**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

| **ý**                                                                                                                                                                                                                                                    | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**  |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                                          |
| **For the Quarterly Period Ended February 27, 2004**                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                                          |
| **OR**                                                                                                                                                                                                                                                        |
|                                                                                                                                                                                                                                                          |
| **o**                                                                                                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |   |
|                                                                                                                                                                                                                                                          |
| **For the transition period  from                  to                  ** |
|                                                                                                                                                                                                                                                          |
| **Commission File No. 0-12867**                                                                                                                                                                                                                               |

 

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**3ComCorporation**

(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 checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.**

 
| **Yes       ****ý** |   | **No       ****o** |
|---------------------------------------------------|--------|---------------------------------------------|

 

**Indicate by checkmark whether the registrant is an accelerated filer (as defined by Rule 12b-2of the Exchange Act).**

 
| **Yes       ****ý** |   | **No       ****o** |
|---------------------------------------------------|--------|---------------------------------------------|

 

**As of March 26,2004, 390,348,969 shares of the registrant’s Common Stock were outstanding.**

 

**This report containsa total of 43 pages of which this page is number 1.**

 

 

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**3ComCorporation**

 

**Tableof Contents**

 
|       |                                                                                        | **Page**                                                                                                                         |
|------------|---------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------|
| PART I.    | FINANCIAL INFORMATION                                                                       |                                                                                                                             |
|       |                                                                                        |                                                                                                                             |
| *Item 1.*  | Financial Statements                                                                        |                                                                                                                             |
|       |                                                                                        |                                                                                                                             |
|       |                                                                                        | Condensed Consolidated Statements of  Operations*Three  and Nine Months Ended February 27, 2004 and February 28, 2003* | 3 |
|       |                                                                                        |                                                                                                                             |   |
|       |                                                                                        | Condensed Consolidated Balance Sheets*February 27,  2004 and May 30, 2003*                                                  | 4 |
|       |                                                                                        |                                                                                                                             |   |
|       |                                                                                        | Condensed Consolidated Statements of Cash  Flows*Nine  Months Ended February 27, 2004 and February 28, 2003*           | 5 |
|       |                                                                                        |                                                                                                                             |   |
|       |                                                                                        | Notes to Condensed Consolidated Financial  Statements                                                                            | 6 |
|       |                                                                                        |                                                                                                                             |
| *Item 2.*  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 17                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 3.*  | Quantitative and Qualitative Disclosures  About Market Risk                                 | 40                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 4.*  | Controls and Procedures                                                                     | 40                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| PART II.   | OTHER INFORMATION                                                                           |                                                                                                                             |
|       |                                                                                        |                                                                                                                             |
| *Item 1.*  | Legal Proceedings                                                                           | 41                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 2.*  | Changes  in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities          | 41                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 3.*  | Defaults Upon Senior Securities                                                             | 41                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 4.*  | Submission of Matters to a Vote of Security  Holders                                        | 42                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 5.*  | Other Information                                                                           | 42                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| *Item 6.*  | Exhibits and Reports on Form 8-K                                                            | 42                                                                                                                               |
|       |                                                                                        |                                                                                                                             |
| Signatures | 43                                                                                          |

 

3Com is a registered trademark of 3Com Corporation or itssubsidiaries.  XRN is a trademark of3Com Corporation or its subsidiaries. CommWorks is a registered trademark ofUTStarcom, Inc.

 

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**PART I.  FINANCIAL INFORMATION**

***Item 1.*****          FinancialStatements**

 

**3Com CorporationCondensed Consolidated Statementsof Operations**

(Unaudited)

 
|                                                                                                                            |   | **Three  Months Ended**     |    | **Nine  Months Ended**      |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
| **(In thousands, except per share  data)**                                                                                      |   | **February 27,  2004** |    | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Sales                                                                                                                           |   | $                           | 171,769 |                        | $      | 216,503 |   | $ | 515,539 |   | $ | 757,866 |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Cost of sales                                                                                                                   |   | 111,500                     |    | 120,465                     |   | 348,376 |   | 399,540 |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Gross margin                                                                                                                    |   | 60,269                      |    | 96,038                      |   | 167,163 |   | 358,326 |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Operating expenses:                                                                                                             |   |                        |    |                        |   |   |   |   |   |
| Sales and marketing                                                                                                             |   | 61,846                      |    | 61,660                      |   | 190,090 |   | 178,498 |   |
| Research and development                                                                                                        |   | 23,776                      |    | 26,350                      |   | 75,124 |   | 86,130 |   |
| General and administrative                                                                                                      |   | 17,599                      |    | 23,952                      |   | 63,522 |   | 72,367 |   |
| Amortization and write down of intangibles                                                                                      |   | 1,071                       |    | 1,705                       |   | 5,553 |   | 8,804 |   |
| Restructuring charges                                                                                                           |   | 39,534                      |    | 52,144                      |   | 147,050 |   | 128,911 |   |
| Loss on land and facilities, net                                                                                                |   | —                      |    | —                      |   | — |   | 887 |   |
| Total operating expenses                                                                                                        |   | 143,826                     |    | 165,811                     |   | 481,339 |   | 475,597 |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Operating loss                                                                                                                  |   | (83,557                     | )       | (69,773                     | )      | (314,176 | ) | (117,271 | ) |
| Gain (loss) on investments, net                                                                                                 |   | 880                         |    | (14,570                     | )      | (11,314 | ) | (33,122 | ) |
| Interest and other income, net                                                                                                  |   | 3,612                       |    | 5,177                       |   | 11,364 |   | 18,683 |   |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Loss from continuing operations before  income taxes, equity interest, and cumulative effect of change in accounting  principle |   | (79,065                     | )       | (79,166                     | )      | (314,126 | ) | (131,710 | ) |
| Income tax provision (benefit)                                                                                                  |   | 1,626                       |    | (7,213                      | )      | (2,909 | ) | 179 |   |
| Equity interest in loss of unconsolidated  joint venture                                                                        |   | (4,196                      | )       | —                      |   | (16,789 | ) | — |   |
| Loss from continuing operations before  cumulative effect of change in accounting principle                                     |   | (84,887                     | )       | (71,953                     | )      | (328,006 | ) | (131,889 | ) |
| Discontinued operations, net of taxes                                                                                           |   | (685                        | )       | (7,289                      | )      | (2,541 | ) | (68,000 | ) |
| Loss before cumulative effect of change in  accounting principle                                                                |   | (85,572                     | )       | (79,242                     | )      | (330,547 | ) | (199,889 | ) |
| Cumulative effect of change in accounting  principle                                                                            |   | —                      |    | —                      |   | — |   | (45,447 | ) |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Net loss                                                                                                                        |   | $                           | (85,572 | )                           | $      | (79,242 | ) | $ | (330,547 | ) | $ | (245,336 | ) |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Basic and diluted loss per share:                                                                                               |   |                        |    |                        |   |   |   |   |   |
| Continuing operations before cumulative  effect of change in accounting principle                                               |   | $                           | (0.22   | )                           | $      | (0.20 | ) | $ | (0.87 | ) | $ | (0.36 | ) |
| Discontinued operations                                                                                                         |   | (0.00                       | )       | (0.02                       | )      | (0.01 | ) | (0.19 | ) |
| Cumulative effect of change in accounting  principle                                                                            |   | —                      |    | —                      |   | — |   | (0.13 | ) |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Net loss                                                                                                                        |   | $                           | (0.22   | )                           | $      | (0.22 | ) | $ | (0.88 | ) | $ | (0.68 | ) |
|                                                                                                                            |   |                        |    |                        |   |   |   |   |   |
| Shares used in computing per share amounts:                                                                                     |   |                        |    |                        |   |   |   |   |   |
| Basic and diluted                                                                                                               |   | 385,019                     |    | 361,020                     |   | 376,077 |   | 359,266 |   |

 

*See notes tocondensed consolidated financial statements.*

 

3

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**3Com CorporationCondensed Consolidated BalanceSheets**

(Unaudited)

 
| **(In thousands, except par value)**                                                                            |   | **February 27,  2004** |      | **May 30,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-----------------------------|-----------|-------------------|--------|
|                                                                                                            |   |                        |      |              |   |
| ASSETS                                                                                                          |   |                        |      |              |   |
| Current assets:                                                                                                 |   |                        |      |              |   |
| Cash and equivalents                                                                                            |   | $                           | 524,493   |              | $      | 515,848 |   |
| Short-term investments                                                                                          |   | 841,514                     |      | 968,740           |   |
| Accounts receivable, net                                                                                        |   | 86,971                      |      | 90,290            |   |
| Inventories                                                                                                     |   | 21,171                      |      | 27,068            |   |
| Other current assets                                                                                            |   | 58,035                      |      | 51,234            |   |
| Total current assets                                                                                            |   | 1,532,184                   |      | 1,653,180         |   |
|                                                                                                            |   |                        |      |              |   |
| Investment in Huawei-3Com joint venture                                                                         |   | 143,281                     |      | —            |   |
| Property and equipment, net                                                                                     |   | 71,770                      |      | 248,790           |   |
| Property and equipment held for sale                                                                            |   | 76,080                      |      | 101,283           |   |
| Deposits and other assets                                                                                       |   | 35,351                      |      | 43,962            |   |
| Deferred income taxes                                                                                           |   | 2,611                       |      | 2,211             |   |
| Intangible assets, net                                                                                          |   | 6,481                       |      | 12,035            |   |
| Goodwill                                                                                                        |   | 899                         |      | 899               |   |
|                                                                                                            |   |                        |      |              |   |
| Total assets                                                                                                    |   | $                           | 1,868,657 |              | $      | 2,062,360 |   |
|                                                                                                            |   |                        |      |              |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                       |   |                        |      |              |   |
| Current liabilities:                                                                                            |   |                        |      |              |   |
| Accounts payable                                                                                                |   | $                           | 96,837    |              | $      | 105,583 |   |
| Accrued liabilities and other                                                                                   |   | 250,442                     |      | 233,239           |   |
| Current portion of debt                                                                                         |   | —                      |      | 346               |   |
| Total current liabilities                                                                                       |   | 347,279                     |      | 339,168           |   |
|                                                                                                            |   |                        |      |              |   |
| Deferred revenue and long-term obligations                                                                      |   | 15,936                      |      | 4,595             |   |
|                                                                                                            |   |                        |      |              |   |
| Stockholders’ equity:                                                                                      |   |                        |      |              |   |
| Preferred stock, $.01 par value, 10,000  shares authorized; none outstanding                                    |   | —                      |      | —            |   |
| Common stock, $.01 par value, 990,000  shares authorized; shares outstanding: 390,101 and 367,796, respectively |   | 2,248,117                   |      | 2,138,016         |   |
| Notes receivable from sale of warrants                                                                          |   | —                      |      | (8,421            | )      |
| Unamortized stock-based compensation                                                                            |   | (2,847                      | )         | (1,474            | )      |
| Retained deficit                                                                                                |   | (736,528                    | )         | (405,981          | )      |
| Accumulated other comprehensive loss                                                                            |   | (3,300                      | )         | (3,543            | )      |
| Total stockholders’ equity                                                                                 |   | 1,505,442                   |      | 1,718,597         |   |
|                                                                                                            |   |                        |      |              |   |
| Total liabilities and stockholders’ equity                                                                 |   | $                           | 1,868,657 |              | $      | 2,062,360 |   |

 

*See notes tocondensed consolidated financial statements.*

 

4

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**3ComCorporation**

**CondensedConsolidated Statements of Cash Flows**

(Unaudited)

 
|                                                                                                                                                                           |   | **Nine  Months Ended**      |     |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|----------|
| **(In thousands)**                                                                                                                                                             |   | **February 27,  2004** |     | **February 28,  2003** |   |
|                                                                                                                                                                           |   |                        |     |   |   |
| Cash flows from operating activities:                                                                                                                                          |   |                        |     |   |   |
| Loss from continuing operations, including  cumulative effect of change in accounting principle                                                                                |   | $                           | (328,006 | ) | $ | (177,336 | ) |
| Adjustments to reconcile loss from  continuing operations, including cumulative effect of change in accounting  principle, to cash provided by (used in) operating activities: |   |                        |     |   |   |
| Loss from discontinued operations                                                                                                                                              |   | (2,541                      | )        | (68,000 | ) |
| Depreciation and amortization                                                                                                                                                  |   | 96,789                      |     | 130,317 |   |
| Write down of intangibles, including  cumulative effect of change in accounting principle                                                                                      |   | 1,905                       |     | 73,251 |   |
| Loss on property and equipment                                                                                                                                                 |   | 41,111                      |     | 77,758 |   |
| Losses on investments, net                                                                                                                                                     |   | 11,314                      |     | 33,122 |   |
| Equity interest in loss of unconsolidated  joint venture                                                                                                                       |   | 16,789                      |     | — |   |
| Deferred income taxes                                                                                                                                                          |   | (207                        | )        | 371 |   |
| Stock-based expense                                                                                                                                                            |   | 2,206                       |     | 5,627 |   |
| Changes in other assets and liabilities:                                                                                                                                       |   |                        |     |   |   |
| Accounts receivable                                                                                                                                                            |   | 3,319                       |     | 26,962 |   |
| Inventories                                                                                                                                                                    |   | (2,090                      | )        | 13,116 |   |
| Other assets                                                                                                                                                                   |   | (8,611                      | )        | 23,560 |   |
| Accounts payable                                                                                                                                                               |   | (8,746                      | )        | (7,137 | ) |
| Accrued liabilities and other                                                                                                                                                  |   | 23,120                      |     | (53,213 | ) |
| Income taxes payable                                                                                                                                                           |   | 4,711                       |     | (243 | ) |
|                                                                                                                                                                           |   |                        |     |   |   |
| Net cash provided by (used in) operating  activities                                                                                                                           |   | (148,937                    | )        | 78,155 |   |
|                                                                                                                                                                           |   |                        |     |   |   |
| Cash flows from investing activities:                                                                                                                                          |   |                        |     |   |   |
| Investment in Huawei-3Com joint venture                                                                                                                                        |   | (160,000                    | )        | — |   |
| Purchase of investments                                                                                                                                                        |   | (662,734                    | )        | (989,548 | ) |
| Proceeds from maturities and sales of  investments                                                                                                                             |   | 776,810                     |     | 753,663 |   |
| Purchase of property and equipment                                                                                                                                             |   | (12,552                     | )        | (17,727 | ) |
| Proceeds from sale of property and  equipment                                                                                                                                  |   | 100,240                     |     | 80,667 |   |
|                                                                                                                                                                           |   |                        |     |   |   |
| Net cash provided by (used in) investing  activities                                                                                                                           |   | 41,764                      |     | (172,945 | ) |
|                                                                                                                                                                           |   |                        |     |   |   |
| Cash flows from financing activities:                                                                                                                                          |   |                        |     |   |   |
| Issuance of common stock                                                                                                                                                       |   | 106,521                     |     | 12,648 |   |
| Repurchase of common stock                                                                                                                                                     |   | —                      |     | (1,548 | ) |
| Collection of note receivable issued for  warrants                                                                                                                             |   | 8,421                       |     | 8,421 |   |
| Repayments of long-term borrowings                                                                                                                                             |   | (346                        | )        | (31,020 | ) |
| Net repayments on line of credit                                                                                                                                               |   | —                      |     | (70,000 | ) |
| Other, net                                                                                                                                                                     |   | —                      |     | (69 | ) |
|                                                                                                                                                                           |   |                        |     |   |   |
| Net cash provided by (used in) financing  activities                                                                                                                           |   | 114,596                     |     | (81,568 | ) |
|                                                                                                                                                                           |   |                        |     |   |   |
| Effect of currency rate changes on cash                                                                                                                                        |   | 1,222                       |     | 762 |   |
|                                                                                                                                                                           |   |                        |     |   |   |
| Increase (decrease) in cash and equivalents                                                                                                                                    |   | 8,645                       |     | (175,596 | ) |
| Cash and equivalents, beginning of period                                                                                                                                      |   | 515,848                     |     | 679,055 |   |
|                                                                                                                                                                           |   |                        |     |   |   |
| Cash and equivalents, end of period                                                                                                                                            |   | $                           | 524,493  |   | $ | 503,459 |   |

 

*See notes tocondensed consolidated financial statements.*

 

5

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**3Com CorporationNotes to Condensed ConsolidatedFinancial Statements**

(Unaudited)

 

1.                                       Basisof Presentation

 

The unaudited condensed consolidated financial statements have beenprepared by 3Com Corporation (3Com or the Company), pursuant to the rules and regulationsof the Securities and Exchange Commission (SEC).  In the opinion of management, these unaudited condensedconsolidated financial statements include all adjustments necessary for a fairpresentation of 3Com’s financial position as of February 27, 2004 and May30, 2003, its results of operations for the three and nine months endedFebruary 27, 2004 and February 28, 2003, and its cash flows for thenine months ended February 27, 2004 and February 28, 2003.

 

On May 23, 2003, 3Com completed the sale of its CommWorks business unitand transferred selected assets and liabilities to UTStarcom, Inc.  Accordingly, the financial informationincluded herein for the three and nine months ended February 28, 2003 hasbeen restated to reflect CommWorks’ results of operations as a discontinuedoperation.

 

3Com uses a 52 or 53-week fiscal year ending on the Friday nearest toMay 31. The results of operations for the three and nine months endedFebruary 27, 2004 may not be indicative of the results to be expected forthe fiscal year ending May 28, 2004. These condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and related notesthereto included in 3Com’s Annual Report on Form 10-K for the fiscal year endedMay 30, 2003.

 

*Recent AccountingPronouncements*

 

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 is effective for fiscal periods beginningafter June 15, 2003; for 3Com, EITF 00-21 became effective for the secondquarter of fiscal 2004. 3Com’s historical revenue recognition policies andpractices conform to the requirements of EITF 00-21 and, thus, the adoption ofEITF 00-21 did not have a material effect on 3Com’s financial position orresults of operations.

 

In December 2003, the SEC released Staff AccountingBulletin No. 104, Revenue Recognition (SAB 104).  SAB 104 clarifies existing guidance regarding revenue forcontracts which contain multiple deliverables to make it consistent with EITFNo. 00-21.  The adoption of SAB 104 didnot have a material effect on 3Com's financial position or results ofoperations.

 

2.                                       Stock-BasedCompensation

 

As permitted under Statement of Financial Accounting Standards (SFAS)123, “Accounting for Stock-Based Compensation,” 3Com has elected to followAccounting Principles Board (APB) Opinion 25 and related Interpretations inaccounting for stock-based awards to employees.  Under APB Opinion 25, compensation cost associated with employeeawards is measured as the difference, if any, between the price to be paid byan employee and the fair value of the underlying common stock on the grantdate, which is usually the measurement date for accounting purposes.  3Com generally recognizes no compensationexpense with respect to granting of such stock option awards.  To the extent that 3Com has modified employeeawards in connection with its restructuring activities (usually throughextensions of the period of exercise for employees following their involuntarytermination), a compensation charge is taken at the time the related cashseverance is recorded.

 

Pro forma information regarding net loss and  loss per share is required by SFAS 123. This information

 

6

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is required to be presented as if 3Com had accounted for itsstock-based awards to employees, including grants of employee stock options andrights to purchase shares under the Employee Stock Purchase Plan (ESPP), underthe fair value method prescribed in that Statement.

 

As of February 27, 2004, and February 28, 2003, the expectedaverage life of employee stock options (ESO) was estimated at approximately oneand a half years after the vesting date. Although there were no purchase rightsgranted under the ESPP for the three months ended February 27, 2004 andFebruary 28, 2003, the expected average life of purchase rights grantedunder the ESPP in prior periods was estimated at six months from thesubscription date. The fair values of options granted during the third quarterof fiscal 2004 and 2003 and the first nine months of fiscal 2004 and 2003, andthe fair values of purchase rights granted under the ESPP during the first ninemonths of fiscal 2004 and 2003, have been estimated as of the date of grantusing the Black-Scholes option pricing model with the following assumptions,and resulting in the following per-share fair values:

 
|                                                        |   | **Three  Months Ended**     |   | **Nine  Months Ended**      |   |
|-------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                        |   | **February 27,  2004** |   | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                                        |   |                        |   |                        |   |   |   |   |   |
| Volatility-ESO                                              |   | 64.0                        | %      | 67.0                        | %      | 67.0 | % | 67.0 | % |
| Volatility-ESPP                                             |   | —                      |   | —                      |   | 45.0 | % | 49.0 | % |
| Risk-free interest rate-ESO                                 |   | 2.7                         | %      | 2.6                         | %      | 2.6 | % | 2.6 | % |
| Risk-free interest rate-ESPP                                |   | —                      |   | —                      |   | 1.0 | % | 1.4 | % |
| Dividend yield-ESO and ESPP                                 |   | 0.0                         | %      | 0.0                         | %      | 0.0 | % | 0.0 | % |
| Per-share fair value of options granted  under ESO          |   | $4.08                       |   | $2.37                       |   | $2.86 |   | $2.31 |   |
| Per-share fair value of purchase rights  granted under ESPP |   | —                      |   | —                      |   | $1.79 |   | $1.54 |   |

 

The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options that have no vesting restrictionsand are fully transferable.  Inaddition, option valuation models require the input of highly subjectiveassumptions, including the expected stock price volatility.  Because 3Com’s options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the fair value estimate,in the opinion of management, the existing models do not necessarily provide areliable single measure of the fair value of its options.

 

The following table illustrates the effect on net loss and net loss pershare if 3Com had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation. For purposes of these pro formadisclosures, the estimated fair value of the options is assumed to be amortizedover the applicable vesting periods.

 
|                                                                                |   | **Three  Months Ended**     |    | **Nine  Months Ended**      |   |
|-------------------------------------------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
| **(in thousands, except per share  amounts)**                                       |   | **February 27,  2004** |    | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                                                                |   |                        |    |                        |   |   |   |   |   |
| Net loss as reported                                                                |   | $                           | (85,572 | )                           | $      | (79,242 | ) | $ | (330,547 | ) | $ | (245,336 | ) |
| Add stock-based compensation included in  reported net loss                         |   | 955                         |    | 744                         |   | 2,206 |   | 3,915 |   |
| Deduct total stock-based compensation  determined under the fair value-based method |   | (4,229                      | )       | (3,951                      | )      | (14,918 | ) | (26,739 | ) |
| Pro forma net loss                                                                  |   | $                           | (88,846 | )                           | $      | (82,449 | ) | $ | (343,259 | ) | $ | (268,160 | ) |
|                                                                                |   |                        |    |                        |   |   |   |   |   |
| Net loss per share-basic and diluted:                                               |   |                        |    |                        |   |   |   |   |   |
| As reported                                                                         |   | $                           | (0.22   | )                           | $      | (0.22 | ) | $ | (0.88 | ) | $ | (0.68 | ) |
| Pro forma                                                                           |   | (0.23                       | )       | (0.23                       | )      | (0.91 | ) | (0.75 | ) |

 

7

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3.                                       RestructuringCharges

 

In fiscal 2001, 3Com began the restructuring of its business to enhancethe focus and cost effectiveness of its business units in serving theirrespective markets. The Company took several actions: it implemented areduction in workforce and other actions aimed at reducing costs and expenses;it exited product lines; it outsourced the manufacturing of certain high volumeserver, desktop and mobile connectivity products in a contract manufacturingarrangement; and it consolidated its real estate portfolio and made plans tosell some of its facilities as part of this restructuring effort. These effortscontinued through fiscal 2002.

 

As a result of a continuing decline in revenues, 3Comtook additional actions in fiscal 2003. The Company announced the integration of the support infrastructure oftwo of its business units to leverage a common infrastructure in order to driveadditional cost out of the business. Additionally, the Company entered into anagreement to outsource certain information technology (IT) functions, andcontinued to consolidate its real estate portfolio.

 

In response to further revenue declines and continuingnet losses, 3Com has taken additional measures to reduce costs in fiscal 2004.These actions include reductions in workforce, outsourcing of the Company’sremaining manufacturing operations in Dublin, Ireland, and continuing effortsto consolidate and dispose of excess facilities.

 

Accrued liabilities associated with restructuringcharges are classified as current, since 3Com intends to satisfy suchliabilities in cash in the current year, and are included in the caption“Accrued liabilities and other” in the accompanying condensed consolidatedbalance sheets.

 

*Fiscal 2004 Actions*

 

The following table provides a summary of the components of accruedrestructuring charges related to the restructuring actions initiated in thefirst three quarters of fiscal 2004, together with changes in the accruedamounts during the first three quarters of fiscal 2004 and the ending balancesof the associated accrued liabilities as of February 27, 2004 (inthousands):

 
|                              |   | **Employee  Separation  Expenses** |   | **Long-term  Asset  Write-downs** |   | **Facilities-  related  Charges** |   | **Other  Restructuring  Costs** |   | **Total** |   |
|-----------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|-----------|--------|
|                              |   |                               |   |                              |   |                              |   |                            |   |      |   |
| Balance at May 30, 2003           |   | **$**                              | — |                              | $      | —                            |   | $                               | — |      | $      | — |   | $ | — |   |
| Provision                         |   | 8,266                              |   | —                            |   | 34,952                            |   | 5,200                           |   | 48,418    |   |
| Payments and non-cash charges     |   | (4,278                             | )      | —                            |   | (34,952                           | )      | (10                             | )      | (39,240   | )      |
| Balance at August 29, 2003   |   | 3,988                              |   | —                            |   | —                            |   | 5,190                           |   | 9,178     |   |
| Provision                         |   | 22,986                             |   | 1,524                             |   | 28,894                            |   | 65                              |   | 53,469    |   |
| Payments and non-cash charges     |   | (8,843                             | )      | (1,524                            | )      | (28,316                           | )      | (65                             | )      | (38,748   | )      |
| Balance at November 28, 2003 |   | 18,131                             |   | —                            |   | 578                               |   | 5,190                           |   | 23,899    |   |
| Provision (benefit)               |   | 16,960                             |   | 674                               |   | 26,250                            |   | (4,681                          | )      | 39,203    |   |
| Payments and non-cash charges     |   | (31,005                            | )      | (674                              | )      | (26,308                           | )      | (509                            | )      | (58,496   | )      |
| Balance at February 27, 2004 |   | $                                  | 4,086  |                              | $      | —                            |   | $                               | 520    |      | $      | — |   | $ | 4,606 |   |

 

Employeeseparation expenses include severance pay, outplacement services, medical andother related benefits.  The reductionin workforce mainly affected employees involved with the Dublin manufacturingoperations, and also affected employees in sales and marketing, research anddevelopment, and general and administrative functions. Through February 27,2004, the total reduction in workforce associated with actions initiated duringfiscal 2004 includes approximately 1,100 employees who have been separated orwere in the separation process, and approximately 50 additional employees whohave been notified but have not yet worked their last day. Also, throughFebruary 27, 2004, total separation payments associated with actionsinitiated during fiscal 2004 have been approximately $42.8 million.

 

Long-termasset write-downs include assets that no longer support the continuingoperations of 3Com.

 

8

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Facilities-relatedcharges include write downs and accelerated depreciation of properties,including properties that were classified as held for sale prior to fiscal2004, as well as expenses related to lease terminations. In the first quarterof fiscal 2004, 3Com recorded $35.0 million in facilities-related charges,including $17.5 million for an impairment and accelerated depreciation of itsDublin manufacturing facility, an $11.2 million write down of a Santa Clara,California facility, $5.5 million of accelerated depreciation of an additionalSanta Clara facility due to 3Com’s plan to vacate the facility and move to asmaller Santa Clara facility already owned by 3Com, and a loss of $1.1 millionrelated to the sale of its Rolling Meadows, Illinois facility. These chargeswere offset by credits of $0.3 million related to fair value adjustments ofproperties classified as held for sale prior to fiscal 2004. In the secondquarter of fiscal 2004, 3Com recorded $28.9 million of facilities-relatedcharges, including $25.5 million of accelerated depreciation related to itsSanta Clara and Dublin facilities referred to above, a $1.4 million loss on thesale of certain other Santa Clara properties, charges of $1.4 million relatedto fair value adjustments of properties classified as held for sale prior tofiscal 2004, and $0.6 million related to estimated lease termination costs. Inthe third quarter of fiscal 2004, 3Com recorded $26.3 million offacilities-related charges, including $26.0 million of accelerated depreciationand impairments related to its Santa Clara and Dublin facilities and $0.3million related to estimated lease termination costs.

 

Otherrestructuring costs related mainly to estimated obligations expected to betriggered by 3Com’s outsourcing of its manufacturing operations in Dublin.  The net benefit recorded in the thirdquarter of fiscal 2004 resulted from settlement of the outsourcing-relatedobligations at amounts less than originally estimated.

 

*Fiscal 2003 Actions*

 

The following table provides a summary of thecomponents of accrued restructuring charges related to the restructuringactions initiated in fiscal 2003, together with changes in the accrued amountsduring the first three quarters of fiscal 2004 and the ending balances of theassociated accrued liabilities as of February 27, 2004 (in thousands):

 
|                              |   | **Employee  Separation  Expenses** |   | **Facilities-  related  Charges** |   | **Total** |   |
|-----------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|-----------|--------|
|                              |   |                               |   |                              |   |      |   |
| Balance at May 30, 2003           |   | $                                  | 4,517  |                              | $      | 2,341     |   | $ | 6,858 |   |
| Provision (benefit)               |   | (803                               | )      | 170                               |   | (633      | )      |
| Payments                          |   | (987                               | )      | (268                              | )      | (1,255    | )      |
| Balance at August 29, 2003   |   | 2,727                              |   | 2,243                             |   | 4,970     |   |
| Provision                         |   | 460                                |   | 1,709                             |   | 2,169     |   |
| Payments                          |   | (44                                | )      | (803                              | )      | (847      | )      |
| Balance at November 28, 2003 |   | 3,143                              |   | 3,149                             |   | 6,292     |   |
| Provision (benefit)               |   | 304                                |   | (184                              | )      | 120       |   |
| Payments                          |   | —                             |   | (260                              | )      | (260      | )      |
| Balance at February 27, 2004 |   | $                                  | 3,447  |                              | $      | 2,705     |   | $ | 6,152 |   |

 

Thenet benefit and additional charges recorded in the first three quarters offiscal 2004 for employee separation expenses relate to revisions of previousestimates of separation expenses associated with workforce reduction actionsinitiated during fiscal 2003.  ThroughFebruary 27, 2004, the total reduction in workforce associated with actionsinitiated during fiscal 2003 included 400 employees in the product development,sales, customer support, and general and administrative functions. Also,through February 27, 2004, total separation payments associated withactions initiated during fiscal 2003 have been approximately $17.0 million.

 

Theadditional charges and net benefit in the first three quarters of fiscal 2004for facilities-related charges relate to revisions in estimates of leasetermination costs for actions initiated in fiscal 2003.

 

9

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*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 three quarters of fiscal 2004 and the endingbalances of the associated accrued liabilities as of February 27, 2004 (inthousands):

 
|                              |   | **Long-term  Asset  Write-downs** |   | **Facilities-  related  Charges** |   | **Other  Restructuring  Costs** |   | **Total** |   |
|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|-----------|--------|
|                              |   |                              |   |                              |   |                            |   |      |   |
| Balance at May 30, 2003           |   | $                                 | — |                              | $      | 6,380                           |   | $         | 1,231  |   | $ | 7,611 |   |
| Provision                         |   | —                            |   | 824                               |   | 15                              |   | 839       |   |
| Payments                          |   | —                            |   | (1,365                            | )      | (676                            | )      | (2,041    | )      |
| Balance at August 29, 2003   |   | —                            |   | 5,839                             |   | 570                             |   | 6,409     |   |
| Provision                         |   | 916                               |   | 2,336                             |   | 2                               |   | 3,254     |   |
| Payments and non-cash charges     |   | (916                              | )      | (1,054                            | )      | (490                            | )      | (2,460    | )      |
| Balance at November 28, 2003 |   | —                            |   | 7,121                             |   | 82                              |   | 7,203     |   |
| Provision (benefit)               |   | 401                               |   | (190                              | )      | —                          |   | 211       |   |
| Payments and non-cash charges     |   | (401                              | )      | (859                              | )      | —                          |   | (1,260    | )      |
| Balance at February 27, 2004 |   | $                                 | — |                              | $      | 6,072                           |   | $         | 82     |   | $ | 6,154 |   |

 

Additionallong-term asset write-downs were related to assets previously used formanufacturing operations that were outsourced in fiscal 2002. Additionalfacilities-related charges were the result of revisions in estimates of leasetermination costs. Activity related to other restructuring costs primarilyreflected payments to suppliers and contract breakage fees.

 

4.                                       ComprehensiveLoss

 

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

 
|                                           |   | **Three  Months Ended**     |    | **Nine  Months Ended**      |   |
|------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                                           |   | **February 27,  2004** |    | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                           |   |                        |    |                        |   |   |   |   |   |
| Net loss                                       |   | $                           | (85,572 | )                           | $      | (79,242 | ) | $ | (330,547 | ) | $ | (245,336 | ) |
|                                           |   |                        |    |                        |   |   |   |   |   |   |   |   |   |
| Other comprehensive income (loss):             |   |                        |    |                        |   |   |   |   |   |
| Net unrealized gain (loss) on investments      |   | 1,075                       |    | (546                        | )      | (258 | ) | (55 | ) |
| Net unrealized loss on cash flow hedges        |   | (713                        | )       | —                      |   | (713 | ) | — |   |
| Change in accumulated translation  adjustments |   | 556                         |    | (224                        | )      | 1,214 |   | 650 |   |
|                                           |   |                        |    |                        |   |   |   |   |   |
| Total comprehensive loss                       |   | $                           | (84,654 | )                           | $      | (80,012 | ) | $ | (330,304 | ) | $ | (244,741 | ) |

 

5.                                       Net Loss PerShare

 

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

 

10

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|                                                                                        |   | **Three  Months Ended**     |    | **Nine  Months Ended**      |   |
|---------------------------------------------------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                                                                                        |   | **February 27,  2004** |    | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                                                                        |   |                        |    |                        |   |   |   |   |   |
| Loss from continuing operations before  cumulative effect of change in accounting principle |   | $                           | (84,887 | )                           | $      | (71,953 | ) | $ | (328,006 | ) | $ | (131,889 | ) |
| Loss from discontinued operations                                                           |   | (685                        | )       | (7,289                      | )      | (2,541 | ) | (68,000 | ) |
| Cumulative effect of change in accounting  principle                                        |   | —                      |    | —                      |   | — |   | (45,447 | ) |
| Net loss                                                                                    |   | $                           | (85,572 | )                           | $      | (79,242 | ) | $ | (330,547 | ) | $ | (245,336 | ) |
|                                                                                        |   |                        |    |                        |   |   |   |   |   |
| Weighted average shares-basic                                                               |   | 385,019                     |    | 361,020                     |   | 376,077 |   | 359,266 |   |
| Effect of dilutive securities:                                                              |   |                        |    |                        |   |   |   |   |   |
| Employee stock options                                                                      |   | —                      |    | —                      |   | — |   | — |   |
| Restricted stock                                                                            |   | —                      |    | —                      |   | — |   | — |   |
| Weighted average shares-diluted                                                             |   | 385,019                     |    | 361,020                     |   | 376,077 |   | 359,266 |   |
|                                                                                        |   |                        |    |                        |   |   |   |   |   |
| Net loss per share-basic and diluted:                                                       |   |                        |    |                        |   |   |   |   |   |
| Loss from continuing operations before  cumulative effect of change in accounting principle |   | $                           | (0.22   | )                           | $      | (0.20 | ) | $ | (0.87 | ) | $ | (0.36 | ) |
| Loss from discontinued operations                                                           |   | —                      |    | (0.02                       | )      | (0.01 | ) | (0.19 | ) |
| Cumulative effect of change in accounting  principle                                        |   | —                      |    | —                      |   | — |   | (0.13 | ) |
| Net loss                                                                                    |   | $                           | (0.22   | )                           | $      | (0.22 | ) | $ | (0.88 | ) | $ | (0.68 | ) |

 

Employeestock options and restricted stock totaling 11.0 million shares, 2.4 millionshares, 7.5 million shares, and 2.8 million shares for the three months endedFebruary 27, 2004 and February 28, 2003 and the nine months endedFebruary 27, 2004 and February 28, 2003, respectively, were notincluded in the diluted weighted average shares calculation as the effects of thesesecurities were anti-dilutive.

 

6.                                       Inventories

 

Inventories consist of (in thousands):

 
|            |   | **February 27,  2004** |   | **May 30,  2003** |   |
|-----------------|--------|-----------------------------|--------|-------------------|--------|
|            |   |                        |   |              |   |
| Finished goods  |   | $                           | 20,311 |              | $      | 15,891 |   |
| Work-in-process |   | 669                         |   | 3,228             |   |
| Raw materials   |   | 191                         |   | 7,949             |   |
|            |   |                        |   |              |   |
| Total           |   | $                           | 21,171 |              | $      | 27,068 |   |

7.                                       Investmentin Unconsolidated Joint Venture

 

OnNovember 17, 2003, 3Com formed the Huawei-3Com Joint Venture (H-3C) with asubsidiary of Huawei Technologies, Ltd. (Huawei). H-3C is domiciled in HongKong with principal operations in Hangzhou, China. At the time of formation,3Com contributed cash of $160.0 million, assets related to its operations inChina and Japan with a carrying value of $0.1 million, and licenses related tocertain intellectual property in exchange for 49 percent of the outstandingcommon shares of H-3C. 3Com recorded its initial investment in H-3C at $160.1million, reflecting 3Com’s carrying value for the assets contributed inexchange for the common shares received. Huawei contributed its enterprisenetworking business assets, including Local Area Network switches and routers,engineering and sales and marketing resources and personnel, and licenses toits related intellectual property in exchange for a 51 percent ownershipinterest.

 

Twoyears after formation of H-3C, 3Com has the one-time option to purchase anadditional two percent ownership interest from Huawei for an amount not toexceed $28 million. Three years after formation of H-3C, 3Com and Huawei eachhave the right to purchase all of the other partner’s ownership interest

 

11

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througha bid process.

 

3Com accounts for its investment in H-3C under the equitymethod. Under this method, 3Com records its proportionate share of H-3C’s netincome or loss based on the most recently available quarterly financialstatements of H-3C. Since H-3C has adopted a calendar year basis of reporting,3Com has reported its equity in H-3C’s net loss for H-3C’s first fiscal periodending December 31, 2003 in 3Com’s results of operations for the thirdquarter of fiscal 2004 under the caption “Equity interest in loss ofunconsolidated joint venture.” The reported loss for the third quarter offiscal 2004 was $4.2 million. Prospectively, 3Com will continue to report its equity in H-3C’s netincome or loss based on H-3C’s most recent quarterly financial statements, twomonths in arrears. Also, at the time of formation of H-3C, 3Com recorded acharge of $12.6 million representing 3Com’s ownership share (49 percent) of thevalue attributed to in-process technology contributed to H-3C by Huawei thathad not yet reached technological feasibility and had no alternative futureuse. This charge was included in 3Com’s results of operations for the secondquarter of fiscal 2004 under the caption “Equity interest in loss ofunconsolidated joint venture.”  For thefirst nine months of fiscal 2004, 3Com’s reported loss related to H-3C totaled$16.8 million.

 

Summarized information from the balance sheet and statementof operations for H-3C as of the end of its first fiscal period onDecember 31, 2003, and as of the date of its formation onNovember 17, 2003 were as follows (in thousands):

 
|                |   | **December 31,  2003** |    | **November 17,  2003** |   |
|---------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                |   |                        |    |                        |   |
| Current assets      |   | $                           | 208,252 |                        | $      | 160,000 |   |
| Non-current assets  |   | 198,502                     |    | 204,088                     |   |
| Current liabilities |   | 50,869                      |    | —                      |   |
|                |   |                        |    |                        |   |
| Sales               |   | 15,478                      |    | —                      |   |
| Gross margin        |   | 5,321                       |    | —                      |   |
| Net loss            |   | 8,187                       |    | 25,700                      |   |
|                     |        |                             |         |                             |        |  |  |

 

In determining 3Com’s share of the net loss of H-3C for its firstfiscal period, certain adjustments were made to H-3C’s financial statements.These adjustments included the deferral of profit for products sold to 3Comthat were part of 3Com’s inventory as of the end of December 31, 2003, aswell as the elimination of expense for the amortization of intangible assetsthat 3Com contributed to H-3C at the time of formation. After such adjustments,3Com recorded a loss of $4.2 million as its share of H-3C’s net loss for H-3C’sfirst fiscal period ended December 31, 2003; this loss is included in3Com’s results of operations for the third quarter and first nine months offiscal 2004 under the caption “Equity interest in loss of unconsolidated jointventure.”

 

3Com and H-3C are parties to agreements for the sale of certainproducts from 3Com to H-3C as well as from H-3C to 3Com. In addition, 3Comprovides certain services to H-3C related to warranty for its products sold toH-3C, as well as information technology services. For the three months endedFebruary 27, 2004, 3Com recorded sales to H-3C of approximately $3 million,and made purchases of approximately $4 million.  As of February 27, 2004, 3Com had trade receivables andpayables with H-3C of approximately $3 million and $4 million, respectively,which are included in the captions “Accounts receivable” and “Accounts payable,”respectively, in the accompanying consolidated balance sheet. Also as ofFebruary 27, 2004, 3Com had an additional receivable from H-3C ofapproximately $1 million related to the reimbursement of costs paid on theirbehalf, and is included in the caption “Other current assets” in theaccompanying consolidated balance sheet.

 

8.                                       Property andEquipment

 

Asa result of 3Com’s workforce reductions and relocation of its headquarters fromSanta Clara to

 

12

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Marlborough,Massachusetts during fiscal 2004, 3Com has excess office space in several buildings it owns in SantaClara.  During the first quarter offiscal 2004, 3Com decided to consolidate its office space and relocate from itscurrent locations into a smaller, vacant facility that was classified as heldfor sale as of May 30, 2003, and had a carrying value of $10.1 million. Due tothis decision, 3Com reclassified this previously held-for-sale facility as heldfor use. No impairment charge was recorded as a result of this reclassificationbecause the carrying value of the facility, which reflected fair value, wasless than what the net book value would have been had depreciation continued onthe facility during the period it was classified as held-for-sale.  During the third quarter of fiscal 2004,3Com relocated into this smaller facility and classified the previouslyoccupied Santa Clara facility as held for sale; the previously occupiedfacility had a carrying value of $33.9 million as of February 27, 2004.

 

In connectionwith 3Com’s outsourcing of its manufacturing operations, as discussed in Note3, 3Com classified certain land and facilities located in Dublin as held forsale at the end of the second quarter of fiscal 2004. The carrying value ofsuch properties was approximately $25.7 million as of February 27, 2004.

 

InNovember 2003, 3Com completed the sale of certain properties in SantaClara that were classified as held for sale as of May 30, 2003.  These properties, consisting ofapproximately 876,000 square feet of office and manufacturing space and relatedfurniture and fixtures, previously had been used by 3Com in its administrative,customer service, research and development, and manufacturing activities. Netproceeds from the sale were $62.4 million, resulting in a loss on the sale of$1.4 million that was recorded in restructuring charges in the second quarterof fiscal 2004.

 

In July 2003, 3Com completed the sale of its 511,000 square footoffice and research and development facility in Rolling Meadows. Net proceedsfrom the sale were $35.8 million, resulting in a loss on the sale of $1.1million that was recorded in restructuring charges in the first quarter offiscal 2004.  As part of the terms of thetransaction, 3Com entered into an agreement to lease back approximately 43,000square feet of space at then-prevailing market rates. This property was not classified as held forsale as of May 30, 2003 due to 3Com’sintention to lease back a portion of the facility.

 

9.                                       IntangibleAssets, Net

 

Intangibleassets, net, consist of (in thousands):

 
|                                 |   | **February 27,  2004** |   | **May 30,  2003** |   |
|--------------------------------------|--------|-----------------------------|--------|-------------------|--------|
|                                 |   |                        |   |              |   |
| Developed and core technology, gross |   | $                           | 37,138 |              | $      | 42,574 |   |
| Accumulated amortization             |   | (30,657                     | )      | (30,619           | )      |
| Net developed and core technology    |   | 6,481                       |   | 11,955            |   |
|                                 |   |                        |   |              |   |
| Customer relationships, gross        |   | 420                         |   | 476               |   |
| Accumulated amortization             |   | (420                        | )      | (396              | )      |
| Net customer relationships           |   | —                      |   | 80                |   |
|                                 |   |                        |   |              |   |
| Total intangible assets, net         |   | $                           | 6,481  |              | $      | 12,035 |   |

 

In the first quarter of fiscal 2004, 3Comrecorded an impairment of intangible assets, consisting mainly of developed andcore technology, associated with its acquisition of the Gigabit Ethernetnetwork interface card business of Alteon Websystems in fiscal 2001. 3Comdetermined the amount of the impairment by comparing the carrying value of theintangible assets against the fair value, which was estimated asthe present value of expected future net cash flows discounted at a rate of tenpercent per year. The impairment resulted from reduced revenue and gross marginprojections as compared to the initial projections at the time of theacquisition, due to the earlier-than-expected end of life of an acquiredproduct. As a result of the impairmentanalysis, 3Com recorded a write down of $1.9 million, which is included in thecaption “Amortization and write down of intangibles” in the condensed

 

13

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consolidated statements of operations for thenine months ended February 27, 2004.

 

Based on the carrying value of 3Com’s intangibleassets as of February 27, 2004, amortization expense is expected to be$1.1 million for the fourth quarter of fiscal 2004, $3.5 million for fiscal2005, and $1.9 million for fiscal 2006.

 

10.                                 AccruedWarranty and Other Guarantees

 

Products are sold with varying lengths of warranty ranging from 90 daysto the lifetime of the products.  Allowances for estimated warranty costs are recorded in the period ofsale, based on historical experience related to product failure rates andactual warranty costs incurred during the applicable warranty period. Also, onan ongoing basis, 3Com assesses the adequacy of its allowances related towarranty obligations recorded in previous periods and may adjust the balancesto reflect actual experience or changes in future expectations.

 

The following table summarizes the activity in the allowance forestimated warranty costs for the nine months ended February 27, 2004 andFebruary 28, 2003 (in thousands):

 
|                                                                               |   | **First nine  months of  fiscal 2004** |   | **First nine  months of  fiscal 2003** |   |
|------------------------------------------------------------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|
|                                                                               |   |                                   |   |                                   |   |
| Accrued warranty, May 30, 2003 and May 31,  2002, respectively                     |   | $                                      | 44,775 |                                   | $      | 53,289 |   |
| Cost of warranty claims                                                            |   | (26,340                                | )      | (32,768                                | )      |
| Accruals for warranties issued during the  period                                  |   | 25,590                                 |   | 22,766                                 |   |
| Adjustments to preexisting warranties                                              |   | (23                                    | )      | 5,551                                  |   |
| Net change associated with discontinued  operations                                |   | —                                 |   | (2,305                                 | )      |
|                                                                               |   |                                   |   |                                   |   |
| Accrued warranty, February 27, 2004  and February 28, 2003, respectively |   | $                                      | 44,002 |                                   | $      | 46,533 |   |

 

In prior years, 3Com entered into several agreements whereby it had soldproduct to resellers who had, in turn, sold the product to others, and 3Com hasguaranteed the payments of the end users. If all end users under theseagreements were to default on their payments as of February 27, 2004, 3Comwould be required to pay approximately $5.6 million. However, since deferredrevenue and other associated accruals related to such sales approximate theguaranteed amounts, any payments resulting from end user defaults would nothave a material impact on 3Com’s results of operations.

 

In connection with the development of its facility in RollingMeadows, 3Com guaranteed a municipal bond in the amount of $2.5 million forsite improvements. 3Com’s obligation pursuant to the guarantee had been accruedas of May 30, 2003. In connection with the completion of the sale of theRolling Meadows facility in the first quarter of fiscal 2004, as discussed inNote 3, 3Com repaid the $2.5 million municipal bond. As of February 27, 2004, 3Com’s liabilities included $2.8million for similar obligations related to various facilities that 3Com hasvacated.

 

11.                                 Stock Plans

 

In September 2003, 3Com’s stockholders approved 3Com’s 2003Stock Plan (the new plan), which replaced the 1983 Stock Option Plan, the 1994Stock Option Plan, the Director Plan, and the Restricted Stock Plan (the priorplans) for all stock awards granted subsequent to the approval date. Inconnection with the approval of the new plan, 3Com cancelled all sharesavailable for issuance under the prior plans (other than those shares underlyingoutstanding awards), which included approximately 128 million shares at thetime of approval; at the same time, 20 million shares were reserved forissuance under the new plan.

 

Inaddition, stockholders approved an increase of five million shares availablefor issuance under

 

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3Com’s1984 Employee Stock Purchase Plan.

 

12.                                 BusinessSegment Information

 

During fiscal 2003, 3Com reported its continuing operationsin three segments. Two of these segments—enterprise networking andconnectivity—represented ongoing business lines, and the third segment relatedto products that were exited prior to fiscal 2003. Effective for fiscal 2004,3Com streamlined its management and operating structure, and merged its previousmultiple operating segments into a single, integrated enterprise networkingbusiness. As a result, 3Com now presents financial information related to itsbusiness on the basis of a single segment.

 

Presented below are 3Com’s sales by geography (in thousands):

 
|                              |   | **Three  Months Ended**     |    | **Nine  Months Ended**      |   |
|-----------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                              |   | **February 27,  2004** |    | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                              |   |                        |    |                        |   |   |   |   |   |
| Americas                          |   | $                           | 56,889  |                        | $      | 75,696 |   | $ | 186,416 |   | $ | 323,054 |   |
| Europe, Middle East, & Africa |   | 86,451                      |    | 101,188                     |   | 238,249 |   | 310,591 |   |
| Asia Pacific Rim                  |   | 28,429                      |    | 39,619                      |   | 90,874 |   | 124,221 |   |
|                              |   | $                           | 171,769 |                        | $      | 216,503 |   | $ | 515,539 |   | $ | 757,866 |   |

 

13.                                 Litigation

 

3Com is aparty to lawsuits in the normal course of its business.  Litigation can be expensive and disruptive tonormal business operations. Moreover, the results of complex legal proceedingsare difficult to predict.  3Com believesthat it has meritorious defenses in each of the cases set forth below in whichit is named as a defendant and is vigorously contesting each of thesematters.  An unfavorable resolution ofone or more of these lawsuits could adversely affect its business, results ofoperations, or financial condition. 3Com cannot estimate the loss or range of loss that may be reasonablypossible for any of the contingencies described and accordingly has notrecorded any associated liabilities in its condensed consolidated balancesheets.

 

On March 4, 2003, 3Com filed suit against PCTEL, Inc., (PCTEL) inthe United 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 3Com 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 group selectable data communication equipment”seeking damages and injunctive relief,****andfurther seeking a declaration that PCTEL does not infringe 3Com PatentsNumbered 5,872,836, 5,646,983, 5,724,413, 6,097,794, 6,696,660, 5,532,898 and5,777,836, and that such patents are void and invalid.  The action which 3Com initiated in the DistrictCourt for the Northern District of Illinois was transferred to the DistrictCourt for the Northern District of California on June 11, 2003 andassigned Civil Action Number C 03 2710. On August 18, 2003, that actionwas consolidated for certain purposes with the action PCTEL initiated against3Com in the Northern District of California.

 

On May 30,2003, PCTEL filed suit against 3Com in the Superior Court of the State ofCalifornia in and for the County of Santa Clara, CV  817522, alleging violations of California unfair competition lawsseeking damages and injunctive relief. 3Com removed the action to the United States District Court for theNorthern District of California on July 3, 2003 and it was assigned CivilAction Number C 03 3124. On December 12, 2003, PCTEL voluntarily dismissedthis suit without prejudice.

 

InNovember 2000, a shareholder derivative and class action lawsuit,captioned *Shaev v. Claflin, et al.*,

 

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No. CV794039,was filed in California Superior Court. The complaint alleges that 3Com’sdirectors and officers breached their fiduciary duties to 3Com in connectionwith the adjustment of employee and director stock options in connection withthe separation of 3Com and Palm. On May 13, 2003, the Court dismissed theSecond Amended Complaint.  The plaintiffhas appealed the Court’s decision.

 

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. 3Com completed its acquisition of these companies on June 14,1997.  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 United States Patent Number5,596,656, entitled “Unistrokes for Computerized Interpretation ofHandwriting.”  Xerox sought to recoverdamages and to permanently enjoin the defendants from infringing the patent inthe future.  In 2000, the District Courtdismissed the case, ruling that there was no infringement.  On appeal, the Court of Appeals for theFederal Circuit affirmed-in-part, reversed-in-part and remanded the case to theDistrict Court for further action.  OnDecember 20, 2001, the District Court granted Xerox’s motion for summaryjudgment that the patent is valid, enforceable, and infringed.  The defendants then filed a Notice ofAppeal.  On February 22, 2002, theDistrict Court denied Xerox’s motion for an injunction prohibiting furtheralleged infringement during the appeal and ordered the defendants to post abond in the amount of $50 million.  Xeroxthen appealed the denial of the injunction. On February 20, 2003, the Court of Appeals issued its decisionaffirming in part and reversing in part the order of the trial court.  The Court of Appeals affirmed the grant ofsummary judgment of infringement, reversed the grant of summary judgment ofvalidity and remanded the case to the trial court to conduct a completevalidity analysis.  In connection withthe separation of Palm from 3Com, pursuant to the terms of the Indemnificationand Insurance Matters Agreement, dated February 26, 2000, between 3Com andPalm, Palm (since renamed palmOne) agreed to indemnify and hold 3Com harmlessfor any damages or losses that might arise out of the Xerox litigation.

 

OnSeptember 25, 2000 Northrop Grumman Corporation (Northrop) filed suit inthe United States District Court for the Eastern District of Texas, CivilAction No. 1:00CV-652, against Intel Corporation, 3Com Corporation, Xircom,Inc., D-Link Systems, Inc. and The Linksys Group, Inc. alleging infringement ofUnited States Patent Number 4,453,229 which was issued in 1982.  Based on the trial court’s claimconstruction after a Markman Hearing on June 8, 2001, and after briefingby the parties, the trial court entered a judgment of noninfringement in favorof defendants 3Com and Linksys Group, Inc., from which Northrop appealed.  On March 31, 2003, the United StatesCourt of Appeals for the Federal Circuit issued its ruling reversing the orderof the trial court and remanding the case back to the trial court for furtherproceedings. 3Com and Northrop settled this matter in the first quarter offiscal 2004.

 

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**3ComCorporation**

 

***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:

 

•                  Financial position and results of operations,including restoring 3Com to profitability, income from continuing operations,general and administrative expense, amortization expense, and total operatingexpenses;

•                  Expected quarterly reductions of cost of sales andoperating expenses resulting from restructuring activities, including theimpact on cash from operations;

•                  Cash flow from operating activities and our ability tosatisfy anticipated cash requirements for the next twelve months;

•                  Sales growth, enhancement of our direct sales, serviceand support capabilities and the development of new sales channels;

•                  Increased revenue and the sources and concentration ofrevenue;

•                  Accounting treatment of our share of the net income /loss of the Huawei-3Com joint venture;

•                  Channelinventory levels;

•                  Development and expansion of our products andsolutions and those of the Huawei-3Com joint venture, our sourcing of productsfrom original equipment manufacturers and the Huawei-3Com joint venture, andour product mix, including the declining sales of our connectivity products;

•                  Relationships with suppliers and strategic partners,including increased reliance on strategic relationships;

•                  Consolidation of operations and the disposal of excessfacilities;

•                  Activities of 3Com Ventures, including capital callpayments to certain venture capital funds;

•                  Our restructuringand cost-reduction efforts, including facilities-related charges and severancecosts and the effects of our restructuring efforts;

•                  Sources of competition;

# **•**                  Prospects regarding certain litigation matters;

# **•**                  Researchand development efforts, including our investment in new technologies;

# **•**                  Obligationsrelated to leases, royalty and patent licensing arrangements and othercommitments and liabilities;

# **•**                  Outsourcingof our manufacturing operations, information technology activities and otherfunctions and operations, such as product testing and shipping; and

•                  Results of the relocation of corporate headquartersand certain management functions, and the relocation of other functions,including development, administrative and transaction processing functions.

 

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,”

 

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“continue,” or the negative of such terms, or othercomparable terminology.  Forward-lookingstatements also include the assumptions underlying or relating to any of theforegoing statements.

 

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 at thetime this report is filed.  We undertakeno obligation to update any forward-looking statements.

 

**BusinessOverview**

** **

3Com was incorporated on June 4, 1979.  A pioneer in the computer networkingindustry, we provide data and voice networking products and solutions, as wellas support and maintenance services, for enterprises and public sectororganizations of all sizes.  Building onour historical success in the networking infrastructure market, 3Com is aleader in delivering innovative networking products and solutions that arefeature-rich so they can support the increasingly more complex and demandingapplication environments in today’s businesses, while remaining easy toinstall, use, and operate, and yet still affordable to own.  3Com is also a leading provider of easy-to-use,reliable, high-performance connectivity solutions at the edge of the networkthat enable users to access information. Our competitive strengths include our strong balance sheet, intellectualproperty portfolio, distributor and customer relationships, and brand identity.

 

3Com has undergone significant changes in recent years,including:

 

•                  exitingproduct lines that were not expected to yield a satisfactory return oninvestment in the short term;

•                  significantheadcount reductions;

•                  outsourcingof information technology and other functions;

•                  outsourcingof all manufacturing activity; and

•                  sellingexcess facilities.

 

We believe an overview of these significant recent events ishelpful to an understanding of our operating results.

 

In the fourth quarter of fiscal2001, we undertook several broad initiatives in an attempt to return 3Com toprofitability. These initiatives included exiting certain product lines thatwere not expected to yield a satisfactory return on investment in the nearterm, and resulted in restructuring charges of $154.9 million in fiscal 2001.Excluding these exited product lines and our CommWorks business unit that wesold in fiscal 2003, our continuing operations included two businessunits—Business Connectivity Company (BCC) and Business Networks Company (BNC).These business units operated throughout all of fiscal 2002. During fiscal2002, we continued to experience declining revenue. In response to thisdecline, we undertook additional measures to further reduce costs, includingheadcount reductions, long term asset retirements, and outsourcingmanufacturing operations.  Thesemeasures led to restructuring charges of $109.0 million in fiscal 2002.

 

In the first quarter of fiscal 2003, as ourrevenue and overall financial performance continued to decline, we undertookseveral additional broad initiatives to achieve further cost savings. The firstof these actions included the integration of certain central functions of BCCand BNC in order to achieve cost savings, and restructuring charges resultedfrom this action. This integration did not substantially change our managementand operating structure, however, and we continued to operate on the basis oftwo separate business units (excluding exited product lines and the CommWorksbusiness unit as discussed above). In fiscal 2003, our business units were (1)connectivity, which included the majority of products previously managed underBCC, and (2) enterprise networking, which included all of the productspreviously managed under BNC as well as certain wireless and security offeringsthat were formerly part of BCC. Other actions pursued in fiscal 2003 wereheadcount reductions, outsourcing of certain information technology (IT)functions, and continuing efforts to sell excess facilities. All of theseactions

 

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generated restructuring charges totaling$184.9 million in fiscal 2003, but also resulted in reductions of ongoing salesand marketing, research and development, and general and administrativeexpenses for fiscal 2003 as compared to fiscal 2002.

 

Infiscal 2004, we are taking a number of actions, affecting both revenue andexpenses, with the objective of restoring 3Com to profitability.  To increase revenue, we are expanding ourportfolio of products to include more Layer 3-plus and higher-end products, afull line of modular switches and routers, and a higher-end Voice-over-InternetProtocol (IP) offering.  As part of thisstrategy, and as described in more detail below, we have formed the Huawei-3ComJoint Venture (H-3C) with Huawei Technologies, Ltd., which will allow us toexpand our product portfolio further to include additional router and modularswitching products. We believe that this expanded product portfolio will allowus to deliver converged voice and data networking solutions not only to ourtraditional customers but also to larger and multi-site enterprises.  Also, in order to drive sales of thesehigher-end products, we are enhancing our direct touch sales, service and supportcapabilities, as well as developing new channels,such as system integrators and service providers.

 

Webelieve that we have begun to see the impact of some of these efforts. Revenuein the first nine months of fiscal 2004 included approximately $10 millionrelated to certain router and switch products that we sourced from Huawei priorto the launch of H-3C and that are now being sourced from H-3C. We willcontinue to maintain a reseller agreement with Huawei for other products notsourced from H-3C.

 

Other effortsare focused on reducing expenses. These efforts include creating a simplifiedbusiness model. Effective for fiscal 2004, we have combined the operations ofour former enterprise networking and connectivity business units, and nowmanage and report our operations as a single, integrated business. Theconnectivity products, while still part of our product portfolio, aredecreasing as a percentage of total revenue. The products formerly associatedwith the enterprise networking segment, managed from Marlborough,Massachusetts, are therefore increasing in importance. Our decision that wasannounced in May 2003 to move our corporate headquarters from Santa Clara,California to Marlborough was, in part, due to this trend. We expect that therelocation of our corporate headquarters and certain management functions toMarlborough will enable us to run the business more effectively andefficiently.

 

InJune 2003, we announced a reduction in workforce, most of which impactedgeneral and administrative expenses.  Inaddition, we relocated certain transaction processing functions to lower costlocations. In September 2003, we announced an additional reduction ofapproximately one-third of our workforce. The majority of the employeesimpacted by this reduction in workforce were involved in manufacturingoperations in Dublin, Ireland; we discontinued our internal manufacturingoperations and outsourced them to contract manufacturers during the thirdquarter of fiscal 2004. The remaining employees impacted by this reduction inworkforce are involved in certain product development functions that will bemoved to lower-cost locations by the end of fiscal 2004.  In March 2004, we made selectedreductions in sales and marketing personnel as part of our ongoing efforts torestructure and enhance our workforce consistent with our increased focus onenterprise networking; we expect to make additional reductions over theremainder of the fourth quarter of fiscal 2004.

 

As a result ofour restructuring efforts described above, including primarily the actions announcedin both June and September of 2003, we recorded restructuring chargesof $147.1 million in the first nine months of fiscal 2004. In addition, weexpect to record additional restructuring charges of approximately $5 millionin the fourth quarter of fiscal 2004. These actual and expected charges include the following main components:

 

•                  $47 million forfacilities-related, severance and other costs related to the outsourcing of ourmanufacturing operations in Dublin and other reductions in the supply chainworkforce;

 

•                  $71 million forother facilities-related costs; and

 

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•                  $30 million forother severance costs.

 

As a result ofthe aforementioned fiscal 2004 restructuring actions and related charges, andbased on our current projections for revenues, costs and expenses, which aresubject to significant uncertainty, we expect that cost of sales and operatingexpenses will be reduced by approximately $4 million per quarter and $16million per quarter, respectively, from the levels reported for the fourthquarter of fiscal 2003.  The expectedreduction in cost of sales reflects the fact that a portion of the direct coststhat we will avoid by outsourcing our manufacturing operations in Dublin willbe incurred in the future as costs of products procured from contractmanufacturers. The estimated reduction of $4 million per quarter  is expected to be fully realized in thefourth quarter of fiscal 2004; additional reductions in cost of sales areexpected in the fourth quarter of fiscal 2004 due to the absence oftransition-related expenses related to the outsourcing of Dublin manufacturingoperations that had been incurred in each of the first three quarters of fiscal2004. The majority of the estimated reduction in operating expenses of $16million is expected to be realized in the fourth quarter of fiscal 2004, andthe full reduction is expected to  berealized in the second quarter of fiscal 2005.

 

In November 2003, we formed H-3C with Huawei. At the time offormation, we contributed $160.0 million in cash, assets with a carrying valueof $0.1 million related to our China and Japan operations, and licenses tocertain intellectual property in exchange for a 49 percent ownership interest.  Huawei contributed its enterprise networkingbusiness assets, including Local Area Network (LAN) switches and routers,engineering and sales and marketing resources and personnel, and licenses toits related intellectual property in exchange for a 51 percent ownership interest.Two years after formation of H-3C, we have the one-time option to purchase anadditional two percent ownership interest from Huawei for an amount not toexceed $28 million. Three years after formation of H-3C, 3Com and Huawei eachhave the right to purchase all of the other partner’s ownership interestthrough a bid process.

 

In China and Japan, H-3C sells its own products, as well as products itpurchases directly from us and Huawei, in China and Japan. Outside of China andJapan, we resell H-3C’s products under the 3Comâbrand. Through this reseller agreement, we are expanding our product line toinclude router products and modular switching products. The addition of theseproducts to our product portfolio increases the size of the market opportunityfor which we can compete.

 

We account for our investment in H-3C under the equity method. At thetime of formation of H-3C, we recorded a charge of $12.6 million representingour ownership share (49 percent) of the value attributed to in-processtechnology contributed to H-3C by Huawei that had not yet reached technologicalfeasibility and had no alternative future use. This charge was included in ourresults of operations for the second quarter of fiscal 2004 under the caption“Equity interest in loss of unconsolidated joint venture.” Since the date offormation, we have recorded our proportionate share of H-3C’s net loss based onthe most recently available quarterly financial statements of H-3C.Accordingly, since H-3C reports on a calendar year basis, we have reported ourequity in H-3C’s net income or loss for the calendar quarter endingDecember 31, 2003 in our financial statements for the third quarter offiscal 2004.  For the first nine monthsof fiscal 2004, we have reported aggregate losses of $16.8 million related toour investment in H-3C. Prospectively, we will continue to report our equity inH-3C’s net income or loss based on H-3C’s most recent quarterly financialstatements, two months in arrears. As H-3C is in the initial stages of itsoperations, we do not expect the impact of H-3C’s results to significantlyaffect our results of operations in the near term.

 

We believethat the actions that we are taking in fiscal 2004 are consistent with ourgoals of increasing revenue and reducing expenses in order to achieveprofitability over the longer term. However, we expect that some of the steps that we are taking to improveour business over the longer term will result in ongoing downward pressure onprofitability in the near term.  Forexample, we are incurring significant charges for severance costs and writedowns of excess facilities. In addition, as we complete the transition of ourbusiness in China and Japan to H-3C, there could be continuing adverse impactson volumes, as well as lower average selling prices since the pricing ofproducts sold to H-3C under an original equipment manufacturer (OEM) agreementis lower than the pricing of products sold through the distributionchannels.  Over the next severalquarters, we believe that we must continue to increase

 

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both revenueand gross margin.  In addition, based onour current projections for revenue and gross margin over the next severalquarters, which are subject to significant uncertainty, we believe that we mustreduce total operating expenses (including restructuring charges) to an amountless than $100 million per quarter, as compared to $143.8 million for the mostrecent quarter, in order to achieve profitability.

 

The assumptions underlying our planned actions in fiscal 2004 couldprove to be inaccurate.  If currenteconomic conditions deteriorate, or if our actions are not successful inachieving our goals, there could be additional adverse impacts on our financialposition, results of operations or cash flows. In that case, we might need to modify our strategic focus andrestructure our business again to realign our resources and achieve additionalcost and expense savings.

 

For information regarding our Critical Accounting Policies, we referthe reader to our annual report on Form 10-K for the year ended May 30, 2003.

 

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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:

 
|                                                                                                                            |   | **Three  months ended**     |   | **Nine  months ended**      |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                                                                                            |   | **February 27,  2004** |   | **February 28,  2003** |   | **February 27,  2004** |   | **February 28,  2003** |   |
|                                                                                                                            |   |                        |   |                        |   |   |   |   |   |
| Sales                                                                                                                           |   | 100.0                       | %      | 100.0                       | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                                                                                                   |   | 64.9                        |   | 55.6                        |   | 67.6 |   | 52.7 |   |
| Gross margin                                                                                                                    |   | 35.1                        |   | 44.4                        |   | 32.4 |   | 47.3 |   |
| Operating expenses:                                                                                                             |   |                        |   |                        |   |   |   |   |   |
| Sales and marketing                                                                                                             |   | 36.0                        |   | 28.5                        |   | 36.9 |   | 23.5 |   |
| Research and development                                                                                                        |   | 13.8                        |   | 12.2                        |   | 14.5 |   | 11.4 |   |
| General and administrative                                                                                                      |   | 10.3                        |   | 11.0                        |   | 12.3 |   | 9.6 |   |
| Amortization and write down of intangibles                                                                                      |   | 0.6                         |   | 0.8                         |   | 1.1 |   | 1.2 |   |
| Restructuring charges                                                                                                           |   | 23.0                        |   | 24.1                        |   | 28.5 |   | 17.0 |   |
| Loss on land and facilities, net                                                                                                |   | —                      |   | —                      |   | — |   | 0.1 |   |
| Total operating expenses                                                                                                        |   | 83.7                        |   | 76.6                        |   | 93.3 |   | 62.8 |   |
| Operating loss                                                                                                                  |   | (48.6                       | )      | (32.2                       | )      | (60.9 | ) | (15.5 | ) |
| Gain (loss) on investments, net                                                                                                 |   | 0.5                         |   | (6.7                        | )      | (2.2 | ) | (4.4 | ) |
| Interest and other income, net                                                                                                  |   | 2.1                         |   | 2.3                         |   | 2.2 |   | 2.5 |   |
| Loss from continuing operations before  income taxes, equity interest, and cumulative effect of change in accounting  principle |   | (46.0                       | )      | (36.6                       | )      | (60.9 | ) | (17.4 | ) |
| Income tax provision (benefit)                                                                                                  |   | 1.0                         |   | (3.4                        | )      | (0.6 | ) | 0.0 |   |
| Equity interest in loss of unconsolidated  joint venture                                                                        |   | (2.4                        | )      | —                      |   | (3.3 | ) | — |   |
| Loss from continuing operations before  cumulative effect of change in accounting principle                                     |   | (49.4                       | )      | (33.2                       | )      | (63.6 | ) | (17.4 | ) |
| Discontinued operations, net of tax                                                                                             |   | (0.4                        | )      | (3.4                        | )      | (0.5 | ) | (9.0 | ) |
| Loss before cumulative effect of change in  accounting principle                                                                |   | (49.8                       | )      | (36.6                       | )      | (64.1 | ) | (26.4 | ) |
| Cumulative effect of change in accounting  principle                                                                            |   | —                      |   | —                      |   | — |   | (6.0 | ) |
| Net loss                                                                                                                        |   | (49.8                       | )%     | (36.6                       | )%     | (64.1 | )% | (32.4 | )% |

 

Sales

 

Sales in the third quarterof fiscal 2004 totaled $171.8 million, a decrease of $44.7 million, or 21percent, compared to the same quarter one year ago. Sales in the first ninemonths of fiscal 2004 totaled $515.5 million, a decrease of $242.3 million, or32 percent, compared to the same period one year ago.

 

Sales of ourdesktop, mobile, and server connectivity products in the third quarter andfirst nine months of fiscal 2004 decreased $27.5 million and $111.5 million,respectively, compared to the same periods one year ago. The decrease in salesof connectivity products was due to lower volumes and lower average sellingprices. We believe the lower volumes resulted from a shift in technologytowards alternative products; overall, product volumes decreased approximately27 percent in the third quarter of fiscal 2004 as compared to the same quarterone year ago and 33 percent in the first nine months of fiscal 2004 as comparedto the same nine-month period one year ago. Overall, average selling prices ofconnectivity products declined approximately 37 percent in the third quarter offiscal 2004 as compared to the same quarter one year ago and 28 percent in thefirst nine months of fiscal 2004 as compared to the same nine-month period oneyear ago. Another factor contributing to the decrease in sales of

 

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connectivityproducts in the first nine months of fiscal 2004 as compared to the samenine-month period one year ago was the one-time recognition of $15.0 million ofroyalty revenue from a paid-up license resulting from settlement of litigationwith Xircom, Inc. in the second quarter of fiscal 2003. We anticipate thatsales of connectivity products will decline approximately 40 percentsequentially in the fourth quarter of fiscal 2004, or approximately $9.0million, due to both reduced demand for our product offerings and increasingpricing pressures.

 

Sales of ourenterprise networking data and voice product lines in the third quarter andfirst nine months of fiscal 2004 decreased $16.2 million and $121.7 million,respectively, compared to the same periods one year ago. Although there wereincreases in unit volumes in enterprise networking data product lines, theoverall decreases in sales were driven primarily by increased price competitionacross all key product lines, and secondarily to an unfavorable shift inproduct mix. Sales of most enterprise data products declined in both thequarterly and nine-month periods. However, sales of our Gigabit Ethernet LAN switch and Wireless offeringsincreased in the third quarter of fiscal 2004 as compared to the same quarterone year ago; sales of Gigabit Ethernet LAN switch products increased in thenine-month period also. Sales of modular switch and router products initiallysourced from Huawei and now sourced from H-3C totaled approximately $5.0million in the third quarter of fiscal 2004 and $10.4 million for the firstnine months of fiscal 2004.  Thedecrease in sales of our enterprise networking voice products in the thirdquarter and first nine months of fiscal 2004 was the result of both increasedmarket competition as well as a slow transition to more competitive productofferings.

 

As compared tothe third quarter and first nine months of one year ago, sales of services andexited products decreased $1.0 million and $9.1 million, respectively. Whilelower maintenance contract renewals contributed to declines in both periods,the decline in sales as compared to the same nine-month period one year ago waslargely attributable to the recognition of revenue in the first quarter offiscal 2003 related to exited products that was deferred as of the end offiscal 2002.

 

*By Geography.* U.S. sales in the third quarterof fiscal 2004 represented 24 percent of total sales compared to 27 percent oftotal sales in the third quarter of fiscal 2003, and U.S. sales in the firstnine months of fiscal 2004 represented 28 percent of total sales compared to 35percent of total sales in the first nine months of fiscal 2003.In the third quarter of fiscal 2004, U.S. sales decreased 31 percentand international sales decreased 17 percent compared to the same period oneyear ago. In the first nine months of fiscal 2004, U.S. sales decreased 46percent and international sales decreased 24 percent compared to the sameperiod one year ago.

 

Thedeclines in sales of connectivity products discussed above occurred in allgeographic regions, but the declines were most pronounced in the U.S. market,where sales in the third quarter and first nine months of fiscal 2004 decreasedby 62 percent and 66 percent, respectively, as compared to the same three andnine-month periods one year ago. This decline in sales of connectivity productsin the U.S. market in the first nine months of fiscal 2004 includes theentirety of the $15 million of royalty revenue that resulted from settlement oflitigation with Xircom, Inc. as discussed above. The decline in sales ofenterprise networking data products in the third quarter of fiscal 2004 ascompared to the same quarter one year ago occurred mainly in the Europe, MiddleEast, and Africa (EMEA) and Asia Pacific Rim regions, whereas the decline inthe first nine months of fiscal 2004 as compared to the same nine-month periodone year ago occurred across all regions. Declines in sales of enterprisenetworking voice products as compared to the same periods one year ago werelargely confined to the U.S. market. The decline in sales of services andexited products in the third quarter of fiscal 2004 as compared to the samequarter one year ago occurred across all regions, whereas the decline in thefirst nine months of fiscal 2004 as compared to the same nine-month period oneyear ago occurred primarily in the U.S. market and, to a lesser extent, in theEMEA region.

 

Gross Margin

 

Grossmargin as a percentage of sales declined 9.3 percentage points from 44.4percent in the third quarter of fiscal 2003 to 35.1 percent in the thirdquarter of fiscal 2004. Gross margin as a percentage of

 

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salesdeclined 14.9 percentage points from 47.3 percent in the first nine months offiscal 2003 to 32.4 percent of sales in the first nine months of fiscal 2004.Significant components of the decrease in gross margins were as follows:

 
|                                                             |   | **Current  quarter** |   | **Year to  Date** |   |
|------------------------------------------------------------------|--------|----------------------|--------|-------------------|--------|
|                                                             |   |                 |   |              |   |
| Declines in standard-related margin                              |   | (3.5                 | )%     | (5.8              | )%     |
| Dublin manufacturing facility closure                            |   | (2.6                 | )      | (1.7              | )      |
| Duty refunds and proceeds from inventory  previously written off |   | (1.2                 | )      | (1.8              | )      |
| Volume-related impacts                                           |   | (0.4                 | )      | (2.5              | )      |
| Impact of royalty revenue                                        |   | —               |   | (1.1              | )      |
| Other                                                            |   | (1.6                 | )      | (2.0              | )      |
| Total                                                            |   | (9.3                 | )%     | (14.9             | )%     |

 

•                  The decline instandard-related margin as compared to the same quarter and nine-month periodone year ago was primarily the result of lower average selling prices (ASPs),and was secondarily due to an unfavorable shift in product mix. Theseunfavorable factors were partially offset by product cost reductions.

 

•                  As a result of our decision to outsource our remainingmanufacturing operations in Dublin, we recorded charges related tomanufacturing assets and other transition-related costs of $4.5 million and$9.2 million in the third quarter and first nine months of fiscal 2004,respectively.

 

•                  Gross margin in the third quarter and first ninemonths of fiscal 2004 did not benefit to any significant degree from dutyrefunds or proceeds from the sale of inventory that was previously writtenoff.  However, gross margin in the thirdquarter and first nine months of fiscal 2003 included benefits for duty refundsof $2.5 million and $13.9 million, respectively, related to such items.

 

•                  Volume-related impacts include higher post-saletechnical support costs, manufacturing overhead costs, and warranty costs as apercentage of sales.  Since a portion ofthese costs is not directly variable with sales, these costs did not decline atthe same rate as sales.

 

•                  Revenue in the first nine months of fiscal 2003included royalty revenue of $15.0 million related to the settlement oflitigation with Xircom. This revenue did not have any associated costs ofgoods.

 

Operating Expenses

 

Total operating expensesin the third quarter of fiscal 2004 were $143.8 million compared to $165.8million in the third quarter of fiscal 2003, or a net decrease of $22.0million.  Research and development andgeneral and administrative expenses decreased by $2.6 million and $6.4 million,respectively. In addition, amortization and write down of intangibles andrestructuring charges decreased by $0.6 million and $12.6 million,respectively.  Sales and marketingexpenses overall were relatively flat, increasing $0.2 million.

 

Total operating expensesin the first nine months of fiscal 2004 were $481.3 million compared to $475.6million in the first nine months of fiscal 2003, or a net increase of $5.7million. Sales and marketing expenses increased by $11.6 million. In addition,restructuring charges increased by $18.1 million. Offsetting these increaseswere lower research and development expenses ($11.0 million), general andadministrative expenses ($8.8 million), amortization and write down ofintangibles ($3.3 million) and reduced losses from asset disposals ($0.9million).

 

As a percent of sales,total operating expenses in the third quarter of fiscal 2004 were 83.7 percent,compared to 76.6 percent in the third quarter of fiscal 2003. In aggregate,sales and marketing, research and development, and general and administrativeexpenses were 60.1 percent of sales in the third quarter

 

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of fiscal 2004, comparedto 51.7 percent in the third quarter of fiscal 2003. As a percent of sales,total operating expenses in the first nine months of fiscal 2004 were 93.3percent, compared to 62.8 percent in the first nine months of fiscal 2003. Inaggregate, sales and marketing, research and development, and general andadministrative expenses were 63.7 percent of sales in the first nine months offiscal 2004, compared to 44.5 percent in the first nine months of fiscal2003.  To a significant degree, theseexpenses are controllable and discretionary over time, but they are notdirectly variable with sales levels within a particular period.

 

We allocate and report ITand facilities-related expenses as a component of cost of sales and operatingexpenses. On an overall basis, total operating expenses for the third quarterand first nine months of 2004 reflected a decrease in IT-related expenses, ascompared to the same three and nine month periods one year ago, largely as aresult of employee reductions and asset write offs associated with our IToutsourcing initiatives during fiscal 2003. Partially offsetting the decreasein IT-related expenses was a net increase in facilities-related expenses due toa reduction in rental and sublease income received. Such rental and subleaseincome is recorded as an offset to the associated facilities-related expenses.

 

Following is a moredetailed discussion of the factors affecting each major component of totaloperating expenses.

 

*Sales and Marketing. *Sales and marketing expenses in the third quarter offiscal 2004 increased $0.2 million as compared to the third quarter of fiscal2003, primarily due to increased workforce-related and travel and entertainmentexpenses, reflecting the addition of direct-touch sales representatives inconnection with our increased focus on the enterprise market, and an increasein facilities-related expenses. Largely offsetting these increases were reducedIT expenses, as well as reduced marketing expenses as a result of a shift inspending towards more focused, product and channel specific programs. Sales andmarketing expenses in the first nine months of fiscal 2004 increased $11.6million as compared to the comparable period of fiscal 2003, primarily due toincreased workforce-related, travel and entertainment and facilities-relatedexpenses as discussed above. Partly offsetting these increases were reduced ITexpenses and reduced marketing spending as discussed above.

 

*Research and Development. *Research and development expenses in the third quarterof fiscal 2004 decreased $2.6 million as compared to the third quarter offiscal 2003 due to reduced IT expenses and reduced workforce expenses as aresult of restructuring activities. Partly offsetting these reductions wereincreased use of third parties for development work, as well as an increase infacilities-related expenses. Research and development expenses in the firstnine months of fiscal 2004 decreased $11.0 million as compared to the firstnine months of fiscal 2003, due to reduced IT expenses, depreciation expenserelated to engineering assets reflecting write-downs and disposals associatedwith our restructuring initiatives, and spending for project tools andmaterials. Partly offsetting these reductions were increased third-partydevelopment work and facilities-related expenses.

 

*Generaland Administrative**. *General and administrative (G&A) expenses in thethird quarter of fiscal 2004 decreased $6.4 million as compared to the thirdquarter of fiscal 2003, due to several factors.  Factors that had the effect of decreasing G&A expenses ascompared to the same quarter one year ago included reduced legal andprofessional services costs related to the formation of H-3C; reducedworkforce-related expenses due to our restructuring initiatives, and reduced ITexpenses.  Partially offsetting thesereductions were increased bad debt expenses. G&A expenses in the first nine months of fiscal 2004 decreased $8.8million as compared to the first nine months of fiscal 2003, due to several factors.  Factors that had the effect of decreasingG&A expenses as compared to the same quarter one year ago included reducedworkforce-related, IT and bad debt expenses. Partially offsetting thesereductions was the impact of sales tax refunds in the prior year period thatdid not recur in the current year.

 

*Amortization and Write Down ofIntangibles.** *Amortization and write down ofintangibles decreased $0.6 million in the third quarter of fiscal 2004 ascompared to the third quarter of fiscal 2003. This decrease was due to reduced amortization expenses reflecting alower base of intangible assets as a result of an impairment charge during thefirst quarter of fiscal 2004. Amortization and write down of

 

25

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intangibles decreased$3.3 million in the first nine months of fiscal 2004 as compared to the firstnine months of fiscal 2003 due to reduced impairment charges, as well asreduced amortization expenses as discussed above. In the first nine months offiscal 2004, there was an impairment charge of $1.9 million related todeveloped and core technology associated with the acquisition of assets fromAlteon Websystems in fiscal 2001; in the prior year period, there was animpairment charge of $3.2 million related to developed and core technologyassociated with the acquisition of NBX Corporation in fiscal 1999.

 

*Restructuring Charges.* Restructuringcharges in the third quarter and first nine months of fiscal 2004 were $39.5million and $147.1 million, respectively. Restructuring charges in the thirdquarter of fiscal 2004 included $25.9 million in facilities-related charges, including$26.0 million of accelerated depreciation and impairments related to the Dublinand Santa Clara facilities. These restructuring charges were offset by a creditof $0.1 million for revised estimates related to lease terminations.  Restructuringcharges in the third quarter of fiscal 2004 also included $17.2 million forseverance-related costs and $1.1 million for other restructuring costs,primarily relating to long-term asset write downs. These restructuring chargeswere offset by a net credit of $4.7 million, which was mainly the result from asettlement of the outsourcing-related obligations in Dublin at amounts lessthan originally estimated. Restructuring charges in the first nine months of fiscal 2004 included $94.8million in facilities-related charges, including $75.6 million of accelerateddepreciation and impairments related to the Hemel Hempstead, Dublin and SantaClara facilities, $13.7 million in charges for the write down and sale ofcertain properties in Santa Clara and Rolling Meadows, Illinois, and $5.5million of other facilities-related charges.**Restructuringcharges in the first nine months of fiscal 2004 also included $48.2 million inseverance-related charges and $4.1 million related to other restructuringcosts. These charges were primarily the result of cost reduction effortsinitiated in fiscal 2004. Additional charges of approximately $5 million,primarily for severance costs, are expected in the fourth quarter of fiscal2004.

 

Restructuringcharges in the third quarter and first nine months of fiscal 2003 were $52.1million and $128.9 million, respectively. Restructuring charges in the thirdquarter of fiscal 2003 primarily consisted of facilities-related charges,including a $41.4 million of accelerated depreciation and impairments offacilities in Santa Clara (which were later sold in the second quarter offiscal 2004) and $5.2 million of lease termination costs. Other restructuringcharges in the third quarter of fiscal 2003 included $5.5 million related tolong-term asset write downs, severance costs, and other facilities-relatedcharges. Restructuring chargers in the first nine months of fiscal 2003primarily consisted of facilities-related charges, including $99.1 million ofaccelerated depreciation and impairments of facilities in Santa Clara,Marlborough, Hemel Hempstead and Dublin and $6.8 million of lease terminationcosts.  In addition to these charges,restructuring charges in the first nine months of fiscal 2003 included $16.3million related to additional severance costs and $6.7 million related tolong-term asset write downs and other restructuring charges. Restructuring charges in the first ninemonths of fiscal 2003 were primarily the result of cost reduction effortsinitiated in fiscal 2003.

 

*Loss on Land and Facilities, Net.* The net loss on land and facilities was$0.9 million for the first nine months of fiscal 2003, primarily related to ourSalt Lake City facility that was sold in the second quarter of fiscal 2003.This property was classified as held for sale prior to the inception of ourrestructuring initiatives and, therefore, the net losses associated with itwere not the result of restructuring actions and were not recorded as part of restructuringcharges.

 

Gain (Loss) onInvestments, Net

 

Net gain on investmentsof $0.9 million in the third quarter of fiscal 2004 was mainly the result of again recognized upon the sale of an investment in a privately-held company($4.3 million), partially offset by write downs of long term equity investments($3.8 million). Net loss on investments of $14.6 million in the first ninemonths of fiscal 2004 was mainly the result of the gain recognized upon thesale of an investment in a privately-held company mentioned above ($4.3million), offset by write downs of long term equity investments ($16.0million). Net loss on investments in the third quarter and first nine months offiscal 2003 was due primarily to market value adjustments of limited partner venturefunds

 

26

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and write downs of longterm equity investments. Also included in the first nine months of fiscal 2003were losses on the sale of investments in limited partner venture funds.

 

Interest and Other Income, Net

 

Interest and otherincome, net of $3.6 million in the third quarter of fiscal 2004 decreased $1.6million compared to the third quarter of fiscal 2003. The decrease reflected areduction in interest income of $2.9 million that resulted from lower interestrates, partially offset by reductions of $1.3 million in other expenses, mainlylower interest expense resulting from the repayment of all outstandingborrowings.

 

Interest and otherincome, net, in the first nine months of fiscal 2004 decreased $7.3 million ascompared to the first nine months of fiscal 2003, with reduced interest income($12.6 million) being partially offset by decreases in other expenses ($5.3million). Interest income decreased due to lower interest rates overall as wellas lower interest income relating to income tax refunds, which generated $1.4million and $5.1 million of interest income in the first nine months of fiscal2004 and 2003, respectively. Partially offsetting the decrease in interestincome were lower interest expense that resulted from the repayment ofborrowings, as well as reduced costs associated with warrants issued toBroadcom Corporation that expired in December 2003.

 

Equity Interest in Loss ofUnconsolidated Joint Venture

 

As described more fully above, we account for our investment in H-3Cunder the equity method. In the third quarter of fiscal 2004, we recorded acharge of $4.2 million representing our share of the net loss incurred by H-3Cduring the quarter ended December 31, 2003. At the time of formation ofH-3C, we recorded a charge of $12.6 million representing our ownership share(49 percent) of the value attributed to in-process technology contributed toH-3C by Huawei that had not yet reached technological feasibility and had noalternative future use; this charge is reflected in our results for the firstnine months of fiscal 2004.

 

Income Tax Provision (Benefit) 

 

Our tax provision in thethird quarter of fiscal 2004 was the result of providing for taxes in certainstate and foreign jurisdictions. Our income tax benefit for the first ninemonths of fiscal 2004 included the benefit of a foreign netoperating loss carryback of $8.5 million, partially offset by a provision of $5.6 million fortaxes in certain state and foreign jurisdictions. The tax provision in thethird quarter and first nine months of fiscal 2003 was the result of providingfor taxes in certain state and foreign jurisdictions.

 

DiscontinuedOperations

 

Discontinued operationsrelate to our CommWorks business unit that was sold in the fourth quarter offiscal 2003. We recorded losses of $0.7 million and $2.5 million in the thirdquarter and first nine months of fiscal 2004, respectively, due to adjustmentsto previous estimates of liabilities related to the sale of CommWorks. In thethird quarter and first nine months of fiscal 2003, the loss relating to theoperations of CommWorks was $7.3 million and $68.0 million, respectively, andincluded $0.3 million and $0.9 million of tax expense, respectively.

 

Cumulative Effectof Change in Accounting Principle

 

As a result of ouradoption of SFAS 142, we conducted a transitional goodwill impairmentevaluation of the $66.5 million of goodwill recorded as of May 31, 2002 andwrote off goodwill totaling $45.4 million relating to continuingoperations as a change in accounting principle effective June 1, 2002. Wealso wrote off $20.2 million of goodwill relating to the CommWorks businessunit, which is included in

 

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discontinuedoperations.

 

**Liquidityand Capital Resources**

 

Cash and equivalents and short-term investments were $1,366.0 millionat February 27, 2004, a decrease of approximately $118.6 million comparedto the balance of $1,484.6 million as of May 30, 2003.

 

Net cash used in operating activities was $148.9 million in the firstnine months of fiscal 2004, primarily reflecting our loss from continuingoperations of $328.0 million. Also included in net cash used in operatingactivities for the first nine months of fiscal 2004 was the impact of afavorable settlement of an intellectual property dispute. Under thissettlement, we collected $8.0 million in the third quarter of fiscal 2004, andrecorded a receivable for the remaining $8.0 million, which will be collectedin four equal installments of $2.0 million each on the settlement anniversarydate. The total settlement of $16.0 million was deferred as of the settlementdate and is being amortized to licensing revenue through fiscal 2009.Significant commitments that will require the use of cash in future periodsinclude obligations under lease, royalty, patent licensing and IT outsourcingagreements. Total future lease obligations as of February 27, 2004 were$56.7 million, of which $19.7 million will be paid over the next twelve months.  Obligations under royalty and patentlicensing arrangements as of February 27, 2004 were approximately $22.2million, of which $10.2 million is expected to be paid over the next twelvemonths. Under our IT outsourcing agreements, we are subject to service levelcommitments providing for minimum payments of $5.1 million annually throughDecember 2013. Termination of such agreements prior to this date wouldresult in early termination penalties that decline over time. If we were toterminate the agreements at the beginning of the fourth quarter of fiscal 2004,such penalties would be approximately $4.3 million.

 

We expect that cash flows from operating activities will be negativeover the next several quarters, and possibly longer, due to continuing netlosses.  There are no assurances that wecan reduce our net losses and negative cash flow in the foreseeable future, orthat we can raise capital as needed to fund our operations on an ongoing basis.However, based on current business conditions and our current operating andfinancial plans, but subject to the discussion in Business Environment andIndustry Trends below, we believe that our existing cash and equivalents andshort-term investments will be sufficient to satisfy our anticipated cash requirementsfor at least the next twelve months. As a result of the aforementioned fiscal2004 restructuring actions and related charges, and based on our currentprojections for revenues, costs and expenses, which are subject to significantuncertainty, we expect net cash flow from operations to be improved byapproximately $18 million per quarter from the levels reported for the fourthquarter of fiscal 2003. This improvement excludes the impact of cashdisbursements to be made in settlement of liabilities accrued as ofFebruary 27, 2004, the majority of which liabilities are expected to befully settled during the first quarter of fiscal 2005.

 

Net cash provided by investing activities was $41.8 million for thefirst nine months of fiscal 2004, primarily resulting from approximately $114.1million of net proceeds related to sales, maturities and purchases of debt andequity securities and $87.7 million of net proceeds related to sales andpurchases of fixed assets, partially offset by our $160.0 million investment inH-3C.

 

For the first nine months of fiscal 2004, we received proceeds ofapproximately $776.8 million from maturities and sales of investments, almostall of which related to municipal and corporate bonds and government agencyinstruments. Offsetting these proceeds were investments totaling $660.3 millionin municipal and corporate bonds and government agency instruments, as well asinvestments totaling $2.4 million in equity securities.

 

Our investments in equity securities include investments made by 3ComVentures. Through 3Com Ventures, we selectively make strategic investments inprivately held companies and in limited partnership venture capital funds,which in turn invest in privately held companies. These investment activitiesare entered into with the intention of complementing our business strategiesand research and development efforts, and may include a strategic commercial ortechnology relationship, such as a component supply agreement or technologylicense arrangement, with these privately held companies.

 

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3Com Ventures has made strategic investments of $2.4 million in thefirst nine months of fiscal 2004 and has committed to make additional capitalcontributions to venture capital funds totaling $10.6 million. We arecontractually obligated to provide funding upon calls for capital. Theexpiration dates for such capital calls are generally five to eight years fromthe inception of the fund, and the amounts and timing of such calls during thatperiod are entirely at the discretion of the funds’ general partners. Weestimate that we will pay approximately $4.4 million over the next twelvemonths as capital calls are made.

 

During the first nine months of fiscal 2004, we made capital expendituresof $12.6 million for new property and equipment.  Also, during this same period, we collected $100.2 million fromsales of property and equipment, primarily relating to the sale of our RollingMeadows facility in July 2003 and certain properties in Santa Clara inNovember 2003. As of February 27, 2004, capital expenditurecommitments outstanding were not material.

 

Net cash provided by financing activities was $114.6 million in thefirst nine months of fiscal 2004, including the collection of the finalinstallments totaling $8.4 million due under a note receivable related to thesale of warrants to Broadcom during fiscal 2002 and $106.5 million of proceedsfrom the issuance of common stock, offset by $0.3 million for payments dueunder capital leases. There were no borrowings or repayments under ourrevolving line of credit during the first nine months of fiscal 2004. As ofFebruary 27, 2004, we were eligible for borrowing under the revolving lineof credit of up to $32 million, had no amounts outstanding, and had $9.4million of bank-issued standby letters of credit and bank guarantees.

 

We did not repurchase any shares of common stock in the first ninemonths of fiscal 2004. Our current stock repurchase program permitsexpenditures of up to $100.0 million through March 2005.  We may use cash in future periods torepurchase shares of our common stock pursuant to this authorization.

 

In the first nine months of fiscal 2004, we issued 22.3million shares of stock under our employee stock option and stock purchaseplans and collected $106.5 million related to such issuances.As of February 27, 2004, ouroutstanding stock options as a percentage of outstanding shares were 16percent. This potential dilution to existing stockholders is mainly the resultof the effect of our distribution of Palm, Inc. common stock in the firstquarter of fiscal 2001. As a result of the Palm distribution, the number ofshares subject to option grants was adjusted to preserve the intrinsic value ofthe stock options, resulting in an increase of 134 million options, andbringing the total option shares outstanding to 169 million at the time of thedistribution. The potential dilution has been an area of focus for seniormanagement. As a result of reductions in the number of employees, stock optionexercises, and management of new grants, the number of outstanding options hasbeen reduced approximately 64 percent since the Palm distribution. In addition,the number of options available for future grant was reduced by a net 108million shares due to approvals of proposals submitted to our stockholders atour annual stockholder meeting in September 2003.

 

Stock option activity during the first nine months of fiscal 2004 andstock option detail as of February 27, 2004, were as follows:

 

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|                                |   | **Number  of shares** |   | **Weighted  average  exercise price** |   |
|-------------------------------------|--------|-----------------------|--------|---------------------------------------|--------|
|                                |   | **(in  thousands)**   |   |                                  |   |
|                                |   |                  |   |                                  |   |
| Outstanding, May 30, 2003           |   | 85,502                |   | $                                     | 7.03   |   |
|                                |   |                  |   |                                  |   |
| Granted                             |   | 9,704                 |   | 5.54                                  |   |
| Exercised                           |   | (20,505               | )      | 4.99                                  |   |
| Canceled                            |   | (13,360               | )      | 8.35                                  |   |
| Outstanding, February 27, 2004 |   | 61,341                |   | $                                     | 7.18   |   |

 

 
|                          |   | **Outstanding  options  as of February 27, 2004** |   | **Exercisable  at February 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                                       |   |   | 5,840 |   | $ | 4.21 |   | 1,779 |   | $ | 4.09 |   |
| 4.30                          | -      | 5.10                                                   |   |                                       | 8,394  |   | 4.83 |   | 5,142 |   | 4.82 |   |
| 5.12                          | -      | 5.54                                                   |   |                                       | 13,380 |   | 5.38 |   | 7,486 |   | 5.49 |   |
| 5.55                          | -      | 6.09                                                   |   |                                       | 10,345 |   | 5.92 |   | 9,604 |   | 5.94 |   |
| 6.10                          | -      | 10.09                                                  |   |                                       | 13,721 |   | 8.20 |   | 10,656 |   | 8.30 |   |
| 10.11                         | -      | 21.57                                                  |   |                                       | 9,661  |   | 13.44 |   | 7,931 |   | 13.40 |   |
| Total                         |   | 61,341                                                 |   | $                                          | 7.18   |   | 42,598 |   | $ | 7.63 |   |

 

The following table summarizes our equity compensation plans as ofFebruary 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      |   | 22,018                                                           |   | $                                                            | 7.75   |                                                                                                                                                       | 27,912 |   |
| Equity compensation plans not approved by stockholders* |   | 39,012                                                           |   | 6.88                                                         |   | —                                                                                                                                                     |   |
|                                                    |   |                                                             |   |                                                         |   |                                                                                                                                                       |   |
| Total                                                   |   | 61,030                                                           |   | $                                                            | 7.19   |                                                                                                                                                       | 27,912 |   |

 

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* Excludes 0.3million outstanding options with an average exercise price of $5.67. Theseoptions were assumed in connection with acquisitions and no additional optionsare available for future issuance under such plans.

 

Options issued outside of thestockholder-approved plans were issued under our broad-based 1994 Stock OptionPlan, as amended. Options granted from this plan were granted at fair value,vest over two to four years, and expire ten years after the date of grant.Effective September 2003, the 2003 Stock Plan was approved by stockholdersand replaced the 1994 Stock Option Plan for all grants subsequent to theapproval date. Also in September 2003, stockholders approveda five million share increase in the number shares available for issuance underthe Employee Stock Purchase Plan.

 

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**Effects of RecentAccounting 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 is effective for fiscal periods beginningafter June 15, 2003; for 3Com, EITF 00-21 became effective for the secondquarter of fiscal 2004. 3Com’s historical revenue recognition policies andpractices conform to the requirements of EITF 00-21 and, thus, the adoption ofEITF 00-21 did not have a material impact on our financial position or resultsof operations.

 

In December 2003, the Securities and Exchange Commissionreleased Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104).  SAB 104 clarifies existing guidanceregarding revenue for contracts which contain multiple deliverables to make itconsistent with EITF No. 00-21.  Theadoption of SAB 104 did not have a material effect on our financial position orresults of operations.

 

**Business Environment and Industry Trends**

** **

Industrytrends and specific risks may affect our future business and results.  The matters discussed below could cause ourfuture results to differ from past results or those described inforward-looking statements.

 

***We have incurred significant net losses in recent fiscal periods,including $331 million for the first three quarters of fiscal 2004 and$284 million, $596 million and $965 million in fiscal years2003, 2002 and 2001, respectively, and we may not be able to return toprofitability.***

 

We incurred a net loss of$331 million for the first three quarters of fiscal 2004, and net lossesof $284 million, $596 million and $965 million in fiscal 2003,2002 and 2001, respectively. Although we are taking steps designed to improveour results of operations, we cannot assure you that we will return to profitability.Further, if we do return to profitability, we cannot assure you that we will beable to sustain or increase such profitability in the future.

 

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

 

•                  declining revenue due to: (a) pricecompetition and (b) reduced incoming order rate and customer backlog whichwe believe reflects decreased demand for our products resulting from theoverall slowdown in the networking industry as well as technological changesand trends in the industry, such as the integration of networking,communications and computer processing functions on computer chips that canperform the same functions as some of our products;

•                  increasedrisk of excess and obsolete inventories;

•                  excessfacilities;

•                  operatingexpenses (particularly general and administrative expenses) that, as apercentage of revenue, have exceeded our desired financial model; and

•                  disruptions resulting from our workforcereductions and employee attrition.

 

***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, we announcedthe formation of a joint venture for enterprise networking products withHuawei, a leading Chinese company.  3Comcurrently has a 49 percent minority interest in the Huawei-3Com jointventure, which has Hangzhou, China as its primary base of operations. Pursuantto the joint venture agreements, 3Com has the right to market and support theHuawei-3Com products under the 3Com brand in all countries except China andJapan. In China and Japan, the joint venture will sell products sourced internallyas well as from 3Com and Huawei under the joint venture’s brand.  The joint venture commenced operations inNovember 2003.  In the thirdquarter of fiscal 2004, we began reflecting the operating results of the jointventure in our operating results to the extent of our ownership interest; the reportedloss for the third quarter of fiscal 2004 was $4.2 million.  Also, at the time of formation of the jointventure, 3Com recorded a charge of $12.6

 

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million representing 3Com’s ownership share (49 percent) ofthe value attributed to in-process technology contributed to the joint ventureby Huawei that had not yet reached technological feasibility and had noalternative future use; this charge was included in 3Com’s results ofoperations for the second quarter of fiscal 2004.  3Com’s reported loss related to the joint venture for the firstnine months of fiscal 2004 totaled $16.8 million.

 

The new joint venture islikely to confront numerous challenges in the future. For example, at theoutset, integration of the business assets and operations being contributed byeach partner will involve complex activities that must be completed in a shortperiod of time. Going forward, there could be disagreements between 3Com andHuawei with respect to important strategic and operational decisions. Thebusiness of the joint venture will also be subject to all of the operationalrisks that would normally arise for a technology company with global operationspertaining to research and development, manufacturing, sales, service,marketing, and corporate functions. In addition, competition in the enterprisenetworking market will involve challenges from numerous, well-establishedcompanies with substantial resources and significant market share.

 

Our business, businessprospects and operating results are heavily dependent upon the success of theHuawei-3Com joint venture. In particular, our product development activitieswill become increasingly interdependent with those of the joint venture. If thejoint venture and our transactions with it are not successful or lesssuccessful than we anticipate, we may not introduce new products needed tobroaden our high-end enterprise networks product line, which may adverselyaffect our revenues, business and business prospects. Even if the joint ventureis successful, there may be disruption to our existing distribution channelsand conflicts with our current channel partners resulting from theestablishment of the joint venture’s operations and distribution arrangements.

 

***Our strategy of outsourcing functions and operations not central to ourbusiness may fail to reduce cost and may disrupt our operations.***

 

We continue to look for waysto decrease cost and improve efficiency by contracting other companies toperform functions or operations that do not contribute to our core technologybusiness. Up until recently, our efforts have focused on using outside vendorsto meet some of our IT and manufacturing needs. In the third quarter of fiscal2004, we completed the outsourcing of all manufacturing of our products. Toachieve more cost savings or operational benefits, we may expand ouroutsourcing of IT activities, as well as aspects of the following operations:human resources, accounting, internal audit, security and engineering. Althoughwe believe that outsourcing these functions will result in lower costs andincreased efficiencies, this may not be the case. For example, outsourcingmeans that we will be relying upon third parties to meet our needs. Becausethese third parties may not be as responsive to our needs as we would beourselves, outsourcing the services increases the risk of disruption to ouroperations. In addition, our agreements with these third parties sometimesinclude substantial penalties for terminating such agreements early or failingto maintain minimum service levels. Because we cannot always predict how longwe will need the services or how much of the services we will use, we may haveto pay these penalties.

 

***Our revenues may decrease, and we may not be able to compensate forsuch lower revenues with cost reductions sufficient to generate positive netincome or cash flow.***

 

We believe that we mustimplement strict cost and expense reductions if we are to generate positive netincome and cash flow from operations in future quarters. If we are not able toeffectively reduce our costs and expenses commensurate with, and at the samepace as, any further deterioration in our revenues, we may not be able togenerate positive net income or cash flow from operations. If we continue toexperience negative cash flow from operations over a prolonged period of time,our ability and efforts to operate our business effectively could be adverselyaffected. We are unable to predict the exact amount of cost reductions requiredfor us to generate positive net income or cash flow from operations because wecannot accurately predict the amount of our future revenue. Our future revenuedepends, in part, on future economic and market conditions, which we are unableto forecast accurately. We also cannot forecast the impact of new products.Although we cannot accurately predict the amount of our future revenue overall,we expect that revenue from sales of desktop, mobile and server connectivityproducts, which represented approximately 14 percent of total revenue for thethird quarter of fiscal

 

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2004, will decline furtherdue to pricing pressures and technological changes and trends in the networkingindustry.

 

***Our efforts to consolidate our real estate portfolio and sell certainreal estate holdings may not generate the expected level of cash proceeds orresult in reductions of operating costs.***

 

In connection with ourongoing restructuring and cost reduction activities, we are making efforts toconsolidate our operations into fewer facilities and to dispose of excessfacilities. We currently have excess facilities held for sale in Santa Clara,Dublin, and Hemel Hempstead. Despite our best efforts, our ability to disposeof our excess real estate holdings may be impaired by adverse conditions in thecommercial real estate market. Additionally, if we continue to own excessfacilities and are unable to lease the facilities to third parties, our operatingresults will be adversely affected by the continuing operating costs associatedwith the excess facilities.

 

***Our workforce reductions, and the high cost of living in certainlocations, may make it more difficult for us to retain and recruit the qualifiedemployees and management personnel that are critical to our success.***

 

Our success depends uponretaining and recruiting highly qualified employees and management personnel.However, the significant downturn in our business environment has had a negativeimpact on our operations. As a result, we have restructured our operations toreduce our workforce and implement other cost reduction activities. Although webelieve these various changes and actions will improve our organizationaleffectiveness and competitiveness, they could lead, in the short term, todisruptions in our business, reduced employee morale and productivity, problemswith retaining existing employees and recruiting future employees, andincreased financial costs. Recruiting and retaining skilled personnel,including engineers, sales representatives and product marketing managers,continues to be difficult. In addition, at certain locations where we operate,the cost of living is extremely high and it may be difficult to attract andretain key employees and management personnel at a reasonable cost. If wecannot successfully recruit and retain qualified employees and managementpersonnel, our product introduction schedules, customer relationships, resultsof operations and financial position may be impaired and our overall ability tocompete may be adversely affected.

 

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

 

Our operating expenses, particularlygeneral and administrative expenses, as a percent of revenue have been higherthan our desired long-term financial model. We have taken, and will continue totake, actions to reduce these expenses. Future actions could include furtherreductions in our workforce, relocation of functions and activities to lowercost locations, changes or modifications in IT systems or applications andprocess reengineering. As a result of these actions, the employment of someemployees with critical skills will be terminated, and other employees willleave our company voluntarily due to the uncertainties associated with ourbusiness environment and their job security. In addition, reductions in overall staffing levels might make it moredifficult for us to achieve our revenue objectives, to adhere to our preferredbusiness practices and to address all of our legal and regulatory obligationsin an effective manner, which could, in turn, ultimately lead to missedbusiness opportunities, higher operating costs or penalties.

 

***If future business conditions present unanticipated challenges, we mayneed to make further changes to our business structure or reductions to ourworkforce.***

 

In response to industry andmarket conditions, we have restructured our business and reduced our workforce.The assumptions underlying our restructuring efforts will be assessed on anongoing basis and may prove to be inaccurate. We may have to restructure ourbusiness again to achieve additional cost savings and to strategically realignour resources. Our restructuring plan is based on certain assumptions regardingthe outlook for the networking industry, our future revenue and the coststructure of our business, which may prove to be inaccurate. Whilerestructuring, we have assessed, and will continue to assess, whether we shouldfurther reduce our workforce or further expand our outsourcing activities. Wemay not be able to successfully implement the initiatives we have undertaken inrestructuring our business; even if successfully implemented, these initiativesmay not be sufficient to meet and keep pace with changing industry and marketconditions and to achieve positive net income and cash flow from operations.

 

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***If our cash flow significantly deteriorates in the future, ourliquidity and ability to operate our business could be adversely affected.***

 

We incurred a significantnet loss and negative cash flow from operations for the first three quarters offiscal 2004. If we continue to incur significant net losses and negative cashflow from operations over a prolonged period, our liquidity and ability tooperate our business could be adversely affected. For example, our ability toraise financial capital may be hindered due to the possibility of continuingnet losses and negative cash flow in the future. An inability to raisefinancial capital would limit our operating flexibility.

 

The following items couldrequire unexpected future cash payments or limit our ability to generate cash:

 

•                  inability to dispose of real estate holdings;

•                  taxes due upon the transfer of cash held inforeign locations; and

•                  taxes assessed by local authorities where weconduct business.

 

***Our decision to move our corporate headquarters will result in costsfor relocation, executive severance, and recruitment costs, and could result indisruptions to our business.***

 

In fiscal 2004, we moved ourcorporate headquarters to our Marlborough facility, which is the primarylocation and base of operations for our ongoing enterprise networking business.Although only a relatively small percentage of our total workforce has been orwill be affected by this move, ongoing efforts and expenses will be required toeffect the relocation. For example, we have incurred and expect to continue toincur relocation costs, severance costs (for those employees not moving toMarlborough), and recruitment costs (for replacing the employees not moving toMarlborough). Also, although we believe the relocation will improve ourorganizational effectiveness, it could lead, in the short term, to disruptionsin our business. The relocation process will be substantially completed duringthe fourth quarter of fiscal 2004.

 

***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 competitivechallenges that are likely to arise from a number of factors, including:

 

•      industryvolatility resulting from rapid product development cycles;

•      increasingprice competition due to maturation of basic networking technologies;

•      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 the resellerand distribution channels.

 

***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 technologies for emerging product lines.  These investments have included XRNTM(eXpandable Resilient Networking) technology, Gigabit Ethernet technology,Internet Protocol (IP) telephony, wireless LANs, Layer 3+ switching, networksecurity technology (such as our embedded firewall products), and Network Jackswitches. We expect new products and solutions based on these technologies tocontribute to future sales growth. 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. Ifcustomer demand for our products and solutions based on these technologies doesnot develop as we expect, or if our sales and marketing strategies for thesetechnologies are not effective, our financial results could be adverselyaffected and we might need to change our business strategy.

 

***We may not be successful at identifying and responding to new andemerging market and product opportunities.***

 

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

 

•                  identify newmarket and product opportunities;

•                  develop andintroduce new products and solutions in a timely manner;

•                  gain marketacceptance of new products and solutions, particularly in the targeted emergingmarkets discussed above; and

•                  rapidly andefficiently transition our customers from older to newer enterprise networkingtechnologies.

 

Ourresults of operations or financial position could suffer if we are notsuccessful in achieving these goals. For example, our business would suffer if:

 

•                  there is adelay in introducing new products;

•                  there are fewercustomers interested in our products than we expected;

•                  our products donot satisfy customers in terms of features, functionality or quality; or

•                  our productscost more to produce than we expect.

 

Ourbusiness would suffer in particular if negative effects such as these were tooccur in those product markets that we have identified as emerging high-growthopportunities. One factor that may cause greater difficulty for us in quicklyand effectively introducing new products with the features, functionality,quality, and costs that are optimal for the market is our increased reliance onrelationships with strategic partners, such as original design manufacturers(ODMs). Because ODMs manufacture the products of other companies as wellas ours, the timeliness of the availability of our products depends, in part,on their production schedules. In addition, we are relying on ODMs tomanufacture products that meet our specifications with regard to quality andcost. We will continue to source other products from OEMs and from theHuawei-3Com joint venture. Finally, since we rely on our strategic partners, wemay not be able to independently identify current product and technology trendsand to respond to such trends as well as if we were working independently.

 

***A significant portion of our revenue is derived from sales to a smallnumber of customers. If any of these customers 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 value-added resellers. We also sell to personalcomputer manufacturers and telecommunications service providers. A significantportion of our revenue is concentrated among a few distributors and OEMcustomers; our two largest customers accounted for a combined 34 percent oftotal sales for the first three quarters of fiscal 2004, a combined 33 percentof total sales for the entirety of fiscal 2003, and a combined 28 percent oftotal sales for each of fiscal 2002 and fiscal 2001. There has been a trend ofdecreased demand for connectivity products from OEM customers such as DellComputer Corporation and Hewlett-Packard Company, due to increased integrationof networking connections with semiconductor components, and also to factorsspecific to our OEM customers. Additionally, consolidation in our distributionchannels and among personal computer (PC) manufacturers is reducing the numberof customers in our domestic and international markets. In an effort tostreamline our operations, we may increase the focus of our distribution salesresources on selected distribution channel customers.

 

***We depend on distributors who maintain inventories of our products. Ifthe distributors reduce their inventories of our products, our revenue could beadversely affected.***

 

Our distributors maintaininventories of our products. We work closely with our distributors to monitorchannel inventory levels and ensure that appropriate levels of products areavailable to resellers and end users. We have improved certain of our supplychain processes so that deliveries to our channel partners can be done morerapidly, thereby enabling our channel partners to hold fewer weeks of supply ofour products in their inventory. At the end of fiscal year 2003, channelinventory levels were at the upper end of our target range of four to six weekssupply on hand at our distributors. At the end of each of the first threequarters of fiscal 2004, channel inventory levels were at approximately 4.5weeks supply. We expect to operate our business with no greater than 4.5 weeksof channel inventory for the remainder of fiscal 2004.**** At this level of channel inventory, some of our

 

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channel partners will holdless than the average level of inventory, and others will be at a higher level.Partners with a below-average inventory level may incur stock outs that wouldadversely impact our revenues. 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 in the sales channel.  If those adjustments are unsuccessful, our revenues may benegatively affected.***

 

As part of our distribution strategy, we are targeting SystemIntegrators (SIs), Service Providers (SPs), and enterprise Value AddedResellers (eVARs).  These resellerstypically have expertise in network design and implementation, which isimportant 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 typically 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 services, marketing, or salesorganization does not provide effective support to such SIs, SPs, and eVARS, wemay not be successful in expanding our distribution model and current SI, SP,and eVAR partners may terminate their relationships with us, which wouldadversely impact our sales and results of operations.

 

***Our strategies to outsource all of our manufacturing requirements tocontract manufacturers,  and forcontract manufacturers to ship directly to our customers, may not resultin  meeting our cost, quality or performancestandards. The inability of any contract manufacturer to meet our cost, qualityor performance standards could adversely affect our 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 our products. Theinability of any contract manufacturer to meet our cost, quality, performance,and availability standards could adversely impact our financial condition orresults of operations. We may not be able to provide contract manufacturerswith product volumes that are high enough to achieve sufficient cost savings.If shipments fall below forecasted levels, we may incur increased costs or berequired to take ownership of the inventory. Also, our ability to control thequality of products produced by contract manufacturers may be limited andquality issues may not be resolved in a timely manner, which could adverselyimpact our financial condition or results of operations. We have implemented aprogram with our manufacturing partners to ship products directly from regionalshipping centers to customers. Through this program, we are relying on thesepartners to fill customer orders in a timely manner. This program may not yieldthe efficiencies that we expect, which would negatively impact our financialperformance. Any disruptions to on-time delivery to customers would adverselyimpact our business and revenues.

 

***We may be unable to manage our supply chain successfully, which wouldadversely impact our revenues, gross margins, 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;

•                  there are a smaller numberof suppliers and we have narrowed our supplier base, including, in some cases,the sole sourcing of specific components from a single 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

•                  wemay experience disruptions to our logistics.

 

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Some of our suppliers arealso our competitors. We cannot be certain that in the future our suppliers,particularly those who are also in active competition with us, will be able orwilling to meet our demand for components in a timely and cost-effectivemanner.

 

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 a smaller number of suppliers and theinability to quickly switch vendors increase the risk of logistics disruptions,unfavorable price fluctuations, or disruptions in supply, particularly in asupply-constrained environment.

 

Operation of the supplychain requires accurate forecasting of demand, which has become morechallenging. If overall demand for our products or the mix of demand for ourproducts is significantly different from our expectations, we may faceinadequate or excess component supply or inadequate or excess manufacturingcapacity. This would result in orders for products that could not bemanufactured in a timely manner, or a buildup of inventory that could noteasily be sold. Either of these situations could adversely affect our marketshare, revenue, results of operations or financial position.

 

***The increased integration of networking, communications, and computerprocessing functions on a reduced number of computer chips may adversely affectour future sales growth and operating results.***

 

The integration ofnetworking, communications, and computer processing functions on a reducednumber of computer chips has become an industry trend. This trend is sometimesreferred to as “siliconization.” Many of these integrated computer chips offerimproved features and increased performance at lower cost.  Some competitors that have a significantshare of the PC chip market may sell chips that contain integrated connectivityat prices not significantly greater than prices for PC chips withoutconnectivity.  If we cannot competesuccessfully against current or future competitors or their product offerings,our business, results of operations or financial position could be adverselyaffected.

 

***The contract manufacturers on whom we rely face currency exchange raterisk that may affect their ability to provide products on a cost competitivebasis, which could in turn impact our operating results and ourcompetitiveness.***

 

We are entirely dependentupon external contract manufacturers for product supplies and, in turn, uponthe ability of these contract manufacturers to remain cost competitive.  A significant component of maintaining thiscost competitiveness is the ability of the contract manufacturers to adjusttheir own costs and manufacturing infrastructure to compensate for possibleadverse exchange rate movements. To the extent that the contract manufacturersare unable to do so, and we are unable to procure alternative product supplies,then our own operating results and our own competitiveness may be adverselyimpacted.

 

***We are exposed to economic currency risk on products sourced from theHuawei-3Com joint venture in China.***

 

Pursuant to our agreementswith Huawei, we have the right to market the Huawei-3Com products under the3Com brand in all countries except China and Japan.  A key factor in the success of this activity is that productsourced from the joint venture remains cost competitive over time. Any futureadverse exchange rate movements between the joint venture’s local currency ofoperations and the U.S. Dollar may adversely impact our operating results.

 

***Our past and futuredecisions to exit certain product lines may have unforeseen negative impacts toour business.***

 

In fiscal 2001, 2002 and2003, we exited or sold some of our businesses and product lines. In somecases, we continue to be responsible pursuant to the original warrantyobligations for these products. Our exiting of these business and product linesmay have adversely affected our relationships with channel partners and endcustomers. Many of these channel partners and customers perceived our remainingproducts as not being part of a larger integrated or complementary solution, orquestioned our commitment to their markets. Consequently, they

 

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chose to purchase productsfrom alternative vendors. We may consider exiting other businesses or productlines that do not meet our goal of delivering satisfactory financial returns.Future decisions to exit businesses or product lines could result indeterioration of our channel partner and customer relationships, increasedemployee costs (such as severance, outplacement and other benefits), contracttermination costs, and asset impairments.

 

***Our increasing reliance on strategic relationships may negativelyimpact our business.***

 

As discussed above, inNovember 2003, we formed a joint venture in China for enterprisenetworking products. In addition, we recently announced alliances withCrossbeam Systems, Inc. and Aspect Communications Corporation. We expect toevaluate other possible strategic relationships, including joint ventures andother types of arrangements, and we may increase our reliance on such strategicrelationships to complement internal development of new technologies andenhancement of existing products and to exploit perceived market opportunities.Strategic relationships can present challenges since we often compete in somebusiness areas with companies with which we, at the same time, have strategicalliances in other business areas. If these companies fail to perform, or ifthese relationships fail to materialize as expected, we could suffer delays inproduct or market development or other operational difficulties. Strategicrelationships may also lead to potential conflicts within our distributionchannel. Furthermore, our results of operations or financial condition could beadversely affected if we experience difficulties managing relationships withour partners or if projects with partners are unsuccessful. In addition, ifthird parties acquire our strategic partners or if our competitors enter intosuccessful strategic relationships, we may face increased competition.

 

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

 

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

 

•                  the emergence of newtechnology or the convergence of technologies such as voice and data networkingor 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 ourrevenue or overall financial performance. In addition, if our technology is notincluded in an industry standard on a timely basis or if we fail to achievetimely certification of compliance to industry standards for our products, ourrevenue from sales of such products or our overall financial performance couldbe adversely affected.

 

Failure to obtain allnecessary regulatory approvals for our products or to comply with allapplicable government regulations could adversely impact our revenue or overallfinancial performance or expose us to fines or other penalties. In addition,new or revised government regulations could adversely affect the basic businesseconomics for new technologies or their rates of acceptance or adoption bypotential customers; in turn, this could adversely impact our revenue oroverall financial performance.

 

***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 our business, we do not typically maintain asignificant amount of backlog, and sales are partially dependent on our abilityto appropriately forecast product demand. In addition, our customershistorically request fulfillment of orders in a short time period, resulting inlimited visibility to sales trends and potential pricing pressures.Consequently, our operating results depend on the volume and timing of ordersand

 

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our ability to fulfillorders in a timely manner. Historically, sales in the third month of thequarter have been higher than sales in each of the first two months of thequarter. Non-linear sales patterns make business planning difficult, andincrease the risk that our quarterly results will fluctuate due to disruptionsin functions such as manufacturing, order management, information systems, andshipping.

 

***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 smallercompanies, universities, and individual inventors have obtained or applied forpatents in areas of technology that may relate 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 the validity and applicability of theseintellectual property rights, and determine in each case whether we mustnegotiate licenses or cross-licenses to incorporate or use the proprietarytechnologies, protocols, or specifications in 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 results of operations orfinancial position could be adversely affected. In addition, if we are allegedto infringe the intellectual property rights of others, we could be required toseek licenses from others or be prevented from manufacturing or selling ourproducts, which could cause disruptions to our operations or the markets inwhich we compete.

 

***We may need to engage in complex and costly litigation in order toprotect or maintain 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 are defending the assertion of intellectualproperty rights against us, or asserting our intellectual property rightsagainst others, intellectual property litigation can be complex, costly,protracted, and highly disruptive to business operations by diverting theattention and energies of management and key 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, the existence of this type of litigation, or anyadverse determinations related to such litigation could subject us tosignificant liabilities and costs. To the extent that any of our OEM, ODM, orjoint venture partners may become involved in intellectual property disputesand may be unable to hold us harmless, then we may incur liabilities or suffertemporary disruption of our business. Also, if we are asserting ourintellectual property rights against others, we could be prevented fromstopping others from manufacturing or selling competitive products. Any one ofthese factors could adversely affect our product margins, results ofoperations, financial position, or cash flows.

 

***Our future quarterly operating results are subject to factors that cancause fluctuations in our stock price.***

 

Historically, our stockprice has experienced substantial volatility. We expect that our stock pricemay continue to experience volatility in the future due to a variety ofpotential factors such as:

 

•                  fluctuations inour quarterly results of operations and cash flow;

•                  changes in ourcash balances;

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

•                  announcementsby our competitors.

 

In addition, over the pastseveral quarters, the stock market has experienced extreme price and volumefluctuations that have affected the stock prices of many technology companies.These factors, as well as general economic and political conditions orinvestors’ concerns regarding the credibility of corporate financial

 

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statements and theaccounting profession, may have a material adverse affect on the market priceof our stock in the future.

 

***We may not be fully able to protect our computer systems, including ourfinancial systems, from breaches of security.***

 

We use computer systems,including our enterprise-wide financial system, which may not include the mostadvanced security features available. There is a risk of unauthorized access toour computer systems and proprietary information, including our financialsystems, intellectual property, and trade secrets. While management makesconcerted efforts to assess risks and prevent and detect security breaches,including periodic audits and upgrades of our systems, our business, results ofoperations or financial position could be affected if any unauthorized accesswere to occur and not be detected through our normal internal controlprocedures.

 

***In fiscal 2004 we are operating in a single business segment focusedprimarily on enterprise networking, and our results of operations may fluctuatebased on factors related entirely to conditions in this market.***

 

In fiscal 2004, we areoperating in a single business segment focused primarily on enterprisenetworking. This single enterprise networking business reflects a streamlinedmanagement and operating structure encompassing all of our operations,including our connectivity business that we previously operated and reported asa separate segment and which we expect will continue to diminish. Our focus onenterprise networking may cause increased risk or volatility associated withdecreased diversification of our business. There will be increased sensitivityto the business risks associated specifically with the enterprise networkingmarket and our ability to execute successfully on our strategies to providesuperior solutions for larger and multi-site enterprise environments. To besuccessful 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 2000. Also, expansion of sales to large enterprises may be disruptive in avariety of ways, such as adding larger systems integrators that may raisechannel conflict issues with existing distributors, or a perception of anydiminished focus on the small and medium enterprise market.

 

***Item 3.******         *Quantitativeand Qualitative Disclosures About Market Risk**

 

3Com holds marketable equity 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 third quarter of fiscal 2004.

 

For interest rate sensitivity and foreign currency exchange risk,reference is made to Part II, Item 7A, Quantitative and Qualitative DisclosuresAbout Market Risk, in our Annual Report on Form 10-K for the year ended May 30,2003.

 

***Item 4.*Controls andProcedures**

 

a.                                       Wecarried out an evaluation, under the supervision and with the participation ofour management, including our President and Chief Executive Officer and ourChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures as of the end of our third fiscalquarter pursuant to Exchange Act Rule 13a-15(b). Based upon that evaluation, ourPresident and Chief Executive Officer and our Chief Financial Officer concludedthat our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rulesand 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

 

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in conformity with accounting principles generally accepted in theUnited States. “Significant deficiencies” are referred to as “reportableconditions,” or control issues that could have a significant adverse effect onour ability to properly authorize transactions, safeguard our assets, orrecord, process, summarize or report financial data in the consolidatedfinancial statements. A “material weakness” is a particularly seriousreportable condition where the internal control does not reduce to a relativelylow level the risk that misstatements caused by error or fraud may occur inamounts that would be material in relation to the consolidated financialstatements and not be detected within a timely period by employees in thenormal course of performing their assigned functions. As part of our internalcontrols procedures, we also address other, less significant control mattersthat we identify, and we determine what revision or improvement to make, ifany, in accordance with our on-going procedures.

 

b.                                      Therehave been no changes in our internal control over financial reporting identified in connection with our evaluationas of the end of the third fiscal quarter that occurred during such quarterthat have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

**PART II.     OTHER INFORMATION**

 

***Item 1.*****          LegalProceedings**

 

The information set forth in Note 13 of Part I, Item 1 ofthis Form 10-Q is incorporated herein by reference.

 

***Item 2******.*****          Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

 

**ShareRepurchase Plan**

 

During the fourthquarter of fiscal 2003, the Board of Directors approved a new stock repurchaseprogram providing for expenditures of up to $100.0 million and authorized atwo-year limit on such repurchases.

 

The followingtable summarizes repurchases of our stock in the quarter endedFebruary 27, 2004:

 
| **Period**                                             |   | **(a) Total  Number of  Shares  Purchased** |   | **(b)  Average  Price Paid per  Share** |   | **(c) Total  Number of  Shares Purchased as  Part of Publicly  Announced  Plans or Programs** |   | **(d) Approximate  Dollar Value of Shares  that May Yet Be  Purchased Under the  Plans or Programs** |        |
|--------------------------------------------------------|--------|---------------------------------------------|--------|-----------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|-------------|
|                                                   |   |                                        |   |                                    |   |                                                                                                    |   |                                                                                                 |        |
| November 29, 2003 through  December 28, 2003 |   | —                                      |   | —                                  |   | —                                                                                                  |   | $                                                                                                    | 100,000,000 |   |
| December 29, 2003 through  January 28, 2004  |   | —                                      |   | —                                  |   | —                                                                                                  |   | $                                                                                                    | 100,000,000 |   |
| January 28, 2004 through  February 27, 2004  |   | —                                      |   | —                                  |   | —                                                                                                  |   | $                                                                                                    | 100,000,000 |   |
| Total                                                  |   | —                                      |   | —                                  |   | —                                                                                                  |   | $                                                                                                    | 100,000,000 |   |

 

***Item 3.*****          DefaultsUpon Senior Securities**

 

None.

 

41

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***Item 4.*****          Submissionof Matters to a Vote of Security Holders**

 

None.

 

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

 

None.

 

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

 

(a)  Exhibits

 
| **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 August 7, 2001                                                                                                                               |   | 10-K                          |   | 0-12867             |   | 3.5 |   | 08/02/02 |   |   |
| 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 |   |   |
| 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 December 17, 2003,we furnished a Current Report on Form 8-K dated  December 17, 2003 under Item 12 of Form 8-K, attaching apress release announcing our second quarter of fiscal 2004 operating results.This Current Report on Form 8-K shall not be deemed to be incorporated byreference into this Quarterly Report on Form 10-Q.

 

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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: | April 7, 2004 |             | By: |   | /s/   Mark  Slaven |   |
|   |               |             | Mark Slaven |
|   |               |             | Executive Vice President, Finance and |
|   |               |             | Chief Financial Officer |
|   |               |             | (Principal Financial and |
|   |               |             | Accounting Officer) |
|        |                    |                  |  |  |  |  |

 

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