**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedAugust 27, 2004**

 

**OR**

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from             to            **

 

**Commission File No. 0-12867**

 

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**3Com Corporation**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **94-2605794**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **350 Campus Drive  Marlborough, Massachusetts**                |       | **01752**                             |
| (Address of principal executive offices)                        |       | (Zip Code)                            |

 

Registrant’s telephone number, including areacode:   **(508)323-5000**

 

Former name, former address and former fiscalyear, if changed since last report:   **N/A**

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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   ý         No   o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

 

Yes   ý         No   o

 

As of September 24, 2004, 379,437,437shares of the registrant’s Common Stock were outstanding.

 

This report contains a total of 43 pages of whichthis page is number 1.

 

 

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**3Com Corporation**

 

**Table of Contents**

 
| ** ** | ** **                                                                                                          | **Page** |
|------------|---------------------------------------------------------------------------------------------------------------------|----------|
|       |                                                                                                                |     |
| PART I.    | FINANCIAL INFORMATION                                                                                               |     |
|       |                                                                                                                |     |
| *Item 1.*  | Financial Statements                                                                                                |     |
|       |                                                                                                                |     |
|       | Condensed Consolidated Statements of  Operations*Three Months Ended August 27, 2004 and  August 29, 2003* | 3        |
|       |                                                                                                                |     |
|       | Condensed Consolidated Balance Sheets*August 27, 2004 and May 28, 2004*                                        | 4        |
|       |                                                                                                                |     |
|       | Condensed Consolidated Statements of Cash  Flows*Three Months Ended August 27, 2004 and  August 29, 2003* | 5        |
|       |                                                                                                                |     |
|       | Notes to Condensed Consolidated Financial  Statements                                                               | 6        |
|       |                                                                                                                |     |
| *Item 2.*  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 16       |
|       |                                                                                                                |     |
| *Item 3.*  | Quantitative and Qualitative Disclosures  About Market Risk                                                         | 39       |
|       |                                                                                                                |     |
| *Item 4.*  | Controls and Procedures                                                                                             | 39       |
|       |                                                                                                                |     |
| PART II.   | OTHER INFORMATION                                                                                                   |     |
|       |                                                                                                                |     |
| *Item 1.*  | Legal Proceedings                                                                                                   | 40       |
|       |                                                                                                                |     |
| *Item 2.*  | Unregistered Sales of Equity Securities and  Use of Proceeds                                                        | 40       |
|       |                                                                                                                |     |
| *Item 3.*  | Defaults Upon Senior Securities                                                                                     | 40       |
|       |                                                                                                                |     |
| *Item 4.*  | Submission of Matters to a Vote of Security Holders                                                                 | 40       |
|       |                                                                                                                |     |
| *Item 5.*  | Other Information                                                                                                   | 40       |
|       |                                                                                                                |     |
| *Item 6.*  | Exhibits and Reports on Form 8-K                                                                                    | 40       |
|       |                                                                                                                |     |
| Signatures | 42                                                                                                                  |
|            |                                                                                                                     |          |  |

 

3Com andXRN are registered trademarks of 3Com Corporation or its subsidiaries.  CommWorks is a registered trademark ofUTStarcom, Inc.  Huawei is a registeredtrademark of Huawei Technologies Co. Ltd. Palm is a trademark of Palm Trademark Holding Company LLC.  Other product and brand names may betrademarks or registered trademarks of their respective owners.

 

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**PARTI.   FINANCIAL INFORMATION**

 

***Item 1.*****          Financial Statements**

 

**3Com Corporation**

**Condensed Consolidated Statements ofOperations**

(Unaudited)

 
| ** **                                                                                         | ** ** | **Three Months Ended**    | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| **(In thousands, except per share data)**                                                          | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                                                                               |       |                      |       |   |   |
| Sales                                                                                              |       | $                         | 162,349    |   | $ | 161,879 |   |
|                                                                                               |       |                      |       |   |   |
| Cost of sales                                                                                      |       | 100,254                   |       | 111,935 |   |
|                                                                                               |       |                      |       |   |   |
| Gross margin                                                                                       |       | 62,095                    |       | 49,944 |   |
|                                                                                               |       |                      |       |   |   |
| Operating expenses:                                                                                |       |                      |       |   |   |
| Sales and marketing                                                                                |       | 55,099                    |       | 62,607 |   |
| Research and development                                                                           |       | 22,435                    |       | 26,927 |   |
| General and administrative                                                                         |       | 15,672                    |       | 24,139 |   |
| Amortization and write down of intangibles                                                         |       | 1,014                     |       | 3,387 |   |
| Restructuring charges                                                                              |       | 2,784                     |       | 48,624 |   |
| Total operating expenses                                                                           |       | 97,004                    |       | 165,684 |   |
|                                                                                               |       |                      |       |   |   |
| Operating loss                                                                                     |       | (34,909                   | )          | (115,740 | ) |
| Gains on investments, net                                                                          |       | 433                       |       | 58 |   |
| Interest and other income, net                                                                     |       | 1,033                     |       | 3,944 |   |
|                                                                                               |       |                      |       |   |   |
| Loss from continuing operations before  income taxes, equity interests and discontinued operations |       | (33,443                   | )          | (111,738 | ) |
|                                                                                               |       |                      |       |   |   |
| Income tax provision (benefit)                                                                     |       | (465                      | )          | (6,035 | ) |
| Equity interest in loss of unconsolidated  joint venture                                           |       | (2,567                    | )          | — |   |
|                                                                                               |       |                      |       |   |   |
| Loss from continuing operations before  discontinued operations                                    |       | (35,545                   | )          | (105,703 | ) |
|                                                                                               |       |                      |       |   |   |
| Discontinued operations, net of taxes                                                              |       | —                    |       | (291 | ) |
|                                                                                               |       |                      |       |   |   |
| Net loss                                                                                           |       | $                         | (35,545    | ) | $ | (105,994 | ) |
|                                                                                               |       |                      |       |   |   |
| Basic and diluted net loss per share:                                                              |       |                      |       |   |   |
| Continuing operations                                                                              |       | $                         | (0.09      | ) | $ | (0.29 | ) |
| Discontinued operations                                                                            |       | —                    |       | — |   |
| Net loss                                                                                           |       | $                         | (0.09      | ) | $ | (0.29 | ) |
|                                                                                               |       |                      |       |   |   |
| Shares used in computing net loss per share  amounts (basic and diluted):                          |       | 387,585                   |       | 367,879 |   |

 

*See notes to condensed consolidated financial statements.*

 

3

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**3Com Corporation**

**Condensed Consolidated Balance Sheets**

(Unaudited)

 
| **(In  thousands, except par value)**                                                                      | ** ** | **August 27,  2004** | ** ** | **May 28,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------|------------|
|                                                                                                       |       |                      |       |              |       |
| **ASSETS**                                                                                                 |       |                      |       |              |       |
| Current assets:                                                                                            |       |                      |       |              |       |
| Cash and equivalents                                                                                       |       | $                         | 439,776    |              | $          | 575,824 |   |
| Short-term investments                                                                                     |       | 823,857                   |       | 807,532           |       |
| Accounts receivable, net                                                                                   |       | 63,423                    |       | 66,372            |       |
| Inventories                                                                                                |       | 23,403                    |       | 27,679            |       |
| Other current assets                                                                                       |       | 44,677                    |       | 42,270            |       |
| Total current assets                                                                                       |       | 1,395,136                 |       | 1,519,677         |       |
|                                                                                                       |       |                      |       |              |       |
| Investment in Huawei-3Com joint venture                                                                    |       | 140,324                   |       | 142,891           |       |
| Property and equipment, net                                                                                |       | 71,591                    |       | 72,452            |       |
| Property and equipment held for sale                                                                       |       | 44,758                    |       | 42,147            |       |
| Deposits and other assets                                                                                  |       | 33,526                    |       | 34,806            |       |
| Deferred income taxes                                                                                      |       | 2,890                     |       | 2,937             |       |
| Intangible assets, net                                                                                     |       | 3,995                     |       | 5,009             |       |
| Goodwill                                                                                                   |       | 899                       |       | 899               |       |
|                                                                                                       |       |                      |       |              |       |
| Total assets                                                                                               |       | $                         | 1,693,119  |              | $          | 1,820,818 |   |
|                                                                                                       |       |                      |       |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                             |       |                      |       |              |       |
| Current liabilities:                                                                                       |       |                      |       |              |       |
| Accounts payable                                                                                           |       | $                         | 67,962     |              | $          | 80,408 |   |
| Accrued liabilities and other                                                                              |       | 215,628                   |       | 226,161           |       |
| Total current liabilities                                                                                  |       | 283,590                   |       | 306,569           |       |
|                                                                                                       |       |                      |       |              |       |
| Deferred revenue and long-term obligations                                                                 |       | 13,522                    |       | 15,135            |       |
|                                                                                                       |       |                      |       |              |       |
| Stockholders’ equity:                                                                                 |       |                      |       |              |       |
| Preferred stock, $.01 par value, 10,000  shares authorized; none outstanding                               |       | —                    |       | —            |       |
| Common stock, $.01 par value, 990,000  shares authorized; shares issued: 393,545 and 392,738, respectively |       | 2,266,898                 |       | 2,262,223         |       |
| Treasury stock, at cost, 14,195 and 0  shares, respectively                                                |       | (69,506                   | )          | —            |       |
| Unamortized stock-based compensation                                                                       |       | (5,701                    | )          | (2,577            | )          |
| Retained deficit                                                                                           |       | (790,789                  | )          | (755,244          | )          |
| Accumulated other comprehensive loss                                                                       |       | (4,895                    | )          | (5,288            | )          |
| Total stockholders’ equity                                                                            |       | 1,396,007                 |       | 1,499,114         |       |
|                                                                                                       |       |                      |       |              |       |
| Total liabilities and stockholders’ equity                                                            |       | $                         | 1,693,119  |              | $          | 1,820,818 |   |

 

*See notes to condensed consolidated financial statements.*

 

4

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**3Com Corporation**

**Condensed Consolidated Statements of CashFlows**

(Unaudited)

 
| ** **                                                                                        | ** ** | **Three Months Ended**    | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| **(In  thousands)**                                                                               | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                                                                              |       |                      |       |   |   |
| Cash flows from operating activities:                                                             |       |                      |       |   |   |
| Loss from continuing operations                                                                   |       | $                         | (35,545    | ) | $ | (105,703 | ) |
| Adjustments to reconcile loss from  continuing operations to cash (used in) operating activities: |       |                      |       |   |   |
| Loss from discontinued operations                                                                 |       | —                    |       | (291 | ) |
| Depreciation and amortization                                                                     |       | 12,388                    |       | 26,637 |   |
| Write down of intangibles                                                                         |       | —                    |       | 1,905 |   |
| (Gains) loss on property and equipment                                                            |       | (2,680                    | )          | 24,291 |   |
| (Gains) on investments, net                                                                       |       | (433                      | )          | (58 | ) |
| Deferred income taxes                                                                             |       | 47                        |       | 310 |   |
| Stock-based compensation expense                                                                  |       | 652                       |       | 298 |   |
| Purchased in-process technology                                                                   |       | 1,675                     |       | — |   |
| Equity interest in loss of unconsolidated  joint venture                                          |       | 2,567                     |       | — |   |
| Changes in current assets and liabilities:                                                        |       |                      |       |   |   |
| Accounts receivable                                                                               |       | 2,949                     |       | 6,681 |   |
| Inventories                                                                                       |       | 2,053                     |       | (836 | ) |
| Other assets                                                                                      |       | (1,523                    | )          | 2,002 |   |
| Accounts payable                                                                                  |       | (12,446                   | )          | (9,403 | ) |
| Accrued liabilities and other                                                                     |       | (19,660                   | )          | 17,295 |   |
| Income taxes payable                                                                              |       | 7,868                     |       | (4,170 | ) |
|                                                                                              |       |                      |       |   |   |
| Net cash (used in) operating activities                                                           |       | (42,088                   | )          | (41,042 | ) |
|                                                                                              |       |                      |       |   |   |
| Cash flows from investing activities:                                                             |       |                      |       |   |   |
| Purchase of investments                                                                           |       | (231,987                  | )          | (226,854 | ) |
| Proceeds from maturities and sales of  investments                                                |       | 211,717                   |       | 257,986 |   |
| Purchase of property and equipment                                                                |       | (3,450                    | )          | (4,207 | ) |
| Purchase of technology assets                                                                     |       | (1,675                    | )          | — |   |
| Proceeds from sale of property and  equipment                                                     |       | 203                       |       | 37,233 |   |
|                                                                                              |       |                      |       |   |   |
| Net cash provided by (used in) investing  activities                                              |       | (25,192                   | )          | 64,158 |   |
|                                                                                              |       |                      |       |   |   |
| Cash flows from financing activities:                                                             |       |                      |       |   |   |
| Issuance of common stock                                                                          |       | 4,758                     |       | 9,378 |   |
| Repurchase of common stock                                                                        |       | (73,365                   | )          | — |   |
| Collection of note receivable issued for  warrants                                                |       | —                    |       | 4,211 |   |
| Repayments of long-term borrowings                                                                |       | —                    |       | (173 | ) |
|                                                                                              |       |                      |       |   |   |
| Net cash provided by (used in) financing  activities                                              |       | (68,607                   | )          | 13,416 |   |
|                                                                                              |       |                      |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                                     |       | (161                      | )          | 17 |   |
|                                                                                              |       |                      |       |   |   |
| Increase (decrease) in cash and equivalents                                                       |       | (136,048                  | )          | 36,549 |   |
| Cash and equivalents, beginning of period                                                         |       | 575,824                   |       | 515,848 |   |
|                                                                                              |       |                      |       |   |   |
| Cash and equivalents, end of period                                                               |       | $                         | 439,776    |   | $ | 552,397 |   |

 

*See notes to condensed consolidated financial statements.*

 

5

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**3Com Corporation**

**Notes to Condensed Consolidated FinancialStatements**

(Unaudited)

 

**Note 1.  Basis of Presentation**

 

The unaudited condensed consolidated financial statements have beenprepared pursuant to the rules and regulations of the Securities and ExchangeCommission.  In the opinion ofmanagement, these unaudited condensed consolidated financial statements includeall adjustments necessary for a fair presentation of our financial position asof August 27, 2004, and our results of operations and cash flows for thethree months ended August 27, 2004 and August 29, 2003.

 

We use a 52 or 53-week fiscal year ending on the Friday nearest to May31.  The results of operations for thethree months ended August 27, 2004 may not be indicative of the results tobe expected for the fiscal year ending June 3, 2005.  These condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and related notes thereto included in our Annual Report on Form 10-Kfor the fiscal year ended May 28, 2004.

 

*Recent Accounting Pronouncements*

 

In November 2002, the Emerging Issues Task Force (EITF)reached a consensus on Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables.” EITF 00-21 addresses certain aspects of the accounting by avendor for arrangements under which the vendor will perform multiple revenuegenerating activities.  EITF 00-21 iseffective for fiscal periods beginning after June 15, 2003; for us, EITF00-21 became effective for the second quarter of fiscal 2004.  The adoption of EITF 00-21 did not have amaterial effect on our financial position or results of operations.

 

In December 2003, the SEC released Staff AccountingBulletin No. 104, Revenue Recognition (SAB 104).  SAB 104 clarifies existing guidance regardingrevenue for contracts which contain multiple deliverables to make it consistentwith EITF No. 00-21.  The adoption of SAB104 did not have a material effect on our financial position or results ofoperations.

 

**Note 2.  Discontinued Operations**

 

On March 4, 2003, we entered into an agreement (Asset PurchaseAgreement) to sell selected assets and liabilities of our CommWorks division toUTStarcom, Inc. in exchange for $100.0 million in cash, subject to certainclosing adjustments.  On May 23, 2003, wecompleted the sale pursuant to the terms of the Asset Purchase Agreement.  As a result, we reported the CommWorksdivision as a discontinued operation beginning in the fourth quarter of fiscal2003 and restated allprior periods presented on a comparative basis. The loss from discontinued operations for the first quarter offiscal 2004 resulted from adjustments to previous estimates of liabilitiesrelated to the sale of the CommWorks division.

 

**Note 3.  Stock-Based Compensation**

 

We have stock option plans under which employees anddirectors may be granted options to purchase common stock.  Options generally are granted with exerciseprices at not less than the fair market value at the date of the grant, vestannually over two to four years, and expire seven to ten years after the grantdate.  InSeptember 2003, our stockholders approved the 2003 Stock Plan (the newplan), which replaced the 1983 Stock Option Plan, the 1994 Stock Option Plan,the Director Plan, and the Restricted Stock Plan (the prior plans) for allstock awards granted subsequent to the approval date.  In connection with the approval of the newplan, we cancelled all shares available for issuance under the prior plans(other than those shares underlying outstanding awards), which includedapproximately 128 million shares at the time of approval; at the same time, 20million shares were reserved for issuance under the new plan.

 

6

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As discussed above, our 2003 Stock Plan replaced theRestricted Stock Plan for the issuance of restricted stock.  Restricted stock represents shares of commonstock that have been issued at no cost to key employees, and that vestgenerally over a one to four-year period and are subject to our right toreacquire those shares upon such person’s termination of employment to theextent that such right has not lapsed. We also grant time accelerated restricted stock awards whereby shareswith a specified time-based vesting period may be accelerated if specificperformance milestones are achieved.

 

We also have an employeestock purchase plan (ESPP) under which eligible employees may authorize payrolldeductions of up to ten percent of their compensation, as defined, to purchasecommon stock at a price of 85 percent of the lower of the fair market value asof the beginning or the end of the six-month offering period.  InSeptember 2003, our stockholders approved an increase of five millionshares available for issuance under the ESPP.

 

As permitted under Statement of Financial AccountingStandards (SFAS) 123, “Accounting for Stock-Based Compensation,” we followAccounting Principles Board (APB) Opinion 25 and related Interpretations inaccounting for stock-based awards to employees. Under APB Opinion 25, compensation expense associated with employeestock awards is measured as the difference, if any, between the price to bepaid by an employee and the fair value of the underlying common stock on thegrant date, which usually is the measurement date for accounting purposes.  Generally, we recognize no compensationexpense with respect to stock-based option awards and stock issued under theESPP.  However, to the extent that wemodify an employee’s stock options in connection with our restructuringactivities (for example, by extending the period of time permitted forexercising a stock option following an employee’s involuntary termination), werecord compensation expense attributable to the modifications at the time therelated severance cost is recorded.  Also,we record compensation expense related to restricted stock over the applicablevesting period; such compensation expense is measured as the fair market valueof the restricted stock at the date of the grant.  Total stock-based compensation expense was $0.7million and $0.3 million for the fiscal quarters ended August 27, 2004 andAugust 29, 2003, respectively.

 

SFAS 123 requires disclosure of the pro forma effects on ourreported net loss and net loss per share of applying the fair value recognitionprovisions of SFAS 123 to stock-based employee compensation.  The following table illustrates such proforma effects for the fiscal quarters ended August 27, 2004 andAugust 29, 2003:

 
| ** **                                                                                             | ** ** | **Three Months Ended**    | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| **(In  thousands, except per share amounts)**                                                          | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                                                                                   |       |                      |       |   |   |
| Net loss as reported                                                                                   |       | $                         | (35,545    | ) | $ | (105,994 | ) |
|                                                                                                   |       |                      |       |   |   |
| Add: Stock-based compensation included in  reported net loss                                           |       | 652                       |       | 298 |   |
| Deduct: Stock-based compensation determined  under fair value-based method, net of related tax effects |       | (4,512                    | )          | (5,277 | ) |
| Pro forma net loss                                                                                     |       | $                         | (39,405    | ) | $ | (110,973 | ) |
|                                                                                                   |       |                      |       |   |   |
| Net loss per share:                                                                                    |       |                      |       |   |   |
| As reported—basic and diluted                                                                     |       | $                         | (0.09      | ) | $ | (0.29 | ) |
| Pro forma—basic and diluted                                                                       |       | (0.10                     | )          | (0.30 | ) |

 

For purposes of this pro forma disclosure, the estimated fair values ofemployee stock options (ESOs) are assumed to be amortized over the applicablevesting periods, and the estimated fair values of ESPP shares are assumed to beamortized over the applicable subscription periods.

 

The fair values of ESOs granted during the first quarters of fiscal2005 and fiscal 2004 have been estimated as of the date of grant using theBlack-Scholes option pricing model.  Theassumptions used

 

7

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in preparing the estimates and the resulting fair values are shownbelow:

 

| ** **                                         | ** ** | **Three Months Ended**    | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                               |       |                      |       |   |   |
| Volatility                                         |       | 57                        | %          | 67 | % |
| Risk-free interest rate                            |       | 3.3                       | %          | 2.6 | % |
| Dividend yield                                     |       | 0.0                       | %          | 0.0 | % |
| Estimated average life (years after vesting  date) |       | 1.5                       |       | 1.5 |   |
| Fair value per share                               |       | $                         | 2.24       |   | $ | 2.66 |   |
|                                                    |            |                           |            |  |  |  |  |

 

During the first quarters of fiscal 2005 and fiscal 2004, there were noshares issued under the ESPP.

 

The Black-Scholes option pricing model was developed for use inestimating the fair value of traded options that have no vesting restrictionsand are fully transferable.  In addition,option valuation models require the input of highly subjective assumptions,including the expected stock price volatility. Because our stock options have characteristics significantly differentfrom those of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, our managementbelieves that the existing models do not necessarily provide a reliable singlemeasure of the fair value of our stock options.

 

**Note 4.  Restructuring Charges**

 

In recent fiscal years, we have undertaken several initiativesinvolving significant changes in our business strategy and cost structure.  In fiscal 2001, we began a broadrestructuring of our business to enhance the focus and cost effectiveness ofour business units in serving their respective markets.  These efforts continued through fiscal2002.  We took the following specificactions in fiscal 2001 and 2002 (the “Fiscal 2001 and 2002 Actions”):  we organized aroundindependent businesses that utilized shared central services; we exited productlines; we outsourced the manufacturing of certain high volume server, desktopand mobile connectivity products in a contract manufacturing arrangement; weimplemented a reduction in workforce; and we consolidated our real estatefacilities and made plans to sell excess facilities.

 

As a result of further sales declines and net losses,we took additional restructuring actions in fiscal 2003 (the “Fiscal 2003Actions”).  We announced the integrationof the support infrastructure of two of our business units to leverage acommon infrastructure in order to drive additional costs out of thebusiness.  Additionally, we entered into an agreement tooutsource certain information technology (IT) functions, reduced our workforce,and continued to consolidate and dispose of excess facilities.

 

In response to continuing sales declines and netlosses, we took additional measures to reduce costs during fiscal 2004 (the“Fiscal 2004 Actions”) and the first quarter of fiscal 2005 (the “Fiscal 2005Actions”).  These actions includedreductions of our workforce, outsourcing of our remaining manufacturing operations,and continuing efforts to consolidate and dispose of excess facilities.

 

Restructuring chargesrelated to these various initiatives in the first quarters of fiscal 2005 andfiscal 2004 were $2.8 million and $48.6 million, respectively.  Such charges were net of credits of $4.9million and $0.8 million in the first quarters of fiscal 2005 and fiscal 2004,respectively, related primarily to revisions of previous estimates of employeeseparation expenses, lease obligation costs, and values on held for saleproperties.

 

Accrued liabilities associated with restructuringcharges are classified as current, since we intend to satisfy such liabilitiesin cash in the current year, and are included in the caption “Accruedliabilities and other” in the accompanying condensed consolidated balancesheets.

 

8

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*Fiscal 2005 Actions*

 

The following table provides a summary of thecomponents of accrued restructuring charges related to the restructuringactions initiated in the first quarter of fiscal 2005, together with changes inthe accrued amounts during the first quarter of fiscal 2005 and the endingbalances as of August 27, 2004 (in thousands):

 
| ** **                      | ** ** | **Employee  Separation  Expenses** | ** ** | **Facilities-  related  Charges** | ** ** | **Other  Restructuring  Costs** | ** ** | **Total** | ** ** |
|---------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|-----------|------------|
| Balance at May 28, 2004         |       | $                                  | —     |                              | $          | —                          |       | $         | —     |   | $ | — |   |
| Provision                       |       | 5,439                              |       | 59                                |       | 333                             |       | 5,831     |       |
| Payments and non-cash charges   |       | (2,192                             | )          | (59                               | )          | (333                            | )          | (2,584    | )          |
|                            |       |                               |       |                              |       |                            |       |      |       |
| Balance at August 27, 2004 |       | $                                  | 3,247      |                              | $          | —                          |       | $         | —     |   | $ | 3,247 |   |

 

Employeeseparation expenses include severance pay, outplacement services, and medicaland other related benefits.  Thereduction in workforce affected employees mainly in the sales and marketing,supply chain, and general and administrative functions.  The total reduction in workforce associatedwith actions initiated during the first quarter of fiscal 2005 includesapproximately 40 employees.  Separationpayments associated with actions initiated during the first quarter of fiscal2005 totaled $3.2 million through August 27, 2004.

 

Facilities-relatedcharges include costs associated with vacating leased offices in fiscal2005.  Other restructuring costs relatemainly to obligations associated with the termination of service agreements.

 

*Fiscal 2004 Actions*

 

The following table provides a summary of thecomponents of accrued restructuring charges related to the restructuringactions initiated in fiscal 2004, together with changes in the accrued amountsduring the first quarter of fiscal 2005 and the ending balances as ofAugust 27, 2004 (in thousands):

 
| ** **                      | ** ** | **Employee  Separation  Expenses** | ** ** | **Facilities-  related  Charges** | ** ** | **Other  Restructuring  Costs** | ** ** | **Total** | ** ** |
|---------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|-----------|------------|
| Balance at May 28, 2004         |       | $                                  | 5,529      |                              | $          | 530                             |       | $         | —     |   | $ | 6,059 |   |
| Provision (benefit)             |       | (2,208                             | )          | (2,455                            | )          | 192                             |       | (4,471    | )          |
| Payments and non-cash charges   |       | (2,596                             | )          | 2,600                             |       | (192                            | )          | (188      | )          |
|                            |       |                               |       |                              |       |                            |       |      |       |
| Balance at August 27, 2004 |       | $                                  | 725        |                              | $          | 675                             |       | $         | —     |   | $ | 1,400 |   |

 

Thenet benefit recorded in the first quarter of fiscal 2005 for employeeseparation expenses related to revisions of previous estimates of employeeseparation expenses.  The reduction inworkforce affected employees in the sales and marketing, customer support,manufacturing, research and development, and general and administrativefunctions.  The total reduction inworkforce associated with actions initiated during fiscal 2004 includedapproximately 1,300 employees who had been separated.  Since the inception of this restructuringinitiative, $55.0 million of separation payments have been made throughAugust 27, 2004.

 

Facilities-relatedcharges in the first quarter of fiscal 2005 relating to restructuring actionsinitiated in fiscal 2004 were the result of revisions in estimates of leaseobligation costs.  Additionally, in thefirst quarter of fiscal 2005, we recorded a $2.6 million benefit related tofair value adjustments of properties classified as held for sale.

 

*Fiscal 2003 Actions*

 

The following table provides a summary of thecomponents of accrued restructuring charges related to

 

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the restructuring actions initiated in fiscal 2003,together with changes in the accrued amounts during the first quarter of fiscal2005 and the ending balances as of August 27, 2004 (in thousands):

 
| ** **                      | ** ** | **Facilities-  related  Charges** | ** ** | **Total** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Balance at May 28, 2004         |       | $                                 | 2,566      |      | $          | 2,566 |   |
| Provision                       |       | 221                               |       | 221       |       |
| Payments and non-cash charges   |       | (360                              | )          | (360      | )          |
|                            |       |                              |       |      |       |
| Balance at August 27, 2004 |       | $                                 | 2,427      |      | $          | 2,427 |   |

 

Facilities-relatedcharges in the first quarter of fiscal 2005 relating to restructuring actionsinitiated in fiscal 2003 were the result of revisions in estimates of lease obligation costs.

 

*Fiscal 2001 and Fiscal 2002 Actions*

 

The following table provides a summary of thecomponents of accrued restructuring charges related to the restructuringactions initiated in fiscal 2001 and fiscal 2002, together with changes in theaccrued amounts during the first quarter of fiscal 2005 and the ending balancesas of August 27, 2004 (in thousands):

 
| ** **                      | ** ** | **Facilities-  related  Charges** | ** ** | **Other  Restructuring  Costs** | ** ** | **Total** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|-----------|------------|
| Balance at May 28, 2004         |       | $                                 | 6,723      |                            | $          | 82        |       | $ | 6,805 |   |
| Provision                       |       | 1,203                             |       | —                          |       | 1,203     |       |
| Payments and non-cash charges   |       | (1,320                            | )          | (31                             | )          | (1,351    | )          |
|                            |       |                              |       |                            |       |      |       |
| Balance at August 27, 2004 |       | $                                 | 6,606      |                            | $          | 51        |       | $ | 6,657 |   |

 

Additionalfacilities-related charges were the result of changes in estimates associatedwith various lease obligations.  Otherrestructuring costs relate mainly to obligations associated with thetermination of service agreements.

 

**Note 5.  Investment inUnconsolidated Joint Venture**

 

On November 17, 2003, we formed the Huawei-3Com JointVenture (H-3C) with a subsidiary of Huawei Technologies, Ltd. (Huawei).  H-3C is domiciled in Hong Kong, and has itsprincipal operating centers in Hangzhou and Beijing, China.

 

At the time of formation, we contributed cash, assets relatedto our operations in China and Japan, and licenses related to certainintellectual property in exchange for 49 percent ownership interest.  We recorded our initial investment in H-3C at$160.1 million, reflecting the carrying value of the assets contributed.  Huawei contributed its enterprise networkingbusiness assets – including Local Area Network (LAN) switches and routers;engineering, sales, and marketing resources and personnel; and licenses to itsrelated intellectual property – in exchange for a 51 percent ownershipinterest.  Huawei’s contributed assetswere valued at $178.2 million at the time of formation.  Two years after formation of H-3C, we havethe one-time option to purchase an additional two percent ownership interestfrom Huawei for an amount not to exceed $28 million.  Three years after formation of H-3C, we andHuawei each have the right to purchase all of the other partner’s ownershipinterest through a bid process.

 

We account for our investment in H-3C by the equity method.  Under this method, we record ourproportionate share of H-3C’s net income or loss based on the most recentlyavailable financial statements.  SinceH-3C follows a calendar year basis of reporting, we report our equity in H-3C’snet

 

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income or loss based on H-3C’s financial statements for the most recentcalendar quarter, two months in arrears. In determining our share of H-3C’s net income or loss, we make certainadjustments to H-3C’s reported results. Such adjustments are made primarily to recognize the value and relatedamortization expense associated with Huawei’s contributed assets, as well as todefer H-3C’s sales and gross profit on sales of products sold to us thatremained in our inventory at the end of the accounting period.  During the first quarter of fiscal 2005, werecorded a loss of $2.6 million related to our share of H-3C’s net loss, asadjusted as described above, for the quarter ended June 30, 2004; thisloss is included in the accompanying Condensed Consolidated Statement ofOperations under the caption “Equity interest in loss of unconsolidated jointventure.”  The carrying value of ourinvestment in H-3C as of August 27, 2004 was $140.3 million.

 

Summarized financial informationfor H-3C as of and for the quarter ended June 30, 2004, as adjusted asdescribed above, is as follows (in thousands):

 
| ** **               | ** ** | **June 30,  2004** | ** ** |
|--------------------------|------------|-------------------------|------------|
| Balance Sheet:           |       |                    |       |
| Current assets           |       | $                       | 241,197    |   |
| Non-current assets       |       | 158,428                 |       |
| Current liabilities      |       | 85,780                  |       |
| Non-current liabilities  |       | 8,866                   |       |
|                     |       |                    |       |
| Statement of Operations: |       |                    |       |
| Sales                    |       | $                       | 62,700     |   |
| Gross margin             |       | 24,590                  |       |
| Net loss                 |       | 5,239                   |       |

 

We and H-3C are parties to agreements providing for the sale of certainproducts between the two companies. During the first quarter of fiscal 2005, we reported sales of productsto H-3C of $3.6 million and made purchases of products from H-3C of $1.9million.  As of August 27, 2004, ouraccounts receivable and accounts payable included $1.9 million and $1.9million, respectively, related to transactions with H-3C.  Also, as of August 27, 2004, we haddeferred approximately $0.1 million related to sales of products to H-3C thathad not yet been shipped to H3-C’s end customers.

 

**Note 6.  Comprehensive Loss**

 

Thecomponents of comprehensive loss, net of tax, are as follows (in thousands):

 
| ** **                                                   | ** ** | **Three Months Ended**    | ** ** |
|--------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                   | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                                         |       |                      |       |   |   |
| Net loss                                                     |       | $                         | (35,545    | ) | $ | (105,994 | ) |
|                                                         |       |                      |       |   |   |
| Other comprehensive income (loss):                           |       |                      |       |   |   |
| Net unrealized gain (loss) on  available-for-sale securities |       | 264                       |       | (1,023 | ) |
| Net unrealized gain on cash flow hedges                      |       | 288                       |       | — |   |
| Change in accumulated translation  adjustments               |       | (161                      | )          | 17 |   |
|                                                         |       |                      |       |   |   |
| Total comprehensive loss                                     |       | $                         | (35,154    | ) | $ | (107,000 | ) |

 

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**Note 7.  Net Loss Per Share**

 

Thefollowing table presents the calculation of basic and diluted net loss pershare (in thousands, except per share data):

 
| ** **                            | ** ** | **Three Months Ended**    | ** ** |
|---------------------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                                  |       |                      |       |   |   |
| Loss from continuing operations       |       | $                         | (35,545    | ) | $ | (105,703 | ) |
| Loss from discontinued operations     |       | —                    |       | (291 | ) |
|                                  |       |                      |       |   |   |
| Net loss                              |       | $                         | (35,545    | ) | $ | (105,994 | ) |
|                                  |       |                      |       |   |   |
| Weighted average shares-basic         |       | 387,585                   |       | 367,879 |   |
| Effect of dilutive securities:        |       |                      |       |   |   |
| Employee stock options                |       | —                    |       | — |   |
| Restricted stock                      |       | —                    |       | — |   |
| Weighted average shares-diluted       |       | 387,585                   |       | 367,879 |   |
|                                  |       |                      |       |   |   |
| Net loss per share-basic and diluted: |       |                      |       |   |   |
| Continuing operations                 |       | $                         | (0.09      | ) | $ | (0.29 | ) |
| Discontinued operations               |       | —                    |       | — |   |
|                                  |       |                      |       |   |   |
| Net loss                              |       | $                         | (0.09      | ) | $ | (0.29 | ) |

 

Employeestock options and restricted stock, totaling 3.6 million and 2.6 million sharesfor the three months ended August 27, 2004 and August 29, 2003,respectively, were not included in the diluted weighted average sharescalculation because the effects of these securities were antidilutive.

 

**Note 8.  Inventories**

 

Inventories consist of (in thousands):

 
| ** **      | ** ** | **August 27,  2004** | ** ** | **May 28,  2004** | ** ** |
|-----------------|------------|---------------------------|------------|-------------------|------------|
|            |       |                      |       |              |       |
| Finished goods  |       | $                         | 21,835     |              | $          | 25,869 |   |
| Work-in-process |       | 609                       |       | 485               |       |
| Raw materials   |       | 959                       |       | 1,325             |       |
|            |       |                      |       |              |       |
| Total inventory |       | $                         | 23,403     |              | $          | 27,679 |   |

 

**Note 9.  Property and Equipment**

 

Property and equipment held for sale as of August 27, 2004 and May28, 2004 includes land, buildings and equipment in Ireland and the U.K.

 

In July 2003, we completed the sale of our 511,000 square footoffice and research and development facility in Rolling Meadows, Illinois.  Net proceeds from the sale were $35.8million, resulting in a loss on the sale of $1.1 million that was recorded inrestructuring charges in the first quarter of fiscal 2004.  As part of the terms of the transaction, weentered into an agreement to lease back approximately 43,000 square feet ofspace at then-prevailing market rates.

 

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**Note 10.  Intangible Assets, Net**

 

Intangibleassets, net, consist of (in thousands):

 
| ** **                   | ** ** | **August 27,  2004** | ** ** | **May 28,  2004** | ** ** |
|------------------------------|------------|---------------------------|------------|-------------------|------------|
|                         |       |                      |       |              |       |
| Intangible assets, gross     |       | $                         | 37,156     |              | $          | 37,156 |   |
| Accumulated amortization     |       | (33,161                   | )          | (32,147           | )          |
|                         |       |                      |       |              |       |
| Total intangible assets, net |       | $                         | 3,995      |              | $          | 5,009 |   |

 

In the first quarter of fiscal 2004, werecorded an impairment of intangible assets, consisting mainly of developed andcore technology, associated with our acquisition of the Gigabit Ethernetnetwork interface card business of Alteon Websystems in fiscal 2001.  We determined the amount of the impairment bycomparing the carrying value of the intangible assets against the fair value,which was estimated as the present value of expected future net cash flowsdiscounted at a rate of ten percent per year. The impairment resulted from reduced sales and gross margin projectionsas compared to the initial projections at the time of the acquisition, due tothe earlier-than-expected discontinuance of an acquired product.  As a result of the impairment analysis, werecorded a write down of $1.9 million, which is included in the caption“amortization and write down of intangibles” in the condensed consolidatedstatements of operations.

 

Based on the carrying value of our intangibleassets as of August 27, 2004, amortization expense is expected to be $2.3million for the remainder of fiscal 2005 and $1.7 million for fiscal 2006.

 

**Note 11.  Accrued Warranty and Other Guarantees**

 

Products are sold with varying lengths of warranty ranging from 90 daysto the lifetime of the products.  Allowancesfor estimated warranty costs are recorded in the period of sale, based onhistorical experience related to product failure rates and actual warrantycosts incurred during the applicable warranty periods.  Also, on an ongoing basis, we assess the adequacyof our allowances related to warranty obligations recorded in previous periodsand may adjust the balances to reflect actual experience or changes in futureexpectations.

 

The following table summarizes the activity in the allowance forestimated warranty costs for the three months ended August 27, 2004 andAugust 29, 2003 (in thousands):

 
| ** **                                                           | ** ** | **First three  months of  fiscal 2005** | ** ** | **First three  months of  fiscal 2004** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
|                                                                 |       |                                    |       |                                    |       |
| Accrued warranty, beginning of period                                |       | $                                       | 43,825     |                                    | $          | 44,775 |   |
| Provision for warranties related to  products sold during the period |       | 7,896                                   |       | 8,881                                   |       |
| Cost of warranty claims processed during  the period                 |       | (9,124                                  | )          | (8,495                                  | )          |
| Adjustments to preexisting warranties                                |       | —                                  |       | 130                                     |       |
|                                                                 |       |                                    |       |                                    |       |
| Accrued warranty, end of period                                      |       | $                                       | 42,597     |                                    | $          | 45,291 |   |

 

Prior to fiscal 2003, we entered into several agreements whereby we hadsold products to resellers who had, in turn, sold the products to others, andwe guaranteed the payments of the end users. If all end users under these agreements were to default on theirpayments as of August 27, 2004, we would be required to pay approximately$2.4 million.  However, since deferredrevenue and accrued liabilities related to such sales approximate theguaranteed amounts, any payments resulting from end user defaults would nothave a material impact on our results of operations.

 

In connection with the development of our Rolling Meadows facility, weguaranteed a municipal bond in

 

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the amount of $2.5 million for site improvements.  Our obligation pursuant to the guarantee hadbeen accrued as of May 30, 2003, and was repaid in connection with thecompletion of the sale of the Rolling Meadows facility in the first quarter offiscal 2004.  As of August 27, 2004,our liabilities included $2.8 million for similar obligations related tovarious other facilities that we have vacated.

 

**Note 12.  Stockholders’ Equity**

 

Inthe first quarter of fiscal 2005, we repurchased approximately 15.0 millionshares of our common stock at a total cost of $73.4 million.  These repurchases were made pursuant to thestock repurchase program that was approved by our Board of Directors inMarch 2003, and that authorizes expenditures of up to $100.0 millionduring a two-year period through March 2005.  At August 27, 2004, approximately $26.6million of the authorization remains available for future repurchases.

 

**Note 13.  Business Segment Information**

 

Effective for fiscal 2004, we streamlined our management and operatingstructure, and merged our previous multiple operating segments into a single,integrated enterprise networking business. As a result, effective for fiscal 2004, we present financial informationrelated to our business on the basis of a single segment.

 

Although we operate as a single, integrated business asdiscussed above, certain product groups accounted for a significant portion ofour sales.  For the three months endedAugust 27, 2004 and August 29, 2003, sales of significant productswere as follows:

 
| ** **                                | ** ** | **Three Months Ended  August 27, 2004** | ** ** | **Three Months Ended  August 29, 2003** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| **Products**                              | ** ** | **Sales**                                    | ** ** | **Sales %**                                  | ** ** | **Sales** | ** ** | **Sales %** | ** ** |
|                                      |       |                                         |       |                                         |       |   |   |   |   |
| Fixed-configuration 10/100 Mbps switching |       | $                                            | 72,303     |                                         | 45         | % | $ | 70,583 |   | 44 | % |
| Fixed-configuration Gigabit switching     |       | 30,474                                       |       | 19                                           |       | 19,999 |   | 12 |   |
| Server, desktop, and mobile connectivity  |       | 15,471                                       |       | 10                                           |       | 31,188 |   | 19 |   |
|                                      |       | $                                            | 118,248    |                                         | 74         | % | $ | 121,770 |   | 75 | % |

 

Sales by geographic region are as follows (in thousands):

 
| ** **                      | ** ** | **Three Months Ended**    | ** ** |
|---------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                            |       |                      |       |   |   |
| Americas                        |       | $                         | 73,831     |   | $ | 68,603 |   |
| Europe, Middle East, and Africa |       | 67,382                    |       | 63,819 |   |
| Asia Pacific Rim                |       | 21,136                    |       | 29,457 |   |
|                            |       | $                         | 162,349    |   | $ | 161,879 |   |

 

Sales information by geography is reported based on thecustomer’s designated delivery point. For the three months ended August 27, 2004 and August 29,2003, sales to customers in the United States (Americas region) totaled $58.6million, or 36 percent of total sales, and $54.8 million, or 34 percent oftotal sales, respectively.  There were noother individual countries for which sales exceeded ten percent of total sales.

 

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**Note 14.  Litigation**

 

We are partyto lawsuits in the normal course of our business.  Litigation can be expensive and disruptive tonormal business operations.  Moreover,the results of complex legal proceedings are difficult to predict.  We believe that we have meritorious defensesin each of the cases set forth below in which we are named as a defendant andwe are vigorously contesting each of these matters.  An unfavorable resolution of one or more ofthese lawsuits could adversely affect our business, financial position, orresults of operations.  We cannotestimate the loss or range of loss that may be reasonably possible for any ofthe contingencies described and, accordingly, we have not recorded anyassociated liabilities in our consolidated balance sheets.

 

On March 4, 2003, we filed suit against PCTEL, Inc. (PCTEL) in theUnited States District Court for the Northern District of Illinois, CivilAction Number 03C 1582, alleging infringement of United States Patents Numbered5,872,836, 5,646,983, 5,724,413, 6,097,794, 6,696,660, 5,532,898 and5,777,836.  On March 5, 2003, PCTELfiled suit against us in the United States District Court for the NorthernDistrict of California, Civil Action Number C 03 0982, alleging infringement ofUnited States Patent Number 4,841,561 entitled “Operating default groupselectable data communication equipment” seeking damages and injunctive relief,****and further seeking a declaration thatPCTEL does not infringe our Patents Numbered 5,872,836, 5,646,983, 5,724,413,6,097,794, 6,696,660, 5,532,898 and 5,777,836, and that such patents are voidand invalid.  The action which weinitiated in the District Court for the Northern District of Illinois wastransferred to the District Court for the Northern District of California onJune 11, 2003 and assigned Civil Action Number C 03 2710.  On August 18, 2003, that action wasconsolidated for certain purposes with the action PCTEL initiated against us inthe Northern District of California.

 

In November 2000, a shareholder derivative and class actionlawsuit, captioned *Shaev v. Claflin, et al.*,No. CV794039, was filed in California Superior Court.  The complaint alleges that our directors andofficers breached their fiduciary duties to 3Com in connection with theadjustment of employee and director stock options in connection with theseparation of 3Com and Palm, Inc. (since renamed palmOne).  On May 13, 2003, the Court dismissed theSecond Amended Complaint.  The plaintiffhas appealed the Court’s decision.  OnJune 21, 2004, the Court of Appeal for the State of California, SixthAppellate District, upheld the Court’s dismissal of the lawsuit without leaveto amend or refile.  The plaintiff fileda Petition for Review with the California Supreme Court on July 29, 2004which was denied by the Court on September 28, 2004.

 

OnApril 28, 1997, Xerox Corporation (Xerox) filed suit against U.S. RoboticsCorporation and U.S. Robotics Access Corporation in the United States DistrictCourt for the Western District of New York. We completed our acquisition of these companies on June 12,1997.  The case is now captioned *Xerox Corporation v. 3Com Corporation, U.S. RoboticsCorporation, U.S. Robotics Access Corporation, Palm Computing, Inc., and Palm,Inc.* (Civil Action Number 97-CV-6182T).  Xerox alleged willful infringement of UnitedStates Patent Number 5,596,656, entitled “Unistrokes for ComputerizedInterpretation of Handwriting.”  Xeroxsought to recover damages and to permanently enjoin the defendants frominfringing the patent in the future.  In2000, the District Court dismissed the case, ruling that there was noinfringement.  On appeal, the Court ofAppeals for the Federal Circuit affirmed-in-part, reversed-in-part and remandedthe case to the District Court for further action.  On December 20, 2001, the District Courtgranted Xerox’s motion for summary judgment that the patent is valid,enforceable, and infringed.  Thedefendants then filed a Notice of Appeal. On February 22, 2002, the District Court denied Xerox’s motion foran injunction prohibiting further alleged infringement during the appeal andordered the defendants to post a bond in the amount of $50 million.  Xerox then appealed the denial of theinjunction.  On February 20, 2003,the Court of Appeals issued its decision affirming in part and reversing inpart the order of the trial court.  TheCourt of Appeals affirmed the grant of summary judgment of infringement,reversed the grant of summary judgment of validity and remanded the case to thetrial court to conduct a complete validity analysis.  In connection with the separation of Palmfrom 3Com, pursuant to the terms of the Indemnification and Insurance MattersAgreement dated February 26, 2000 between 3Com and Palm, Palm agreed toindemnify and hold 3Com harmless for any damages or losses that might arise outof the Xerox litigation.  On May 21,2004, the District Court awarded summary judgment to the defendant, holdingthat Xerox’s patent was invalid, and dismissed the remaining claims.  Xerox has appealed the decision.

 

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**3Com Corporation**

 

***Item 2.*****                            Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion should be read in conjunction withthe condensed consolidated financial statements and the related notes thatappear elsewhere in this document.

 

This quarterly report on Form 10-Q contains forward-lookingstatements.  These forward-lookingstatements include, without limitation, predictions regarding the followingaspects of our future:

 

•                                          Theenvironment for enterprise networking equipment;

•                                          Ourgoals for sales growth, gross margin expansion and profitability;

•                                          Thecompetitive pricing environment;

•                                          Theimpact of Industry conditions on component suppliers and contractmanufacturers;

•                                          Newcompetitors entering the market for higher end, enterprise core routing andswitching products;

•                                          Aggressiveactions by competitors targeted at gaining share in the small to medium-sizedenterprise market;

•                                          Theadvanced nature and ready availability of merchant silicon, which allowslow-end competitors to deliver feature rich products;

•                                          Ourprojections for sales and gross margin for the second quarter of fiscal 2005;

•                                          Ourprojections for a net loss and negative cash flow for the second quarter offiscal 2005;

•                                          Executionof our business plan to grow sales by improving our product lines and theeffectiveness of our existing sales channels and the development of new saleschannels;

•                                          Thedependence of our future success on sales of our enterprise networkingproducts;

•                                          Expansionof our product lines targeting mid- to large-sized enterprise customers, ourlargest growth opportunities;

•                                          Thetrend towards standardization of routing and switching technology;

•                                          Theevolution of networking technology enabling convergence of data, voice andvideo over Internet Protocol (IP) networks and the expected benefits ofconverged networks;

•                                          Ourgoal of growth and profitability over the long term;

•                                          Cashflow from operating activities and our ability to satisfy anticipated cashrequirements for the next twelve months;

•                                          Improvementsin our net cash flow from operations resulting from our restructuring actions;

•                                          Activitiesof 3Com Ventures, including capital call payments to certain venture capitalfunds;

•                                          Sourcesof competition, including Huawei Technologies, Ltd.;

•                                          Thedecline in sales of our desktop, mobile and server connectivity products;

•                                          Ourrestructuring and cost-reduction efforts, including workforce reductions andthe effect on employees;

•                                          Acquisitionsof companies or technologies;

•                                          Ourreliance on strategic relationships, including our joint venture with HuaweiTechnologies, Ltd.;

•                                          Outsourcingof some of our functions and dependence on contract manufacturing;

•                                          Industrytrends and our response to those trends;

•                                          Outcomeand effect of current and potential and future litigation;

•                                          Protectionand enforcement of intellectual property rights; and

•                                          Ourcommon stock, including trading price, dividends, and repurchases.

 

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You can identify these and other forward-looking statementsby the use of words such as “may,” “will,” “should,” “expects,” “plans,”“anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,”“continue,” or the negative of such terms, or other comparableterminology.  Forward-looking statementsalso include the assumptions underlying or relating to any of the foregoingstatements.

 

Actual results could differ materially from those anticipatedin these forward-looking statements as a result of various factors, includingthose set forth under Business Environment and Industry Trends.  All forward-looking statements included inthis document are based on our assessment of information available to us atthis time.  We undertake no obligation toupdate any forward-looking statements.

 

**Overview**

** **

**PRESENTATION OF DISCONTINUED OPERATIONS—COMMWORKS**

 

The following information relates to the continuingoperations of 3Com Corporation and our consolidated subsidiaries (3Com).

 

On May 23, 2003, we completed the sale of the CommWorks division andtransferred certain assets and liabilities to UTStarcom, Inc. pursuant to theterms of the Asset Purchase Agreement. As a result of the sale, we reported the CommWorks division as adiscontinued operation beginning in the fourth quarter of fiscal 2003.  Accordingly, the Condensed ConsolidatedFinancial Statements and the related notes that appear elsewhere in thisdocument reflect the CommWorks division as a discontinued operation for allperiods presented.  Unless otherwiseindicated, the following discussion relates to our continuing operations.

 

**BUSINESS OVERVIEW**

 

We provide innovative, practical and high-value data and voicenetworking products, services and solutions for enterprises of all sizes andpublic sector organizations.  We are acompany with a global presence, strong brand identity, large intellectual propertyportfolio and strong balance sheet.  Webelieve that our relationships with strategic partners, broad product portfolioand significant distribution channels provide us with strong foundation forfuture growth.

 

We generally sell our products through a two-tier distribution channelcomprised of distributors and resellers. Distributors are the first tier of the channel providing globaldistribution, logistics, market development and other services.  Distributors generally sell to the secondtier of the channel, comprising value added resellers (VARs) and other channelpartners targeting the small and mid-sized enterprise businesses.  Although a majority of our sales are madethrough our two-tier distribution channel, we also work closely with systemsintegrators, major telecommunications service providers, and directmarketers.  We also maintain a fieldsales organization that works alongside our channel partners to assist them inachieving their sales goals.

 

In previous periods, a substantial portion of our sales has beenderived from a limited number of distributors, the largest of which are IngramMicro Inc. and Tech Data Corporation.  Weexpect that these distributors will continue to represent a significantpercentage of our sales for the foreseeable future.  The table below sets forth the percentage ofsales derived from these major distributors for the first quarters of fiscal2005 and fiscal 2004, respectively.

 

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| ** **            | ** ** | **Three Months Ended**    | ** ** |
|-----------------------|------------|---------------------------|------------|
| ** **            | ** ** | **August 27,  2004** | ** ** | **August 29,  2003** | ** ** |
|                  |       |                      |       |   |   |
| Ingram Micro, Inc.    |       | 23                        | %          | 22 | % |
| Tech Data Corporation |       | 14                        |       | 13 |   |
| Total                 |       | 37                        | %          | 35 | % |

 

We have undergone significant changes in recent years, including:

 

•                  exiting productlines that were not expected to yield a satisfactory return on investment;

•                  significant headcountreductions;

•                  outsourcing ofcertain information technology functions (IT) and other functions;

•                  outsourcing ofall manufacturing activity;

•                  selling excessfacilities;

•                  forming theHuawei-3Com Joint Venture (H-3C);

•                  introducing newproduct lines targeted at mid- to large-sized enterprises; and

•                  realigning oursales and marketing channels and expenditures.

 

We believe an overview of these significant changes is helpful to anunderstanding of our operating results.

 

*Significant Events*

 

In the fourth quarter of fiscal 2001, we undertook several broadinitiatives in an attempt to return 3Com to profitability.  These initiatives included exiting certainproduct lines that were not expected to yield a satisfactory return oninvestment.  During fiscal 2002, wecontinued to experience declining sales. In response to this decline, we undertook additional measures to furtherreduce costs, including headcount reductions, long term asset retirements, andoutsourcing manufacturing operations. During fiscal 2003, as our sales and overall financial performancecontinued to decline, we undertook several additional broad initiatives toachieve further cost savings.  The firstof these initiatives involved the integration of certain central functions ofour business units in order to achieve cost savings.  Other actions included headcount reductions,outsourcing of certain IT functions, and continuing efforts to consolidate andsell excess facilities.  All of theseactions generated restructuring charges, but also resulted in reductions insales and marketing, research and development, and general and administrativeexpenses.

 

During fiscal 2004, we undertook a number of actions, affecting bothsales and expenses, with the objective of restoring 3Com to profitability.  We expanded our product portfolio to includemore Layer 3-plus and higher-end products, additional modular switches androuters, and a higher-end Voice-over-Internet Protocol (VoIP) offering.  We believe that such an expanded productportfolio will allow us to deliver converged data and voice networkingsolutions not only to our traditional customers but also to larger andmulti-site enterprises.  We consolidatedour company’s operations into a single integrated business organized alongfunctional lines, and we relocated headquarters and key management positionsand functions from our Santa Clara, California location to our Marlborough,Massachusetts location as a more effective way to run this simplified businessmodel.  Also, we consolidated our operationsinto fewer facilities, disposed of excess real estate, relocated transactionprocessing activities to lower cost locations, outsourced our Dublin, Irelandmanufacturing operations to our contract manufacturers, and upgraded andmodified our IT infrastructure and systems to more cost-effectivealternatives.  In connection with thesevarious actions, we reduced our overall workforce by approximately fortypercent.

 

On November 17, 2003, we formed our joint venture, Huawei-3Com(H-3C), which is domiciled in Hong Kong and has its principal operating centersin Hangzhouand Beijing, China.  Wecontributed $160 million in cash, assets related to our operations in China andJapan, and licenses to related intellectual property in exchange for 49 percentownership interest of the joint

 

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venture.  In the first quarter offiscal 2005, we expanded the joint venture’s market to include Hong Kong inaddition to China and Japan.  We expectthis venture to provide three key benefits to us – an expanded product line,access to low cost and highly effective engineering talent, and a significantpresence in the China, Japan and, beginning in the first quarter of fiscal2005, Hong Kong markets.

 

During the first quarter of fiscal 2005, we undertook severaladditional actions that we believe will enhance our competitiveness, executionand profitability over the longer term. We introduced new products targeted at market segments that we expectwill grow in the future; these products include modular routers and switchessourced from H-3C, as well as voice, security and wireless solutions.  Also, we are increasing our focus on salesand marketing activities.  Currentinitiatives include developing an expanded set of “enterprise class” channelsto handle our expanded product line, and implementing marketing programs thatwe believe will improve our effectiveness and productivity in our existingchannels, particularly those that target small and mid-sized businesses.  For example, we are decreasing volume rebatesand replacing them with even higher levels of funding in the form of marketdevelopment funds, which will allow us to create more end user demand for bothus and our partners.  To further lowerour costs and expenses, we reduced our total workforce by approximately fourpercent.  Some of these reductions in ourworkforce will be backfilled in the future in connection with selective hiringconsistent with our strategy and focus – for example, by increases in ourdirect field sales organization targeting mid- to large-sized businesses.

 

*Summaryof Financial Performance for the First Quarter of Fiscal 2005*

 

•                  Our sales for the first quarter of fiscal2005 were $162.3 million, essentially flat compared to sales for the first quarterof fiscal 2004 of $161.9 million.

 

•                  Our gross margin increased to 38.2% for thefirst quarter of fiscal 2005 from 30.9% for the first quarter of fiscal 2004.

 

•                  Our operating expenses for the first quarterof fiscal 2005 were $97.0 million, compared to $165.7 million for the firstquarter of fiscal 2004, a net decrease of $68.7 million or 41.5%.  Operating expenses for the first quarter offiscal 2005 and fiscal 2004 included restructuring charges of $2.8 million and$48.6 million, respectively.

 

•                  Our net loss for the first quarter of fiscal2005 was $35.5 million compared to a net loss for the first quarter of fiscal2004 of $106.0 million, an improvement of $70.5 million.

 

•                  Our balance sheet remains strong with cashand short-term investment balances at the end of the first quarter of fiscal2005 of $1,263.6 million, compared to cash and short-term investment balancesof $1,383.4 million at the end of the fourth quarter of fiscal 2004.

 

*BusinessEnvironment and Future Trends*

 

We believe that we have begun to see the positive impacts of some ofour growth-related and restructuring initiatives undertaken in recentperiods.  In the first quarter of fiscal2005, sales from our enterprise networking products – the focus of our strategy– were $146.8 million, an increase of 12 percent over the amount reported forthe first quarter of fiscal 2004. Although reported sales for the first quarter of fiscal 2004 werenegatively impacted by a change in our channel inventory model, sales fromenterprise networking products grew on a year-over-year basis, even consideringthe impact of this change.  Also, weachieved significant improvements in gross margin, costs and expenses andprofitability on a year-over-year basis.

 

Despite these positive developments, we are facing a difficult anduncertain environment.  Networkingindustry analysts and participants differ widely in their assessmentsconcerning the prospects for near-term industry growth.  We have observed signs of growth in certainindustry segments over the past few months, but such growth has been modest andmay not be sustained in the months ahead. Other industry factors and trends also present significant challengeswith respect

 

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to our goals for sales growth, gross margin expansion and profitabilityin the short term.  Such factors andtrends include:

 

•                  The impact of the uncertain industryenvironment on product pricing;

 

•                  The impact of the uncertain industryenvironment on component suppliers and contract manufacturers, and the relatedissues of component and capacity availability and costs;

 

•                  New, formidable competitors entering themarket for higher end, enterprise core routing and switching products;

 

•                  Aggressive actions by competitors targeted atgaining share in market segments where we have had a strong positionhistorically, such as the small to medium-sized enterprise market; and

 

•                  The advanced nature and ready availability ofmerchant silicon, which allows low-end competitors to deliver feature richproducts and makes it increasingly difficult for us to differentiate ourproducts.

 

Based on our current projections for sales and gross margin for thesecond quarter of fiscal 2005 — $170 million to $180 million and 38 percent,respectively – we believe that we will incur a net loss and negative cash flowfrom operations for the quarter. Accordingly, although there are signs of progress with our enterprisenetworking strategy, we must accelerate the pace of improvement.  Our key focus for the remainder of fiscal2005 is on execution of our business plan to grow sales – both in terms ofimproving the breadth and depth of our product lines as well as improving theeffectiveness of our existing channels while developing new channels.  Our future success is highly dependent onincreased sales of our enterprise networking products, and our largest growthopportunities continue to be linked to the expansion of our product linestargeting mid- to large-sized enterprise customers.  We believe that, through our expandingportfolio of products and solutions, we can offer such customers a number ofadvantages, including the following:

 

•                  Withinthe industry, there is a trend towards increased standardization of routing andswitching technology.  Our products andsolutions are basedon open technology standards, and are designed and engineered to reducereliance on proprietary systems, complexity and total cost of ownership.

 

•                  Traditionally, enterpriseshave deployed separate data networking and telephone infrastructures, with theattendant costs to install, operate and maintain the separateinfrastructures.  However, the continuedevolution of networking technology is enabling convergence of data, voice andvideo over Internet Protocol (IP) networks. Now, in many cases, enterprises are finding that new IP telephonynetworking technology can enable them to converge their traffic over a singleinfrastructure and achieve substantial cost savings – in terms of initialpurchase price as well as ongoing costs of operation and maintenance – andprovide new productivity-enhancing telephony features to their employees.  Similarly, the evolution of networkingtechnology is now enabling enterprise-class wireless solutions as well asenhanced security solutions for both wired and wireless environments.  Our convergence ready data, voice andwireless are solutions built on an open architecture to protect networkinvestments that support evolutionary migrations, heterogeneous networks, andease of integration for new applications.

 

In summary, we believe that our recent initiatives and our plannedactions for fiscal 2005 are consistent with our goals of growth andprofitability over the longer term. However, these initiatives and actions are based on certain assumptionsconcerning the overall economic outlook for the markets in which we operate,the expected demand for enterprise networking products, our ability to competeeffectively and gain market share, and the cost and expense structure of ourbusiness.  These assumptions could proveto be inaccurate.  If current economicconditions deteriorate, or if our planned actions are not successful inachieving our goals, there could be additional adverse impacts on our financialposition, sales, profitability or cash flows. In that case, we might need to modify our strategic focus andrestructure our

 

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business again to realign our resources and achieve additional cost andexpense savings.

 

**CRITICAL ACCOUNTING POLICIES**

 

Our significant accounting policies are described in Note 2 to theConsolidated Financial Statements, which are included in our Annual Report onForm 10-K for the fiscal year ended May 28, 2004.  Some of those accounting policies require usto make assumptions and estimates that affect the amounts reflected in ourfinancial statements.  The followingaccounting policies are those which often require significant judgment andcomplex estimation:

 

*Revenue recognition:*  We recognize a sale when the product has beendelivered and risk of loss has passed to the customer, collection of theresulting receivable is reasonably assured, persuasive evidence of anarrangement exists, and the fee is fixed or determinable.  The assessment of whether the fee is fixed ordeterminable considers whether a significant portion of the fee is due afterour normal payment terms.  If wedetermine that the fee is not fixed or determinable, we recognize revenue atthe time the fee becomes due, provided that all other revenue recognitioncriteria have been met.  Also, salesarrangements may contain customer-specific acceptance requirements for bothproducts and services.  In such cases,revenue is deferred at the time of delivery of the product or service and isrecognized upon receipt of customer acceptance.

 

For arrangements that involve multiple elements, such as sales ofproducts that include maintenance or installation services, revenue isallocated to each respective element based on its relative fair value andrecognized when revenue recognition criteria for each element have beenmet.  We use the residual method torecognize revenue when an arrangement includes one or more elements to bedelivered at a future date and vendor-specific objective evidence of the fairvalue of all the undelivered elements exists. Under the residual method, the fair value of the undelivered elements isdeferred and the remaining portion of the arrangement fee is recognized asrevenue.  If evidence of fair value ofone or more undelivered elements does not exist, revenue is deferred andrecognized when delivery of those elements occurs or when fair value can beestablished.

 

We assess collectibility based on a number of factors, includinggeneral economic and market conditions, past transaction history with the customer,and the creditworthiness of the customer. If we determine that collection of the fee is not reasonably assured,then we defer the fee and recognize revenue upon receipt of payment.  We do not typically request collateral fromour customers.

 

A significant portion of our sales is made to distributors andVARs.  Revenue is generally recognizedwhen title and risk of loss pass to the customer, assuming all other revenuerecognition criteria have been met. Sales to these customers are recorded net of appropriate allowances,including estimates for product returns, price protection, and excess channelinventory levels.

 

For sales of products that contain software that is marketedseparately, we apply the provisions of AICPA Statement of Position 97-2, “SoftwareRevenue Recognition” as amended.  Salesof services, including professional services, system integration, projectmanagement, and training, are recognized upon delivery and completion ofperformance.  Other service revenue, suchas that related to maintenance and support contracts, is recognized ratablyover the contract term, provided that all other revenue recognition criteriahave been met.  Royalty revenue fromlicensing is recognized as earned.

 

*Allowance for doubtful accounts: *We continuously monitor payments from ourcustomers and maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments.  When we evaluate the adequacy of our allowancesfor doubtful accounts, we take into account various factors including ouraccounts receivable aging, customer creditworthiness, historical bad debts, andgeographic and political risk.  If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances might berequired.  As of August 27, 2004,our net accounts receivable balance was $63.4 million.

 

*Inventory:* Inventory is stated at the lower of standard cost, which approximatescost, or net realizable

 

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value.  Cost is determined on afirst-in, first-out basis.  We performdetailed reviews related to the net realizable value of inventory on an ongoingbasis, for both inventory on hand and inventory that we are committed topurchase, giving consideration to deterioration, obsolescence, and otherfactors.  If actual market conditionsdiffer from those projected by management and our estimates prove to beinaccurate, additional write-downs or adjustments to cost of sales might berequired; alternatively, we might realize benefits through cost of sales forsale or disposition of inventory that had been previously written off.  As of August 27, 2004, our net inventorybalance was $23.4 million.

 

*Goodwill and intangible assets:*  We review the value of our long-lived assets,including goodwill, for impairment whenever events or changes in businesscircumstances indicate that the carrying amount of the assets may not be fullyrecoverable or that the useful lives of these assets are no longerappropriate.  As of August 27, 2004,we had $4.0 million of net intangible assets and $0.9 million of goodwillremaining on the balance sheet, which we believe to be realizable based on theestimated future cash flows of the associated products and technology.  However, it is possible that the estimatesand assumptions used in assessing the carrying value of these assets, such asfuture sales and expense levels, may need to be reevaluated in the case ofcontinued market deterioration, which could result in further impairment ofthese assets.

 

*Equity securities and other investments:*  As of August 27, 2004, we had $156.4million of equity securities and other investments, including $140.3 millionrelated to our investment in H-3C.  Weaccount for non-marketable equity securities and other investments athistorical cost or, if we have the ability to exert significant influence overthe investee, by the equity method. Investments accounted for by the equity method include investments inlimited partnership venture capital funds and our investment in H-3C.  In accounting for these investments by theequity method, we record our proportionate share of the fund’s net income orloss, or H-3C’s net income or loss, based on the most recently availablequarterly financial statements.  SinceH-3C has adopted a calendar year basis of reporting, we report our equity inH-3C’s net income or loss based on H-3C’s most recent quarterly financialstatements, two months in arrears.

 

We review all of our investments for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theinvestment may not be fully recoverable. The impairment review requires significant judgment to identify eventsor circumstances that would likely have a significant adverse effect on thefair value of the investment. Investments identified as having an indication of impairment are subjectto further analysis to determine if the impairment is other than temporary; inthe event that the indicated impairment is other than temporary, we write theinvestment down to its impaired value.

 

*Restructuring charges:*  Over the last several years we haveundertaken significant restructuring initiatives.  These initiatives have required us to recordrestructuring charges related to severance and outplacement costs, leasecancellations, accelerated depreciation and write-downs of held for saleproperties, write-downs of other long-term assets, and other restructuringcosts.  Given the significance of ourrestructuring activities and the time required for execution and completion ofsuch activities, the process of estimating restructuring charges is complex andinvolves periodic reassessments of estimates made at the time the originaldecisions were made.  The accounting forrestructuring costs and asset impairments requires us to record charges when wehave taken actions or have the appropriate approval for taking action, and whena liability is incurred.  Our policiesrequire us to continually evaluate the adequacy of the remaining liabilitiesunder our restructuring initiatives.  Aswe continue to evaluate our business, we might be required to record additionalcharges for new restructuring activities as well as changes in estimates toamounts previously recorded.

 

*Warranty:* We provide a limited warranty on our products for periods ranging from90 days to the lifetime of the product, depending upon the product, and werecord allowances for estimated warranty costs during the period of sale.  The determination of such allowances requiresus to make estimates of product return rates and expected costs to repair orreplace the products under warranty.  Ifactual return rates or repair and replacement costs differ significantly fromour estimates, adjustments to recognize additional cost of sales might berequired.

 

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*Income taxes: *Weare subject to income tax in a number of jurisdictions.  A certain degree of estimation is required inrecording the assets and liabilities related to income taxes, and it isreasonably possible that such assets may not be recovered and that suchliabilities may not be paid or that payments in excess of amounts initiallyestimated and accrued may be required. We assess the likelihood that our deferred tax assets will be recoveredfrom our future taxable income and, to the extent we believe that recovery isnot likely, we establish a valuation allowance. We consider historical taxable income, estimates of future taxable income,and ongoing prudent and feasible tax planning strategies in assessing theamount of the valuation allowance.  Basedon various factors, including our recent losses and estimates of futureprofitability, we have concluded that future taxable income will, more likelythan not, be insufficient to recover our U.S. net deferred tax assets as ofAugust 27, 2004.  Accordingly, wehave established an appropriate valuation allowance to offset such deferred taxassets.  Adjustments could be required inthe future if we determine that the amount to be realized is greater or lessthan the valuation allowance we have recorded.

 

**Effects of Recent Accounting Pronouncements**

 

In November 2002, the Emerging Issues Task Force (EITF)reached a consensus on Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables.” EITF 00-21 addresses certain aspects of the accounting by avendor for arrangements under which the vendor will perform multiple revenuegenerating activities.  EITF 00-21 iseffective for fiscal periods beginning after June 15, 2003; for us, EITF00-21 became effective for the second quarter of fiscal 2004.  The adoption of EITF 00-21 did not have amaterial effect on our financial position or results of operations.

 

In December 2003, the SEC released Staff Accounting Bulletin No.104, Revenue Recognition (SAB 104).  SAB104 clarifies existing guidance regarding revenue for contracts which containmultiple deliverables to make it consistent with EITF No. 00-21.  The adoption of SAB 104 did not have amaterial effect on our financial position or results of operations.

 

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**Resultsof Operations**

** **

The following table sets forth, for the periods indicated, thepercentage of total sales represented by the line items reflected in ourcondensed consolidated income statements:

 
|                                                                                               |   | **Quarter  Ended**        |   |
|----------------------------------------------------------------------------------------------------|--------|---------------------------|--------|
|                                                                                               |   | **August 27,  2004** |   | **August 29,  2003** |   |
|                                                                                               |   |                      |   |   |   |
| Sales                                                                                              |   | 100.0                     | %      | 100.0 | % |
| Cost of sales                                                                                      |   | 61.8                      |   | 69.1 |   |
| Gross margin                                                                                       |   | 38.2                      |   | 30.9 |   |
| Operating expenses:                                                                                |   |                      |   |   |   |
| Sales and marketing                                                                                |   | 33.9                      |   | 38.7 |   |
| Research and development                                                                           |   | 13.8                      |   | 16.6 |   |
| General and administrative                                                                         |   | 9.7                       |   | 14.9 |   |
| Amortization and write down of intangibles                                                         |   | 0.6                       |   | 2.1 |   |
| Restructuring charges                                                                              |   | 1.7                       |   | 30.1 |   |
| Total operating expenses                                                                           |   | 59.7                      |   | 102.4 |   |
| Operating loss                                                                                     |   | (21.5                     | )      | (71.5 | ) |
| Gains on investments, net                                                                          |   | 0.3                       |   | 0.1 |   |
| Interest and other income, net                                                                     |   | 0.6                       |   | 2.4 |   |
| Loss from continuing operations before  income taxes, equity interests and discontinued operations |   | (20.6                     | )      | (69.0 | ) |
| Income tax provision (benefit)                                                                     |   | (0.3                      | )      | (3.7 | ) |
| Equity interest in loss of unconsolidated  joint venture                                           |   | (1.6                      | )      | — |   |
| Loss from continuing operations                                                                    |   | (21.9                     | )      | (65.3 | ) |
| Discontinued operations, net of taxes                                                              |   | —                    |   | (0.2 | ) |
|                                                                                               |   |                      |   |   |   |
| Net loss                                                                                           |   | (21.9                     | )%     | (65.5 | )% |

 

Sales 

 

Sales in the firstquarter of fiscal 2005 totaled $162.3 million, and were essentially flat whencompared to the same quarter one year ago. However, in the first quarter of fiscal 2004, we reduced our channelinventory model to approximately 4.5 weeks of supply to reflect our improvedsupply chain processes and efficiency. This change decreased sales reported in the first quarter of fiscal2004.

 

Sales of ourenterprise networking products in the first quarter of fiscal 2005 were $146.8million, an increase of 12 percent from the first quarter of fiscal 2004 salesof $130.5 million.  The increase was dueprimarily to substantial growth in sales of our Gigabit switchingsolutions,  reflecting increasing demandfor Gigabit products as the industry continues its transition from 10/100 Mbpsproducts.  Also contributing to the increasewere higher sales of voice products and modular switches and routers sourcedfrom H-3C, reflecting enhanced sales and marketing efforts targeting mid- tolarge-sized enterprise customers. Enterprise networking products represented 90 percent of total sales inthe first quarter of fiscal 2005 compared to 81 percent in the same quarter oneyear ago.

 

Sales of ourdesktop, mobile and server connectivity products in the first quarter of fiscal2005 were $15.5 million, a decrease of 50 percent from the first quarter offiscal 2004 sales of $31.2 million.  Thedecrease in sales of connectivity products is the result of lower unit demandfor these products, reflecting the continued shift in technology fromtraditional network interface card (NIC), personal computer (PC) card, andmini-peripheral component interconnect (Mini-PCI) form factors to PC chipsetswith embedded networking technology, as well as lower average selling prices(ASPs).

 

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*By Geography. *U.S. sales in the first quarter of fiscal 2005 grew approximately 7%over the first quarter of fiscal 2004, and represented approximately 36 percentof total sales compared to approximately 34 percent of total sales in the prioryear quarter.  The growth in U.S. saleswas attributable to higher sales of Gigabit switching solutions, voiceproducts, and modular switches and routers sourced from H-3C.  These increases were offset, in part, by adecrease in sales of connectivity products.

 

Internationalsales in the first quarter of fiscal 2005 decreased 3 percent when compared tothe same quarter one year ago.  Themajor factors contributing to these decreases were lower sales of connectivityproducts, and to a lesser extent, 10/100 Mbps switching products.  These decreases were offset, in part, byincreases in sales of Gigabit switching solutions and modular switches androuters sourced from H-3C.

 

Gross Margin

 

Grossmargin as a percentage of sales was 38.2 percent in the first quarter of fiscal2005 compared to 30.9 percent in the first quarter of fiscal 2004.  Gross margin improved due to severalfactors, as follows:

 
|                                           |   | **Current  quarter** |   |
|------------------------------------------------|--------|----------------------|--------|
| Outsourced manufacturing and facility  closure |   | 3.4                  | %      |
| IT and facility-related expenses               |   | 2.3                  |   |
| Standard-related margin                        |   | 0.9                  |   |
| Warranty provision                             |   | 0.6                  |   |
| Impact of freight rates                        |   | 0.4                  |   |
| Other                                          |   | (0.3                 | )      |
| Total                                          |   | 7.3                  | %      |

 

•                  Gross marginbenefited by 3.4 percentage points compared to the prior year quarter due toeffects associated with our decision to outsource our remaining manufacturingoperations in Dublin during fiscal 2004. Such effects include lower operating costs ($2.7 million) and theabsence of impairment and transition costs incurred in the prior year quarter($2.7 million).

 

•                  We allocate andreport both IT and facilities-related expenses as a component of cost of salesand operating expenses.  On ayear-to-year basis, the portion of such expenses allocated to cost of salesdecreased by $3.7 million.

 

•                  Standard-relatedmargin is a measure of product selling prices less direct manufacturingcosts.  The increase in standard-relatedmargin as compared to the same quarter one year ago was primarily related toproduct cost reductions.

 

•                  Warranty costsdecreased in the first quarter of fiscal 2005 compared to the prior yearquarter, primarily due to a reduction in returned materials.

 

•                  Freight costs decreasedin the first quarter of fiscal 2005 compared to the prior year quarter,primarily due to reduced rates.

 

Operating Expenses

 

Operating expenses in thefirst quarter of fiscal 2005 were $97.0 million compared to $165.7 million inthe first quarter of fiscal 2004, or a net decrease of $68.7 million.  Sales and marketing, research anddevelopment, and general and administrative expenses in the first quarter offiscal 2005 decreased by $7.5 million, $4.5 million, and $8.5 million,respectively from the prior year quarter. Additionally, amortization and write-down of intangibles andrestructuring charges in the first quarter of fiscal 2005 decreased by $2.4million and $45.8 million, respectively, from the prior year quarter.

 

As a percent of sales,total operating expenses in the first quarter of fiscal 2005 were 59.7 percent,compared to 102.4 percent in the first quarter of fiscal 2004.  In aggregate, sales and marketing, researchand development and general and administrative expenses were 57.4 percent ofsales in the first quarter

 

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of fiscal 2005, comparedto 70.2 percent in the same period of fiscal 2004, and decreased $20.5 millionon a year-to-year basis.  To asignificant degree, these expenses are controllable and discretionary overtime, but they are not directly variable with sales levels within a particularperiod.

 

We allocate and reportboth IT and facilities-related expenses as a component of cost of sales andoperating expenses.  On an overallbasis, total operating expenses in the first quarter of fiscal 2005 reflected anet decrease of $5.4 million in IT-related expenses compared to fiscal 2004,largely as a result of reductions of employee-related and other costsassociated with our IT outsourcing initiatives, and a net decrease of $1.9million in facilities-related expenses as a result of our continuing efforts toconsolidate and dispose of excess facilities.

 

A more detaileddiscussion of the factors affecting each major component of total operatingexpenses is provided below.

 

*Sales and Marketing. *Sales and marketing expenses in the first quarter offiscal 2005 decreased $7.5 million, or 12 percent, compared to the firstquarter of fiscal 2004, and decreased to 34 percent of total sales for thefirst quarter of fiscal 2005, compared to 39 percent of total sales for thefirst quarter of fiscal 2004.  Thedecreases were mainly due to reduced IT and facilities expenses, as well asreduced marketing expense as a result of more focused product and channelspecific programs.

 

*Research and Development. *Research and development expenses in the first quarterof fiscal 2005 decreased $4.5 million, or 17 percent, compared to the firstquarter of fiscal 2004, and decreased to 14 percent of sales in the firstquarter of fiscal 2005 compared to 17 percent of total sales in the firstquarter of fiscal 2004.  The decreaseswere due mainly to reduced IT and facilities expenses and loweremployee-related expenses resulting from reduced headcount.  These decreases were offset to some degreeby a charge of approximately $1.7 million related to technology assetspurchased during the first quarter of fiscal 2005 that we intend to incorporateinto our future VoIP technology offerings. Because these assets had not reached technological feasibility, had noalternative future use at the time of the purchase, we recorded the purchaseprice as research and development expense.

 

G*eneral and Administrative. *General and administrativeexpenses in the first quarter of fiscal 2005 decreased $8.5 million, or 35percent, compared to the first quarter of fiscal 2004, and decreased to 10percent of total sales in the first quarter of fiscal 2005 compared to 15percent of total sales for the first quarter of fiscal 2004.  Contributing to the decrease in general andadministrative expenses compared to the same period one year ago were loweremployee-related expenses due to headcount reductions, as well as reductions inbad debt expenses, fees for professional services related to the establishmentof H-3C venture and legal settlement costs.

 

*Amortization and Write Down ofIntangibles.** *Amortization and write down ofintangibles decreased $2.4 million in the first quarter of fiscal 2005 ascompared to the first quarter of fiscal 2004. The principal factor in the year-to-year comparison was a $1.9 millionimpairment charge in the first quarter of fiscal 2004; this impairment chargewas related to developed and core technology associated with the acquisition ofassets from Alteon Websystems in fiscal 2001. Additionally, the first quarter of fiscal 2004 had increasedamortization expense as a result of a higher amortizable intangible assetbases.

 

*Restructuring Charges. *Restructuring charges inthe first quarter of fiscal 2005 were $2.8 million, compared to $48.6 millionin the first quarter of fiscal 2004.  Restructuring charges in the firstquarter of fiscal 2005 included $3.3 million for severance and outplacementcosts and $0.5 million for other restructuring costs, primarily costsassociated with the termination of service agreements.  Restructuring charges in the first quarterof fiscal 2005 also included a net benefit of $1.0 million forfacilities-related costs, reflecting additional charges of $1.6 million relatedto revisions in estimates of lease obligation costs offset by a $2.6 millionbenefit related to fair value adjustments of properties classified as held forsale.

 

Restructuringcharges in the first quarter of fiscal 2004 included $35.9 million in facilities-related charges,including $17.5 million for an impairment and accelerated depreciation of ourDublin manufacturing facility, an $11.2 million write down of a Santa Clarafacility, $5.5 million of accelerated depreciation of an additional Santa Clarafacility, a loss of $1.1 million related to the sale of our Rolling

 

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Meadows, Illinoisfacility, and $0.6 million of other facilities-related charges.  Restructuringcharges in the first quarter of fiscal 2004 also included $7.5 million inseverance related charges and $5.2 million related to other restructuringcosts, primarily relating to other obligations associated with the outsourcingof our manufacturing operations.  Thesecharges were primarily the result of cost reduction efforts initiated in fiscal2004.

 

Gains onInvestments, Net

 

Net gains on investmentsin the first quarters of fiscal 2005 and fiscal 2004, equal to $0.4 million and$0.1 million, respectively, were not significant.

 

Interest and Other Income, Net

 

Interest and otherincome, net, was $1.0 million in the first quarter of fiscal 2005, a decreaseof $2.9 million compared to $3.9 million in the first quarter of fiscal2004.  The decrease was due primarily toa provision for unrecoverable Value Added Tax for prior years as a result of anunfavorable tax authority ruling($2.4 million) and lower interest incomeassociated with reduced income tax refunds ($1.1 million, net).

 

Income Tax Provision (Benefit) 

 

Our income tax benefitwas $0.5 million for the first quarter of fiscal 2005 compared to $6.0 millionfor the first quarter of fiscal 2004. The net benefit in the first quarter of fiscal 2005 reflected aprovision for income taxes in certain state and foreign jurisdictions ($0.9million), more than offset by the benefit associated with favorable resolutionof an income tax audit in a foreign jurisdiction that had been pending forseveral years ($1.4 million).  The netbenefit in the first quarter of fiscal 2004 reflected a provision of $2.5million for taxes in certain state and foreign jurisdictions, more than offsetby the benefit of a foreign net operating loss carryback of $8.5 million.

 

DiscontinuedOperations

 

Discontinued operationsrelate to our CommWorks business that was sold in the fourth quarter of fiscal2003.  We recorded a loss of $0.3million in the first quarter of fiscal 2004 due to adjustments to previousestimates of liabilities related to the sale of CommWorks.

 

**Liquidityand Capital Resources**

** **

Cash and equivalents and short-term investments at August 27, 2004were $1,263.6 million, a decrease of approximately $119.7 million compared tothe balance of $1,383.4 million as of May 28, 2004.

 

Netcash used in operating activities was $42.1 million in the first quarter offiscal 2005, primarily reflecting our loss from continuing operations of $35.5million.  We expect that cash flows fromoperating activities will be negative during the second quarter of fiscal 2005,and possibly longer, primarily due to continuing net losses.  There can be no assurances that we canreduce our net losses and negative cash flow in the foreseeable future, or thatwe can raise capital as needed to fund our operations on an ongoing basis.  However, based on current businessconditions and our current operating and financial plans, but subject to thediscussion in Business Environment and Industry Trends below, we believe thatour existing cash and equivalents and short-term investments will be sufficientto satisfy our anticipated cash requirements for at least the next 12months.  As a result of theaforementioned fiscal 2005 restructuring actions and related charges, and basedon our current projections for sales, costs and expenses, which are subject tosignificant uncertainty, we expect net cash flow from operations to be improvedby approximately $2 million per quarter from the level reported for the firstquarter of fiscal 2005.  Thisimprovement excludes the impact of cash disbursements to be made in settlementof liabilities accrued as of August 27, 2004.

 

Net cash used in investing activities was $25.2 million for the firstquarter of fiscal 2005, including

 

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approximately $20.3 million of net outflows related to purchases, salesand maturities of investments, $3.2 million of net outflows related topurchases and sales of fixed assets, and expenditures of $1.7 million relatedto the purchase of technology assets.

 

Our investments in equity securities include investments made by 3ComVentures.  3Com Ventures selectivelymakes strategic investments in privately-held companies and in limitedpartnership venture capital funds, which in turn invest in privately-heldcompanies.  This may include a strategiccommercial or technology relationship, such as a component supply agreement ortechnology license arrangement, with these privately-held companies.  These investments were entered into with theintention of complementing our business strategies and research and developmentefforts.  3Com Ventures made strategicinvestments of $0.5 million in the first quarter of fiscal 2005 and hascommitted to make additional capital contributions to certain venture capitalfunds totaling $8.1 million.  We arecontractually obligated to provide funding upon calls for capital.  The expiration dates for such capital callsare generally five to eight years from the inception of the fund, and theamounts and timing of such calls during that period are entirely at thediscretion of the funds’ general partners. We estimate that we will pay approximately $4.4 million over the nexttwelve months as capital calls are made.

 

During the first quarter of fiscal 2005, we made capital expendituresof $3.5 million for new property and equipment.  As of August 27, 2004, capital expenditure commitmentsoutstanding were not material.

 

Net cash used in financing activities was $68.6 million inthe first quarter of fiscal 2005.  Therewere no borrowings or repayments under our revolving line of credit during thefirst quarter of fiscal 2005.  As ofAugust 27, 2004, we were eligible for borrowing under the revolving lineof credit of up to $19.7 million, had no amounts outstanding, and had $13.6million of bank-issued standby letters of credit and bank guarantees.

 

In the first quarter of fiscal 2005, we collected $4.8 million from theissuance of approximately 0.9 million shares of stock under our employee stockoption program.  Our employee stockoption program is a broad-based, long-term retention program that is intendedto attract and retain talented employees and align stockholder and employeeinterests.  We consider our optionprogram critical to our operations and productivity; accordingly, essentiallyall of our employees participate.

 

In the first quarter of fiscal 2005, we repurchased approximately 15.0million shares of our common stock at a total cost of $73.4 million.  These repurchases were made pursuant to thestock repurchase program that was approved by our Board of Directors inMarch 2003, and that authorizes expenditures of up to an aggregate of$100.0 million during a two-year period through March 2005.  At August 27, 2004, approximately $26.6million of the authorization remains available for future repurchases.

 

As of August 27, 2004, our outstanding stock options asa percentage of outstanding shares were 15 percent.  This potential dilution is mainly the result of our distributionof Palm, Inc. common stock in the first quarter of fiscal 2001.  As a result of the Palm distribution, thenumber of shares of 3Com common stock subject to option grants was adjusted topreserve the intrinsic value of the stock options, resulting in an increase of134 million options, and bringing the total option shares outstanding to 169million at the time of the distribution. We have closely managed new option grants during recent fiscal yearswith the goal of reducing the potential dilution associated with outstandingstock options.  As a result of theseefforts, as well as the effects of option exercises and cancellations, thetotal number of outstanding options has been reduced approximately 66 percentsince the Palm distribution.  Inaddition, as discussed below, the number of options available for future grantwas reduced by 108 million shares due to approvals of proposals submitted toour stockholders at our annual stockholder meeting in September 2003.

 

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Stock option activity during the first quarter of fiscal 2005 and stockoption detail as of August 27, 2004, were as follows:

 
|                              |   | **Number  of shares** |   | **Weighted  average  exercise price** |   |
|-----------------------------------|--------|-----------------------|--------|---------------------------------------|--------|
|                              |   | **(in  thousands)**   |   |                                  |   |
|                              |   |                  |   |                                  |   |
| Outstanding, May 28, 2004         |   | 56,885                |   | $                                     | 7.18   |   |
| Granted                           |   | 5,135                 |   | 4.74                                  |   |
| Exercised                         |   | (920                  | )      | 5.23                                  |   |
| Canceled                          |   | (3,016                | )      | 7.47                                  |   |
| Outstanding, August 27, 2004 |   | 58,084                |   | $                                     | 6.98   |   |

 
|                          |   | **Outstanding  options  as of August 27, 2004** |                                     |                                  |   |                  |   |
|-------------------------------|--------|------------------------------------------------------|------------------------------------------|---------------------------------------|--------|-----------------------|--------|
|                          |   |                                                 | **Exercisable  at August 27, 2004** |                                  |
| **Range of  exercise prices** |   | **Number  of shares**                                |                                     | **Weighted  average  exercise price** |   | **Number  of shares** |   | **Weighted  average  exercise price** |   |
|                          |   | **(in  thousands)**                                  |                                     |                                  |   | **(in  thousands)**   |   |   |   |
|                          |   |                                                 |                                     |                                  |   |                  |   |   |   |
| $                             | 0.13   | -                                                    | $                                        | 4.29                                  |   | 4,792                 |   | $ | 4.21 |   | 2,518 |   | $ | 4.17 |   |
| 4.30                          | -      | 5.10                                                 |                                     | 12,030                                |   | 4.76                  |   | 4,905 |   | 4.83 |   |
| 5.11                          | -      | 5.54                                                 |                                     | 11,262                                |   | 5.38                  |   | 7,681 |   | 5.44 |   |
| 5.55                          | -      | 6.09                                                 |                                     | 9,161                                 |   | 5.92                  |   | 8,562 |   | 5.94 |   |
| 6.10                          | -      | 10.09                                                |                                     | 12,392                                |   | 8.07                  |   | 9,940 |   | 8.29 |   |
| 10.10                         | -      | 21.57                                                |                                     | 8,447                                 |   | 13.39                 |   | 8,376 |   | 13.38 |   |
| Total                         |   | 58,084                                               |                                     | $                                     | 6.98   |                  | 41,982 |   | $ | 7.65 |   |
|                               |        |                                                      |                                          |                                       |        |                       |        |  |  |  |  |  |  |  |  |

 

The following table summarizes our equity compensation plans as ofAugust 27, 2004:

 
|                                                    |   | **Number of securities to  be issued upon  exercise of options** |   | **Weighted average  exercise price of  outstanding options** |   | **Number of securities  remaining available  for future issuance under  equity compensation plans  (excluding securities  reflected in 1st column)** |   |
|---------------------------------------------------------|--------|------------------------------------------------------------------|--------|--------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                    |   | **(in thousands)**                                               |   |                                                         |   | **(in thousands)**                                                                                                                                   |   |
|                                                    |   |                                                             |   |                                                         |   |                                                                                                                                                 |   |
| Equity compensation plans approved by stockholders      |   | 26,951                                                           |   | $                                                            | 7.20   |                                                                                                                                                 | 21,019 |   |
| Equity compensation plans not approved by stockholders* |   | 30,900                                                           |   | 6.79                                                         |   | —                                                                                                                                               |   |
|                                                    |   |                                                             |   |                                                         |   |                                                                                                                                                 |   |
| Total                                                   |   | 57,851                                                           |   | $                                                            | 6.98   |                                                                                                                                                 | 21,019 |   |

 

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*Excludes 0.2million outstanding options with an average exercise price of $5.68.  These options were assumed in connectionwith acquisitions and no additional options are available for future issuanceunder such plans.

 

Options issuedoutside of the stockholder-approved plans were issued under our broad-based1994 Stock Option Plan, as amended. Options granted from this plan were granted at fair value, vest over twoto four years, and expire ten years after the date of grant.  Effective September 2003, the 2003Stock Plan was approved by stockholders and replaced the 1994 Stock Option Planfor all grants subsequent to the approval date.  Also in September 2003, stockholders approved an increase offive million shares in the number of total shares available for issuance underthe Employee Stock Purchase Plan.

 

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**Business Environment and Industry Trends**

** **

Industry trends and specificrisks may affect our future business and results.  The matters discussed below could cause our future results todiffer from past results or those described in forward-looking statements andcould have a material adverse effect on our business, financial condition,results of operations and stock price.

 

***We have incurred significant net losses in recent fiscal periods,including******$36 million forthe first quarter of fiscal 2005, and $349 million, $284 million and$596 million for fiscal years 2004, 2003 and 2002, respectively, and wemay not be able to return to profitability.***

 

We incurred a net loss of$36 million for the first quarter of fiscal 2005, and net losses of $349 million,$284 million and $596 million for fiscal 2004, 2003 and 2002,respectively.  Although we are takingsteps designed to improve our results of operations, we cannot assure you thatwe will return to profitability.

 

We have faced a number ofchallenges that have affected our operating results over the last severalfiscal years.  Specifically, we haveexperienced, and may continue to experience, the following:

 

•                  decliningsales due to price competition and reduced incoming order rate;

 

•                  increasedrisk of excess and obsolete inventories;

 

•                  excessfacilities;

 

•                  operatingexpenses that, as a percentage of sales, have exceeded our desired financialmodel; and

 

•                  disruptionsresulting from our workforce reductions and employee attrition.

 

***We focus primarily on enterprise networking, and our results ofoperations may fluctuate based on factors related entirely to conditions inthis market.***

 

In fiscal 2004, we beganoperating in a single business segment focused primarily on enterprisenetworking.  This single enterprisenetworking business reflects a streamlined management and operating structureencompassing all of our operations, including our connectivity business that wepreviously operated and reported as a separate segment and which we expect willcontinue to diminish.  Our focus onenterprise networking may cause increased risk or volatility associated withdecreased diversification of our business. There will be increased sensitivity to the business risks associatedspecifically with the enterprise networking market and our ability to executesuccessfully on our strategies to provide superior solutions for larger andmulti-site enterprise environments.  Tobe successful in the enterprise networking market, we will need to overcomenegative perceptions of our company held by certain chief information officersof large enterprises, who may be skeptical of our long-term commitment to thehigh-end networking business as a result of our withdrawal from that businessin fiscal 2000.  Also, expansion of salesto large enterprises may be disruptive in a variety of ways, such as addinglarger systems integrators that may raise channel conflict issues with existingdistributors, or a perception of any diminished focus on the small and mediumenterprise market.

 

***We may not respond effectively to increased competition caused byindustry volatility and consolidation.***

 

Our business could beseriously harmed if we do not compete effectively.  We face competitive challenges that are likely to arise from anumber of factors, including:

 

•                  industryvolatility resulting from rapid product development cycles;

 

•                  increasingprice competition due to maturation of basic networking technologies;

 

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•                  industryconsolidation resulting in competitors with greater financial, marketing, andtechnical resources;

 

•                  thepresence of existing competitors with greater financial resources together withthe potential emergence of new competitors with lower cost structures and morecompetitive offerings; and

 

•                  greatercompetition for fewer customers as a result of consolidation in thedistribution and reseller channels.

 

***We may not be able to compensate for lower sales or unexpected cashoutlays with cost reductions sufficient to generate positive net income or cashflow.***

 

Although we have implementedstrict cost and expense reductions, if we are unable to achieve our growthobjectives, we will need to further reduce costs which may in turn reduce oursales.  If we are not able to effectivelyreduce our costs and expenses commensurate with, and at the same pace as, anyfurther deterioration in our sales, we may not be able to generate positive netincome or cash flow from operations.  Ifwe continue to experience negative cash flow from operations over a prolongedperiod of time, our liquidity and ability to operate our business effectivelycould be adversely affected.  Forexample, our ability to raise financial capital may be hindered due to the possibilityof continuing net losses and negative cash flow in the future.  An inability to raise financial capitalwould limit our operating flexibility.

 

We are unable to predict theexact amount of cost reductions required for us to generate positive net incomeor cash flow from operations because we cannot accurately predict the amount ofour future sales.  The amount of ourfuture sales depends, in part, on future economic and market conditions, whichwe are unable to forecast accurately. Although we cannot accurately predict the amount of our future salesoverall, we expect that sales from sales of desktop, mobile and serverconnectivity products, which represented approximately nine percent oftotal sales for the first quarter of fiscal 2005, will decline further due topricing pressures and technological changes and trends in the networkingindustry.

 

***Efforts to reduce operating expenses could involve further workforcereductions and lead to reduced sales and other disruptions in our business.***

 

Our operating expenses,particularly general and administrative expenses, as a percent of sales havebeen higher than our desired long-term financial model.  We have taken, and will continue to take,actions to reduce these expenses. Future actions could include further reductions in our workforce, relocationof functions and activities to lower cost locations, changes or modificationsin IT systems or applications, or process reengineering.  As a result of these actions, the employmentof some employees with critical skills might be terminated, and other employeesmight leave our company voluntarily due to the uncertainties associated withour business environment and their job security.  In addition, reductions in overall staffing levels might make itmore difficult for us to achieve our growth objectives, to adhere to ourpreferred business practices and to address all of our legal and regulatoryobligations in an effective manner, which could, in turn, ultimately lead tomissed business opportunities, higher operating costs or penalties.

 

***We entered into a joint venture in China with Huawei that, if notsuccessful, could materially and adversely impact our business, businessprospects and operating results.***

 

In November 2003, weannounced the formation of a joint venture for enterprise networking productswith Huawei, a leading Chinese company. 3Com currently has a 49 percent minority interest in H-3C, which isdomiciled in Hong Kong and has its principal operations in Hangzhou andBeijing, China.  Pursuant to the jointventure agreements, as amended and supplemented in the first quarter of fiscal2005, we have the right to market and support the H-3C products under the 3Comâ brand in allcountries except China and Japan.  Thejoint venture sells products sourced internally as well as from

 

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3Com and Huawei under H-3C’sbrand as well as the 3Com brand and the Huawei brand directly in China, Japanand, beginning in the first quarter of fiscal 2005, Hong Kong.  H-3C commenced operations in November 2003. We began reflecting our share of theoperating results of H-3C in our operating results in the third quarter offiscal 2004.

 

The business of H-3C issubject to all of the operational risks that normally arise for a technologycompany with global operations pertaining to research and development,manufacturing, sales, service, marketing, and corporate functions.  In addition, there could be disagreementsbetween 3Com and Huawei with respect to important strategic and operationaldecisions.  A key factor in the successof H-3C is that product sourced from it remains competitive over timeparticularly with respect to features, performance, quality and cost.  For example, one factor that could affectcost competitiveness is future adverse exchange rate movements between H-3C’slocal currency of operations and the U.S. Dollar.  In addition, competition in the enterprise networking market willinvolve challenges from numerous, well-established companies with substantialresources and significant market share.

 

Our business, businessprospects and operating results have dependencies upon the success ofH-3C.  In particular, our productdevelopment activities will become increasingly interdependent with those ofH-3C.  If H-3C and our transactions withit are not successful, we may not introduce new products needed to broaden ourhigh-end enterprise networking product line, which may adversely affect oursales and overall results of operations. Also, if H-3C enters into OEM agreements with companies who compete withus, we could face increased competition in the markets in which we operate.

 

***We may pursue acquisitions of other companies that, if not successful,could adversely affect our business, financial position and results ofoperations.***

 

The networking business ishighly competitive.  As a result, oursuccess is dependant, in part, on our ability to meet the needs of newcustomers and markets by enhancing existing products and solutions, andintroducing new products and solutions, on a timely basis.  Our efforts to enhance existing offeringsand develop new offerings include internal research and development activities,the H-3C joint venture, and other strategic relationships.  In the future, we may pursue acquisitions ofother companies with established market access and position or promisingtechnology and products to enhance our existing capabilities.

 

Acquisitions involvenumerous risks, including the following:

 

•                  potentialdifficulties related to integrating the technologies, products and operationsof the acquired company;

 

•                  divertingmanagement’s attention from the normal daily operations of the business;

 

•                  potentialdifficulties in completing projects associated with purchased in-processresearch and development;

 

•                  enteringmarkets in which we have no or limited direct prior experience and wherecompetitors in such markets have stronger market positions;

 

•                  potentialloss of key employees of the acquired company; and

 

•                  anuncertain sales and earnings stream from the acquired company, which may resultin unexpected dilution to our earnings.

 

There can be no assurancesthat any acquisitions that we might pursue will be successful.  If we pursue an acquisition but are notsuccessful in completing it, or if we complete an acquisition but are notsuccessful in integrating the acquired company’s technology, products oroperations successfully, our business, financial position or results ofoperations could be adversely affected.

 

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***We expect to utilize joint ventures and otheralliances as key elements in our strategy, if we are not successful in formingdesired ventures and alliances or if such ventures and alliances are notsuccessful, our ability to achieve our growth and profitability goals could beadversely affected.***

 

As discussed above, in November2003, we formed a joint venture in China for enterprise networkingproducts.  In addition, we haveannounced alliances with Electronic Data Systems Corporation (EDS), AspectCommunications Corporation, Crossbeam Systems, Inc., and Trapeze Networks.  At the present time, these relationships arein the early stages of development and have not yet produced the benefits thatwe hope to ultimately achieve.  In thefuture, we expect to evaluate other possible strategic relationships, includingjoint ventures and other types of alliances, and we may increase our relianceon such strategic relationships to broaden our sales channels, complementinternal development of new technologies and enhancement of existing products,and exploit perceived market opportunities. 

 

Strategic relationships canpresent a number of challenges. For example, we often compete in business areaswith companies with which we, at the same time, have strategic alliances inother business areas.  Also, if we failto form the number and quality of strategic relationships that we desire, or ifsuch strategic relationships are not successful, we could suffer missed marketopportunities, channel conflicts, delays in product development or delivery, orother operational difficulties. Further, if third parties acquire our strategic partners or if ourcompetitors enter into successful strategic relationships, we may faceincreased competition.  Any of thesedifficulties could have an adverse effect on our future sales and results ofoperations.    

 

***Our strategy of outsourcing functions and operations may fail to reducecost and may disrupt our operations.***

 

We continue to look for waysto decrease cost and improve efficiency by contracting with other companies toperform functions or operations that, in the past, we have performedourselves.  In the third quarter offiscal 2004, we completed the outsourcing of all manufacturing of our products.  We now rely on outside vendors to meet allof our manufacturing needs as well as a significant portion of our ITneeds.  To achieve more cost savings oroperational benefits, we may expand our outsourcing activities where we believea third party may be able to provide those services in a more efficientmanner.  Although we believe thatoutsourcing will result in lower costs and increased efficiencies, this may notbe the case.  Because these thirdparties may not be as responsive to our needs as we would be ourselves,outsourcing increases the risk of disruption to our operations.  In addition, our agreements with these thirdparties sometimes include substantial penalties for terminating such agreementsearly or failing to maintain minimum service levels.  Because we cannot always predict how long we will need the servicesor how much of the services we will use, we may have to pay these penalties orincur costs if our business conditions change.

 

***We may not be successful at identifying and responding to new andemerging market and product opportunities, or at responding quickly enough totechnologies or markets that are in decline.***

 

The markets in which wecompete are characterized by rapid technology transitions and short productlife cycles.  Therefore, our successdepends on our ability to:

 

•                  identifynew market and product opportunities;

 

•                  predictwhich technologies and markets will see declining demand;

 

•                  developand introduce new products and solutions in a timely manner;

 

•                  gainmarket acceptance of new products and solutions, particularly in the targetedemerging markets discussed above; and

 

•                  rapidlyand efficiently transition our customers from older to newer enterprisenetworking technologies.

 

Our financial position orresults of operations could suffer if we are not successful in achieving thesegoals.  For example, our business wouldsuffer if:

 

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•                  thereis a delay in introducing new products;

 

•                  thereare fewer customers interested in our products than we expected;

 

•                  ourproducts do not satisfy customers in terms of features, functionality orquality; or

 

•                  ourproducts cost more to produce than we expect.

 

Our business would suffer ifnegative effects such as these were to occur in those product markets that wehave identified as emerging high-growth opportunities.  One factor that may cause greater difficultyfor us in quickly and effectively introducing new products with the features,functionality, quality, and costs that are optimal for the market is our increasedreliance on relationships with strategic partners, such as original designmanufacturers (ODMs).  Because ODMsmanufacture the products of other companies as well as ours, the timeliness ofthe availability of our products depends, in part, on their productionschedules.  In addition, we are relyingon ODMs to manufacture products that meet our specifications with regard toquality and cost.  We will continue tosource other products from OEMs and from H-3C. Finally, since we rely on our strategic partners, we may not be able toindependently identify current product and technology trends and to respond tosuch trends as well as if we were working independently.

 

***Our past and possible future decisions to exit certain product linesmay have unforeseen negative impacts to our business.***

 

We previously exited or soldsome of our businesses and product lines. In some cases, we continue to be responsible pursuant to the originalwarranty obligations for these products. Our exiting of these businesses and product lines may have adverselyaffected our relationships with channel partners and end customers.  Many of these channel partners and customersperceived our remaining products as not being part of a larger integrated orcomplementary solution, or questioned our commitment to their markets.  Consequently, they chose to purchaseproducts from alternative vendors.  Wemay consider exiting other businesses or product lines that do not meet ourgoal of delivering satisfactory financial returns.  Future decisions to exit businesses or product lines could resultin deterioration of our channel partner and customer relationships, increasedemployee costs (such as severance, outplacement and other benefits), contracttermination costs, and asset impairments.

 

***Our investment in technologies which are unproven or for which we havenot yet demonstrated success in the marketplace may not produce the benefits weexpect.***

 

We are making significantinvestments in various new technologies and product lines.  These investments have included XRNâ (eXpandableResilient Networking) technology, Gigabit Ethernet technology, InternetProtocol (IP) telephony, wireless LANs, Layer 3+ switching, network securitytechnology (such as our embedded firewall products), and Network Jack switches.  We expect new products and solutions basedon these technologies to contribute to future growth in our sales.  However, the markets for some of theseproducts and solutions are still emerging and the market potential for ourproducts and solutions based on these technologies remains unproven.  If customer demand for our products andsolutions based on these technologies does not develop as we expect, or if oursales and marketing strategies for these technologies are not effective, ourfinancial results could be adversely affected and we might need to change ourbusiness strategy.

 

***Our reliance on industry standards, a favorable regulatory environment,technological change in the marketplace, and new product initiatives may causeour sales to fluctuate or decline.***

 

The networking industry inwhich we compete is characterized by rapid changes in technology and customerrequirements, evolving industry standards, and complex governmentregulation.  As a result, our successdepends on:

 

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•                  theemergence of new technology or the convergence of technologies such as data andvoice networking or IP telephony;

 

•                  ourability to develop new products to address changes in technologies and relatedcustomer requirements on a timely basis;

 

•                  thetimely adoption and market acceptance of industry standards, and timelyresolution of conflicting U.S. and international industry standards;

 

•                  ourability to influence the development of emerging industry standards and tointroduce new and enhanced products that are compatible with such standards;and

 

•                  afavorable regulatory environment.

 

Slow market acceptance ofnew technologies, products, or industry standards could adversely affect oursales or overall results of operations. In addition, if our technology is not included in an industry standardon a timely basis or if we fail to achieve timely certification of complianceto industry standards for our products, our sales from sales of such productsor our overall results of operations could be adversely affected.

 

***A significant portion of our sales is derived from sales to a smallnumber of partners.  If any of thesepartners reduces its business with us, our business could be seriously harmed.***

 

We distribute many of ourproducts through two-tier distribution channels that include distributors,systems integrators and VARs.  Asignificant portion of our sales is concentrated among a few distributors; ourtwo largest customers accounted for a combined 37 percent of total sales forthe first quarter of fiscal 2005, a combined 33 percent of total sales forboth fiscal 2004 and fiscal 2003 and a combined 28 percent of total salesfor fiscal 2002.  Consolidation in ourdistribution channels and among personal computer manufacturers is reducing thenumber of customers in our domestic and international markets.  Also, we are implementing new marketingprograms that we believe will improve our effectiveness and productivity in ourexisting channels, particularly those that target small and mid-sizedbusinesses.  As an example, we aredecreasing volume rebates and replacing them with even higher levels of fundingin the form of market development funds, which will allow us to create more enduser demand for both us and our partners. In addition, we are reducing the total number of channel partners, andreducing the level of support provided to our lower volume channel partners, inorder to improve the focus and efficiency of our marketing expenditures.  If we are not successful in achieving ourobjectives for these initiatives, our sales and overall results of operationscould be adversely affected.

 

We also sell to personalcomputer manufacturers and telecommunications service providers.  There has been a trend of decreased demandfor connectivity products from our OEM customers due to increased integrationof networking connections with semiconductor components, and also to factorsspecific to our OEM customers.

 

***We depend on distributors who maintain inventories of ourproducts.  If the distributors reducetheir inventories of our products, our sales could be adversely affected.***

 

Our distributors maintaininventories of our products.  We workclosely with our distributors to monitor channel inventory levels and ensurethat appropriate levels of products are available to resellers and endusers.  We have improved certain of oursupply chain processes so that deliveries to our channel partners can be donemore rapidly, thereby enabling our channel partners to hold fewer weeks of supplyof our products in their inventory.  Ourtarget range for channel inventory levels is between four and five weeks supplyon hand at our distributors.  At the endof the first quarter of fiscal 2005, channel inventory levels were atapproximately 4.5 weeks supply.  Weexpect to operate our business with no greater than 4.5 weeks of channelinventory for the remainder of fiscal 2005. At this level of channel inventory, some of our channel partners willhold less than the average level of inventory, and others will be at a

 

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higher level.  Partners with a below-average inventorylevel may incur stock outs that would adversely impact our sales.  If our channel partners further reduce theirlevels of inventory of our products, our sales would be negatively impactedduring the period of change.

 

***We are in the process of making adjustments to the manner in which wesell our products and services.  Ifthose adjustments are unsuccessful, our sales may be negatively affected.***

 

As part of our distributionstrategy, we are targeting System Integrators (SIs), Service Providers (SPs),and enterprise VARs (eVARs).  Theseresellers typically have expertise in network design and implementation, whichis important when deploying end-to-end networking infrastructure solutions inlarger enterprises.  In addition tospecialized technical expertise, SIs, SPs and eVARs typically offersophisticated services capabilities that are frequently desired by largerenterprise customers.  In order toexpand our distribution channel to include resellers with such capabilities, wemust be able to provide effective support to these resellers.  If our sales, marketing or servicescapabilities are not sufficiently robust to provide effective support to suchSIs, SPs, and eVARs, we may not be successful in expanding our distributionmodel and current SI, SP, and eVAR partners may terminate their relationshipswith us, which would adversely impact our sales and overall results ofoperations.

 

***Our competition with Huawei in the enterprise networking market couldhave a material adverse affect on our sales and our results of operations.***

 

As Huawei expands itsinternational operations, there will be increasing instances where we competedirectly with Huawei in the enterprise networking market.  We expect to be able to compete effectivelywith Huawei in this market as a result of our strengths in a number of areasincluding our brand identity, breadth of products and solutions offerings, andprofessional services capabilities.  Wealso are free to engineer derivative models of products sourced from H-3C thatwould not be available to Huawei or other H-3C customers.  However, as a co-owner and OEM customer ofH-3C, Huawei will have access to many of H-3C’s products just as we do, therebyenhancing Huawei’s current ability to compete directly with us in marketsoutside of China and Japan.  If thisoccurs, we could lose a competitive advantage in those markets, which couldhave a material adverse effect on our sales and overall results of operations.  At the same time, however, to the extentthat this occurs and Huawei becomes a more significant customer of H-3C, wecould benefit indirectly as a result of our 49% ownership interest in H-3C.

 

***We may be unable to manage our supply chain successfully, which wouldadversely impact our sales, gross margin, and profitability.***

 

Current business conditionsand operational challenges in managing our supply chain affect our business ina number of ways:

 

•                  inthe past, some key components have had limited availability;

 

•                  thereare a smaller number of suppliers and we have narrowed our supplier base,including, in some cases, the sole sourcing of specific components from asingle supplier;

 

•                  asintegration of networking features on a reduced number of computer chipscontinues, we are increasingly facing competition from parties who are oursuppliers;

 

•                  ourability to accurately forecast demand is diminished, especially in light ofgeneral economic weakness and uncertainty following wars and terrorist events;

 

•                  oursignificantly increased reliance on, and long-term arrangements with,third-party manufacturers places much of the supply chain process out of ourdirect control and heightens the need for accurate forecasting and reduces ourability to transition quickly to alternative supply chain strategies; and

 

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•                  wemay experience disruptions to our logistics.

 

Some of our suppliers arealso our competitors.  We cannot becertain that in the future our suppliers, particularly those who are also inactive competition with us, will be able or willing to meet our demand forcomponents in a timely and cost-effective manner.

 

Increasingly, we have beensourcing a greater number of components from a smaller number of vendors. Also,there has recently been a trend toward consolidation of vendors of electroniccomponents.  This greater reliance on asmaller number of vendors and the inability to quickly switch vendors increasethe risk of logistics disruptions, unfavorable price fluctuations, ordisruptions in supply, particularly in a supply-constrained environment.

 

More recently, supplies ofcertain key components, such as memory, have become tighter as industry demandfor such components has increased. Also, the prices of certain other components have increased as theunderlying prices of raw materials needed to manufacture such components haveincreased.  This is putting upwardpressure on our costs as well as increasing the time necessary to obtain thesecomponents.  If this persists, we mayexperience an adverse impact to gross margin as costs either increase or do notdecline as fast as they had in the past.

 

Operation of the supplychain requires accurate forecasting of demand, which has become morechallenging.  If overall demand for ourproducts or the mix of demand for our products is significantly different fromour expectations, we may face inadequate or excess component supply orinadequate or excess manufacturing capacity. This would result in orders for products that could not be manufacturedin a timely manner, or a buildup of inventory that could not easily besold.  Either of these situations couldadversely affect our market share, sales, results of operations or financialposition.

 

***Our strategies to outsource all of our manufacturing requirements tocontract manufacturers, and for contract manufacturers to ship directly to ourcustomers, may not result in meeting our cost, quality or performancestandards.  The inability of anycontract manufacturer to meet our cost, quality or performance standards couldadversely affect our sales and overall results from operations.***

 

The cost, quality,performance, and availability of contract manufacturing operations are and willbe essential to the successful production and sale of many of ourproducts.  The inability of any contractmanufacturer to meet our cost, quality, performance, and availability standardscould adversely impact our sales and overall results of operations.  We may not be able to provide contractmanufacturers with product volumes that are high enough to achieve sufficientcost savings.  If shipments fall belowforecasted levels, we may incur increased costs or be required to takeownership of inventory.  In addition, asignificant component of maintaining cost competitiveness is the ability of ourcontract manufacturers to adjust their own costs and manufacturinginfrastructure to compensate for possible adverse exchange rate movements.  To the extent that the contractmanufacturers are unable to do so, and we are unable to procure alternativeproduct supplies, then our own competitiveness and results of operations couldbe adversely impacted.

 

Also, our ability to controlthe quality of products produced by contract manufacturers may be limited andquality issues may not be resolved in a timely manner, which could adverselyimpact our sales and overall results of operations.  We have implemented a program with our manufacturing partners toship products directly from regional shipping centers to customers.  Through this program, we are relying onthese partners to fill customer orders in a timely manner.  This program may not yield the efficienciesthat we expect, which would negatively impact our results of operations.  Any disruptions to on-time delivery tocustomers would adversely impact our sales and overall results of operations.

 

***Our customer order fulfillment capabilities fluctuate and maynegatively impact our operating results.***

 

The timing and amount of oursales depend on a number of factors that make estimating future operatingresults difficult.  Throughout ourbusiness, we do not typically maintain a significant amount of backlog,

 

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and sales are partiallydependent on our ability to appropriately forecast product demand.  In addition, our customers historicallyrequest fulfillment of orders in a short time period, resulting in limitedvisibility to sales trends and potential pricing pressures.  Consequently, our operating results dependon the volume and timing of orders and our ability to fulfill orders in atimely manner.  Historically, sales inthe third month of the quarter have been higher than sales in each of the firsttwo months of the quarter.  Non-linearsales patterns make business planning difficult, and increase the risk that ourquarterly results will fluctuate due to disruptions in functions such asmanufacturing, order management, information systems, and shipping.

 

***We may need to engage in complex and costly litigation in order toprotect, maintain or enforce our intellectual property rights.***

 

In addition to disputesrelating to the validity or alleged infringement of other parties’ rights, wemay become involved in disputes relating to our assertion of our intellectualproperty rights.  Whether we aredefending the assertion of intellectual property rights against us, orasserting our intellectual property rights against others, intellectualproperty litigation can be complex, costly, protracted, and highly disruptive tobusiness operations by diverting the attention and energies of management andkey technical personnel.  Further,plaintiffs in intellectual property cases often seek injunctive relief and themeasures of damages in intellectual property litigation are complex and oftensubjective or uncertain.  Thus, theexistence of this type of litigation, or any adverse determinations related tosuch litigation, could subject us to significant liabilities and costs.  If any of our OEM, ODM, or joint venturepartners become involved in intellectual property disputes and are unable tohold us harmless, then we may incur liabilities or suffer temporary disruptionof our business.  Any one of thesefactors could adversely affect our sales, gross margin, overall results of operations,cash flow or financial position.

 

***We may not be able to defend ourselves successfully against claims thatwe are infringing the intellectual property rights of others.***

 

Many of our competitors,such as telecommunications, networking, and computer equipment manufacturers,have large intellectual property portfolios, including patents that may covertechnologies that are relevant to our business.  In addition, many smaller companies, universities, and individualinventors have obtained or applied for patents in areas of technology that mayrelate to our business.  The industry ismoving towards aggressive assertion, licensing, and litigation of patents andother intellectual property rights.

 

In the course of ourbusiness, we frequently receive claims of infringement or otherwise becomeaware of potentially relevant patents or other intellectual property rightsheld by other parties.  We evaluate thevalidity and applicability of these intellectual property rights, and determinein each case whether we must negotiate licenses or cross-licenses toincorporate or use the proprietary technologies, protocols, or specificationsin our products.  If we are unable toobtain and maintain licenses on favorable terms for intellectual propertyrights required for the manufacture, sale, and use of our products,particularly those that must comply with industry standard protocols andspecifications to be commercially viable, our financial position or results ofoperations could be adversely affected. In addition, if we are alleged to infringe the intellectual propertyrights of others, we could be required to seek licenses from others or beprevented from manufacturing or selling our products, which could causedisruptions to our operations or the markets in which we compete.

 

***Fluctuations in our operating results and other factors may contributeto volatility in the market price of our stock.***

 

Historically, our stockprice has experienced substantial volatility. We expect that our stock price may continue to experience volatility inthe future due to a variety of potential factors such as:

 

•                  fluctuationsin our quarterly results of operations and cash flow;

 

•                  changesin our cash and short term investment balances;

 

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•                  variationsbetween our actual financial results and the published analysts’ expectations;and

 

•                  announcementsby our competitors.

 

In addition, over the pastseveral quarters, the stock market overall has experienced significant priceand volume fluctuations that have affected the stock prices of many technologycompanies.  These factors, as well asgeneral economic and political conditions or investors’ concerns regarding thecredibility of corporate financial statements and the accounting profession,may have a material adverse affect on the market price of our stock in thefuture.

 

***Item3******.******         *Quantitative andQualitative Disclosures About Market Risk**

 

We hold marketable equity traded securities that have a brief tradinghistory and are highly subject to market price volatility.  Equity security price fluctuations of plusor minus 50 percent would not have a material impact on the value of thesesecurities as of the end of the first quarter of fiscal 2005.

 

Additional information related to interest rate sensitivity and foreigncurrency exchange risk, is contained in Part II, Item 7A, Quantitative andQualitative Disclosures About Market Risk, in our Annual Report on Form 10-Kfor the fiscal year ended May 28, 2004.

 

***Item4******.*Controls and Procedures**

 

a.               We carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures as of the end ofour first fiscal quarter pursuant to Exchange Act Rule 13a-15(b).  Based upon that evaluation, our ChiefExecutive Officer and our Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed by us in reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.

 

Our review of our internal controls was made within the context of therelevant professional auditing standards defining “internal controls,”“reportable conditions,” and “material weaknesses.” “Internal controls” areprocesses designed to provide reasonable assurance that our transactions areproperly authorized, our assets are safeguarded against unauthorized orimproper use, and our transactions are properly recorded and reported, all topermit the preparation of our consolidated financial statements in conformitywith accounting principles generally accepted in the United States.“Significant deficiencies” are referred to as “reportable conditions,” orcontrol issues that could have a significant adverse effect on our ability toproperly authorize transactions, safeguard our assets, or record, process,summarize or report financial data in the consolidated financial statements. A“material weakness” is a particularly serious reportable condition where theinternal control does not reduce to a relatively low level the risk thatmisstatements caused by error or fraud may occur in amounts that would bematerial in relation to the consolidated financial statements and not bedetected within a timely period by employees in the normal course of performingtheir assigned functions. As part of our internal controls procedures, we alsoaddress other, less significant control matters that we identify, and wedetermine what revision or improvement to make, if any, in accordance with ouron-going procedures.

 

b.              There have been no changes in ourinternal control over financialreporting that occurred during our first fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II.      OTHER INFORMATION**

 

***Item1******.*****          Legal Proceedings**

 

The information set forth in Note 14 of Part I, Item 1 ofthis Form 10-Q is incorporated herein by reference.

 

***Item2******.*****          Unregistered Sales ofEquity Securities and Use of Proceeds**

 

During the fourth quarter offiscal 2003, our Board of Directors approved a new stock repurchase programthat authorizes expenditures of up to $100.0 million and is effective for atwo-year period through March 2005. We did not repurchase shares of ourcommon stock pursuant to this authorization in fiscal 2003 or 2004.  However, we began repurchasing shares of ourcommon stock pursuant to this authorization in the first quarter of fiscal2005, and we may use cash to repurchase additional shares in future periods. Inaddition, upon vesting of restricted stock awards, employees are permitted toreturn to us a portion of the newly vested shares to satisfy the taxwithholding obligations that arise in connection with such vesting.

 

The following table summarizes repurchases of our stock, includingshares returned to satisfy tax withholding obligations, in the quarter endedAugust 27, 2004:

 

 
| **Period**                                      |   | **Total  Number of  Shares  Purchased (1)** |   | **Average  Price Paid per  Share** |   | **Total  Number of  Shares Purchased as  Part of Publicly  Announced  Plans or Programs (2)** |       | **Approximate  Dollar Value of Shares  that May Yet Be  Purchased Under the  Plans or Programs** |        |
|-------------------------------------------------|--------|---------------------------------------------|--------|------------------------------------|--------|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|-------------|
|                                            |   |                                        |   |                               |   |                                                                                                    |       |                                                                                             |        |
| May 29, 2004 through June 28, 2004         |   | —                                      |   | —                             |   | —                                                                                                  |       | $                                                                                                | 100,000,000 |   |
| June 29, 2004 through July 28, 2004   |   | 7,094,281                                   |   | $                                  | 5.13   |                                                                                                    | 7,090,313  |                                                                                             | $           | 63,609,595 |   |
| July 29, 2004 through August 27, 2004 |   | 7,892,831                                   |   | $                                  | 4.68   |                                                                                                    | 7,892,831  |                                                                                             | $           | 26,635,406 |   |
| Total                                           |   | 14,987,112                                  |   | $                                  | 4.90   |                                                                                                    | 14,983,144 |                                                                                             |        |   |

 

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(1)          Includes 3,968shares returned to us from an employee to satisfy tax withholding obligationsthat arose upon the vesting of a restricted stock award.

 

(2)          Our currentstock repurchase program was announced on March 19, 2003 and permitsexpenditures of up to $100.0 million through March 2005.

 

***Item3******.*****          Defaults Upon SeniorSecurities**

 

None.

 

***Item 4.*****          Submission****of Mattersto a Vote of Security Holders**

 

None.

 

***Item 5.*****          OtherInformation**

 

None.

 

***Item 6.*****          Exhibitsand Reports on Form 8-K**

 

(a) Exhibits

 

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| **Exhibit****Number** |   | **Exhibit Description**                                                                                                                                                                   |   | **Incorporated by Reference** |   | **Filed****Herewith** |
|-----------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|-----------------------|
| **Form**              |   | **File No.**                                                                                                                                                                              |   | **Exhibit**                   |   | **Filing Date**       |
| 2.1                   |   | Master Separation and Distribution Agreement between the Registrant  and Palm, Inc. effective as of December 13, 1999                                                                |   | 10-Q                          |   | 0-12867               |   | 2.1 |   | 04/04/00 |   |   |
| 2.2                   |   | Tax Sharing Agreement between the Registrant and Palm, Inc.                                                                                                                               |   | 10-Q                          |   | 0-12867               |   | 2.7 |   | 04/04/00 |   |   |
| 2.3                   |   | Indemnification and Insurance Matters Agreement between the  Registrant and Palm, Inc.                                                                                                    |   | 10-Q                          |   | 0-12867               |   | 2.11 |   | 04/04/00 |   |   |
| 3.1                   |   | Corrected Certificate of Merger filed to correct an error in the  Certificate of Merger                                                                                                   |   | 10-Q                          |   | 0-12867               |   | 3.4 |   | 10/08/99 |   |   |
| 3.2                   |   | Registrant’s Bylaws, as amended on July 15, 2003                                                                                                                                |   | 10-K                          |   | 0-12867               |   | 3.2 |   | 08/09/04 |   |   |
| 3.3                   |   | Certificate of Designation of Rights, Preferences and Privileges of  Series A Participating Preferred Stock                                                                               |   | 10-Q                          |   | 0-12867               |   | 3.6 |   | 10/11/01 |   |   |
| 4.1                   |   | Third Amended and Restated Preferred Shares Rights Agreement, dated  as of November 4, 2002                                                                                          |   | 8-A/A                         |   | 0-12867               |   | 4.1 |   | 11/27/02 |   |   |
| 10.1                  |   | Severance Agreement and General Release as of July 21, 2004 by  and between the Registrant and Mark Slaven.                                                                          |   |                          |   |                  |   |   |   |   |   | X |
| 31.1                  |   | Certification of Principal Executive Officer                                                                                                                                              |   |                          |   |                  |   |   |   |   |   | X |
| 31.2                  |   | Certification of Principal Financial Officer                                                                                                                                              |   |                          |   |                  |   |   |   |   |   | X |
| 32.1                  |   | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |   |                          |   |                  |   |   |   |   |   | X |

 

(b) Reports on Form 8-K

 

(i)            On June 22, 2004, we furnished aCurrent Report on Form 8-K dated June 22, 2004 under Item 12 of Form 8-K,attaching a press release announcing our fourth quarter of fiscal 2004operating results.  This Current Reporton Form 8-K shall not be deemed to be incorporated by reference into thisQuarterly Report on Form 10-Q.

 

(ii)           On July 20, 2004, we furnished aCurrent Report on Form 8-K under Item 9 of Form 8-K, disclosing statements madeby Bruce Claflin, President and Chief Executive Officer of 3Com Corporation atan event hosted by Morgan Stanley. 

 

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**Signatures**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   |                  |   | 3Com Corporation                                               |
|--------|-----------------------|--------|----------------------------------------------------------------|
|   |                  |   | (Registrant)                                                   |
|   |                  |   |                                                           |
|   |                  |   |                                                           |
| Dated: | October 5,  2004 |   | By:                                                            | /s/ Donald M. Halsted, III |   |
|   |                  |   | Donald M. Halsted, III                                         |
|   |                  |   | Executive Vice President, Finance and  Chief Financial Officer |
|   |                  |   | (Principal Financial and  Accounting Officer)                  |
|        |                       |        |                                                                |  |  |

 

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**Exhibit Index**

 

 
| **Exhibit  Number** |   | **Exhibit Description**                                                                                                                                                                   |   | **Incorporated by Reference** |   | **Filed****Herewith** |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|-----------------------|
| **Form**            |   | **File No.**                                                                                                                                                                              |   | **Exhibit**                   |   | **Filing Date**       |   |
| 2.1                 |   | Master Separation and Distribution Agreement between the Registrant  and Palm, Inc. effective as of December 13, 1999                                                                |   | 10-Q                          |   | 0-12867               |   | 2.1 |   | 04/04/00 |   |   |
| 2.2                 |   | Tax Sharing Agreement between the Registrant and Palm, Inc.                                                                                                                               |   | 10-Q                          |   | 0-12867               |   | 2.7 |   | 04/04/00 |   |   |
| 2.3                 |   | Indemnification and Insurance Matters Agreement between the  Registrant and Palm, Inc.                                                                                                    |   | 10-Q                          |   | 0-12867               |   | 2.11 |   | 04/04/00 |   |   |
| 3.1                 |   | Corrected Certificate of Merger filed to correct an error in the  Certificate of Merger                                                                                                   |   | 10-Q                          |   | 0-12867               |   | 3.4 |   | 10/08/99 |   |   |
| 3.2                 |   | Registrant’s Bylaws, as amended on July 15, 2003                                                                                                                                |   | 10-K                          |   | 0-12867               |   | 3.2 |   | 08/09/04 |   |   |
| 3.3                 |   | Certificate of Designation of Rights, Preferences and Privileges of  Series A Participating Preferred Stock                                                                               |   | 10-Q                          |   | 0-12867               |   | 3.6 |   | 10/11/01 |   |   |
| 4.1                 |   | Third Amended and Restated Preferred Shares Rights Agreement, dated  as of November 4, 2002                                                                                          |   | 8-A/A                         |   | 0-12867               |   | 4.1 |   | 11/27/02 |   |   |
| 10.1                |   | Severance Agreement and General Release as of July 21, 2004 by  and between the Registrant and Mark Slaven.                                                                          |   |                          |   |                  |   |   |   |   |   | X |
| 31.1                |   | Certification of Principal Executive Officer                                                                                                                                              |   |                          |   |                  |   |   |   |   |   | X |
| 31.2                |   | Certification of Principal Financial Officer                                                                                                                                              |   |                          |   |                  |   |   |   |   |   | X |
| 32.1                |   | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |   |                          |   |                  |   |   |   |   |   | X |

 

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