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Sycamore Networks 10-K 2007
FORM 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended July 31, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     .

Commission File Number: 000-27273

SYCAMORE NETWORKS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   04-3410558
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

220 Mill Road

Chelmsford, Massachusetts 01824

(Address of principal executive office)

(978) 250-2900

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class   Name of Each Exchange on which Registered
COMMON STOCK $0.001 PAR VALUE   THE NASDAQ STOCK MARKET LLC

Securities registered pursuant to Section 12(g) of the Act: NONE

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 Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act Check one:

Large Accelerated Filer  x                    Accelerated Filer  ¨                    Non-accelerated Filer   ¨

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 as of January 27, 2007 was approximately $687,889,310.

As of September 7, 2007 there were 280,350,606 shares outstanding of the Registrant’s common stock, $0.001 par value.

 



Table of Contents

DOCUMENTS INCORPORATED BY REFERENCE

PART III—Portions of the definitive Proxy Statement for the Annual Meeting of Stockholders to be held on December 17, 2007 are incorporated by reference into Part III (Items 10, 11, 12, 13 and 14) to this Annual Report on Form 10-K.

Table of Contents

 

Part I

Item 1.

   Business    3

Item 1A.

   Risk Factors    12

Item 1B.

   Unresolved Staff Comments    24

Item 2.

   Properties    24

Item 3.

   Legal Proceedings    25

Item 4.

   Submission of Matters to a Vote of Security Holders    28
Part II

Item 5.

  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   29

Item 6.

   Selected Financial Data    31

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    32

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    45

Item 8.

   Financial Statements and Supplementary Data    46

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    76

Item 9A.

   Controls and Procedures    76

Item 9B.

   Other Information    77
Part III

Item 10.

   Director and Executive Officers of the Registrant    78

Item 11.

   Executive Compensation    78

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   78

Item 13.

   Certain Relationships and Related Transactions and Director Independence    78

Item 14.

   Principal Accountant Fees and Services    78
Part IV

Item 15.

   Exhibits and Financial Statement Schedules    79

 

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PART I

 

ITEM 1. BUSINESS

General

We develop and market intelligent bandwidth management solutions for fixed line and mobile network operators worldwide and provide services associated with such products. Our current and prospective customers include domestic and international wireline and wireless network service providers, utility companies, multiple systems operators (MSOs) and government entities with private fiber networks (collectively referred to as “service providers”). Our comprehensive portfolio of optical switches, multiservice access platforms, and advanced networking software extends across the network, from multiservice access and regional backhaul to the optical core. We believe that our products enable network operators to efficiently and cost-effectively provision and manage multiservice access and optical network capacity to support a wide range of converged services such as voice, video and data.

On September 6, 2006, we acquired Eastern Research, Inc., an innovative provider of network access multiservice switching solutions for fixed-line and mobile network operators worldwide. Eastern Research’s customers include fixed-line service providers, wireless carriers, utility companies, and government agencies. We believe that the addition of Eastern Research’s products, technology and talent positions us to diversify and increase our customer base, expand our addressable markets, and broaden our customer offerings.

We incorporated under the laws of the State of Delaware on February 17, 1998 and shipped our first product in May 1999. We completed our initial public offering on October 21, 1999 and a follow-on public offering on March 14, 2000. Our principal executive offices are located at 220 Mill Road, Chelmsford, Massachusetts 01824. Our telephone number is (978) 250-2900, and our website address is www.sycamorenet.com.

We file annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K with the Securities and Exchange Commission (the “SEC”). These reports, any amendments to these reports, proxy and information statements and certain other documents we file with the SEC are available through the SEC’s website at www.sec.gov or free of charge on our website as soon as reasonably practicable after we file the documents with the SEC. The public may also read and copy these reports and any other materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

Industry Background

Industry Trends

The telecommunications industry has undergone periods of significant change since data-centric applications first began to have an impact on service provider infrastructure networks in the mid 1990’s. Following deregulation and privatization in the global telecommunications industry during the late 1990’s, there were many new entrants into the service provider market. Emerging service providers built networks and began competing with incumbent service providers in an effort to accommodate rapid traffic growth and projected growth in demand for bandwidth and telecommunication services. In early 2001, however, due to excess capacity resulting from the over building of the telecommunications infrastructure, service providers began curtailing their capital spending for network build-outs. As a result, there was a slowdown in service provider equipment purchases and a sharp decline in demand for networking equipment. During this time period, numerous service providers failed and sought bankruptcy protection.

Despite the decline in the telecommunications industry discussed above, overall data traffic on service provider networks continued to grow as consumers and businesses increasingly used these networks for applications such as electronic mail, web browsing, electronic commerce, and other voice, video and data

 

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services. During the past several years, the communications industry as a whole began to emerge from this period of decline. During this same period, however, consolidation among some of the larger service providers resulted in a trend among these service providers to reduce the number of communications equipment suppliers in their networks. This trend results in concentration of purchasing power, pricing pressure, and competitive leverage for incumbent equipment suppliers.

Today, large and small enterprises, organizations such as government agencies and utility companies, and individuals continue to rely on communication services offered by network operators. These services include voice, private line connections, broadband internet access, text messaging and the like. In response to increased demand for broadband and data services by consumers and businesses, wireline and wireless service providers began to increase capital spending in certain segments of their communication networks. These trends have resulted in increased spending in the access, regional, and core segments of service provider infrastructure networks.

Intelligent Multiservice Access and Optical Networking

Multiservice access and core optical networks are critical components of a high-capacity communications network that enable service providers to create and distribute high-speed bandwidth and services to their customers.

During the past few years, as demand for broadband services and content-rich applications by consumers and businesses increased, wireline and wireless service providers began to gradually increase capital spending in their infrastructure networks, including certain segments of the access and optical network.

We believe that a service provider’s competitive advantage and differentiation comes from its ability to provide bandwidth when and where needed and to create and offer new services quickly and cost-effectively. Given the global competitive landscape within the communications industry, we believe that many service providers will want to optimize their capital expenditures, lower their operating costs and improve the profitability of their next generation, converged voice, video and data services.

Most service providers own and operate traditional high speed communications networks that originally were designed primarily to support voice traffic and point-to-point data traffic with moderate bandwidth demands. These traditional networks impose a number of limitations on a service provider’s ability to offer services which provide a competitive advantage due to the following factors:

 

   

Networks initially designed for voice traffic. Service providers initially built and operated their networks to transmit voice traffic using specialized equipment and sophisticated operational processes. As a result, these networks cannot easily or cost-effectively accommodate the growing levels of bandwidth and data optimized traffic across the network.

 

   

Inefficient utilization of network capacity. In traditional optical networks, at most one half of the available capacity is used for delivering services. The other portion remains idle in the event of a network failure. This traditional architecture supports the high-availability requirements of traditional voice services, but is inefficient for data traffic, which is more dynamic in nature and does not always require the same level of protection.

 

   

Expensive to build and operate. Having separate networks to carry different traffic types is capital-intensive and requires the interconnection and management of multiple network devices. These separate devices require substantial space and power, and increase the cost and complexity of network operations.

 

   

Time consuming, complex service delivery. In existing networks, the delivery of high-speed services is a highly complex, labor-intensive process that requires a highly skilled workforce and can take months to complete.

 

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Difficult and expensive network expansion. Adding or changing high-speed services in existing networks is difficult and expensive. As a result, service providers cannot quickly or cost-effectively respond to unplanned changes in their customers’ demand or accommodate rapid increases in data network traffic.

 

   

Limited ability to offer new services. Traditional optical network services are optimized for voice, not data. The inefficient nature of traditional optical networks limits the types of high-speed services that can be offered to customers. In addition, the high cost of creating and managing high-speed services in traditional optical networks impacts a service provider’s market competitiveness.

The Sycamore Solution

Our comprehensive portfolio of optical switches, multiservice access platforms, and industry-leading networking software extends across the network, from multiservice access and regional backhaul to the optical core. We believe that our products enable network operators to efficiently and cost-effectively provision and manage multiservice access and optical network capacity to support a wide range of converged services such as voice, video and data. We believe that our products reduce service providers’ capital and operating costs, simplify network operations, and provide the foundation for a new generation of dynamic services. Key benefits of our optical switching solutions include:

 

   

Improved network design. Using our expertise in access and optical networking, network management, data networking, and advanced hardware and software systems design, we develop innovative switching products that lower the costs of building and managing multiservice networks, and optimize the network for the growing level of data traffic.

 

   

Improved utilization of network capacity. Our switching products exchange real-time information about network traffic to enable better utilization of otherwise idle capacity, improve network efficiencies, and adapt more dynamically to data traffic patterns.

 

   

Cost-effective solution. Our products replace multiple traditional networking devices with a single, compact switching system which simplifies the network architecture. Our products are designed to reduce initial capital expenditures and ongoing operating costs and simplify the management of network services. In addition, our switching products consolidate multiple networking functions into a single platform, reducing the number of network elements a service provider must deploy and manage.

 

   

Rapid service delivery. Our products enable service providers to rapidly deliver high-speed services, simplify operational procedures and automate labor-intensive provisioning and network management processes. In some cases the time it takes service providers to deliver revenue-generating services to their customers is decreased from months to nearly real-time.

 

   

Easy network expansion. Our products enable service providers to easily and cost-effectively increase bandwidth when and where needed. In addition, the ability of our optical switches to communicate real-time information enables the network to quickly respond to rapid increases in data-oriented network traffic.

 

   

Creation of new services. Our products enable service providers to create new high-speed services and deliver such services more efficiently and cost-effectively. As a result, service providers can generate new sources of revenue and further differentiate their high-speed service offerings.

 

   

Compatible with existing network devices. We designed our standards-based products to be compatible with existing network devices, enabling service providers to protect their traditional network investments while easily and cost-effectively transitioning to a more flexible and efficient high-speed service infrastructure. In addition, we offer comprehensive network management, planning and administration software that communicates with existing network management systems through common standards and interfaces.

 

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Sycamore’s Strategy

As we remain focused on improvements in our business, our management and Board of Directors continue to consider strategic options that may serve to maximize shareholder value. These options include, but are not limited to (i) acquisitions of, or mergers or other combinations with, companies with either complementary technologies or in adjacent market segments, (ii) alliances with another entity, and (iii) recapitalization alternatives, including stock buybacks, cash distributions or cash dividends.

On September 6, 2006, we acquired Eastern Research, Inc., an innovative provider of network access solutions for fixed line and mobile network operators worldwide. We believe that the addition of Eastern Research’s products, technology and talent positions us to diversify and increase our customer base, expand our addressable markets, and broaden our customer offerings.

Key elements of our strategy include the following:

 

   

Target incumbent service providers. We intend to target sales to incumbent service providers. Because incumbent service providers have the largest fiber optic infrastructure, we believe that our optical networking solutions offer them the most cost-effective way to expand and operate their networks and offer new revenue-generating services.

 

   

Expand our customer base. We intend to actively pursue additional new customers both domestically and internationally, while continuing to expand our relationships with existing customers. We intend to pursue new customers via direct sales efforts as well as through strategic partners. We believe that data traffic growth will cause service providers to seek optical networking solutions that will optimize network capacity and transition their networks toward a more flexible and data-optimized infrastructure.

 

   

Expand strategic relationships including resellers. Our sales and marketing efforts involve building and broadening strategic relationships, particularly with resellers, to expand our access to a broader set of customers around the world. We believe that such strategic relationships may address portions of the market, such as the government market or certain international markets, which we cannot reach with our own sales force without a significant investment of time and resources.

 

   

Continue to invest in sales and customer service. We believe that continued investment in sales and customer service is necessary in order to expand and support our customer base both domestically and internationally. We believe that ongoing sales and customer service is critical to successful long-term relationships with, and follow-on sales to, our current and prospective customers.

 

   

Continue to invest in research and development. We believe that continued investment in research and development is necessary in order to continue to provide innovative optical networking solutions that meet our current and prospective customers’ needs. In order to provide such products to our customers, we believe we must make significant and sustained investment in research and development.

 

   

Manage costs and preserve cash. We believe that our cash position coupled with no long-term debt differentiates us from our competition. While we continue to invest in strategic areas of the business, we also continue to focus on cost management and cash preservation.

 

   

Outsource manufacturing. We outsource the manufacturing of our products and purchase key components from third parties. Outsourcing enables us to reduce expenses and focus on our core competencies such as product development, sales and customer service.

Sycamore’s Products

Our intelligent bandwidth management solutions form the foundation for some of the world’s most respected fixed line and mobile networks. These products include multiservice cross-connects, multiservice access platforms, access gateways, optical switching platforms, and element/network management and design software.

 

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Optical Switching

Optical switching products enable scalable, high-capacity bandwidth management in regional and core optical networks, with integrated ring and mesh protection options for optimal performance in any network topology.

Optical Switching—SN 16000, SN 16000 SC, and SN 3000 intelligent optical switches share the same optical signaling, routing, and management software across each platform, to support high-density, multiservice aggregation and diverse, resilient protection options from the metro edge to the optical core. Advanced optical networking software and an ASON/GMPLS-compliant control plane simplify provisioning and enhance capacity utilization.

Optical Network Management—Standards-based, network-aware management systems and interfaces ensure seamless integration and interoperability, while enabling flexible bandwidth services. SILVX® empowers comprehensive performance management, in-service scalability, and dynamic service delivery without compromising existing systems.

Optical Network Design & Analysis—SILVX InSight® software offers state-of-the-art ring and mesh network modeling, configuration, emulation, and capacity planning – all fully integrated with SILVX network management.

Multiservice Access

Network access products perform critical bandwidth management functions, such as grooming, access concentration, and circuit provisioning, in a range of transmission network applications.

Multiservice Cross-Connects—Scalable DNX platforms for traffic aggregation and grooming which handle narrowband to broadband switching and transport, and are architected for resiliency and modular growth.

Multiservice Access Platforms—OM optical multiplexers, the IAB-3000 integrated access bank, and the SPS-1000 signaling process system add cost-effective flexibility and capability to access networks and support voice and data integration at end-user sites, next-gen Ethernet-over-SONET/SDH transport and telemetry applications.

Access Gateways—Deployed at mobile cell sites, DNX-1u access gateways optimize RAN backhaul transport, with integrated telemetry and remote IP management features to improve site visibility and control.

Network Management—ENvision Plus network management software provides sophisticated provisioning, path protection, and disaster recovery.

Services. We offer complete engineering, furnishing, installation and testing services as well as comprehensive customer support and maintenance from multiple locations worldwide.

Customers

Our current and prospective customers include domestic and international wireline and wireless network service providers, utility companies, multiservice operators (MSOs) and government entities with private fiber networks (collectively referred to as “service providers”). We expect that our revenue will continue to be highly concentrated in a relatively small number of customers.

During the year ended July 31, 2007, two customers, Sprint Corporation and Vodafone Group PLC accounted for 53% and 16% of our revenue, respectively. During the year ended July 31, 2006, three customers, Vodafone Group PLC, Sprint Corporation and Siemens accounted for 43%, 26% and 19% of our revenue, respectively. During the year ended July 31, 2005, four customers, Vodafone Group PLC, Sprint Government Systems Division (as a reseller to the federal government), Sprint Corporation and NTT Communications

 

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accounted for 36%, 24%, 12% and 11% of our revenue, respectively. International revenue was 27% of total revenue during the year ended July 31, 2007, compared to 67% during the year ended July 31, 2006, and 63% during the year ended July 31, 2005. See “Concentrations and Significant Customer Information” and “Segment Information” in Note 2 to “Notes to Consolidated Financial Statements” and Item 1A. “Risk Factors” for additional details.

Our contracts with customers typically include the purchase of our hardware products, right to use fees, the license of our SILVX and Envision Plus network management system, and in some cases, maintenance and support services. These contracts include terms and conditions, including payment, delivery and termination that we believe are customary and standard in our industry. None of our customers are contractually committed to purchase any minimum quantities of products from us and orders are generally cancelable prior to shipment. In addition, the federal government may terminate their contracts with any party at any time. As a result, we do not disclose our order backlog, since we believe that our order backlog at any particular date is not necessarily indicative of actual revenue for any future period.

Sales and Marketing

There are a limited number of current and prospective optical switch customers in each geographic market. Each service provider owns and operates a unique fiber optic network. The network complexity affects the integration of our optical networking products into each service providers network. As a result, sales are made on a customer-by-customer basis and the sales cycle may extend beyond one year.

We sell our products worldwide through a direct sales force with a local presence in several locations around the world. In certain markets, we also have strategic distribution partners, independent marketing representatives or independent sales consultants. We intend to further establish relationships with select distribution and marketing partners to extend our reach to serve new markets.

The primary focus of our sales efforts is to continue to develop strong relationships with incumbent service providers and resellers. Our sales and pre-sales engineering organizations work collaboratively with both current and prospective customers to identify optical switching applications that help optimize their network as well as create new services that they can offer to their customers. We also provide comprehensive post-sales customer support including network planning and deployment, technical assistance centers and logistics support. Our customer support organization leverages a network of highly qualified service partners to extend our reach and capabilities.

In support of our sales efforts, we conduct marketing programs to position and promote market awareness of Sycamore and our products. We also participate in conferences, trade shows and provide marketing information on our website. In addition, we conduct public relations activities, including interviews and demonstrations for the business and trade media, and industry analysts.

Research and Development

We believe that ongoing investment in research and development is necessary in order to continue to provide innovative, intelligent bandwidth management solutions that meet our current and prospective customers’ needs. We believe that our solutions will allow current and prospective customers to optimize bandwidth and capacity management while also allowing them to reduce their capital expenditures and operating costs. In order to provide such products to our customers, we believe we must make sustained investment in research and development. Our research and development efforts focus primarily on improvements to the features and functionality of existing products, while also developing next-generation systems. We intend to continue to focus our research and development efforts on solutions that help our customers optimize their networks for the voice, video and data services driving network growth.

 

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Our research and development expenditures were $45.9 million, $31.4 million and $48.0 million for the years ended July 31, 2007, 2006 and 2005, respectively. All of our expenditures for research and development, as well as share-based compensation expense relating to research and development of $1.7 million, $2.4 million and $5.3 million, for the years ended July 31, 2007, 2006 and 2005, respectively, have been expensed as incurred. As of July 31, 2007, we had approximately 213 employees involved in research and development.

Competition

The number of optical switching opportunities worldwide is limited. Competition for these opportunities is intense and includes considerable pricing pressure. Based on the current level of spending by communications service providers, we expect that competition will continue to be very intense.

Sycamore’s competition includes large incumbent suppliers of network infrastructure equipment and optical networking equipment, such as Alcatel-Lucent, Ciena, Cisco, Ericsson, Huawei, Nortel and Tellabs. The multiservice access market is equally competitive, with a highly fragmented group of suppliers which includes Tellabs, Alcatel-Lucent, Adtran and Kentrox. Many of our established competitors have longer operating histories and greater financial, technical, sales, marketing, manufacturing and field resources and are able to devote greater resources to the research and development of new products than we do. In addition, these competitors generally have more diverse product lines which allow them the flexibility to price their products more aggressively and absorb the significant cost structure associated with optical switching research and development across their entire business. Most of our competitors also have more extensive customer bases and broader customer relationships than we do, including relationships with our prospective customers in their local geographies. In addition, we continue to see new entrants into the market with new products that compete with our products. Some of these new entrants are located in geographies with lower cost infrastructures than ours. In order to compete effectively in the optical switching market, we must deliver products that:

 

   

provide a cost-effective solution to service providers for expanding capacity and provides intelligent bandwidth management;

 

   

lower a service provider’s cost of building and operating their fiber optic network;

 

   

provide extremely high network reliability;

 

   

interoperate with existing network devices;

 

   

simplify the network architecture by replacing multiple traditional networking devices into a single compact optical switch; and

 

   

provide effective network management.

In addition, we believe that our knowledge of communications infrastructure requirements and experience working with service providers to assist in the development of new services for their customers are important competitive factors in our market.

Proprietary Rights and Licensing

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect the proprietary aspects of our technology. We license software to our customers pursuant to signed or shrink- wrapped license agreements, which impose certain restrictions on the licensee’s ability to utilize the software. Our practice is to require employees and consultants to execute non-disclosure and proprietary rights agreements upon commencing employment or consulting with us. Despite our efforts to protect our proprietary rights,

 

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unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. We enforce our intellectual property rights vigorously against infringement or misappropriation.

We license third party software, including certain technologies that are (i) embedded into our hardware platforms and into our SILVX and Envision Plus network management systems; (ii) used internally by us as hardware design tools; and (iii) used internally by us as software development tools. We also utilize publicly available technology. The majority of these licenses have perpetual terms but will generally terminate after an uncured breach of the agreement by us. We believe, based upon past experience and standard industry practice, that such licenses generally could be obtained on commercially reasonable terms in the future. Nonetheless, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all.

As of July 31, 2007, we had received 38 United States patents and had pending 3 United States patent applications. Of the United States patents that have been issued, the earliest any will expire is February 2019. As of July 31, 2007, we had 8 allowed or registered United States trademarks and 17 allowed or registered foreign trademarks. All of the registered United States trademarks have a duration of ten years from the date of application, the earliest of which will expire in February 2011.

Manufacturing

We outsource almost all of the manufacturing of our products. We utilize contract manufacturers, who provide manufacturing services, including material procurement and handling, printed circuit board assembly and mechanical board assembly. We design, specify, and monitor all of the tests that are required to meet our internal and external quality standards. We work closely with our contract manufacturers to manage costs and delivery times. Our contract manufacturing agreements generally have indefinite terms and are cancelable by either party with advance notice.

We believe that outsourced manufacturing enables us to deliver products more quickly and allows us to focus on our core competencies, including research and development, sales and customer service.

We have limited internal manufacturing operations. Our internal manufacturing operations primarily consist of quality assurance for materials and components, final testing, assembly and shipment of selected products, and depot repair of products. We also use a limited number of other manufacturers to supply certain non-significant product sub-assemblies and components.

Our optical networking and multiservice access products utilize hundreds of individual component parts, some of which are customized for our products. Component suppliers in the specialized, high technology end of the optical communications industry are generally not as plentiful or, in some cases, as reliable, as component suppliers in more mature industries. We work closely with our strategic component suppliers to pursue new component technologies that could either reduce cost or enhance the performance of our products.

We currently purchase several key components, including commercial digital signal processors, central processing units, field programmable gate arrays, switch fabric, and optical transceivers, from single or limited sources. We purchase each of these components on a purchase order basis and have no long-term contracts for these components. Although we believe that there are alternative sources for each of these components, in the event of a disruption in supply, we may not be able to develop an alternate source in a timely manner or at favorable prices.

Throughout the downturn in the telecommunications industry and the continued spending constraints in the optical networking market, the optical component industry has been downsizing manufacturing capacity while consolidating product lines from earlier acquisitions. Several suppliers have exited the optical components market, and others have announced reductions of their product offerings. These announcements, or similar decisions by other suppliers, could result in reduced competition and higher prices for the components we

 

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purchase. In addition, the loss of a source of supply for key components could require us to incur additional costs to redesign our products that use those components or to stockpile component inventory for production of future product.

Employees

As of July 31, 2007, we employed 426 persons of which 213 were primarily engaged in research and development, 58 in sales and marketing, 39 in customer service and support, 52 in manufacturing, and 64 in general and administration. None of our employees are currently represented by a collective bargaining unit. We believe our relations with our employees are good.

Executive Officers of the Registrant

Set forth below is information concerning our current executive officers and their ages as of July 31, 2007.

 

Name

   Age   

Position

Daniel E. Smith

   57    President, Chief Executive Officer and Director

Richard J. Gaynor *

   47    Chief Financial Officer, Vice President, Finance and Administration, Treasurer and Assistant Secretary

John E. Dowling

   54    Vice President, Operations

John B. Scully

   45    Vice President, Worldwide Sales and Support

Kevin J. Oye

   49    Vice President, Systems and Technology

Alan R. Cormier

   56    General Counsel

* Mr. Gaynor will be leaving his position as Chief Financial Officer, Vice President of Finance and Administration, Treasurer and Assistant Secretary by the end of September.

Daniel E. Smith has served as our President, Chief Executive Officer and as a member of our Board of Directors since October 1998. From June 1997 to July 1998, Mr. Smith was Executive Vice President and General Manager of the Core Switching Division of Ascend Communications, Inc., a provider of wide area network switches and access data networking equipment. Mr. Smith was also a member of the board of directors of Ascend Communications, Inc. during that time. From April 1992 to June 1997, Mr. Smith served as President and Chief Executive Officer and a member of the board of directors of Cascade Communications Corp.

Richard J. Gaynor has served as our Chief Financial Officer, Vice President of Finance and Administration, Treasurer and Assistant Secretary since October 2004. From January 2001 to September 2004, Mr. Gaynor was Vice President, Corporate Controller and Principal Accounting Officer of Manufacturers Services Ltd., a global provider of sub-contract electronic manufacturing services. From January 2000 to January 2001, Mr. Gaynor was Chief Financial Officer of Evans and Sutherland Computer Corporation, a developer and manufacturer of flight simulation hardware and software. From March 1994 to December 1999, Mr. Gaynor was Vice President of Finance and Operations Controller at Cabletron Systems, Inc., a global provider of enterprise networking products.

John E. Dowling has served as our Vice President of Operations since August 1998. From July 1997 to August 1998, Mr. Dowling served as Vice President of Operations of Aptis Communications, a manufacturer of carrier-class access switches for network service providers. Mr. Dowling served as Vice President of Operations of Cascade Communications Corp. from May 1994 to June 1997.

John B. Scully has served as our Vice President of Worldwide Sales and Support since September 2006. From January 1998 to September 2006, Mr. Scully served as Vice President of Worldwide Sales and Support for

 

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Eastern Research, Inc. Mr. Scully served as Vice President of Sales for Test Link/Tel Link from 1997 to 1998. Prior to that, he spent several years in senior sales positions at Madge Networks/Teleos, Datatel, Cray Communications and Data Decisions.

Kevin J. Oye has served as our Vice President of Systems and Technology since November 2001. From October 1999 through October 2001, Mr. Oye served as our Vice President of Business Development. From March 1998 to October 1999, Mr. Oye served as Vice President of Strategy and Business Development at Lucent Technologies, Inc. and from September 1993 to March 1998, Mr. Oye served as the Director of Strategy, Business Development, and Architecture at Lucent Technologies, Inc. From June 1980 to September 1993, Mr. Oye held various positions with AT&T Bell Laboratories where he was responsible for advanced market planning as well as development and advanced technology management.

Alan R. Cormier has served as our General Counsel and Secretary since November 2006. From December 2004 to October 2006, Mr. Cormier served as our Counsel and Assistant Secretary. From July 2000 through March 2004 he was Vice President, General Counsel and Secretary of Manufacturers’ Services Limited, a contract manufacturing company. Mr. Cormier served, from January 2000 through July 2000, as Vice President, General Counsel and Clerk of Dynamics Research Corporation, a provider of information technology, engineering, logistics and other consulting services to federal and state agencies. Prior to that, he spent several years in senior positions in the legal department of Wang Global Corporation (formerly Wang Laboratories, Inc.).

 

ITEM 1A. RISK FACTORS

Set forth below and elsewhere in this report and in other documents we file with the SEC are descriptions of the risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward looking statements contained in this report.

Our results may be adversely affected by unfavorable conditions in the telecommunications industry and the economy in general.

We expect industry and economic conditions to affect our business in many ways, including the following:

 

   

our current and prospective customers may make limited capital expenditures;

 

   

consolidation of our customers may cause delays, disruptions or reductions in their capital spending plans as well as increase their relative purchasing power in any negotiation;

 

   

we will continue to have limited ability to forecast the volume and product mix of our sales;

 

   

we will experience a continuing high level of competition as a result of limited demand and we may experience downward pressure on the pricing of our products which reduces gross margins and constrains revenue growth;

 

   

many of our competitors have more diverse product lines which allow them the flexibility to price their products more aggressively;

 

   

new competitive entrants may be located in geographies with lower cost infrastructures than ours allowing them a greater degree of price flexibility;

 

   

we will need to continue to balance our initiatives to manage our operating costs against the need to keep pace with technological advances;

 

   

intense competition may enable customers to demand more favorable terms and conditions of sales including extended payment terms; and

 

   

any bankruptcies or weakening financial condition of any of our customers may require us to write off amounts due from prior sales.

These factors could have an adverse impact on our revenue, operating results and financial condition.

 

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We currently depend entirely on our optical switching and multiservice access products and our revenue depends upon their commercial success.

Our revenue depends on the commercial success of our line of optical switching and multiservice access products. Our research and development efforts focus exclusively on these products. In order to remain competitive, we believe that continued investment in research and development is necessary in order to provide innovative solutions to our current and prospective customers. We cannot assure you that we will be successful in:

 

   

anticipating and successfully meeting evolving customer requirements;

 

   

completing the development, introduction or production of new products; or

 

   

enhancing our existing products.

If our current and prospective customers do not adopt our optical switching and multiservice access products and do not purchase and successfully deploy our current and future products, our business, operating results and financial condition could be materially adversely affected.

Industry consolidation may lead to increased competition and may harm our business.

The communications industry has experienced consolidation and we expect this trend to continue. Several larger communications service providers have announced merger transactions which will have a significant impact on the telecommunications industry. Such consolidation among our customers may cause delays or reductions in their capital expenditure plans and may cause increased competitive pricing pressures as the number of available customers declines and their relative purchasing power increases in relation to suppliers. Consolidation may also result in a combined entity choosing to standardize on a certain vendors’ optical networking platform. Any of these factors could adversely affect our business.

Matters related to the investigations into our historical stock option granting practices and the resulting restatements of our previously issued financial statements may result in additional litigation, regulatory proceedings and government enforcement actions.

Our historical stock option granting practices and the initial restatement and further restatement of our previously issued financial statements have exposed us to greater risks associated with litigation, regulatory proceedings and government enforcement actions. For more information regarding our current litigation and related inquiries, please see Part I, Item 3- “Legal Proceedings” as well as the other risk factors related to litigation set forth in this Item 1A. We have provided the results of our independent investigations to the SEC and in that regard we have responded to formal and informal requests for documents and additional information. We have also provided documents and other information to the United States Attorney’s Office for the District of Massachusetts (the “DOJ”). We intend to continue to cooperate with these governmental agencies.

While we believe that we have made appropriate judgments in determining the correct measurement dates for our stock option grants, the SEC may disagree with the manner in which we accounted for and reported, or not reported, the corresponding financial impact. Accordingly, there is a risk that we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.

No assurance can be given regarding the outcomes from litigation, regulatory proceedings or government enforcement actions relating to our past stock option practices. The resolution of these matters will be time consuming, expensive, and may distract management from the conduct of our business. Furthermore, if we are subject to adverse findings in litigation, regulatory proceedings or government enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could harm our business, financial condition, results of operations and cash flows.

 

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As a result of our independent investigations and related restatements, we are subject to investigations by the SEC, DOJ, IRS and the DOL, which may not be resolved favorably and have required, and may continue to require, a significant amount of management time and attention and accounting and legal resources, which could adversely affect our business, operating results or financial condition.

The SEC, DOJ, IRS and the DOL are currently conducting investigations of the Company. The period of time necessary to resolve such investigations is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of our business. If we are subject to an adverse finding resulting from any or all such investigations, we could be required to pay damages or penalties or have other remedies imposed upon us. The recent restatements of our financial statements, the ongoing investigations and the resulting shareholder derivative lawsuits could have an adverse affect on our business, operating results or financial condition. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures may continue to be incurred in the future.

If we do not maintain our compliance with the requirements of the NASDAQ Global Market, our common stock may be delisted from the NASDAQ Global Market and transferred to the National Quotation Service Bureau, or “Pink Sheets”, which may, among other things, reduce the price of our common stock and the levels of liquidity available to our stockholders.

Our common stock is currently traded on the NASDAQ Global Market. If our common stock is delisted from NASDAQ, it would subsequently trade on the Pink Sheets. The trading of our common stock on the Pink Sheets may reduce the price of the Company’s common stock and the levels of liquidity available to its stockholders. In addition, the trading of the Company’s common stock on the Pink Sheets will materially adversely affect its access to the capital markets, and the limited liquidity and potentially reduced price of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to the Company or at all. Stocks that trade on the Pink Sheets are no longer eligible for margin loans, and a company trading on the Pink Sheets cannot avail itself of federal preemption of state securities or “blue sky” laws, which adds substantial compliance costs to securities issuances, including pursuant to employee stock option plans, stock purchase plans and private or public offerings of securities. If our common stock is delisted in the future from NASDAQ and transferred to the Pink Sheets, there may also be other negative implications, including the potential loss of confidence by suppliers, customers and employees and the loss of institutional investor interest in our Company.

If we fail to successfully integrate the operations of acquisitions, we may not realize the potential benefits of the acquisition and our business, results of operations and financial condition could be harmed.

We have made, and may continue to make, acquisitions in order to enhance our business. In fiscal 2007, we acquired Eastern Research, Inc. and decided to discontinue the development of Eastern Research’s OX8000 and BSG products. As a result of the Company’s decision to discontinue the OX8000 and BSG products, we recorded asset impairment charges of $6.6 million and $10.7 million, respectively.

Acquisitions involve numerous risks, including problems combining the purchased operations, technologies or products, unanticipated costs, diversion of management’s attention from our core businesses, adverse effects on existing business relationships with suppliers and customers, risks associated with entering markets in which we have no or limited prior experience and potential loss of key employees. There can be no assurance that we will be able to successfully integrate any businesses, products, technologies or personnel that we have acquired or might acquire, including Eastern Research. If we fail in our integration efforts with respect to our acquisitions and are unable to efficiently operate as a combined organization utilizing common information and communication systems, operating procedures, financial controls and human resources practices, our business and financial condition may be adversely affected. It is also possible that the businesses we have acquired, such as Eastern Research, Inc., or any other businesses we may acquire in the future, may perform worse than expected or prove to be more difficult to integrate and manage than expected. In that event, there may be a material adverse effect on our business, results of operations and financial condition. In addition, the goodwill

 

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and intangible assets associated with acquisitions are subject to impairment testing on a regular basis, such charges would have the effect of decreasing our earnings or increasing our losses in such period. If we are required to take a substantial impairment charge, our earnings could be materially adversely affected in such period.

We must continue to make investments in product development in order to keep pace with technological advances and succeed in existing and new markets for our products.

In order to be successful, we must balance our initiatives to reduce operating costs against the need to keep pace with technological advances. The markets for our products are characterized by rapidly changing technology, frequent introductions of new products and evolving customer requirements. To succeed, we must continue to develop new products and new features for existing products that meet customer requirements and market demand. We may fail to develop products that incorporate new technologies highly sought after by customers. We may also allocate development resources toward products or technologies for which market demand is ultimately lower than anticipated. Managing our efforts to keep pace with new technologies and reduce operating expense is difficult and there is no assurance that we will be successful. We expect that our decision to make substantial investments in product development will require us to generate revenue above current levels in order to achieve and maintain operating profitability and as a result we may incur net losses. We cannot assure you that our revenue will increase or that we will generate sufficient revenue to achieve or sustain such operating profitability.

We face intense competition that could adversely affect our sales and profitability.

Competition for limited optical switching opportunities is intense and continues to be dominated by large, incumbent equipment suppliers. Competition is based upon a combination of price, established customer relationships, broad product portfolios, large service and support teams, functionality and scalability. Large companies, such as Alcatel-Lucent, Ciena, Ericsson, Nortel and Tellabs have historically dominated this market. Many of our competitors have longer operating histories and greater financial, technical, sales, marketing and manufacturing resources than we do and are able to devote greater resources to the research and development of new products. These competitors also have long standing existing relationships with our current and prospective customers. New competitors, such as Huawei, have entered the optical networking market using the latest available technology and aggressive pricing tactics in order to compete with our products. Our competitors may forecast market developments more accurately and could develop new technologies that compete with our products or even render our products less desirable or even obsolete. Moreover, these competitors have more diverse product lines which allow them the flexibility to price their products more aggressively. The multiservice access market is equally competitive, with a highly fragmented group of suppliers.

As a result of the intensified competition, we expect to encounter aggressive tactics such as the following:

 

   

price discounting;

 

   

early announcements of competing products and other marketing efforts;

 

   

customer financing assistance;

 

   

complete solution sales from one single source;

 

   

bundling multi-vendor solution integration services with turnkey network operating service offerings;

 

   

marketing and advertising assistance; and

 

   

intellectual property disputes.

These tactics may be effective in a highly concentrated customer base like ours. Our customers are under increasing pressure to deliver their services at the lowest possible cost. As a result, the price of an optical networking system may become an important factor in customer decisions. In certain cases, our larger

 

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competitors have more diverse product lines that allow them the flexibility to price their products more aggressively and absorb the significant cost structure associated with optical switching research and development across their entire business. If we are unable to offset any reductions in the average selling price of our products by a reduction in the cost of our products, our gross margins will be adversely affected.

If we are unable to compete successfully against our current and future competitors, we could experience revenue reductions, order cancellations and reduced gross margins, any one of which could have a material adverse effect on our business, operating results and financial condition.

Substantially all of our revenue is generated from a limited number of customers, and our success depends on increasing both direct sales and indirect sales through distribution channels to a limited number of service providers.

Our revenue is concentrated among a limited number of customers. None of our customers are contractually committed to purchase any minimum quantities of products from us and orders are generally cancelable prior to shipment. We expect that our revenue will continue to depend on sales of our products to a limited number of customers. While expanding our customer base is a key objective, at the present time, the number of prospective customer opportunities for our products is limited. In addition, we believe that the telecommunications industry will continue in a consolidation phase which may further reduce the number of prospective customers, slow purchases and delay optical switching deployment decisions.

Our direct sales efforts primarily target service providers, many of which have already made significant investments in traditional optical networking infrastructures. In addition, we are utilizing established channel relationships with distribution partners including resellers, distributors and systems integrators for the sale of our products to service providers including the federal government. We have entered into agreements with several distribution partners, some of whom also sell products that compete with our products. We cannot be certain that we will be able to retain or attract distribution partners on a timely basis or at all, or that the distribution partners will devote adequate resources to selling our products. Since we have only limited experience in developing and managing such channels, the extent to which we will be successful is uncertain. If we are unable to develop and manage new channels of distribution to sell our products to service providers, or if our distribution partners are unable to convince service providers to deploy our optical networking solutions, our business, operating results and financial condition will be materially adversely affected.

We rely on a limited number of customers for a significant portion of our revenue and the loss of one or more of these customers could materially harm our business.

A significant portion of our revenue is generated from a limited number of customers and that trend is likely to continue. The loss of any one of these customers or any substantial reduction in orders by any one of these customers could materially and adversely affect our business, operating results and financial condition.

Historically, we have depended on a government agency, through our reseller, for a significant amount of our revenue and the loss or decline of existing or future government agency funding could adversely affect our revenue and cash flows.

This government agency, the Defense Information Systems Agency (DISA), may be subject to budget cuts, budgetary constraints, a reduction or discontinuation of funding or changes in the political or regulatory environment that may cause the agency to terminate the projects, divert funds or delay implementation or expansion. A significant reduction in funds available for the agency to purchase equipment could significantly reduce our revenue and cash flows. The significant reduction or delay in orders by the agency could also significantly reduce our revenue and cash flows. As with most government contracts, the agency may terminate the contract at any time without cause. Additionally, government contracts are generally subject to audits and investigations by government agencies. If the results of these audits or investigations are negative, our reputation

 

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could be damaged, contracts could be terminated or significant penalties could be assessed. If a contract is terminated for any reason, our ability to fully recover certain amounts may be impaired resulting in a material adverse impact on our business, operating results and financial condition.

Certain larger customers may have substantial negotiating leverage, which may require that we agree to terms and conditions that may have an adverse effect on our business.

Large communications providers, key resellers and the federal government, who make up a large part of our target market, have substantial purchasing power and potential leverage in negotiating contractual arrangements with us. These customers and prospects may require us to develop additional features and require penalties for failure to deliver such features. As we seek to increase sales into our target markets, we may be required to agree to such terms and conditions, which may affect the timing of revenue recognition and amount of deferred revenues and may have other unfavorable effects on our business and financial condition.

Our strategy to pursue acquisitions or strategic investments may not be successful.

Our business strategy includes the ongoing consideration of acquiring or making strategic investments in companies with either complementary technologies or in adjacent markets to add complementary products and services, expand the markets we serve and diversify our customer base. To do so, we may issue additional shares that could dilute the holdings of existing common stockholders, or we may utilize cash.

Any decision regarding an acquisition or strategic investment would be subject to inherent risk, and we cannot guarantee that we will be able to identify appropriate opportunities, successfully negotiate economically beneficial terms, successfully integrate any acquired business, retain key employees, successfully market and sell products of the acquired business or achieve the anticipated synergies or benefits of any acquisition or strategic investment which may be selected. In implementing a strategy, we may enter markets in which we have little or no prior experience and there can be no assurance that we will be successful. Further, there can be no assurances concerning the success, type, form, structure, nature, results, timing or terms and conditions of any such potential action.

Whether or not we pursue any acquisition or strategic investment, the value of your shares may decrease.

Our business strategy includes the ongoing consideration of acquiring or making strategic investments in companies with either complementary technologies or in adjacent markets to add complementary products and services, expand the markets we serve and diversify our customer base. We cannot predict whether, or when, we may be able to consummate such acquisition or strategic investment or that such acquisition or strategic investment would provide you with a positive return on your investment. Accordingly, whether or not we pursue any such acquisition or strategic investment, the value of your shares may decrease.

Any acquisitions or strategic investments we make could disrupt our business and seriously harm our financial condition.

As part of our business strategy, we consider acquisitions and strategic investments including those in complementary companies, products or technologies, or in adjacent market segments and otherwise. We may consider such acquisitions or strategic investments to add complementary products and services, expand the markets we serve and diversify our customer base. In the event of an acquisition or strategic investment, we may:

 

   

issue stock that would dilute our current stockholders’ holdings;

 

   

consume cash, which would reduce the amount of cash available for other purposes and the interest income we generate from our cash;

 

   

incur debt or assume liabilities;

 

   

increase our ongoing operating expenses and level of capital expenditures;

 

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record goodwill and non-amortizable intangible assets subject to impairment testing and potential periodic impairment charges;

 

   

incur amortization expenses related to certain intangible assets;

 

   

incur large and immediate write-offs; or

 

   

become subject to litigation.

Our ability to achieve the benefits of any acquisition or strategic investment, will also involve numerous risks, including:

 

   

problems combining the purchased operations, technologies or products;

 

   

difficulty in marketing and selling products of an acquired business;

 

   

unanticipated costs or liabilities;

 

   

diversion of management’s attention from other business issues and opportunities;

 

   

disruption to in-process product development initiatives;

 

   

adverse effects on existing business relationships with suppliers and customers;

 

   

problems entering markets in which we have no or limited prior experience;

 

   

problems with integrating employees and potential loss of key employees; and

 

   

additional regulatory compliance issues.

We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire in the future and any failure to do so could disrupt our business and seriously harm our financial condition.

Current economic and market conditions make forecasting difficult.

Current economic and market conditions together with the inherent inconsistent and unpredictable ordering patterns of our customers have limited our ability to forecast the volume and product mix of our sales, making it difficult to provide estimates of revenue and operating results. We continue to have limited visibility into the capital spending plans of our current and prospective customers. Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our planned expense levels depend in part on our expectations of future revenue. Our planned expenses include significant investments, particularly within the research and development organization, which we believe are necessary to continue to provide innovative optical networking solutions to meet our current and prospective customers’ needs. As a result, it is difficult to forecast revenue and operating results. If our revenue and operating results are below the expectations of our investors and market analysts, it could cause a decline in the price of our common stock.

The unpredictability of our quarterly results may adversely affect our common stock price.

In general, our revenue and operating results in any reporting period may fluctuate significantly due to a variety of factors including, but not limited to:

 

   

fluctuation in demand for our products;

 

   

the timing, volume and product mix of sales of our products;

 

   

changes in customer requirements, including delays or order cancellations;

 

   

the introduction of new products by us or our competitors;

 

   

changes in the price or availability of components for our products;

 

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the timing of revenue recognition and deferred revenue;

 

   

readiness of customer sites for installation;

 

   

changes in our pricing policies or the pricing policies of our competitors;

 

   

satisfaction of contractual customer acceptance criteria and related revenue recognition issues;

 

   

manufacturing and shipment delays;

 

   

changes in accounting rules, such as the requirement to record share-based compensation expense for employee stock option grants made at fair market value; and

 

   

general economic conditions as well as those specific to the telecommunications and related industries.

We believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. You should not rely on our results for one quarter as any indication of our future performance. The factors discussed above are extremely difficult to predict and impact our revenue and operating results. In addition, our ability to forecast our future business has been significantly impaired by economic and market conditions. As a result, we believe that our revenue and operating results are likely to continue to vary significantly from quarter to quarter and may cause our stock price to fluctuate.

Customer purchase decisions have historically taken a long period of time. We believe that most customers who make a decision to deploy our products will expand their networks slowly and deliberately. In addition, we could receive purchase orders on an irregular and unpredictable basis. Because of the nature of our business, we cannot predict these sales and deployment cycles. The long sales cycles, as well as our expectation that customers may tend to issue large purchase orders sporadically with short lead times, may cause our revenue and results of operations to vary significantly and unexpectedly from quarter to quarter. As a result, our future operating results may be below our expectations or those of public market analysts and investors, and our revenue may decline or recover at a slower rate than anticipated by us or analysts and investors. In either event, the price of our common stock could decrease.

We utilize contract manufacturers and any disruption in these relationships may cause us to fail to meet our customers’ demands and may damage our customer relationships.

We have limited internal manufacturing capabilities. We outsource the manufacturing of our products to contract manufacturers who manufacture our products in accordance with our specifications and fill orders on a timely basis. We may not be able to manage our relationships with our contract manufacturers effectively, and our contract manufacturers may not meet our future requirements for timely delivery. Our contract manufacturers also build products for other companies, and we cannot be assured that they will have sufficient quantities of inventory available to fill our customer orders or that they will allocate their internal resources or capacity to fill our orders on a timely basis. Unforecasted customer demand may increase the cost to build our products due to fees charged to expedite production and other related charges.

The contract manufacturing industry is a highly competitive, capital-intensive business with relatively low profit margins, and in which acquisition or merger activity is relatively common. Qualifying a new contract manufacturer and commencing volume production is expensive and time consuming, and could result in a significant interruption in the supply and/or quality of our products. If we are required or choose to change contract manufacturers for any reason, our revenue, gross margins and customer relationships could be adversely affected.

 

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We and our contract manufacturers rely on single or limited sources for supply of certain components and our business may be seriously harmed if our supply of any of these components is disrupted.

We and our contract manufacturers purchase several key components from single or limited sources. These key components include commercial digital signal processors, central processing units, field programmable gate arrays, switch fabric, and optical transceivers. We generally purchase our key components on a purchase order basis and have no long-term contracts for these components. In the event of a disruption in supply of key components including, but not limited to, production disruptions, low yield or discontinuance of manufacture, we may not be able to develop an alternate source in a timely manner or on acceptable terms. Any such failure could impair our ability to deliver products to customers, which would adversely affect our revenue and operating results.

In addition, our reliance on key component suppliers exposes us to potential supplier production difficulties or quality variations. The loss of a source of supply for key components or a disruption in the supply chain could require us to incur additional costs to redesign our products that use those components. Conversely, electronic products are experiencing shorter product life cycles which may require us to build inventories in excess of demand.

During the past year, component suppliers have planned their production capacity to better match demand. If the demand for certain components increases beyond the component suppliers planned production capacity, there may be component shortages which may increase procurement costs. In addition, consolidation in the optical component industry could result in reduced competition for supply of key components and higher component prices. If any of these events occurred, our revenue and operating results could be adversely affected.

Our inability to anticipate inventory requirements may result in inventory charges or delays in product shipments.

During the normal course of business, we may provide purchase orders to our contract manufacturers for up to six months prior to scheduled delivery of products to our customers. If we overestimate our product requirements, the contract manufacturers may assess cancellation penalties or we may have excess inventory which could negatively impact our gross margins. If we underestimate our product requirements, the contract manufacturers may have inadequate inventory that could interrupt manufacturing of our products and result in delays in shipment to our customers. We also could incur additional charges to expedite the manufacture of our products to meet our customer deployment schedules. If we over or underestimate our product requirements, our revenue and gross profit may be impacted.

Product performance problems could adversely effect our revenue, operating results and financial condition.

If our products do not meet our customers’ performance or reliability requirements, our relationships with current and prospective customers may be adversely affected. The design, development and deployment of our products often involve problems with software, components, manufacturing processes and interoperability with other network elements. If we are unable to identify and fix errors or other problems, or if our customers experience interruptions or delays that cannot be promptly resolved, we could experience:

 

   

loss of revenue or delay in revenue recognition or accounts receivable collection;

 

   

loss of customers and market share;

 

   

inability to attract new customers or achieve market acceptance;

 

   

diversion of development and other resources;

 

   

increased service, warranty and insurance costs; and

 

   

legal actions by our customers.

 

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These factors may adversely impact our revenue, operating results and financial condition. In addition, our products are often critical to the performance of our customers’ network. Generally, we seek to limit liability in our customer agreements. If we are not successful in limiting our liability, or these contractual limitations are not enforceable or if we are exposed to product liability claims that are not covered by insurance, a successful claim could harm our business.

The global nature of our business exposes us to multiple risks.

International sales have historically represented a significant amount of our total sales including 27% of total revenue for fiscal 2007 and we have a substantial international customer base. We are subject to foreign exchange translation risk to the extent that our revenue is denominated in currencies other than the U.S. dollar. Doing business internationally requires significant management attention and financial resources to successfully develop direct and indirect sales channels and to support customers in international markets. We may not be able to maintain or expand international market demand for our products.

In addition, international operations are subject to other inherent risks, including:

 

   

greater difficulty in accounts receivable collection and longer collection periods;

 

   

difficulties and costs of staffing, managing and conducting foreign operations in compliance with local laws and customs;

 

   

reliance on distribution partners for the resale of our products in certain markets and for certain types of product offerings, such as the integration of our products into third-party product offerings;

 

   

necessity to work with third parties in certain countries to perform installation and obtain customer acceptance may impact the timing of revenue recognition;

 

   

necessity to maintain staffing, or to work with third parties, to provide service and support in international locations;

 

   

the impact of slowdowns or recessions in economies outside the United States;

 

   

unexpected changes in regulatory requirements, including trade and environmental protection measures and import and licensing requirements;

 

   

obtaining export licensing authority on a timely basis and maintaining ongoing compliance with import, export and reexport regulations;

 

   

certification requirements;

 

   

currency fluctuations;

 

   

reduced protection for intellectual property rights in some countries;

 

   

potentially adverse tax consequences; and

 

   

political and economic instability, particularly in emerging markets.

These factors may adversely impact our revenue, operating results and financial condition.

If we are unable to retain and recruit key personnel, our business may be harmed.

We depend on the continued services of our executive officers and other key engineering, sales, marketing and support personnel, who have critical industry experience and relationships that we rely on to implement our business strategy, many of whom would be difficult to replace. None of our officers or key employees is bound by an employment agreement for any specific term. We do not have “key person” life insurance policies or similar perquisites covering any of our employees.

 

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Virtually all of our key employees have been granted share-based awards that are intended to represent an integral component of their compensation package. These share-based awards may not provide the intended incentive to our employees if our stock price declines, experiences significant volatility or if our failure to make our timely SEC filings prevents our employees from receiving or exercising stock options. The loss of the services of any of our key employees, the inability to attract and retain qualified personnel in the future, or delays in hiring qualified personnel could delay the development and introduction of our products, and negatively impact our ability to sell and support our products.

Adverse resolution of litigation and claims may harm our business, operating results or financial condition.

We are a defendant in an Initial Public Offering securities lawsuit and a party to other litigation and claims in the normal course of our business. We are also subject to two derivative action lawsuits arising from our recent stock option investigation and related restatements of our financial statements, and we may be named in additional litigation. The highly technical nature of our products makes them susceptible to allegations of patent infringement. Litigation is by its nature uncertain and unpredictable and there can be no assurance that the ultimate resolution of such claims will not exceed the amounts accrued for such claims, if any. Litigation can be expensive, lengthy, and disruptive to normal business operations. An unfavorable resolution of a legal matter could have a material adverse affect on our business, operating results, or financial condition. For additional information regarding certain lawsuits and other disputes in which we are involved, see Part I, Item 3 “Legal Proceedings”.

Our ability to compete and pursue strategic alternatives could be jeopardized if we are unable to protect our intellectual property rights or infringe on intellectual property rights of others.

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners and control access to and distribution of our products, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete and pursue strategic alternatives effectively could be harmed. Litigation may be necessary to enforce our intellectual property rights. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse affect on our business, operating results and financial condition.

Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patents and other intellectual property rights. In the course of our business, we may receive claims of infringement or otherwise become aware of potentially relevant patents or other intellectual property rights held by other parties. We evaluate the validity and applicability of these intellectual property rights, and determine in each case whether we must negotiate licenses or cross-licenses to incorporate or use the proprietary technologies in our products.

Any parties asserting that our products infringe upon their proprietary rights would require us to defend ourselves, and possibly our customers, manufacturers or suppliers against the alleged infringement. Regardless of their merit, these claims could result in costly litigation and subject us to the risk of significant liability for damages. Such claims would likely be time consuming and expensive to resolve, would divert management time and attention and would put us at risk to:

 

   

stop selling, incorporating or using our products that incorporate the challenged intellectual property;

 

   

obtain from the owner of the intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, or at all;

 

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redesign those products that use such technology; or

 

   

accept a return of products that use such technologies.

If we are forced to take one or more of the foregoing actions, our business may be seriously harmed.

In addition, we license public domain software and proprietary technology from third parties for use in our existing products, as well as new product development and enhancements. We cannot be assured that such licenses will be available to us on commercially reasonable terms in the future, if at all. The inability to maintain or obtain any such license required for our current or future products and enhancements could require us to substitute technology of lower quality or performance standards or at greater cost, either of which could adversely impact the competitiveness of our products.

Prior to July 19, 2007, we were not current in our SEC filings. If we do not remain current in our SEC filings, we will face several adverse consequences.

In addition to possible delisting, if we are unable to remain current in our SEC filings, investors in our common stock will not have information regarding our business and financial condition with which to make decisions regarding investment in our securities. In addition, we will not be able to have a registration statement under the Securities Act of 1933, covering a public offering of securities, declared effective by the SEC, and will not be able to make offerings pursuant to existing registration statements or pursuant to certain “private placement” rules of the SEC under Regulation D to any purchasers not qualifying as “accredited investors.” We also would not be eligible to use a “short form” registration statement on Form S-3 for a period of 12 months after the time we become current in our filings. As previously reported, we were not timely in filing our Annual Report on Form 10-K for the year ended July 31, 2006 and our Quarterly Reports on Form 10-Q for the periods ended October 28, 2006, January 27, 2007 and April 28, 2007. As a result, we will not be eligible to use a “short form” registration statement on Form S-3 until July 20, 2008, which is 12 months from when we became current in our filings. These restrictions could adversely affect our financial condition or our ability to pursue specific strategic alternatives.

Adverse outcomes resulting from examination of our tax returns could adversely affect our results.

We are subject to the continuous examination of our tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provisions. Our federal income tax returns for the tax years ended July 31, 2004 and 2005 are currently under examination by the IRS and our Massachusetts state income tax returns for the tax years ended July 31, 2002, 2003 and 2004 are currently under examination by the Massachusetts Department of Revenue. While we believe that we have adequately provided for our tax liabilities, including the outcome of these examinations, it is possible that the amount paid upon resolution of issues raised may differ from the amount provided. Differences between the reserves for tax contingencies and the amounts owed by us are recorded in the period they become known. The ultimate outcome of these tax contingencies could have a material effect on our financial position, results of operations or cash flows.

Our stock price may be volatile.

Historically, the market for technology stocks has been extremely volatile. Our common stock has experienced, and may continue to experience, substantial price volatility. The occurrence of any one or more of the factors noted above could cause the market price of our common stock to fluctuate. In addition, the following factors could cause the market price of our common stock to fluctuate:

 

   

loss of a major customer;

 

   

significant changes or slowdowns in the funding and spending patterns of our current and prospective customers;

 

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the addition or departure of key personnel;

 

   

variations in our quarterly operating results;

 

   

announcements by us or our competitors of significant contracts, new products or product enhancements;

 

   

failure by us to meet product milestones;

 

   

acquisitions, distribution partnerships, joint ventures or capital commitments;

 

   

regulatory changes in telecommunications;

 

   

variations between our actual results and the published expectations of securities analysts;

 

   

changes in financial estimates by securities analysts;

 

   

sales of our common stock or other securities in the future;

 

   

changes in market valuations of networking and telecommunications companies;

 

   

fluctuations in stock market prices and volumes and;

 

   

announcements or implementation of a stock buyback or cash distribution.

In addition, the stock market in general, and the NASDAQ Global Market and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against such companies.

Significant insider ownership, provisions of our charter documents and provisions of Delaware law may limit shareholders’ ability to influence key transactions, including changes of control.

As of July 31, 2007, our officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 35% of our outstanding common stock. These stockholders, if acting together, would be able to significantly influence matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. In addition, provisions of our amended and restated certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to certain stockholders.

 

ITEM 1B. Unresolved Staff Comments

Not applicable.

 

ITEM 2. PROPERTIES

As of July 31, 2007, we lease one facility in Chelmsford, Massachusetts, containing a total of approximately 114,000 square feet. In Moorestown, New Jersey, we currently lease one facility containing a total of approximately 86,000 square feet, in Wallingford, Connecticut, we currently lease one facility containing a total of approximately 13,000 square feet and in Shanghai, China, we currently lease one facility containing a total of approximately 37,000 square feet. These facilities consist of offices and engineering laboratories used for research and development, administration, sales and customer support, ancillary light manufacturing, storage and shipping activities. We also maintain smaller offices to provide sales and customer support at various domestic and international locations. These facilities are presently adequate and suitable for our needs, and we do not expect to require additional space during fiscal 2008.

 

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We also own a parcel of undeveloped land, containing approximately 102 acres, in Tyngsborough, Massachusetts.

 

ITEM 3. LEGAL PROCEEDINGS

IPO Allocation Case

Beginning on July 2, 2001, several purported class action complaints were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors (the “Individual Defendants”) and the underwriters for the Company’s initial public offering on October 21, 1999. Some of the complaints also include the underwriters for the Company’s follow-on offering on March 14, 2000. The complaints were consolidated into a single action and an amended complaint was filed on April 19, 2002. The amended complaint, which is the operative complaint, was filed on behalf of persons who purchased the Company’s common stock between October 21, 1999 and December 6, 2000. The amended complaint alleges claims against the Company, several of the Individual Defendants and the underwriters for violations under Sections 11 and 15 of the Securities Act of 1933, as amended (the “Securities Act”), primarily based on the assertion that the Company’s lead underwriters, the Company and several of the Individual Defendants made material false and misleading statements in the Company’s Registration Statements and Prospectuses filed with the Securities and Exchange Commission, or the SEC, in October 1999 and March 2000 because of the failure to disclose (a) the alleged solicitation and receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock to certain investors in the Company’s public offerings and (b) that certain of the underwriters allegedly had entered into agreements with investors whereby underwriters agreed to allocate the public offering shares in exchange for which the investors agreed to make additional purchases of stock in the aftermarket at pre-determined prices. It also alleges claims against the Company, the Individual Defendants and the underwriters under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), primarily based on the assertion that the Company’s lead underwriters, the Company and the Individual Defendants defrauded investors by participating in a fraudulent scheme and by making materially false and misleading statements and omissions of material fact during the period in question. The amended complaint seeks damages in an unspecified amount.

The action against the Company is being coordinated with approximately three hundred other nearly identical actions filed against other companies. Due to the large number of nearly identical actions, the court has ordered the parties to select up to twenty “test” cases. To date, along with sixteen other cases, the Company’s case has been selected as one such test case. As a result, among other things, the Company will be subject to broader discovery obligations and expenses in the litigation than non-test case issuer defendants.

On October 9, 2002, the court dismissed the Individual Defendants from the case without prejudice based upon Stipulations of Dismissal filed by the plaintiffs and the Individual Defendants. This dismissal disposed of the Section 15 and Section 20(a) claims without prejudice, because these claims were asserted only against the Individual Defendants. On October 13, 2004, the court denied the certification of a class in the action against the Company with respect to the Section 11 claims alleging that the defendants made material false and misleading statements in the Company’s Registration Statement and Prospectuses. The certification was denied because no class representative purchased shares between the date of the IPO and January 19, 2000 (the date unregistered shares entered the market), and thereafter suffered a loss on the sale of those shares. The court certified a class in the action against the Company with respect to the Section 10(b) claims alleging that the Company and the Individual Defendants defrauded investors by participating in a fraudulent scheme and by making materially false and misleading statements and omissions of material fact during the period in question. The underwriter defendants appealed the district court’s ruling on class certification to the Court of Appeals for the Second Circuit.

The Company, the Individual Defendants, the plaintiff class and the vast majority of the other approximately three hundred issuer defendants and the individual defendants currently or formerly associated with those companies reached a settlement and related agreements (the “Settlement Agreement”) which set forth

 

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the terms of a settlement between these parties. Among other provisions, the Settlement Agreement provides for a release of the Company and the Individual Defendants for the conduct alleged in the action to be wrongful and for the Company to undertake certain responsibilities, including agreeing to assign away, not assert, or release, certain potential claims the Company may have against its underwriters. In addition, no payments would be required by the issuer defendants under the Settlement Agreement to the extent plaintiffs recover at least $1 billion from the underwriter defendants, who are not parties to the Settlement Agreement and who filed a memorandum of law in opposition to the approval of the Settlement Agreement. To the extent that plaintiffs recover less than $1 billion from the underwriter defendants, the approximately three-hundred issuer defendants would be required to make up the difference. It is anticipated that any potential financial obligation of the Company to plaintiffs pursuant to the terms of the Settlement Agreement would be covered by existing insurance. The Company currently is not aware of any material limitations on the expected recovery of any potential financial obligation to the plaintiffs from the Company’s insurance carriers. The Company’s insurance carriers are solvent, and the Company is not aware of any uncertainties as to the legal sufficiency of an insurance claim with respect to any recovery by the plaintiffs. Therefore, we do not expect that the Settlement Agreement will involve any payment by the Company. If material limitations on the expected recovery of any potential financial obligation to the plaintiffs from the Company’s insurance carriers should arise, the Company’s maximum financial obligation to plaintiffs pursuant to the Settlement Agreement would be less than $3.4 million. On February 15, 2005, the court granted preliminary approval of the settlement agreement, subject to certain modifications consistent with its opinion. Those modifications were made.

On December 5, 2006, a panel of the Court of Appeals for the Second Circuit reversed the district court’s class certification decision. On April 6, 2007, the Second Circuit panel denied plaintiffs’ petition for rehearing. In light of the Second Circuit opinion, the issuer parties have informed the district court that the settlement presented to the court cannot be approved because the defined settlement class, like the litigation class, cannot be certified. We cannot predict whether the parties will be able to negotiate a revised settlement that complies with the standards set out in the Second Circuit’s decision. Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the matter. If the parties are not able to renegotiate a settlement and the Company is found liable, we are unable to estimate or predict the potential damages that might be awarded, whether such damages would be greater than the Company’s insurance coverage, and whether such damages would have a material impact on our results of operations or financial condition in any future period. On August 14, 2007, the plaintiffs filed a Second Amended Class Action complaint against the Company.

360networks Bankruptcy Case

On April 1, 2003, a complaint was filed against the Company in the United States Bankruptcy Court for the Southern District of New York by the creditors’ committee (the “Committee”) of 360networks (USA), inc. and 360networks services inc. (the “Debtors”). The Debtors were the subject of Chapter 11 bankruptcy cases. The complaint seeks recovery of alleged preferential payments in the amount of approximately $16.1 million, plus interest. The Committee alleges that the Debtors made the preferential payments under Section 547(b) of the Bankruptcy Code to the Company during the 90-day period prior to the Debtors’ bankruptcy filing on account of preexisting claims. Settlement discussions have been ongoing. Trial on the complaint is currently scheduled to be held in late 2007.

Derivative Lawsuits

On May 31, 2006, a purported shareholder derivative action, captioned Weisler v. Barrows (“Weisler”), was filed in the United States District Court for the District of Delaware (the “Delaware Court”), on the Company’s behalf, against it as nominal defendant, the Company’s Board of Directors and certain of its current and former officers (as amended on October 4, 2006). The plaintiff derivatively claims, among other things, violations of Section 14(a) of the Securities Exchange Act of 1934, Section 304 of the Sarbanes-Oxley Act of 2002, and breaches of fiduciary duty by the defendants in connection with the Company’s historical stock option granting practices. The plaintiff seeks unspecified damages, profits, the return of compensation paid by the Company, an

 

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injunction and costs and attorneys’ fees. Substantially similar actions, captioned Vanpraet v. Deshpande (“Vanpraet”) and Patel v. Deshpande (“Patel”), were filed in the United States District Court for the District of Massachusetts on June 28, 2006 and July 13, 2006, respectively (the “Massachusetts Court”), and Ariel v. Barrows (“Ariel”) was filed on July 21, 2006 in the United States District Court for the Eastern District of New York (the “New York Court”). None of the plaintiffs made presuit demand on the Company’s Board of Directors prior to filing suit. By Memorandum and Order dated November 6, 2006, the Delaware Court transferred Weisler to the District of Massachusetts. By stipulation of the parties, on November 21, 2006, the New York Court transferred Ariel to the District of Massachusetts. By margin order dated May 24, 2007, the Massachusetts Court consolidated Weisler, Vanpraet, Patel and Ariel (the “Federal Action”). A consolidated demand letter was served on the Company. Proceedings are stayed until October 4, 2007 pending a response to the demand letter. This purported derivative action does not seek affirmative relief from the Company.

On June 9, 2006, a purported shareholder derivative action, captioned DeSimone v. Barrows (“DeSimone”), was filed in the Court of Chancery for the State of Delaware, in New Castle County (the “Chancery Court”), on the Company’s behalf, against it as nominal defendant, the Company’s Board of Directors and certain of its current and former officers (as amended on August 21, 2006). The plaintiff derivatively claimed, among other things, breaches of fiduciary duty by the defendants in connection with the Company’s historical stock option granting practices. The plaintiff sought unspecified damages, profits, the return of compensation paid by the Company, an injunction and costs and attorneys’ fees. The plaintiff did not make presuit demand on the Company’s Board of Directors prior to filing suit. On September 5, 2006, all defendants filed motions to dismiss, which were fully briefed by February 20, 2007. On March 9, 2007, the Chancery Court heard oral argument on the motions to dismiss and, after argument, took the matter under advisement. The purported derivative action did not seek affirmative relief from the Company. On June 7, 2007, the Chancery Court granted the defendant’s motion to dismiss.

On September 19, 2006, an additional purported shareholder derivative action, captioned McMahon v. Smith, was filed in the Middlesex Superior Court for the Commonwealth of Massachusetts, on the Company’s behalf, against it as nominal defendant, the Company’s Board of Directors and certain of its current and former officers. The plaintiff derivatively claims, among other things, breaches of fiduciary duty by the defendants in connection with the Company’s historical stock option granting practices, and also that certain defendants misappropriated confidential Company information for personal profit by selling Company stock while in possession of material, non-public information. The plaintiff seeks unspecified damages, profits, an injunction and costs and attorneys’ fees. The plaintiff did not make presuit demand on the Company’s Board of Directors prior to filing suit. On February 16, 2007, the court granted the parties’ joint motion seeking a temporary stay of proceedings. An amended complaint was filed on July 16, 2007 which also named additional officers of the Company as defendants. On August 15, 2007, the defendants filed a motion to dismiss. The purported derivative action does not seek affirmative relief from the Company.

Other Matters

On June 29, 2006, a former employee of the Company filed a complaint in Massachusetts Superior Court alleging, among other things, claims relating to wrongful termination of an employment agreement, fraud in the inducement, retaliation and claims relating to certain of the Company’s stock option grant practices in 1999-2001. The complaint demanded lost wages, unspecified monetary damages and reinstatement of medical benefits, among other things. The case was moved to the Business Litigation Session of the Suffolk County Superior Court and, following an oral hearing on a motion to dismiss, the case was ordered dismissed on January 24, 2007. The plaintiff has filed a Notice of Appeal of the order and judgment.

The Company is subject to legal proceedings, claims, and litigation, including those from intellectual property matters, arising in the ordinary course of business. On a quarterly basis, the Company reviews its commitments and contingencies to reflect the effect of ongoing negotiations, settlements, rulings, advice of counsel, and other information and events pertaining to a particular case. We are also subject to potential tax

 

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liabilities associated with ongoing tax audits and examinations by various tax authorities. As a result, during the third quarter of fiscal 2005, the Company accrued $10.3 million associated with contingencies related to claims, litigation and other disputes, as well as potential liabilities associated with various tax matters. During the fourth quarter of fiscal 2006, the Company increased this accrual by $6.8 million Based on ongoing negotiations and settlement discussions, the Company decreased this accrual by $2.2 million during the fourth quarter of fiscal 2007. While we believe the total amounts accrued are adequate, any subsequent change in our estimates will be recorded at such time the change is probable and estimable.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At the Company’s Annual Meeting of Stockholders held on July 30, 2007, the stockholders of the Company elected the following nominees, each to serve for a three-year term as a Class I Director and until their respective successors are elected and qualified:

 

Nominees

   For        Withheld    

Robert E. Donahue

   252,883,664    5,332,389

John W. Gerdelman

   225,934,926    32,281,127

Gururaj Deshpande, Daniel E. Smith, Paul W. Chisholm and Paul J. Ferri also continued as directors of the Company after the Annual Meeting.

At the same Annual Meeting, the stockholders of the Company ratified the appointment of PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm for the fiscal year ending July 31, 2007 by the following vote:

 

For

   Against    Abstention

254,478,154

   3,668,542    69,357

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market for Common Stock

Our common stock has been traded on the NASDAQ National Market under the symbol “SCMR” since October 22, 1999. As of August 1, 2006, our common stock is traded on the NASDAQ Global Market under the same symbol. The following table sets forth, for the periods indicated, the high and low closing sale prices as reported on the NASDAQ Global Market for Sycamore common stock, as adjusted for all stock splits.

Fiscal year 2007:

 

     High    Low

Fourth Quarter ended July 31, 2007

   $ 4.30    $ 3.67

Third Quarter ended April 28, 2007

     4.03      3.61

Second Quarter ended January 27, 2007

     3.92      3.64

First Quarter ended October 28, 2006

     4.08      3.52

Fiscal year 2006:

 

     High    Low

Fourth Quarter ended July 31, 2006

   $ 4.84    $ 3.62

Third Quarter ended April 29, 2006

     5.09      4.36

Second Quarter ended January 28, 2006

     4.97      3.69

First Quarter ended October 29, 2005

     3.88      3.53

As of September 7, 2007, there were approximately 843 stockholders of record.

Dividend Policy

We have never paid or declared any cash dividends on our common stock or other securities. Any future determination to pay cash dividends will be at the discretion of the board of directors and will be dependent upon our financial condition, results of operations, capital requirements, general business condition and such other factors as the board of directors may deem relevant.

Equity Compensation Plan Information

The following table sets forth certain information as of July 31, 2007 with respect to compensation plans under which shares of our common stock may be issued:

 

     (a)    (b)    (c)

Plan Category

   Number of Securities to be
Issued upon Exercise of
Outstanding Options
   Weighted Average
Exercise Price of
Outstanding
Options
   Number of Securities Remaining
Available for Future Issuance
under Equity Compensation
Plans (Excluding Securities
Reflected in Column (a))

Equity Compensation Plans Approved by Security Holders

   20,468,484    $ 6.71    125,391,457

Equity Compensation Plans Not Approved by Security Holders

   —        —      —  
                

Total

   20,468,484    $ 6.71    125,391,457
                

 

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STOCK PERFORMANCE GRAPH

The following graph compares the yearly percentage change in the cumulative total stockholder return on the Company’s Common Stock during the period from the July 31, 2002 through July 31, 2007, with the cumulative total return on the S&P 500 and the Nasdaq Telecommunications Index. The comparison assumes $100 was invested on July 31, 2002 in the Company’s Common Stock and in each of the foregoing indices and assumes reinvestment of dividends, if any. The performance shown is not necessarily indicative of future performance.

LOGO

 

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ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data has been derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto and with “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this report. The historical results are not necessarily indicative of results to be expected for any future period.

 

    For the years ended July 31,  
    2007     2006     2005     2004     2003  
    (in thousands, except per share data)  

Consolidated Statement of Operations Data:

         

Revenue

  $ 156,048     $ 87,395     $ 65,434     $ 44,547     $ 38,276  

Cost of revenue

    88,210       43,942       34,425       31,149       37,520  
                                       

Gross profit

    67,838       43,453       31,009       13,398       756  

Operating expenses:

         

Research and development

    45,912       31,377       47,969       66,250       74,937  

Sales and marketing

    23,712       11,690       12,214       19,991       23,771  

General and administrative

    28,684       11,634       10,366       11,337       15,300  

Asset impairments

    17,268       —         —         —         —    

In-process research and development

    12,400       —         —         —         —    

Restructuring charges

    1,486       —         679       —         (4,447 )

Litigation settlement

    —         750       —         —         —    

Reserve for contingencies

    (2,184 )     6,847       10,282       —         —    
                                       

Total operating expenses

    127,278       62,298       81,510       97,578       109,561  
                                       

Loss from operations

    (59,440 )     (18,845 )     (50,501 )     (84,180 )     (108,805 )

Interest and other income, net

    47,089       39,063       20,648       15,890       23,342  
                                       

Income (loss) before income taxes

    (12,351 )     20,218       (29,853 )     (68,290 )     (85,463 )

Income tax expense

    854       830       63       —         —    
                                       

Net income (loss)

  $ (13,205 )   $ 19,388     $ (29,916 )   $ (68,290 )   $ (85,463 )
                                       

Basic net income (loss) per share

  $ (0.05 )   $ 0.07     $ (0.11 )   $ (0.25 )   $ (0.32 )

Diluted net income (loss) per share

  $ (0.05 )   $ 0.07     $ (0.11 )   $ (0.25 )   $ (0.32 )

Shares used in per-share calculation—basic

    279,588       277,782       275,023       272,123       265,702  

Shares used in per-share calculation—diluted

    279,588       281,205       275,023       272,123       265,702  
    As of July 31,  
    2007     2006     2005     2004     2003  
    (in thousands)  

Consolidated Balance Sheet Data:

         

Cash, cash equivalents and investments

  $ 924,751     $ 985,137     $ 955,035     $ 961,325     $ 995,583  

Working capital

    910,171       828,858       931,246       511,662       583,877  

Total assets

    1,033,070       1,018,052       982,063       990,918       1,032,628  

Total stockholders’ equity

    973,049       975,706       939,545       955,440       992,515  

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with “Item 6.—Selected Financial Data” and our consolidated financial statements and the related notes thereto included elsewhere in this report. Except for the historical information contained herein, we wish to caution you that certain matters discussed in this report constitute forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including, without limitation, those risks and uncertainties discussed under the heading “Item 1A.—Factors That May Affect Future Results” contained in this Form 10-K and any other reports filed by us from time to time with the Securities and Exchange Commission. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise. Forward-looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words.

Executive Summary

We develop and market intelligent bandwidth management solutions for fixed line and mobile network operators worldwide and provide services associated with such products. Our current and prospective customers include domestic and international wireline and wireless network service providers, utility companies, multiple systems operators (MSOs) and government entities with private fiber networks (collectively referred to as “service providers”). Our comprehensive portfolio of optical switches, multiservice access platforms, and industry-leading networking software extends across the network, from multiservice access and regional backhaul to the optical core. We believe that our products enable network operators to efficiently and cost-effectively provision and manage multiservice access and optical network capacity to support a wide range of converged services such as voice, video and data.

On September 6, 2006, we acquired Eastern Research, Inc., a provider of network access multiservice switching solutions for fixed-line and mobile network operators worldwide for a total purchase price of approximately $85.2 million. Eastern Research’s customers include fixed-line service providers, wireless carriers, utility companies, and government agencies. We believe that the addition of Eastern Research’s products, technology and talent positions us to diversify and increase our customer base, expand our addressable markets, and broaden our customer offerings.

Total revenue for fiscal 2007 was $156.0 million, an increase of 79% compared to fiscal 2006. Total revenue for fiscal 2006 was $87.4 million, an increase of 34% compared to fiscal 2005. Our net loss for fiscal 2007 was $13.2 million compared to net income for fiscal 2006 of $19.4 million. The net loss for fiscal 2007 includes acquisition related charges of $12.4 million for in-process research and development and asset impairment charges of $17.3 million. Eastern Research’s OX8000 product was in the development stage on the date of acquisition and accordingly we recorded in-process research and development expense of $12.4 million on the date of the acquisition. In fiscal 2007, the Company decided to discontinue the development of Eastern Research’s OX8000 and BSG products. As a result of the Company’s decision to discontinue the OX8000 and BSG products, we recorded asset impairment charges of $6.6 million and $10.7 million, respectively. We continue to maintain a significant cost structure, relative to our revenue, particularly within the research and development organization. We believe that these investments have enabled us to advance our technology and secure new business.

As we remain focused on improvements in our business, our management and Board of Directors will continue to consider strategic options that may serve to maximize shareholder value. These options include acquiring or making strategic investments in companies with either complementary technologies or in adjacent markets to add complementary products and services, expand the markets we serve and diversify our customer base.

 

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Our total cash, cash equivalents and investments were $924.8 million at July 31, 2007. Included in this amount were cash and cash equivalents of $249.3 million. We intend to fund our operations, including fixed commitments under operating leases, and any required capital expenditures over the next few years using our existing cash, cash equivalents and investments. We believe that, based on our business plans and current conditions, our existing cash, cash equivalents and investments will be sufficient to satisfy our anticipated cash requirements for the next twelve months. We also believe that our current cash, cash equivalents and investments will enable us to pursue the strategic options discussed above.

As of July 31, 2007, Sycamore and its subsidiaries employed approximately 426 persons, which was a net increase of 180 persons from the approximately 246 persons employed on July 31, 2006.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. The preparation of these financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires us to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses and disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, including those relating to revenue recognition, allowance for doubtful accounts, warranty obligations, inventory allowance, litigation and other contingencies, intangible assets and goodwill and share-based compensation expense. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.

We believe that the following critical accounting policies affect the most significant judgments, assumptions and estimates we use in preparing our consolidated financial statements. Changes in these estimates can affect materially the amount of our reported net income or loss.

Revenue Recognition

We recognize revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which states that revenue is realized or realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the price to the buyer is fixed or determinable; and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. Revenue for maintenance services is generally deferred and recognized ratably over the period during which the services are to be performed.

Through our acquisition of Eastern Research, we acquired network management software that increases network management efficiencies and can be integrated with certain of our communications networking equipment. Accordingly, on transactions involving this software, we account for revenue in accordance with the American Institute of Certified Public Accountants’ Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), and all related interpretations. SOP 97-2 includes criteria similar to SAB 104: however, collectibility must be probable rather than reasonably assured.

For arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets, except as otherwise covered by SOP 97-2, the determination as to how the arrangement consideration should be measured and allocated to the separate deliverables of the arrangement is determined in accordance with EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective

 

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element based on its relative fair value and recognized when revenue recognition criteria for each element are met. Fair value for each element is established based on the sales price charged when the same element is sold separately. If fair value does not exist for any undelivered element, revenue is not recognized until the earlier of (i) the undelivered element is delivered or (ii) fair value of the undelivered element exists, unless the undelivered element is a service, in which case revenue is recognized as the service is performed once the service is the only undelivered element.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts. In the event that we become aware of deterioration in a particular customer’s financial condition, a review is performed to determine if additional provisions for doubtful accounts are required.

Warranty Obligations

We accrue for warranty costs at the time revenue is recognized based on contractual rights and on the historical rate of claims and costs to provide warranty services. If we experience an increase in warranty claims above historical experience or our costs to provide warranty services increase, we may be required to increase our warranty accrual. An increase in the warranty accrual will have an adverse impact on our gross margin.

Inventory Allowance

We continuously monitor inventory balances and record inventory allowances for any excess of the cost of the inventory over its estimated market value, based on assumptions about future demand, manufacturing quantities and market conditions. While such assumptions may change from period to period, we measure the net realizable value of inventories using the best information available as of the balance sheet date. If actual market conditions are less favorable than those projected, or we experience a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, additional inventory allowances may be required. Once we have written down inventory to its estimated net realizable value, we cannot increase its carrying value due to subsequent changes in demand forecasts. Accordingly, if inventory previously written down to its net realizable value is subsequently sold, we may realize improved gross profit margins on these transactions.

Reserve for Contingencies

We are subject to various claims, litigation and other disputes, as well as potential liabilities associated with various tax matters. Periodically, we review the status of each significant matter 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, litigation and other disputes and potential liabilities associated with various tax matters. 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.

Intangible Assets and Goodwill

Intangible assets are valued based on estimates of future cash flows and amortized over their estimated useful life. The Company evaluates goodwill and intangible assets for impairment annually and when events occur or circumstances change that may reduce the value of the asset below its carrying amount using forecasts of discounted future cash flows. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and intangible assets totaled $20.3 million and $11.4 million, respectively, at July 31, 2007. Estimates of future cash flows require

 

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assumptions related to revenue and operating income growth, asset-related expenditures, working capital levels and other factors. Different assumptions from those made in the Company’s analysis could materially affect projected cash flows and the Company’s evaluation of goodwill for impairment. Should the fair value of the Company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary.

Share-Based Compensation Expense

The Company accounts for share-based compensation expense in accordance with SFAS 123R, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. We have estimated the fair value of share-based payment awards on the date of grant using the Black Scholes pricing model, which is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee option exercise behaviors, risk free interest rate and expected dividends. We are also required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates.

Results of Operations

Fiscal Years ended July 31, 2007 and 2006

Revenue

The following table presents product and service revenue (in thousands, except percentages):

 

     Year Ended July 31,   

Variance

in Dollars

   Variance
in Percent
 
     2007    2006      

Revenue

           

Product

   $ 132,120    $ 68,558    $ 63,562    93 %

Service

     23,928      18,837      5,091    27 %
                           

Total revenue

   $ 156,048    $ 87,395    $ 68,653    79 %
                           

Total revenue increased in fiscal 2007 compared to fiscal 2006. The increase was due to an increase in both product revenue and service revenue. Product revenue consists primarily of sales of our intelligent bandwidth management solutions. Our multiservice access products, acquired on September 6, 2006 through the acquisition of Eastern Research, contributed approximately $29.1 million to product revenue for fiscal 2007. Product revenue increased in fiscal 2007 compared to fiscal 2006 primarily due to a higher level of orders from our existing customers to increase the capacity of their networks and the revenue contribution from our newly acquired multiservice access products. Service revenue consists primarily of fees for services relating to the maintenance of our products, installation services and training. Service revenue increased in fiscal 2007 compared to fiscal 2006 primarily due to service revenue from our newly acquired multiservice access business and a higher base of maintenance renewal contracts.

For fiscal 2007, two customers accounted for 53% and 16% of revenue or 69% of our total revenue. Three customers accounted for 43%, 26% and 19% of revenue in fiscal 2006 or 88% of our total revenue. International revenue represented 27% of revenue in fiscal 2007, compared to 67% of revenue in fiscal 2006. We expect future revenue to continue to be highly concentrated in a relatively small number of customers and that international revenue may represent a significant percentage of future revenue. Customer deployments in any given quarter may cause significant shifts in the percentage mix of domestic and international revenue. The loss of any one of these customers or any substantial reduction in orders by any one of these customers could materially adversely affect our business, financial condition and results of operations.

 

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Gross profit

The following table presents gross profit for product and services, including non-cash share-based compensation expense (in thousands, except percentages):

 

     Year Ended July 31,  
     2007     2006  

Gross profit:

    

Product

   $ 54,056     $ 33,372  

Service

     13,782       10,081  
                

Total

   $ 67,838     $ 43,453  
                

Gross profit:

    

Product

     41 %     49 %

Service

     58 %     54 %
                

Total

     43 %     50 %
                

Product gross profit

Cost of product revenue consists primarily of amounts paid to third-party contract manufacturers for purchased materials and services and other fixed manufacturing costs. Product gross profit percentage decreased in fiscal 2007 compared to fiscal 2006. The decrease was primarily the result of a $3.8 million purchase accounting step up charge related to acquired inventory, a $1.4 million charge related to inventory of Eastern Research’s OX8000 and BSG products which the Company decided to discontinue, unfavorable product and customer mix, partially offset by higher margins from our newly acquired multiservice access business. In the future, we believe that product gross profit may fluctuate due to pricing pressures resulting from intense competition in our industry as well as the enhanced negotiating leverage of certain larger customers. In addition, product gross profit may be affected by changes in the mix of products sold, channels of distribution, shipment volume, overhead absorption, sales discounts, increases in labor costs, excess inventory and obsolescence charges, increases in component pricing or other material costs, the introduction of new products or the entry into new markets with different pricing and cost structures.

Service gross profit

Cost of service revenue consists primarily of costs of providing services under customer service contracts which include salaries and related expenses and other fixed costs. Service gross profit increased in fiscal 2007 compared to fiscal 2006. The increase was primarily due to increased maintenance revenues. As most of our service cost of revenue is fixed, increases or decreases in revenue will have a significant impact on service gross profit. Service gross profit may be affected in future periods by various factors including, but not limited to, the change in mix between technical support services and advanced services, competitive and economic pricing pressures, the enhanced negotiating leverage of certain larger customers, and maintenance renewals and timing of renewals.

 

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Operating Expenses

The following table presents operating expenses (in thousands, except percentages):

 

     Year Ended July 31,    Variance
in Dollars
    Variance
in Percent
 
     2007     2006     

Research and development

   $ 45,912     $ 31,377    $ 14,535     46 %

Sales and marketing

     23,712       11,690      12,022     103 %

General and administrative

     28,684       11,634      17,050     147 %

Asset impairments

     17,268       —        17,268     —    

In-process research and development

     12,400       —        12,400     —    

Restructuring charges

     1,486       —        1,486     —    

Litigation settlement

     —         750      (750 )   (100 %)

Reserve for contingencies

     (2,184 )     6,847      (9,031 )   (132 %)
                             

Total operating expenses

   $ 127,278     $ 62,298    $ 64,980     104 %
                             

Research and Development Expenses

Research and development expenses consist primarily of salaries and related expenses and prototype costs relating to design, development, testing and enhancements of our products. Research and development expenses increased in fiscal 2007 compared to fiscal 2006. The increase was primarily due to the acquisition of Eastern Research, which contributed additional research and development expenses. We continue to focus our research and development investments on features and functionality targeted at existing and prospective customer requirements.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions and related expenses, customer evaluations inventory and other sales and marketing support expenses. Sales and marketing expenses increased in fiscal 2007 compared to fiscal 2006. The increase was primarily due to the acquisition of Eastern Research, which contributed additional sales and marketing expenses and the costs associated with an employment agreement between the Company and the Company’s former Vice President of Worldwide Sales and Support and a resulting charge arising from the modification of his stock option agreement which was recorded in the first quarter of fiscal 2007. Within our existing spend levels, we continue to reallocate sales and marketing resources to those geographic regions where we see the most attractive opportunities.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and related expenses for executive, finance and administrative personnel, professional fees and other general corporate expenses. General and administrative expenses increased in fiscal 2007 compared to fiscal 2006. The increase was primarily due to costs of approximately $12.0 million associated with the Audit Committee’s independent stock option investigation, $4.3 million of amortization expense related to purchased intangibles and the acquisition of Eastern Research, which contributed additional general and administrative expenses.

Asset Impairments

The Company evaluates goodwill and intangible assets for impairment annually and when events occur or circumstances change that may reduce the value of the asset below its carrying amount using forecasts of discounted future cash flows. In the first quarter of fiscal 2007, the Company decided to discontinue the development of Eastern Research’s OX8000 product. This product was in the development stage on the date of acquisition and accordingly we recorded in-process research and development expense of $12.4 million on the

 

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date of the acquisition. As a result of the Company’s decision to discontinue the OX8000 product, we recorded an asset impairment charge of $6.6 million in the first quarter of fiscal 2007. The charge related to certain tangible and intangibles assets associated with the OX8000 product, specifically customer relationships and other related fixed assets. In addition, the Company recorded a charge of $1.1 million related to OX8000 inventory in cost of product revenue.

In the fourth quarter of fiscal 2007, the Company decided to cease further development and marketing of Eastern Research’s BSG product. As a result of the Company’s decision to cease development and marketing of the BSG product, we recorded an asset impairment charge of $10.7 million in the fourth quarter of fiscal 2007. The charge related to certain tangible and intangible assets associated with the BSG product, specifically technology and customer relationships and other related fixed assets. In addition, the Company recorded a charge of $0.3 million related to BSG inventory in cost of product revenue.

In-process Research and Development

In-process research and development of $12.4 million was written-off in the first quarter of fiscal 2007 and related to a project under development for which technological feasibility had not been established and no future alternative uses for the technology existed at the time of acquisition. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology.

Restructuring Charges

During the fourth quarter of fiscal 2007, the Company reduced its workforce by 46 employees to better align development resources with future growth opportunities, further improve operational efficiencies, and capitalize on additional acquisition synergies. As a result of these actions, the Company recorded a restructuring charge of $1.5 million that was comprised primarily of expenses related to the workforce reduction, which will be substantially paid by the second quarter of fiscal 2008. In addition, the Company expects to incur charges in the first half of fiscal 2008 related to facility consolidations.

Reserve for Contingencies

During the third quarter of fiscal 2005, the Company accrued $10.3 million associated with contingencies related to claims, litigation and other disputes, as well as potential liabilities associated with various tax matters. During the fourth quarter of fiscal 2006, the Company increased this accrual by $6.8 million. Based on ongoing negotiations and settlement discussions, the Company decreased this accrual by $2.2 million during the fourth quarter of fiscal 2007. In accordance with SFAS No. 5, a liability is recorded when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The Company reviews the need for any such provision on a quarterly basis and records any necessary adjustments to reflect the effect of ongoing negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case in the period they become known. We are also subject to tax audits by various tax authorities. Management has recorded its best estimate of the probable liability resulting from these audits as of July 31, 2007. While we believe that the amounts accrued are adequate, any subsequent change in our estimates will be recorded at such time the change is probable and estimable.

Interest and Other Income, Net

The following table presents interest and other income, net (in thousands, except percentages):

 

     Year Ended July 31,    Variance
in Dollars
   Variance
in Percent
 
     2007    2006      

Interest and other income, net

   $ 47,089    $ 39,063    $ 8,026    21 %
                           

 

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Interest and other income, net increased for fiscal 2007 compared to fiscal 2006. The increase was primarily due to higher interest rates.

Income Tax Expense

Income tax expense of $0.9 million was recorded in fiscal 2007 for alternative minimum tax and taxes due on income generated in foreign tax jurisdictions and certain states. We did not record any net tax benefits relating to our net losses due to the uncertainty surrounding the realization of these future tax benefits.

As a result of incurring substantial net operating losses from 2001 through 2005, the Company determined that it is more likely than not that its deferred tax assets may not be realized. Therefore, in accordance with the requirements of FASB 109, the Company maintains a full valuation allowance. If the Company generates sustained future taxable income against which these tax attributes may be applied, some or all of the valuation allowance would be reversed. If the valuation allowance were reversed, a portion would be recorded as an increase to paid in capital and the remainder would be recorded as a reduction in income tax expense.

Fiscal Years ended July 31, 2006 and 2005

Revenue

The following table presents product and service revenue (in thousands, except percentages):

 

     Year Ended July 31,    Variance
in Dollars
   Variance
in Percent
 
     2006    2005      

Revenue

           

Product

   $ 68,558    $ 49,922    $ 18,636    37 %

Service

     18,837      15,512      3,325    21 %
                           

Total revenue

   $ 87,395    $ 65,434    $ 21,961    34 %
                           

Total revenue increased in fiscal 2006 compared to fiscal 2005. The increase was due to an increase in both product revenue and service revenue. Product revenue increased in fiscal 2006 compared to fiscal 2005. The increase was primarily due to a higher level of orders from our existing customers to increase the capacity of their networks. Service revenue increased in fiscal 2006 compared to fiscal 2005. The increase was primarily due to a higher level of maintenance renewal contracts.

For fiscal 2006, three customers accounted for 43%, 26% and 19% of revenue or 88% of our total revenue. Four customers accounted for 36%, 24%, 12% and 11% of revenue in fiscal 2005 or 83% of our total revenue. International revenue represented 67% of revenue in fiscal 2006, compared to 63% of revenue in fiscal 2005.

Gross profit

The following table presents gross profit for product and services, including non-cash share-based compensation expense (in thousands, except percentages):

 

     Year Ended July 31,  
     2006     2005  

Gross profit:

    

Product

   $ 33,372     $ 23,782  

Service

     10,081       7,227  
                

Total

   $ 43,453     $ 31,009  
                

Gross profit:

    

Product

     49 %     48 %

Service

     54 %     47 %
                

Total

     50 %     47 %
                

 

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Product gross profit

Product gross profit percentage increased slightly in fiscal 2006 compared to fiscal 2005. The increase was primarily the result of a more favorable product and customer mix and cost efficiencies associated with increased product revenue.

Service gross profit

Service gross profit increased in fiscal 2006 compared to fiscal 2005. The increase was primarily due to reduced fixed support costs and lower personnel-related expenses and higher revenue levels.

Operating Expenses

The following table presents operating expenses (in thousands, except percentages):

 

     Year Ended July 31,    Variance
in Dollars
    Variance
in Percent
 
     2006    2005     

Research and development

   $ 31,377    $ 47,969    $ (16,592 )   (35 )%

Sales and marketing

     11,690      12,214      (524 )   (4 )%

General and administrative

     11,634      10,366      1,268     12 %

Litigation settlement

     750      —        750     —    

Reserve for contingencies

     6,847      10,282      (3,435 )   (33 )%

Restructuring charges

     —        679      (679 )   (100 )%
                            

Total operating expenses

   $ 62,298    $ 81,510    $ (19,212 )   (24 )%
                            

Research and Development Expenses

Research and development expenses decreased in fiscal 2006 compared to fiscal 2005. The decrease was primarily due to lower personnel-related expenses and to a lesser degree lower share-based compensation expense, reduced fixed overhead costs and lower project related costs.

Sales and Marketing Expenses

Sales and marketing expenses decreased in fiscal 2006 compared to fiscal 2005. The slight decrease was primarily due to lower personnel-related expenses and to a lesser degree a reduction in the cost of evaluation equipment and reduced fixed overhead costs.

General and Administrative Expenses

General and administrative expenses increased in fiscal 2006 compared to fiscal 2005. The increase was primarily due to costs of approximately $3.8 million associated with the stock option investigation and to a lesser extent an increase in share-based compensation, partially offset by lower personnel-related expenses.

Litigation Settlement

In the second quarter of fiscal 2006, we entered into an Agreement of Settlement and Release to resolve a 2003 lawsuit that had been filed by a component supplier to a company that we acquired. Under the terms of the agreement, the Company paid the supplier $1.0 million and the parties filed a stipulation of dismissal with prejudice in the underlying lawsuit. In the second quarter of fiscal 2006 we recorded $0.8 million as an operating expense with the remaining being charged to our existing reserve for contingencies.

 

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Reserve for Contingencies

During the third quarter of fiscal 2005, the Company accrued $10.3 million associated with contingencies related to claims, litigation and other disputes, as well as potential liabilities associated with various tax matters. In the fourth quarter of fiscal 2006, the Company increased this accrual by $6.8 million.

Restructuring Charges

During the third quarter of fiscal 2005, the Company reduced its workforce by approximately 20 employees as a result of the rationalization of certain R&D initiatives. The Company recorded a restructuring charge of $0.7 million that was comprised of expenses related to the workforce reduction and contract termination costs. As a result, the Company wrote down $0.2 million of certain development assets to their fair value based on the expected discounted cash flows they would generate over their remaining economic life.

Interest and Other Income, Net

The following table presents interest and other income, net (in thousands, except percentages):

 

     Year Ended July 31,    Variance
in Dollars
   Variance
in Percent
 
     2006    2005      

Interest and other income, net

   $ 39,063    $ 20,648    $ 18,415    89 %
                           

Interest and other income, net increased for fiscal 2006 compared to fiscal 2005. The increase was primarily due to higher interest rates.

Income Tax Expense

Income tax expense of $0.8 million was recorded in fiscal 2006 for alternative minimum tax and taxes due on income generated in foreign tax jurisdictions and certain states. We did not record any net tax benefits relating to our net losses due to the uncertainty surrounding the realization of these future tax benefits.

Liquidity and Capital Resources

Year Ended July 31, 2007

Total cash, cash equivalents and investments were $924.8 million at July 31, 2007. Included in this amount were cash and cash equivalents of $249.3 million, compared to $169.8 million at July 31, 2006. The increase in cash and cash equivalents of $79.5 million was attributable to cash provided by investing activities of $48.7 million, cash provided by operating activities of $28.0 million and cash provided by financing activities of $2.7 million.

Net cash provided by investing activities was $48.7 million and consisted primarily of net proceeds from maturities and sales of investments, offset by cash used for the Eastern Research acquisition of $82.3 million and to a lesser extent purchases of property and equipment of $9.8 million.

Net cash generated by operating activities was $28.0 million. Net loss was $13.2 million and included significant non-cash charges including depreciation and amortization of $11.3 million, share-based compensation of $5.3 million, in-process research and development of $12.4 million, asset impairment charges of $17.2 million and adjustments to provisions for excess and obsolete inventory of $1.4 million. Accounts receivable increased to $30.5 million at July 31, 2007 from $14.1 million at July 31, 2006. Days sales outstanding as of July 31, 2007 was 75 days and days sales outstanding as of July 31, 2006 was 80 days. Our accounts receivable and days sales outstanding are impacted primarily by the timing of shipments, collections performance and timing of support contract renewals. Inventory levels increased to $21.7 million at July 31, 2007 from $6.0 million at July 31, 2006. The increase in inventory was primarily related to the timing of receipts as well as inventory acquired in

 

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our Eastern Research acquisition. We continue to manage our inventory levels. Deferred revenue increased to $14.4 million at July 31, 2007 from $9.5 million at July 31, 2006. The change in deferred revenue is primarily due to the timing of maintenance contract renewals and the ongoing amortization of deferred maintenance revenue. Accounts payable increased to $13.6 million at July 31, 2007 from $5.7 million at July 31, 2006. Accrued expenses and other current liabilities increased to $28.5 million at July 31, 2007 from $24.9 million at July 31, 2006. The increase is primarily due to the increases in accrued warranty, accrued compensation and other current liabilities, partially offset by the decrease in the reserve for contingencies.

For the year ended July 31, 2007, net cash provided by financing activities was $2.7 million and consisted of proceeds from employee stock plan activity.

Our primary source of liquidity comes from our cash and investments, which totaled $924.8 million at July 31, 2007. Our investments are classified as available-for-sale and consist of securities that are readily convertible to cash, including certificates of deposits and government securities. At July 31, 2007, $658.3 million of investments with maturities of less than one year were classified as short-term investments, and $17.2 million of investments with maturities of greater than one year were classified as long-term investments. Based on our current expectations, we anticipate that some portion of our existing cash and cash equivalents and investments may be consumed by operations. Our accounts receivable, while not considered a primary source of liquidity, represents a concentration of credit risk because the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. At July 31, 2007, more than 77% of our accounts receivable balance was attributable to five customers. As of July 31, 2007, we do not have any outstanding debt or credit facilities, and do not anticipate entering into any debt or credit agreements in the foreseeable future. Our fixed commitments for cash expenditures consist primarily of payments under operating leases and inventory purchase commitments. We do not currently have any material commitments for capital expenditures, or any other material commitments aside from operating leases for our facilities and inventory purchase commitments. We currently intend to fund our operations, including our fixed commitments under operating leases, and any required capital expenditures using our existing cash, cash equivalents and investments.

As of July 31, 2007, the future restructuring cash payments of $1.9 million consist primarily of charges related to workforce reductions that will be substantially paid by the second quarter of fiscal 2008.

Based on our current plans and business conditions, we believe that our existing cash and investments will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months. We will continue to consider appropriate action with respect to our cash position in light of the present and anticipated business needs as well as providing a means by which our shareholders may realize value in connection with their investment.

Year Ended July 31, 2006

Total cash, cash equivalents and investments were $985.1 million at July 31, 2006. Included in this amount were cash and cash equivalents of $169.8 million, compared to $508.3 million at July 31, 2005. The decrease in cash and cash equivalents of $338.5 million was attributable to cash used in investing activities of $372.9 million, partially offset by cash provided by operating activities of $24.0 million and cash provided by financing activities of $10.4 million.

Cash used in investing activities of $372.9 million consisted primarily of net purchases of investments of $367.4 million. Cash provided by operating activities of $24.0 million consisted of net income for the period of $19.4 million, adjusted for net non-cash charges totaling $9.4 million and offset by changes in working capital totaling $4.7 million. Net non-cash charges included depreciation and amortization, share-based compensation, adjustments to provisions for excess and obsolete inventory and loss on disposal of equipment. The most significant changes in working capital were a decrease in accrued restructuring costs of $6.2 million and increases in accounts receivable, accounts payable and accrued expense and other liabilities. Cash provided by financing activities of $10.4 million consisted of the proceeds received from employee stock plan activity.

 

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Recent Accounting Pronouncements

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2008. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements, (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for fiscal years beginning after July 1, 2008 and as a result, are effective for the Company in the first quarter of fiscal 2009. The Company is currently evaluating the potential impact of the SFAS 157 on its consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretative guidance on the process of quantifying financial statement misstatements and is effective for fiscal years ending after November 15, 2006. The Company applied the provisions of SAB 108 beginning in the first quarter of fiscal 2007 and there was no impact to the consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards which require certain assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and as a result, is effective for the Company in the first quarter of fiscal 2009. The Company is currently evaluating the potential impact of SFAS 159 on its consolidated financial statements.

Commitments, Contractual Obligations and Off-Balance Sheet Arrangements

At July 31, 2007, our future contractual obligations, which consist of contractual commitments for operating leases and inventory and other purchase commitments, were as follows (in thousands):

 

     Total   

Less than

1 Year

   1-3
Years
   3-5
Years
   Thereafter

Operating leases

   $ 15,562    $ 2,759    $ 7,536    $ 3,064    $ 2,203

Inventory and other purchase commitments

     8,302      8,302      —        —        —  
                                  

Total

   $ 23,864    $ 11,061    $ 7,536    $ 3,064    $ 2,203
                                  

Payments made under operating leases will be treated as rent expense. Payments made for inventory purchase commitments will initially be capitalized as inventory, and will then be recorded as cost of revenue as the inventory is sold or otherwise disposed of.

 

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Related Party Transactions

In July 2000, we made an investment of $2.2 million in Tejas Networks India Private Limited (“Tejas”). The Chairman of the Board of Directors of Sycamore also serves as the Chairman of the Board of Directors of Tejas. An executive officer of our Company also serves as a board member of Tejas. We have no obligation to provide any additional funding to Tejas. During the fiscal years ended July 31, 2007, 2006 and 2005, we recognized revenue of $0.3 million, $0.3 million and $0.1 million, respectively, relating to transactions with Tejas.

Eastern Research executed an OEM agreement with Tejas in March of 2006 under which Tejas provided Eastern Research with hardware, software and support for the sale of the OM 1000 product. In April of 2007 Sycamore amended the OEM agreement with Tejas to assign the agreement to Sycamore and add the OM 1500 and OM 4000 products.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

The primary objective of our current investment activities is to preserve investment principal while maximizing income without significantly increasing risk. We maintain a portfolio of cash equivalents and short-term and long-term investments in a variety of securities including commercial paper, certificates of deposit, money market funds and government debt securities. These available-for-sale investments are subject to interest rate risk and may fall in value if market interest rates increase. If market interest rates increased immediately and uniformly by 10 percent from levels at July 31, 2007, the fair value of the portfolio would decline by approximately $1.2 million. Depending on the outcome of our review of strategic and financial alternatives, we may not hold our investments to maturity and as a result, may realize a gain or loss.

Exchange Rate Sensitivity

While the majority of our operations are based in the United States, our business includes sales globally, with international revenue representing 27% of total revenue in fiscal 2007. We expect that international sales may continue to represent a significant portion of our revenue. Fluctuations in foreign currencies may have an impact on our financial results, although to date the impact has not been material. We are prepared to hedge against fluctuations in foreign currencies if the exposure is material, although we have not engaged in hedging activities to date.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

Report of Independent Registered Public Accounting Firm

   47

Consolidated Balance Sheets as of July 31, 2007 and 2006

   48

Consolidated Statements of Operations for the years ended July 31, 2007, 2006 and 2005

   49

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended July 31, 2007, 2006 and 2005

   50

Consolidated Statements of Cash Flows for the years ended July 31, 2007, 2006 and 2005

   51

Notes to Consolidated Financial Statements

   52

 

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of

Sycamore Networks, Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders’ equity and comprehensive income (loss) and of cash flows present fairly, in all material respects, the financial position of Sycamore Networks, Inc. and its subsidiaries at July 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended July 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our audits (which were integrated audits in 2007 and 2006). 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP

Boston, Massachusetts

September 25, 2007

 

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SYCAMORE NETWORKS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

 

    

July 31,

2007

   

July 31,

2006

 
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 249,262     $ 169,820  

Short-term investments

     658,307       674,518  

Accounts receivable, net of allowance for doubtful accounts of $4,132 at July 31, 2007 and July 31, 2006

     30,521       14,090  

Inventories

     21,715       6,013  

Prepaids and other current assets

     4,062       4,184  
                

Total current assets

     963,867       868,625  

Property and equipment, net

     19,612       7,824  

Long-term investments

     17,182       140,799  

Purchased intangibles, net

     11,411       —    

Goodwill

     20,334       —    

Other assets

     664       804  
                

Total assets

   $ 1,033,070     $ 1,018,052  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 13,565     $ 5,695  

Accrued compensation

     2,973       1,362  

Accrued warranty

     3,400       1,136  

Accrued expenses

     4,313       3,788  

Accrued restructuring costs

     1,885       2,280  

Reserve for contingencies

     14,695       16,974  

Deferred revenue

     9,765       6,918  

Other current liabilities

     3,100       1,614  
                

Total current liabilities

     53,696       39,767  

Long term deferred revenue

     4,674       2,579  

Long term liability

     1,651       —    
                

Total liabilities

     60,021       42,346  
                

Commitments and contingencies (Notes 7 and 14)

    

Stockholders’ equity:

    

Preferred stock, $.01 par value; 5,000 shares authorized, none issued and outstanding at July 31, 2007 and July 31, 2006

     —         —    

Common stock, $.001 par value; 2,500,000 shares authorized, 280,040 and 278,902 shares issued at July 31, 2007 and July 31, 2006 respectively

     280       279  

Additional paid-in capital

     2,020,724       2,011,147  

Accumulated deficit

     (1,047,669 )     (1,034,464 )

Accumulated other comprehensive loss

     (286 )     (1,256 )
                

Total stockholders’ equity

     973,049       975,706  
                

Total liabilities and stockholders’ equity

   $ 1,033,070     $ 1,018,052  
                

The accompanying notes are an integral part of the consolidated financial statements.

 

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SYCAMORE NETWORKS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

     Year Ended July 31,  
     2007     2006     2005  

Revenue

      

Product

   $ 132,120     $ 68,558     $ 49,922  

Service

     23,928       18,837       15,512  
                        

Total revenue

     156,048       87,395       65,434  
                        

Cost of revenue

      

Product

     78,064       35,186       26,140  

Service

     10,146       8,756       8,285  
                        

Total cost of revenue

     88,210       43,942       34,425  
                        

Gross profit

     67,838       43,453       31,009  

Operating expenses:

      

Research and development

     45,912       31,377       47,969  

Sales and marketing

     23,712       11,690       12,214  

General and administrative

     28,684       11,634       10,366  

Asset impairments

     17,268       —         —    

In-process research and development

     12,400       —         —    

Restructuring charges

     1,486       —         679  

Litigation settlement

     —         750       —    

Reserve for contingencies

     (2,184 )     6,847       10,282  
                        

Total operating expenses

     127,278       62,298       81,510  
                        

Loss from operations

     (59,440 )     (18,845 )     (50,501 )

Interest and other income, net

     47,089       39,063       20,648  
                        

Income (loss) before income taxes

     (12,351 )     20,218       (29,853 )

Income tax expense

     854       830       63  
                        

Net income (loss)

   $ (13,205 )   $ 19,388     $ (29,916 )
                        

Net income (loss) per shares:

    

Basic

   $ (0.05 )   $ 0.07     $ (0.11 )

Diluted

   $ (0.05 )   $ 0.07     $ (0.11 )

Weighted average shares outstanding:

      

Basic

     279,588       277,782       275,023  

Diluted

     279,588       281,205       275,023  

The accompanying notes are an integral part of the consolidated financial statements.

 

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SYCAMORE NETWORKS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND

COMPREHENSIVE INCOME (LOSS)

(in thousands)

 

    Common Stock  

Additional

Paid-in

Capital

   

Accumulated

Deficit

   

Deferred

Compensation

    Treasury Stock  

Accumulated

Other

Comprehensive
Income (Loss)

   

Total

Stockholders’

Equity

 
  Shares     Amount         Shares     Amount    

Balance, July 31, 2004

  273,887     $ 274   $ 1,989,814     $ (1,023,936 )   $ (7,968 )   —       $ —     $ (2,744 )   $ 955,440  
                                                               

Net loss.

  —         —       —         (29,916 )     —       —         —       —         (29,916 )

Unrealized gain on investments

  —         —       —         —         —       —         —       338       338  
                       

Total comprehensive loss

                    (29,578 )

Treasury stock purchases.

  —         —       —         —         —       14       —       —         —    

Treasury stock retirements.

  (14 )     —       —         —         —       (14 )     —       —         —    

Issuance of common stock under employee and director stock plans

  2,173       2     5,956       —         —       —         —       —         5,958  

Share-based compensation expense

  —         —       366       —         7,359     —         —       —         7,725  

Adjustments to deferred compensation for terminated employees

  —         —       (401 )     —         401     —         —       —         —    
                                                               

Balance, July 31, 2005

  276,046       276     1,995,735       (1,053,852 )     (208 )   —         —       (2,406 )     939,545  
                                                               

Net income.

  —         —       —         19,388       —       —         —       —         19,388  

Unrealized gain on investments, net of tax of $49

  —         —       —         —         —       —         —       1,150       1,150  
                       

Total comprehensive income

                    20,538  

Issuance of common stock under employee and director stock plans

  2,856       3     9,575       —         —       —         —       —         9,578  

Share-based compensation expense

  —         —       6,045       —         —       —         —       —         6,045  

Adjustments to deferred compensation for the adoption of SFAS 123R

  —         —       (208 )     —         208     —         —       —         —    
                                                               

Balance, July 31, 2006.

  278,902       279     2,011,147       (1,034,464 )     —       —         —       (1,256 )     975,706  
                                                               

Net loss.

  —         —       —         (13,205 )     —       —         —       —         (13,205 )

Unrealized gain on investments

  —         —       —         —         —       —         —       970       970  
                       

Total comprehensive loss

                    (12,235 )

Issuance of common stock under employee and director stock plans

  1,138       1     2,728       —         —       —         —       —         2,729  

Stock options issued in acquisition

  —         —       1,496       —         —       —         —       —         1,496  

Share-based compensation expense

  —         —       5,353       —         —       —         —       —         5,353  
                                                               

Balance, July 31, 2007.

  280,040     $ 280   $ 2,020,724     $ (1,047,669 )   $ —       —       $ —     $ (286 )   $ 973,049  
                                                               

The accompanying notes are an integral part of the consolidated financial statements.

 

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SYCAMORE NETWORKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Year Ended July 31,  
     2007     2006     2005  

Cash flows from operating activities:

      

Net income (loss)

   $ (13,205 )   $ 19,388     $ (29,916 )

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

      

Depreciation and amortization

     11,277       3,802       4,790  

Share-based compensation

     5,353       6,045       7,725  

In-process research and development

     12,400       —         —    

Asset impairments

     17,240       —         —    

Adjustments to provisions for excess and obsolete inventory

     1,390       (678 )     —    

Loss on disposal of equipment

     60       200       —    

Restructuring charges

     —         —         169  

Changes in operating assets and liabilities, net of acquisition:

      

Accounts receivable

     (10,189 )     (5,706 )     2,221  

Inventories

     (6,292 )     813       (1,533 )

Prepaids and other current assets

     (837 )     392       1,325  

Deferred revenue

     4,494       (787 )     2,132  

Accounts payable

     5,411       3,551       (3,458 )

Accrued expenses and other liabilities

     1,286       3,190       11,916  

Accrued restructuring costs

     (395 )     (6,175 )     (3,550 )
                        

Net cash provided by (used in) operating activities

     27,993       24,035       (8,179 )
                        

Cash flows from investing activities:

      

Purchases of property and equipment

     (9,813 )     (4,093 )     (3,587 )

Acquisition of business

     (82,265 )     (1,438 )     —    

Purchases of investments

     (764,401 )     (1,261,597 )     (215,361 )

Proceeds from maturities and sales of investments

     905,199       894,233       684,840  
                        

Net cash provided by (used in) investing activities

     48,720       (372,895 )     465,892  
                        

Cash flows from financing activities:

      

Proceeds from issuance of common stock, net

     2,729       10,399       5,138  
                        

Net cash provided by financing activities

     2,729       10,399       5,138  
                        

Net increase (decrease) in cash and cash equivalents

     79,442       (338,461 )     462,851  

Cash and cash equivalents, beginning of period

     169,820       508,281       45,430  
                        

Cash and cash equivalents, end of period

   $ 249,262     $ 169,820     $ 508,281  
                        

Supplemental cash flow information:

      

Cash paid for interest

     —         —         —    

Cash paid for income taxes

   $ 552     $ 659       —    

The accompanying notes are an integral part of the consolidated financial statements.

 

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SYCAMORE NETWORKS, INC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. Description of Business:

Sycamore Networks, Inc. (the “Company”) was incorporated in Delaware on February 17, 1998. The Company develops and markets intelligent bandwidth management solutions for fixed line and mobile network operators worldwide that are designed to enable network operators to efficiently and cost-effectively provision and manage multiservice access and optical network capacity to support a wide range of converged services such as voice, video and data. Sycamore’s global customer base includes include domestic and international wireline and wireless network service providers, utility companies, multiple systems operators (MSOs) and government entities with private fiber networks (collectively referred to as “service providers”).

On September 6, 2006, the Company completed the acquisition of Eastern Research, Inc. (“Eastern Research”), a provider of network access solutions. The Company believes that the addition of Eastern Research’s products, technology and workforce will help Sycamore to broaden its customer relationships, expand the markets it serves and leverage its core strengths to offer a more comprehensive suite of solutions optimized for emerging broadband networks. The Company has recorded this acquisition using the purchase method of accounting; accordingly, the results of Eastern Research have been included in the consolidated financial statements since that date.

 

2. Summary of Significant Accounting Policies:

The accompanying financial statements of the Company reflect the application of certain significant accounting policies as described below. The Company believes these accounting policies are critical because changes in such estimates can materially affect the amount of the Company’s reported net income or loss.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Cash Equivalents and Investments

Cash equivalents are short-term, highly liquid investments with original or remaining maturity dates of three months or less at the date of acquisition. Cash equivalents are carried at cost plus accrued interest, which approximates fair market value. The Company’s investments are classified as available-for-sale and are recorded at fair value with any unrealized gain or loss recorded as an element of stockholders’ equity. The fair value of investments is determined based on quoted market prices at the reporting date for those instruments. The Company would recognize an impairment charge when a decline in the fair value of its investments below the cost basis is judged to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the Company’s cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. As of July 31, 2007 and 2006, investments consisted of (in thousands):

July 31, 2007:

 

    

Amortized

Cost

  

Gross
Unrealized

Gains

  

Gross
Unrealized

Losses

    Fair Market
Value

Government securities

   $ 675,678    $ 42    $ (231 )   $ 675,489
                            

Total

   $ 675,678    $ 42    $ (231 )   $ 675,489
                            

 

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July 31, 2006:

 

    

Amortized

Cost

  

Gross
Unrealized

Gains

  

Gross
Unrealized

Losses

    Fair Market
Value

Government securities

   $ 816,490    $ 65    $ (1,238 )   $ 815,317
                            

Total

   $ 816,490    $ 65    $ (1,238 )   $ 815,317
                            

At July 31, 2007, contractual maturities of the Company’s investment securities were as follows (in thousands):

 

    

Amortized

Cost

   Fair Market
Value

Less than one year

   $ 658,499    $ 658,307

Due in one to three years

     17,179      17,182
             

Total

   $ 675,678    $ 675,489
             

The following tables provide the breakdown of the investments with unrealized losses at July 31, 2007 and 2006 (in thousands):

July 31, 2007

 

    Less than 12 Months     12 Months or Greater     Total  
   

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

   

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

   

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

 

Government securities

  $ 660,561   $ 42   $ (154 )   $ 14,928   $ —     $ (77 )   $ 675,489   $ 42   $ (231 )
                                                           

Total

  $ 660,561   $ 42   $ (154 )   $ 14,928   $ —     $ (77 )   $ 675,489   $ 42   $ (231 )
                                                           

July 31, 2006

 

    Less than 12 Months     12 Months or Greater   Total  
   

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

   

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

 

Fair
Market

Value

 

Gross
Unrealized

Gain

 

Gross
Unrealized

Losses

 

Government securities

  $ 815,317   $ 65   $ (1,238 )   $ —     $ —     $ —     $ 815,317   $ 65   $ (1,238 )
                                                         

Total

  $ 815,317   $ 65   $ (1,238 )   $ —     $ —     $ —     $ 815,317   $ 65   $ (1,238 )
                                                         

The Company also has certain investments in non-publicly traded companies for the promotion of business and strategic objectives. These investments are included in other long-term assets in the Company’s balance sheet and are carried at cost less appropriate reductions or impairment charges. As of July 31, 2007 and 2006, $0.4 million of these investments are included in other long-term assets.

Inventories

Inventories are stated at the lower of cost (first-in, first-out basis) or market (net realizable value).

 

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Revenue Recognition

We recognize revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which states that revenue is realized or realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the price to the buyer is fixed or determinable; and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. Revenue for maintenance services is generally deferred and recognized ratably over the period during which the services are to be performed.

Through our acquisition of Eastern Research, we acquired network management software that increases network management efficiencies and can be integrated with certain of our communications networking equipment. Accordingly, on transactions involving this software, we account for revenue in accordance with the American Institute of Certified Public Accountants’ Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), and all related interpretations. SOP 97-2 includes criteria similar to SAB 104: however, collectibility must be probable rather than reasonably assured.

For arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets, except as otherwise covered by SOP 97-2, the determination as to how the arrangement consideration should be measured and allocated to the separate deliverables of the arrangement is determined in accordance with EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. Fair value for each element is established based on the sales price charged when the same element is sold separately. If fair value does not exist for any undelivered element, revenue is not recognized until the earlier of (i) the undelivered element is delivered or (ii) fair value of the undelivered element exists, unless the undelivered element is a service, in which case revenue is recognized as the service is performed once the service is the only undelivered element.

Share-Based Compensation

Effective August 1, 2005, the Company accounts for share-based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant). Prior to August 1, 2005, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company also followed the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”. The Company elected to adopt the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior periods presented in this Form 10-K have not been restated to reflect the fair value method of expensing share-based compensation.

SFAS 123R requires companies to estimate the fair value of share-based awards on the date of grant using an option-pricing model. The value of awards that are ultimately expected to vest is recognized as expense over the requisite service periods, or in the period of grant if the requisite service period has been provided, in the Company’s Consolidated Statement of Operations. The Company uses the Black-Scholes option pricing model to determine the fair value of stock options under SFAS 123R. The fair value of a restricted stock unit is equivalent to the market price of the Company’s common stock on the grant date.

 

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Property and Equipment

Property and equipment is stated at cost and depreciated over the estimated useful lives of the assets using the straight-line method, based upon the following asset lives:

 

Computer and telecommunications equipment

  2 to 3 years

Computer software

  3 years

Furniture and office equipment

  5 years

Leasehold improvements

  Shorter of lease term or useful life of asset

The cost of significant additions and improvements is capitalized and depreciated while expenditures for maintenance and repairs are charged to expense as incurred. Costs related to internal use software are capitalized in accordance with AICPA Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”. Upon retirement or sale of an asset, the cost and related accumulated depreciation of the assets are removed from the accounts and any resulting gain or loss is reflected in the determination of net income or loss.

Currently, the Company’s long-lived assets consist entirely of property and equipment. Long-lived assets to be held and used are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Determination of recoverability is based on a comparison of the carrying value of the asset to an estimate of the undiscounted future cash flows resulting from the use and eventual disposition of the asset. An impairment loss is recognized when the fair value of the asset, or the present value of the discounted cash flows expected to result from the use of the asset, is less than the carrying value. Long-lived assets to be disposed of are reported at the lower of carrying value or fair value less costs to sell.

Research and Development and Software Development Costs

The Company’s products are highly technical in nature and require a large and continuing research and development effort. All research and development costs are expensed as incurred. Software development costs incurred prior to the establishment of technological feasibility are charged to expense. Technological feasibility is demonstrated by the completion of a working model. Software development costs incurred subsequent to the establishment of technological feasibility are capitalized until the product is available for general release to customers. Amortization is based on the greater of (i) the ratio that current gross revenue for a product bears to the total of current and anticipated future gross revenue for that product or (ii) the straight-line method over the remaining estimated life of the product. To date, the period between achieving technological feasibility and the general availability of the related products has been short and software development costs qualifying for capitalization have not been material. Accordingly, the Company has not capitalized any software development costs.

Income Taxes

Income taxes are accounted for under the liability method. Under this method, deferred tax assets and liabilities are recorded based on temporary differences between the financial statement amounts and the tax bases of assets and liabilities measured using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company periodically evaluates the realizability of its net deferred tax assets and records a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.

 

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Concentrations and Significant Customer Information

Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash equivalents, investments and accounts receivable. The Company invests its excess cash primarily in deposits with commercial banks, high-quality corporate securities and U.S. government securities. For the year ended July 31, 2007, two customers accounted for 53% and 16% of the Company’s revenue. For the year ended July 31, 2006, three customers accounted for 43%, 26% and 19% of the Company’s revenue. For the year ended July 31, 2005, four customers accounted for 36%, 24%, 12% and 11% of the Company’s revenue. The Company generally does not require collateral for sales to customers, and the Company’s accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. At July 31, 2007 more than 77% of the Company’s accounts receivable balance was attributable to five customers. At July 31, 2006, more than 94% of the Company’s accounts receivable balance was attributable to three customers.

Many emerging service providers, from which the Company had derived a large percentage of its revenue through fiscal 2001, have experienced severe financial difficulties, causing them to dramatically reduce their capital expenditures, and in some cases, file for bankruptcy protection. As a result, the Company has directed its sales efforts towards incumbent service providers, which typically have longer sales evaluation cycles than emerging service providers.

Certain components and parts used in the Company’s products are procured from a single source. The Company generally obtains parts from one vendor only, even where multiple sources are available, to maintain quality control and enhance working relationships with suppliers. These purchases are made under purchase orders.

Allowance for Doubtful Accounts

The Company evaluates its outstanding accounts receivable balances on an ongoing basis to determine whether an allowance for doubtful accounts should be recorded. Activity in the Company’s allowance for doubtful accounts is summarized as follows (in thousands):

 

     Year Ended July 31,
     2007    2006    2005

Beginning balance

   $ 4,132    $ 4,132    $ 4,132

Additions charged to expenses

     —        —        —  
                    

Ending balance

   $ 4,132    $ 4,132    $ 4,132
                    

Other Comprehensive Income (Loss)

The Company reports comprehensive income (loss) in accordance with Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (SFAS 130). For all periods presented, the unrealized gain or loss on investments, which is recorded as a component of stockholders’ equity, was the primary difference between the reported net income (loss) and total comprehensive income (loss).

Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period less unvested restricted stock. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and common equivalent shares outstanding during the period, if dilutive. Common equivalent shares are composed of unvested shares of restricted common stock and the incremental common

 

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shares issuable upon the exercise of stock options and warrants outstanding. The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data):

 

     Year Ended July 31,  
     2007     2006    2005  

Net income (loss)

   $ (13,205 )   $ 19,388    $ (29,916 )

Denominator:

       

Weighted-average shares of common stock outstanding

     279,588       277,782      275,081  

Weighted-average shares subject to repurchase

     —         —        (58 )
                       

Shares used in per-share calculation—basic

     279,588       277,782      275,023  
                       

Weighted-average shares of common stock outstanding

     279,588       277,782      275,023  

Weighted common stock equivalents

     —         3,423      —    
                       

Shares used in per-share calculation—diluted

     279,588       281,205      275,023  
                       

Net income (loss) per share:

       

Basic

   $ (0.05 )   $ 0.07    $ (0.11 )
                       

Diluted

   $ (0.05 )   $ 0.07    $ (0.11 )
                       

Options to purchase 10.7 million, 10.9 million and 26.7 million shares of common stock have not been included in the computation of diluted net income (loss) per share for the years ended July 31, 2007, 2006 and 2005, because their effect would have been anti dilutive.

Segment Information

The Company has determined that it conducts its operations in one business segment. For the year ended July 31, 2007, the geographical distribution of revenue was as follows: United States—73%, Netherlands—16%, and all other countries—11%. For the year ended July 31, 2006, the geographical distribution of revenue was as follows: United States—33%, England—28%, Korea—18% Netherlands—15%, and all other countries—6%. For the year ended July 31, 2005, the geographical distribution of revenue was as follows: United States—40%, England—33%, Japan—9% and all other countries—18%. Long-lived assets consist entirely of property and equipment and are principally located in the United States for all periods presented.

Recent Accounting Pronouncements

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2008. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements, (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for fiscal years beginning after July 1, 2008 and as a result, are effective for the Company in the first quarter of fiscal 2009. The Company is currently evaluating the potential impact of the SFAS 157 on its consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”).

 

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SAB 108 provides interpretative guidance on the process of quantifying financial statement misstatements and is effective for fiscal years ending after November 15, 2006. The Company applied the provisions of SAB 108 beginning in the first quarter of fiscal 2007 and there was no impact to the consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards which require certain assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and as a result, is effective for the Company in the first quarter of fiscal 2009. The Company is currently evaluating the potential impact of SFAS 159 on its consolidated financial statements.

 

3. Merger Agreement with Allen Organ Company to acquire Eastern Research, Inc.

On September 6, 2006, Sycamore Networks, Inc., through its wholly-owned subsidiary, Bach Group LLC (“Bach”), a Delaware limited liability company, completed its acquisition of Allen Organ Company, a Pennsylvania corporation (“Allen Organ”), and its wholly owned subsidiary, Eastern Research, Inc., a New Jersey corporation (“Eastern Research”), through a merger of Allen Organ with and into Bach (the “Merger”) pursuant to an Agreement and Plan of Merger dated as of April 12, 2006 and amended and restated as of August 3, 2006 (the “Merger Agreement”) by and among Sycamore, Allen Organ, MusicCo, LLC, a Pennsylvania limited liability company and wholly-owned subsidiary of Allen Organ, LandCo Real Estate, LLC, a Pennsylvania limited liability company and wholly-owned subsidiary of Allen Organ, AOC Acquisition, Inc. and the representative of the holders of capital stock of Allen Organ.

Under the terms of the amended agreement, the Allen Organ shareholders and the minority shareholders of Eastern Research were paid an aggregate of $80 million in cash. In addition, the Company assumed all Eastern Research stock options that were outstanding immediately prior to the effective date of the transaction. All unvested Eastern Research stock options became fully vested immediately upon the completion of the transaction. The Eastern Research stock options assumed were converted into options to purchase approximately 951,000 shares of Sycamore common stock. The Company accounted for this acquisition using the purchase method and, accordingly, the results of Eastern Research’s operations have been included in the consolidated financial statements since that date. The total purchase price of the acquisition was as follows (in thousands):

 

     Amount

Cash

   $ 78,818

Fair value of Eastern Research stock options assumed

     1,496

Acquisition related transaction costs

     4,885
      

Total purchase price

   $ 85,199
      

The Company allocated the purchase price to tangible assets, liabilities and identifiable intangible assets acquired, as well as, in-process research and development, based on their estimated fair values. In-process research and development of $12.4 million was written-off in the first quarter of fiscal 2007 and related to a project under development for which technological feasibility had not been established and no future alternative uses for the technology existed at the time of acquisition. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. The excess of the purchase price over the aggregate fair values was recorded as goodwill, which is not deductible for tax purposes. The Company considered a number of factors to determine the purchase price allocation, including

 

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engaging a third party valuation firm to independently appraise the fair value of certain assets acquired. Purchased intangibles are amortized on a straight-line basis over their respective estimated useful lives. The total allocation of the purchase price is as follows (in thousands):

 

     Amount  

Current assets

   $ 17,744  

Property, plant, and equipment

     9,951  

Intangible assets

     31,650  

Goodwill

     20,334  

Liabilities

     (6,880 )

In-process research and development

     12,400  
        

Net assets acquired

   $ 85,199  
        

Intangible assets consist primarily of customer relationships which relate to Eastern Research’s ability to sell existing, in-process and future versions of its products to its existing customers and technology. The following table presents details of the purchased intangible assets acquired as part of the Eastern Research acquisition (in thousands):

 

     Amount   

Estimated
Useful Life

(in years)

Trademarks

   $ 400    1

Customer relationships

     16,000    6-10

Technology

     15,250    4-10
         

Total

   $ 31,650   
         

In the first quarter of fiscal 2007, the Company decided to discontinue the development of Eastern Research’s OX8000 product. This product was in the development stage on the date of acquisition and accordingly the fair value associated with this product was recorded as in-process research and development and expensed on the date of the acquisition. As a result of the Company’s decision to discontinue the OX8000 product, an asset impairment charge of $6.6 million was recorded in the first quarter of fiscal 2007. The charge related to certain intangibles associated with the OX8000 product, specifically customer relationships and other related assets. In addition, the Company recorded a charge of $1.1 million related to OX8000 inventory in cost of product revenue in the first quarter of fiscal 2007. In the fourth quarter of fiscal 2007, the Company decided to cease further development of Eastern Research’s BSG product. As a result of the Company’s decision to cease development of the BSG product, we recorded an asset impairment charge of $10.7 million in the fourth quarter of fiscal 2007. The charge related to certain intangible assets associated with the BSG product, specifically technology of $7.5 million, customer relationships of $2.9 million and other related assets of $0.3 million. In addition, the Company recorded a charge of $0.3 million related to BSG inventory in cost of product revenue.

The Company has undertaken certain restructuring activities at Eastern Research. These activities, which include reductions in staffing and the elimination of a facility, were accounted for in accordance with Emerging Issues Task Force (EITF) Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. The cost of these actions was charged to the cost of the acquisition and a corresponding liability of $1.8 million was included in accrued restructuring in the accompanying balance sheet. In accordance with EITF Issue No. 95-3, the Company has finalized its restructuring plans no later than one year from the respective date of the acquisition. Upon finalization of restructuring plans or settlement of obligations for less than the expected amount, any excess reserves are reversed with a corresponding decrease in goodwill or other intangible assets when no goodwill exists.

The following represents the unaudited pro forma results for Sycamore and Eastern Research as though the acquisition of Eastern Research had occurred at the beginning of each period shown (in thousands, except per

 

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share data). The unaudited pro forma information, however, is not necessarily indicative of the results that would have resulted had the acquisition occurred at the beginning of the periods presented, nor is it necessarily indicative of future results.

 

     Pro Forma  
     Year Ended July 31,  
     2007     2006  
     (Unaudited)  

Revenue

   $ 159,421     $ 145,074  

Net loss

   $ (17,305 )   $ (9,512 )

Net loss per share:

    

Basic

   $ (0.06 )   $ (0.03 )

Diluted

   $ (0.06 )   $ (0.03 )

 

4. Inventories

Inventories consisted of the following at July 31, 2007 and 2006 (in thousands):

 

     2007    2006

Raw materials

   $ 2,845    $ 1,438

Work in process

     4,781      1,848

Finished goods

     14,089      2,727
             

Total

   $ 21,715    $ 6,013
             

 

5. Property and Equipment

Property and equipment consisted of the following at July 31, 2007 and 2006 (in thousands):

 

     2007     2006  

Computer software and equipment

   $ 76,154     $ 65,035  

Land

     3,000       3,000  

Furniture and office equipment

     2,675       1,459  

Leasehold improvements

     7,614       2,998  
                
     89,443       72,492  

Less accumulated depreciation

     (69,831 )     (64,668 )
                

Total

   $ 19,612     $ 7,824  
                

Depreciation expense was $6.6 million, $3.5 million and $4.4 million for the years ended July 31, 2007, 2006 and 2005, respectively.

The Company owns approximately 102 acres of land in Tyngsborough, Massachusetts.

 

6. Purchased Intangibles

Purchased intangibles consisted of the following at July 31, 2007 (in thousands):

 

     Gross    Impairment
Charges
  

Accumulated

Amortization

   Net

Trademarks

   $ 400    $ —      $ 361    $ 39

Customer relationships

     16,000      8,443      1,608      5,949

Technology

     15,250      7,506      2,321      5,423
                           

Total

   $ 31,650    $ 15,949    $ 4,290    $ 11,411
                           

 

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The estimated future amortization expense of purchased intangibles as of July 31, 2007, is as follows (in thousands):

 

2008

   $ 2,956

2009

     2,917

2010

     2,917

2011

     1,339

2012

     1,167

Thereafter

     115
      

Total future minimum lease payments.

   $ 11,411
      

 

7. Lease Commitments

Operating Leases

Rent expense under operating leases was $2.7 million, $1.9 million and $2.5 million for the years ended July 31, 2007, 2006 and 2005, respectively. At July 31, 2007, future minimum lease payments under all non-cancelable operating leases are as follows (in thousands):

 

2008

   $ 2,759

2009

     2,492

2010

     2,509

2011

     2,535

2012

     2,219

Thereafter

     3,048
      

Total future minimum lease payments

   $ 15,562
      

 

8. Income Taxes

Substantially all of the income (loss) before income taxes as shown in the Consolidated Statement of Operations for the years ended July 31, 2007, 2006 and 2005 is derived in the United States.

During the years ended July 31, 2007, 2006 and 2005, due to the Company’s cumulative taxable losses, the net losses incurred during each period and the inability to carryback these losses, the Company has not recorded a current tax benefit for the net operating losses.

The following table presents the components of our provision for income taxes (in thousands):

 

     July 31,
     2007    2006    2005

Current:

        

Federal

   $ 572    $ 390    $ —  

State

     4      39      —  

Foreign

     123      401      63
                    
     699      830      63
                    

Deferred:

        

Federal

     142      —        —  

State

     13      —        —  

Foreign

     —        —        —  
                    
     155      —        —  
                    

Total Tax Provision

   $ 854    $ 830    $ 63
                    

 

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A reconciliation between the statutory federal income tax rate and the Company’s effective tax follows (in thousands):

 

     July 31,  
     2007     2006     2005  

Statutory federal income tax (benefit)

   $ (4,323 )   $ 7,077     $ (10,449 )

State taxes, net of federal benefit

     (757 )     686       (907 )

Non-deductible stock compensation

     —         (24 )     609  

In-process research and development

     4,340       —         —    

Research and development credits

     (1,332 )     —         —    

Valuation allowance

     2,573       (9,533 )     12,015  

Other

     353       2,624       (1,205 )
                        

Tax expense

   $ 854     $ 830     $ 63  
                        

The components of the Company’s net deferred tax assets at July 31, 2007 and 2006 are as follows (in thousands):

 

     2007     2006  

Deferred tax assets:

    

Net operating loss

   $ 262,697     $ 275,364  

Credit carryforwards

     19,458       15,711  

Restructuring and related accruals

     6,676       6,213  

Accrued expenses

     3,564       4,268  

Stock Based Compensation Expense

     37,392       34,752  

Capital loss

     7,076       7,076  

Contingencies

     5,621       6,224  

Depreciation

     3,415       5,126  

Other, net

     3,598       1,612  
                

Total deferred tax assets

   $ 349,497     $ 356,346  
                

Deferred tax liabilities:

    

Identified intangibles

     (4,365 )     —    

Indefinite lived intangibles

     (155 )     —    
                

Total deferred tax liabilities

     (4,520 )     —    
                

Net deferred tax asset

     344,977       356,346  

Valuation allowance

     (345,132 )     (356,346 )
                

Net deferred tax assets (liabilities)

   $ (155 )   $ —    
                

At July 31, 2007, the Company had federal and state net operating loss (“NOL”) carryforwards of approximately $738.8 million and $120.2 million, respectively. The federal and state net operating loss carryforwards will expire at various dates through 2025. The Company also had federal and state research and development credit carryforwards of approximately $11.1 million and $7.5 million, respectively, which begin to expire in 2019 and 2014, respectively. In fiscal year 1999 (just prior to the initial public offering (“IPO”)), the Company experienced a change in ownership as defined by Section 382 of the Internal Revenue Code. In general, an ownership change, as defined by Section 382, results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50 percentage points over a three-year period. Since the Company’s formation, the Company has raised capital through the issuance of capital stock on several occasions which, combined with shareholders’ subsequent disposition of those shares, has resulted in one change of control, as defined by Section 382. As a result of the 1999 ownership change, utilization of the Company’s NOLs were subject to an annual limitation under Section 382 determined by

 

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multiplying the value of the Company’s stock at the time of the ownership change by the applicable long-term tax-exempt rate resulting in an annual limitation which was fully utilized in 2000. Since the 1999 ownership change through April 2006, which is the date of the last ownership change testing, the Company has not experienced any subsequent ownership change and therefore, is not subject to any limitation. Subsequent ownership changes, as defined in Section 382, could further limit the amount of net operating loss carryforwards and research and development credits that can be utilized annually to offset future taxable income.

The Company has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets and has established a full valuation allowance of approximately $345,132,000 for such assets, which are comprised principally of net operating loss carryforwards, research and development credits and stock based compensation. The Company recorded a decrease to the valuation allowance of $11.2 million and $12.1 million for the years ended July 31, 2007 and 2006, respectively, which offset the decrease in the net deferred tax assets. The decrease in the valuation allowance was the result of utilizing previously unbenefited net operating loss carryforwards in the current period. As a result of the adoption of SFAS No. 142, Goodwill and Other Intangible Assets and the fiscal year 2007 acquisition of Eastern Research, the Company has recorded a valuation allowance in excess of its net deferred tax assets to the extent the difference between the book and tax basis of indefinite lived intangible assets is not expected to reverse during the net operating loss carryforward period. The net deferred tax liability of $0.2 million at July 31, 2007 is due to the difference in accounting for the Company’s goodwill, which is amortizable over 15 years for tax purposes, but not amortized for book purposes, in accordance with SFAS No. 142. The net deferred tax liabilities cannot be offset against the Company’s deferred tax assets under U.S. generally accepted accounting principals since they relate to indefinite-lived assets and are not anticipated to reverse in the same period.

Included in the net operating loss carryforwards are stock option deductions of approximately $125.0 million. The benefits of these stock option deductions approximate $47.8 million and will be credited to additional paid-in capital when realized or recognized. As of July 31, 2007, the Company had net operating loss carryforwards of approximately $4.4 million related to the exercise of stock options subsequent to the adoption of SFAS 123R. This amount represents the excess benefit as defined by SFAS 123R and has not been included in the gross deferred tax asset reflected for net operating losses. The benefit of approximately $1.4 million will be credited to additional paid-in capital and approximately $0.3 million will be credited to goodwill when the Company recognizes a cash savings.

 

9. Stockholders’ Equity

Preferred Stock

The Company’s Board of Directors (the “Board”) has the authority to issue up to 5,000,000 shares of preferred stock without stockholder approval in one or more series and to fix the rights, preferences, privileges and restrictions of ownership. No shares of preferred stock were outstanding at July 31, 2007 or July 31, 2006.

Common Stock

The Company is authorized to issue up to 2,500,000,000 shares of its common stock. The holders of the common stock are entitled to one vote for each share held. The Board may declare dividends from legally available funds, subject to any preferential dividend rights of any outstanding preferred stock and restrictions under the Company’s loan agreements, if any. Holders of the common stock are entitled to receive all assets available for distribution on the dissolution or liquidation of the Company, subject to any preferential rights of any outstanding preferred stock.

 

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10. Share-Based Compensation

The Company accounts for share-based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant).

The following table presents share-based compensation expense included in the Company’s consolidated statements of operations for the years ended July 31, 2007 and 2006 (in thousands):

 

     July 31,  
     2007     2006  

Cost of product revenue

   $ 172     $ 208  

Cost of service revenue

     161       743  

Research and development

     1,707       2,415  

Sales and marketing

     2,184       1,283  

General and administrative

     1,129       1,396  
                

Share-based compensation expense before tax

     5,353       6,045  

Income tax benefit

     (134 )     (242 )
                

Net compensation expense

   $ 5,219     $ 5,803  
                

The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted in fiscal 2007 and 2006. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards.

Araldo Menegon, the Company’s former Vice President, Worldwide Sales and Support, resigned as an executive officer effective September 6, 2006. The Company and Mr. Menegon entered into a Transition Agreement and Release, which provides that, in consideration of Mr. Menegon’s execution of such Agreement and Release and the continuation of his employment through September 6, 2007, Mr. Menegon, is eligible to be covered under the Company’s health plan and receive pay during such period equal to his base salary. In addition, all equity awards granted to Mr. Menegon during his employment will continue to vest through September 6, 2007. The Company determined that, at the date of the Transition Agreement and Release, all service conditions had been satisfied and accordingly, the Company recorded an additional non-cash stock-based compensation charge of $1.5 million related to this modification. Also during fiscal year 2007 the Company modified the terms of certain equity awards for approximately 75 employees to allow additional time to exercise and as a result, the Company recorded additional non-cash share-based compensation expense of $0.8 million.

 

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The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:

 

     July 31,
     2007    2006

Expected option term (1)

   6.3 years    6.5 years

Expected volatility factor (2)

   54.9%    60.1%

Risk-free interest rate (3)

     4.7%      4.7%

Expected annual dividend yield

     0.0%      0.0%

(1) The option term was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.
(2) The stock volatility for each grant is measured using the weighted average of historical daily price changes of the Company’s common stock over the most recent period equal to the expected option life of the grant, adjusted for activity which is not expected to occur in the future.
(3) The risk-free interest rate for periods equal to the expected term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant.

Prior to August 1, 2005, the Company accounted for share-based compensation in accordance with the provisions of APB Opinion No. 25, as permitted by SFAS No. 123, and accordingly the Company did not recognize compensation expense for employee share-based awards when the exercise price of the Company’s employee stock awards equaled the market price of the underlying stock on the date of grant. The Company did recognize compensation expense under APB 25 relating to certain stock options and restricted stock with exercise prices below fair market value on the date of grant.

The Company had previously adopted the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”), as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” through disclosure only. The following table illustrates the effects on net income and earnings per share for the year ended July 31, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards (in thousands).

 

     July 31,
2005
 

Net loss as reported:

   $ (29,916 )

Add: Share-based compensation expense included in reported net loss under APB 25

     7,725  

Deduct: Share-based compensation expense that would have been included in reported net loss if the fair value provisions of FAS 123 had been applied to all awards

     (65,033 )
        

Pro forma net loss

   $ (87,224 )
        

Basic and diluted net loss per share:

  

As reported

   $ (0.11 )
        

Pro forma

   $ (0.32 )
        

The fair value of each option grant was estimated on the grant date using the Black-Scholes option pricing model with the following assumptions:

 

    

July 31,

2005

Expected option term

   5.0 years

Expected volatility factor

   78%

Risk-free interest rate

   3.8%

Expected annual dividend yield

   0.0%

 

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Stock Incentive Plans

The Company currently has four primary stock incentive plans: the 1998 Stock Incentive Plan (the “1998 Plan”), the 1999 Stock Incentive Plan (the “1999 Plan”), the Sirocco 1998 Stock Option Plan (the “Sirocco 1998 Plan”) and the Eastern Research, Inc. Stock Option Plan (the “ERI Plan”). A total of 143,639,941 shares of common stock have been reserved for issuance under these plans. The 1999 Plan is the only one of the four primary plans under which new awards are currently being issued. The total amount of shares that may be issued under the 1999 Plan is the remaining shares to be issued under the 1998 Plan, plus 25,000,000 shares, plus an annual increase equal to the lesser of (i) 18,000,000 shares, (ii) 5% of the outstanding shares on August 1 of each year, or (iii) a lesser number as determined by the Board. The Board of Directors of the Company (the “Board”) voted to not authorize an increase in the number of shares for the 1999 Plan for fiscal year 2007. The plans provide for the grant of incentive stock options, nonstatutory stock options, restricted stock awards and other share-based awards to officers, employees, directors, consultants and advisors of the Company. No participant may receive any award, or combination of awards, for more than 1,500,000 shares in any calendar year. Options may be granted at an exercise price less than, equal to or greater than the fair market value on the date of grant; however, options are generally granted at a price equal to fair market value of the common stock on the date of grant. The Board determines the term of each option, the option exercise price, and the vesting terms. Stock options generally expire ten years from the date of grant and vest over three to five years.

All employees who have been granted options by the Company under the 1998 and 1999 Plans are eligible to elect immediate exercise of all such options. However, shares obtained by employees who elect to exercise prior to the original option vesting schedule are subject to the Company’s right of repurchase, at the option exercise price, in the event of termination. The Company’s repurchase rights lapse at the same rate as the shares would have become vested under the original vesting schedule. As of July 31, 2007, there were no shares related to immediate option exercises subject to repurchase by the Company.

The Company also has a Non-Employee Director Option Plan (“the Director Plan”) under which a total of 2,220,000 shares of common stock have been authorized and reserved for issuance. As of August 1 of each year, the aggregate number of common shares available for the grant of options under the Director Plan is automatically increased by the number of common shares necessary to cause the total number of common shares available for grant to be 1,500,000. Each non-employee director is granted an option to purchase 90,000 shares which vests over three years upon their initial appointment as a director, and immediately following each annual meeting of stockholders, each non-employee director is automatically granted an option to purchase 30,000 shares which vests in one year. The Board of Directors voted to not authorize an increase in the number of shares for the Director Plan for fiscal year 2007. The Company granted 180,000, 120,000 and 120,000 options under the Director Plan during the years ended July 31, 2007, 2006 and 2005, respectively. At July 31, 2007, 1,200,000 shares were available for grant under the Director Plan. Stock options granted under the Director Plan generally expire ten years from the date of grant and vest over one to three years.

 

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Stock Option Activity

Stock option activity under all of the Company’s stock plans during the three years ended July 31, 2007 is summarized as follows:

 

   

Number of

Shares

   

Weighted
Average

Exercise

Price

 

Weighted

Average

Contractual

Term

(Years)

  Weighted
Average Fair
Value of options
granted at
market value
  Weighted
Average Fair
Value of options
granted below
market value
  Weighted
Average Fair
Value of options
granted above
market value

Outstanding at July 31, 2004

  30,846,472     $ 6.95   7.5   $ 2.69   $ 2.69   $ 0.62
                                 

Options granted

  1,626,500       3.77        

Options exercised

  (1,595,084 )     2.65        

Options canceled

  (4,192,193 )     7.15        
                   

Outstanding at July 31, 2005

  26,685,695     $ 6.98   6.6   $ 2.67   $ 2.42   $ 2.56
                                 

Options granted

  793,750       4.30        

Options exercised

  (2,855,475 )     3.35        

Options canceled

  (3,442,122 )     11.20        
                   

Outstanding at July 31, 2006

  21,181,848     $ 6.68   5.8      
                     

Options assumed

  950,869       2.58        

Options granted

  745,000       3.75        

Options exercised

  (1,137,764 )     2.40        

Options canceled

  (1,271,469 )     5.29        
                   

Outstanding at July 31, 2007

  20,468,484     $ 6.71   4.9      
                     

The weighted average grant date fair value of stock options granted was $2.15, $2.69 and $2.67 during fiscal years 2007, 2006 and 2005, respectively.

The intrinsic value of stock options exercised, calculated as the difference between the market value of the shares on the exercise date and the exercise price of the option was $1.7 million, $2.8 million and $1.8 million for fiscal years 2007, 2006 and 2005, respectively.

The total cash received from employees as a result of employee stock option exercises during fiscal years 2007, 2006 and 2005 was $2.7 million, $10.4 million and $5.1 million, respectively.

The following table summarizes information about stock options outstanding at July 31, 2007:

 

     Stock Options Outstanding    Stock Options Exercisable

Range of
Exercise Prices

  

Number

Outstanding

  

Weighted

Average

Remaining

Contract

Life

  

Weighted

Average

Exercise

Price

  

Aggregate

Intrinsic

Value

  

Number

Exercisable

  

Weighted

Average

Exercise

Price

  

Aggregate

Intrinsic

Value

$ 0.11— $ 3.77

   10,143,849    5.3    $ 3.27    $ 9,028,026    9,357,754    $ 3.25    $ 8,515,556

$ 3.78 —$ 4.87

   3,116,196    6.3    $ 4.16      —      2,125,682    $ 4.23      —  

$ 4.89— $ 4.89

   3,973,666    4.4    $ 4.89      —      3,973,666    $ 4.89      —  

$ 4.90— $ 54.75

   2,947,273    3.1    $ 14.34      —      2,917,773    $ 14.43      —  

$62.62—$154.00

   287,500    2.7    $ 102.52      —      287,500    $ 102.52      —  
                                          

$0.11 —$154.00

   20,468,484    4.9    $ 6.71    $ 9,028,026    18,662,375    $ 6.99    $ 8,515,556
                                          

As of July 31, 2007, there was $3.9 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Company’s stock plans. That cost is expected to be recognized over a weighted-average period of 1.4 years.

 

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Restricted Stock

Restricted stock may be issued to employees, officers, directors, consultants, and other advisors. Shares acquired pursuant to a restricted stock agreement are subject to a right of repurchase by the Company which lapses as the restricted stock vests. In the event of termination of services, the Company has the right to repurchase unvested shares at the original issuance price. The vesting period is generally three to five years. The Company issued no shares of restricted stock during the years ended July 31, 2007, 2006 and 2005.

The following table summarizes the status of the Company’s nonvested restricted shares since July 31, 2006:

 

    

Number of

Shares

    Weighted Average
Fair Value

Nonvested at July 31, 2006

   165     $ 7.54

Granted

   —         —  

Vested

   (165 )     7.54

Forfeited

   —         —  
            

Nonvested at July 31, 2007

   —       $ 7.54
            

The total fair value of shares vested during fiscal 2007, 2006 and 2005 was approximately $1 thousand, $8 thousand and $1.1 million, respectively.

Employee Stock Purchase Plan

The Company had an Employee Stock Purchase Plan under which a total of 2,250,000 shares of common stock had been reserved for issuance. Eligible employees could purchase common stock at a price equal to 85% of the lower of the fair market value of the common stock at the beginning or end of each six-month offering period. Participation was limited to 10% of an employee’s eligible compensation not to exceed amounts allowed by the Internal Revenue Code. On August 1 of each year, the aggregate number of common shares available for purchase under the Employee Stock Purchase Plan was automatically increased by the number of common shares necessary to cause the number of common shares available for purchase to be 2,250,000. During the year ended July 31, 2005, 578,333 shares of common stock were issued under the plan. Effective May 1, 2005, the Company terminated the Employee Stock Purchase Plan.

Deferred Stock Compensation

In connection with the grant of certain stock options and restricted shares to employees through the year ended July 31, 2001, the Company recorded deferred stock compensation equal to the difference between the deemed fair market value of the common stock on the date of grant and the exercise price. Deferred compensation related to options and restricted shares which vest over time is recorded as a component of stockholders’ equity and is amortized over the vesting periods of the related options and restricted shares. During the years ended July 31, 2007, 2006 and 2005, the Company recorded share-based compensation expense relating to these options and restricted shares totaling $5.3 million, $6.0 million and $7.7 million, respectively. During the years ended July 31, 2006 and 2005, the Company reversed deferred stock compensation of $0.2 million and $0.4 million, respectively, relating to former employees that had terminated prior to vesting in the stock options and restricted shares.

Treasury Stock

At July 31, 2003, the Company held 147,000 shares of treasury stock, recorded at the acquisition cost of $11,000. Treasury stock relates to the repurchase upon employee terminations of unvested shares of restricted stock and options exercised prior to vesting. The shares of treasury stock held are either retired or reissued upon the exercise of options or the issuance of other share-based equity awards. During the year ended July 31, 2005, the Company retired 14,000 shares of treasury stock at its acquisition cost of approximately $0.

 

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11. Employee Benefit Plan

The Company sponsors a defined contribution plan covering substantially all of its employees which is designed to be qualified under Section 401(k) of the Internal Revenue Code. Eligible employees are permitted to contribute to the 401(k) plan through payroll deductions within statutory and plan limits. The Company made matching contributions of $0.8 million, $0.3 million and $0.4 million to the plan during fiscal 2007, 2006 and 2005, respectively.

 

12. Related Party Transactions

In July 2000, the Company and the Chairman of the Company’s Board of Directors (the “Chairman”) entered into an Investor Agreement with Tejas Networks India Private Limited, a private company incorporated in India (“Tejas”), pursuant to which the Company and the Chairman each invested $2.2 million in Tejas in exchange for equity shares of Tejas. The Chairman also serves as the Chairman of the Board of Directors of Tejas. An executive officer of the Company also serves as a board member of Tejas. The Company has entered into various agreements with Tejas under which the Company has licensed certain proprietary software development tools to Tejas, and Tejas will assist the Company’s business development efforts in India and also provide maintenance and other services to the Company’s customers in India. During the years ended July 31, 2007, 2006 and 2005, the Company recognized revenue relating to transactions with Tejas of $0.3 million, $0.3 million and $0.1 million, respectively.

Eastern Research executed an OEM agreement with Tejas in March of 2006 under which Tejas provided Eastern Research with hardware, software and support for the sale of the OM 1000 product. In April of 2007 Sycamore amended the OEM agreement with Tejas to assign the agreement to Sycamore and add the OM 1500 and OM 4000 products.

 

13. Restructuring Charges and Related Asset Impairments

In fiscal 2001, the telecommunications industry began a severe decline which had a significant impact on our business. In response to the telecommunications industry downturn and to reposition the Company to changing market requirements, the Company enacted four separate restructuring programs: the first in the third quarter of fiscal 2001 (the “fiscal 2001 restructuring”), the second in the first quarter of fiscal 2002 (the “first quarter fiscal 2002 restructuring”), the third in the fourth quarter of fiscal 2002 (the “fourth quarter fiscal 2002 restructuring”), and the fourth in the third quarter of fiscal 2005 (the “third quarter fiscal 2005 restructuring”).

In the first quarter of fiscal 2007, the Company carried out certain restructuring activities in connection with the Eastern Research acquisition which included certain reductions in staffing and the elimination of a facility in Michigan (the “first quarter fiscal 2007 restructuring”). The cost associated with these actions is being charged to the cost of the acquisition and a corresponding liability of $1.8 million is included in the restructuring reserve. During the third quarter of fiscal 2007, the Company adjusted the liability for facility consolidations and certain other costs of $0.1 million due to the expiration of applicable statute of limitations and a lease termination.

In the fourth quarter of fiscal 2007, the Company enacted a restructuring plan and reduced its workforce by 46 employees to better align development resources with future growth opportunities, further improve operational efficiencies, and capitalize on additional acquisition synergies (the “fourth quarter fiscal 2007 restructuring”). As a result of these actions, the Company recorded a restructuring charge of $1.5 million that was comprised primarily of expenses related to the workforce reduction.

As of July 31, 2007, the future restructuring cash payments for the fiscal 2001, the first quarter of fiscal 2002, the fourth quarter of fiscal 2002, the third quarter of fiscal 2005, the first quarter fiscal 2007 and the fourth quarter fiscal 2007 restructuring programs of $1.9 million consist primarily of charges related to workforce

 

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reductions that will be substantially paid by the second quarter of fiscal 2008. The restructuring charges and related asset impairments recorded in the fiscal 2001, the first quarter fiscal 2002, the fourth quarter fiscal 2002, the third quarter fiscal 2005, the first quarter fiscal 2007 and the fourth quarter fiscal 2007 restructuring programs, and the reserve activity since that time, are summarized below (in thousands):

 

   

Original

Restructuring
Charge