**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**ý****                                ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(****d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedNovember 28, 2003**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(****d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition periodfrom           to           **

 

**Commission File No. 0-12867**

 

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**3Com Corporation**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                                                           |   | **94-2605794**                         |
|--------------------------------------------------------------------------------------------------------|--------|----------------------------------------|
| (State or  other jurisdiction of  incorporation or organization)                                       |   | (I.R.S.  Employer  Identification No.) |
|                                                                                                   |   |                                   |
| **350 Campus Drive  Marlborough, Massachusetts**                                                       |   | **01752**                              |
| (Address of  principal executive offices)                                                              |   | (Zip Code)                             |
|                                                                                                   |   |                                   |
| Registrant’s telephone number,  including area code:   **(508)  323-5000**              |
|                                                                                                   |   |                                   |
| Former name, former address and  former fiscal year, if changed since last report:   **N/A** |

 

**Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 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**

 

**Indicateby check mark whether the registrant is an accelerated filer (as defined byRule 12b-2 of the Exchange Act).**

 

**Yes     ****ý****                                                                                                No     ****o**

 

**Asof December 26, 2003, 382,603,894 shares of the registrant’s Common Stockwere outstanding.**

 

**Thisreport contains a total of 44 pages of which this page is number 1.**

 

 

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**3Com Corporation**

 

**Table of Contents**

 
|       |                                                                                        | **Page**                                                                                                                        |
|------------|---------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
| PART I.    | FINANCIAL INFORMATION                                                                       |                                                                                                                            |
|       |                                                                                        |                                                                                                                            |
| *Item 1.*  | Financial Statements                                                                        |                                                                                                                            |
|       |                                                                                        |                                                                                                                            |
|       |                                                                                        | Condensed Consolidated Statements of  Operations*Three  and Six Months Ended November 28, 2003 and November 29, 2002* | 3 |
|       |                                                                                        |                                                                                                                            |   |
|       |                                                                                        | Condensed Consolidated Balance Sheets*November 28,  2003 and May 30, 2003*                                            | 4 |
|       |                                                                                        |                                                                                                                            |   |
|       |                                                                                        | Condensed Consolidated Statements of Cash  Flows*Six  Months Ended November 28, 2003 and November 29, 2002*           | 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 and Use of Proceeds                                                  | 41                                                                                                                              |
|       |                                                                                        |                                                                                                                            |
| *Item 3.*  | Defaults  Upon Senior Securities                                                            | 41                                                                                                                              |
|       |                                                                                        |                                                                                                                            |
| *Item 4.*  | Submission  of Matters to a Vote of Security Holders                                        | 41                                                                                                                              |
|       |                                                                                        |                                                                                                                            |
| *Item 5.*  | Other  Information                                                                          | 42                                                                                                                              |
|       |                                                                                        |                                                                                                                            |
| *Item 6.*  | Exhibits  and Reports on Form 8-K                                                           | 42                                                                                                                              |
|       |                                                                                        |
| Signatures | 44                                                                                          |

 

 

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 Corporation**

**Condensed Consolidated Statements ofOperations**

(Unaudited)

 
|                                                                                                                            |   | **Three Months Ended**      |     | **Six Months Ended**        |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|----------|-----------------------------|--------|
| **(In  thousands, except per share data)**                                                                                      |   | **November 28,  2003** |     | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Sales                                                                                                                           |   | $                           | 181,891  |                        | $      | 272,186 |   | $ | 343,770 |   | $ | 541,363 |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Cost of  sales                                                                                                                  |   | 124,941                     |     | 134,566                     |   | 236,876 |   | 279,075 |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Gross margin                                                                                                                    |   | 56,950                      |     | 137,620                     |   | 106,894 |   | 262,288 |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Operating  expenses:                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Sales and  marketing                                                                                                            |   | 65,637                      |     | 60,151                      |   | 128,244 |   | 116,838 |   |
| Research and  development                                                                                                       |   | 24,421                      |     | 28,303                      |   | 51,348 |   | 59,780 |   |
| General and  administrative                                                                                                     |   | 21,784                      |     | 23,704                      |   | 45,923 |   | 48,415 |   |
| Amortization  and write down of intangibles                                                                                     |   | 1,095                       |     | 5,149                       |   | 4,482 |   | 7,099 |   |
| Restructuring  charges                                                                                                          |   | 58,892                      |     | 57,180                      |   | 107,516 |   | 76,767 |   |
| (Gain) loss  on land and facilities, net                                                                                        |   | —                      |     | (265                        | )      | — |   | 887 |   |
| Total  operating expenses                                                                                                       |   | 171,829                     |     | 174,222                     |   | 337,513 |   | 309,786 |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Operating  loss                                                                                                                 |   | (114,879                    | )        | (36,602                     | )      | (230,619 | ) | (47,498 | ) |
| Loss on  investments, net                                                                                                       |   | (12,252                     | )        | (7,087                      | )      | (12,194 | ) | (18,552 | ) |
| Interest and  other income, net                                                                                                 |   | 3,808                       |     | 3,909                       |   | 7,752 |   | 13,506 |   |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Loss from  continuing operations before income taxes, equity interest, and cumulative  effect of change in accounting principle |   | (123,323                    | )        | (39,780                     | )      | (235,061 | ) | (52,544 | ) |
| Income tax  provision (benefit)                                                                                                 |   | 1,500                       |     | 3,715                       |   | (4,535 | ) | 7,392 |   |
| Equity  interest in loss of unconsolidated joint venture                                                                        |   | (12,593                     | )        | —                      |   | (12,593 | ) | — |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle                                    |   | (137,416                    | )        | (43,495                     | )      | (243,119 | ) | (59,936 | ) |
| Discontinued  operations, net of taxes                                                                                          |   | (1,565                      | )        | (25,018                     | )      | (1,856 | ) | (60,711 | ) |
| Loss before  cumulative effect of change in accounting principle                                                                |   | (138,981                    | )        | (68,513                     | )      | (244,975 | ) | (120,647 | ) |
| Cumulative  effect of change in accounting principle                                                                            |   | —                      |     | —                      |   | — |   | (45,447 | ) |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Net loss                                                                                                                        |   | $                           | (138,981 | )                           | $      | (68,513 | ) | $ | (244,975 | ) | $ | (166,094 | ) |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Basic and diluted loss  per share:                                                                                              |   |                        |     |                        |   |   |   |   |   |
| Continuing operations  before cumulative effect of change in accounting principle                                               |   | $                           | (0.37    | )                           | $      | (0.12 | ) | $ | (0.65 | ) | $ | (0.16 | ) |
| Discontinued operations                                                                                                         |   | —                      |     | (0.07                       | )      | (0.01 | ) | (0.17 | ) |
| Cumulative effect of  change in accounting principle                                                                            |   | —                      |     | —                      |   | — |   | (0.13 | ) |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Net loss                                                                                                                        |   | $                           | (0.37    | )                           | $      | (0.19 | ) | $ | (0.66 | ) | $ | (0.46 | ) |
|                                                                                                                            |   |                        |     |                        |   |   |   |   |   |
| Shares used in  computing per share amounts:                                                                                    |   |                        |     |                        |   |   |   |   |   |
| Basic and diluted                                                                                                               |   | 375,332                     |     | 359,340                     |   | 371,606 |   | 358,389 |   |

 

*See notes to condensed consolidated financial statements.*

 

3

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**3Com Corporation**

**Condensed Consolidated Balance Sheets**

(Unaudited)

 
| **(In thousands, except par value)**                                                                            |   | **November 28,  2003** |      | **May 30,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-----------------------------|-----------|------------------------|--------|
|                                                                                                            |   |                        |      |                   |   |
| ASSETS                                                                                                          |   |                        |      |                   |   |
| Current  assets:                                                                                                |   |                        |      |                   |   |
| Cash and  equivalents                                                                                           |   | $                           | 443,946   |                   | $      | 515,848 |   |
| Short-term  investments                                                                                         |   | 948,410                     |      | 968,740                |   |
| Accounts  receivable, net                                                                                       |   | 70,905                      |      | 90,290                 |   |
| Inventories                                                                                                     |   | 30,342                      |      | 27,068                 |   |
| Other  current assets                                                                                           |   | 46,469                      |      | 51,234                 |   |
| Total  current assets                                                                                           |   | 1,540,072                   |      | 1,653,180              |   |
|                                                                                                            |   |                        |      |                   |   |
| Investment  in Huawei-3Com joint venture                                                                        |   | 147,485                     |      | —                 |   |
| Property and  equipment, net                                                                                    |   | 131,663                     |      | 248,790                |   |
| Property and  equipment held for sale                                                                           |   | 44,803                      |      | 101,283                |   |
| Deposits and  other assets                                                                                      |   | 34,753                      |      | 43,962                 |   |
| Deferred  income taxes                                                                                          |   | 2,398                       |      | 2,211                  |   |
| Intangible  assets, net                                                                                         |   | 7,554                       |      | 12,035                 |   |
| Goodwill                                                                                                        |   | 899                         |      | 899                    |   |
|                                                                                                            |   |                        |      |                   |   |
| Total assets                                                                                                    |   | $                           | 1,909,627 |                   | $      | 2,062,360 |   |
|                                                                                                            |   |                        |      |                   |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                      |   |                        |      |                   |   |
| Current  liabilities:                                                                                           |   |                        |      |                   |   |
| Accounts  payable                                                                                               |   | $                           | 102,522   |                   | $      | 105,583 |   |
| Accrued  liabilities and other                                                                                  |   | 260,241                     |      | 233,239                |   |
| Current  portion of debt                                                                                        |   | —                      |      | 346                    |   |
| Total  current liabilities                                                                                      |   | 362,763                     |      | 339,168                |   |
|                                                                                                            |   |                        |      |                   |   |
| Other  long-term obligations                                                                                    |   | 5,002                       |      | 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: 380,936 and 367,796, respectively |   | 2,200,352                   |      | 2,138,016              |   |
| Notes receivable from sale of  warrants                                                                         |   | —                      |      | (8,421                 | )      |
| Unamortized stock-based compensation                                                                            |   | (3,316                      | )         | (1,474                 | )      |
| Retained  deficit                                                                                               |   | (650,956                    | )         | (405,981               | )      |
| Accumulated  other comprehensive loss                                                                           |   | (4,218                      | )         | (3,543                 | )      |
| Total  stockholders’ equity                                                                                |   | 1,541,862                   |      | 1,718,597              |   |
|                                                                                                            |   |                        |      |                   |   |
| Total  liabilities and stockholders’ equity                                                                |   | $                           | 1,909,627 |                   | $      | 2,062,360 |   |

 

*See notes to condensed consolidated financial statements.*

 

4

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**3Com Corporation**

**Condensed Consolidated Statements of CashFlows**

(Unaudited)

 
|                                                                                                                                                                            |   | **Six Months Ended**       |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|------------|
| **(In  thousands)**                                                                                                                                                             |   | **November 28, 2003** |       | **November 29, 2002** |   |
|                                                                                                                                                                            |   |                       | ** ** |   | ** ** |
| Cash flows from  operating activities:                                                                                                                                          |   |                       |       |   |   |
| Loss from continuing  operations, including cumulative effect of change in accounting principle                                                                                 |   | $                          | (243,119   | ) | $ | (105,383 | ) |
| 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                                                                                                                                              |   | (1,856                     | )          | (60,711 | ) |
| Depreciation and  amortization                                                                                                                                                  |   | 67,897                     |       | 74,972 |   |
| Write down of  intangibles, including cumulative effect of change in accounting principle                                                                                       |   | 1,905                      |       | 73,251 |   |
| Loss on property and  equipment                                                                                                                                                 |   | 29,848                     |       | 59,234 |   |
| Losses on investments,  net                                                                                                                                                     |   | 12,194                     |       | 18,552 |   |
| Equity interest in loss  of unconsolidated joint venture                                                                                                                        |   | 12,593                     |       | — |   |
| Deferred income taxes                                                                                                                                                           |   | (6                         | )          | 246 |   |
| Stock-based expense                                                                                                                                                             |   | 1,251                      |       | 4,883 |   |
| Changes in current  assets and liabilities:                                                                                                                                     |   |                       |       |   |   |
| Accounts  receivable                                                                                                                                                            |   | 19,385                     |       | 9,266 |   |
| Inventories                                                                                                                                                                     |   | (8,637                     | )          | 12,567 |   |
| Other assets                                                                                                                                                                    |   | 3,454                      |       | 15,863 |   |
| Accounts  payable                                                                                                                                                               |   | (3,061                     | )          | (16,853 | ) |
| Accrued  liabilities and other                                                                                                                                                  |   | 23,697                     |       | (37,906 | ) |
| Income taxes  payable                                                                                                                                                           |   | 3,311                      |       | 10,763 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Net cash  provided by (used in) operating activities                                                                                                                            |   | (81,144                    | )          | 58,744 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Cash flows from  investing activities:                                                                                                                                          |   |                       |       |   |   |
| Investment in  Huawei-3Com joint venture                                                                                                                                        |   | (160,000                   | )          | — |   |
| Purchase of investments                                                                                                                                                         |   | (552,691                   | )          | (714,302 | ) |
| Proceeds  from maturities and sales of investments                                                                                                                              |   | 562,550                    |       | 453,428 |   |
| Purchase of  property and equipment                                                                                                                                             |   | (8,232                     | )          | (10,777 | ) |
| Proceeds  from sale of property and equipment                                                                                                                                   |   | 99,640                     |       | 79,944 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Net cash  used in investing activities                                                                                                                                          |   | (58,733                    | )          | (191,707 | ) |
|                                                                                                                                                                            |   |                       |       |   |   |
| Cash flows  from financing activities:                                                                                                                                          |   |                       |       |   |   |
| Issuance of  common stock                                                                                                                                                       |   | 59,242                     |       | 10,604 |   |
| Repurchase  of common stock                                                                                                                                                     |   | —                     |       | (1,548 | ) |
| Collection  of note receivable issued for warrants                                                                                                                              |   | 8,421                      |       | 4,211 |   |
| Repayments  of long-term borrowings                                                                                                                                             |   | (346                       | )          | (22,581 | ) |
| Net  repayments on line of credit                                                                                                                                               |   | —                     |       | (70,000 | ) |
| Other, net                                                                                                                                                                      |   | —                     |       | 71 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Net cash  provided by (used in) financing activities                                                                                                                            |   | 67,317                     |       | (79,243 | ) |
|                                                                                                                                                                            |   |                       |       |   |   |
| Effect of currency translation                                                                                                                                                  |   | 658                        |       | 843 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Decrease in  cash and equivalents                                                                                                                                               |   | (71,902                    | )          | (211,363 | ) |
| Cash and  equivalents, beginning of period                                                                                                                                      |   | 515,848                    |       | 679,055 |   |
|                                                                                                                                                                            |   |                       |       |   |   |
| Cash and  equivalents, end of period                                                                                                                                            |   | $                          | 443,946    |   | $ | 467,692 |   |

 

*See notes to condensed consolidated financial statements.*

 

5

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**3Com Corporation**

**Notes to Condensed Consolidated FinancialStatements**

(Unaudited)

 

1.                                       Basisof Presentation

 

The unaudited condensed consolidated financial statements have beenprepared by 3Com Corporation (3Com or the Company), pursuant to the rules andregulations of the Securities and Exchange Commission.  In the opinion of management, theseunaudited condensed consolidated financial statements include all adjustmentsnecessary for a fair presentation of 3Com’s financial position as ofNovember 28, 2003 and May 30, 2003, its results of operations for thethree and six months ended November 28, 2003 and November 29, 2002,and its cash flows for the six months ended November 28, 2003 andNovember 29, 2002.

 

On May 23, 2003, 3Com completed the sale of its CommWorks businessunit and transferred selected assets and liabilities to UTStarcom, Inc.  Accordingly, the financial informationincluded herein for the three and six months ended November 29, 2002 has beenrestated 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 six months endedNovember 28, 2003 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 Accounting Pronouncements*

 

In November 2002, the Emerging Issues Task Force (EITF)reached a consensus on Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables.” EITF 00-21 addresses certain aspects of the accounting by avendor for arrangements under which the vendor will perform multiple revenuegenerating activities. EITF 00-21 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 or results of operations.

 

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, 3Com generally recognizes no compensationexpense with respect to granting of such stock option awards.

 

Pro forma information regarding net income and earnings per share isrequired by SFAS 123. This information is required to be determined as if 3Comhad accounted for its stock-based awards to employees, including grants ofemployee stock options and rights to purchase shares under the Employee StockPurchase Plan (ESPP), under the fair value method of that Statement.

 

As of November 28, 2003, and November 29, 2002, the expectedaverage life of employee stock options (ESO) was estimated at approximately oneand a half years after the vesting date, and the expected average life ofpurchase rights granted under the ESPP was estimated at six months from thesubscription date. The fair values of options granted during the second quarterof fiscal 2004 and 2003 and the first six months of fiscal 2004 and 2003, andthe fair values of purchase rights

 

6

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granted under the ESPP during those periods, have been estimated as ofthe date of grant using the Black-Scholes option pricing model with thefollowing assumptions, and resulting in the following per-share fair values:

 
|                                                        |   | **Three Months Ended**      |   | **Six Months Ended**        |   |
|-------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                        |   | **November 28,  2003** |   | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                                        |   |                        |   |                        |   |   |   |   |   |
| Volatility-ESO                                              |   | 66.0                        | %      | 67.0                        | %      | 67.0 | % | 67.0 | % |
| Volatility-ESPP                                             |   | 45.0                        | %      | 49.0                        | %      | 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                         | %      | 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          |   | $                           | 3.21   |                        | $      | 2.15 |   | $ | 2.75 |   | $ | 2.31 |   |
| Per-share  fair value of purchase rights granted under ESPP |   | $                           | 1.79   |                        | $      | 1.54 |   | $ | 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**      |     | **Six Months Ended**        |   |
|-------------------------------------------------------------------------------------|--------|-----------------------------|----------|-----------------------------|--------|
| **(in  thousands, except per share amounts)**                                       |   | **November 28,  2003** |     | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                                                                |   |                        |     |                        |   |   |   |   |   |
| Net loss as  reported                                                               |   | $                           | (138,981 | )                           | $      | (68,513 | ) | $ | (244,975 | ) | $ | (166,094 | ) |
| Add  stock-based compensation included in reported net loss                         |   | 953                         |     | 3,297                       |   | 1,251 |   | 4,883 |   |
| Deduct  total stock-based compensation determined under the fair value-based method |   | (5,412                      | )        | (9,021                      | )      | (10,689 | ) | (24,500 | ) |
| Pro  forma net loss                                                                 |   | $                           | (143,440 | )                           | $      | (74,237 | ) | $ | (254,413 | ) | $ | (185,711 | ) |
|                                                                                |   |                        |     |                        |   |   |   |   |   |
| Net loss per  share-basic and diluted:                                              |   |                        |     |                        |   |   |   |   |   |
| As reported                                                                         |   | $                           | (0.37    | )                           | $      | (0.19 | ) | $ | (0.66 | ) | $ | (0.46 | ) |
| Pro forma                                                                           |   | (0.38                       | )        | (0.21                       | )      | (0.68 | ) | (0.52 | ) |

 

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. 3Com took several actions: it implemented a reduction inworkforce and other actions aimed at reducing costs and expenses; it exited productlines; it outsourced the manufacturing of certain high volume server, desktopand mobile connectivity products in a contract manufacturing arrangement; andit consolidated its real estate portfolio and made plans to sell some of itsfacilities as part of this restructuring effort. These efforts continuedthrough fiscal 2002.

 

7

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As a result of a continuing decline in revenues, 3Com took additionalactions in fiscal 2003. The Company announced the integration of the supportinfrastructure of two of its business units to leverage a common infrastructurein order to drive additional cost out of the business. Additionally, 3Comentered into an agreement to outsource certain information technology (IT) functions,and continued to consolidate its real estate portfolio.

 

In response to further revenue declines and continuing net losses, 3Comhas taken additional measures to reduce costs in fiscal 2004. These actionsinclude a reduction in workforce, outsourcing of the Company’s remaining manufacturing operations inDublin, Ireland, and continuing efforts to consolidate  and dispose of excess facilities.

 

Accrued liabilities associated with restructuring charges areclassified as current, since 3Com intends to satisfy such liabilities in cashin the current year, and are included in the caption “accrued liabilities andother” in the accompanying condensed consolidated balance sheets.

 

*Fiscal 2004 Actions*

 

The following table provides a summary of the components of accruedrestructuring charges related to the restructuring actions initiated in thefirst and second quarters of fiscal 2004, together with changes in the accruedamounts during the first and second quarters of fiscal 2004 and the endingbalances of the associated accrued liabilities as of November 28, 2003 (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 |   |

 

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. ThroughNovember 28, 2003, the total reduction in workforce associated withactions initiated during fiscal 2004 includes approximately 200 employees whohave been separated or were in the separation process, and approximately 600additional employees who have been notified but have not yet worked their lastday. Also, through November 28, 2003, total separation payments associatedwith actions initiated during fiscal 2004 have been approximately $12.5million.

 

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

 

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 the Company, and a loss of $1.1million related to the sale of its Rolling Meadows, Illinois facility in thefirst quarter of fiscal 2004. These charges were offset by credits of $0.3million related to fair value adjustments of properties classified as 

 

8

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heldfor sale prior to fiscal 2004. In the second quarter of fiscal 2004, 3Comrecorded $28.9 million of facilities-related charges, including $25.5 millionof accelerated depreciation related to its Dublin and Santa Clara facilitiesreferred to above, a $1.4 million loss on the sale of certain other Santa Claraproperties, charges of $1.4 million related to fair value adjustments ofproperties classified as held for sale prior to fiscal 2004, and $0.6 millionrelated to estimated lease termination costs.

 

Otherrestructuring costs relate mainly to estimated obligations associated with3Com’s outsourcing of its manufacturing operations in Dublin.

 

*Fiscal 2003 Actions*

 

The following table provides a summary of the components of accruedrestructuring charges related to the restructuring actions initiated in fiscal2003, together with changes in the accrued amounts during the first and secondquarters of fiscal 2004 and the ending balances of the associated accruedliabilities as of November 28, 2003 (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 |   |

 

Thenet benefit and additional charges recorded in the first and second quarters,respectively, of fiscal 2004 for employee separation expenses relate torevisions of previous estimates of employee separation expenses.  Through November 28, 2003, the totalreduction in workforce associated with actions initiated during fiscal 2003included 400 employees in the product development, sales, customer support, andgeneral and administrative functions. Also, through November 28, 2003,total separation payments associated with actions initiated during fiscal 2003have been approximately $17.0 million.

 

Facilities-relatedcharges in the first and second quarters of fiscal 2004 relating torestructuring actions initiated in fiscal 2003 were the result of revisions inestimates of lease termination costs.

 

*Fiscal 2001 and Fiscal 2002 Actions*

 

The following table provides a summary of the components of accruedrestructuring charges related to the restructuring actions initiated in fiscal2001 and fiscal 2002, together with changes in the accrued amounts during thefirst and second quarters of fiscal 2004 and the ending balances of theassociated accrued liabilities as of November 28, 2003 (in thousands):

 
|                              |   | **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 |   |

 

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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.                                       Comprehensive Loss

 

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

 
|                                           |   | **Three Months Ended**      |     | **Six Months Ended**        |   |
|------------------------------------------------|--------|-----------------------------|----------|-----------------------------|--------|
|                                           |   | **November 28,  2003** |     | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                           |   |                        |     |                        |   |   |   |   |   |
| Net  loss                                      |   | $                           | (138,981 | )                           | $      | (68,513 | ) | $ | (244,975 | ) | $ | (166,094 | ) |
|                                           |   |                        |     |                        |   |   |   |   |   |
| Other  comprehensive income (loss):            |   |                        |     |                        |   |   |   |   |   |
| Net  unrealized gain (loss) on investments     |   | (310                        | )        | 482                         |   | (1,333 | ) | 94 |   |
| Change  in accumulated translation adjustments |   | 641                         |     | (502                        | )      | 658 |   | 873 |   |
|                                           |   |                        |     |                        |   |   |   |   |   |
| Total  comprehensive loss                      |   | $                           | (138,650 | )                           | $      | (68,533 | ) | $ | (245,650 | ) | $ | (165,127 | ) |

 

5.                                       Net Loss Per Share

 

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

 
|                                                                                         |   | **Three Months Ended**      |     | **Six Months Ended**        |   |
|----------------------------------------------------------------------------------------------|--------|-----------------------------|----------|-----------------------------|--------|
|                                                                                         |   | **November 28,  2003** |     | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                                                                         |   |                        |     |                        |   |   |   |   |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle |   | $                           | (137,416 | )                           | $      | (43,495 | ) | $ | (243,119 | ) | $ | (59,936 | ) |
| Loss from  discontinued operations                                                           |   | (1,565                      | )        | (25,018                     | )      | (1,856 | ) | (60,711 | ) |
| Cumulative  effect of change in accounting principle                                         |   | —                      |     | —                      |   | — |   | (45,447 | ) |
| Net  loss                                                                                    |   | $                           | (138,981 | )                           | $      | (68,513 | ) | $ | (244,975 | ) | $ | (166,094 | ) |
|                                                                                         |   |                        |     |                        |   |   |   |   |   |
| Weighted  average shares-basic                                                               |   | 375,332                     |     | 359,340                     |   | 371,606 |   | 358,389 |   |
| Effect  of dilutive securities:                                                              |   |                        |     |                        |   |   |   |   |   |
| Employee  stock options                                                                      |   | —                      |     | —                      |   | — |   | — |   |
| Restricted  stock                                                                            |   | —                      |     | —                      |   | — |   | — |   |
| Weighted  average shares-diluted                                                             |   | 375,332                     |     | 359,340                     |   | 371,606 |   | 358,389 |   |
|                                                                                         |   |                        |     |                        |   |   |   |   |   |
| Net loss per  share-basic and diluted:                                                       |   |                        |     |                        |   |   |   |   |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle |   | $                           | (0.37    | )                           | $      | (0.12 | ) | $ | (0.65 | ) | $ | (0.16 | ) |
| Loss from  discontinued operations                                                           |   | —                      |     | (0.07                       | )      | (0.01 | ) | (0.17 | ) |
| Cumulative  effect of change in accounting principle                                         |   | —                      |     | —                      |   | — |   | (0.13 | ) |
| Net loss                                                                                     |   | $                           | (0.37    | )                           | $      | (0.19 | ) | $ | (0.66 | ) | $ | (0.46 | ) |

 

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Employeestock options and restricted stock totaling 8.9 million shares, 2.8 millionshares, 5.8 million shares, and 3.0 million shares for the three months endedNovember 28, 2003 and November 29, 2002 and the six months endedNovember 28, 2003 and November 29, 2002, respectively, were notincluded in the diluted weighted average shares calculation as the effects ofthese securities were anti-dilutive.

 

6.                                       Inventories

 

Inventories consist of (in thousands):

 
|            |   | **November 28,  2003** |   | **May 30,  2003** |   |
|-----------------|--------|-----------------------------|--------|------------------------|--------|
|            |   |                        |   |                   |   |
| Finished  goods |   | $                           | 17,920 |                   | $      | 15,891 |   |
| Work-in-process |   | 4,330                       |   | 3,228                  |   |
| Raw  materials  |   | 8,092                       |   | 7,949                  |   |
|            |   |                        |   |                   |   |
| Total           |   | $                           | 30,342 |                   | $      | 27,068 |   |

 

7.                                       Investment in Unconsolidated Joint Venture

 

On November 17, 2003, 3Com formed the Huawei-3ComJoint Venture (H-3C) with a subsidiary of Huawei Technologies, Ltd. (Huawei).H-3C will be domiciled in Hong Kong with principal operations in Hangzhou,China. At the time of formation, 3Com contributed cash of $160.0 million,assets related to its operations in China and Japan with a carrying value of$0.1 million, and licenses related to certain intellectual property in exchangefor 49 percent of the outstanding common shares of H-3C. 3Com recorded itsinitial investment in H-3C at $160.1 million, reflecting 3Com’s carrying valuefor the assets contributed in exchange for the common shares received. Huaweicontributed its enterprise networking business assets, including Local AreaNetwork switches and routers, engineering and sales and marketing resources andpersonnel, and licenses to its related intellectual property in exchange for a51 percent ownership interest.

 

Two years after formation of H-3C, 3Com has theone-time option to purchase an additional two percent ownership interest fromHuawei for an amount not to exceed $28 million. Three years after formation ofH-3C, 3Com and Huawei each have the right to purchase all of the otherpartner’s ownership interest through a bid process.

 

3Com accounts for its investment in H-3C under the equity method. Underthis method, 3Com records its proportionate share of H-3C’s net income or lossbased on the most recently available quarterly financial statements of H-3C.Since H-3C has adopted a calendar year basis of reporting, 3Com will report itsequity in H-3C’s net income or loss for the calendar quarter endingDecember 31, 2003 in the Company’s financial statements for the thirdquarter of fiscal 2004.  Prospectively,the Company will continue to report its equity in H-3C’s net income or lossbased on H-3C’s most recent quarterly financial statements, two months inarrears. At the time of formation of H-3C, 3Com recorded a charge of $12.6million representing 3Com’s ownership share (49 percent) of the valueattributed to in-process technology contributed to H-3C by Huawei that had notyet reached technological feasibility and had no 

 

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alternative future use. This charge was included in 3Com’s results ofoperations for the second quarter and first six months of fiscal 2004 under thecaption “Equity interest in loss of unconsolidated joint venture.”

 

Summarized balance sheet information for H-3C as of the date of itsformation on November 17, 2003 was as follows (in thousands):

 
|                     |   | **November 17,  2003** |    |
|--------------------------|--------|-----------------------------|---------|
| Current  assets          |   | $                           | 160,000 |   |
| Non-current  assets      |   | 207,088                     |    |
| Current  liabilities     |   | —                      |    |
| Non-current  liabilities |   | —                      |    |
|                          |        |                             |         |  |

 

3Com and H-3C are parties to agreements for the saleof certain products from 3Com to H-3C as well as from H-3C to 3Com. Inaddition, 3Com provides certain services to H-3C related to warranty for itsproducts sold to H-3C, as well as information technology services. Transactionsand outstanding balances between 3Com and H-3C for the three months endedNovember 28, 2003 and as of November 28, 2003, were not material.

 

8.                                       Property and Equipment

 

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 connectionwith 3Com’s plans to discontinue its manufacturing operations as discussed inNote 3, 3Com classified certain land and facilities located in Dublin as heldfor sale at the end of the second quarter of fiscal 2004. The carrying value ofsuch properties was approximately $27.5 million as of November 28, 2003.

 

Also,as a result of 3Com’s workforce reductions and relocation of its headquartersfrom Santa Clara to Marlborough, Massachusetts during fiscal 2004, the Companyhas excess office space in several buildings it owns in Santa Clara.  During the first quarter of fiscal 2004, 3Comdecided to consolidate its office space and relocate from its current locationsinto a smaller, vacant facility that was classified as held for sale as ofMay 30, 2003, and had a carrying value of $10.1 million. Due to thisdecision, 3Com reclassified this previously held-for-sale facility as held foruse. 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.

 

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 ofthe transaction, 3Com is leasing back approximately 43,000 square feet of spaceat prevailing market rates. This property was not classified as held for sale as of May 30,2003 due to the Company’s intention to lease back a portion of the facility.

 

12

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9.                                       Intangible Assets, Net

 

Intangibleassets, net, consist of (in thousands):

 
|                                  |   | **November 28,  2003** |   | **May 30,  2003** |   |
|---------------------------------------|--------|-----------------------------|--------|------------------------|--------|
|                                  |   |                        |   |                   |   |
| Developed  and core technology, gross |   | $                           | 37,138 |                   | $      | 42,574 |   |
| Accumulated  amortization             |   | (29,584                     | )      | (30,619                | )      |
| Net  developed and core technology    |   | 7,554                       |   | 11,955                 |   |
|                                  |   |                        |   |                   |   |
| Customer  relationships, gross        |   | 420                         |   | 476                    |   |
| Accumulated  amortization             |   | (420                        | )      | (396                   | )      |
| Net  customer relationships           |   | —                      |   | 80                     |   |
|                                  |   |                        |   |                   |   |
| Total  net intangible assets          |   | $                           | 7,554  |                   | $      | 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 condensedconsolidated statements of operations for the six months endedNovember 28, 2003.

 

Based on the carrying value of 3Com’sintangible assets as of November 28, 2003, amortization expense isexpected to be $2.2 million for the second half of fiscal 2004, $3.5 millionfor fiscal 2005, and $1.9 million for fiscal 2006.

 

10.                                 Accrued Warranty and OtherGuarantees

 

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 six months ended November 28, 2003 andNovember 29, 2002 (in thousands):

 
|                                                                               |   | **First six  months of****2004** |   | **First six  months of****2003** |   |
|------------------------------------------------------------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
| Accrued  warranty, May 30, 2003 and May 31, 2002, respectively           |   | $                                | 44,775 |                             | $      | 53,289 |   |
| Cost  of warranty claims                                                           |   | (17,494                          | )      | (22,135                          | )      |
| Accruals  for warranties issued during the period                                  |   | 17,481                           |   | 15,585                           |   |
| Adjustments  to preexisting warranties                                             |   | (23                              | )      | 2,838                            |   |
| Net  change associated with discontinued operations                                |   | —                           |   | (1,878                           | )      |
| Accrued  warranty, November 28, 2003 and November 29, 2002, respectively |   | $                                | 44,739 |                             | $      | 47,699 |   |

 

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In prior years, 3Com entered into several agreements whereby it hadsold product to resellers who had, in turn, sold the product to others, and3Com has guaranteed the payments of the end users. If all end users under theseagreements were to default on their payments as of November 28, 2003, 3Comwould be required to pay approximately $7.5 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.

 

Additional amounts could also be owed for obligations relating tovarious facilities that 3Com has or is in the process of vacating. As ofNovember 28, 2003, 3Com’s liabilities included $12.4 million related tosuch obligations, including $5.2 million that was recorded as a charge torestructuring costs during the first quarter of fiscal 2004.

 

11.                                 Stock Plans

 

In September 2003,3Com’s stockholders approved the Company’s 2003 Stock Plan (the new plan),which replaced the 1983 Stock Option Plan, the 1994 Stock Option Plan, theDirector Plan, and the Restricted Stock Plan (the prior plans) for all stockawards granted subsequent to the approval date. In connection with the approvalof the new plan, 3Com cancelled all shares available for issuance under theprior plans (other than those shares underlying outstanding awards), whichincluded approximately 128 million shares at the time of approval; at the sametime, 20 million shares were reserved for issuance under the new plan.

 

Inaddition, stockholders approved an increase of five million shares availablefor issuance under the Company’s 1984 Employee Stock Purchase Plan.

 

12.                                 Business Segment 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 itsprevious multiple operating segments into a single, integrated enterprisenetworking business. As a result, 3Com now presents financial information relatedto its business on the basis of a single segment.

 

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

 
|                               |   | **Three Months Ended**      |    | **Six Months Ended**        |   |
|------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                               |   | **November 28,  2003** |    | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                               |   |                        |    |                        |   |   |   |   |   |
| Americas                           |   | $                           | 60,924  |                        | $      | 119,211 |   | $ | 129,527 |   | $ | 247,358 |   |
| Europe,  Middle East, & Africa |   | 87,979                      |    | 112,100                     |   | 151,798 |   | 209,403 |   |
| Asia  Pacific Rim                  |   | 32,988                      |    | 40,875                      |   | 62,445 |   | 84,602 |   |
|                               |   | $                           | 181,891 |                        | $      | 272,186 |   | $ | 343,770 |   | $ | 541,363 |   |

 

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13.                                 Litigation

 

3Com is aparty to lawsuits in the normal course of its business.  Litigation can be expensive and disruptiveto normal business operations. Moreover, the results of complex legalproceedings are difficult to predict. 3Com believes that it has meritorious defenses in each of the cases setforth below in which it is named as a defendant and is vigorously contestingeach of these matters.  An unfavorableresolution of one or more of these lawsuits could adversely affect itsbusiness, results of operations, or financial condition.  3Com cannot estimate the loss or range ofloss that may be reasonably possible for any of the contingencies described andaccordingly has not recorded any associated liabilities in its condensedconsolidated balance sheets.

 

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 theDistrict Court for the Northern District of Illinois was transferred to theDistrict Court for the Northern District of California on June 11, 2003and assigned Civil Action Number C 03 2710. On August 18, 2003, thataction was consolidated for certain purposes with the action PCTEL initiatedagainst 3Com 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.*,No. CV794039, was filed in California Superior Court. The complaint allegesthat 3Com’s directors and officers breached their fiduciary duties to theCompany in connection with the adjustment of employee and director stockoptions in connection with the separation of 3Com and Palm. On May 13,2003, the Court dismissed the Second Amended Complaint.  The plaintiff has 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 *XeroxCorporation v. 3Com Corporation, U.S. Robotics Corporation, U.S. RoboticsAccess Corporation, Palm Computing, Inc., and Palm, Inc.* (CivilAction Number 97-CV-6182T).  Xeroxalleged willful infringement of United States Patent Number 5,596,656, entitled“Unistrokes for Computerized Interpretation of Handwriting.”  Xerox sought to recover damages and topermanently enjoin the defendants from infringing the patent in the future.  In 2000, the District Court dismissed thecase, ruling that there was no infringement. On appeal, the Court of Appeals for the Federal Circuitaffirmed-in-part, reversed-in-part and remanded the case to the District Courtfor 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. Xerox then appealed the denial of 

 

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theinjunction.  On February 20, 2003,the Court of Appeals issued its decision affirming in part and reversing inpart the order of the trial court.  TheCourt of Appeals affirmed the grant of summary judgment of infringement,reversed the grant of summary judgment of validity and remanded the case to thetrial court to conduct a complete validity analysis.  In connection with the separation of Palm from 3Com, pursuant tothe terms of the Indemnification and Insurance Matters Agreement, datedFebruary 26, 2000, between 3Com and Palm, Palm (since renamed palmOne) agreedto indemnify and hold 3Com harmless for any damages or losses that might ariseout 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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**3Com Corporation**

 

***Item 2.*****                                  Management’s Discussion and Analysis ofFinancial 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:

 

•                  Financialposition and results of operations, including income from continuingoperations, general and administrative expense, amortization expense, and totaloperating expenses;

•                  Expectedquarterly reductions of cost of sales and operating expenses resulting fromrestructuring activities, including the impact on cash from operations;

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

•                  Salesgrowth, enhancement of our direct sales, service and support capabilities andthe development of new sales channels;

•                  Increasedrevenue and the sources and concentration of revenue;

•                  Accountingtreatment of our share of the net income / loss of the Huawei-3Com jointventure;

•                  Channelinventory levels;

•                  Developmentand expansion of our products and solutions and those of the Huawei-3Com jointventure, our sourcing of products from original equipment manufacturers and theHuawei-3Com joint venture, and our product mix, including the declining salesof our connectivity products;

•                  Relationshipswith suppliers and strategic partners, including increased reliance onstrategic relationships;

•                  Consolidationof operations and the disposal of excess facilities;

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

•                  Ourrestructuring and cost-reduction efforts, including facilities-related chargesand severance costs and the effects of our restructuring efforts;

•                  Sourcesof competition;

•                  Prospectsregarding 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 all remaining internal manufacturing operations and outsourcing ofinformation technology activities and other functions and operations, such asproduct testing and shipping; and

•                  Resultsof the relocation of corporate headquarters and certain management functions,and the relocation of other functions, including development, administrativeand transaction processing functions

 

You can identify these and other forward-looking statementsby the use of words such as “may,” “will,”

 

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“should,” “expects,” “plans,” “anticipates,” “believes,”“estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative ofsuch terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying orrelating to any of the foregoing 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.

 

**Overview**

 

In the fourth quarter of fiscal2001, we undertook several broad initiatives aimed at increasing revenue andreducing costs in an attempt to return 3Com to profitability. These initiativesincluded exiting certain product lines that were not expected to yield asatisfactory return on investment in the near term, and resulted inrestructuring charges of $154.9 million in fiscal 2001. Excluding these exitedproduct lines and our CommWorks business unit that we sold in fiscal 2003, ourcontinuing operations included two business units—Business Connectivity Company(BCC) and Business Networks Company (BNC). These business units operatedthroughout all of fiscal 2002. During fiscal 2002, we continued to experiencedeclining revenue. As a response to this decline, we undertook additionalmeasures to further reduce costs, including headcount reductions, long termasset retirements, and outsourcing manufacturing operations; these measures ledto 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 products previouslymanaged under BNC as well as certain wireless and security offerings that wereformerly part of BCC. Other actions pursued in fiscal 2003 were headcountreductions, outsourcing of certain information technology (IT) functions, andcontinuing efforts to sell excess facilities. All of these actions generatedrestructuring charges, totaling $184.9 million in fiscal 2003, but alsoresulted in reductions of ongoing sales and marketing, research anddevelopment, and general and administrative expenses for fiscal 2003 ascompared to fiscal 2002.

 

Infiscal 2004, we are taking a number of steps with the objective of restoring3Com to profitability.  To increaserevenues, we are expanding our product portfolio to include more Layer 3-plusand higher end products, a full line of modular switches and routers, and ahigher-end Voice-over-Internet Protocol (IP) offering.  In addition, as described in more detailbelow, we have formed the Huawei-3Com Joint Venture (H-3C) withHuawei Technologies, Ltd., which will allow us to expand our product portfoliofurther to include router and modular switching products.  We believe that such an expanded productportfolio will allow us to deliver converged voice and data networking solutionsnot only to our traditional customers but also to larger and multi-siteenterprises.  Also, in order to drivesales of these higher end products, we are enhancing our direct touch sales,service and support capabilities, 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 second quarter of fiscal 2004 increased 12 percent sequentially. Part ofthis increase was attributable to certain router and switch products that we sourcedfrom Huawei prior to the launch of our joint venture with Huawei, discussedfurther below. Going forward, these router and switch products will be sourcedfrom the joint venture, but we will continue to maintain a reseller’s agreementwith Huawei for other products. The increase in sales was also attributable toboth pricing actions taken in the previous quarter that stimulated sales, aswell as the fact that the previous quarter is seasonally a slower quarter inour international regions. On a geographic basis, our revenue growth in thesecond quarter of fiscal 2004

 

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wasdriven largely by increased sales in our Europe, Middle East & Africa(EMEA) region, and to a smaller extent in our Asia Pacific Rim (APR) region.Partially offsetting these increases was a sequential decrease in domesticsales. This sequential decrease was partly due to the fact that the secondquarter is seasonally a weaker quarter in the domestic market.

 

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 was announced inMay 2003 to move our corporate headquarters from Santa Clara, Californiato Marlborough was, in part, due to this trend. We expect that the relocationof our corporate headquarters and certain management functions to Marlboroughwill enable us to run the business more effectively and efficiently.

 

InJune 2003, we announced a reduction in workforce, most of which willimpact general and administrative expenses. In addition, we are relocating transaction processing functions to lowercost locations.  In September 2003,we announced an additional reduction of approximately one-third of ourworkforce. The majority of the employees impacted by this reduction inworkforce are involved in manufacturing operations in Dublin, Ireland; we planto discontinue such internal manufacturing operations and outsource them tocontract manufacturers during the third quarter of fiscal 2004. Also impactedby this reduction in workforce are certain product development functions thatwill be moved to lower-cost locations by the end of fiscal 2004.

 

As a result ofour restructuring efforts as described above, including primarily the actionsannounced in both June and September of 2003, we recorded restructuring chargesof $107.5 million in the first six months of fiscal 2004.  In addition, we expect to record additionalrestructuring charges associated with these actions of approximately $29million in the third quarter of fiscal 2004. These actual and expected charges include the following main components:

 

•                  $52 million forfacilities-related, severance and other costs related to the outsourcing of theCompany’s remaining manufacturing operations in Dublin and other reductions inthe supply chain workforce;

 

•                  $67 million forother facilities-related costs; and

 

•                  $15 million forother severance costs.

 

As a result of theaforementioned fiscal 2004 restructuring actions and related charges, and basedon our current projections for revenues, costs and expenses, which are subjectto significant uncertainty, we expect that cost of sales and operating expenseswill be reduced by approximately $4 million per quarter and $10 million perquarter, respectively, which effects will not be fully realized until thefourth quarter of fiscal 2004. The expected reduction in cost of sales reflectsthe fact that a portion of the direct costs that we will avoid by outsourcingour manufacturing operations in Dublin will be incurred in the future as costsof products procured from contract manufacturers instead. In addition to theaforementioned expected reductions in costs and expenses associated with ourrestructuring actions announced to date, we believe that we must further reducetotal operating expenses over the next several quarters to be less than $100million per quarter, as compared to $171.8 million for the most recent quarter,in order to achieve profitability.

 

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 ownershipinterest.  Huawei contributed itsenterprise networking business assets, including Local Area Network (LAN)switches and routers, engineering and sales and marketing resources andpersonnel, and licenses to its related intellectual property in exchange for a51 percent ownership interest. Two years after formation of H-3C, we have theone-time option to purchase an additional two percent ownership interest fromHuawei for an amount not to exceed $28 million. Three years after formation ofH-3C, 3Com and Huawei each have the right to purchase all of the otherpartner’s ownership interest through a bid process.

 

H-3C will sell its own products, as well as products it purchasesdirectly from us and Huawei, in China and Japan under H-3C brand, Huawei-3Com.Outside of China and Japan, we will be offering for resale H-3C’s products underthe 3Comâ brand. Throughthis reseller agreement, we will be expanding our product line to includerouter products and modular switching products. The addition of these productsto our product portfolio will increase the size of the market opportunity forwhich we may now 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-process technologycontributed 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 and first six months of fiscal2004 under the caption “Equity interest in loss of unconsolidated jointventure.” Prospectively, from the date of formation, we will

 

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record our proportionate share of H-3C’s net income or loss based onthe most recently available quarterly financial statements of H-3C. Since H-3Chas adopted a calendar year basis of reporting, we will report our equity inH-3C’s net income or loss for the calendar quarter ending December 31,2003 in our financial statements for the third quarter of fiscal 2004.  Thereafter, we will continue to report ourequity in H-3C’s net income or loss based on H-3C’s most recent quarterlyfinancial statements, two months in arrears. As H-3C is in the initial stagesof its operations, we do not expect the impact of H-3C’s results tosignificantly affect our results of operations for the next two to threequarters.

 

We expect thatsome of the steps that we are taking will result in ongoing downward pressureon income from continuing operations in the near term.  For example, we are incurring significantcharges for severance costs and write downs of excess facilities related to thereductions of workforce and the closing of our manufacturing operations. Inaddition, as we transition our business in China and Japan to H-3C, there maybe a disruption in volumes, as well as lower average selling prices since weexpect the pricing of products sold to H-3C under an original equipmentmanufacturer (OEM) agreement to be lower than the pricing of products soldthrough the distribution channels. Further, general and administrative expenses will be affected byrelocation and recruiting costs associated with the ongoing relocation of keycorporate functions from Santa Clara to Marlborough. However, we believe thatthe steps that we are taking are appropriate at this time and fully consistentwith our goals of increasing revenues and restoring profitability over thelonger term.

 

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, revenues, profitability 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**      |   | **Six months ended**        |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                                                                                            |   | **November 28,  2003** |   | **November 29,  2002** |   | **November 28,  2003** |   | **November 29,  2002** |   |
|                                                                                                                            |   |                        |   |                        |   |   |   |   |   |
| Sales                                                                                                                           |   | 100.0                       | %      | 100.0                       | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                                                                                                   |   | 68.7                        |   | 49.4                        |   | 68.9 |   | 51.5 |   |
| Gross margin                                                                                                                    |   | 31.3                        |   | 50.6                        |   | 31.1 |   | 48.5 |   |
| Operating expenses:                                                                                                             |   |                        |   |                        |   |   |   |   |   |
| Sales and marketing                                                                                                             |   | 36.1                        |   | 22.1                        |   | 37.3 |   | 21.6 |   |
| Research and development                                                                                                        |   | 13.4                        |   | 10.4                        |   | 14.9 |   | 11.0 |   |
| General and administrative                                                                                                      |   | 12.0                        |   | 8.7                         |   | 13.4 |   | 8.9 |   |
| Amortization and write down of  intangibles                                                                                     |   | 0.6                         |   | 1.9                         |   | 1.3 |   | 1.3 |   |
| Restructuring charges                                                                                                           |   | 32.4                        |   | 21.0                        |   | 31.3 |   | 14.2 |   |
| (Gain) loss on land and facilities,  net                                                                                        |   | —                      |   | (0.1                        | )      | — |   | 0.2 |   |
| Total operating expenses                                                                                                        |   | 94.5                        |   | 64.0                        |   | 98.2 |   | 57.2 |   |
| Operating loss                                                                                                                  |   | (63.2                       | )      | (13.4                       | )      | (67.1 | ) | (8.7 | ) |
| Loss on investments, net                                                                                                        |   | (6.7                        | )      | (2.6                        | )      | (3.5 | ) | (3.4 | ) |
| Interest and other income, net                                                                                                  |   | 2.1                         |   | 1.4                         |   | 2.2 |   | 2.4 |   |
| Loss from continuing operations  before income taxes, equity interest, and cumulative effect of change in  accounting principle |   | (67.8                       | )      | (14.6                       | )      | (68.4 | ) | (9.7 | ) |
| Income tax provision (benefit)                                                                                                  |   | 0.8                         |   | 1.4                         |   | (1.3 | ) | 1.4 |   |
| Equity interest in loss of  unconsolidated joint venture                                                                        |   | (6.9                        | )      | —                      |   | (3.7 | ) | — |   |
| Loss from continuing operations  before cumulative effect of change in accounting principle                                     |   | (75.5                       | )      | (16.0                       | )      | (70.8 | ) | (11.1 | ) |
| Discontinued operations, net of tax                                                                                             |   | (0.9                        | )      | (9.2                        | )      | (0.5 | ) | (11.2 | ) |
| Loss before cumulative effect of  change in accounting principle                                                                |   | (76.4                       | )      | (25.2                       | )      | (71.3 | ) | (22.3 | ) |
| Cumulative effect of change in  accounting principle                                                                            |   | —                      |   | —                      |   | — |   | (8.4 | ) |
|                                                                                                                            |   |                        |   |                        |   |   |   |   |   |
| Net loss                                                                                                                        |   | (76.4                       | %)     | (25.2                       | %)     | (71.3 | %) | (30.7 | %) |

 

Sales

 

Salesin the second quarter of fiscal 2004 totaled $181.9 million, a decrease of$90.3 million, or 33 percent, compared to the same quarter one year ago. Salesin the first six months of fiscal 2004 totaled $343.8 million, a decrease of$197.6 million, or 36 percent, compared to the same quarter one year ago.

 

Sales of ourdesktop, mobile, and server connectivity products in the second quarter andfirst six months of fiscal 2004 decreased $50.6 million and $84.0 million,respectively, compared to the same periods one year ago. The decrease in salesof connectivity products as compared to the same periods one year ago waspartially attributable to the recognition of $15.0 million of royalty revenue froma paid-up license resulting from settlement of litigation with Xircom, Inc. inthe second quarter of fiscal 2003, and no such royalty revenue was included inthe current year. The remainder of the decrease in sales of connectivityproducts was due to lower volumes, lower average selling prices, and anunfavorable shift in product mix towards lower-priced products.  We believe the lower volumes resulted from ashift in technology towards alternative products; overall unit sales decreasedapproximately 23 percent as compared to the same quarter one year ago, and 35percent as compared to the same six-month period one year ago. Also reflectedin the decrease in sales were declining overall average selling prices ofapproximately 40 percent as compared to the same quarter one year ago, and 26percent as compared to the same six-month period one year ago, reflecting thenet effect of both declining average selling prices and an unfavorable shift inproduct mix. We anticipate that sales of connectivity products will declineapproximately 30 percent sequentially in the third quarter

 

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of fiscal2004, or approximately $9.0 million, due to both reduced demand for our productofferings and increasing pricing pressures.

 

Sales of ourenterprise networking infrastructure product lines in the second quarter andfirst six months of fiscal 2004 decreased $30.1 million and $90.1 million,respectively, compared to the same periods one year ago. This decrease wasdriven by increased price competition and a shift in mix towards lower pricedproducts. While sales of most enterprise data products declined, we saw anincrease in sales of our Gigabit Ethernet LAN switch offerings. Also includedin these net decreases were increases in the second quarter and first sixmonths of fiscal 2004 in sales of approximately $4.7 million and $5.6 million,respectively, of modular switch products and router products sourced fromHuawei.

 

Sales of ourvoice products in the second quarter and first six months of fiscal 2004decreased $8.9 million and $15.4 million, respectively, which was the result ofboth increased market competition as well as delays in introducing morecompetitive product offerings.

 

As compared tothe same six-month period one year ago, sales of services decreased $2.4million due to lower maintenance contract renewals, and sales declined anadditional $5.7 million due to the prior period’s recognition of revenuerelated to exited products that was deferred as of the end of fiscal 2002.Subsequent to the first quarter of fiscal 2003, there was no significantrevenue recognized associated with sales of such products. Sales related toservices and exited products declined a combined $0.7 million in the secondquarter of fiscal 2004 compared to the same quarter one year ago.

 

*By Geography.*In the second quarter of fiscal 2004, U.S.sales decreased 53 percent and international sales decreased 22 percentcompared to the same period one year ago. In the first six months of fiscal2004, U.S. sales decreased 51 percent and international sales decreased 28percent compared to the same period one year ago. With respect to the productlines discussed above, the decline in connectivity products as compared to thesame periods one year ago was most pronounced in the domestic market—whichincluded the entirety of the $15.0 million decline in royalty revenue discussedabove—as well as the EMEA and Americas (which excludes the U.S.) regions.Declines in sales of enterprise data and voice products as compared to the sameperiods one year ago impacted all regions, but were more pronounced in ourdomestic market. There was no significant geographic variation in the declinein sales of services and exited products as compared to the same quarter one yearago. As compared to the same six-month period one year ago, the decline insales of exited products was primarily in the domestic market, and the declinein sales of services was across both international and domestic markets. U.S. sales in the second quarter of fiscal 2004represented 26 percent of total sales, compared to 36 percent of total sales inthe second quarter of fiscal 2003, and U.S. sales in the first six months offiscal 2004 represented 30 percent of total sales, compared to 38 percent oftotal sales in the first six months of fiscal 2003.

 

Gross Margin

Gross margin as a percentage of sales declined 19.3percentage points from 50.6 percent in the second quarter of fiscal 2003 to31.3 percent in the second quarter of fiscal 2004. Gross margin as a percentageof sales declined 17.4 percentage points from 48.5 percent in the first sixmonths of fiscal 2003 to 31.1 percent of sales in the first six months offiscal 2004. Significant components of the decrease in gross margins were asfollows:

 
|                                                             |   | **Current quarter** |   | **Year to Date** |   |
|------------------------------------------------------------------|--------|---------------------|--------|------------------|--------|
| Declines in  standard-related margin                             |   | (7.6                | )%     | (7.1             | )%     |
| Volume-related  impacts                                          |   | (2.9                | )      | (3.5             | )      |
| Impact  of royalty revenue                                       |   | (2.9                | )      | (1.5             | )      |
| Duty  refunds and proceeds from inventory previously written off |   | (2.3                | )      | (2.2             | )      |
| Dublin  manufacturing facility closure                           |   | (1.0                | )      | (1.3             | )      |
| Manufacturing  asset write offs                                  |   | (0.7                | )      | (0.4             | )      |
| Other                                                            |   | (1.9                | )      | (1.4             | )      |
| Total                                                            |   | (19.3               | )%     | (17.4            | )%     |

 

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•                  The decline instandard-related margin as compared to the same quarter one year ago was theresult of the net effect of lower average selling prices (ASPs), net of anyproduct cost reductions, as well as an unfavorable shift in product mix. TheseASP and mix factors impacted margins by approximately six percentage points andtwo percentage points, respectively. The decline in standard-related margin ascompared to the same six-month period one year ago was the result of the effectof lower ASPs, net of any product cost reductions.

 

•                  Volume-related impacts include higherpost-sale technical support costs, manufacturing overhead costs, and warrantycosts as a percentage of sales.  Since aportion of these costs is not directly variable with sales, these costs did notdecline at the same rate as sales.

 

•                  Revenue in the second quarter andfirst six months of fiscal 2003 included royalty revenue of $15.0 millionrelated to the settlement of litigation with Xircom. This revenue did not haveany associated costs of goods.

 

•                  Gross margin in the second quarterand first six months of fiscal 2003 included benefits for duty refunds of $4.4million and $7.9 million, respectively, as well as proceeds from the sale anddisposition of inventory that was previously written off totaling $1.5 millionand $3.5 million, respectively. Such benefits did not recur in either thesecond quarter or first six months of fiscal 2004.

 

•                  As a result of our decision tooutsource our remaining manufacturing operations in Dublin, we recorded chargesrelated to manufacturing assets and other transition-related costs of $2.0million and $4.7 million in the second quarter and first six months of fiscal2004, respectively.

 

•                  In the second quarter of fiscal 2004we wrote off manufacturing assets related to testing products. In futureperiods this testing will be conducted by our supplier of the related products.This write off was not related to the closure of the Dublin manufacturingfacility.

 

Operating Expenses

Total operating expenses in the second quarter of fiscal 2004 were$171.8 million compared to $174.2 million in the second quarter of fiscal 2003,or a net decrease of $2.4 million. Research and development and general andadministrative expenses decreased by $3.9 million and $1.9 million,respectively. In addition, amortization and write down of intangibles decreasedby $4.1 million.  Offsetting thesedecreases were higher sales and marketing expenses ($5.5 million),restructuring charges ($1.7 million) and lower gains from asset disposals ($0.3million).

 

As a percent of sales, total operating expenses in the second quarterof fiscal 2004 were 94.5 percent, compared to 64.0 percent in the secondquarter of fiscal 2003.  In aggregate,sales and marketing, research and development, and general and administrativeexpenses were 61.5 percent of sales in the second quarter of fiscal 2004,compared to 41.2 percent in the second quarter of fiscal 2003.  To a significant degree, these expenses arecontrollable and discretionary over time, but they are not directly variablewith sales levels within a particular period. Amortization and write down of intangibles and restructuring costs were0.6 percent and 32.4 percent of sales, respectively, in the second quarter offiscal 2004, compared to 1.9 percent and 21.0 percent, respectively, in thesecond quarter of fiscal 2003.

 

Total operating expenses in thefirst six months of fiscal 2004 were $337.5 million compared to $309.8 millionin the first six months of fiscal 2003, or a net increase of $27.7 million.Sales and marketing expenses increased by $11.4 million. In addition,restructuring charges increased by $30.7 million. Offsetting these increaseswere lower research and development expenses ($8.4 million), general andadministrative expenses ($2.5 million), amortization and write down ofintangibles ($2.6 million) and reduced losses from asset disposals ($0.9million).

 

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As a percent of sales, totaloperating expenses in the first six months of fiscal 2004 were 98.2 percent,compared to 57.2 percent in the first six months of fiscal 2003.  In aggregate, sales and marketing, researchand development, and general and administrative expenses were 65.6 percent ofsales in the first six months of fiscal 2004, compared to 41.6 percent in thefirst six months of fiscal 2003.  To asignificant degree, these expenses are controllable and discretionary overtime, but they are not directly variable with sales levels within a particularperiod.  Amortization and write down ofintangibles and restructuring costs were 1.3 percent and 31.3 percent of sales,respectively, in the first six months of fiscal 2004, compared to 1.3 percentand 14.2 percent, respectively, in the first six months of fiscal 2003.

 

We allocate and reportIT-related and facilities-related expenses as a component cost of sales andoperating expenses.  On an overallbasis, total operating expenses for the second quarter and first half of 2004reflected a decrease in IT-related expenses, as compared to the same three andsix-month periods one year ago, largely as a result of employee reductions andasset write offs associated with our IT outsourcing initiatives during fiscal2003. Partially offsetting the decrease in IT-related expenses was a netincrease in facilities-related expenses due to a reduction in rental andsublease income received. Such rental and sublease income is recorded as anoffset to the associated facilities-related expenses.

 

Following is a more detaileddiscussion of the factors affecting each major component of total operatingexpenses.

 

*Sales and Marketing. *Sales and marketingexpenses in the second quarter of fiscal 2004 increased $5.5 million ascompared to the second quarter of fiscal 2003, primarily due to increasedworkforce-related and travel and entertainment expenses, reflecting theaddition of direct-touch sales representatives in connection with our increasedfocus on the enterprise market, and an increase in facilities-related expenses.Partly offsetting theses increases were reduced IT expenses, as well as reducedmarketing expenses as a result of a shift in spending towards more focused,product specific programs. Sales and marketing expenses in the first six monthsof fiscal 2004 increased $11.4 million as compared to the comparable period offiscal 2003, primarily due to increased workforce-related, travel andentertainment and facilities-related expenses as discussed above, as well ashigher marketing spending overall in an effort to stimulate demand for theCompany’s products. Partly offsetting theses increases were reduced ITexpenses.

 

*Research and Development. *Research anddevelopment expenses in the second quarter of fiscal 2004 decreased $3.9million as compared to the second quarter of fiscal 2003 due to reduceddepreciation expense related to engineering assets, reflecting write-downs anddisposals associated with our restructuring initiatives, as well as reduced ITexpenses. Partly offsetting these reductions were increased facilities-relatedexpenses. Research and development expenses in the first six months of fiscal2004 decreased $8.4 million as compared to the first six months of fiscal 2003,due to reduced depreciation and IT expenses as discussed above, as well asreduced spending for project tools and materials. Partly offsetting thesereductions were increased facilities-related expenses.

 

G*eneral andAdministrative. *General andadministrative (G&A) expenses in the second quarter of fiscal 2004decreased $1.9 million as compared to the second quarter of fiscal 2003, due toseveral factors.  Factors that had theeffect of decreasing G&A expenses as compared to the same quarter one yearago included reduced workforce-related expenses, due to our restructuringinitiatives, as well as reduced bad debt, IT and legal expenses.  Partially offsetting these reductions wereincreased professional services costs related to the formation of H-3C; also,the prior year quarter benefited from sales tax audit refunds that did notrecur in the current year quarter. G&A expenses in the first six months of fiscal 2004 decreased $2.5million as compared to the first six months of fiscal 2003, due to severalfactors.  Factors that had the effect ofdecreasing G&A expenses as compared to the same quarter one year agoincluded reduced workforce-related, bad debt and IT expenses as discussedabove. Partially offsetting these reductions were increased professionalservices costs and the impact of sales tax audit refunds in the prior yearperiod as discussed above, as well as higher facilities-related expenses.

 

*Amortization and Write Down ofIntangibles.** *Amortizationand write down of intangibles decreased $4.1 million in the second quarter offiscal 2004 as compared to the second quarter of fiscal 2003.  This decrease was due to both reducedimpairment charges, as well as reduced amortization expenses reflecting a lowerbase of intangible assets as a result of impairment charges during the pastseveral quarters. In the second quarter of fiscal 2004, there were noimpairment charges related to intangible assets; in the second quarter offiscal 2003, there was an impairment charge of $3.2 million related todeveloped and core technology associated with the acquisition of NBXCorporation in fiscal 1999. Amortization and write down of intangiblesdecreased $2.6 million in the first six months of fiscal 2004 as compared tothe first six months of fiscal 2003 due to reduced impairment charges, as wellas reduced amortization expenses as discussed above. In the first six 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, as discussed above.

 

*Restructuring Charges.* Restructuring charges in the second quarterand first six months of fiscal 2004

 

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were $58.9 million and $107.5 million,respectively. Restructuring charges in the second quarter of fiscal 2004included $32.9 million in facilities-related charges, including $20.9million for accelerated depreciation of a Santa Clara facility, $4.6 million ofaccelerated depreciation of our Dublin manufacturing facility, a $1.4 millionloss on the sale of certain Santa Clara properties, $1.4 million of fair valueadjustments related to properties held for sale in Hemel Hempstead, U.K., andDublin, and $4.6 million of other facilities charges related to leaseterminations.**Restructuringcharges in the second quarter of fiscal 2004 also included $23.5 million inseverance related charges and $2.5 million related to other restructuringcosts, primarily relating to long-term asset write downs. Restructuring chargesin the first six months of fiscal 2004 included $68.8 million infacilities-related charges, including $26.4 million of accelerated depreciationof a Santa Clara facility, $22.1 million for an impairment and accelerateddepreciation of our Dublin manufacturing facility, $12.6 million in charges forthe write down and sale of certain Santa Clara properties, a loss of $1.1million related to the sale of our Rolling Meadows, Illinois facility, $1.1million of fair value adjustments related to properties held for sale in HemelHempstead and Dublin, and $5.5 million of other facilities-related charges.**Restructuring charges in the first sixmonths of fiscal 2004 also included $31.0 million in severance related charges and $7.7 million related toother restructuring costs, primarily relating to the outsourcing of ourmanufacturing operations. These charges were primarily the result ofcost reduction efforts initiated in fiscal 2004. Additional charges ofapproximately $29.0 million for facilities and severance costs are expected inthe second half of fiscal 2004 as we continue execution of our plans to disposeof excess facilities, transition our manufacturing operations to third-partyproviders, and relocate development and administrative functions.

 

Restructuring charges in the second quarter andfirst six months of fiscal 2003 were $57.2 million and $76.8 million,respectively. Restructuring charges in the second quarter of fiscal 2003primarily consisted of facilities-related charges, including a $29.4 millionloss on the sale of our Marlborough facility, $9.0 million of accelerated depreciationon a Santa Clara facility (which was later sold in the second quarter of fiscal2004), and $14.0 million of write downs of properties in Hemel Hempstead andDublin. Other restructuring charges in the second quarter of fiscal 2003 of$4.8 million related to long-term asset write downs, severance costs, and otherfacilities-related charges. In addition to these charges, restructuring chargesin the first six months of fiscal 2003 included additional severance costs, animpairment of a Santa Clara property, and long term asset write downs. Restructuringcharges in the first six months of fiscal 2003 were primarily the result ofcost reduction efforts initiated in fiscal 2003.

 

*Loss on Land and Facilities, Net.*The net gain on land and facilities in the second quarter of fiscal 2003 was$0.3 million and related to the sale of our Salt Lake City, Utah facility. Thenet loss on land and facilities was $0.9 million for the first six months offiscal 2003, and included a $1.2 million write down of our Salt Lake Cityfacility that was recorded in the first quarter of fiscal 2003. This propertywas classified as held for sale prior to the inception of our restructuringinitiatives and, therefore, the net losses associated with it were not theresult of restructuring actions and were not recorded as part of restructuringcharges.

 

Losson Investments, Net

Netloss on investments in the second quarter and first six months of fiscal 2004was mainly the result of write downs of long term equity investments. Net losson investments in the second quarter of fiscal 2003 was due primarily to marketvalue adjustments of limited partner venture funds and write downs of long termequity investments. Net loss on investments in the first half of fiscal 2003was due primarily to market value adjustments and sale of investments inlimited partner venture funds.

 

Interest and Other Income, Net

Interestand other income, net, in the second quarter of fiscal 2004 was relatively flatas compared to the second quarter of fiscal 2003, with decreases in interestincome of $4.2 million that resulted from lower interest rates being largelyoffset by $4.1 million of decreases in other expenses. A reduction in otherexpenses included lower interest expense resulting from the repayment of all outstandingborrowings, reduced foreign exchange losses, and the charge of $1.7 million inthe prior year quarter related to a one-year extension of the expiration datefor the warrants issued to Broadcom Corporation; the warrants expired inDecember 2003.

 

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Interestand other income, net, in the first six months of fiscal 2004 decreased $5.8million as compared to the first six months of fiscal 2003, with reducedinterest income being partially offset by decreases in other expenses. Interestincome decreased $9.7 million as compared to the same six-month period one yearago due to both a decrease in interest rates as well as lower interest incomerelating to income tax refunds, which generated $1.4 million and $5.1 millionof interest income in the first six months of fiscal 2004 and 2003,respectively. Partially offsetting the decrease in interest income weredecreases of interest expense that resulted from the repayment of borrowings,as well as the charge of $1.7 million in the prior year period related thewarrants issued to Broadcom as discussed above.

 

Equity Interest in Loss ofUnconsolidated Joint Venture

As discussed above, we account for our investment in H-3Cunder the equity method. At the time of formation of H-3C, we recorded a chargeof $12.6 million representing our ownership share (49 percent) of the valueattributed to in-process technology contributed to H-3C by Huawei that had notyet reached technological feasibility and had no alternative future use.

 

Income Tax Provision (Benefit) 

Ourtax provision in the second quarter of fiscal 2004 was the result of providingfor taxes in certain state and foreign jurisdictions. Our income tax benefitfor the first six months of fiscal 2004 included the benefit of a foreign net operating losscarryback of $8.5 million, partially offset by a provision of $4.0million for taxes in certain state and foreign jurisdictions. The tax provisionin the second quarter and first six months of fiscal 2003 was the result ofproviding for taxes in certain state and foreign jurisdictions.

 

DiscontinuedOperations

Discontinuedoperations relate to our CommWorks business unit that was sold in the fourthquarter of fiscal 2003. We recorded losses of $1.6 million and $1.9 million inthe second quarter and first six months of fiscal 2004, respectively, due toadjustments to previous estimates of liabilities related to the sale ofCommWorks. In the second quarter and first six months of fiscal 2003 the lossrelating to the operations of CommWorks was $25.0 million and $60.7 million,respectively, and included $0.3 million and $0.6 million of tax expense,respectively.

 

CumulativeEffect of Change in Accounting Principle

As aresult of our adoption of SFAS 142, we conducted a transitional goodwillimpairment evaluation of the $66.5 million of goodwill recorded as ofMay 31, 2002 and wrote off goodwill totaling $45.4 million relating to continuing operations as achange in accounting principle effective June 1, 2002. We also wrote off$20.2 million of goodwill relating to the CommWorks business unit, which isincluded in discontinued operations.

 

**Liquidityand Capital Resources**

 

Cash and equivalents and short-term investments at November 28,2003 were $1,392.4 million, a decrease of approximately $92.2 million comparedto the balance as of May 30, 2003 of $1,484.6 million.

 

Net cash used in operatingactivities was $81.1 million in the first six months of fiscal 2004, primarilyreflecting our loss from continuing operations of $243.1 million. We expectthat cash flows from operating activities will be negative over the next twoquarters, and possibly longer, due to continuing net losses.  There are no assurances that we can reduceour net losses and negative cash flow in the foreseeable future, or that we canraise capital as needed to fund our operations on an ongoing basis. However,based on current business conditions and our current operating and financialplans, but subject to the discussion in Business Environment and IndustryTrends below, we believe that our existing cash and equivalents and short-terminvestments will be sufficient to satisfy our anticipated cash requirements forat least the next twelve months.  As aresult of the aforementioned fiscal 2004 restructuring charges, and based onour current projections for revenues, costs and expenses, which are subject tosignificant uncertainty, we expect net cash flow from operations to be improvedby approximately $12 million per quarter. This improvement excludes theimpact of cash disbursements to be made in settlement of liabilities accrued asof November 28, 2003 and is not expected to be fully realized until the firstquarter of fiscal 2005.

 

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Significant commitments that will require the use of cash in futureperiods include obligations under lease, royalty and patent licensingarrangements, and IT outsourcing agreements. Total future lease obligations asof November 28, 2003 were $59.1 million, of which $18.8 million will bepaid over the next twelve months. Obligations under royalty and patent licensing arrangements as ofNovember 28, 2003 were approximately $22.3 million, of which $10.3 millionis expected to be paid over the next twelve months. Under our IT outsourcingagreements, we are subject to minimum service levels of $5.2 million annuallythrough December 2013. Termination of such agreements prior to this datewould result in early termination penalties that decline over time. If we wereto terminate the agreement at the beginning of the third quarter of fiscal2004, such penalties are estimated to be approximately $4.6 million.

 

Net cash used in investing activities was $58.7 million for the firstsix months of fiscal 2004, primarily resulting from our $160.0 millioninvestment to fund H-3C as discussed earlier, partially offset by approximately$9.9 million of net proceeds related to sales, maturities, and purchases ofdebt and equity securities, and $91.4 million of net proceeds related to salesand purchases of fixed assets.

 

For the first six months of fiscal 2004, we received proceeds ofapproximately $562.6 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 $550.9 millionin municipal and corporate bonds and government agency instruments, as well asinvestments totaling $1.8 million in equity securities.

 

The investments in equity securities discussed above include theactivities of 3Com Ventures. 3Com Ventures selectively makes strategicinvestments in privately-held companies and in limited partnership venturecapital funds, which in turn invest in privately-held companies. Theseinvestment activities may include a strategic commercial or technologyrelationship, such as a component supply agreement or technology licensearrangement, with these privately-held companies. These investments wereentered into with the intention of complementing our business strategies andresearch and development efforts. 3Com Ventures has made strategic investmentsof $1.8 million in the first six months of fiscal 2004 and has committed tomake additional capital contributions to certain venture capital funds totaling$11.3 million. We are contractually obligated to provide funding upon calls forcapital. The expiration dates for such capital calls are generally five toeight years from the inception of the fund, and the amounts and timing of suchcalls during that period are entirely at the discretion of the funds’ generalpartners. We estimate that we will pay approximately $4.4 million over the nexttwelve months as capital calls are made.

 

During the first six months of fiscal 2004, we made capitalexpenditures of $8.2 million for new property and equipment.  Also, we collected $99.6 million from salesof 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 November 28, 2003, capital expenditurecommitments outstanding were not material.

 

Net cash provided by financing activities was $67.3 million in thefirst six months of fiscal 2004, including the collection of the finalinstallments of $8.4 million due under a note receivable related to the sale ofwarrants to Broadcom during fiscal 2002 and $59.2 million of proceeds from theissuance of common stock, offset by $0.3 million for payments due under capitalleases. There were no borrowings or repayments under our revolving line ofcredit during the first six months of fiscal 2004. As of November 28,2003, we had borrowing capacity of $34.0 million under the revolving line ofcredit, had no amounts outstanding, and had $8.0 million of bank-issued standbyletters of credit and bank guarantees. Also, we did not repurchase any sharesof common stock in the first six months of fiscal 2004. Our current stockrepurchase program permits expenditures of up to $100.0 million throughMarch 2005.

 

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In the firstsix months of fiscal 2004, we issued 13.1 million shares of stock under ouremployee stock option and stock purchase plans and collected $59.2 millionrelated to such issuances. Our stock option program is a broad-based, long-termretention program that is intended to attract and retain talented employees andalign stockholder and employee interests. We consider our stock option programcritical to our operations and productivity; essentially all of our employeesparticipate. The program consists of four plans. The first three plans includeone under which officers and employees were granted options to purchase sharesof our stock (1983 Stock Option Plan), one under which non-employee directorswere granted options (the Director Plan), and a broad-based plan under whichoptions may be granted to all employees other than officers and directors (the1994 Stock Option Plan). Although options are still outstanding under thesethree plans, no future grants may be made from such plans. In September 2003,our stockholders approved the 2003 Stock Plan (the new plan), which replacedthese three previous plans as well as the Restricted Stock Plan (the priorplans) for all stock awards granted subsequent to the approval date. Inconnection with the approval of the new plan, we cancelled all shares availablefor issuance under the prior plans, which included approximately 128 millionshares as of the approval date; at the same time, 20 million shares werereserved for issuance under the new plan.

 

As of November 28, 2003, our outstanding stock optionsas a percentage of outstanding shares were 19 percent. This potential dilutionto existing stockholders is mainly the result of the effect of our distributionof Palm, Inc. common stock in the first quarter of fiscal 2001. As a result ofthe Palm distribution, the number of shares subject to option grants wasadjusted to preserve the intrinsic value of the stock options, resulting in anincrease of 134 million options, and bringing the total option sharesoutstanding to 169 million at the time of the distribution. The potentialdilution has been an area of focus for senior management. As a result ofreductions in the number of employees, stock option exercises, stock repurchaseprograms, and management of new grants, the number of outstanding options hasbeen reduced approximately 56 percent since the Palm distribution. In addition,as discussed above, the number of options available for future grant wasreduced by a net 108 million shares due to approvals of proposals submitted toour stockholders at our annual stockholder meeting in September 2003.

 

Stock option activity during the first six months of fiscal 2004 andstock option detail as of November 28, 2003, 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                              |   | 8,881                 |   | 5.30                                 |   |
| Exercised                            |   | (11,270               | )      | 4.88                                 |   |
| Canceled                             |   | (9,542                | )      | 7.98                                 |   |
| Outstanding,  November 28, 2003 |   | 73,571                |   | $                                    | 7.03   |   |

 
|                          |   | **Outstanding options  as of November 28, 2003** |   | **Exercisable at November 28, 2003** |   |
|-------------------------------|--------|-------------------------------------------------------|--------|-------------------------------------------|--------|
| **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   |                                      |   | 7,981 |   | $ | 3.98 |   | 3,287 |   | $ | 3.57 |   |
| 4.30                          | -      | 5.10                                                  |   |                                      | 10,859 |   | 4.83 |   | 7,446 |   | 4.83 |   |
| 5.12                          | -      | 5.54                                                  |   |                                      | 16,238 |   | 5.38 |   | 10,001 |   | 5.46 |   |
| 5.55                          | -      | 6.09                                                  |   |                                      | 12,565 |   | 5.92 |   | 11,703 |   | 5.94 |   |
| 6.10                          | -      | 10.09                                                 |   |                                      | 14,913 |   | 8.20 |   | 11,851 |   | 8.26 |   |
| 10.11                         | -      | 21.57                                                 |   |                                      | 11,015 |   | 13.49 |   | 8,931 |   | 13.48 |   |
| Total                         |   |                                                  |   |                                      | 73,571 |   | $ | 7.03 |   | 53,219 |   | $ | 7.33 |   |

 

The following table summarizes our equity compensation plans as ofNovember 28, 2003:

 
|                                                     |   | **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      |   | 24,270                                                            |   | $                                                            | 7.77   |                                                                                                                                                  | 28,721 |   |
| Equity compensation plans not approved by  stockholders* |   | 48,309                                                            |   | 6.73                                                         |   | —                                                                                                                                                |   |
|                                                     |   |                                                              |   |                                                         |   |                                                                                                                                                  |   |
| Total                                                    |   | 72,579                                                            |   | $                                                            | 7.08   |                                                                                                                                                  | 28,721 |   |

 

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*Excludes 1.0million outstanding options with an average exercise price of $3.17. 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. Asdiscussed above, effective September 2003, the 2003 Stock Plan wasapproved by stockholders and has replaced the 1994 Stock Option Plan for allgrants subsequent to the approval date. Also inSeptember 2003, stockholders approved a five million share increase in thenumber shares available for issuance under the Employee Stock Purchase Plan.

 

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**Effectsof Recent Accounting Pronouncements**

 

In November 2002, the Emerging Issues Task Force (EITF)reached a consensus on Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables.” EITF 00-21 addresses certain aspects of the accounting by avendor for arrangements under which the vendor will perform multiple revenuegenerating activities. EITF 00-21 will be effective for fiscal periodsbeginning after June 15, 2003; for 3Com, EITF 00-21 became effective forthe second quarter of fiscal 2004. 3Com’s historical revenue recognitionpolicies and practices conform to the requirements of EITF 00-21 and, thus, theadoption of EITF 00-21 did not have a material impact on our financial positionor results of operations.

 

**BusinessEnvironment and Industry Trends**

** **

Industry trends and specific risks may affect ourfuture business and results.  Thematters discussed below could cause our future results to differ from pastresults or those described in forward-looking statements.

 

***We have incurred significant net losses in recentfiscal periods, including $245 million for the first half 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 anet loss of $245 million for the first half 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 toprofitability. Further, if we do return to profitability, we cannot assure youthat we will be able to sustain or increase such profitability in the future.

 

We have faceda number of challenges that have affected our operating results over the lastseveral fiscal years. Specifically, we have experienced, and may continue toexperience, the following:

 

•                  decliningrevenue due to: (a) price competition and (b) reduced incoming orderrate and customer backlog which we believe reflects decreased demand for ourproducts resulting from the overall slowdown in the networking industry as wellas technological changes and trends in the industry, such as the integration ofnetworking, communications and computer processing functions on computer chipsthat can perform the same functions as some of our products.  Although our revenue increased during thesecond quarter of fiscal 2004 compared to the preceding quarter, we cannotassure you that we will be able to maintain revenue at the current level orincrease revenue in the future;

•                  increasedrisk of excess and obsolete inventories;

•                  excessfacilities and manufacturing capacity;

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

•                  disruptionsresulting from our workforce reductions and employee attrition.

 

***We entered into a joint venture in China with Huaweithat, if not successful, may materially and adversely impact our business,business prospects and operating results.***

 

InNovember 2003, we announced the formation of a joint venture forenterprise networking products with Huawei, a leading Chinese company.   Initially 3Com will have a 49 percentminority interest in the Huawei-3Com joint venture, which will have Hangzhou,China as its primary base of operations. Pursuant to the joint ventureagreements, 3Com has the rights to market and support the Huawei-3Com productsunder the 3Com brand in all countries except China and Japan. In China andJapan, the joint venture will sell products sourced internally as well as from3Com and Huawei under the joint venture’s brand.  The joint venture commenced operations inNovember 2003.   Starting in thethird quarter of fiscal 2004, we will reflect the operating results of thejoint venture in our operating results to the extent of our ownership interest,and any losses of the joint venture would adversely impact our operatingresults.

 

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The new jointventure is likely to confront numerous challenges in the future.  For example, at the outset, integration ofthe business assets and operations being contributed by each partner willinvolve complex activities that must be completed in a short period of time.Going forward, there potentially could be disagreements between 3Com and themajority owner with respect to important strategic and operational decisions.Also, the business of the joint venture will be subject to all of theoperational risks that would normally arise for a technology company withglobal operations pertaining to research and development, manufacturing, sales,service, marketing, and corporate functions. As well, competition in theenterprise networking market will involve challenges from numerous,well-established companies with substantial resources and significant marketshare.

 

Our business,business prospects and operating results are heavily dependent upon the successof the Huawei-3Com joint venture. In particular, our product developmentactivities will become increasingly interdependent with those of the jointventure. If the joint venture and our transactions with it are not successfulor less successful than we anticipate, we may not introduce new products neededto broaden 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 potential conflict with our current channel partners resulting from theestablishment of the joint venture’s operations and distribution arrangements.

 

***Our strategy of outsourcing functions and operationsnot central to our business may fail to reduce cost and may disrupt ouroperations.***

 

We continueto look for ways to decrease cost and improve efficiency by contracting othercompanies to perform functions or operations that do not contribute to our coretechnology business. Up to now, our efforts have focused on using outsidevendors to meet some of our IT and manufacturing needs. We have recentlyannounced our intention to outsource all manufacturing. To achieve more costsavings or operational benefits, we may expand our outsourcing of ITactivities, as well as aspects of the following operations: human resources,accounting, internal audit, security and engineering. Although we believe thatoutsourcing these functions will result in lower costs and increasedefficiencies, this may not be the case. For example, outsourcing means that wewill be relying upon third parties to meet our needs. Because these thirdparties may not be as responsive to our needs as we would be ourselves, we mayincrease the risk of disruption to our operations. In addition, our agreementswith these third parties sometimes include substantial penalties forterminating such agreements early or failing to maintain minimum servicelevels. Because we cannot always predict how long we will need the services orhow much of the services we will use, we may have to pay these penalties.

 

***Our revenues may decrease, and we may not be able tocompensate for such lower revenues with cost reductions sufficient to generatepositive net income or cash flow.***

 

We believethat we must implement strict cost and expense reductions if we are to generatepositive net income and cash flow from operations in future quarters. If we arenot able to effectively reduce our costs and expenses commensurate with, and atthe same pace as, any further deterioration in our revenues, we may not be ableto generate 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 17% of total revenue for the secondquarter of fiscal 2004, will decline further due to pricing pressures andtechnological changes and trends in the networking industry.

 

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***Our efforts to consolidate our real estate portfolioand sell certain real estate holdings may not generate the expected level of cashproceeds or result in reductions of operating costs.***

 

In connectionwith our ongoing restructuring and cost reduction activities, we are makingefforts to consolidate our operations into fewer facilities and to dispose ofexcess facilities. We currently have, or expect to have in the near future,excess facilities held for sale in Santa Clara, Dublin, and Hemel Hempstead.Despite our best efforts, our ability to dispose of our excess real estateholdings may be impaired by adverse conditions in the commercial real estatemarket. Additionally, to the extent that we continue to own excess facilitiesand are unable to lease the facilities to third parties, our operating resultswill be adversely affected by the continuing operating costs associated with thefacilities.

 

***Our workforce reductions, and the high cost of livingin certain locations, may make it more difficult for us to retain and recruitthe qualified employees and management personnel that are critical to oursuccess.***

 

Our successdepends upon retaining and recruiting highly qualified employees and managementpersonnel. However, the significant downturn in our business environment hashad a negative impact on our operations. As a result, we have restructured ouroperations to reduce our workforce and implement other cost reductionactivities. Although we believe these various changes and actions will improveour organizational effectiveness and competitiveness, they could lead, in theshort term, to disruptions in our business, reduced employee morale andproductivity, problems with retaining existing employees and recruiting futureemployees and increased financial costs. Recruiting and retaining skilledpersonnel, including engineers, sales representatives and product marketingmanagers, continues to be difficult. In addition, at certain locations where weoperate, the cost of living is extremely high and it may be difficult toattract and retain key employees and management personnel at a reasonable cost.If we cannot 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 involvefurther workforce reductions and lead to reduced revenues and other disruptionsin our business.***

 

Our operatingexpenses, particularly general and administrative expenses, as a percent ofrevenue have been higher than our desired long-term financial model. We havetaken, and will continue to take, actions to reduce these expenses. Futureactions could include further reductions in our workforce, relocation offunctions and activities to lower cost locations, changes or modifications inIT systems or applications and process reengineering. As a result of theseactions, some employees with critical skills will be severed, and otheremployees will leave our company voluntarily due to the uncertaintiesassociated with our business environment and their job security.  In addition, reductions in overall staffinglevels might make it more difficult for us to achieve our revenue objectives,to adhere to our preferred business practices and to address all of our legaland regulatory obligations in an effective manner, which could, in turn,ultimately lead to missed business opportunities, higher operating costs orpenalties.

 

***If future business conditions present unanticipatedchallenges, we may need to make further changes to our business structure orreductions to our workforce.***

 

In responseto industry and market conditions, we have restructured our business andreduced our workforce. The assumptions underlying our restructuring effortswill be assessed on an ongoing basis and may prove to be inaccurate. We mayhave to restructure our business again to achieve additional cost savings andto strategically realign our resources. Our restructuring plan is based oncertain assumptions regarding the outlook for the networking industry, our futurerevenue and the cost structure of our business, which may prove to beinaccurate. While restructuring, we have assessed, and will continue to assess,whether we should further reduce our workforce or further expand ouroutsourcing activities. We may not be able to successfully implement theinitiatives we have undertaken in

 

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restructuringour business; even if successfully implemented, these initiatives may not besufficient to meet and keep pace with changing industry and market conditionsand to achieve positive net income and cash flow from operations.

 

***If our cash flow significantly deteriorates in thefuture, our liquidity and ability to operate our business could be adverselyaffected.***

 

We incurred asignificant net loss and negative cash flow from operations for the first halfof fiscal 2004. If we continue to incur significant net losses and negativecash flow 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 followingitems could require unexpected future cash payments or limit our ability togenerate cash:

 

•                  inabilityto dispose of real estate holdings;

•                  taxesdue upon the transfer of cash held in foreign locations; and

•                  taxesassessed by local authorities where we conduct business.

 

***Our decision to move our corporate headquarters willresult in costs for relocation, executive severance, and recruitment costs, andcould result in disruptions to our business.***

 

In fiscal2004, we moved our corporate headquarters to our Marlborough facility, which isthe primary location and base of operations for our ongoing enterprisenetworking business. We expect to relocate additional functions to Marlboroughin the future.  Although a relativelysmall percentage of our total workforce will be affected by the relocation ofour corporate headquarters, such changes will involve ongoing efforts andexpenses to effect the relocation. For example, we have incurred and expect tocontinue to incur relocation costs, severance costs (for those employees notmoving to Marlborough), and recruitment costs (for replacing the employees notmoving to Marlborough). Also, although we believe the relocation will improveour organizational effectiveness, it could lead, in the short term, todisruptions in our business.

 

***We may not respond effectively to increased competitioncaused by industry volatility and consolidation.***

 

Our businesscould be seriously 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.

 

***The increased integration of networking,communications, and computer processing functions on a reduced number ofcomputer chips may adversely affect our future sales growth and operatingresults.***

 

Theintegration of networking, communications, and computer processing functions ona reduced number of computer chips has become an industry trend. This trend issometimes referred to as “siliconization.” Many of these integrated computerchips offer improved features and increased performance at lower cost. However,we are not a computer chip company. Rather, we make products

 

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thatfunction with computer chips but are not contained on the chips themselves. Asa result, increased siliconization may make our products obsolete if thefunctions performed by our products can be better and less expensivelyperformed by these integrated computer chips. If this happens, our future salesgrowth and operating results will suffer. For example, a significant portion ofour sales of connectivity products are made to personal computer (PC)manufacturers like Dell Computer Corp., Gateway, Hewlett-Packard Company (HP),and International Business Machines Corp. All of these companies aremanufacturers that incorporate our connectivity products into their products.However, these companies also include computer chips from other vendors thatintegrate a connectivity function into their products. As this integratedconnectivity technology matures, computer chip makers may include more and moreof the features performed by our connectivity products directly in the basiccircuitry and components of computers, leading to cheaper computerconfigurations. This means that some competitors that have a significant shareof the PC computer chip market may sell chips that contain integratedconnectivity at prices not significantly greater than prices for PC computerchips without connectivity. If our PC manufacturer customers can buy chips thatcontain the same connectivity features as our products at a lower cost thanbuying our connectivity products separately, they will be less likely to buyour products. We expect that PC manufacturers and designers increasingly willpurchase the lower-priced integrated connectivity products. If we cannot lowerthe costs of our products or persuade customers to purchase products withhigher average selling prices, then our margins will be reduced and ourfinancial results will be adversely affected. In addition, as networkingfunctions become more embedded in the basic circuitry and components ofcomputers, we face increased competition from other companies that are also ourcurrent suppliers of products. If we cannot compete successfully againstcurrent or future competitors, our business, results of operations or financialposition could be adversely affected.

 

***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 makingsignificant investments in various technologies for emerging productlines.  These investments have includedXRNTM (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 sales growth in the future. However, the markets for some ofthese products and solutions are still emerging and the market potential forour products 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 respondingto new and emerging market and product opportunities.***

 

The marketsin which we compete are characterized by rapid technology transitions and shortproduct life cycles. Therefore, our success depends on our ability to:1) identify new market and product opportunities, 2) develop andintroduce new products and solutions in a timely manner, 3) gain marketacceptance of new products and solutions, particularly in the targeted emergingmarkets discussed above, and 4) rapidly and efficiently transition ourcustomers from older to newer enterprise networking technologies. Our resultsof operations or financial position could suffer if we are not successful inachieving these goals. For example, our business would suffer if there is adelay in introducing new products, if there are fewer customers interested inour products than we expected, if our products do not satisfy customers interms of features, functionality or quality; or if the products cost more toproduce than we expect. Our business would suffer in particular if negativeeffects such as these were to occur in those product markets that we haveidentified as emerging high-growth opportunities. One factor that may cause greater difficultyfor us in quickly and effectively introducing new products with the features,functionality, quality, and costs that are optimal for the market is ourincreased reliance on relationships with strategic partners, such as originaldesign manufacturers (ODMs). Because ODMs manufacture the products ofother companies as well as ours, the timeliness of the availability of ourproducts depends, in part, on their production schedules. In addition, we arerelying on them to manufacture products that

 

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meetour specifications with regard to quality and cost. We will continue to sourceother products from OEMs and from the Huawei-3Com joint venture. Finally,since we rely on our strategic partners, we may not be able to independentlyidentify current product and technology trends and to respond to such trends aswell as if we were working independently.

 

***A significant portion of our revenue is derived fromsales to a small number of customers. If any of these customers reduces itsbusiness with us, our business could be seriously harmed.***

 

We distributemany of our products through two-tier distribution channels that includedistributors, systems integrators and value-added resellers. We also sell topersonal computer manufacturers and telecommunications service providers. Asignificant portion of our revenue is concentrated among a few distributors andOEM customers; our two largest customers accounted for a combined 33 percent oftotal sales for both the first half of fiscal 2004 and the entirety of fiscal2003, and a combined 28 percent of total sales for each of fiscal 2002 andfiscal 2001. There has been a trend of decreased demand for connectivityproducts from OEM customers such as Dell and HP, due to increased integrationof networking connections with semiconductor components, and also to factorsspecific to our OEM customers. Additionally, consolidation in our distributionchannels and among PC manufacturers is reducing the number of customers in ourdomestic and international markets. In an effort to streamline our operations,we may increase the focus of our distribution sales resources on selecteddistribution channel customers.

 

***We depend on distributors who maintain inventories ofour products. If the distributors reduce their inventories of our products, ourrevenue could be adversely affected.***

 

Ourdistributors maintain inventories of our products. We work closely with ourdistributors to monitor channel inventory levels and ensure that appropriatelevels of products are available to resellers and end users. We have improvedcertain of our supply chain processes so that deliveries to our channelpartners can be done more rapidly, thereby enabling our channel partners tohold fewer weeks of supply of our products in their inventory. At the end offiscal year 2003, channel inventory levels were at the upper end of our targetrange of four to six weeks supply on hand at our distributors. At the end ofour first and second quarters of fiscal 2004, channel inventory levels were atapproximately 4.5 weeks supply and we expect to operate our business with nogreater than 4.5 weeks of channel inventory for the remainder of fiscal 2004.At this level of channel inventory, some of our channel partners will hold lessthan 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 themanner in which we sell our products and services in the sales channel.  If those adjustments are unsuccessful, ourrevenues may be negatively affected.***

 

As partof our distribution strategy, we are targeting System Integrators (SIs),Service Providers (SPs), and enterprise Value Added Resellers (eVARs).  These resellers typically have expertise innetwork design and implementation, which is important when deploying end-to-endnetworking infrastructure solutions in larger enterprises.  In addition to specialized technicalexpertise, SIs, SPs and eVARS typically offer sophisticated servicescapabilities that are typically desired by larger enterprise customers.  In order to expand our distribution channelto include resellers with such capabilities, we must be able to provideeffective support to these resellers.  If our services, marketing, or sales organization does not provideeffective support to such SIs, SPs, and eVARS, we may not be successful inexpanding our distribution model and current SI, SP, and eVAR partners mayterminate their relationships with us, which would adversely impact our salesand results of operations.

 

***Our strategies to outsource 3Com’s remaining internalmanufacturing in Dublin, and for contract manufacturers to ship directly to ourcustomers, may not result in savings or meet our performance***

 

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***needs. The inability of any contract manufacturer tomeet our cost, quality or performance standards could adversely affect ourresults from operations.***

 

The followingis a discussion of the factors that could determine whether our strategy toshift the production of our products to contract manufacturing is successful.The cost, quality, performance, and availability of contract manufacturingoperations are and will be essential to the successful production and sale ofmany of our products. The inability of any contract manufacturer to meet ourcost, quality, performance, and availability standards could adversely impactour financial condition or results of operations. We may not be able to providecontract manufacturers with product volumes that are high enough to achievesufficient cost savings. If shipments fall below forecasted levels, we mayincur increased costs or be required to take ownership of the inventory. Also,our ability to control the quality of products produced by contractmanufacturers may be limited and quality issues may not be resolved in a timelymanner, which could adversely impact our financial condition or results ofoperations. We have implemented a program with our manufacturing partners toship products directly from regional shipping centers to customers. Throughthis program, we are relying on these partners to fill customer orders in atimely manner. This program may not yield the efficiencies that we expect,which would negatively impact our financial performance. Any disruptions toon-time delivery to customers would adversely impact our business and revenues.

 

***We may be unable to manage our supply chainsuccessfully, which would adversely impact our revenues, gross margins, andprofitability.***

 

Currentbusiness conditions and operational challenges in managing our supply chainaffect our business in a number of ways:

 

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

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

•                  asintegration of networking features on a reduced number of computer chipscontinues, we are increasingly facing competition from parties who havetraditionally been and are currently our suppliers;

•                  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-partymanufacturers places much of the supply chain process out of our direct controland heightens the need for accurate forecasting and reduces our ability totransition quickly to alternative supply chain strategies;

•                  ourpresent manufacturing capacity exceeds our current needs; and

•                  wemay experience disruptions to our logistics.

 

Some of oursuppliers are also our competitors. We cannot be certain that in the future oursuppliers, particularly those who are also in active competition with us, willbe able or willing to meet our demand for components in a timely andcost-effective manner.

 

Increasingly,we have been sourcing a greater number of components from a smaller number ofvendors. Also, there has recently been a trend toward consolidation of vendorsof electronic components. This greater reliance on a smaller number ofsuppliers and the inability to quickly switch vendors increase the risk oflogistics disruptions, unfavorable price fluctuations, or disruptions insupply, particularly in a supply-constrained environment.

 

Operation ofthe supply chain 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.

 

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***The contract manufacturers on whom we relyface currency exchange rate risk that may affect their ability to provideproducts on a cost competitive basis, which could in turn impact our operatingresults and our competitiveness.***

 

Whenwe complete the outsourcing of our remaining internal manufacturing operationsduring the third quarter of fiscal 2004, we will be entirely dependent uponexternal contract manufacturers for product supplies and, in turn, upon theability of these contract manufacturers to remain cost competitive. Asignificant component of maintaining this cost competitiveness is the abilityof the contract manufacturers to adjust their own costs and manufacturinginfrastructure to compensate for possible adverse exchange rate movements. Tothe extent that the contract manufacturers are unable to do so, and we areunable to procure alternative product supplies then our own operating resultsand our own competitiveness may be adversely impacted.

 

***We are exposed to economic currency risk onproducts sourced from the Huawei-3Com joint venture in China.***

 

Pursuant toour agreements with Huawei, we have the right to market the Huawei-3Comproducts under the 3Com brand in all countries except China and Japan.  A key factor in the success of this activityis that product sourced from the joint venture remains cost competitive overtime.

 

Any futureadverse exchange rate movements between the joint venture’s local currency ofoperations and the U.S. Dollar may adversely impact our operating results.

 

***Ourcurrent and future decisions to exit certain product lines may have unforeseennegative impacts to our business.***

 

In fiscal2001, 2002 and 2003, we exited or sold some of our businesses and productlines. In some cases, we continue to be responsible pursuant to the originalwarranty obligations for these products. Our exiting of these business andproduct lines may have adversely affected our relationships with channelpartners and end customers. Many of these channel partners and customersperceived our remaining products as not being part of a larger integrated orcomplementary solution, or questioned our commitment to their markets.Consequently, they chose to purchase products from alternative vendors. We mayconsider exiting other businesses or product lines that do not meet our goal ofdelivering satisfactory financial returns. Future decisions to exit businessesor product lines could result in deterioration of our channel partner andcustomer relationships, increased employee costs (such as severance,outplacement and other benefits), contract termination costs, and assetimpairments.

 

***Our increasing reliance on strategic relationships maynegatively impact our business.***

 

As discussedabove, in November 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.

 

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***Our reliance on industry standards, a favorableregulatory environment, technological change in the marketplace, and newproduct initiatives may cause our revenues to fluctuate or decline.***

 

Thenetworking industry in which we compete is characterized by rapid changes intechnology and customer requirements, evolving industry standards, and complexgovernment regulation. As a result, our success depends on:

 

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

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

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

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

•                  afavorable regulatory environment.

 

Slow marketacceptance of new technologies, products, or industry standards could adverselyaffect our revenue or overall financial performance. In addition, if ourtechnology is not included in an industry standard on a timely basis or if wefail to achieve timely certification of compliance to industry standards for our products, ourrevenue from sales of such products or our overall financial performance couldbe adversely affected.

 

Failure toobtain all necessary regulatory approvals for our products or to comply withall applicable government regulations could adversely impact our revenue oroverall financial performance or expose us to fines or other penalties. Inaddition, new or revised government regulations could adversely affect thebasic business economics for new technologies or their rates of acceptance oradoption by potential customers; in turn, this could adversely impact ourrevenue or overall financial performance.

 

***Our customer order fulfillment capabilities fluctuateand may negatively impact our operating results.***

 

The timingand amount of our sales depend on a number of factors that make estimatingfuture operating results difficult. Throughout our business, we do nottypically maintain a significant amount of backlog, and sales are partiallydependent on our ability to appropriately forecast product demand. In addition,our customers historically request fulfillment of orders in a short timeperiod, resulting in limited visibility to sales trends and potential pricingpressures. Consequently, our operating results depend on the volume and timingof orders and our ability to fulfill orders in a timely manner. Historically,sales in the third month of the quarter have been higher than sales in each ofthe first two months of the quarter. Non-linear sales patterns make businessplanning difficult, and increase the risk that our quarterly results willfluctuate due to disruptions in functions such as manufacturing, ordermanagement, information systems, and shipping.

 

***We may not be able to defend ourselves successfullyagainst claims that we are infringing the intellectual property rights ofothers.***

 

Many of ourcompetitors, such as telecommunications, networking, and computer equipmentmanufacturers, have large intellectual property portfolios, including patentsthat may cover technologies that are relevant to our business. In addition,many smaller companies, universities, and individual inventors have obtained orapplied for patents in areas of technology that may relate to our business. Theindustry is moving towards aggressive assertion, licensing, and litigation ofpatents and other intellectual property rights.

 

In the courseof our business, we frequently receive claims of infringement or otherwisebecome aware of potentially relevant patents or other intellectual propertyrights held by other parties. We evaluate the validity and applicability ofthese intellectual property rights, and determine in each case whether we

 

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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 litigationin order to protect or maintain our intellectual property rights.***

 

In additionto disputes relating to the validity or alleged infringement of other parties’rights, we may become involved in disputes relating to our assertion of ourintellectual property rights. Whether we are defending the assertion ofintellectual property rights against us, or asserting our intellectual propertyrights against 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 tofactors that can cause fluctuations in our stock price.***

 

Historically,our stock price has experienced substantial volatility. We expect that ourstock price may continue to experience volatility in the future due to avariety of potential factors such as fluctuations in our quarterly results ofoperations and cash flow, changes in our cash balances, variations between ouractual financial results and the published analysts’ expectations, andannouncements by our competitors. In addition, over the past several quarters,the stock market has experienced extreme price and volume fluctuations thathave affected the stock prices of many technology companies. These factors, as wellas general economic and political conditions or investors’ concerns regardingthe credibility of corporate financial statements and the accountingprofession, may have a material adverse affect on the market price of our stockin the future.

 

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

 

We usecomputer systems, including our enterprise-wide financial system, which may notinclude the most advanced security features available. There is a risk ofunauthorized access to computer systems and proprietary information, includingour financial systems, intellectual property, and trade secrets. Whilemanagement makes concerted efforts to assess risks and prevent and detectsecurity breaches, including periodic audits and upgrades of our systems, ourbusiness, results of operations or financial position could be affected if anyunauthorized access were to occur and not be detected through our normalinternal control procedures.

 

***In fiscal 2004 we are operating in a single businesssegment focused primarily on enterprise networking, and our results ofoperations may fluctuate based on factors related entirely to conditions inthis market.***

 

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In fiscal2004, we are operating in a single business segment focused primarily onenterprise networking. This single enterprise networking business reflects astreamlined management and operating structure encompassing all of ouroperations, including our connectivity business that we previously operated andreported as a separate segment and which we expect will continue to diminish.Our focus on enterprise networking may cause increased risk or volatilityassociated with decreased diversification of our business. There will beincreased sensitivity to the business risks associated specifically with theenterprise networking market and our ability to execute successfully on ourstrategies to provide superior solutions for larger and multi-site enterpriseenvironments. To be successful in the enterprise networking market, we willneed to overcome negative perceptions of our company held by certain chiefinformation officers of large enterprises, who may be skeptical of ourlong-term commitment to the high-end networking business as a result of ourwithdrawal from that business in 2000. Also, expansion of sales to largeenterprises may be disruptive in a variety of ways, such as adding largersystems integrators that may raise channel conflict issues with existingdistributors, or a perception of any diminished focus on the small and mediumenterprise market.

 

***Item3.*Quantitativeand Qualitative Disclosures About Market Risk**

 

3Com holds marketable equity traded securities that have a brieftrading history 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 second 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 endedMay 30, 2003.

 

***Item4.*Controls andProcedures**

 

a.               We carried out an evaluation, under thesupervision and with the participation of our management, including ourPresident and Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of our second fiscal quarter pursuant to Exchange ActRule 13a-15(b). Based upon that evaluation, our President and Chief ExecutiveOfficer and our Chief Financial Officer concluded that our disclosure controlsand procedures are effective in ensuring that information required to bedisclosed by us in reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.

 

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

 

b.              There have been no changes in ourinternal control over financialreporting identified in connection

 

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with our evaluation as of the end of the secondfiscal quarter that occurred during such quarter that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial 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 and Use of Proceeds**

 

None.

 

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

 

None.

 

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

 

(a)                                  TheAnnual Meeting of Shareholders was held on September 23, 2003.

 

(b)                                 Eachof the persons named in the Proxy Statement as a nominee for director waselected and the proposals listed below were approved.  The following are the voting results of the proposals:

 
| **Proposal I**         |   | **For**     |   | **Withheld** |   | **Broker Non-Votes** |   |
|------------------------|--------|-------------|--------|--------------|--------|----------------------|--------|
| Election of Directors: |   |        |   |         |   |                 |   |
|                   |   |        |   |         |   |                 |   |
| Bruce L. Claflin       |   | 332,324,140 |   | 8,210,089    |   | 0                    |   |
| Paul G. Yovovich       |   | 325,401,530 |   | 15,132,699   |   | 0                    |   |

 

Other Directors whose term of office as a director continued after themeeting were Eric A. Benhamou, Gary T. DiCamillo, James R. Long, and Raj Reddy.

 
| **Proposal  II**                                                                                                                                              |   | **For**     |   | **Against** |   | **Abstain** |   | **Broker Non-Votes** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|--------|-------------|--------|-------------|--------|----------------------|--------|
| To approve  the 2003 Stock Plan with an initial share reserve of 20,000,000 and eliminate  the shares available for future grant under prior equity programs: |   | 170,530,696 |   | 59,716,786  |   | 2,520,904   |   | 107,765,844          |   |

 
| **Proposal  III**                                                                     |   | **For**     | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|---------------------------------------------------------------------------------------|--------|-------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| To approve  an increase in share reserve under the 1984 Employee Stock Purchase Plan: |   | 198,288,356 |       | 31,963,920  |       | 2,516,110   |       | 107,765,844          |       |

 
| **Proposal  IV**                                                                                                                                            |   | **For**     | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| To ratify  the appointment of Deloitte & Touche LLP as the Company’s independent  public accountants for the fiscal year ending May 28, 2004: |   | 317,135,316 |       | 22,716,447  |       | 682,445     |       | 0                    |       |

 

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

 

None.

 

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

 

(a)  Exhibits

 
| **Exhibit** |   |                                                                                                                                                                                      |   | **Incorporated  by Reference** |   | **Filed**    |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|--------|--------------|
| **Number**  |   | **Exhibit  Description**                                                                                                                                                                  |   | **Form**                       |   | **File No.** |   | **Exhibit** |   | **Filing  Date** |   | **Herewith** |
| 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         |   | Amended and Restated Rights Agreement dated  December 31, 1994                                                                                                                       |   | 10-Q                           |   | 0-12867      |   | 4.1 |   | 01/17/95 |   |   |
| 4.2         |   | Third Amended and Restated Preferred Shares  Rights Agreement, dated as of November 4, 2002                                                                                          |   | 8-A/A                          |   | 0-12867      |   | 4.2 |   | 11/27/02 |   |   |
| 10.1        |   | Management Retention Agreement with Bruce  Claflin, effective as of July 15, 2003*                                                                                                   |   |                           |   |         |   |   |   |   |   | ý |
| 10.2        |   | Management Retention Agreement with Dennis  Connors, effective as of July 15, 2003*                                                                                                  |   |                           |   |         |   |   |   |   |   | ý |
| 10.3        |   | Management Retention Agreement with Mark  Slaven, effective as of July 15, 2003*                                                                                                     |   |                           |   |         |   |   |   |   |   | ý |
| 10.4        |   | Management Retention Agreement with Nick  Ganio, effective as of July 24, 2003*                                                                                                      |   |                           |   |         |   |   |   |   |   | ý |
| 10.5        |   | Management Retention Agreement with Anik  Bose, effective as of July 28, 2003*                                                                                                       |   |                           |   |         |   |   |   |   |   | ý |
| 10.6        |   | 3Com Corporation 2003 Stock Plan*                                                                                                                                                         |   | S-8                            |   | 333-109983   |   | 10.1 |   | 10/24/03 |   |   |
| 31.1        |   | Certification of Principal Executive  Officer                                                                                                                                             |   |                           |   |         |   |   |   |   |   | ý |
| 31.2        |   | Certification of Principal Financial  Officer                                                                                                                                             |   |                           |   |         |   |   |   |   |   | ý |
| 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 |   |                           |   |         |   |   |   |   |   | ý |

 

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*  Indicates a managementcontract or compensatory plan.

 

42

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(b)  Reports on Form 8-K

 
| **Date**                |   | **Item Number** |   | **Description**                                                                                                         |
|-------------------------|--------|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------|
|                    |   |            |   |                                                                                                                    |
| September 18, 2003 |   | Item 12         |   | 3Com announced its financial results for  the first quarter of fiscal 2003 and included the press release thereto.      |
|                    |   |            |   |                                                                                                                    |
| November 10, 2003  |   | Item 5          |   | 3Com announced the completion of the sale  of certain properties in Santa Clara, California.                            |
|                    |   |            |   |                                                                                                                    |
| November 19, 2003  |   | Item 5          |   | 3Com announced the launch of its joint  venture with Huawei Technologies, Ltd. and included the press release  thereto. |

 

43

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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: | January 12, 2004 |                                                                                                          | By: |   | /s/ | Mark Slaven |   |
|   |                  | Mark Slaven                                                                                                   |
|   |                  | Executive Vice President, Finance and  Chief Financial Officer  (Principal Financial and  Accounting Officer) |
|        |                       |                                                                                                               |  |  |  |  |  |

 

44

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