Extreme Networks 10-K 2010
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended June 27, 2010
For the transition period from to .
Commission file number 000-25711
Extreme Networks, Inc.
(Exact name of Registrant as specified in its charter)
Registrants telephone number, including area code: (408) 579-2800
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common stock, $.001 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check One):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $256.4 million as of December 27, 2009, the last business day of the Registrants most recently completed second fiscal quarter, based upon the per share closing price of the Registrants common stock as reported on The Nasdaq Global Market reported on such date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose.
90,749,782 shares of the Registrants Common stock, $.001 par value, were outstanding as of August 16, 2010.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates by reference from the definitive proxy statement for the Companys 2010 Annual Meeting of Stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
FORWARD LOOKING STATEMENTS
This annual report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, particularly, our expectations regarding results of operations, our ability to expand our market penetration, our ability to expand our distribution channels, customer acceptance of our products, our ability to meet the expectations of our customers, product demand and revenue, cash flows, product gross margins, our expectations to continue to develop new products and enhance existing products, our expectations regarding the amount of our research and development expenses, our expectations relating to our selling, general and administrative expenses, our efforts to achieve additional operating efficiencies and to review and improve our business systems and cost structure, our expectations to continue investing in technology, resources and infrastructure, our expectations concerning the availability of products from suppliers and contract manufacturers, anticipated product costs and sales prices, our expectations that we have sufficient capital to meet our requirements for at least the next twelve months, our expectations regarding the rationalization of our workforce and facilities and our expectations regarding materials and inventory management. These forward-looking statements involve risks and uncertainties, and the cautionary statements set forth below and those contained in the section entitled Risk Factors identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified in this Form 10-K and other filings we have made with the Securities and Exchange Commission. More information about potential factors that could affect our business and financial results is set forth under Risk Factors and Managements Discussion and Analysis of Financial Condition and Results of Operations.
Item 1. Business
Extreme Networks, Inc., together with its subsidiaries, (collectively referred to as Extreme and as we, us and our) is a leading provider of network infrastructure equipment and services for enterprises, data centers, and metropolitan telecommunications service providers. Our customers include businesses, hospitals, schools, hotels, telecommunications companies and government agencies around the world. Since we were established in 1996 through to the present day, we have had a single technology vision of Ethernet Everywhere a unifying network strategy that uses Ethernet technology to simplify each element and component of the network, and, through simplification, provide services at a lower cost. As networks internal to businesses and the Internet become more and more pervasive and critical to a wide variety of business and social communications, the volume and the demands of applications, data, users and devices on networks continue to increase. Our vision of Ethernet Everywhere helps us design and deliver easily deployable, highly scalable, secure and comprehensively managed networks which are reliable, fast, flexible and cost-effective. We primarily sell our products through an ecosystem of our channel partners who combine our Ethernet products with their offerings to create compelling information technology solutions for end user customers.
Businesses, governments, educational institutions, service providers, data center operators and other organizations have become highly dependent on their internal networks and the Internet. In fact, modern society is significantly dependent upon the Internet and the myriad of services and systems to which it provides access. The Internet and internal business networks serve as a central communications infrastructure that connect internal and external sites and deliver data, voice and video communications to a dramatically increasing number of users. Over the course of the past ten years, the wide adoption of the Internet Protocol (or IP) has enabled the spread of high speed networks from educational facilities and corporations out to residences around the globe. In
addition, IP enabled devices as diverse as servers, printers, laptops, desk phones, televisions, residential networks, cell phones and various wireless devices are now connected to both hard-wired and wireless Ethernet networks over which IP information flows. A variety of critical computing applications that are central to business and communications, such as Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), Sales Force Automation (SFA), large enterprise data warehouses, and sophisticated e-commerce and e-business applications depend upon high-speed, reliable networks. Communication in todays world operates through the existence of business-to-business and business-to-consumer Ethernet network connectivity. Looking ahead, the continued explosive growth of peer-to-peer networking will continue to drive the ever increasing demand for network connectivity and capacity.
The networking industry has evolved significantly over the past 10 years. We believe that the following trends have and will continue to influence the industry as it continues to rapidly evolve to meet network demands:
The Extreme Networks Strategy
Our goal is to be the provider of innovative, business relevant and compelling network solutions that create an improved applications and services infrastructure for enterprises, data centers and metropolitan service providers. We seek to provide our customers with a best-of-breed alternative to single-sourced, highly proprietary networking equipment from larger competitors.
Key elements of our strategy include:
We focus our development efforts specifically on converged networks which must reliably deliver data, voice and video to users.
The following key benefits of our products allow our customers to operate highly scalable, secure and comprehensively managed networks which are reliable, fast, flexible and cost-effective.
Our product categories include:
Sales, Marketing and Distribution
We conduct our sales and marketing activities on a worldwide basis through a distribution channel utilizing distributors, resellers and our field sales organization. We primarily sell our products through an ecosystem of channel partners who combine our Ethernet products with their offerings to create compelling information technology solutions for end user customers. We utilize our field sales organization to support our channel partners and to sell direct to end-user customers, including some large global accounts.
Strategic Relationships. We have strategic relationships with Motorola Inc., Dell, Inc., Ericsson Enterprise AB, Nokia Siemens Networks and others who sell our products as part of an overall solution.
Distributors. We have established several key relationships with leading distributors in the electronics and computer networking industries. Each of our distributors primarily resells our products to resellers. The distributors enhance our ability to sell and provide support to resellers, who may benefit from the broad service and product fulfillment capabilities offered by these distributors. One distributor, Tech Data Corporation, accounted for 12%, 11% and 11% of our net revenue in fiscal years 2010, 2009 and 2008, respectively. Distributors are generally given the right to return a portion of inventory to us for the purpose of stock rotation and participate in various cooperative marketing programs to promote the sale of our products and services. We defer recognition of revenue on all sales to distributors who maintain inventory of our products until the distributors sell the product, as evidenced by monthly sales-out reports that the distributors provide to us, provided other revenue recognition criteria are met. (See Revenue Recognition in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.)
Resellers. We rely on many resellers worldwide that sell directly to end-user customer. Our resellers include regional networking system resellers, resellers who focus on specific vertical markets, value added resellers, network integrators and wholesale resellers. We provide training and support to our resellers and our resellers generally provide the first level of contact to end-users of our products. Our relationships with resellers are generally on a non-exclusive basis. Our resellers are not given rights to return inventory and do not automatically participate in any cooperative marketing programs. We generally recognize product revenue from our reseller and end-user customers at the time of shipment, provided other revenue recognition criteria are met. When significant obligations or contingencies remain after products are delivered, such as installation or customer acceptance, revenue and related costs are deferred until such obligations or contingencies are satisfied. (See Revenue Recognition in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.)
Field Sales. We have trained our field sales organization to support and develop leads for our resellers and to establish and maintain key accounts and strategic end user customers. To support these objectives, our field sales force:
As of June 27, 2010, our worldwide sales and marketing organization consisted of 302 individuals, including directors, managers, sales representatives, and technical and administrative support personnel. We have domestic sales offices located in 13 states and international sales offices located in 23 countries.
International sales are an important portion of our business. In fiscal 2010, sales to customers outside of North America accounted for 60% of our consolidated net revenue, compared to 61% in fiscal 2009 and 56% in fiscal 2008. These sales are conducted primarily through foreign-based distributors and resellers managed by our worldwide sales organization. In addition, we have direct sales to end-user customers, including large global accounts. The primary markets for sales outside of North America are countries in Europe and Asia. (See Net Revenue in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.)
See Note 2 of our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for more information regarding our long-lived assets.
We continue to develop and execute on a number of marketing programs to support the sale and distribution of our products by communicating the value of our solutions to our existing and potential customers, our distribution channels and our resellers. Our marketing efforts include participation in industry tradeshows, technical conferences and technology seminars, preparation of competitive analyses, sales training, and publication of technical and educational articles in industry journals, a publicly available website, promotions, web-based training courses, advertising and public relations. We also submit our products for independent product testing and evaluation.
Our products are often sold on the basis of standard purchase orders that are cancelable prior to shipment without significant penalties. In addition, purchase orders are subject to changes in quantities of products and delivery schedules in order to reflect changes in customer requirements and manufacturing capacity. Our business is characterized by seasonal variability in demand and short lead-time orders and delivery schedules. Actual shipments depend on the then-current capacity of our contract manufacturers and the availability of materials and components from our vendors. We believe that only a small portion of our order backlog is non-cancelable and that the dollar amount associated with the non-cancelable portion is not material. Accordingly, we do not believe that backlog at any given time is a meaningful indicator of future revenue.
Like many of our competitors, we historically have experienced seasonal fluctuations in customer spending patterns, which generally adversely affect our first and third fiscal quarters. This pattern should not be relied upon, however, as it has varied in the past.
Customer Service and Support
Our customers seek high reliability and maximum uptime for their networks. To that extent, we provide the following service offerings:
We outsource the majority of our manufacturing and supply chain management operations as part of our strategy to maintain global manufacturing capabilities and to reduce our costs. We conduct quality assurance, manufacturing engineering, document control and test development at our main campus in Santa Clara, California. This approach enables us to reduce fixed costs and to flexibly respond to changes in market demand.
We have a relationship with Flextronics International, Ltd. for the manufacture of some of our products in Guadalajara, Mexico. Flextronics manufacturing processes and procedures are ISO 9001 certified. We determine the components that are incorporated in our products and select the appropriate suppliers of such components.
We also maintain a relationship with Alpha Networks, Inc. headquartered in Hsinchu, Taiwan. Alpha Networks is a global networking Original Design Manufacturer (ODM) leader with core competencies in areas such as Ethernet, LAN/MAN, Wireless, Broadband and VoIP. Alpha Networks manufacturing processes and procedures are ISO 9001 certified. We partner with Alpha Networks to design and build some of our products.
We have a relationship with Benchmark Electronics Huntsville Inc. for the manufacture of some of our products in Huntsville, Alabama. Benchmark manufacturing processes and procedures are ISO 9001 certified. We determine the components that are incorporated in our products and select the appropriate suppliers of such components.
Our wireless products are supplied under an OEM supply agreement with Symbol Technologies, Inc, a subsidiary of Motorola, Inc. (Motorola). Motorola rebrands and customizes the wireless products for us to resell to customers. Motorolas manufacturing processes and procedures are ISO 9001 certified. Motorola has made ongoing supply and support commitments during the term of the agreement and is required to provide support for a defined period of time after any termination of the agreement.
These manufacturers utilize automated testing equipment to perform product testing and burn-in with specified tests. Together we rely upon comprehensive inspection testing and statistical process controls to assure the quality and reliability of our products.
We use our forecast of expected demand to determine our material requirements. Lead times for materials and components vary significantly, and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. We order most of our materials and components on an indirect basis through our contract manufacturer. Purchase commitments with our manufacturers are generally on a purchase order basis.
Research and Development
The success of our products to date is due in large part to our focus on research and development. We believe that continued success in the marketplace will depend on our ability to develop new and enhanced products employing leading-edge technology. Accordingly, we are undertaking development efforts with an emphasis on increasing the reliability, performance and features of our family of products, and designing innovative products to reduce the overall network operating costs of customers.
Our product development activities focus on solving the needs of enterprises, data centers, and service providers. Current activities include the continuing development of our innovative switching technology aimed at extending the capabilities of our products. Our ongoing research activities cover a broad range of areas, including, in particular, 10 Gigabit and higher-speed Ethernet, Metro and Internet routing, network security, network management software, datacenter equipment broadband access equipment and wireless networking equipment.
We continued to enhance the functionality of our modular operating system (ExtremeXOS) which has been designed to provide high reliability and availability. This allows us to leverage a common operating system across different hardware and network chipsets.
As of June 27, 2010, our research and development organization consisted of 205 individuals. Research and development efforts are conducted in several locations, including Santa Clara, California; Raleigh, North Carolina; and Chennai, India. Our research and development expenses in fiscal years 2010, 2009 and 2008 were $49.4 million, $58.2 million and $65.3 million, respectively.
The market for network switches, which is part of the broader market for networking equipment, is extremely competitive and characterized by rapid technological progress, frequent new product introductions, changes in customer requirements and evolving industry standards. We believe the principal competitive factors in the network switching market are:
We believe that we compete with our competitors with respect to many of the foregoing factors. However, the market for network switching solutions is dominated by a few large companies, particularly Cisco Systems, Inc. In addition to Cisco Systems, we compete with public and private companies that offer switching solutions or provide alternative networking solutions, including, Alcatel-Lucent, Brocade Communications Systems, Inc., Hewlett-Packard Company, Huawei Technologies Corporation, Juniper Networks, Inc. and Siemens Enterprise Communications GmBH & Co. KG. Most of these competitors have longer operating histories, greater name recognition, larger customer bases, broader product lines and substantially greater financial, technical, sales, marketing and other resources.
We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Based on our commitment to build a patent portfolio, we have in process a number of patent applications relating to our proprietary technology in the United States and in selected other countries. With respect to trademarks, we have a number of pending and registered trademarks in the United States and abroad.
We 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. In addition, we provide our software products to end-user customers primarily under shrink-wrap license agreements. These agreements are not negotiated with or signed by the licensee, and thus these agreements may not be enforceable in some jurisdictions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.
We maintain compliance with various regulations related to the environment, including the Waste Electrical and Electronic Equipment and Restriction of the Use of Certain Hazardous Substances in Electrical and
Electronic Equipment regulations adopted by the European Union. Further, we are committed to energy efficiency in our product lines. For example, certain of our products consume far less power than offerings from our major competitors. Accordingly, we believe this is an area that affords us a competitive advantage for our products in the marketplace. To date, our compliance efforts with various U.S. and foreign regulations related to the environment has not had a material effect on our operating results.
As of June 27, 2010, we employed 740 people, including 302 in sales and marketing, 205 in research and development, 62 in operations, 96 in customer support and service, and 75 in finance and administration. We have never had a work stoppage and no personnel are represented under collective bargaining agreements. We consider our employee relations to be good.
We believe that our future success depends on our continued ability to attract, integrate, retain, train and motivate highly qualified personnel, and upon the continued service of our senior management and key personnel. None of our executive officers or key employees is bound by an employment agreement which mandates that the employee render services for any specific term. The market for qualified personnel is competitive, particularly in the San Francisco Bay Area, where our headquarters is located.
We were incorporated in California in May 1996 and reincorporated in Delaware in March 1999. Our corporate headquarters are located at 3585 Monroe Street, Santa Clara, CA 95051 and our telephone number is (408) 579-2800. We electronically file our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 with the Securities Exchange Commission. The public can obtain copies of our SEC filings from our website found at www.extremenetworks.com free of charge, or on the Securities Exchange Commissions website at www.sec.gov. The public may also read or copy any materials we file with the Securities Exchange Commission at the Securities Exchange Commissions Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the Securities Exchange Commission at 1-800-SEC-0330.
Our corporate governance guidelines, the charters of our audit committee, our compensation committee and our nominating and corporate governance committee and our code of ethics policy (including code of ethics provisions that apply to our principal executive officer, principal financial officers, controller and senior financial officers) are available on our website at www.extremenetworks.com under Corporate Governance. These items are also available to any stockholder who requests them by calling (408) 579-2800.
Executive Officers of the Registrant
The following table sets forth information regarding our executive officers as of August 20, 2010:
Bob L. Corey. Mr. Corey is Acting Executive Chief Executive Officer, as well as the Senior Vice President and Chief Financial Officer of Extreme Networks. Prior to joining Extreme Networks, Mr. Corey served on our
board of directors, from 2003 to 2009, and was the chairman of our audit committee. Prior to Extreme Networks, Mr. Corey served as Executive Vice President and Chief Financial Officer for Thor Technologies, Inc., a provider of enterprise provisioning software, from May 2003 until January 2006. Oracle Corporation acquired Thor Technologies in November 2005. Mr. Corey served as Executive Vice President and Chief Financial Officer of Documentum, Inc., a provider of enterprise content management software, from May 2000 to August 2002. Mr. Corey served as Senior Vice President of Finance and Administration and Chief Financial Officer for Forte Software, Inc., a provider of software development tools and services, from May 1998 to April 2000. In February 1999, Mr. Corey was elected to its Board of Directors prior to Forte Softwares acquisition by Sun Microsystems in October 1999. Mr. Corey also served as Chairman of the Board of Directors of Interwoven, Inc., a publicly-traded provider of enterprise content management software, until its acquisition by Autonomy Corporation plc in March 2009 and continues to serve on the Board of Directors of Veraz Networks, a publicly-traded provider of IP soft switches, media gateways and digital compression products. Mr. Corey holds a Bachelors of Administration with a concentration in accounting from California State University at Fullerton.
Paul A. Hooper. Mr. Hooper serves as Extreme Networks Chief Marketing Officer. Hooper, a 15 year veteran of the High Tech industry, oversees Extreme Networks worldwide marketing efforts, where he leads the strategic focus of solutions and technical marketing, global field marketing and corporate communications. Prior to that, he served as Vice President and General Manager for the Volume Products Group, responsible for the strategy, product development and business management for Extreme Networks Summit family of fixed configuration switches, the BlackDiamond 8800 family of modular switches, wireless LAN solution and security solutions. Hooper also serves as Extreme Networks executive sponsor for data center and enterprise LAN initiatives. Prior to that, as Extreme Networks Chief Information Officer, Mr. Hooper oversaw the strategic use of IT systems and adherence to corporate compliance for data throughout a globally distributed business. Specifically, Mr. Hooper led the planning, procurement and ongoing support of business applications, network infrastructure and related services supporting more than 800 employees across 50 countries. Prior to joining Extreme Networks, Mr. Hooper served as vice president of information technology at myCFO, Inc., where he was responsible for the Enterprise Applications and Infrastructure for the fast-growing Financial Services and Advisory company. Mr. Hooper has also held senior-level IT positions with JDS Uniphase, Netscape Communications and Sun Microsystems.
Suresh K. Gopalakrishnan. Mr. Gopalakrishnan leads the Companys engineering team and is responsible for all technology strategy and product development for Extreme Networks. Mr. Gopalakrishnan leverages a rich background in business strategy, marketing, systems engineering and product development to this role. Mr. Gopalakrishnan previously held the roles of vice president and general manager of Scalable Products Group where he was responsible for Extreme Networks carrier business; vice president and general manager of Emerging Product Group where he was responsible for Extreme Networks wireless and security business; Chief Marketing Officer of Extreme Networks where he was responsible for worldwide marketing, product management and solutions marketing; as well as vice president and general manager of Converged Systems, where he was responsible for IP Telephony alliances. Prior to joining Extreme Networks, Mr. Gopalakrishnan was the executive vice president of engineering at Riverstone Networks and served as the director of corporate strategy at Cabletron Systems. Mr. Gopalakrishnan has also held management positions at Sun Microsystems and engineering positions at Hewlett Packard. Mr. Gopalakrishnan is a member of the Board of Expert Advisors of the California Emerging Technology Fund (CETF) and has been an adjunct faculty member at University of Idaho and Santa Clara University. He holds a Ph.D. in Electrical Engineering from the University of Idaho.
Mike L. Seaton. Mr. Seaton serves as Vice President for Worldwide Sales and Services at Extreme Networks, an organization that includes worldwide sales, channels and global customer support serving enterprise, data center and carrier customers. Mr. Seaton, a 20 year industry veteran, previously held the role of Vice President and General Manager of Worldwide Services for Extreme Networks, where he oversaw the delivery of technical support, education, advanced technical and professional services. Prior to that, Mr. Seaton was the Vice President of Sales Operations and Strategic Alliances, where he was responsible for ensuring that
the benefit of combined solutions and a strategic relationship realized by Extreme Networks joint business partners and customers worldwide. Prior to joining Extreme Networks, Mr. Seaton held various positions at AT&T, Lucent Technologies and Avaya throughout his career. Mr. Seatons experience is highlighted by programming, services, sales, sales management, sales leadership, operations and internal business consulting. Mr. Seaton holds a Bachelor of General Studies with a concentration in Mathematics and Computer Science from the University of Michigan and an MBA from Florida State University.
Diane C. Honda. Ms. Honda serves as our Senior Vice President, General Counsel and Secretary. She has been employed by the Company since November 2004, and prior to her current positions was Vice President and Associate General Counsel. She previously held legal or business positions with Speedera Networks, Inc., Riverstone Networks, Inc., Legato Systems, Inc., and Hewlett-Packard Company. She received a bachelors in science in Applied Math Computer Science and Industrial Management from Carnegie Mellon University and a J.D. from Santa Clara University School of Law.
Justin A. DiMacchia. Mr. DiMacchia serves as our Vice President, Controller. He has been employed by Extreme Networks since August 2004, and prior to his current positions was Director of Internal Audit. He has held various positions in Extreme Networks finance group, including Interim Vice President Corporate Controller. Before joining Extreme Networks, Mr. DiMacchia held various Financial Management positions with increasing responsibility while at Palm, Inc. Prior to Palm, Inc., he was the Vice President Chief Financial Officer of The Appletree Companies. Mr. DiMacchia commenced his career with Arthur Andersen & Co and is a Certified Public Accountant in California.
Item 1A. Risk Factors
The following is a list of risks and uncertainties which may have a material and adverse effect on our business, financial condition or results of operations. The risks and uncertainties set out below are not the only risks and uncertainties we face, and some are endemic to the networking industry.
We Cannot Assure You That We Will Be Profitable in the Future Because A Number of Factors Could Negatively Affect Our Financial Results.
Although we reported profits for fiscal 2010, we have reported losses in some of our prior fiscal years. In addition, in years when we reported profits, we were not profitable in each quarter during those years. We anticipate continuing to incur significant sales and marketing, product development and general and administrative expenses. A high percentage of these expenses are fixed in the short term, so any delay in generating or recognizing revenue could result in a loss for a quarter or full year. Even if we are profitable, our operating results may fall below the expectations of public market analysts or investors, which could cause the price of our stock to fall.
We may experience challenges or delays in generating or recognizing revenue for a number of reasons and our revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including, but not limited to, the following:
Due to the foregoing factors, period-to-period comparisons of our operating results should not be relied upon as an indicator of our future performance.
Intense Competition in the Market for Networking Equipment Could Prevent Us from Increasing Revenue and Achieving Profitability.
The market for network switching solutions is intensely competitive and dominated primarily by Cisco Systems and a few other large companies. Most of our competitors have longer operating histories, greater name recognition, larger customer bases, broader product lines and substantially greater financial, technical, sales, marketing and other resources. As a result, these competitors are able to devote greater resources to the development, promotion, sale and support of their products. In addition, they have larger distribution channels, stronger brand names, access to more customers, a larger installed customer base and a greater ability to make
attractive offers to channel partners and customers than we do. For example, we have encountered, and expect to continue to encounter, many potential customers who are confident in and committed to the product offerings of our principal competitors, including Cisco Systems. Accordingly, these potential customers may not consider or evaluate our products. When such potential customers have considered or evaluated our products, we have in the past lost, and expect in the future to lose, sales to some of these customers as large competitors have offered significant price discounts to secure these sales.
The pricing policies of our competitors impact the overall demand for our products and services. Some of our competitors are capable of operating at significant losses for extended periods of time, increasing pricing pressure on our products and services. If we do not maintain competitive pricing, the demand for our products and services, as well as our market share, may decline. From time to time, we may lower the prices of our products and services in response to competitive pressure. When this happens, if we are unable to reduce our component costs or improve operating efficiencies, our revenue and margins will be adversely affected.
Our Success is Dependent on Our Ability to Continually Introduce New Products and Features that Achieve Broad Market Acceptance.
The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirements and evolving industry standards. If we do not regularly introduce new products in this dynamic environment, our product lines will become obsolete. These new products must be compatible and interoperate with products and architectures offered by other vendors. We have and may in the future experience delays in product development and releases, and such delays have and could in the future adversely affect our ability to compete and our operating results.
When we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer or cancel orders for our existing products. These actions could have a material adverse effect on our operating results by unexpectedly decreasing sales, increasing inventory levels of older products and exposing us to greater risk of product obsolescence.
Even if we introduce new switching products, alternative technologies could achieve widespread market acceptance and displace the Ethernet technology on which we have based our product architecture. For example, developments in routers and routing software could significantly reduce demand for our products. As a result, we may not be able to achieve widespread market acceptance of our current or future new products.
The Unfavorable Economic Environment Has and May Continue to Negatively Impact our Business and Operating Results.
The challenges and uncertainty currently affecting global economic conditions may negatively impact our business and operating results in the following ways:
If global economic conditions do not show continued improvement, we believe that we will experience material adverse impacts to our business and operating results.
Claims of Infringement by Others May Increase and the Resolution of Such Claims May Adversely Affect Our Operating Results.
Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patents, copyrights (including rights to open source software), and other intellectual property rights. Because of the existence of a large number of patents in the networking field, the secrecy of some pending patents and the issuance of new patents at a rapid pace, it is not possible to determine in advance if a product or component might infringe the patent rights of others. Because of the potential for courts awarding substantial damages and the lack of predictability of such awards, it is not uncommon for companies in our industry to settle even potentially unmeritorious claims for very substantial amounts. Further, the entities with whom we have or could have disputes or discussions include entities with extensive patent portfolios and substantial financial assets. These entities are actively engaged in programs to generate substantial revenue from their patent portfolios and are seeking or may seek significant payments or royalties from us and others in our industry.
Litigation resulting from claims that we are infringing the proprietary rights of others has resulted and could in the future result in substantial costs and a diversion of resources, and could have a material adverse effect on our business, financial condition and results of operations. We have received notices from entities alleging that we may be infringing their patents, and we are currently parties to patent litigation as described under Part I, Item 3, Legal Proceedings. Without regard to the merits of these or any other claims, an adverse court order or a settlement could require us, among other actions, to:
In addition, our products include so-called open source software. Open source software is typically licensed for use at no initial charge, but imposes on the user of the open source software certain requirements to license to others both the open source software as well as modifications to the open source software. Our use of open source software subjects us to certain additional risks for the following reasons:
We believe that even if we do not infringe the rights of others, we will incur significant expenses in the future due to disputes or licensing negotiations, though the amounts cannot be determined. These expenses may be material or otherwise adversely affect our operating results.
Our Operating Results May be Negatively Affected by Defending or Pursuing Claims or Lawsuits.
We have and may in the future pursue or be subject to claims or lawsuits in the normal course of our business. In addition to the intellectual property lawsuits described above, we are currently parties to securities and contract litigation as described in Item 3. Legal Proceedings. Regardless of the result, litigation can be expensive, lengthy and disruptive to normal business operations. Moreover, the results of complex legal
proceedings are difficult to predict. An unfavorable resolution of a lawsuit in which we are a defendant could result in a court order against us or payments to other parties that would have an adverse effect on our business, results of operations, or financial condition. Even if we are successful in prosecuting claims and lawsuits, we may not recover damages sufficient to cover our expenses incurred to manage, investigate and pursue the litigation. In addition, subject to certain limitations, we may be obligated to indemnify our current and former directors, officers and employees in certain lawsuits. We do not maintain insurance coverage which will cover all of our litigation costs and liabilities.
If We Fail To Protect Our Intellectual Property, Our Business Could Suffer.
We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. However, we cannot ensure that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independently develop similar or competing products that do not infringe on our patents. We generally enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our intellectual property and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology, which would adversely affect our business.
We Expect the Average Selling Prices of Our Products to Decrease, Which May Reduce Gross Margin and/or Revenue.
The network equipment industry has traditionally experienced an erosion of average selling prices due to a number of factors, including competitive pricing pressures, promotional pricing and technological progress. We anticipate that the average selling prices of our products will decrease in the future in response to competitive pricing pressures, excess inventories, increased sales discounts and new product introductions by us or our competitors. We may experience substantial decreases in future operating results due to the erosion of our average selling prices. To maintain our gross margin, we must develop and introduce on a timely basis new products and product enhancements and continually reduce our product costs. Our failure to do so would likely cause our revenue and gross margins to decline.
When Our Products Contain Undetected Errors, We May Incur Significant Unexpected Expenses and Could Lose Sales.
Network products frequently contain undetected errors when new products or new versions or updates of existing products are released to the marketplace. In the past, we have experienced such errors in connection with new products and product updates. We have experienced component problems in prior years that caused us to incur higher than expected warranty, service costs and expenses, and other related operating expenses. In the future, we expect that, from time to time, such errors or component failures will be found in new or existing products after the commencement of commercial shipments. These problems may have a material adverse effect on our business by causing us to incur significant warranty, repair and replacement costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causing significant customer relations problems. Further, if products are not accepted by customers due to such defects, and such returns exceed the amount we accrued for defective returns based on our historical experience, our operating results would be adversely affected.
Our products must successfully interoperate with products from other vendors. As a result, when problems occur in a network, it may be difficult to identify the sources of these problems. The occurrence of system errors, whether or not caused by our products, could result in the delay or loss of market acceptance of our products and any necessary revisions may cause us to incur significant expenses. The occurrence of any such problems would likely have a material adverse effect on our business, operating results and financial condition.
We Purchase Several Key Components for Products From Single or Limited Sources and Could Lose Sales if These Suppliers Fail to Meet Our Needs.
We currently purchase several key components used in the manufacture of our products from single or limited sources and are dependent upon supply from these sources to meet our needs. Certain components such as tantalum capacitors, SRAM, DRAM, and printed circuit boards, have been in the past, and may in the future be, in short supply. We have encountered, and are likely in the future to encounter, shortages and delays in obtaining these or other components, and this could have a material adverse effect on our ability to meet customer orders. Our principal sole-source components include:
Our principal limited-source components include:
We use our forecast of expected demand to determine our material requirements. Lead times for materials and components we order vary significantly, and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. If forecasts exceed orders, we may have excess and/or obsolete inventory, which could have a material adverse effect on our operating results and financial condition. If orders exceed forecasts, we may have inadequate supplies of certain materials and components, which could have a material adverse effect on our ability to meet customer delivery requirements and to recognize revenue.
Generally, we do not have agreements fixing long-term prices or minimum volume requirements from suppliers. From time to time we have experienced shortages and allocations of certain components, resulting in delays in filling orders. Qualifying new suppliers to compensate for such shortages may be time-consuming and costly, and may increase the likelihood of errors in design or production. In addition, during the development of our products, we have experienced delays in the prototyping of our chipsets, which in turn has led to delays in product introductions. Similar delays may occur in the future. Furthermore, the performance of the components as incorporated in our products may not meet the quality requirements of our customers.
Our Dependence on Three Manufacturers for All of Our Manufacturing Requirements Could Harm Our Operating Results.
We primarily rely on three manufacturing partners to manufacture our products. In addition, each of our products is manufactured by only one of these companies. We have experienced delays in product shipments from our manufacturing partners in the past, which in turn delayed product shipments to our customers. These or similar problems may arise in the future, such as delivery of products of inferior quality, delivery of insufficient quantity of products, or the interruption or discontinuance of operations of a manufacturer, any of which could have a material adverse effect on our business and operating results. While we maintain strong relationships with
our manufacturing partners, our agreements with these manufacturers are generally of limited duration and pricing, quality and volume commitments are negotiated on a recurring basis. The failure to maintain continuing agreements with our manufacturing partners could adversely affect our business. We intend to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers.
As part of our cost-reduction efforts, we will need to realize lower per unit product costs from our manufacturing partners by means of volume efficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such price reductions will occur. The failure to obtain such price reductions would adversely affect our gross margins and operating results.
Our Dependence on an OEM for All of Our Wireless Products Could Harm Our Operating Results.
We rely on Motorola to provide our wireless products. If we experience delays in product shipments from our OEM or if they experience delays from their suppliers, which in turn delays product shipments to our customers, our financial results could be negatively impacted. Problems such as delivery of products of inferior quality, delivery of insufficient quantity of products, or the interruption or discontinuance of operations of our OEM, may arise in the future, any of which could have a material adverse effect on our business and operating results.
We Depend Upon International Sales for a Significant Portion of Our Revenue Which Imposes a Number of Risks on Our Business.
International sales constitute a significant portion of our net revenue. Our ability to grow will depend in part on the expansion of international sales. Our international sales primarily depend on the success of our resellers and distributors. The failure of these resellers and distributors to sell our products internationally would limit our ability to sustain and grow our revenue. There are a number of risks arising from our international business, including:
Substantially all of our international sales are U.S. dollar-denominated. Future increases in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. In
the future, we may elect to invoice some of our international customers in local currency, which would expose us to fluctuations in exchange rates between the U.S. dollar and the particular local currency. If we do so, we may decide to engage in hedging transactions to minimize the risk of such fluctuations.
We have entered into foreign exchange forward contracts to offset the impact of payment of operating expenses in local currencies to some of our operating foreign subsidiaries. However, if we are not successful in managing these foreign currency transactions, we could incur losses from these activities.
We Must Continue to Develop and Increase the Productivity of Our Indirect Distribution Channels to Increase Net Revenue and Improve Our Operating Results.
Our distribution strategy focuses primarily on developing and increasing the productivity of our indirect distribution channels. If we fail to develop and cultivate relationships with significant channel partners, or if these channel partners are not successful in their sales efforts, sales of our products may decrease and our operating results could suffer. Many of our channel partners also sell products from other vendors that compete with our products. Our channel partners may not continue to market or sell our products effectively or to devote the resources necessary to provide us with effective sales, marketing and technical support. We may not be able to successfully manage our sales channels or enter into additional reseller and/or distribution agreements. Our failure to do any of these could limit our ability to grow or sustain revenue.
Our operating results for any given period have and will continue to depend to a significant extent on large orders from a relatively small number of channel partners and other customers. However, we do not have binding purchase commitments from any of them. A substantial reduction or delay in sales of our products to a significant reseller, distributor or other customer could harm our business, operating results and financial condition because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term. Under specified conditions, some third-party distributors are allowed to return products to us and unexpected returns could adversely affect our results.
The Sales Cycle for Our Products is Long and We May Incur Substantial Non-Recoverable Expenses or Devote Significant Resources to Sales that Do Not Occur When Anticipated.
Our products represent a significant strategic decision by a customer regarding its communications infrastructure. The decision by customers to purchase our products is often based on the results of a variety of internal procedures associated with the evaluation, testing, implementation and acceptance of new technologies. Accordingly, the product evaluation process frequently results in a lengthy sales cycle, typically ranging from three months to longer than a year, and as a result, our ability to sell products is subject to a number of significant risks, including risks that:
If We Lose Key Personnel or are Unable to Hire Additional Qualified Personnel as Necessary, We May Not Be Able to Successfully Manage Our Business or Achieve Our Goals.
Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, service and operations personnel, many of whom would be difficult to replace. We do not have employment contracts with these individuals who mandate that they render services for any specific term, nor do we carry life insurance on any of our key personnel. We have experienced and may in the future experience significant turn over in our executive personnel. In addition, retention has generally become more difficult for us, in part because the exercise price of most of the stock options granted to many of our employees is below the market price. As a result, we experienced high levels of attrition. We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing, service, finance and operations personnel. The market for these personnel is competitive, especially in the San Francisco Bay Area, and we have had difficulty in hiring employees, particularly engineers, in the timeframe we desire.
Companies in the networking industry whose employees accept positions with competitors frequently claim that competitors have engaged in unfair hiring practices. We have from time to time been involved in claims like this with other companies and, although to date they have not resulted in material litigation, we do not know whether we will be involved in additional claims in the future. We could incur substantial costs in litigating any such claims, regardless of the merits.
Failure of Our Products to Comply With Evolving Industry Standards and Complex Government Regulations May Adversely Impact Our Business.
If we do not comply with existing or evolving industry standards and government regulations, we may not be able to sell our products where these standards or regulations apply. The network equipment industry in which we compete is characterized by rapid changes in technology and customers requirements and evolving industry standards. As a result, our success depends on:
In the past, we have introduced new products that were not compatible with certain technological standards, and in the future, we may not be able to effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards.
Our products must also comply with various U.S. federal government regulations and standards defined by agencies such as the Federal Communications Commission, standards established by governmental authorities in various foreign countries and recommendations of the International Telecommunication Union. In some circumstances, we must obtain regulatory approvals or certificates of compliance before we can offer or distribute our products in certain jurisdictions or to certain customers. Complying with new regulations or obtaining certifications can be costly and disruptive to our business. For example, we expended significant resources and expenses in order to comply with the European Unions Directive 2002/96/EC Waste Electrical and Electronic Equipment and Directive 2002/95/EC on Restriction on the Certain Hazardous Substances in Electrical and Electronic Equipment.
If we do not comply with existing or evolving industry standards or government regulations, we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our net revenue or achieving profitability.
Changes in Effective Tax Rates Including From the Release of the Valuation Allowance Recorded Against Our Net U.S. Deferred Tax Assets, or Adverse Outcomes Resulting From Examination of Our Income or Other Tax Returns or Change in Ownership, Could Adversely Affect Our Results.
Our future effective tax rates may be volatile or adversely affected by changes in our business or U.S. or foreign tax laws, including: the partial or full release of the valuation allowance recorded against our net U.S. deferred tax assets; expiration of or lapses in the research and development tax credit laws; transfer pricing adjustments; tax effects of stock-based compensation; or costs related to restructurings. In addition, we are subject to the examination of our income tax returns by the Internal Revenue Service and other tax authorities. Although we regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes, there is no assurance that such determinations by us are in fact adequate. Changes in our effective tax rates or amounts assessed upon examination of our tax returns may have a material, adverse impact on our cash flows and our financial condition.
Our future effective tax rate in particular could be adversely affected by a change in ownership pursuant to U.S. Internal Revenue Code Section 382. If a change in ownership occurs, it may limit our ability to utilize our net operating losses to offset our U.S. taxable income. If U.S. taxable income is greater than the change in ownership limitation, we will pay a higher rate of tax with respect to the amount of taxable income that exceeds the limitation. This would have a material adverse impact on our results of operations. On June 30, 2010, we amended our Rights Agreement to mitigate against the possibility of a Section 382 change in ownership with the objective of preserving our tax attributes.
If We Do Not Adequately Manage and Evolve Our Financial Reporting and Managerial Systems and Processes, Our Ability to Manage and Grow Our Business May Be Harmed.
Our ability to successfully implement our business plan and comply with regulations requires an effective planning and management process. We need to continue improving our existing, and implement new, operational and financial systems, procedures and controls. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to record and report financial and management information on a timely and accurate basis, or to forecast future results.
Failure to Maintain Effective Internal Control Over Financial Reporting May Cause Us to Delay Filing Our Periodic Reports with the SEC, Affect Our Nasdaq Listing, and Adversely Affect Our Stock Price.
The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on internal control over financial reporting in their annual reports on Form 10-K. In addition, our independent registered public accounting firm must attest to and report on our internal control over financial reporting. Although we review our internal control over financial reporting in order to ensure compliance with the Section 404 requirements, if our independent registered public accounting firm is not satisfied with our internal control over financial reporting or the level at which these controls are documented, designed, operated or reviewed, or if the independent registered public accounting firm interprets the requirements, rules and/or regulations differently from our interpretation, then they may decline to attest to managements assessment or may issue an adverse opinion on the effectiveness of internal control over financial reporting because of the existence of one or more material weaknesses. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact our stock price.
Compliance with Laws, Rules and Regulations Relating to Corporate Governance and Public Disclosure May Result in Additional Expenses.
Federal securities laws, rules and regulations, as well as Nasdaq rules and regulations, require companies to maintain extensive corporate governance measures, impose comprehensive reporting and disclosure requirements, set strict independence and financial expertise standards for audit and other committee members
and impose civil and criminal penalties for companies and their Chief Executive Officers, Chief Financial Officers and directors for securities law violations. These laws, rules and regulations and the interpretation of these requirements are evolving, and we are making investments to evaluate current practices and to continue to achieve compliance. As a result, our compliance programs have increased and will continue to increase general and administrative expenses and have diverted and will continue to divert management time and attention from revenue-generating activities.
Our Headquarters and Some Significant Supporting Businesses Are Located in Northern California and Other Areas Subject to Natural Disasters That Could Disrupt Our Operations and Harm Our Business.
Our corporate headquarters are located in Silicon Valley in Northern California. Historically, this region has been vulnerable to natural disasters and other risks, such as earthquakes, fires and floods, which at times have disrupted the local economy and posed physical risks to our property. We have contract manufacturers located in Mexico and Taiwan where similar natural disasters and other risks may disrupt the local economy and pose physical risks to our property and the property of our contract manufacturer.
In addition, the continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to the economies of the U.S. and other countries. If such disruptions result in delays or cancellations of customer orders for our products, our business and operating results will suffer.
We currently do not have redundant, multiple site capacity in the event of a natural disaster, terrorist act or other catastrophic event. In the event of such an occurrence, our business would suffer.
Failure to Successfully Expand Our Sales and Support Teams or Educate Them In Regard to Technologies and Our Product Families May Harm Our Operating Results.
The sale of our products and services requires a concerted effort that is frequently targeted at several levels within a prospective customers organization. We may not be able to increase net revenue unless we expand our sales and support teams in order to address all of the customer requirements necessary to sell our products.
We cannot assure you that we will be able to successfully integrate employees into our company or to educate current and future employees in regard to rapidly evolving technologies and our product families. A failure to do so may hurt our revenue growth and operating results.
We May Engage in Future Acquisitions that Dilute the Ownership Interests of Our Stockholders, Cause Us to Incur Debt and Assume Contingent Liabilities.
As part of our business strategy, we review acquisition and strategic investment prospects that we believe would complement our current product offerings, augment our market coverage or enhance our technical capabilities, or otherwise offer growth opportunities. In the event of any future acquisitions, we could:
These actions could have a material adverse effect on our operating results or the price of our common stock. Moreover, even if we do obtain benefits in the form of increased sales and earnings, these benefits may be recognized much later than the time when the expenses associated with an acquisition are incurred. This is particularly relevant in cases where it is necessary to integrate new types of technology into our existing portfolio
and new types of products may be targeted for potential customers with which we do not have pre-existing relationships. Acquisitions and investment activities also entail numerous risks, including:
We may not be able to successfully integrate any businesses, products, technologies, or personnel that we might acquire in the future, and our failure to do so could have a material adverse effect on our business, operating results and financial condition.
We May Need Additional Capital to Fund Our Future Operations and, If It Is Not Available When Needed, Our Business Will Be Adversely Impacted.
We believe that our existing working capital and cash available from credit facilities and future operations will enable us to meet our working capital requirements for at least the next twelve months. However, if cash from future operations is insufficient, or if cash is used for acquisitions or other currently unanticipated uses, we may need additional capital. The development and marketing of new products and the expansion of reseller and distribution channels and associated support personnel requires a significant commitment of resources. In addition, if the markets for our products develop more slowly than anticipated, or if we fail to establish significant market share and achieve sufficient net revenue, we may continue to consume significant amounts of capital. As a result, we could be required to raise additional capital. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution of the shares held by existing stockholders. If additional funds are raised through the issuance of debt securities, such securities may provide the holders certain rights, preferences, and privileges senior to those of common stockholders, and the terms of such debt could impose restrictions on our operations. We cannot assure you that additional capital, if required, will be available on acceptable terms, or at all. If we are unable to obtain sufficient amounts of additional capital, we may be required to reduce the scope of our planned product development and marketing efforts, which could harm our business, financial condition and operating results.
We Have Entered into Long-Term Lease Agreements for Several Facilities that are Currently Vacant and May be Difficult to Sublease due to Current Real Estate Market Conditions.
We have certain long-term real estate lease commitments carrying future obligations for non-cancelable lease payments. Reductions in our workforce and the restructuring of operations since fiscal 2002 have resulted in the need to consolidate certain of these leased facilities, located primarily in Northern California, for which we recorded a reversal of excess facilities charges, net of approximately $0.3 million in fiscal 2010, $0.5 million expense reversal, net in fiscal 2009, $0.9 million expense in fiscal 2008, $4.0 million expense in fiscal 2007, and $3.3 million expense in fiscal 2006. We may incur additional charges for excess facilities as a result of additional reductions in our workforce or future restructuring of operations. We will continue to be responsible for all carrying costs of these facilities until such time as we can sublease these facilities or terminate the applicable leases based on the contractual terms of the lease agreements, and these costs may have an adverse effect on our business, operating results and financial condition.
Our Stock Price Has Been Volatile In the Past and Our Stock Price May Significantly Fluctuate in the Future.
In the past, our common stock price has fluctuated significantly. This could continue as we or our competitors announce new products, our results or those of our customers or competition fluctuate, conditions in the networking or semiconductor industry change, or when investors, change their sentiment toward stocks in the networking technology sector.
In addition, fluctuations in our stock price and our price-to-earnings multiple may make our stock attractive to momentum, hedge or day-trading investors who often shift funds into and out of stock rapidly, exacerbating price fluctuations in either direction, particularly when viewed on a quarterly basis.
Provisions in Our Charter Documents and Delaware Law and Our Adoption of a Stockholder Rights Plan May Delay or Prevent an Acquisition of Extreme, Which Could Decrease the Value of Our Common Stock.
Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our Board of Directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, our Board of Directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Although we believe these provisions of our certificate of incorporation and bylaws and Delaware law and our stockholder rights plan, which is described below, will provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions apply even if the offer may be considered beneficial by some of our stockholders.
Our Board of Directors adopted a stockholder rights plan, under which we declared and paid a dividend of one right for each share of common stock held by stockholders of record as of May 14, 2001. Under the plan, each right will entitle stockholders to purchase a fractional share of our preferred stock for $150.00. Each such fractional share of the new preferred stock has terms designed to make it substantially the economic equivalent of one share of common stock. Initially the rights will not be exercisable and will trade with our common stock. Generally, the rights may become exercisable if a person or group acquires beneficial ownership of 4.95% or more of our common stock or commences a tender or exchange offer upon consummation of which such person or group would beneficially own 4.95% or more of our common stock. When the rights become exercisable, our Board of Directors has the right to authorize the issuance of one share of our common stock in exchange for each right that is then exercisable.
Item 2. Properties
Our principal administrative, sales, marketing and research and development facilities are located in Santa Clara, California. We also lease office space and executive suites in various other geographic locations domestically and internationally for sales and service personnel and engineering operations. Our aggregate lease expense for fiscal 2010 was approximately $4.2 million. We believe our current facilities will adequately meet our growth needs for the foreseeable future. In addition, we are actively engaged in efforts to sell excess property we acquired in prior years.
Item 3. Legal Proceedings
We may from time to time be party to litigation arising in the course of our business, including, without limitation, allegations relating to commercial transactions, business relationships or intellectual property rights.
Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources. Litigation in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings are difficult to predict.
Shareholder Litigation Relating to Historical Stock Option Practices
On April 25, 2007, an individual identifying herself as one of our shareholders filed a derivative action in the United States District Court for the Northern District of California purporting to assert claims on behalf of and in our name against various of our current and former directors and officers relating to historical stock option granting from 1999 to 2002 and related accounting practices. Two similar derivative actions were filed thereafter in the same court by other individuals and the three cases were consolidated by order of the Court. After two amended complaints were filed by the lead plaintiff, we filed a motion to dismiss the second amended complaint, which was granted without prejudice on August 12, 2008.
On August 22, 2008, Kathleen Wheatley, an individual identifying herself as one of our shareholders, filed a motion for the Court to reconsider its ruling on August 12, 2008 granting our motion to dismiss. In response, we asked the Court to reject Ms. Wheatleys motion on various grounds, including that Ms. Wheatley is not a party to this derivative action. The Court has not yet ruled on Ms. Wheatleys motion. On September 4, 2008, Ms. Wheatley filed both a motion to intervene in the derivative action and a third amended complaint, which differs little from the first amended complaint. The third amended complaint continues to allege that various of our current and former directors and officers breached their fiduciary duties and other obligations to us and violated state and federal securities laws in connection with the our historical grants of stock options. We are named as a nominal defendant in the action, but we have customary indemnification agreements with the named defendants. On our behalf, Ms. Wheatley seeks unspecified monetary and other relief against the named defendants. The Court has granted Ms. Wheatleys motion to intervene. On October 16, 2008, we, as nominal defendant, moved to dismiss the third amended complaint. On November 17, 2009, the Court denied our motion to dismiss the third amended complaint, and on December 3, 3009, we filed a motion for reconsideration or in the alternative, a motion to certify the Order denying the Motion to Dismiss for immediate appeal. On December 30, 2009, the Court issued an Order granting us leave to file the motion for reconsideration and will rule on our alternative motion to certify the Order for appeal if it denies the motion for reconsideration. On April 2, 2010, the Court denied our Motion for Reconsideration and for Stay of Action and Certification and Appeal. No dates have been set for our response to the Third Amended Complaint. We intend to continue to defend the derivative action vigorously, but due to the uncertainty of litigation, we cannot predict the ultimate outcome of this matter at this time.
Intellectual Property Litigation
On April 20, 2007, we filed suit against Enterasys Networks in the United States District Court for the Western District of Wisconsin, Civil Action No. 07-C-0229-C. The complaint alleged willful infringement of U.S. Patents Nos. 6,104,700, 6,678,248, and 6,859,438, and sought injunctive relief against Enterasys continuing sale of infringing goods and monetary damages. Enterasys responded to the complaint on May 30, 2007, and also filed counterclaims alleging infringement of three U.S. patents owned by Enterasys. On April 9, 2008, the Court dismissed Enterasys counterclaims on one of its patents with prejudice. On May 5, 2008, the Court granted our motion for summary judgment, finding that we do not infringe Enterasys two remaining patents and dismissing all of Enterasys remaining counterclaims with prejudice. On May 30, 2008, a jury found that Enterasys infringed all three of our patents and awarded us damages in the amount of $0.2 million. The Court also ruled in our favor on Enterasys challenge to the validity of our patents. On October 29, 2008, the Court denied Enterasys post-trial motion for judgment as a matter of law, and granted Extreme Networks motion for a permanent injunction against Enterasys. The injunction order permanently enjoins Enterasys from manufacturing, using, offering to sell, selling in the U.S. and importing into the U.S. the Enterasys products accused of infringing Extreme Networks three patents. The injunction will run until the expiration of our patents the last of which is not set to expire until March of 2020. On March 16, 2009, the Court also denied Enterasys motion for a new trial, but granted Enterasys motion for a stay of the injunction pending appeal. On April 17, 2009, Enterasys filed its
notice of appeal and on May 1, 2009, we filed our cross appeal. The appeal is pending at the U.S. Court of Appeals for the Federal Circuit and we are defending the appeal. Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of the matter at this time.
On June 21, 2005, Enterasys filed suit against Extreme and Foundry Networks, Inc. (Foundry) in the United States District Court for the District of Massachusetts, Civil Action No. 05-11298 DPW. The complaint alleges willful infringement of U.S. Patent Nos. 5,251,205; 5,390,173; 6,128,665; 6,147,995; 6,539,022; and 6,560,236, and seeks: a) a judgment that we willfully infringe each of the patents; (b) a permanent injunction from infringement, inducement of infringement and contributory infringement of each of the six patents; (c) damages and a reasonable royalty to be determined at trial; (d) treble damages; (e) attorneys fees, costs and interest; and (f) equitable relief at the Courts discretion. Foundry brought a claim for reexamination of five of the patents at issue to the U.S. Patent and Trademark Office (PTO). The stay of Massachusetts action was lifted on May 21, 2010, and set a claims construction hearing for September 15, 2010. No trial date has been set. We intend to defend the lawsuit vigorously, but, due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of the matter at this time.
On February 7, 2008, Network-1 Security Solutions, Inc. sued us along with Cisco, Cisco-Linksys, Inc., Adtran, Inc., Enterasys Networks, Inc., Netgear, Inc. and 3Com Corporation in the United States District Court for the Eastern District of Texas (Case No. 6:08cv030). On July 16, 2010, we entered into a Memorandum of Understanding with Nework-1 setting forth the terms for settlement of the lawsuit and license agreement, in which Extreme was granted licenses to certain patents in exchange for a payment of $2.4 million. On August 3, 2010, the Court dismissed the case with prejudice.
On February 26, 2008, Fenner Investments, Ltd. filed suit against us along with D-Link Systems, Zyxel Communications, SMC Networks, Enterasys, Foundry, Netgear, Inc. and 3Com Corporation in the United States District Court for the Eastern District of Texas, Civil Action No. 08-CV-00061. The suit alleges infringement of US Patent No. 7,145,906 and 5,842,224, and seeks damages for the alleged infringement, injunctions against infringement and payment of attorneys fees, costs and interest. On September 24, 2009, we entered into a settlement and license agreement with Fenner Investments, in which Extreme was granted licenses to certain patents in exchange for amounts paid. On October 5, 2009, the Court dismissed the case with prejudice.
Other Legal Matters
Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District of New York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ. No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint names us as defendants; six of our present and former officers and/or directors, including our former CEO and current Chairman of the Board (the Extreme Networks Defendants); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondary offering. The complaint alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that the registration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings in exchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in the aftermarket at predetermined prices. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and 2000. The cases were consolidated for pretrial purposes.
The parties to the lawsuits have reached a settlement, which was approved by the Court on October 6, 2009. Extreme Networks Defendants is not required to make any cash payments in the settlement. The Court subsequently entered a final judgment of dismissal. Certain objectors have appealed the judgment. If the appeal is successful, we intend to defend the lawsuit vigorously, but, due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of the matter at this time.
Subject to certain limitations, we may be obligated to indemnify our current and former directors, officers and employees. These obligations arise under the terms of our certificate of incorporation, our bylaws, applicable contracts, and Delaware and California law. The obligation to indemnify, where applicable, generally means that we are required to pay or reimburse, and in certain circumstances we have paid or reimbursed, the individuals reasonable legal expenses and possibly damages and other liabilities incurred in connection with these matters. It is not possible to estimate the maximum potential amount under these indemnification agreements due to the limited history of these claims. The cost to defend us and the named individuals could have a material adverse effect on our consolidated financial position, results of operations and cash flows in the future. Recovery of such costs under our directors and officers insurance coverage is uncertain.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Market Prices and Dividends
Our common stock commenced trading on The Nasdaq Global Market on April 9, 1999 under the symbol EXTR. The following table sets forth the high and low sales prices as reported by Nasdaq. Such prices represent prices between dealers, do not include retail mark-ups, mark-downs or commissions and may not represent actual transactions.
As of August 13, 2010, there were 302 stockholders of record of our common stock and 17,754 beneficial shareholders. We have never declared or paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future earnings for the development of our business.
Certain information regarding our equity compensation plan(s) as required by Part II is incorporated by reference from our definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for our 2010 Annual Meeting of Stockholders (the Proxy Statement) not later than 120 days after the end of the fiscal year covered by this report.
STOCK PRICE PERFORMANCE GRAPH
Set forth below is a stock price performance graph comparing the annual percentage change in the cumulative total return on our common stock with the cumulative total returns of the CRSP Total Return Index for The Nasdaq Stock Market (U.S. companies) and the Nasdaq Computer Manufacturers Securities for the period commencing July 3, 2005 and ending on June 27, 2010. The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.
Comparison of Five-Year Cumulative Total Returns
Performance Graph for Extreme Networks, Inc.
Prepared by CRSP (www.crsp.uchicago.edu), Center for Research in Security Prices, Booth School of Business, The University of Chicago. Used with permission. All rights reserved.
Item 6. Selected Financial Data
The following table sets forth selected consolidated financial data for each of the fiscal years ended June 27, 2010, June 28, 2009, June 29, 2008, July 1, 2007 and July 2, 2006 derived from audited financial statements. These tables should be reviewed in conjunction with the Consolidated Financial Statements in Item 8 and related Notes, as well as Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations. Historical results may not be indicative of future results.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
We develop and sell network infrastructure equipment and offer related services contracts for extended warranty and maintenance to our enterprise, data center and metropolitan telecommunications service provider customers. Substantially all of our revenue is derived from the sale of our networking equipment and related service contracts. In fiscal 2010, our revenue decreased $26.2 million, gross profit decreased $14.2 million, operating profit decreased $3.5 million and net income decreased $2.6 million as compared to fiscal 2009.
We believe that understanding the following key developments is helpful to an understanding of our operating results for fiscal 2010.
Supply Chain Constraints
We use our forecast of expected demand to determine our material requirements. Lead times for materials and components we order vary significantly, and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. In the fourth quarter of fiscal 2009, customer orders exceeded our forecast, especially with respect to certain products. In addition, our contract manufacturers and their component suppliers had significantly reduced their capacity due to the world-wide economic slowdown, and therefore lead times significantly increased during the first fiscal quarter across our supply chain as our contract manufacturers and their component suppliers struggled to meet increasing demands. As a result, we were unable to deliver products based on customer requests. This adversely affected our revenue and sales for the first quarter of fiscal 2010 since we were unable to deliver products in that quarter in a timely manner and certain customers cancelled orders or chose other vendors based on product availability. We have made substantial progress with our suppliers to improve timely delivery of our products to meet customers demands in the second quarter through the fourth quarter of fiscal 2010. We continue to work to manage our forecast and supply chain in light of our customers demands as accurately as possible.
Impact of the Global Economic Developments
In addition to issues with our supply chain, we believe that the credit market crisis, global recession and other challenges affecting global economic conditions were the significant drivers of our financial performance during fiscal 2010. Sales in the United States and some European countries were most impacted as a result of the weak global economy and the global credit crisis in the financial market, while sales in Asia were only minimally impacted by global economic developments and grew during the period. We believe that limited access to credit, conservative purchasing patterns and delays or cancellation of IT infrastructure plans in the face of continued uncertainty regarding the global economy, may continue to negatively impact overall demand for networking solutions, including Ethernet equipment.
We have taken and plan to continue to take other steps to manage our business in the current economic environment. For example, we have managed from time to time our contingent work force, scheduled shutdown weeks, reduced travel and other discretionary spending, and controlled all hiring activities.
Increasing Demand for Bandwidth
We believe that the continued increase in demand for bandwidth will over time drive future demand for high performance Ethernet solutions. Wide-spread adoption of electronic communications in all aspects of our lives, proliferation of next generation converged mobile devices and deployment of triple-play services to residences and businesses alike, continues to generate demand for greater network performance across broader geographic locations. In parallel to these transformational forces within society and the community at large, the accelerating adoption of internet and intranet cloud solutions within business enterprises is enabling organizations to offer greater business scalability to improve efficiency and through more effective operations, improve profitability. In
order to realize the benefits of these developments, customers require additional bandwidth and high performance from their network infrastructure at affordable prices. As the economy continues its paced recovery, we are already seeing the initial indications that the Ethernet segment of the networking equipment market will return to growth as enterprise, data center and carrier customers continue to recognize the performance and operating cost benefits of Ethernet technology.
Expanding Product Portfolio
We believe that continued success in our marketplace is dependent upon a variety of factors that includes, but is not limited to, our ability to design, develop and distribute new and enhanced products employing leading-edge technology. During fiscal 2010, we further extended our Ethernet product portfolio through the addition of the Summit X480 family of products targeted at Data Center customers, a further set of modules for the BlackDiamond 8900 family and the next release of the ExtremeXOS modular operating system, release 12.4.1.
The market for network infrastructure equipment is highly competitive and dominated by a few large companies. The difficult economic climate has further driven consolidation of vendors within the Ethernet networking market and with vendors from adjacent markets, including storage, security, wireless and voice applications. We believe that the underpinning technology for all of these adjacent markets is Ethernet. As a result, independent Ethernet switch vendors are being acquired or merged with larger, adjacent market vendors to enable them to deliver complete and broad solutions. As a result, we believe that, as an independent Ethernet switch vendor, we must provide products that, when combined with the products of our large strategic partners, create compelling solutions for end user customers.
On October 22, 2009, we restructured the organization, including restructuring from a business unit organization to a functional organization. In connection with the restructuring, we had a reduction in force (RIF), terminated 8% of our workforce and eliminated certain redundant engineering projects. Total restructuring charges related to the RIF and engineering projects recognized in fiscal 2010 was $4.6 million.
As a result of the RIF, operating expenses significantly decreased in fiscal 2010 as compared to fiscal 2009, as discussed further below.
Results of Operations
Our operations and financial performance have been affected by the economic factors described above, and during fiscal 2010, we achieved the following results:
The following table presents net product and service revenue for the fiscal years 2010, 2009 and 2008 (dollars in thousands):
Product revenue decreased in fiscal 2010 as compared to fiscal 2009 primarily due to the global economic downturn and competitive pricing. In addition, in the first quarter of fiscal 2010, the Company experienced supply constraint issues which resulted in the loss of business.
Product revenue decreased in fiscal 2009 as compared to fiscal 2008 primarily due to lower sales volumes mainly as a result of the weakness in the U.S. economy.
Service revenue decreased in fiscal 2010 as compared to fiscal 2009 primarily due to a reduction in renewals of service maintenance agreements for products which are entering end of support life.
Service revenue increased in fiscal 2009 as compared to fiscal 2008 primarily due to improved execution in the EMEA maintenance renewal business, resulting in higher maintenance renewal rates.
We operate in three regions: North America, which includes the United States, Canada and Central America; EMEA, which includes Europe, Middle East, Africa and South America; and APAC which includes Asia Pacific and Japan. The following table presents the total net revenue geographically for the fiscal years 2010, 2009 and 2008 (dollars in thousands):
Revenue in North America decreased in fiscal 2010 as compared to fiscal 2009 primarily due to supply chain issues in the first quarter of fiscal 2010 and a weaker economy in the United States. Revenue in EMEA decreased in fiscal 2010 as compared to fiscal 2009 primarily due to weaker service provider sales in Europe and a weaker economy in Western Europe. Revenue in APAC increased in fiscal 2010 as compared to fiscal 2009 primarily due to stronger sales in China to a large service provider end user.
Revenue in North America decreased in fiscal 2009 as compared to fiscal 2008 primarily due to the economic downturn in the United States. Revenue in EMEA increased in fiscal 2009 as compared to fiscal 2008 primarily due to increased sales to service providers in Europe. Revenue in APAC decreased in fiscal 2009 as compared to fiscal 2008 primarily due to weakness in Japan and China due to sales execution issues.
We rely upon multiple channels of distribution, including a two-tiered distribution channel. One of these distribution channels, tier 1 distributors, consists of large distributors who purchase our products and make them available to resellers. Revenue through our tier 1 distributor channel was 59% of total product revenue in fiscal 2010, 53% in fiscal 2009 and 47% in fiscal 2008. The increase in distributor channel revenue over the past three years was due to a shift in business from direct sales to the channel as business through our strategic partners decreased coupled with strong sales from a new distributor in the U.S.
The level of sales to any one customer, including a distributor, may vary from period to period.
Cost of Revenue and Gross Profit
The following table presents the gross profit on product and service revenue and the gross profit percentage of net revenue for the fiscal years 2010, 2009 and 2008 (dollars in thousands):
Cost of product revenue includes costs of raw materials, amounts paid to third-party contract manufacturers, costs related to warranty obligations, charges for excess and obsolete inventory, royalties under technology license agreements, and internal costs associated with manufacturing overhead, including management, manufacturing engineering, quality assurance, development of test plans, and document control. We outsource substantially all of our manufacturing and supply chain management operations, and we conduct quality assurance, manufacturing engineering, document control and distribution at our facility in Santa Clara, California. Accordingly, a significant portion of our cost of product revenue consists of payments to our primary contract manufacturers, Flextronics International, Ltd. located in Guadalajara, Mexico, Alpha Networks, located in Hsinchu, Taiwan and Benchmark Electronic, Inc, located in Huntsville, Alabama, U.S.A. In addition, we OEM our wireless product line from Motorola.
Product gross profit in fiscal 2010 decreased as compared to fiscal 2009 primarily due to a $17.7 million decrease in sales volume driven by supply chain constraints in the first quarter of fiscal 2010 offset by a $1.1 million recovery of warranty expense incurred in the third quarter of fiscal 2010 from our outside design manufacturer and lower operating costs of $0.7 million due to cost controls.
Product gross profit in fiscal 2009 decreased as compared to fiscal 2008 primarily due to lower volume of $21.7 million and increased material cost of $6.1 million, offset by changes in product mix of $2.6 million, lower distribution cost of $1.9 million, lower royalties of $1.0 million due to the completion of amortization expense related to certain technology agreements and lower operating costs of $0.7 million due to cost controls.
Our cost of service revenue consists primarily of labor, overhead, repair and freight costs and the cost of spares used in providing support under customer service contracts. Service gross profit in fiscal 2010 increased as compared to fiscal 2009 primarily due to lower return material authorization costs of $1.6 million and cost savings in professional services.
Service gross profit in fiscal 2009 increased as compared to fiscal 2008 primarily due to the result of an increase of $2.3 million in maintenance revenue primarily in EMEA, the use of written down inventory of $1.2 million, a reduction of customer specific warranty programs of $0.9 million and lower repair costs of $2.2 million due to improved quality.
The following table presents operating expenses and operating income (in thousands, except percentages):
The following table highlights our operating expenses and operating income as a percentage of net revenues:
Sales and Marketing Expenses
Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing and sales functions, as well as trade shows and promotional expenses. Sales and marketing expenses decreased in fiscal 2010 as compared to fiscal 2009 primarily due to lower salaries and benefits expenses of $1.1 million due to lower headcount and lower rent expense of $1.2 million due to the consolidation of sales offices worldwide, offset by $0.4 million increase in commissions due to mix of commissions based on large deals and $0.3 million in travel expenses due to year-end sales meetings.
Sales and marketing expenses decreased in fiscal 2009 as compared to fiscal 2008 primarily due to lower salaries and benefits of $1.3 million, lower commission expenses of $2.5 million resulting from lower revenue, lower travel of $1.1 million due to cost cutting measures and lower share-based compensation expense of $0.3 million. These decreases were offset by increases in general expenses of $1.1 million.
Research and Development Expenses
Research and development expenses consist primarily of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development, and testing of our products. Research and
development decreased in fiscal 2010 as compared to fiscal 2009 primarily due lower salaries and benefits expenses of $6.7 million due to lower headcount and lower engineering project expenses of $2.7 million due to discontinuation of several engineering projects, offset by a $0.5 million increase in stock-based compensation expense. We expense all research and development expenses as incurred.
Research and development expenses decreased in fiscal 2009 as compared to fiscal 2008 primarily due to lower project spending of $2.6 million on modular and stackable products, lower salaries and benefits of $2.2 million driven mainly by lower variable compensation expense, a decrease in the Avaya warrant amortization expense of $1.0 million, lower supplies and small equipment expense of $0.8 million and lower depreciation expense of $0.6 million.
General and Administrative Expenses
General and administrative expenses decreased in fiscal 2010 as compared to fiscal 2009 primarily due to lower professional fees of $2.9 million and lower salaries and benefits expense of $1.4 million due to lower headcount, offset by an increase in share-based compensation expense of $0.9 million.
General and administrative expenses decreased in fiscal 2009 as compared to fiscal 2008 primarily due to lower litigation fees of $4.0 million, lower share-based compensation of $0.4 million, and lower insurance costs of $0.4 million.
Restructuring Charge, Net of Reversal
During fiscal 2010, 2009 and 2008, we recorded restructuring charges of $4.2 million, $2.2 million, and $0.9 million, respectively.
Charges in fiscal 2010 were:
Charges in fiscal 2009 were:
These charges were offset by a reversal of $0.5 million of restructuring expense due to higher than projected sublease receipt from a sublease renewal arrangement.
On July 16, 2010, we entered into a Memorandum of Understanding (Network-1 MOU) with Network-1 Security Solutions, Inc. The Network-1 MOU provides for a nonexclusive and worldwide license to certain patents of each party, and a release of claims based on any prior infringement of such patents. The license term is nine years and eight months and expires in March 2020. The release covers any potential claims arising out of the past use or practice of any of the patents. Total fees for the grant of the license under the Network-1 MOU were $2.4 million. We charged the estimated value of the release of prior claims of $0.2 million to Cost of Product Revenues for claims incurred in fiscal 2010 and $0.8 million to Litigation Settlement for claims incurred prior to fiscal 2010 in its fiscal 2010 financial statements. The remaining $1.4 million was recorded as other assets and is being recognized ratably over the license period in Cost of Product Revenue.
Interest income was $1.5 million in fiscal 2010, $3.4 million in fiscal 2009 and $10.2 million in fiscal 2008, representing a decrease of $1.9 million in fiscal 2010 from fiscal 2009, and a decrease of $6.8 million in fiscal 2009 from fiscal 2008. The decrease in interest income in fiscal 2010 from fiscal 2009 was due to a decrease in average funds available for investment and a decline in average interest yield from 2.4% in fiscal 2009 to 1.6% in fiscal 2010. The decrease in interest income in fiscal 2009 from fiscal 2008 was due to a decrease in funds available for investment as a result of cash expenditure of $101.4 million in connection with the repurchase of 28,571,428 shares of common stock in the first quarter of fiscal 2009 and a decline in average interest yield from 4.7% in fiscal 2008 to 2.4% in fiscal 2009.
Interest expense was $0.1 million for each fiscal year 2010, 2009 and 2008. Interest expense in fiscal 2010 and fiscal 2009 were primarily related to interest amortization of technology agreements.
Other Income (Expense), net
Other income (expense) net, was expense of $0.1 million in fiscal 2010, income of $13,000 in fiscal 2009 and expense of $0.5 million in fiscal 2008.
Other expense in fiscal 2010 was primarily comprised of foreign currency losses of $0.4 million, offset by realized gain on investments of $0.1 million.
Other income in fiscal 2009 was primarily comprised of foreign currency gains due to the strengthening of the U.S. dollar in fiscal 2009.
Other income (expense), net for the fiscal year 2010 also includes an unrealized loss of $2.1 million on our Auction Rate Securities offset by $2.1 million gain in fair value of the Put Option related to our acceptance of the UBS Rights offer to repurchase our ARS in the third quarter of fiscal 2009.
Provision (Benefit) for Income Taxes
We recorded an income tax benefit of $0.4 million for fiscal 2010. The effective tax rate in fiscal 2010 was 223.6% which differs from the federal statutory tax rate of 35% due primarily to the tax impact of income from foreign operations, the release of previously established tax reserves and the recording of a valuation allowance against the majority of our deferred tax assets. As of June 27, 2010, we had net operating loss carryforwards for federal and state tax purposes of $262.8 million and $90.0 million, respectively, of which $53.7 million and $32.0 million, respectively, represent deductions from share-based compensation for which a benefit would be recorded in additional paid-in capital when realized. We also had federal and state tax credit carryforwards of
$8.4 million and $18.5 million, respectively, as of June 27, 2010. Federal net operating loss carryforwards of $262.8 million will expire between 2013 through 2030 and state net operating losses of $90.0 million will expire between 2011 through 2020, if not utilized. Federal tax credits of $8.4 million will expire beginning in 2020, if not utilized and state tax credits of $1.7 million will expire beginning in 2011, if not utilized. The additional state tax credits of $16.8 million will carry forward indefinitely.
The provisions for income taxes of $2.5 million and $2.2 million for fiscal 2009 and 2008, respectively, were recorded for taxes due on income generated in U.S federal, certain states and foreign tax jurisdictions. The effective tax rate was 46.8% and 20.6% for fiscal 2009 and 2008, respectively, which differs from the federal statutory tax rate of 35% due primarily to the benefit of U.S. net operating losses carryforwards and the tax impact of income from foreign operations.
Adjustments to Share Based Compensation Expense During Fiscal 2010
We were notified by our third party software provider that it had made certain changes to how its software program calculates stock-based compensation expense. Specifically, the prior version of this software that we had been using calculated stock-based compensation expense by incorrectly applying a weighted average forfeiture rate to the vested portion of stock option awards until the grants final vest date, rather than calculating stock-based compensation expense based upon the actual vested portion of the grant date fair value, resulting in an understatement of stock-based compensation expense in certain periods prior to the grants final vest date. Consequently, we identified errors in the calculation of stock-based compensation expense for fiscal years ended June 29, 2008, July 1, 2007 and July 2, 2006. The errors identified relate only to the timing of stock-based compensation expense recognition.
We determined that the cumulative error from the understatement of stock-based compensation expense related to the periods discussed above totaled $0.9 million through June 29, 2008. The impact of the errors on the fiscal years ended June 29, 2008, July 1, 2007 and July 2, 2006, is to decrease net income by $0.3 million for each year.
Management has determined that the impact of this error is not material to the previously issued annual and interim financial statements. Accordingly, the annual consolidated financial statements for the fiscal year ending June 27, 2010 include the cumulative adjustment to increase stock-based compensation expense by $0.9 million (or $0.01 per share) to correct these errors. We do not believe the correction of these errors is material to the annual consolidated financial statements for the fiscal year ending June 27, 2010.
Critical Accounting Policies and Estimates
Our significant accounting policies are more fully described in Note 2 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The preparation of consolidated financial statements in accordance with generally accepted accounting principles requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By their nature, these estimates, assumptions and judgments are subject to an inherent degree of uncertainty. We base our estimates, assumptions and judgments on historical experience, market trends and other factors that are believed to be reasonable under the circumstances. Estimates, assumptions and judgments are reviewed on an ongoing basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies have been discussed with the Audit Committee of the Board of Directors. We believe the critical accounting policies stated below, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
We use the Black-Scholes option-pricing model to determine the fair value of option award and Employee Stock Purchase Plan (ESPP) on the date of grant with the weighted average assumptions. The expected term of options granted is derived from historical data on employee exercise and post-vesting employment termination behavior. The expected term of ESPP represents the contractual life of the ESPP purchase period. The risk-free rate based upon the estimated life of the option and ESPP is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on both the implied volatilities from traded options on our stock and historical volatility on our stock. We do not currently pay cash dividends on our common stock and do not anticipate doing so in the foreseeable future. Accordingly, our expected dividend yield is zero. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. Our estimated forfeiture rate in fiscal 2010 based on our historical forfeiture experience is approximately 12%. We modified our estimated forfeiture rate in the fourth quarter of fiscal 2010 and recognized the cumulative effect of the change, as a decrease in compensation expense, in that quarter of approximately $0.1 million. We use the straight-line method for expense attribution, and we estimate forfeitures and only recognize expense for those shares expected to vest.
We allocate revenue to each element of multiple element arrangements that include products containing software that is more-than-incidental using the residual method based on vendor specific objective evidence of fair value of the undelivered elements. We determine vendor specific objective evidence of fair value based on the price charged when the item is sold separately. Under the residual method, we first allocate the revenue for a multiple element arrangement to the undelivered elements based on their VSOE of fair value, and the remainder of the arrangement fee to the delivered elements.
We derive the majority of our revenue from sales of our networking equipment, with the remaining revenue generated from service fees relating to the service contracts, professional services, and training on our products. We generally recognize product revenue from our value-added resellers, non-stocking distributors and end-user customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the sales proceeds is reasonably assured. In instances where the criteria for revenue recognition are not met, revenue is deferred until all criteria have been met. Revenue from service obligations under service contracts is deferred and recognized on a straight-line basis over the contractual service period. Service contracts typically range from one to two years. Our total deferred product revenue was $1.4 million and $1.3 million as of June 27, 2010 and June 28, 2009, respectively. Our total deferred revenue for services, primarily from service contracts, was $36.4 million as of June 27, 2010 and $36.7 million as of June 28, 2009. Service contracts typically range from one to two years. Shipping costs are included in cost of product revenues.
We make certain sales to partners in two distribution channels, or tiers. The first tier consists of a limited number of independent distributors that sell primarily to resellers and, on occasion, to end-user customers. We defer recognition of revenue on all sales until the distributors sell the product, as evidenced by monthly sales-out reports that the distributors provide to us. We grant these distributors the right to return a portion of unsold inventory for the purpose of stock rotation. We also grant these distributors certain price protection rights. The distributor-related deferred revenue and receivables are adjusted at the time of the stock rotation return or price reduction. We also provide distributors with credits for changes in selling prices, and allow distributors to participate in cooperative marketing programs. We maintain estimated accruals and allowances for these exposures based upon our contractual obligations. In connection with cooperative advertising programs, we do not meet the criteria in our accounting policy for recognizing the expenses as marketing expenses and accordingly, the costs are recorded as a reduction to revenue in the same period that the related revenue is recorded.
The second tier of the distribution channel consists of a large number of third-party value-added resellers that sell directly to end-users. For product sales to value-added resellers, we do not grant return privileges, except for defective products during the warranty period, nor do we grant pricing credits. Accordingly, we recognize revenue upon transfer of title and risk of loss to the value-added reseller, which is generally upon shipment. We reduce product revenue for cooperative marketing activities that may occur under contractual arrangements that we have with our resellers.
We provide an allowance for sales returns based on our historical returns, analysis of credit memo data and our return policies. The allowance for sales returns was $0.9 million as of June 27, 2010 and June 28, 2009 for estimated future returns that were recorded as a reduction of our accounts receivable. The provision for returns is charged to net revenue in the accompanying consolidated statements of operations, and was $7,000, $0.9 million and $1.0 million in fiscal 2010, fiscal 2009 and fiscal 2008, respectively. If the historical data that we use to calculate the estimated sales returns and allowances does not properly reflect future levels of product returns, these estimates will be revised, thus resulting in an impact on future net revenue. We estimate and adjust this allowance at each balance sheet date.
Our inventory balance was $21.8 million as of June 27, 2010, compared with $12.4 million as of June 28, 2009. We value our inventory at lower of cost or market. Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. We provide inventory allowances based on excess and obsolete inventories determined primarily by future demand forecasts. The allowance is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and charged to the provision for inventory, which is a component of cost of sales. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Any written down or obsolete inventory subsequently sold has not had a material impact on gross margin for any of the periods disclosed. Inventory write-downs charged to cost of product revenue were $1.8 million in fiscal 2010, $2.3 million in fiscal 2009 and $2.2 million in fiscal 2008.
Networking products may contain undetected hardware or software errors when new products or new versions or updates of existing products are released to the marketplace. In the past, we had experienced such errors in connection with products and product updates. Our standard hardware warranty period is typically 12 months from the date of shipment to end-users and 90 days for software. For certain access products, we offer a limited lifetime hardware warranty commencing on the date of shipment from us and ending five (5) years following the our announcement of the end of sale of such product. Upon shipment of products to our customers, including both end-users and channel partners, we estimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability through charges to cost of product revenue for this amount.
Our accrued warranty balance was $3.2 million as of June 27, 2010 and June 28, 2009. The determination of our warranty requirements is based on our actual historical experience with the product or product family, estimates of repair and replacement costs and any product warranty problems that are identified after shipment. We estimate and adjust this accrual at each balance sheet date in accordance with changes in these factors. In fiscal 2010, we recorded $0.6 million for a change in estimate resulting from losses identified related to a failure in one of our products, and recovered in a settlement all estimated costs related to this issue from our outside design manufacturer.
The cost of new warranties issued that was charged to cost of product revenue was $6.3 million in fiscal 2010, $7.1 million in fiscal 2009 and $5.7 million in fiscal 2008.
Accounts Receivable and Allowance for Doubtful Accounts
Our accounts receivable balance, net of allowance for doubtful accounts, was $42.1 million and $37.6 million as of June 27, 2010 and June 28, 2009, respectively. The allowance for doubtful accounts for trade accounts receivable as of June 27, 2010 was $0.8 million, compared to $1.0 million as of June 28, 2009. We continually monitor and evaluate the collectability of our trade receivables based on a combination of factors. We record specific allowances for bad debts in general and administrative expense when we become aware of a specific customers inability to meet its financial obligation to us, such as in the case of bankruptcy filings or deterioration of financial position. Estimates are used in determining our allowances for all other customers based on factors such as current trends in the length of time the receivables are past due and historical collection experience. We mitigate some collection risk by requiring most of our customers in the Asia-Pacific region, excluding Japan and Australia, to pay cash in advance or secure letters of credit when placing an order with us. Our provision for doubtful accounts was an expense of $26,000 in fiscal 2010, expense of $0.2 million in fiscal 2009 and expense of $0.4 million in fiscal 2008.
Deferred Tax Asset Valuation Allowance
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Significant management judgment is required in determining our valuation allowance recorded against our net deferred tax assets. We make an assessment of the likelihood that our net deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not believed to be likely, a valuation allowance is established. We provided a full valuation allowance against all of our U.S. federal and state net deferred tax assets in fiscal 2003 in the amount of $194.8 million in accordance with our policy. In fiscal 2010, the valuation allowance increased by $11.5 million to $155.1 million, and in fiscal 2009, the valuation allowance decreased by $14.1 million to $143.6 million. We have not provided a valuation allowance against any of our non-U.S. deferred tax assets.
The valuation allowance requires an assessment of both negative and positive evidence when measuring the need for a valuation allowance. Evidence, such as operating results during the most recent three-year period was given more weight than our expectations of future profitability, which are inherently uncertain. Our U.S. losses during those periods represented sufficient negative evidence to require a full valuation allowance against our U.S. federal and state net deferred tax assets. This valuation allowance will be evaluated periodically and can be reversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets.
Accounting for Uncertainty in Income Taxes
We had unrecognized tax benefits of $23.9 million as of June 27, 2010. If fully recognized in the future, $1.0 million would impact our effective tax rate, and $22.9 million would result in adjustments to deferred tax assets and corresponding adjustments to the valuation allowance. We do not anticipate any material changes to our uncertain tax positions during the next twelve months.
We are currently involved in various claims and legal proceedings, including negotiations regarding potential licenses from third parties who have notified us that they believe our products may infringe certain patents. Periodically, we review the status of each significant matter, whether litigation or licensing negotiation, and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals, if any, are based only on the most current and dependable information available at any given time. As additional information becomes available, we may reassess the potential liability from pending claims and litigation and the probability of claims being successfully asserted against us. As a result, we
may revise our estimates related to these pending claims and litigation. Such revisions in the estimates of the potential liabilities could have a material impact on our consolidated results of operations, financial position and cash flows in the future. For further detail, see Note 3 of Notes to Consolidated Financial Statements for a description of legal proceedings.
Liquidity and Capital Resources
The following summarizes information regarding our cash, investments, and working capital (in thousands):
Cash and cash equivalents increased by $2.8 million primarily due to cash provided by operating activities of $9.3 million and cash from financing activities of $1.1 million, offset by cash used in investing activities of $7.6 million. Refer to further discussions below under Key Components of Cash Flows and Liquidity.
Short-term investments increased by $55.9 million primarily due to the transfer of securities maturing within one year from marketable securities and the reclassification of $40.7 million of ARS balance from marketable securities in the first quarter of fiscal 2010. Refer to further discussions below under Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Marketable securities decreased by $53.7 million primarily due to the reclassification of $40.7 million of ARS balance to short-term investments and the transfer of securities maturing within one year to short-term investments.
The increase in working capital of $59.2 million was primarily due to the reclassification of ARS from marketable securities to short-term investments.
Key Components of Cash Flows and Liquidity
A summary of the sources and uses of cash and cash equivalents is as follows (in thousands):
Cash and cash equivalents, short-term investments and marketable securities were $132.4 million and $127.4 million at June 27, 2010 and June 28, 2009, respectively, representing an increase of $5.0 million. This increase was primarily due to cash provided by operations of $9.3 million and cash provided by financing activities of $1.1 million, offset by capital expenditures of $5.1 million.
Cash provided by operating activities was $9.3 million, an increase of $4.6 million compared to cash provided by operating activities of $4.7 million in fiscal 2009. Net income was $0.2 million and included significant non-cash charges including depreciation of $5.6 million, $6.2 million in share-based compensation
expense and $1.8 million in the provision for excess and obsolete inventory. Accounts receivable, net, decreased to $42.1 million at June 27, 2010 from $37.6 million at June 28, 2009. Days sales outstanding in receivables increased to 45 days at June 27, 2010 from 42 days at June 28, 2009. The increase in accounts receivable and days sales outstanding were primarily due to increased billings in the fourth quarter of fiscal 2010. Inventories increased to $21.8 million at June 27, 2010 from $12.4 million at June 28, 2009. Inventory balance of $12.4 million at June 28, 2009 was lower than the normal inventory balance between $16.0 million to $18.0 million due to decreased inventory forecast demand. We increased our inventory balance to $21.8 million as of June 27, 2010 in anticipation of increased sales demand for the upcoming first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010. Deferred revenue, net decreased to $37.2 million at June 27, 2010 from $37.5 million at June 28, 2009. This decrease was due primarily to a reduction in renewals of service maintenance agreements for products which are entering end of support life.
Cash flow used in investing activities was $7.6 million. Capital expenditures were $5.1 million and purchases of investments were $51.6 million, offset by proceeds from maturities of investments and marketable securities of $34.5 million and sales of investments and marketable securities of $14.6 million.
Cash provided by financing activities was $1.1 million from the issuance of common stock.
As of June 27, 2010, we had letters of credit totaling $0.2 million secured by cash. These letters of credit are primarily issued in lieu of making cash deposits with third parties.
In October 2008, we entered into a secured line of credit with UBS, collateralized by our ARS held by UBS. The maximum amount of credit available under this line of credit is $28.8 million. On November 7, 2008 we accepted the UBS Rights offer and hence the terms of the no net cost loan program apply to this line of credit. Under this program, the interest rate on this secured credit facility will be equivalent to the interest rate earned by us on the ARS at UBS, resulting in no net interest cost to us. There are currently no outstanding borrowings under this line of credit. On June 30, 2010, we exercised our UBS Rights to redeem the remaining ARS at par. Upon exercising the UBS Rights, this line of credit was terminated.
Employee Stock Option Exchange Program
On December 23, 2009, our stockholders approved a voluntary program (Exchange Program) that permitted eligible employees to exchange certain outstanding stock options that were underwater for a lesser number of shares of restricted stock units to be granted under the Extreme Networks, Inc. 2005 Equity Incentive Plan (the 2005 Plan) and to exchange certain other stock options that are more substantially underwater for a cash payment. The Exchange Program was open to all of our United States employees, except for members of our Board of Directors and our executive officers. The Exchange Program commenced on February 4, 2010 and ended March 4, 2010. On March 5, 2010, we cancelled a total of 3,058,761 tendered stock options, issued a total of 569,189 replacement restricted stock units under the 2005 Plan, and incurred a cash outlay of $8,769 which was paid out at the end of March 2010.
The following summarizes our contractual obligations at June 27, 2010, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):
Non-cancelable inventory purchase commitments represent the purchase of long lead-time component inventory that our contract manufacturers procure in accordance with our forecast. Inventory purchase commitments were $39.1 million as of June 27, 2010, an increase of $19.2 million from $19.9 million as of June 28, 2009. The increase was due to higher projected sales in the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010. We did not have any material commitments for capital expenditures as of June 27, 2010. Other non-cancelable purchase commitments represent OEM and technology agreements.
Off-Balance Sheet Arrangements
We did not have any off-balance sheet arrangements as of June 27, 2010.
Capital Resources and Financial Condition
As of June 27, 2010, in addition to $49.0 million in cash and cash equivalents, we had $64.9 million invested in short-term investments and $18.6 million invested in long-term marketable investments for a total cash and cash equivalents, short-term investments and marketable securities of $132.4 million.
At June 27, 2010, we held approximately $25.3 million (par value) of illiquid non-current Auction Rate Securities (ARS). The decline in value of these securities reflects market related liquidity conditions resulting from the general collapse of the credit markets and not the issuers creditworthiness. The ARS are collateralized by student loan portfolios that are approximately 93% guaranteed by the US Department of Education and maintain a credit rating of AAA and AA. Historically, these securities provided liquidity to investors through their interest rate reset feature i.e., interest rates on these securities are reset through a bidding process (or auction) at frequent, pre-determined intervals (typically every 7 to 28 days). At each reset, investors could either rollover and maintain their holdings or liquidate them at par value. Since February 2008, auctions related to our ARS have failed as a result of the deterioration of the credit markets, rendering these securities illiquid.
On November 7, 2008, we accepted an offer (the UBS Rights Offer) from UBS AG (UBS), providing us with certain rights related to our ARS (the Rights). The Rights permit us to require UBS to purchase our ARS at par value, which is defined as the price equal to the liquidation preference of the ARS plus accrued but unpaid dividends or interest, at any time during the period of June 30, 2010 through July 2, 2012. Conversely, UBS has the right, in its discretion, to purchase or sell our ARS at any time until July 2, 2012, so long as we receive payment at par value upon any sale or disposition. As of June 27, 2010, UBS exercised its rights to call back the ARS at par for $9.8 million and issuers redeemed $5.7 million of ARS at par. On June 30, 2010, we sold the remaining ARS balance of $25.3 million at par under the Rights. On July 1, 2010, we received $25.3 million plus accrued interest in cash from UBS for the ARS settlement.
In October 2008, we entered into a secured line of credit with UBS, collateralized by our ARS held by UBS. The maximum amount of credit available under this line of credit is $28.8 million. When we accepted the UBS Rights Offer in November 2008, the terms of the UBS no net cost loan program were applied to this line of credit. Under this program, the interest rate on this secured credit facility will be equivalent to the interest rate earned by us on the ARS, resulting in no net interest cost to us. As of June 27, 2010, there was no outstanding borrowing under this line of credit. On June 30, 2010, we exercised our UBS Rights to redeem the remaining ARS at par. Upon exercising the UBS Rights, this line of credit was terminated.
We believe that our current cash and cash equivalents, short-term investments, marketable securities and cash available from credit facilities and future operations will enable us to meet our working capital requirements for at least the next 12 months.
New Accounting Pronouncements
In January 2010, the FASB issued a new accounting standards update for fair value measurements and disclosures. A reporting entity should disclose separately the amounts of significant transfers in and out of
Level 1 and Level 2 and describe the reasons for the transfers. A reporting entity should separately disclose information about purchases, sales, issuances and settlements for Level 3 reconciliation disclosures. The new disclosures and clarifications of existing disclosures are effective for financial statements issued interim or annual financial periods ending after December 15, 2009, with the exception for the reconciliation disclosures for Level 3, which are effective for financial statements issued interim or annual financial periods ending after December 15, 2010. The adoption of the new accounting standards update did not have a material impact on our consolidated results of operations, financial condition or financial disclosures.
In October 2009, the FASB issued a new accounting standard which excludes from the scope of software revenue guidance the revenue arrangements that include tangible products containing software components and non-software components that function together to deliver the tangible products essential functionality. At the same time, the FASB also issued a new accounting standard which updates existing guidance pertaining to the separation and allocation of consideration in a multiple element arrangement. This new guidance will be applicable to our multiple element arrangements that include such tangible products. The new standards are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The adoption of this accounting standard is not expected to have a material effect on the amount of revenue reported.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Sensitivity
The primary objective of our investment activities is to preserve principal while at the same time maximize the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, other non-government debt securities and money market funds.
As of June 27, 2010, we held a variety of interest bearing ARS that represent investments in pools of student loans. These ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The recent uncertainties in the credit markets have affected all of our holdings in ARS investments and auctions for our investments in these securities have failed to settle on their respective settlement dates. On November 7, 2008, we accepted the UBS Rights Offer from UBS, providing us with rights related to our ARS. The Rights permit us to require UBS to purchase our ARS at par value, which is defined as the price equal to the liquidation preference of the ARS plus accrued but unpaid dividends or interest, at any time during the period of June 30, 2010 through July 2, 2012. Conversely, UBS has the right, in its discretion, to purchase or sell our ARS at any time until July 2, 2012, so long as we receive payment at par value upon any sale or disposition. During the first quarter of fiscal 2010, we reclassified our entire balance of ARS from marketable securities to short-term securities in our consolidated balance sheet. The reclassification is a result of the Put Option being due within less than one year from the balance sheet date. Beginning in 2010, we began to sell our ARS under the Rights. As of June 27, 2010, UBS exercised its rights to call back the ARS at par for $9.8 million and issuers redeemed $5.7 million of ARS at par. On June 30, 2010, we sold the remaining ARS balance of $25.3 million at par under the Rights. On July 1, 2010, we received $25.3 million plus accrued interest in cash from UBS for the ARS settlement.
The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities, discount rates and ongoing strength and quality of market credit and liquidity.
If the current market conditions deteriorate further, or the anticipated recovery in market values does not occur, we may be required to record impairment charges in future quarters.
The following table presents the amounts of our cash equivalents, short-term investments and marketable securities that are subject to market risk by range of expected maturity and weighted-average interest rates as of June 27, 2010 and June 28, 2009. This table does not include money market funds because those funds are generally not subject to market risk. Included within short-term investments as of June 27, 2010 within this table is our ARS portfolio held at UBS.
We accumulate unrealized gains and losses on our available-for-sale debt securities, net of tax, in accumulated other comprehensive income in the stockholders equity section of its balance sheets. Such an unrealized gain or loss does not reduce net income for the applicable accounting period. If the fair value of an available-for-sale debt instrument is less than its amortized cost basis, an other-than-temporary impairment is triggered in circumstances where (1) we intend to sell the instrument, (2) it is more likely than not that we will be required to sell the instrument before recovery of its amortized cost basis, or (3) we do not expect to recover the entire amortized cost basis of the instrument (that is, a credit loss exists). If we intend to sell or it is more likely than not that we will be required to sell the available-for-sale debt instrument before recovery of its amortized cost basis, we recognize an other-than-temporary impairment in earnings equal to the entire difference between the debt instruments amortized cost basis and its fair value. For available-for-sale debt instruments that are considered other-than-temporarily impaired due to the existence of a credit loss, if we do not intend to sell and it is not more likely than not that we will be required to sell the instrument before recovery of its remaining amortized cost basis (amortized cost basis less any current-period credit loss), we separate the amount of the impairment into the amount that is credit related and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the debt instruments amortized cost basis and the present value of its expected future cash flows. The remaining difference between the debt instruments fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income (loss).
Exchange Rate Sensitivity
Currently, substantially all of our sales and the majority of our expenses are denominated in United States dollars and, as a result, we have experienced no significant foreign exchange gains and losses to date. While we conduct some sales transactions and incur certain operating expenses in foreign currencies and expect to continue to do so, we do not anticipate that foreign exchange gains or losses will be significant, in part because of our foreign exchange risk management process discussed below.
Foreign Exchange Forward Contracts
We record all derivatives on the balance sheet at fair value. Changes in the fair value of derivatives are recognized in earnings as Other Income (Expense). We enter into foreign exchange forward contracts to mitigate the effect of gains and losses generated by the foreign currency forecasted transactions related to certain operating expenses and remeasurement of certain assets and liabilities denominated in Japanese Yen, the Euro, the Swedish Krona, the Indian Rupee and the British Pound. These derivatives do not qualify as hedges. At June 27, 2010, these forward foreign currency contracts had a notional principal amount of $19.1 million and fair value was $0.1 million. These contracts have maturities of less than 60 days. Changes in the fair value of these foreign exchange forward contracts are offset largely by remeasurement of the underlying assets and liabilities.
Foreign currency transaction gains and losses from operations were a loss of $0.4 million in fiscal 2010, a loss of $0.1 million in fiscal 2009 and a loss of $0.7 million in fiscal 2008.
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF EXTREME NETWORKS, INC.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Extreme Networks, Inc.
We have audited the accompanying consolidated balance sheets of Extreme Networks, Inc. as of June 27, 2010 and June 28, 2009, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended June 27, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Extreme Networks, Inc. at June 27, 2010 and June 28, 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 27, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 6 to the consolidated financial statements, in fiscal year 2008, Extreme Networks, Inc. changed its method of accounting for uncertain tax positions in accordance with the guidance provided in Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (codified in FASB ASC Topic 740, Income Taxes).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Extreme Networks, Inc.s internal control over financial reporting as of June 27, 2010, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 20, 2010 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Francisco, California
August 20, 2010
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to the consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business
Extreme Networks, Inc. (Extreme Networks or the Company) is a leading provider of network infrastructure equipment and markets its products primarily to business, governmental, health care, service provider, and educational customers with a focus on large corporate enterprises and metropolitan service providers on a global basis. The Company conducts its sales and marketing activities on a worldwide basis through distributors, resellers and the Companys field sales organization. Extreme Networks was incorporated in California in 1996 and reincorporated in Delaware in 1999.
2. Basis of Presentation and Summary of Significant Accounting Policies
The Companys fiscal year is a 52/53-week fiscal accounting year that closes on the Sunday closest to June 30th every year. Fiscal 2010, 2009 and fiscal 2008 were 52-week fiscal years. All references herein to fiscal 2010 or 2010 represent the fiscal year ended June 27, 2010. The Company has evaluated all subsequent events through the date the financial statements were filed with the SEC.
Principles of Consolidation
The consolidated financial statements include the accounts of Extreme Networks and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated.
The Company uses the U.S. dollar predominately as its functional currency. The functional currency for certain of its foreign subsidiaries is the local currency. For those subsidiaries that operate in a local currency functional environment, all assets and liabilities are translated to United States dollars at current rates of exchange; and revenue and expenses are translated using average rates. Foreign currency transaction gains and losses from operations were a loss of $0.4 million in fiscal 2010, a loss of $0.1 million in fiscal 2009 and a loss of $0.7 million in fiscal 2008.
Certain prior period amounts have been reclassified to conform to the current presentation. Such reclassifications impacted the Consolidated Balance Sheets, Consolidated Statements of Operations, Consolidated Statements of Cash Flows and Consolidated Statements of Stockholders Equity. Specifically, the Company reclassified back-end rebate for distributors from Other Accrued Liabilities to contra Accounts Receivable and gains and losses from foreign currency transactions from Cost of Revenues and Operating Expenses to Other Income (Expense) beginning in the second and fourth quarter of fiscal 2010, respectively, with the prior periods updated to conform to this presentation.
The audited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments and out of period share based compensation adjustments totaling $0.9 million that, in the opinion of management, are necessary for a fair presentation of the results of operations and cash flows for the annual period presented and the financial condition of Extreme Networks at June 27, 2010.
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the
EXTREME NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
amounts reported in the financial statements and accompanying notes. Estimates are used for, but are not limited to, the accounting for the allowances for doubtful accounts and sales returns, inventory valuation, depreciation and amortization, valuation of ARS, valuation of UBS Put Option, impairment of long-lived assets, warranty accruals, restructuring liabilities, measurement of share-based compensation costs and income taxes. Actual results could differ materially from these estimates.
The Company allocates revenue to each element of multiple element arrangements that include products containing software that is more-than-incidental using the residual method based on vendor specific objective evidence of fair value of the undelivered elements. The Company determines vendor specific objective evidence of fair value based on the price charged when the item is sold separately. Under the residual method, the Company first allocates the revenue for a multiple element arrangement to the undelivered elements based on their VSOE of fair value, and the remainder of the arrangement fee to the delivered elements.
The Company derives the majority of its revenue from sales of its networking equipment, with the remaining revenue generated from service fees relating to the service contracts, professional services, and training for its products. The Company generally recognizes product revenue from its value-added resellers and end-user customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable, and collection of the sales proceeds is reasonably assured. In instances where the criteria for revenue recognition are not met, revenue is deferred until all criteria have been met. Revenue from service obligations under service contracts is deferred and recognized on a straight-line basis over the contractual service period. Service contracts typically range from one to two years. The Companys total deferred product revenue was $1.4 million and $1.3 million as of June 27, 2010 and June 28, 2009, respectively. The Companys total deferred revenue for services, primarily from service contracts, was $36.4 million as of June 27, 2010 and $36.7 million as of June 28, 2009. Service contracts typically range from one to two years. Shipping costs are included in cost of product revenues.
The Company makes certain sales to partners in two distribution channels, or tiers. The first tier consists of a limited number of independent distributors that sell primarily to resellers and, on occasion, to end-user customers. The Company defers recognition of revenue on all sales to these distributors until the distributors sell the product, as evidenced by monthly sales-out reports that the distributors provide. The Company grants these distributors the right to return a portion of unsold inventory for the purpose of stock rotation. The Company also grants these distributors certain price protection rights. The distributor-related deferred revenue and receivables are adjusted at the time of the stock rotation return or price reduction. The Company also provides distributors with credits for changes in selling prices, and allows distributors to participate in cooperative marketing programs. The Company maintains estimated accruals and allowances for these exposures based upon the Companys historical experience. In connection with cooperative advertising programs, the Company does not meet the criteria in its accounting policy for recognizing the expenses as marketing expenses and accordingly, the costs are recorded as a reduction to revenue in the same period that the related revenue is recorded.
The second tier of the distribution channel consists of a large number of third-party value-added resellers that sell directly to end-users. For product sales to value-added resellers, the Company does not grant return privileges, except for defective products during the warranty period, nor does the Company grant pricing credits. Accordingly, the Company recognizes revenue upon transfer of title and risk of loss to the value-added reseller, which is generally upon shipment. The Company reduces product revenue for cooperative marketing activities and certain price protection rights that may occur under contractual arrangements with its resellers.
EXTREME NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
The Company provides an allowance for sales returns based on its historical returns, analysis of credit memo data and its return policies. The allowance for sales returns was $0.9 million as of June 27, 2010 and June 28, 2009 for estimated future returns that were recorded as a reduction of our accounts receivable. The provision for returns is charged to net revenue in the accompanying consolidated statements of operations, and was $7,000, $0.9 million and $1.0 million in fiscal 2010, fiscal 2009 and fiscal 2008, respectively. If the historical data that the Company uses to calculate the estimated sales returns and allowances does not properly reflect future levels of product returns, these estimates will be revised, thus resulting in an impact on future net revenue. The Company estimates and adjusts this allowance at each balance sheet date.
Cash Equivalents, Short-Term Investments and Marketable Securities
Summary of Available-for-Sale Securities and Trading Securities
The following is a summary of available-for-sale securities (in thousands):
EXTREME NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
The amortized cost and estimated fair value of available-for-sale investments in debt securities at June 27, 2010, by contractual maturity, were as follows (in thousands):
The Company considers highly liquid investments with maturities of three months or less at the date of purchase to be cash equivalents. Investments with maturities of greater than three months at the date of purchase are classified as non-cash equivalents. Of these, investments with maturities of less than one year at balance sheet date are classified as Short Term Investments. Investments with maturities of greater than one year at balance sheet date are classified as Marketable Securities. Except for direct obligations of the United States government, securities issued by agencies of the United States government, and money market funds, the Company diversifies its investments by limiting its holdings with any individual issuer.
Investments include available-for-sale investment-grade debt securities and trading securities that the Company carries at fair value. The Company accumulates unrealized gains and losses on the Companys available-for-sale debt securities, net of tax, in accumulated other comprehensive income in the stockholders equity section of its balance sheets. Such an unrealized gain or loss does not reduce net income for the applicable accounting period. If the fair value of an available-for-sale debt instrument is less than its amortized cost basis, an other-than-temporary impairment is triggered in circumstances where (1) the Company intends to sell the instrument, (2) it is more likely than not that the Company will be required to sell the instrument before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the instrument (that is, a credit loss exists). If the Company intends to sell or it is more likely than not that the Company will be required to sell the available-for-sale debt instrument before recovery of its amortized cost basis, the Company recognizes an other-than-temporary impairment in earnings equal to the entire difference between the debt instruments amortized cost basis and its fair value. For available-for-sale debt instruments that are considered other-than-temporarily impaired due to the existence of a credit loss, if the Company does not intend to sell and it is not more likely than not that the Company will be required to sell the instrument before recovery of its remaining amortized cost basis (amortized cost basis less any current-period credit loss), the Company separates the amount of the impairment into the amount that is credit related and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the debt instruments amortized cost basis and the present value of its expected future cash flows. The remaining difference between the debt instruments fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income (loss).
The Company records unrealized and realized gains and losses on the Companys trading securities, net of tax, in other income (expense), net, in its statements of operations. The ARS are held with UBS AG (UBS) and the Company accepted a Rights offer on November 7, 2008 (see discussions below). The ARS and Put Option (as defined below) represent a fair value of $25.3 million and are reflected in short-term investments trading as of June 27, 2010. The reclassification to short-term investment is made based on the Companys intention to exercise the Put Option which first comes due in less than one year from the balance sheet date.
EXTREME NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
The following table presents the Companys investments gross unrealized losses and fair values, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
Realized gains or losses recognized on the sale of investments were not significant for fiscal 2010, fiscal 2009 and fiscal 2008. The unrealized gains / (losses) on the Companys investments were caused by interest rate fluctuations. Substantially all of the Companys available-for-sale investments are investment grade government and corporate debt securities that have maturities of less than 3 years. The Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of its amortized costs.
Fair Value of Financial Instruments
The Company measures certain financial assets and liabilities at fair value on a recurring basis, including cash equivalents, available-for-sale securities, trading securities and foreign currency derivatives. Fair value is measured based on a fair value hierarchy following three levels of inputs, of which the first two are considered observable and the last unobservable:
The following table presents the Companys fair value hierarchy for its financial assets measured at fair value on a recurring basis:
EXTREME NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)
The following table provides a summary of changes in the fair value of the Companys Level 3 financial assets for fiscal 2010 (in thousands):
Level 3 assets consist of ARS whose underlying assets are student loans which are substantially backed by the federal government. Since the auctions for these securities have continued to fail since February 2008, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated fair value of the ARS no longer approximates par value. These ARS are held by UBS, the Companys investment provider. In November 2008, the Company acc