are recorded for any differences between the cost of the inventory and its estimated market value, based on assumptions about future demand and market conditions. To the extent that a severe decline in forecasted demand occurs, significant charges for excess inventory are likely to occur, such as the $102.4 million charge we recorded in the first quarter of fiscal 2002. During the third quarter of fiscal 2001 and the first quarter of fiscal 2002, we recorded charges for restructuring and related asset impairments totaling $368.4 million, including inventory related charges of $186.4 million. These restructuring activities required us to make numerous assumptions and estimates, including future revenue levels and product mix, the timing of and the amounts received for subleases of excess facilities, the fair values of impaired assets, the amounts of other than temporary impairments of strategic investments, and the projected administrative expenses and professional fees associated with the restructuring activities. The estimates and assumptions relating to the restructuring activities must be continually monitored and evaluated, and if these estimates and assumptions change, we may be required to record additional charges or credits against the reserves previously recorded for these restructuring activities. For example, during the third quarter of fiscal 2002, we recorded a $9.0 million credit to cost of revenue, due to changes in estimates relating to the restructuring charge that had been recorded in the first quarter of fiscal 2002. RESULTS OF OPERATIONS REVENUE Revenue decreased 75% or $40.6 million to $13.6 million for the three months ended April 27, 2002 compared to $54.2 million for the same period in fiscal 2001. Revenue decreased 83% or $267.3 million to $56.6 million for the nine months ended April 27, 2002 compared to $323.9 million for the same period in fiscal 2001. The decrease in revenue was due to the decline in the overall economic environment, in particular the reductions in capital spending by our target customers. For the three and nine months ended April 27, 2002, product revenue declined significantly while service revenue increased compared to the same periods in fiscal 2001. The increase in service revenue was due to revenue from maintenance and other services associated with product shipments that occurred in previous periods. For the nine months ended April 27, 2002, two international customers represented the majority of the Company's revenue. For the full fiscal year ending July 31, 2002, the Company anticipates that revenue will continue to be highly concentrated in a relatively small number of customers, and that international revenue will represent a relatively high percentage of total revenue. Sales to emerging carriers, which had represented a large percentage of our revenue in the first half of fiscal 2001, were insignificant in the first three quarters of fiscal 2002, and we expect this trend to continue for the foreseeable future. While we have redirected our marketing efforts towards incumbent carriers, these customers typically have longer sales evaluation cycles than emerging carriers, and many incumbent carriers have also announced significant reductions in their capital expenditure budgets. Accordingly, there can be no certainty as to the severity or duration of the current economic downturn and its impact on our future revenue. 13 COST OF REVENUE Cost of revenue decreased $129.1 million to $3.1 million for the three months ended April 27, 2002 compared to $132.2 million for the same period in fiscal 2001. Cost of revenue for the three months ended April 27, 2002 included a credit of $9.0 million, due to changes in estimates relating to the excess inventory charge recorded in the first quarter of fiscal 2002. Cost of revenue for the three months ended April 28, 2001 included an inventory write-down of $84.0 million associated with the consolidation and elimination of certain product lines. Excluding the impact of these charges, cost of revenue as a percentage of revenue was 89% for the three months ended April 27, 2002, compared to 89% for the same period in fiscal 2001. Cost of revenue as a percentage of revenue for each period reflects the lower utilization of certain fixed manufacturing and customer support costs at reduced revenue levels. Cost of revenue for services decreased $6.3 million to $5.6 million for the three months ended April 27, 2002 compared to $11.9 million for the same period in fiscal 2001, due primarily to the overall decrease in revenue and the corresponding decrease in customer support costs due to the Company's restructuring activities. In addition to the costs associated with supporting existing customers, cost of revenue for services includes costs to support evaluations and trials for potential customers, such as incumbent carriers which typically have relatively long sales evaluation cycles. Cost of revenue decreased $130.4 million to $145.1 million for the nine months ended April 27, 2002 compared to $275.5 million for the same period in fiscal 2001. Cost of revenue for the nine months ended April 27, 2002 included a net charge of $93.4 million relating to excess inventory due to a significant reduction in the Company's demand forecasts in the first quarter of fiscal 2002. The original charge of $102.4 million, recorded in the first quarter of fiscal 2002, was reduced by a $9.0 million credit in the third quarter of fiscal 2002 due to changes in estimates. Cost of revenue for the nine months ended April 28, 2001 included an inventory write-down of $84.0 million associated with the consolidation and elimination of certain product lines. Excluding the effect of these charges, cost of revenue as a percentage of revenue was 91% for the nine months ended April 27, 2002, compared to 59% for the same period in fiscal 2001. Excluding the impact of the excess inventory charges, the increase in cost of revenue as a percentage of revenue reflects the overall decrease in revenue and lower utilization of certain fixed manufacturing and customer support costs. Cost of revenue for services decreased $6.9 million to $20.8 million for the nine months ended April 27, 2002 compared to $27.7 million for the same period in fiscal 2001, due primarily to the overall decrease in revenue and corresponding decrease in customer support costs. RESEARCH AND DEVELOPMENT EXPENSES Research and development expenses decreased $18.9 million to $25.5 million for the three months ended April 27, 2002 compared to $44.4 million for the same period in fiscal 2001. Research and development expenses decreased $34.4 million to $88.0 million for the nine months ended April 27, 2002 compared to $122.4 million for the same period in fiscal 2001. The decreases in expenses were primarily due to reduced costs for project related materials and a decrease in personnel related expenses due to the Company's restructuring activities, which resulted in a consolidation of product offerings and more focused development efforts. SALES AND MARKETING EXPENSES Sales and marketing expenses decreased $13.3 million to $8.9 million for the three months ended April 27, 2002 compared to $22.2 million for the same period in fiscal 2001. Sales and marketing expenses decreased $27.5 million to $34.0 million for the nine months ended April 27, 2002 compared to $61.5 million for the same period in fiscal 2001. The decrease in expenses for each period was primarily due to reduced costs for personnel and related expenses due to the Company's restructuring activities as well as decreased program marketing costs. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses decreased $2.2 million to $2.2 million for the three months ended April 27, 2002 compared to $4.4 million for the same period in fiscal 2001. General and administrative expenses decreased $5.0 million to $8.0 million for the nine months ended April 27, 2002 compared to $13.0 million for the same period in fiscal 2001. The decrease in expenses for each period was primarily due to reduced costs for personnel and related expenses due to the Company's restructuring activities. AMORTIZATION OF STOCK COMPENSATION Amortization of stock compensation expense decreased $1.8 million to $5.5 million for the three months ended April 27, 2002 compared to $7.3 million for the same period in fiscal 2001. Amortization of stock compensation expense decreased $37.1 million to $19.4 million for the nine months ended April 27, 2002 compared to $56.5 million for the same period in fiscal 2001. Amortization of stock compensation expense primarily resulted from the granting of stock options and restricted shares with exercise or sale prices which were deemed to be below fair market value. The decrease in amortization expense for the three 14 months ended April 27, 2002 was primarily due to headcount reductions due to the Company's restructuring activities. The significant decrease in amortization expense for the nine months ended April 27, 2002 was primarily due to $36.3 million of amortization expense recorded during the first quarter of fiscal 2001, due to the accelerated vesting of certain restricted stock and stock options in connection with the acquisition of Sirocco Systems, Inc. ("Sirocco"). Amortization of stock compensation is expected to impact our reported results of operations through the fourth quarter of fiscal 2005. RESTRUCTURING CHARGES AND RELATED ASSET IMPAIRMENTS As a result of a continued decline in overall economic conditions and further reductions in capital spending by telecommunications service providers, we implemented a second restructuring program in the first quarter of fiscal 2002, designed to further reduce expenses to align resources with long-term growth opportunities. The restructuring program included a workforce reduction, consolidation of excess facilities, and charges related to excess inventory and other asset impairments. As a result of the restructuring program, we recorded restructuring charges and related asset impairments of $77.3 million classified as operating expenses and an excess inventory charge of $102.4 million classified as cost of revenue. In addition, we recorded charges totaling $22.7 million classified as a non-operating expense, relating to impairments of investments in non-publicly traded companies that were determined to be other than temporary. We expect pretax savings of approximately $45 million in annual operating expenses in connection with the restructuring program and certain cost reduction initiatives, as compared to the levels immediately preceding the restructuring program. The following paragraphs provide detailed information relating to the restructuring charges and related asset impairments which were recorded during the first quarter of fiscal 2002. Workforce reduction The restructuring program resulted in the reduction of 239 regular employees across all business functions and geographic regions. The workforce reductions were substantially completed in the first quarter of fiscal 2002. We recorded a workforce reduction charge of approximately $7.1 million relating primarily to severance and fringe benefits. In addition the number of temporary and contract workers employed by us was also reduced. Consolidation of facilities and certain other costs We recorded a charge of $17.2 million relating to the consolidation of excess facilities and certain other costs. The total charge includes $11.2 million related to the write-down of certain land, as well as lease terminations and non-cancelable lease costs. We also recorded other restructuring costs of $6.0 million relating primarily to administrative expenses and professional fees in connection with the restructuring activities. Inventory and asset write-downs We recorded a charge of $155.5 million relating to the write-down of inventory to its net realizable value and the impairment of certain other assets. The total charge includes $102.4 million of inventory write-downs and purchase commitments for inventory which was recorded as part of cost of revenue. This excess inventory charge was due to a severe decline in the demand for our products. We also recorded charges totaling $53.1 million for asset impairments, including the assets related to our vendor financing agreements and fixed assets that were abandoned by us. Since revenue had been recognized under the vendor financing agreements on a cash basis, the amount of the impairment loss was limited to the cost of the systems shipped to the vendor financing customers, which had been recorded in other long-term assets. Losses on investments We recorded charges totaling $22.7 million for impairments of investments in non-publicly traded companies that were determined to be other than temporary. The impairment charges were classified as a non-operating expense. 15 The restructuring charges and related asset impairments recorded in the first quarter of fiscal 2002, and the reserve activity since that time, are summarized as follows (in thousands):
Accrual Original Balance at Restructuring Non-cash Cash April 27, Charge Charges Payments Adjustments 2002 ------ ------- -------- ----------- ---- Workforce reduction $ 7,106 $ 173 $ 6,088 $ -- $ 845 Facility consolidations and certain other costs 17,181 8,572 1,195 -- 7,414 Inventory and asset write-downs 155,451 102,540 39,306 9,039 4,566 Losses on investments 22,737 22,737 -- -- -- --------- -------- -------- ----------- --------- Total $ 202,475 $134,022 $ 46,589 $ 9,039 $ 12,825 ========= ======== ======== =========== =========
During the third quarter of fiscal 2002, we recorded a $9.0 million credit to cost of revenue due to changes in estimates, the majority of which related to favorable settlements with contract manufacturers. The remaining cash expenditures relating to workforce reductions will be substantially paid by the fourth quarter of fiscal 2002. Facility consolidation charges will be paid over the respective lease terms through fiscal 2005. We expect to substantially complete the fiscal 2002 restructuring program by the first quarter of fiscal 2003. Fiscal 2001 Restructuring In the third quarter of fiscal 2001, we implemented our first restructuring program, designed to reduce expenses in order to align resources with long-term growth opportunities. The restructuring program included a workforce reduction, consolidation of excess facilities, and the restructuring of certain business functions to eliminate non-strategic products and overlapping feature sets. As a result of the restructuring program, we recorded restructuring charges and related asset impairments of $81.9 million classified as operating expenses and an excess inventory charge of $84.0 million relating to the discontinued product lines, which was classified as cost of revenue. The fiscal 2001 restructuring program was substantially completed during the first half of fiscal 2002. The remaining cash payments consist primarily of facility consolidation charges that will be paid over the respective lease terms through fiscal 2007 and administrative expenses associated with the restructuring activities. ACQUISITION COSTS Acquisition costs for the first quarter of fiscal 2001 were $4.9 million related to the acquisition of Sirocco. These costs included legal and accounting services and other professional fees associated with the transaction. INTEREST AND OTHER INCOME, NET Interest and other income, net decreased $10.1 million to $8.8 million for the three months ended April 27, 2002 compared to $18.9 million for the same period in fiscal 2001. Interest and other income decreased $35.9 million to $31.7 million for the nine months ended April 27, 2002 compared to $67.6 million for the same period in fiscal 2001. The decreases in interest and other income were primarily attributable to lower interest rates and a lower average cash balance during each period in fiscal 2002. PROVISION FOR INCOME TAXES We did not provide for income taxes for the three and nine months ended April 27, 2002 due to the net losses sustained in each period. During the three and nine months ended April 28, 2001, we recorded provisions for income taxes of $5.7 million and $13.1 million, respectively. During the second quarter of fiscal 2001, we recorded a tax provision of $7.4 million because our expectation at that time was that we would generate taxable income for the full fiscal year. During the third quarter of fiscal 2001, we began to incur net losses and accordingly, the provision for taxes currently payable that was recorded in the second quarter of fiscal 2001 was subsequently reversed. However, due to the cumulative net losses, we determined that it was more likely than not that the net deferred tax assets would not be realized, and accordingly, we recorded a provision of $13.1 million to establish a full valuation allowance against the net deferred tax assets. 16 LIQUIDITY AND CAPITAL RESOURCES Total cash, cash equivalents and investments were $1.06 billion at April 27, 2002. Included in this amount were cash and cash equivalents of $262.3 million, compared to $492.5 million at July 31, 2001. The decrease in cash and cash equivalents of $230.2 million was attributable to cash used in operating activities of $183.9 million and cash used in investing activities of $49.0 million, offset by cash provided by financing activities of $2.7 million. Cash used in operating activities of $183.9 million consisted of the net loss for the period of $306.1 million, adjusted for non-cash charges totaling $185.9 million and changes in working capital totaling $63.7 million, the most significant components of which were decreases in accounts payable of $49.7 million and accrued restructuring costs of $29.4 million. Non-cash charges included depreciation and amortization, restructuring charges and related asset impairments, and amortization of stock compensation. Cash used in investing activities of $49.0 million consisted primarily of net purchases of investments of $41.3 million and purchases of property and equipment of $13.0 million. Cash provided by financing activities of $2.7 million consisted primarily of the proceeds received from employee stock plan activity. During the first quarter of fiscal 2002, each of our two major vendor financing customers experienced a significant deterioration in their financial condition. As a result, we determined that we were unlikely to realize any significant proceeds from these vendor financing agreements. Accordingly, we recorded an impairment charge for the assets related to these financing agreements, which consisted of the cost of the systems shipped to the vendor financing customers, and had been recorded in other long-term assets. As a result of the financial demands of major network deployments, service providers are continuing to request financing assistance from their suppliers. From time to time we have provided extended payment terms on trade receivables to certain key customers to assist them with their network deployment plans. In addition, we may provide or commit to extend additional credit or credit support, such as vendor financing, to our customers, as we consider appropriate in the course of our business. Our ability to provide customer financing is limited and depends on a number of factors, including our capital structure, the level of our available credit and our ability to factor commitments. The extension of financing to our customers will limit the capital that we have available for other uses. Currently, our primary source of liquidity comes from our cash and cash equivalents and investments, which total $1.06 billion at April 27, 2002. Our investments are classified as available-for-sale and consist of securities that are readily convertible to cash, including certificates of deposits, commercial paper and government securities, with original maturities ranging from 90 days to three years. At April 27, 2002, $588.8 million of investments with maturities of less than one year were classified as short-term investments, and $206.1 million of investments with maturities of greater than one year were classified as long-term investments. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents and investments will continue to be consumed by operations. Our accounts receivable, while not considered a primary source of liquidity, represents a concentration of credit risk because the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. At April 27, 2002, more than 90% of our accounts receivable balance was attributable to two international customers. As of April 27, 2002, we do not have any outstanding debt or credit facilities, and do not anticipate entering into any debt or credit agreements in the foreseeable future. Our fixed commitments for cash expenditures consist primarily of payments under operating leases, and are substantially unchanged from those which were disclosed in Note 5 to the consolidated financial statements included in the Company's Form 10-K for the year ended July 31, 2001. Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and investments will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months. 17 FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS RISKS RELATED TO OUR BUSINESS WE ARE EXPOSED TO GENERAL ECONOMIC CONDITIONS AND CONDITIONS SPECIFIC TO THE TELECOMMUNICATIONS INDUSTRY As a result of unfavorable economic conditions and a sudden and severe decline in the purchasing patterns of our customers, our revenue began to decline in the third quarter of fiscal 2001, and we have incurred significant operating losses since that time. The economic downturn and reduced capital spending by telecommunications service providers has also resulted in longer selling cycles with extended trial periods for new equipment purchases. While we have implemented restructuring and cost control programs to reduce our business expenses, our costs are largely based on the requirements that we believe are necessary to support sales to incumbent carriers, and a high percentage of our expenses are, and will continue to be, fixed. As a result, we currently expect to continue to incur operating losses unless revenue increases significantly above the current levels. In addition to the economic downturn and the decline in capital spending by telecommunications service providers, recent terrorist acts and related military actions appear to have added additional uncertainty to an already weak overall economic environment. Further acts of war or terrorism, or related effects such as disruptions in air transportation, enhanced security measures and political instability in certain foreign countries, may adversely affect our business, operating results and financial condition. Although the overall economy in the United States has shown some preliminary signs of recovery in recent months, the telecommunications equipment industry has remained severely depressed. Our business and results of operations have been and will continue to be seriously harmed if current economic conditions do not improve. WE ARE ENTIRELY DEPENDENT ON OUR LINE OF INTELLIGENT OPTICAL NETWORKING PRODUCTS AND OUR FUTURE REVENUE DEPENDS ON THEIR COMMERCIAL SUCCESS Our future revenue depends on the commercial success of our line of intelligent optical networking products. As of April 27, 2002, our SN 3000 Optical Access Switch, SN 8000 Intelligent Optical Transport Node, SN 10000 Intelligent Optical Transport System, SN 16000 Intelligent Optical Switch and Silvx Manager Network Management System are the only products that are currently available for sale to customers. To be successful, we believe that we must continually enhance the capabilities of our existing products, and successfully develop and introduce new products. We cannot assure you that we will be successful in completing the development, introduction or production manufacturing of new products or enhancing our existing products. Failure of our current or planned products to operate as expected could delay or prevent their adoption. If our target customers do not adopt, purchase and successfully deploy our current and planned products, our results of operations could be adversely affected. Our line of intelligent optical networking products enables the creation of a fundamentally different, more flexible and data-centric network architecture than those created by traditional SONET/SDH-based network equipment that has historically been used by incumbent carriers for optical networking. While we believe that our mesh-based architecture offers significant competitive advantages over traditional SONET/SDH-based equipment, we are directing our sales efforts towards incumbent carriers, many of which have made significant investments in SONET/SDH-based equipment. If we are unable to convince incumbent carriers to deploy our intelligent optical networking solutions and transition their networks toward more flexible, data-centric mesh architectures, our business and results of operations will be seriously harmed. WE EXPECT THAT SUBSTANTIALLY ALL OF OUR REVENUE WILL BE GENERATED FROM A LIMITED NUMBER OF CUSTOMERS, AND OUR REVENUE IS SUBSTANTIALLY DEPENDENT UPON SALES OF PRODUCTS TO THESE CUSTOMERS We currently have a limited number of customers, one of whom, Williams Communications, accounted for 47%, 92%, and 100% of our revenue during fiscal 2001, 2000 and 1999, respectively. Another customer, 360networks, accounted for 11% of our revenue in fiscal 2001. As a result of unfavorable economic and other conditions, several of our largest customers to date, including Williams and 360networks, have slowed their capital expenditures and decreased their rate of ordering products from us. In any given quarter, a relatively small number of customers typically comprise a large percentage of total revenue, though the composition of these customers may vary from quarter to quarter. For the nine months ended April 27, 2002, two international customers represented the majority of the Company's revenue. Historically, a large percentage of our sales have been made to emerging carriers such as Williams and 360networks. Many of these emerging carriers have experienced severe financial difficulties, causing them to dramatically reduce their capital expenditures, and in some cases, file for bankruptcy protection. As a result, we believe that sales to emerging carriers are likely to 18 remain at reduced levels. To be successful, we will need to increase our sales to incumbent carriers, which typically have longer sales evaluation cycles and have also reduced their capital spending plans. In addition, we have relatively limited experience in selling our products to incumbent carriers. There can be no assurance that we will be successful in increasing our sales to incumbent carriers. None of our customers are contractually committed to purchase any minimum quantities of products from us. We expect that in the foreseeable future a majority of our revenue will continue to depend on sales of our intelligent optical networking products to a limited number of customers. The rate at which our current and prospective customers purchase products from us will depend, in part, on their success in selling communications services based on these products to their own customers. Many incumbent carriers have recently announced reductions in their capital expenditure budgets, reduced their revenue forecasts, or announced restructurings. Any failure of current or prospective customers to purchase products from us for any reason, including any determination not to install our products in their networks or a downturn in their business, would seriously harm our financial condition or results of operations. WE EXPECT GROSS MARGINS TO REMAIN AT REDUCED LEVELS IN THE NEAR TERM Our gross margins declined significantly compared to historical levels beginning in the third quarter of fiscal 2001. For the first nine months of fiscal 2002, after excluding the effect of special charges, our gross profit was 9% of revenue, as compared to 47% of revenue for the first half of fiscal 2001. We currently anticipate that gross margins are likely to continue to be adversely affected by several factors, including reduced demand for our products, the effects of new product introductions including volumes and manufacturing efficiencies, component limitations, the mix of products and services sold, competitive pricing, and possible increases in inventory levels which could increase our exposure to excess and obsolete inventory charges, such as the charge which occurred in the first quarter of fiscal 2002. CURRENT ECONOMIC CONDITIONS COMBINED WITH OUR LIMITED OPERATING HISTORY MAKES FORECASTING DIFFICULT Current economic conditions in the telecommunications industry, combined with our operating history, make it difficult to accurately forecast revenue, and there is limited historical data upon which to base our planned operating expenses. At the present time, our operating expenses are largely based on the requirements that we believe are necessary to support sales to incumbent carriers, and a high percentage of these expenses are and will continue to be fixed. Our ability to sell products and the level of success, if any, we may achieve depend, among other things, upon the level of demand for intelligent optical networking products, which continues to be a rapidly evolving market. In addition, we continue to have limited visibility into the capital spending plans of our current and prospective customers, which increases the difficulty of forecasting our revenue or predicting any recovery in capital spending trends. We have directed our sales efforts towards incumbent carriers, many of which have historically financed their capital expenditures using significant amounts of debt. In recent months, many of these incumbent carriers have come under increased scrutiny from credit rating agencies and investors due to their relatively high debt levels, which may limit their ability to make future equipment purchases. We expect that these conditions are likely to continue to limit our ability to forecast our revenue. If operating results are below the expectations of our investors and market analysts, this could cause declines in the price of our common stock. OUR FAILURE TO GENERATE SUFFICIENT REVENUE WOULD PREVENT US FROM ACHIEVING PROFITABILITY Beginning in the third quarter of fiscal 2001, our revenue has declined considerably and we have incurred significant operating losses since that time. As of April 27, 2002, we had an accumulated deficit of $607.6 million. We cannot assure you that our revenue will increase or that we will generate sufficient revenue to achieve or sustain profitability. While we have implemented restructuring programs designed to decrease the Company's business expenses, we will continue to have large fixed expenses and we expect to continue to incur significant sales and marketing, product development, customer support and service, administrative and other expenses. As a result, we will need to generate significantly higher revenue over the current levels in order to achieve and maintain profitability. THE UNPREDICTABILITY OF OUR QUARTERLY RESULTS MAY ADVERSELY AFFECT THE TRADING PRICE OF OUR COMMON STOCK Our revenue and operating results have varied significantly from quarter to quarter. For example, from the fourth quarter of fiscal 1999 through the second quarter of fiscal 2001, our revenue increased each quarter sequentially compared to the previous quarter. However, beginning in the third quarter of fiscal 2001, our revenue declined due to a sudden and severe decline in the 19 purchasing patterns of our customers, and as a result, we have incurred significant operating losses since that time. We believe that our revenue and operating results are likely to continue to vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control and any of which may cause our stock price to fluctuate. The primary factors that may affect us include the following: * fluctuation in demand for intelligent optical networking products; * the timing and size of sales of our products; * the length and variability of the sales cycle for our products, which we believe is increasing in length, due to overall market conditions and our emphasis on selling to incumbent carriers; * the timing of recognizing revenue and deferred revenue; * new product introductions and enhancements by our competitors and ourselves; * changes in our pricing policies or the pricing policies of our competitors; * our ability to develop, introduce and ship new products and product enhancements that meet customer requirements in a timely manner; * delays or cancellations by customers; * our ability to obtain sufficient supplies of sole or limited source components; * increases in the prices of the components we purchase; * our ability to attain and maintain production volumes and quality levels for our products; * manufacturing lead times; * the timing and level of prototype expenses; * costs related to acquisitions of technology or businesses; * general economic conditions as well as those specific to the telecommunications, Internet and related industries. While we have implemented restructuring and cost control programs, we plan to continue to invest in our business, to continue to maintain a strong product development and customer support infrastructure that will enable us to move quickly when economic conditions improve. Our operating expenses are largely based on the requirements that we believe are necessary to support sales to incumbent carriers, and a high percentage of our expenses are, and will continue to be, fixed. As a result, we currently expect to continue to incur operating losses unless revenue increases significantly above the current levels. Due to the foregoing factors, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. You should not rely on our results for one quarter as any indication of our future performance. Occurrences of the foregoing factors are extremely difficult to predict. In addition, our ability to forecast our future business has been significantly impaired by the general economic downturn. As a result, our future operating results may be below our expectations or those of public market analysts and investors, and our net sales may continue to decline or recover at a slower rate than anticipated by us or analysts and investors. In either event, the price of our common stock could decrease. OUR PRODUCTS ARE COMPLEX AND ARE DEPLOYED IN COMPLEX ENVIRONMENTS AND MAY HAVE ERRORS OR DEFECTS THAT WE FIND ONLY AFTER FULL DEPLOYMENT, WHICH COULD SERIOUSLY HARM OUR BUSINESS Our intelligent optical networking products are complex and are designed to be deployed in large and complex networks. Our customers may discover errors or defects in the hardware or the software, or the product may not operate as expected after it has been fully deployed. From time to time, there may be interruptions or delays in the deployment of our products due to product performance problems or post delivery obligations. If we are unable to fix errors or other problems, or if our customers experience interruptions or delays that cannot be promptly resolved, we could experience: 20 * loss of or delay in revenue and loss of market share; * loss of customers; * failure to attract new customers or achieve market acceptance; * diversion of development resources; * increased service and warranty costs; * delays in collecting accounts receivable; * legal actions by our customers; and * increased insurance costs, any of which could seriously harm our financial condition or results of operations. THE LONG AND VARIABLE SALES CYCLES FOR OUR PRODUCTS MAY CAUSE REVENUE AND OPERATING RESULTS TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER A customer's decision to purchase our intelligent optical networking products involves a significant commitment of its resources and a lengthy evaluation, testing and product qualification process. As a result, our sales cycle is lengthy and recently has increased in length, as we have directed our sales efforts towards incumbent carriers. Throughout the sales cycle, we spend considerable time and expense educating and providing information to prospective customers about the use and features of our products. Even after making a decision to purchase our products, we believe that most customers will deploy the products slowly and deliberately. Timing of deployment can vary widely and depends on the economic environment of our customers, the skills of our customers, the size of the network deployment and the complexity of our customers' network environment. Customers with complex networks usually expand their networks in large increments on a periodic basis. Accordingly, we may receive purchase orders for significant dollar amounts on an irregular and unpredictable basis. Because of our limited operating history and the nature of our business, we cannot predict these sales and deployment cycles. The long sales cycles, as well as our expectation that customers will tend to sporadically place large orders with short lead times, may cause our revenue and results of operations to vary significantly and unexpectedly from quarter to quarter. 21 WE MAY NOT BE SUCCESSFUL IF OUR CUSTOMER BASE DOES NOT GROW Our future success will depend on our attracting additional customers. Due to the overall economic downturn in our industry and the financial difficulties experienced by emerging carriers, the number of potential customers for our products at the current time has been reduced. Our ability to attract new customers could also be adversely affected by: * customer unwillingness to implement our optical networking architecture; * any delays or difficulties that we may incur in completing the development, introduction and production manufacturing of our planned products or product enhancements; * new product introductions by our competitors; * any failure of our products to perform as expected; or * any difficulty we may incur in meeting customers' delivery, installation or performance requirements. OUR BUSINESS IS SUBJECT TO RISKS FROM INTERNATIONAL OPERATIONS International sales represented 35% of total revenue in fiscal 2001, and a substantial majority of total revenue in the first three quarters of fiscal 2002, and we expect that international sales will continue to represent a significant portion of our revenue. Doing business internationally requires significant management attention and financial resources to successfully develop direct and indirect sales channels and to support customers in international markets. While international sales currently represent a high percentage of total revenue, these sales are concentrated within a relatively small number of customers. We may not be able to maintain or expand international market demand for our products. We have relatively limited experience in marketing, distributing and supporting our products internationally and to do so, we expect that we will need to develop versions of our products that comply with local standards. In addition, international operations are subject to other inherent risks, including: * greater difficulty in accounts receivable collection and longer collection periods; * difficulties and costs of staffing and managing foreign operations in compliance with local laws and customs; * necessity to work with third parties in certain countries to perform installation and obtain customer acceptance, and the resulting impact on revenue recognition; * the impact of recessions in economies outside the United States; * unexpected changes in regulatory requirements, including trade protection measures and import and licensing requirements; * certification requirements; * currency fluctuations; * reduced protection for intellectual property rights in some countries; * potentially adverse tax consequences; and * political and economic instability, particularly in emerging markets. 22 WE RELY ON SINGLE SOURCES FOR SUPPLY OF CERTAIN COMPONENTS AND OUR BUSINESS MAY BE SERIOUSLY HARMED IF OUR SUPPLY OF ANY OF THESE COMPONENTS OR OTHER COMPONENTS IS DISRUPTED We currently purchase several key components, including commercial digital signal processors, RISC processors, field programmable gate arrays, SONET transceivers and erbium doped fiber amplifiers, from single or limited sources. We purchase each of these components on a purchase order basis and have no long-term contracts for these components. Although we believe that there are alternative sources for each of these components, in the event of a disruption in supply, we may not be able to develop an alternate source in a timely manner or at favorable prices. Such a failure could hurt our ability to deliver our products to our customers and negatively affect our operating margins. In addition, our reliance on our suppliers exposes us to potential supplier production difficulties or quality variations. For example, component yield limitations negatively impacted our ability to manufacture and meet customer demand for the SN 16000 product during fiscal 2001. While these yield limitations have since been resolved, any future disruption in supply could seriously impact our revenue and results of operations. During the past year, the optical component industry has been downsizing manufacturing capacity while consolidating product lines from earlier acquisitions. This business environment could impact product deliveries and result in the consolidation of product offerings. Because optical components are integrated into our products, the business environment for optical component manufacturers could negatively impact our revenue and results of operations. WE DEPEND UPON CONTRACT MANUFACTURERS AND ANY DISRUPTION IN THESE RELATIONSHIPS MAY CAUSE US TO FAIL TO MEET THE DEMANDS OF OUR CUSTOMERS AND DAMAGE OUR CUSTOMER RELATIONSHIPS We have limited internal manufacturing capabilities. We rely on contract manufacturers to manufacture our products in accordance with our specifications and to fill orders on a timely basis. Currently, the majority of our products are produced under an agreement with Jabil Circuit, Inc., which provides comprehensive manufacturing services, including assembly, test, control and shipment to our customers, and procures material on our behalf. During the normal course of business, we may provide demand forecasts to our contract manufacturers up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, the contract manufacturers may assess cancellation penalties or we may have excess inventory which could negatively impact our gross margins. If we underestimate our requirements, the contract manufacturers may have inadequate inventory, which could interrupt manufacturing of our products and result in delays in shipment to our customers and revenue recognition. During the first quarter of fiscal 2002, we recorded an excess inventory charge of $102.4 million due to a severe decline in our forecasted revenue. A portion of this charge was related to inventory purchase commitments. We may not be able to effectively manage our relationship with our contract manufacturers, and such contract manufacturers may not meet our future requirements for timely delivery. Our contract manufacturers also build products for other companies, and we cannot assure you that they will always have sufficient quantities of inventory available to fill orders placed by our customers or that they will allocate their internal resources to fill these orders on a timely basis. In addition, our reliance on contract manufacturers limits our ability to control the manufacturing processes of our products, which exposes us to risks including the unpredictability of manufacturing yields and a reduced ability to control the quality of finished products. The contract manufacturing industry is a highly competitive, capital-intensive business with relatively low profit margins. In addition, there have been a number of major acquisitions within the contract manufacturing industry in recent periods. While to date there has been no significant impact on our contract manufacturers, future acquisitions could potentially have an adverse effect on our working relationship with our contract manufacturers. For example, in the event of a major acquisition involving one of our contract manufacturers, difficulties could be encountered in the merger integration process that could negatively impact our working relationship. Qualifying a new contract manufacturer and commencing volume production is expensive and time consuming and could result in a significant interruption in the supply of our products. If we are required or choose to change contract manufacturers, we may lose revenue and damage our customer relationships. 23 IF WE DO NOT RESPOND RAPIDLY TO TECHNOLOGICAL CHANGES, OUR PRODUCTS COULD BECOME OBSOLETE The market for intelligent optical networking products continues to evolve, and has been characterized by rapid technological change, frequent new product introductions and changes in customer requirements. We may be unable to respond quickly or effectively to these developments. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent our development, introduction or marketing of new products and enhancements. The introduction of new products by competitors, market acceptance of products based on new or alternative technologies or the emergence of new industry standards could render our existing or future products obsolete. In developing our products, we have made, and will continue to make, assumptions about the standards that may be adopted by our customers and competitors. If the standards adopted are different from those which we have chosen to support, market acceptance of our products may be significantly reduced or delayed and our business will be seriously harmed. The introduction of products incorporating new technologies and the emergence of new industry standards could render our existing products obsolete. In addition, in order to introduce products incorporating new technologies and new industry standards, we must be able to gain access to the latest technologies of our customers, our suppliers and other network vendors. Any failure to gain access to the latest technologies could impair the competitiveness of our products. CUSTOMER REQUIREMENTS ARE LIKELY TO EVOLVE, AND WE WILL NOT RETAIN CUSTOMERS OR ATTRACT NEW CUSTOMERS IF WE DO NOT ANTICIPATE AND MEET SPECIFIC CUSTOMER REQUIREMENTS Our current and prospective customers may require product features and capabilities that our current products do not have. To achieve market acceptance for our products, we must effectively and timely anticipate and adapt to customer requirements and offer products and services that meet customer demands. Our failure to develop products or offer services that satisfy customer requirements would seriously harm our ability to increase demand for our products. We intend to continue to invest in product and technology development. The development of new or enhanced products is a complex and uncertain process that requires the accurate anticipation of technological and market trends. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent the development, introduction, volume production or marketing of new products and enhancements. The introduction of new or enhanced products also requires that we manage the transition from older products in order to minimize disruption in customer ordering patterns and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. Our inability to effectively manage this transition would cause us to lose current and prospective customers. OUR MARKET IS HIGHLY COMPETITIVE, AND OUR FAILURE TO COMPETE SUCCESSFULLY COULD ADVERSELY AFFECT OUR MARKET POSITION Competition in the public network infrastructure market is intense. This market has historically been dominated by large companies, such as Nortel Networks, Lucent Technologies, Alcatel and Ciena Corporation. In addition, a number of smaller companies have either announced plans for new products or introduced new products to address the same network problems which our products address. Many of our current and potential competitors have significantly greater selling and marketing, technical, manufacturing, financial and other resources, including vendor-sponsored financing programs. Moreover, our competitors may foresee the course of market developments more accurately and could develop new technologies that compete with our products or even render our products obsolete. Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources may enter those markets, thereby further intensifying competition. In order to compete effectively, we must deliver products that: * provide extremely high network reliability; * scale easily and efficiently with minimum disruption to the network; * interoperate with existing network designs and equipment vendors; * reduce the complexity of the network by decreasing the need for overlapping equipment; 24 * provide effective network management; and * provide a cost-effective solution for service providers. In addition, we believe that knowledge of the infrastructure requirements applicable to service providers, experience in working with service providers to develop new services for their customers and an ability to provide vendor-sponsored financing, are important competitive factors in our market. We have a limited ability to provide vendor-sponsored financing and this may influence the purchasing decisions of prospective customers, who may decide to purchase products from one of our competitors who are able to provide more extensive financing programs. Furthermore, as we are increasingly directing our sales efforts towards incumbent carriers which typically have longer sales evaluation cycles, we believe that being able to demonstrate strong financial viability is becoming an increasingly important consideration to our customers in making their purchasing decisions. If we are unable to compete successfully against our current and future competitors, we could experience price reductions, order cancellations and reduced gross margins, any one of which could materially and adversely affect our business, results of operations and financial condition. THE INDUSTRY IN WHICH WE COMPETE IS SUBJECT TO CONSOLIDATION We believe that the industry in which we compete may enter into a consolidation phase. Recently, one of our larger competitors, Ciena Corporation, announced an agreement to acquire another company in our industry, ONI Systems. Over the past 12-18 months, the market valuations of the majority of companies in our industry have declined significantly, and many companies have experienced dramatic decreases in revenue due to decreased customer demand in general, a smaller customer base due to the financial difficulties impacting emerging carriers, reductions in capital expenditures by incumbent carriers, and other factors. We expect that the weakened financial position of many companies in our industry may cause acquisition activity to increase. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. This could lead to more variability in operating results as we compete to be a single vendor solution and could have a material adverse effect on our business, operating results, and financial condition. THE INTELLIGENT OPTICAL NETWORKING MARKET IS EVOLVING AND OUR BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT The market for intelligent optical networking products continues to evolve. In recent periods, there has been a sharp decline in capital spending by our current and prospective customers. We cannot assure you that a viable market for our products will develop or be sustainable. If this market does not develop, develops more slowly than we expect or is not sustained, our business, results of operations and financial condition would be seriously harmed. IF OUR PRODUCTS DO NOT INTEROPERATE WITH OUR CUSTOMERS' NETWORKS, INSTALLATIONS WILL BE DELAYED OR CANCELLED AND WE COULD HAVE SUBSTANTIAL PRODUCT RETURNS, WHICH COULD SERIOUSLY HARM OUR BUSINESS Many of our customers utilize multiple protocol standards, and each of our customers may have different specification requirements to interface with their existing networks. Our customers' networks contain multiple generations of products that have been added over time as these networks have grown and evolved. Specifically, incumbent carriers typically have less evolutionary networks that contain more generations of products. Our products must interoperate with all of the products within our customers' networks as well as future products in order to meet our customers' requirements. The requirement that we modify product design in order to achieve a sale may result in a longer sales cycle, increased research and development expense and reduced margins on our products. If our products do not interoperate with those of our customers' networks, installations could be delayed, orders for our products could be cancelled or our products could be returned. This would also seriously harm our reputation, all of which could seriously harm our business and prospects. 25 UNDETECTED SOFTWARE OR HARDWARE ERRORS AND PROBLEMS ARISING FROM USE OF OUR PRODUCTS IN CONJUNCTION WITH OTHER VENDORS' PRODUCTS COULD RESULT IN DELAYS OR LOSS OF MARKET ACCEPTANCE OF OUR PRODUCTS Networking products frequently contain undetected software or hardware errors when first introduced or as new versions are released. We expect that errors will be found from time to time in new or enhanced products after we begin commercial shipments. In addition, service providers typically use our products in conjunction with products from other vendors. As a result, when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty, support and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. The occurrence of these problems could result in the delay or loss of market acceptance of our products and would likely have a material adverse effect on our business, results of operations and financial condition. Defects, integration issues or other performance problems in our products could result in financial or other damages to our customers or could damage market acceptance for our products. Our customers could also seek damages for losses from us. A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly. OUR FAILURE TO ESTABLISH AND MAINTAIN KEY CUSTOMER RELATIONSHIPS MAY RESULT IN DELAYS IN INTRODUCING NEW PRODUCTS OR CAUSE CUSTOMERS TO FOREGO PURCHASING OUR PRODUCTS Our future success will also depend upon our ability to develop and manage key customer relationships in order to introduce a variety of new products and product enhancements that address the increasingly sophisticated needs of our customers. Our failure to establish and maintain these customer relationships may adversely affect our ability to develop new products and product enhancements. In addition, we may experience delays in releasing new products and product enhancements in the future. Material delays in introducing new products and enhancements or our inability to introduce competitive new products may cause customers to forego purchases of our products and purchase those of our competitors, which could seriously harm our business. The majority of our product sales to date have been to emerging carriers rather than incumbent carriers. We believe that it is important for us to increase our sales to incumbent carriers, including incumbent local exchange carriers such as the Regional Bell Operating Companies ("RBOCs"). Incumbent carriers typically have longer sales evaluation cycles than emerging carriers, and we have limited experience in selling our products to incumbent carriers. In addition, we are currently investing in product certification standards such as the OSMINE standard, which will be necessary for us to increase our sales to the RBOCs. While we have made a commitment to invest resources in obtaining these certification standards, there is no assurance that such efforts will enable us to increase our sales to incumbent carriers. Any failure to establish or maintain strong customer relationships would likely have a material adverse effect on our business and results of operations. OUR FAILURE TO CONTINUALLY IMPROVE OUR INTERNAL CONTROLS AND SYSTEMS, AND RETAIN NEEDED PERSONNEL COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS Since inception, the scope of our operations has increased and we have grown our headcount substantially. However, beginning in the third quarter of fiscal 2001, our headcount levels have been reduced significantly, due primarily to our restructuring activities. At April 27, 2002, we had a total of 665 employees, which represents a reduction of approximately 40% from headcount levels immediately prior to the restructuring actions. Our initial growth, followed by more recent headcount reductions, has placed a significant strain on our management systems and resources. Our ability to successfully offer our products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. We expect that we will need to continue to improve our financial, managerial and manufacturing controls and reporting systems, and will need to effectively manage our headcount levels worldwide. We may not be able to implement adequate control systems in an efficient and timely manner. In spite of recent economic conditions, competition for highly skilled personnel is intense, especially in the New England area where we are headquartered. Any failure to attract, assimilate or retain qualified personnel to fulfill our current or future needs could adversely affect our results of operations. 26 WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY CHANGING MARKET, AND IF WE ARE UNABLE TO RETAIN OUR KEY EMPLOYEES, OUR ABILITY TO COMPETE COULD BE HARMED We depend on the continued services of our executive officers and other key engineering, sales, marketing and support personnel, who have critical industry experience and relationships that we rely on to implement our business plan. None of our officers or key employees is bound by an employment agreement for any specific term. We do not have "key person" life insurance policies covering any of our employees. All of our key employees have been granted stock-based awards which are intended to represent an integral component of their compensation package. These stock-based awards may not provide the intended incentive to our employees if our stock price declines or experiences significant volatility. The loss of the services of any of our key employees, the inability to attract and retain qualified personnel in the future, or delays in hiring qualified personnel could delay the development and introduction of, and negatively impact our ability to sell, our products. IF WE BECOME SUBJECT TO UNFAIR HIRING, WRONGFUL TERMINATION OR OTHER EMPLOYMENT RELATED CLAIMS, WE COULD INCUR SUBSTANTIAL COSTS IN DEFENDING OURSELVES Companies in our industry, whose employees accept positions with competitors, frequently claim that their competitors have engaged in unfair hiring practices. We cannot assure you that we will not receive claims of this kind or other claims relating to our employees, or that those claims will not result in material litigation. During the third quarter of fiscal 2001 and the first quarter of fiscal 2002, we terminated approximately 371 employees in response to changing business conditions, and as a result, we may face claims relating to their compensation and/or wrongful termination based on discrimination. We could incur substantial costs in defending ourselves or our employees against such claims, regardless of their merits. In addition, defending ourselves or our employees against such claims could divert the attention of our management away from our operations. OUR ABILITY TO COMPETE COULD BE JEOPARDIZED IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS FROM THIRD-PARTY CHALLENGES We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners and control access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete effectively could be harmed. IF NECESSARY LICENSES OF THIRD-PARTY TECHNOLOGY ARE NOT AVAILABLE TO US OR ARE VERY EXPENSIVE, THE COMPETITIVENESS OF OUR PRODUCTS COULD BE IMPAIRED From time to time we may be required to license technology from third parties to develop new products or product enhancements. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, either of which could seriously harm the competitiveness of our products. WE COULD BECOME SUBJECT TO CLAIMS REGARDING INTELLECTUAL PROPERTY RIGHTS, WHICH COULD SERIOUSLY HARM OUR BUSINESS AND REQUIRE US TO INCUR SIGNIFICANT COSTS In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. Our industry in particular is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patents and other intellectual property rights. In the course of our business, we may receive claims of infringement or otherwise become aware of potentially relevant patents or other intellectual property rights held by other parties. We evaluate the validity and applicability of these intellectual property rights, and determine in each case whether we must negotiate licenses or cross-licenses to incorporate or use the proprietary technologies in our products. Any parties asserting that our products infringe upon their proprietary rights would force us to defend ourselves and possibly our customers, manufacturers or suppliers against the alleged infringement. Regardless of their merit, these claims could result in costly litigation and subject us to the risk of significant liability for damages. These claims, again regardless of their merit, would likely be time consuming and expensive to resolve, would divert management time and attention and would put the Company at risk to: 27 * stop selling, incorporating or using our products that use the challenged intellectual property; * obtain from the owner of the intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; * redesign those products that use such technology; or * accept a return of products that use such technologies. If we are forced to take any of the foregoing actions, our business may be seriously harmed. ANY ACQUISITIONS OR STRATEGIC INVESTMENTS WE MAKE COULD DISRUPT OUR BUSINESS AND SERIOUSLY HARM OUR FINANCIAL CONDITION As part of our ongoing business development strategy, we consider acquisitions and strategic investments in complementary companies, products or technologies. We completed the acquisition of Sirocco Systems, Inc. in September 2000, and may consider making other acquisitions from time to time. In the event of an acquisition, we could: * issue stock that would dilute our current stockholders' percentage ownership; * consume cash, which would reduce the amount of cash available for other purposes; * incur debt; * assume liabilities; * increase our ongoing operating expenses and level of fixed costs; * record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges; * incur amortization expenses related to certain intangible assets; * incur large and immediate write-offs; or * become subject to litigation; Our ability to achieve the benefits of any acquisition, will also involve numerous risks, including: * problems combining the purchased operations, technologies or products; * unanticipated costs; * diversion of management's attention from other business issues and opportunities; * adverse effects on existing business relationships with suppliers and customers; * risks associated with entering markets in which we have no or limited prior experience; and * problems with integrating employees and potential loss of key employees. We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire in the future and any failure to do so could disrupt our business and seriously harm our financial condition. As of April 27, 2002, we have made strategic investments in privately held companies totaling approximately $26.0 million, and we may decide to make additional investments in the future. During the first quarter of fiscal 2002, we recorded impairment losses of $22.7 million relating to these investments. These types of investments are inherently risky as the market for 28 the technologies or products they have under development are typically in the early stages and may never materialize. We could lose our entire investment in certain or all of these companies. Our strategic investments in privately held companies include an investment of $2.2 million in Tejas Networks India Private Limited ("Tejas"), which was made during the fiscal year ended July 31, 2001. The Chairman of the Board of Sycamore also serves as the Chairman of the Board of Tejas. We have no obligation to provide any additional funding to Tejas, and have not engaged in any material transactions with Tejas since the date of our original investment. ANY EXTENSION OF CREDIT TO OUR CUSTOMERS MAY SUBJECT US TO CREDIT RISKS AND LIMIT THE CAPITAL THAT WE HAVE AVAILABLE FOR OTHER USES We are experiencing increased demands for customer financing and we expect these demands to continue. We believe it is a competitive factor in obtaining business. From time to time we have provided extended payment terms on trade receivables to certain key customers to assist them with their network deployment plans. In addition, we may provide or commit to extend additional credit or credit support, such as vendor financing, to our customers as we consider appropriate in the course of our business. Such financing activities subject us to the credit risk of customers whom we finance. In addition, our ability to recognize revenue from financed sales will depend upon the relative financial condition of the specific customer, among other factors. Although we have programs in place to monitor the risk associated with vendor financing, we cannot assure you that such programs will be effective in reducing our risk of an impaired ability to pay on the part of a customer whom we have financed. We could experience losses due to customers failing to meet their financial obligations which could harm our business and materially adversely affect our operating results and financial condition, such as the losses that we incurred during the first quarter of fiscal 2002. During the first quarter of fiscal 2002, we experienced losses relating to our two existing vendor financing customers, as each of them experienced a significant deterioration in their financial condition. As a result, we determined that we were unlikely to realize any significant proceeds from these vendor financing agreements. Accordingly, we recorded an impairment charge for the assets related to these financing agreements, which consisted of the cost of the systems shipped to the vendor financing customers, and had been recorded in other long-term assets. RISKS RELATED TO THE SECURITIES MARKET OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE Historically, the market for technology stocks has been extremely volatile. Our common stock has experienced, and may continue to experience, substantial price volatility. The following factors could cause the market price of our common stock to fluctuate significantly: * our loss of a major customer; * significant changes or slowdowns in the funding and spending patterns of our current and prospective customers; * the addition or departure of key personnel; * variations in our quarterly operating results; * announcements by us or our competitors of significant contracts, new products or product enhancements; * failure by us to meet product milestones; * acquisitions, distribution partnerships, joint ventures or capital commitments; * variations between our actual results and the published expectations of analysts; * changes in financial estimates by securities analysts; * sales of our common stock or other securities in the future; * changes in market valuations of networking and telecommunications companies; and * fluctuations in stock market prices and volumes. 29 In addition, the stock market in general, and the Nasdaq National Market and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company's securities, securities class-action litigation has often been instituted against such companies. Beginning on July 2, 2001, several purported securities class action complaints were filed against the Company, several of its officers and directors and the Company's lead underwriters in connection with the Company's initial public offering and follow-on offering. The Company believes that the claims against it are without merit and intends to defend against the complaints vigorously. However, defending the Company and its officers against these complaints may result in substantial costs and a diversion of management's attention and resources. See Part II, Item 1 - Legal Proceedings for additional details regarding these cases. THERE MAY BE SALES OF A SUBSTANTIAL AMOUNT OF OUR COMMON STOCK THAT COULD CAUSE OUR STOCK PRICE TO FALL, OR INCREASE THE VOLATILITY OF OUR STOCK PRICE As of April 27, 2002, options to purchase a total of 29.7 million shares of our common stock were outstanding. Included in this amount were options to purchase approximately 12.6 million shares that were issued during the second quarter of fiscal 2002, in accordance with the terms of an option exchange program in which most of our employees were eligible to participate. While these options are subject to vesting schedules, a number of the shares underlying these options are freely tradable. Sales of a substantial number of shares of our common stock could cause our stock price to fall or increase the volatility of our stock price. In addition, sales of shares by our stockholders could impair our ability to raise capital through the sale of additional stock. INSIDERS OWN A SUBSTANTIAL NUMBER OF SYCAMORE SHARES AND COULD LIMIT YOUR ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS, INCLUDING CHANGES OF CONTROL As of April 27, 2002, the executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 39.6% of our outstanding common stock. These stockholders, if acting together, would be able to significantly influence matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. PROVISIONS OF OUR CHARTER DOCUMENTS AND DELAWARE LAW MAY HAVE ANTI-TAKEOVER EFFECTS THAT COULD PREVENT A CHANGE OF CONTROL Provisions of our amended and restated certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. 30 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes. Interest Rate Sensitivity We maintain a portfolio of cash equivalents and short-term and long-term investments in a variety of securities including: commercial paper, certificates of deposit, money market funds and government and non-government debt securities. These available-for-sale securities are subject to interest rate risk and may fall in value if market interest rates increase. If market interest rates increase immediately and uniformly by 10 percent from levels at April 27, 2002, the fair value of the portfolio would decline by approximately $1.2 million. We have the ability to hold our fixed income investments until maturity, and therefore do not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio. Exchange Rate Sensitivity We operate primarily in the United States, and the majority of our sales to date have been made in US dollars. However, our business has become increasingly global, with international revenue representing 35% of total revenue in fiscal 2001, and a substantial majority of total revenue in the first three quarters of fiscal 2002. We anticipate that international sales will continue to represent a significant portion of total revenue. As a result, we expect that sales in non-dollar currencies and our exposure to foreign currency exchange rate fluctuations are likely to increase. To date, international sales that create exposure to foreign currency exchange rate fluctuations have been made primarily in British Pounds and Japanese Yen. We are prepared to hedge against fluctuations in foreign currencies if the exposure is material, although we have not engaged in hedging activities to date. PART II. OTHER INFORMATION Item 1. Legal Proceedings Beginning on July 2, 2001, several purported class action complaints were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors and the underwriters for the Company's initial public offering on October 21, 1999. Some of the complaints also include the underwriters for the Company's follow-on offering on March 14, 2000. The complaints were consolidated into a single action and an amended complaint was filed on April 19, 2002. The amended complaint was filed on behalf of persons who purchased the Company's common stock between October 21, 1999 and December 6, 2000. The amended complaint alleges violations of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, primarily based on the assertion that the Company's lead underwriters, the Company and the other named defendants made material false and misleading statements in the Company's Registration Statements and Prospectuses filed with the SEC in October 1999 and March 2000 because of the failure to disclose (a) the alleged solicitation and receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock to certain investors in the Company's public offerings and (b) that certain of the underwriters allegedly had entered into agreements with investors whereby underwriters agreed to allocate the public offering shares in exchange for which the investors agreed to make additional purchases of stock in the aftermarket at pre-determined prices. The amended complaint alleges claims against the Company, several of the Company's officers and directors and the underwriters under Sections 11 and 15 of the Securities Act. It also alleges claims against the Company, the individual defendants and the underwriters under Sections 10(b) and 20(a) of the Securities Exchange Act. The action against the Company is being coordinated with over three hundred other nearly identical actions filed against other companies. No date has been set for a response to the amended complaint. The actions seek damages in an unspecified amount. The Company believes that the claims against it are without merit and intends to defend against the complaints vigorously. The Company is not currently able to estimate the possibility of loss or range of loss, if any, relating to these claims. The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company's results of operations or financial position. 31 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K Exhibits: (a) List of Exhibits Number Exhibit Description ------ ------------------- 3.1 Amended and Restated Certificate of Incorporation of the Company (2) 3.2 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of the Company (2) 3.3 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of the Company (3) 3.4 Amended and Restated By-Laws of the Company (2) 4.1 Specimen common stock certificate (1) 4.2 See Exhibits 3.1, 3.2, 3.3 and 3.4, for provisions of the Certificate of Incorporation and By-Laws of the Registrant defining the rights of holders of common stock of the Company (2)(3) 4.3 Second Amended and Restated Investor Rights Agreement dated February 26, 1999, as amended by Amendment No. 1 dated as of July 23, 1999 (1) 4.4 Amendment No. 2 dated as of August 5, 1999 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) 4.5 Amendment No. 3 dated as of September 20, 1999 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) 4.6 Amendment No. 4 dated as of February 11, 2000 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) (1) Incorporated by reference to Sycamore Networks Inc.'s Registration Statement on Form S-1 (Registration Statement No. 333-84635). (2) Incorporated by reference to Sycamore Networks Inc.'s Registration Statement on Form S-1 (Registration Statement File No. 333-30630). (3) Incorporated by reference to Sycamore Networks Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended January 27, 2001 filed with the Commission on March 13, 2001. (b) Reports on Form 8-K : None 32 SIGNATURE 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. Sycamore Networks, Inc. /s/ Frances M. Jewels - --------------------- Frances M. Jewels Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer) Dated: June 7, 2002 33 EXHIBIT INDEX Number Exhibit Description ------ ------------------- 3.1 Amended and Restated Certificate of Incorporation of the Company (2) 3.2 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of the Company (2) 3.3 Certificate of Amendment to the Amended and Restated Certificate of Incorporation of the Company (3) 3.4 Amended and Restated By-Laws of the Company (2) 4.1 Specimen common stock certificate (1) 4.2 See Exhibits 3.1, 3.2, 3.3 and 3.4, for provisions of the Certificate of Incorporation and By-Laws of the Registrant defining the rights of holders of common stock of the Company (2)(3) 4.3 Second Amended and Restated Investor Rights Agreement dated February 26, 1999, as amended by Amendment No. 1 dated as of July 23, 1999 (1) 4.4 Amendment No. 2 dated as of August 5, 1999 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) 4.5 Amendment No. 3 dated as of September 20, 1999 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) 4.6 Amendment No. 4 dated as of February 11, 2000 to the Second Amended and Restated Investor Rights Agreement dated February 26, 1999 (2) (1) Incorporated by reference to Sycamore Networks Inc.'s Registration Statement on Form S-1 (Registration Statement No. 333-84635). (2) Incorporated by reference to Sycamore Networks Inc.'s Registration Statement on Form S-1 (Registration Statement File No. 333-30630). (3) Incorporated by reference to Sycamore Networks Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended January 27, 2001 filed with the Commission on March 13, 2001. 34 -----END PRIVACY-ENHANCED MESSAGE-----