**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM10-K**

**(Mark One)**
| **ý** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                    |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                   |
| ** ** | **FOR THE FISCAL YEAR ENDED  DECEMBER 31, 2005.**                                                                                                                                                                                            |
| ** ** | ** **                                                                                                                                                                                                                                   |
| **o**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                |
| ** ** | ** **                                                                                                                                                                                                                                   |
| ** ** | **FOR  THE TRANSITION PERIOD FROM                TO                 .** |

**Commissionfile number: 000-30575**

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**AVOCENTCORPORATION**

(Exact name of registrant as specified in its charter)
| **Delaware**                                                    |   | **91-2032368**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State  or Other Jurisdiction of Incorporation or Organization) |   | (I.R.S.  Employer Identification No.) |
|                                                            |   |                                  |
| **4991 Corporate Drive**                                        |   |                                  |
| **Huntsville, Alabama**                                         |   | **35805**                             |
| (Address  of Principal Executive Offices)                       |   | (Zip  Code)                           |

 
| **256-430-4000**                                                         |
|--------------------------------------------------------------------------|
| (Registrant’s  telephone number, including area code)               |
|                                                                     |   |   |
| Securities  registered under Section 12(b) of the Exchange Act: **None** |
|                                                                     |   |   |
| Securities  registered under Section 12(g) of the Exchange Act:     |
| **Common Stock, $0.001 par value per share**                             |

Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes  ý    No  o

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes  o    No  ý

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  ý    No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and disclosure will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  o

Indicate by check markwhether the registrant is an accelerated filer (as defined by Rule 12b-2 of theAct).  Yes  ý     No  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Largeaccelerated filer ý                    Accelerated filer o              Non-accelerated filer o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct). Yes  o    No  ý

The aggregate market valueof the voting and non-voting common stock held by non-affiliates of theregistrant as of the last business day of the registrant’s most recentlycompleted second fiscal quarter was approximately $1,306,303,308.

The number of sharesoutstanding of the registrant’s common stock as of February 28, 2006 was 49,272,933.

**DOCUMENTSINCORPORATED BY REFERENCE**

Information with respect toitems 10 to 14 of Part III of this Form 10-K may be found in thedefinitive proxy statement to be delivered to stockholders in connection withthe 2006 Annual Meeting of Stockholders. Such information is incorporatedherein by reference.

 

 

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**PART I**

 

**Item 1.  Business.**

 

*THISANNUAL REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS ANDUNCERTAINTIES. THE STATEMENTS CONTAINED IN THIS ANNUAL REPORT THAT ARE NOTPURELY HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THESECURITIES EXCHANGE ACT OF 1934, AS AMENDED. THESE FORWARD-LOOKING STATEMENTS INCLUDE, WITHOUT LIMITATION, STATEMENTSRELATING TO FUTURE ECONOMIC CONDITIONS IN GENERAL AND STATEMENTS ABOUT OURFUTURE:*

 

•              *STRATEGY AND BUSINESS PROSPECTS;*

 

•              *ENGINEERING AND DESIGN ACTIVITIES, DEVELOPMENT ANDINTRODUCTION OF NEW PRODUCTS AND TECHNOLOGIES, AND THE SIZE, GROWTH, ANDLEADERSHIP OF THE POTENTIAL MARKETS FOR THESE PRODUCTS AND TECHNOLOGIES;*

 

•              *DEVELOPMENT OF NEW OEM, DISTRIBUTOR, RESELLER, ANDSUPPLIER RELATIONSHIPS;*

 

•              *SALES, EARNINGS, INCOME, EXPENSES, OPERATING RESULTS,TAX RATES, OPERATING AND GROSS PROFIT AND PROFIT MARGINS, INVENTORY LEVELS ANDVALUATIONS, RECEIVABLES, RESERVES, LIQUIDITY, INVESTMENT INCOME, CURRENCYRATES, EMPLOYEE STOCK OPTION EXERCISES, CAPITAL RESOURCE NEEDS, CUSTOMERS, ANDCOMPETITION;*

 

•               *ABILITY TO OBTAIN AND PROTECT OUR INTELLECTUALPROPERTY AND PROPRIETARY RIGHTS;*

 

•               *EXPANSION OF INTERNATIONAL SALES; AND*

 

•              *ACQUISITIONS AND TRANSACTION COSTS AND ADJUSTMENTS.*

 

*ALL OFTHESE FORWARD-LOOKING STATEMENTS ARE BASED ON INFORMATION AVAILABLE TO US ONTHE DATE OF THIS ANNUAL REPORT.  OURACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE DISCUSSED IN THIS ANNUALREPORT.  THE FORWARD-LOOKING STATEMENTSCONTAINED IN THIS ANNUAL REPORT, AND OTHER WRITTEN AND ORAL FORWARD-LOOKINGSTATEMENTS MADE BY US FROM TIME TO TIME, ARE SUBJECT TO CERTAIN RISKS ANDUNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSEANTICIPATED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITEDTO, THOSE DISCUSSED UNDER THE CAPTION “FACTORS THAT MAY AFFECT FUTURE RESULTS.”*

 

**Overview**

 

AvocentCorporation designs, manufactures, licenses, and sells products andtechnologies that provide connectivity and centralized management ofinformation technology (IT) infrastructure. We (meaning Avocent and its wholly-owned subsidiaries) provide connectivityand management products and technologies that centralize control of servers,desktop computers, serial devices, wireless devices, mobile devices, andnetwork appliances, thus increasing the efficiency of IT personnel.  Server manufacturers resell private-labeledAvocent KVM (keyboard, video, and mouse) switches and embedded technology intheir systems, and companies large and small depend on our products andtechnologies for managing their growing IT infrastructure.

 

Our technologicalinnovations include internet protocol (IP) based switching, centralizedmanagement, and intuitive software interfaces. Our products and technologies manage servers, desktop computers, serialdevices, wireless devices, mobile devices, and embedded infrastructure.  With more than two decades of experience, wehave grown through product innovations, global expansion, and strategicacquisitions.  Formed as a result of themerger in 2000 between Apex Inc. and Cybex Computer Products Corporation, wesubsequently acquired Equinox Systems Inc. in 2001, 2C Computing, Inc. in 2002,Soronti, Inc. in 2003, and Crystal Link Technologies, OSA Technologies, Inc.,and Sonic Mobility, Inc. in 2004.  InJanuary 2006, we announced the signing of a definitive agreement to acquireCyclades Corporation, and this acquisition is expected to close in March 2006.

 

Our KVM switching systemseliminate the need for extra keyboards, monitors, and mice and allow businessesto save critical space in their data centers. Our KVM over IP switching systems eliminate distance limitations andprovide 24/7 access and control of thousands of servers, even when the serversare dispersed in different physical locations. Our DSView*®*management software and KVM over IP switching systems allow IT managers to usea single console to gain secure, local and remote access and control of serversand other network data center devices from any location.  Our innovative advances for the data centerinclude multi-platform switching, analog matrix switching, KVM extension overCAT 5 cable, PCI bus extension, our proprietary on-screen menu switchingsystem, remote KVM over IP connectivity, digital serial over IP, digital-analogintegrated access to multiple servers, the intelligent

 

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platform management interface (IPMI),wireless KVM, PDA, and hand-held management software, and centralizedmanagement software for access and control of network infrastructure.

 

Our *DSR®Series* switches combine analog and digital connections, serialconnectivity, and external modem support in one switch.  These appliances integrate our KVM over IPswitching technology and CAT 5 connectivity. IT managers and network administrators gain worldwide access and controlof their servers and serial devices and can monitor and manage them all from asingle computer screen.  In addition, weprovide plug and play switching systems for the many network administration,management, and storage problems faced by corporate customers, data centers,and mid-sized businesses.  Ourconnectivity products and technologies are sold or licensed under the Avocent,Cybex, and Equinox brands, including our *AMX**®*,***AutoView®, Cstation*TM,*DSView®, DS Series, LongView®,  SuperSerial*,*SwitchView®*, *Emerge*TM, *SonicAdmin*TM,and *SonicSentinel*TM products.

 

We market our productsaround the world to a diversified group of original equipment manufacturers(OEMs), dealers, distributors, resellers, and end users, primarily through oursales and customer support staff, advertisements in trade publications, on-linesponsorships, and participation in major industry trade shows.  A substantial portion of our sales is tomajor server OEMs that purchase our switching systems on a private-labelor branded basis.

 

Our corporate Internetaddress is *www.avocent.com*.  At this website, we make available free ofcharge our annual report on Form 10-K, our annual proxy statement, ourquarterly reports on Form 10-Q, any current reports on Form 8-K, and anyamendments to these reports, as soon as reasonably practicable after weelectronically file them with, or furnish them to, the Securities and ExchangeCommission.  Also available at thiswebsite are our Code of Business Conduct and Ethics, our Corporate GovernanceGuidelines, our Whistleblower Policy, the Nominating and Governance Committee’sPolicies and Procedures for Director Candidates, and the Charters for ourAcquisition and Strategy Committee, Audit Committee, Compensation Committee,and Nominating and Governance Committee. If any amendment to our Code of Business Conduct and Ethics or anywaiver granted under it is applicable to our principal executive officer, ourprincipal financial officer, our principal accounting officer or controller (orany persons performing similar functions) and relates to the code of ethicsdefinition enumerated in the SEC’s regulations, we will disclose such amendmentor waiver at this website within five business days after the date of suchamendment or waiver.  The informationfound on our website is not part of this Form 10-K.  In addition to our website, the SEC maintainsan Internet site at *www.sec.gov*that contains reports, proxy and information statements, and other informationregarding us and other issuers that file electronically with the SEC.

 

Apex, AMX, AVWorks, AMWorks,Dambrackas Video Compression, Avocent, the Avocent logo, AutoView, Cybex, DSR,DSView, Equinox, LongView, The Power of Being There, SwitchView, and XP are trademarksor registered trademarks owned by us. ** **This annual report also includestrademarks of other companies.

 

**Industry Background**

 

Information technology iscritical to most business operations as computers perform multiple and diversefunctions throughout many different types of organizations.  Many corporations have decentralizedcomputing power while sharing technology resources and providing broad accessto enterprise data.  This has resulted inthe widespread adoption of distributed network computing environments using anetwork-based architecture of interconnected computers.  The typical data center installation consistsof a local area network (LAN), with a large number of  computers operating as servers dedicated toperforming specific functions for the many client computers connected to theLAN and, in many cases, may include a wide-area network (WAN).

 

In addition, with the shiftof software applications to a web services model, the demand for servers andstorage is growing.  Users are accessingmore data and resources using intranets and the internet.  This growth causes a proliferation of serversand increases the need to manage this growing network of servers and networkdevices.

 

Corporate LANs, WANs,internet service providers (ISPs), application service providers (ASPs), serverfarms, and data centers face significant network administration, environmental,and space limitations.  Facilitiesmanagers and network administrators, who may manage hundreds or thousands ofservers and other networked devices, must identify and access relevant serversand devices, add or delete users, add, change, or upgrade applications, tunesystems for better performance, and diagnose and correct network failures.  These servers are generally designed tooperate as stand-alone systems, each with its own console, and facilitiesmanagers and network administrators must therefore deal with a large number ofconsoles, whether centrally located or dispersed throughout the organization,when performing administration and management tasks.

 

Information technologyresources are critical to organizations. Accordingly, constant availability is crucial to the operation of manybusinesses.  The time that an ISP, anASP, a data center, a server farm, or corporate network is down or degraded cancause significant inconvenience, loss of productivity, and financial loss.  Because the diagnosis and the correction ofabnormal server or network behavior often require support personnel to physicallyaccess each affected server through its own console, quick and efficient faultmanagement can be difficult, especially when there are a large number ofdispersed servers involved.  In addition,when a network fails, the ability of a facilities manager or networkadministrator to quickly and efficiently diagnose and correct the problem isoften hampered by the inability to access the software tools that reside on thenetwork and that are normally used to manage network failures.

 

 

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In addition to theseadministration and management problems, as organizations grow and theircomputing needs increase, the number of servers, consoles, peripherals, andcables grows.  Without efficient storageand configuration, networked hardware consumes substantial and often expensivefloor space, creates clutter that hampers network administration andmanagement, and increases the risk of physical damage to expensivehardware.  The space managementalternatives available to facilities managers and network administrators havegenerally consisted of racks or cabinets designed to house only one type ofserver, and most have not been technically designed for ease of access.  Organizations with distributed, heterogeneousclient/server networks are primary customer prospects for our products andtechnologies.

 

**Products and Technologies**

 

We provide a variety ofproducts and technologies to solve many of the network administration,management, and storage problems faced by facilities managers and networkadministrators responsible for monitoring and servicing servers and networkinstallations.  In an effort to become more streamlined and to putvital decisions closer to the customers who purchase or license our productsand technologies, in the fourth quarter of 2005 we announced a plan toreorganize into the following five business divisions that sell or license ourprincipal products and technologies, with the changes becoming effective in thefirst quarter of 2006.  Although we have nowsubstantially completed reconfiguring our systems and defining new cost centersand operating measures to track the performance of the divisions and to use asa basis for managing and allocating resources, we did not manage our businessunder these divisions during 2005.

 

**•****              The Management Systems Division,consisting of our branded and OEM KVM, serial console, power control, andmanagement appliance businesses.**

 

This division focuses on (i)IP-based products and technologies for data centers, (ii) scalable products forremote access and control of branch office IT infrastructure, (iii) simplifiedaccess and control for mid-size server rooms, and (iv) desktop switching andUSB hubs for simplified control of desktops, small offices, and home-basedbusinesses.

 

The products andtechnologies offered by our Management Systems Division include:

 

•              Our *DS Series*TMproducts, which allow users to control servers from remote locations using anInternet or network connection without the necessity of remote access hardwareor software on the computers or servers being accessed.  The *DS Series*KVMproducts digitize keyboard, video, and mouse information and compress andtransport that information in packets over traditional network connectionsoptimizing performance for busy data centers. Our *DSR* switching systemsfeature a digital console connection that allows facilities managers andnetwork administrators access to servers utilizing standard networkinginfrastructure and our *KVM over IP*TMtechnology.  Our *DS Series*appliances are managed with *DSView*TMcentralized management software,**providing access and control of servers andserial devices in the network operations center or from almost any location inthe world using TCP/IP connectivity. IT administrators can securely manage all connected data center devicesand gain “point-and-click” access and control over these devices using abrowser interface.

 

**•****             **Our*AutoView*®**switch family, which offers users a varietyof analog and digital KVM switches.  Our *AutoView*TM**2000 switch is an analog switch that features end-to-end CAT 5connectivity, while our *AutoView*1000Rand *AutoView*2000R switchescombine an analog port for local access and an Ethernet port for extended andremote IP-based digital access using our digital *KVM over IP*server management tool.  With end-to-endCAT 5 connectivity, convenient on-screen management, and flexible access, the *AutoView*1000R and 2000R switches providelocal and remote users with access to servers from any location in the worldthat has an internet or dial-up connection. For control of multi-platform servers, our *AVWorks**®* administration software is bundled with eachswitch.  Our *AutoView®Wireless* switch provides wireless connectivity between computers andmonitors, keyboards, mice, and audio devices.

 

•              Our *AMX*TM analog matrix switching systems, which provide simpleraccess and easier manageability of servers in multi-rack, multi-platformenvironments.  Our *AMX*switches increase the number of userswith simultaneous access and offer efficient scalability with an architecturethat makes it easy to add and support additional servers.  Our advanced *AMWorks*®software isalso included with our *AMX*switchesfor central administration.

 

•              Our KVM extension product lines,including our CAT 5 extension products, fiber optic and copper extensionproducts, and wireless extension products. The *LongView*® extender allows users toextend a keyboard, monitor, mouse, speakers, microphone, and serial port up to500 feet away from the computer or KVM switch with one CAT 5 UTP cable.  Our *LongView Wireless*product**is a KVM extender, which can wirelessly connect monitors(VGA, SVGA, and XGA), keyboards, mice, and audio devices to a computer up to1,000 feet away.

 

•              Our CCM appliances, which deliversecure, serial over IP access to console ports of servers and serially manageddevices such as power management systems and network hubs and routers.  These serial appliance and attached devicescan be centrally managed using our management software.

 

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**•****              The Embedded Solutions andSoftware Division, consisting of the IPMI business developed by OSA and ourinternally-developed embedded KVM systems.**

 

This division focuses onintegrating our embedded virtual presence infrastructure (eVPI) with appliancesand management consoles.  These embedded “buildingblocks” include intelligent platform management infrastructure (IPMI), theDambrackas Video Compression® (DVC) algorithm, and virtual media.  In addition, we incorporate thesetechnologies into integrated products such as remote access cards and bladeserver management modules marketed as complete management solutions inpartnership with our OEM customers.  Weare also providing our embedded technologies for desktops, notebooks, storage,and telecommunications devices.

 

The products andtechnologies offered by our Embedded Solutions and Software Division include:

 

•              Our embedded products, which areprovided as a combination of hardware products and licensed technologies.  These technologies consist of IPMI firmware,drivers, and utilities, KVM switching and compression technologies, virtualmedia firmware and utilities, and desktop management applications.  These technologies are licensed to our OEMcustomers for inclusion in their servers, desktops, notebooks, and otherdevices.  Our hardware products consistof a number of management cards and chassis management products that are alsosold to our OEMs for inclusion with their systems.

 

•              This division also provides the technologyto our Management Systems Division that links our embedded technologies and ourDSView management software.

 

**•****              The Retail Point-of-Sale andAudio/Visual Division, consisting of the established Equinox serial businessand our wireless connectivity products.**

 

This division focuses onthree markets:  serial connectivity,audio/visual (with an emphasis on digital signage), and broadcast.  Our wireless and wired video extensionproducts are sold through our traditional serial product channel partners, predominantlysystems integrators for commercial point-of-sale products.  Our wireless and wired products andtechnologies allow displays to be placed at the point of need while greatlyreducing installation costs.

 

The products andtechnologies offered by our Retail Point-of-Sale and Audio/Visual Divisioninclude:

 

•              Our Avocent Equinox brandedproducts, which add high-performance, reliable, and affordable server-basedproducts for serial and dial access applications.  The *SuperSerial*product line includes network-based appliances and bus-based adapters.  These products provide serial connectivityfor security, commercial point-of-sale, process control, industrial automation,data collection, remote access, fax servers, Internet access, and customapplications.

 

•              Our Avocent Emerge family ofproducts, which provide both wired and wireless video extension and switchingfor use in a range of markets.  OurEmerge Wireless Media Streamer (EWMS) is ideal for use in boardrooms, classrooms,and commercial digital signage applications. Our Emerge Media Streamer (EMS) product offers CAT 5 wired videoextension for use in similar markets. Our ECMS delivers CAT 5 KVM extension with high quality video that isrequired in markets such as broadcast and digital signage.

 

**•****              The Desktop Solutions Division,consisting of our existing extension products.**

 

Thisdivision’s technology allows a PC or blade to be centralized by providingremote access to the PCs or blades.  Thistechnology is also sold as a building block or “blade enabler” to OEMs andsystems integrators to allow large institutions to introduce blades asworkstations and take advantage of the density that blades bring.  The technology also allows the IT staff tohandle the moves, adds, and changes in a very efficient manner, and iscurrently deployed within areas of the Federal government, trading floors forfinancial institutions, hazardous computing environments, and manufacturingcompanies.

 

The products andtechnologies offered by our Desktop Solutions Division include:

 

•              Our digital extension productlines, which feature our bus extension technology that extends keyboard, video,mouse, audio, and USB over an IP network and allows administrators tocentralize all PCI-based computers for ease of maintenance while providingusers with full PC functionality at the desktop.  These fiber optic or CAT 5 extension productsenable a distributed computing environment that can provide access tocentralized PC assets from up to 2,400 feet away*.*

 

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**•****              The Mobile Technologies Division,consisting of the products and technology we acquired with Sonic Mobility.**

 

Thisdivision includes our mobile device management and secure wireless systemsadministration, which grew from our Sonic Mobility product base.

 

The products andtechnologies offered by our Mobile Technologies Division include:

 

•              Our *SonicAdmin*software, which provides IT administrators with the ability to manage networkand data center infrastructure from mobile handheld devices.  Anadministrator can, among other things, reboot servers, unlock/change passwords,restart services not functioning properly, view event logs, move files, andsend messages to logged-in users.

 

•              Our *SonicSentinel*software offers the remote control and administration of PDAs and smart phonesthat connect to a computer network.  IT administrators can, among otherthings, monitor all mobile devices for current status, apply passwords tounprotected devices, and sensitive data for mobile devices that are lost orstolen.

 

**Sales and Marketing**

 

We market and sell ourproducts through our own sales force and various distribution channels,including OEMs, distributors, and reseller arrangements.  We market our products primarily throughdirect customer sales calls, advertisements in trade publications, onlinesponsorships, participation in major industry trade shows, promotions withdistributors and resellers, direct marketing, telemarketing, publicityprograms, and through our website.  Wealso devote a substantial portion of our marketing efforts to developing,monitoring, and enhancing our relationships with our network of OEMs,independent dealers, distributors, resellers, and end users.  Our sales personnel are supported by ourengineers and our customer service representatives who provide technicalsupport and advice to customers.  As ofDecember 31, 2005, we employed 296 people in sales, marketing, andcustomer support.

 

We currently sell or licensevarious switching products and technologies to Dell, Hewlett-Packard, IBM, andother OEMs pursuant to private-label, branded, and licensing arrangements.  These OEM customers integrate and sell ourproducts and technologies with or within their own products, includingnetworked servers.  We devote significantsales, engineering, operations, and customer service resources to our OEMaccounts.  We have significant experiencein working with our OEM and other server manufacturers, and we intend to usethat experience to enter into new relationships with other computermanufacturers in the United States, Europe, and Asia.  We believe that the architecture, quality,and reliability of our products and technologies, together with our commitmentto customer service, are attractive to server manufacturers.

 

We have relationships with avariety of distributors and resellers, value added resellers (VARs), andsystems integrators, for the distribution and sale of Avocent, Cybex, andEquinox branded products in the United States, Canada, Europe, South America,Asia, and elsewhere.  We devote resourcesto educating our distributors and resellers about the benefits of our productsand training them in the proper installation and support of our products.  We will continue to devote additionalresources to increase these branded sales, and we will pursue additionalrelationships with distributors and resellers, both domestically andinternationally, who have the technical capability and market presence toassist end-user customers in developing network space management, access, andcontrol products and technologies to meet their particular needs.  Our future success will depend in part on ourability to attract, train, and motivate additional distributors and resellers.

 

We provide discounts, otherspecial pricing arrangements, and certain return privileges to ourOEMs and our distributors and resellers. Our agreements with our distributors and resellers are generallynonexclusive and may be terminated on short notice by either party withoutcause.  Our distributors and resellersare not within our control, are not obligated to purchase products from us, andfrequently offer products from several different manufacturers, includingproducts that compete with our products.

 

International salesaccounted for approximately 43% of net sales in 2005, 41% of net sales in 2004,and 40% of net sales in 2003, and were made primarily to OEMs, distributors,and resellers located in Europe, Canada, Asia, and other foreigncountries.  No foreign country accountedfor more than 10% of 2005 sales.  Salesto customers in the Netherlands, including the European distribution facilityfor one of our OEM customers, accounted for 10% of sales in 2004.  Sales to customers in the United Kingdom,including the European distribution facility for one of our OEM customers,accounted for 10% of 2003 sales.  Noother foreign country accounted for more than 10% of 2004 or 2003 sales.  We are expanding our international salesefforts within Europe, Asia, and the Pacific Rim through the utilization of oursales offices in Beijing, Guangzhou, and Shanghai, China; London, England;Paris, France; Rotterdam, Holland; Shannon, Ireland; Steinhagen, Germany; Taipei,Taiwan; Tokyo, Japan; Hong Kong; and Singapore.

 

**Customers**

 

To date, a substantialportion of our net sales has been generated from sales of our switchingproducts and technologies to OEMs for integration with their productofferings.  Sales to OEM customersrepresented 48% of net sales in 2005, 45% of net sales in 2004, and 46% of netsales in 2003.  While we have contractswith some of our OEM customers, none of them is obligated to purchase productsfrom us except pursuant to binding purchase orders.  Consequently, any OEM customer could ceasedoing business with us at

 

 

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any time. The loss of, or material decline in orders from, certain of our currentOEM customers would have a material adverse effect on our business, financialcondition, results of operations, and cash flow.

 

In addition to our OEMcustomers, our principal customers include a diversified group of dealers,major distributors, VARs, and direct end users who purchase our brandedproducts (52% of net sales in 2005, 55% of net sales in 2004, and 54% of netsales in 2003).  We believe that ourbroad range of products sold at different price points offers us theopportunity to market our products to customers of all sizes, in differentindustries, and with varying degrees of technical sophistication.

 

Sales to Hewlett-Packard andDell represented approximately 20% and 15%, respectively, of net sales in2005.  Sales to Tech Data and IngramMicro represented approximately 11% and 10%, respectively, of net sales in2005.  Sales to Hewlett-Packardrepresented approximately 23% of net sales in each of 2004 and 2003.  Sales to Dell represented approximately 12%of net sales in 2004 and 14% of net sales in 2003.  Sales to Tech Data represented approximately11% of net sales in 2004 and 12% of net sales in 2003.  Sales to Ingram Micro representedapproximately 11% of net sales in 2004. No other customer accounted for more than 10% of our net sales in 2005,2004, or 2003.

 

**Seasonality**

 

Our operating results areaffected by seasonal trends and by general conditions in the servermarket.  We have experienced, and expectto continue to experience, some degree of seasonality due to customer buyingcycles.  We believe that the third andfourth quarters will generally have higher net sales levels due to customerbudgeting and procurement cycles, which may depress net sales in otherquarters.  In the past, revenue in our fourth quarter of each year has typicallybeen higher than revenue in prior quarters for the year.  In addition, we typically see a sequentialdecline in revenue from the fourth quarter of a year to the first quarter ofthe following year.  While it isdifficult to predict revenue in any quarter, we expect that this pattern willcontinue in the future.

 

**Customer Service**

 

We emphasize customerservice by developing high quality products, encouraging customer feedbackthrough contact with our key customers, providing technical support andinformation on our website, and providing a customer hotline that offerstechnical support for the life of our products. We strive to respond quickly to our customers’ requests for technicalsupport and service, and our engineering department often works with individualcustomers to troubleshoot problems and develop custom solutions.  We offer warranties for parts and service onall of our products, ranging from one to three years.  We also offer a 30-day money-back guaranteefor all of our appliance products sold in North America.  To date, we have not experienced anysignificant product returns.  We may, asa result of competitive pressures, change our warranty policies in the futureto provide coverage that is greater in scope and duration than the coverage wecurrently offer.  If we were to increaseour warranty coverage, our risk of warranty claims, and therefore our warrantyexpense and reserves, would likely increase.

 

**Development of New Products andTechnologies**

 

We believe that the timelydevelopment of enhancements to our existing products and technologies and ofnew products and technologies is essential to building our competitiveposition.  The market for our productshas experienced rapid technological advances, frequent new product introductions and enhancements, andsignificant price competition.  Theintroduction of products incorporating superior or alternative technologies(such as switching software), the creation or adoption of new technologies, theemergence of new industry standards, or changes in the market’s pricingstructure could render our existing products and technologies and the productsand technologies we have under development obsolete or unmarketable.  Our products generally combine components,such as printed circuit boards, semiconductors, memory, connectors, cableassemblies, power supplies, and enclosures, that are manufactured by othercompanies and are generally available to our competitors and potentialcompetitors.  Our future success willdepend in large part upon continued innovative application of commerciallyavailable components, together with continued enhancements to our proprietarysoftware, firmware, and other technologies, the expansion and enhancement ofour existing products, and the development and introduction of new technologiesand products that address changing customer needs on a cost-effective andtimely basis.  By emphasizing customer-drivenresearch and development, we have been able to develop innovative, practical,and marketable products that have had immediate application andacceptance.  Our failure to respond on atimely basis to technological changes or customer requirements could have amaterial adverse effect on our business, financial condition, results ofoperations, and cash flow.

 

Due to our significantreliance on OEM relationships, some of our product development efforts arefocused on developing new products or enhancements for OEM customers.  At times, these new products or enhancementsmay not be available to, or readily marketable to, other customers withoutsignificant modifications or delay.

 

Our engineering and productdevelopment efforts focus on anticipating the needs of our customers byproviding innovative, practical, and marketable products and technologies thathave immediate applications in their markets. By maintaining contact with customers throughout the installation andtechnical support process, we are able to identify and test potential designmodifications and improvements as well as new applications and extensions forexisting products and technologies.  Weexpect this process will enable

 

 

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us to develop new product categories and applicationsbased on existing technology developed to meet specific customer needs.  Many of our products and technologies aredesigned to accommodate future modifications and additional features, which webelieve facilitates the development and integration of future modifications andfeatures if we see a market need.

 

Our engineering and productdevelopment expenses were approximately $56.9 million in 2005, $45.4 million in2004 (excluding $29.3 in expensed in-process research and development expensesrelated to our acquisitions of Crystal Link Technologies, OSA Technologies,Inc., and Sonic Mobility, Inc.), and $29.8 million in 2003 (excluding $3.9million in expensed in-process research and development expenses related to ouracquisition of Soronti).  As of December 31,2005, we employed 346 people in our engineering department.  In addition, we use independent contractorsfrom time to time.  As ofDecember 31, 2005, we were working with approximately 18 independentcontractors on various development projects.

 

To meet the challenges ofthe rapidly changing technology in the computer industry, we expect to makesubstantial investments in product development in the future.  There can be no assurance that these new orenhanced versions or any other of our product development efforts will lead tocommercially viable products or technologies, will be completed on a timelybasis, or will include the features required to achieve market acceptance.

 

A key component of ourengineering and product development strategy is the acquisition of newtechnologies and companies.  We acquiredEquinox Systems Inc. in 2001, 2C Computing, Inc. in 2002, Soronti, Inc. in2003, and Crystal Link Technologies, OSA Technologies, Inc., and SonicMobility, Inc. in 2004, and we anticipate completing our acquisition ofCyclades Corporation in March of 2006. We intend to continue to evaluate opportunities to acquire technologiesand companies, and it is likely that we will complete additional acquisitionsin the future.  There can be no assurancethat these acquisitions will result in the timely development of commerciallyviable products or technologies that achieve market acceptance.

 

**Manufacturing**

 

We do not manufacture any ofour products in their entirety.  Instead,we manage product planning, purchasing, and shipping, and we perform finalassembly, quality assurance, and testing on some of our products while weoutsource some or all of these functions on other products.  In order to avoid the capital investmentrequired to establish and maintain in-house manufacturing capabilities, we relyon subcontractors throughout the world for the assembly of printed circuitboard assemblies, subassemblies, chassis, and equipment enclosures.  We believ that our chosen subcontractors cantypically perform these functions at a lower cost than we can, whilemaintaining our high standards for quality and delivery.  Outsourcing our manufacturing functionsallows us to concentrate our resources on research and development, productdesign, quality assurance, sales and marketing, and customer service.  We (or our subcontractors) subject our mostcritical components and products to automated testing, equipment burn-inprocedures, comprehensive quality audits, functional testing, and regulatoryscreening to assure quality and reliability. As of December 31, 2005, we employed 169 people in ourmanufacturing and logistics department.

 

We currently rely on severalthird party manufacturers, including Kontron, Elcoteq Network Corporation,Plexus Services Corp., and Likom Computer Products, for subassembly of ourproducts.  These outsourcingarrangements, and any future outsourcing arrangements, involve numerous risks,including reduced control over product quality, delivery schedules,manufacturing yields, and costs.  Inaddition, while these third-party manufacturers have arrangements for warrantyobligations, we remain primarily responsible to our customers for warrantyobligations.  We attempt to diversify ouroutsourced manufacturing operations and believe we have an adequate supply ofalternative subcontractors.

 

We generally purchaseindustry-standard parts and components, including power supplies,semiconductors, memory, cable assemblies, line filters, enclosures, and printedcircuit boards, for the assembly of our products from multiple vendors andsuppliers through a worldwide sourcing program. Custom molded cables and certain turn-key products procured from outsidesources have significant delivery times (10 to 12 weeks), and failure to obtainadequate supplies could adversely affect our product deliveries.  We buy components under purchase orders andgenerally do not have long-term agreements with our suppliers.  Circuit board assemblies are currentlyobtained from a number of sources, including Kontron, Elcoteq NetworkCorporation, Plexus Services Corp., and Likom Computer Products.  We believe that there are adequatealternative sources for our product components. Any termination of, or significant disruption in, the business oraffairs of our suppliers or our third-party manufacturers or in ourrelationship with them may prevent us from filling customer orders in a timelymanner since we generally do not maintain large inventories of our components.

 

In the past, we haveexperienced delays in the receipt of certain components, which have resulted indelays in related product deliveries.  Weattempt to manage these risks through developing alternative sources,committing internal resources to supply chain management, and maintainingrelationships and close personal contact with each of our contractmanufacturers and suppliers.  There canbe no assurance, however, that delays in component and product deliveries willnot occur in the future, and the inability to obtain sufficient components orto develop alternative sources, if and as required in the future, could resultin delays or reductions in product shipments, which, in turn, could have amaterial adverse effect on our business, financial condition, results ofoperations, or cash flow.  Some of thecomponents for our products are available from a single supplier or a limitednumber of suppliers.  We attempt tomaintain quality relationships and close contact with each of our suppliers.

 

 

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**Competition**

 

The market for our productsis highly fragmented and competitive, and we expect competition to increase inthe future.  In the market for switchingsystems, we compete with companies such as Raritan Computer, Rose Electronics,Minicom Advanced Systems, Agilent Technologies, Aten International, Belkin,Lantronix, and Digi International, some of which may have substantially greaterfinancial, marketing, and technical resources than we have.  We also compete with other companies (such asIntel, Microsoft, Computer Associates, Tivoli, and BMC Software) that offeralternative technologies or products (such as software) that compete with ourswitching systems.  In addition, certainof our OEM customers, such as Dell, Hewlett-Packard, and IBM, offertechnologies and products that are competitive with our products, and we expectthese technologies and products to remain competitive in the features theyoffer.  Our products and technologies arealso in competition with the products and technologies offered by hardwaremanufacturers and network management companies such as Intel, Microsoft, Cisco,and EMC.

 

In the market for ourproducts, we compete primarily on the basis of technological capabilities,performance in relation to price, product features, quality, reliability, developmentcapabilities, product availability, and customer service and support.  Our future success will be highly dependentupon timely completion, introduction, and distribution of new products,technologies, and features at competitive price and performance levels thataddress the evolving needs of our customers. We continually experience price competition and expect that pricingpressures could increase in the future.

 

**Proprietary Technology**

 

Our future success isdependent in part upon our ability to protect our intellectual property and ourproprietary rights in our products and technologies.  We seek to protect our intellectual propertyrights by invoking the benefits of the patent, trademark, copyright, trade secret,and unfair competition laws of the United States, which provide only limitedprotection.  We have been issued 48 U.S.patents and have 26 U.S. patent applications pending.  We have various corresponding patent applicationspending under the provisions of the Patent Cooperation Treaty, which permitsthe filing of corresponding foreign patent applications in numerous foreigncountries within a limited time period. We also have other foreign patent applications pending.  There can be no assurance that any additionalpatents will be issued from any of our pending applications, that any patentswill be issued in any additional countries where our products or technologiescan be sold or licensed, or that any claims allowed in our patents or in anypending patent applications will be of sufficient scope or strength for, orprovide any meaningful protection or any commercial advantage to, us.  Moreover, our competitors may challenge thevalidity of, or be able to design around, these patents or any other patentsthat may be issued to us.  The laws ofcertain foreign countries in which our products are or may be developed,manufactured, or sold (particularly countries in Asia) may not protect ourproducts or intellectual property rights to the same extent as do the laws ofthe United States and thus increase the likelihood of piracy of our productsand technologies.

 

We believe that certainproducts of certain competitors infringe one or more of our U.S. patents.  In 2005, we settled our patent infringementsuit against Raritan Computer Inc.  Wereceived an initial payment of $5 million, and we will receive royalty paymentsfor five years from the date of the settlement based on a fixed percentage ofthe sales of certain Raritan products subject to a minimum quarterly payment of$750,000.

 

InOctober 2003, we filed a complaint for patent infringement in the United StatesDistrict Court for the Northern District of Alabama against ClearCubeTechnology, Inc.  The ClearCube complaintseeks injunctive relief, damages, attorneys’ fees, and costs under threeAvocent patents.  ClearCube has filedcounterclaims alleging non-infringement, unenforceability, invalidity, andmisuse of the Avocent patents.  A Markman hearing on claims construction washeld in February 2006.

 

In the future, we may fileadditional lawsuits against other companies regarding the allegedinfringement.  Patent litigation, and anyother litigation relating to our intellectual property to which we become aparty, is expensive and subject to numerous risks and uncertainties, and therecan be no assurance that we will be successful in any such litigation.  There can be no assurance that the steps wetake to protect our intellectual property rights will be adequate to preventmisappropriation of our technologies or that we can use our intellectualproperty rights to successfully prevent competitors from commercializingtechnologies that are substantially equivalent or superior to our products andtechnologies.  Additionally, current orfuture competitors could develop their own proprietary technologies or obtainpatents that may prevent us from developing or selling our products andtechnologies.

 

**Employees**

 

As of December 31,2005, we had 560 full-time employees working in the United States.  Of our domestic full-time employees, 173 werein marketing, sales, and customer support, 190 were in engineering, research,and development, 113 were in manufacturing and logistical operations, and 84were in administration.  As ofDecember 31, 2005, we had 383 full-time employees working at ourfacilities outside of the United States. Of our international full-time employees, 123 were in marketing, sales,and customer support, 153 were in engineering, research, and development, 56were in manufacturing and logistical operations, and 51 were in administration.  Our employees are not covered by anycollective bargaining agreements relating to their employment by us.  We believe that we have good relations withour employees.

 

 

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**Backlog**

 

Backlog consists of purchaseorders with delivery dates scheduled within the next six months.  None of our customers is obligated topurchase products from us except pursuant to binding purchase orders.  Because of the timing of orders and thepossibility of customer changes to delivery schedules, our backlog as of anyparticular date is not representative of actual sales for any succeedingperiod.  Moreover, with recentindustry-wide initiatives by OEMs, distributors, and resellers to reduceinventories and shorten lead times, we do not view backlog as an importantindicator of our future results, and we do not believe it is a meaningfulindicator of actual sales for any succeeding period.

 

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**Item 1A. Risk Factors.**

 

*THIS ANNUAL REPORTCONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THATCOULD CAUSE OUR ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE DISCUSSED INTHIS ANNUAL REPORT.  THESE RISKS ANDUNCERTAINTIES INCLUDING THE FOLLOWING:*

 

**Intense competition from new andexisting competitors could impair our ability to grow our business and sell ourproducts and technologies.**

 

The markets for our productsand technologies are highly fragmented and intensely competitive.  Aggressive competition from both hardware andsoftware products and technologies could result in price reductions and loss ofsales, which would materially harm our business.  Our business is becoming increasinglysensitive to the introduction of new products and technologies, price changes,and marketing efforts by numerous and varied competitors.  Accordingly, our future success will behighly dependent upon our timely completion and introduction of new productsand technologies and features at competitive prices and performance levels thataddress the evolving needs of our customers. We continue to experience aggressive price competition and increasedcustomer sensitivity to product prices, and pricing and margin pressures arelikely to increase in the future. Because of this competition, we may have to continue to lower the pricesof many of our products and technologies to stay competitive, while at the sametime trying to maintain or improve our revenue and gross margin.  Because our business model is based onproviding innovative and high quality products, we may spend a proportionatelygreater amount on research and development than some of our competitors.  If we cannot proportionately decrease ourcost structure on a timely basis in response to competitive price pressures,our gross margin and profitability could be adversely affected.  In addition, if our pricing and other factorsare not sufficiently competitive, or if there is an adverse reaction to ourproduct decisions, we may lose market share in certain areas, which couldadversely affect our revenue and prospects.

 

We compete for sales ofswitching systems and extension products with companies such as RaritanComputer, Rose Electronics, Minicom Advanced Systems, Agilent Technologies,Aten International, Belkin, Lantronix, and Digital V6.  We also face competition from softwareproviders (such as Microsoft, Computer Associates, Tivoli, and BMC Software),who may be able to offer competitive software products at a much lower cost oreven bundled for free, and from server manufacturers (including our OEMcustomers), who are able to offer their competitive technologies or products atthe time of the server sale.  Thesesoftware and hardware products address many of the problems our switching systemsand technologies, extension products, and remote access products are designedto address.

 

Current and potentialcompetitors may be able to respond more quickly to new or emerging technologiesor products and to changes in customer requirements or to devote greaterresources to the research, development, promotion, and sale of their productsand technologies than we do.  Inaddition, current and potential competitors have established or may establishcooperative relationships among themselves or with third parties that enhancethe ability of their products and technologies to address the needs of ourcurrent and prospective customers.  Wemay not be able to compete successfully against current and future competitorsand competitive pressure may materially harm our business.

 

Certain of our customers,such as Dell, Hewlett-Packard, IBM, and Microsoft, presently offer competitivehardware and/or software products and technologies that address many of theproblems our products and technologies address. These customers could decide to manufacture their own switching orremote access products, enhance their own internally-developed switching, IPMI,or other embedded technologies, or offer products or technologies supplied bycompetitors.  Companies with hardwaremanufacturing experience or network management products, many of which aresubstantially larger than we are and have significantly more financialresources than we do, also offer products or technologies that compete withus.  Established companies with hardwaremanufacturing or network management experience (such as Intel, Cisco, or EMC)could also offer new products, new technologies, or new solutions that competewith our products and technologies.

 

**Our failure to respond to rapidtechnological change or to introduce successful new products and technologiesmay result in reduced revenue or revenue growth.**

 

The process of developing oracquiring new products and technologies and enhancing existing products andtechnologies is complex, costly, and uncertain, and any failure by us toanticipate customers’ changing needs and emerging technological trendsaccurately could significantly harm our market share and results ofoperations.  We must make long-terminvestments, develop or obtain appropriate intellectual property, and commitsignificant resources before knowing whether our predictions will accuratelyreflect customer demand for our products and services.  After we develop a product, we must thenaccurately forecast volumes and configurations that meet customer requirements,manufacture appropriate volumes quickly and at low cost, and train our salesforce and resellers.  Any delay in thedevelopment, production, marketing of, or training for new products ortechnologies could result in our not being among the first to market, whichcould further harm our competitive position.

 

Sales of switching,extension, and remote access products and technologies are characterized byrapid technological advances, frequent new product and technologicalintroductions and enhancements, and significant price competition.  If we do not

 

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keep pace with these changes, we will losecustomers, and our business will be adversely affected.  The introduction of products or technologiesincorporating superior alternatives such as switching software, the emergenceof new industry standards, or changes in pricing structure could render ourexisting products and technologies and those under development obsolete orunmarketable.  New technologies offeredby us or our competitors could compete with our existing products at a lowerprice, which would reduce our revenue.

 

Our products combinecomponents, such as printed circuit boards, connectors, semiconductors, memory,cable assemblies, power supplies and enclosures that are manufactured by othercompanies and are generally available to competitors and potentialcompetitors.  Our future success willdepend in large part upon continued innovative application of such commerciallyavailable components, together with continued enhancements to our proprietarysoftware, firmware, and other technologies, the expansion and enhancement ofexisting products and technologies, and the development and introduction of newproducts and technologies that address changing customer needs on a cost-effectiveand timely basis.  If we fail to respondon a timely basis to technological developments, changes in industry standards,customer requirements, or software innovations, we will lose customers, and ourbusiness will be greatly harmed.  Similarresults could occur if we experience significant delays in the development orintroduction of new products or technologies.

 

Due to our significantreliance on OEM relationships, our development efforts may often be focused ondeveloping new products, technologies, or enhancements for OEM customers.  As a result, our OEM relationships maynegatively affect our ability to develop new and enhanced products andtechnologies for our non-OEM customers. Moreover, these new products, technologies, or enhancements for OEMcustomers may not be available to, or readily marketable to, other customerswithout significant modification and delay. The termination or significant disruption of our relationship withcertain OEMs or other customers for whom we devote significant productdevelopment resources is likely to result in lost opportunities with respect tothe development of products, technologies, or enhancements for our othercustomers.

 

**We are likely to experiencefluctuations in operating results.**

 

We have in the pastexperienced substantial fluctuations in operating results, on a quarterly andan annual basis, and we expect these fluctuations will continue in thefuture.  Our operating results will beaffected by a number of factors, including, but not limited to:

 

•              The volume and timing of orders,particularly from OEM and other large customers;

 

•              The timing of shipments;

 

•              The timing of new productintroductions, new technologies, and enhancements by us and by our competitors;

 

•              Changes in product or distributionchannel mixes;

 

•              Changes in pricing policies orprice reductions;

 

•              Competition from new products andtechnologies and price reductions by competitors;

 

•              The availability and cost ofsupplies and components;

 

•              Sales and marketing expensesrelated to entering into new markets, introducing new products, newtechnologies, and retaining current OEM and other large customers; and

 

•              Fluctuations in sales of serversdue to changes in economic conditions or capital spending levels.

 

Our operating results willcontinue to be affected by seasonal trends, by general conditions in the servermarket, and by general economic conditions. We have experienced, and we expect to continue to experience, somedegree of seasonality due to customer buying cycles.  We believe that the third and fourth quarterswill generally have higher net sales levels due to customer budgeting andprocurement cycles, which may depress net sales in other quarters.  In addition, European sales are often weakerduring the summer months.  In the past, revenue in our fourth quarter ofeach year has typically been higher than revenue in prior quarters for theyear, and we typically see a sequential decline in revenue from the fourthquarter of a year to the first quarter of the following year.  While it is difficult to predict revenue inany quarter, we expect that this pattern will continue in the future.  Many of the factors that create andaffect seasonal trends are beyond our control.

 

Our quarterly sales havealso reflected a pattern in which a disproportionate percentage of each quarter’stotal sales occur toward the end of the quarter, and this trend has become morepronounced in recent periods.  Thisuneven sales pattern makes

 

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prediction of revenue, earnings, and workingcapital for each financial period difficult, increases the risk ofunanticipated variations in quarterly results and financial condition, andplaces pressure on our inventory management and logistics systems.  If predicted demand is substantially greaterthan orders, there will be excess inventory. Alternatively, if orders substantially exceed predicted demand, we maynot be able to fulfill all of the orders received in the last few weeks of eachquarter.  Other developments late in aquarter, such as a systems failure, component pricing movements, or globallogistics disruptions, could adversely impact inventory levels and results ofoperations in a manner that is disproportionate to the number of days in thequarter affected.

 

We believe thatquarter-to-quarter comparisons of our historical financial results are notmeaningful indicators of our future operating results, and you should not relyon them as an indication of our future performance.  If our quarterly operating results fail tomeet the expectations of equity research analysts, the price of our commonstock could be negatively affected.

 

**Due to the international natureof our business, political or economic changes or other factors could harm ourfuture revenue, increase our costs and expenses, and impair our financialcondition.**

 

Sales outside the UnitedStates make up almost half of our revenue, and over half of our manufacturingtakes place outside the United States. Accordingly, our future revenue, gross margin, expenses, and financialcondition could suffer due to a variety of international factors, including:

 

•              Ongoing instability or changes ina country’s or region’s economic or political conditions, including inflation,recession, interest rate fluctuations, and actual or anticipated military orpolitical conflicts;

 

•              Currency fluctuations, which couldcontribute to variations in sales of products and technologies and could alsoaffect our reported results expressed in U.S. dollars;

 

•              Longer accounts receivable cyclesand financial instability among customers;

 

•              Tax or trade regulations andprocedures and actions affecting production, pricing, and marketing of orpayments for products;

 

•              Local labor conditions and otherregulations;

 

•              Differing technology standards orcustomer requirements;

 

•              Fluctuations in freight costs anddisruptions at important geographic points of exit and entry;

 

•              Natural or manmade disasters, suchas earthquakes, tsunamis, hurricanes, and typhoons, fires, power shortages, blackouts,or telecommunications failures; and

 

•              Medical epidemics, such as “BirdFlu” or Severe Acute Respiratory Syndrome.

 

The factors described abovealso could disrupt our product manufacturing and key suppliers located outsideof the United States.  For example, werely on manufacturers in Asia and Europe for the assembly and manufacture ofmany of our products.

 

**Our gross margins are expected to vary and maydecline.**

 

Gross margins may vary ordecline from period-to-period depending on a number of factors, including:

 

•              The ratio of OEM sales to brandedsales, since OEM sales typically have lower gross margins than branded sales;

 

•              Product mix, because sales of someof our products and technologies will have lower gross margins than sales ofother products or technologies;

 

•              Raw materials, freight, and laborcosts;

 

•              Introduction of new products andtechnologies by us and by our competitors; and

 

•              The level of outsourcing of ourmanufacturing and assembly services.

 

We expect that our grossmargins may vary and may decline in the future primarily due to the factorslisted above and to

 

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increased competition and the introduction ofnew products and technologies that may affect product prices.

 

**A substantialportion of our business consists of sales to a limited number of OEM customersthat are not obligated to continue doing business with us, and these sales varyconsiderably from quarter to quarter.**

 

A substantial portion of oursales is concentrated among a limited number of OEM customers.  Sales to these OEMs representedapproximately 48% of net sales in 2005, 45% of net sales in 2004, and 46% ofnet sales in 2003.  Sales toHewlett-Packard represented approximately 20% of our net sales in 2005, 23% ofour net sales in 2004, and 23% of our net sales in 2003.  Sales to Dell represent approximately 15% ofour net sales in 2005, 12% of our net sales in 2004, and 14% of our sales in2003.

 

We have experienced, and weexpect to continue to experience, period-to-period variability in sales tothese OEM customers.  Any cancellation,rescheduling, or reduction of orders by OEM customers in the future couldmaterially adversely affect our operating results.  Although our OEM customers typically placeorders for products up to several months prior to scheduled shipment dates,these orders are subject to cancellation.

 

Our OEM business is subjectto many risks, including:

 

•              Contract termination or reduced ordelayed orders;

 

•              Short order cycles and difficultyin predicting sales because our OEM customers do not have long-term commitmentsto purchase from us;

 

•              Changes in the OEMs’ internalproduct life cycles including the delay of planned new product introductionsand uncertainty over product end-of-life decisions;

 

•              Adoption of competing products ortechnologies developed by third parties for the OEMs or by the OEMs’ internaldevelopment teams; and

 

•              Changes in corporate ownership,financial condition, business direction, or product mix by the OEMs.

 

Any of these risks couldhave a material adverse effect on our business, financial condition, andresults of operations.  We haveexperienced, and expect to continue to experience, pricing pressures andsignificant variability in orders from our OEM customers, which may in thefuture have a material adverse effect on our quarterly sales and operatingresults.

 

The loss of one or morelarge OEM customers would materially harm our business.  While we have contracts with some of ourexisting OEM customers, none of our OEM customers is obligated to purchaseproducts from us except pursuant to binding purchase orders.  Consequently, any OEM customer could ceasedoing business with us at any time.  Ourdependence upon a few OEMs also results in a significant concentration ofcredit risk, thus a substantial portion of our trade receivables outstandingfrom time to time may be concentrated among a limited number of customers.  In addition, OEM customers have longerpayment cycles that increase the likelihood of aged or problem accountsreceivable.

 

We use multiple warehousesfor many of our OEM customers to fulfill their orders under a just-in-timeinventory management system, which requires us to maintain sufficient inventorylevels of our products at each of these warehouses to satisfy our OEMsanticipated customer demand, and we generally recognize revenue only when theseOEM customers take possession of our products. We are required to plan production, order components, and undertake ourmanufacturing activities prior to the time that these orders become firm or theproducts are accepted.  In addition, ourOEM customers have requested, and are likely to continue to request from timeto time, that we delay shipment dates or cancel orders for products that aresubject to firm orders.  As a result, atany time we may be holding a significant amount of OEM-branded products ininventory, and our sales to OEMs for future quarters are difficult topredict.  The inability to accuratelypredict the timing and volume of orders for our OEM customers during any givenquarter could adversely affect operating results for that quarter and,potentially, for future quarters.  If weunderestimate sales, we may not be able to fill orders on a timely basis.  This could cause customer dissatisfaction andloss of future business.  If weoverestimate sales, we may experience increased costs from inventory storage,waste, and obsolescence.

 

**A substantial portion of ourbusiness consists of sales of branded products, and these sales are difficult toforecast.  Failure to accurately forecastthese sales could lead to costly overproduction or product shortages.**

 

A substantial portion of oursales consists of sales of branded products. We expect these sales to increase in the future, and if we are successfulin increasing branded sales as a percentage of net sales, our quarterly salesand operating results will become more dependent upon the volume and timing ofbranded product orders received during the quarter.  Because many customers of our brandedproducts typically place orders shortly before their requested shipment date,revenues from branded sales are difficult to forecast.  With continued industry-wide initiatives bydistributors and resellers to reduce their inventories and to shorten their lead

 

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times, our major distributor and resellercustomers are reducing early commitments to firm orders.  Furthermore, many purchasers typicallyrequire prompt delivery of products.  Thisresults in a limited backlog of orders for these products and requires us tomaintain sufficient inventory levels to satisfy anticipated customerdemand.  The inability to accuratelyforecast the timing and volume of orders for branded products during any givenquarter could adversely affect operating results for such quarter and,potentially, for future periods.  If weunderestimate sales, we will not be able to fill orders on a timely basis.  This could cause customer dissatisfaction andloss of future business.  If we overestimatesales, we will experience increased costs from inventory storage, waste, andobsolescence.

 

**We will need to expand sales through distributors andresellers in order to develop our business and increase revenue.**

 

We expect to relyincreasingly on distributors and resellers, VARs, and systems integrators forthe distribution and sale of our branded products.  Our strategy contemplates the expansion ofour distributor and reseller network both domestically and internationally,particularly in Asia.  Our future successwill depend in part on our ability to attract, train, and motivate newdistributors and resellers and expand our relationships with currentdistributors and resellers.  We may notbe successful in expanding our distributor and reseller relationships.  We will be required to invest significantadditional resources in order to expand these relationships, and the cost ofthis investment may exceed the margins generated from this investment.

 

In addition, distributorsand resellers often have rights of return, and in the future, these returnsfrom our existing or any new distributors and resellers may have a materialadverse effect on our business, financial condition, and results ofoperations.  Our agreements with ourcurrent distributors and resellers are generally nonexclusive and may beterminated on short notice by either party without cause, and any newdistributor or reseller agreements are likely to contain similarprovisions.  Distributors and resellersare not obligated to purchase products from us and frequently offer products ofseveral different manufacturers, including competitors’ products, anddistributors and resellers may give higher priority to the sale of ourcompetitors’ products.  A reduction insales efforts by our distributors or resellers could lead to a reduction in oursales and could materially adversely affect our business, financial condition,and results of operations.

 

**If we are unable to successfullydevelop our international distribution networks and international salesefforts, results of operations may suffer.**

 

We are working to develop,integrate, and expand our international distribution networks in an effort toincrease international sales of switching, extension, remote access, and otherproducts.  We may not be successful indeveloping or expanding the international distribution network or in marketingand selling products in foreign markets, particularly Asia.  If the revenues generated by ourinternational sales are not adequate to recover the expense of establishing,expanding, and maintaining an international distribution network, our business,financial condition, and results of operations could be materially adverselyaffected.  If international sales becomea more significant component of net sales, our business could become morevulnerable to the risks inherent in doing business on an international level,including:

 

•              Difficulties in managing foreignresellers;

 

•              Longer payment cycles and problemsin collecting accounts receivable;

 

•              The effects of seasonal customerdemand;

 

•              Changes in regulatoryrequirements;

 

•              Difficulties in meeting therequirements of different international product regulations;

 

•              Risks relating to the protectionof our intellectual property rights;

 

•              The impact on our marketingexpenses and our research and development resources as we localize our productofferings to meet local user requirements such as language translations andhardware compatibility issues;

 

•              Export restrictions, tariffs, andother trade barriers;

 

•              Fluctuations in currency exchangerates; and

 

•              Potentially adverse taxconsequences and political instability.

 

The existence or occurrenceof any one of these factors could have a material adverse effect on ourbusiness, financial condition, and results of operations.

 

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**We are dependent upon third-partysuppliers and outsourced manufacturing. Disruption of our access to these supplies and services, or problemswith the quality of supplies or services, could prevent us from fillingcustomer orders and harm our business.**

 

The principal components ofour products are electronic components, power supplies, semiconductors, memory,cable assemblies, line filters, enclosures, and printed circuit boards, all ofwhich are purchased from outside vendors. We generally buy components under purchase orders and generally do nothave long-term agreements with our suppliers. Also, we generally do not maintain large inventories of components.  Any termination of, or significant disruptionof, our relationships with the suppliers of our product components may preventus from filling customer orders in a timely manner which could result incustomer dissatisfaction and lost sales.

 

We have occasionallyexperienced, and we may in the future experience, shortages or delays indelivery of components.  Althoughalternate suppliers are available for most of the components and servicesneeded to produce our products, the number of suppliers of some components islimited, and qualifying a replacement supplier and receiving components fromalternate suppliers could take several months.

 

We have limited ability tocontrol quality issues (particularly with respect to faulty componentsmanufactured by third parities), and we depend upon suppliers to delivercomponents that are free from defects, competitive in functionality and cost,and in compliance with specifications and delivery schedules.  Disruption in supply, a significant increasein the cost of one or more components, failure of a third party supplier toremain competitive in functionality or price, or the failure of a supplier tocomply with any of our procurement needs could delay or interrupt our abilityto manufacture and deliver our products to customers on a timely basis, therebydelaying our revenue recognition and adversely affecting our business,financial condition, and results of operations.

 

We rely on third partymanufacturers for subassembly of products and for final assembly, qualityassurance, and testing of some of our products. These outsourcing arrangements and any future outsourcing arrangementsinvolve numerous risks, including the economic and financial viability of thesemanufacturers, reduced control over product quality, delivery schedules,manufacturing yields, and costs. Moreover, although arrangements with such manufacturers may containprovisions for warranty obligations on the part of such manufacturers, we areprimarily responsible to our customers for warranty obligations.

 

**Our products are subject to warranty claims andreturns.  Increased warranty claims orreturns could harm our business.**

 

We typically offer a 30-dayunconditional money-back guarantee on our appliance products sold in NorthAmerica.  We also offer warranties forparts and service on all our products, ranging from one to three years (and, inthe case of some of our Equinox branded products, five years).  Although our historical return experience hasnot been significant, our returns may increase in the future.  An increase in returns would have an adverseeffect on our sales and could negatively affect our financial results.  We may, as a result of competitive pressuresor customer demands, change our warranty policies in the future to provide coveragethat is greater in scope and duration than the coverage we currentlyoffer.  If we were to increase ourwarranty coverage, our risk of warranty claims, and therefore our warrantyexpense and reserves, would likely increase.

 

**We must meet the increased demands on customer serviceoperations or customer satisfaction and sales could suffer.**

 

Continued growth of oursales is likely to be accompanied by increasing demands on customer serviceoperations.  As a result of ourcommitment to a high level of customer service, we will need to invest significantresources in the maintenance and improvement of our customer serviceresources.  Any failure to maintainadequate customer service could cause customer dissatisfaction, result inreduced sales of products and, accordingly, materially adversely affect ourbusiness, financial condition, and

results of operations.

 

**Executive officers and other keypersonnel may depart, which could adversely affect our results of operationsand harm our ability to grow the business.**

 

We are greatly dependent onthe ability to retain key management, sales, and technical personnel, and ourfuture success is highly dependent upon the personal efforts of our management,sales, and technical personnel.  The lossof services of key personnel could have a material adverse effect on ourbusiness, financial condition, and results of operations.  We have historically used stock options as akey component in our executive and employee compensation programs in order toalign employees’ interests with the interests of our stockholders, encourageemployee retention, and provide competitive compensation packages.  Many of our employee stock options eitherhave exercise prices in excess of our stock price, which reduces the value ofthe stock options to employees, or are fully vested.  This could affect our ability to retainpresent employees.  In addition, theFinancial Accounting Standards Board and other agencies have finalized changesto U.S. generally accepted accounting principles that now require us to recorda charge to earnings for employee stock option grants and other equityincentives.  Moreover, applicable stockexchange listing standards relating to obtaining stockholder approval of equitycompensation plans could make it more difficult or expensive for us to grantoptions to employees in the future.  As aresult, we may incur increased compensation costs, change our equitycompensation strategy, or find it

 

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difficult to attract, retain, and motivateemployees, any of which could materially adversely affect our business.  Competition for employees with the skillsrequired, particularly engineering and other technical personnel, is intense,and there can be no assurance that we will be able to attract and retain highlyskilled employees in sufficient numbers to sustain our current business or tosupport future growth.  We may need tooffer additional compensation or incentives to attract and retain these andother employees.

 

**Difficulties encountered duringchanging economic conditions could adversely affect our results of operations.**

 

For the last several years,we have experienced rapid revenue and customer growth and expansion in thenumber of employees, product offerings, customers, operating locations, andsuppliers.  In addition, we have acquireda number of companies in the same time period. This growth and these acquisitions have placed significant strain on ourmanagerial, operational, and financial resources and resulted in new andincreased responsibilities for management personnel.  There can be no assurance that ourmanagement, personnel, systems, procedures, and controls are, or will be,adequate to support our existing and future operations or that we will continueto grow.

 

Our ability to effectivelymanage during changing economic conditions will require us to continue toimplement and improve our operational, financial, and information systems andinternal controls and will likely require additional management personnel.  In addition, we believe that we must continueto develop greater engineering, marketing, sales, and customer servicecapabilities in order to develop new products and technologies, secure newcustomers, and effectively serve the evolving needs of present and futurecustomers.  We may not be successful instrengthening these capabilities. Without adequate management, engineering, product development,marketing, sales, and customer service capabilities, our ability to effectivelymanage during changing economic conditions, expand and enhance our productlines, further penetrate existing markets, and develop new markets will besignificantly limited.  If we are unableto effectively manage during changing economic conditions, our business,financial condition, and results of operations could be materially adverselyaffected.

 

Because our business andoperating results depend to a significant extent on the general conditions inthe server market, any adverse change in the server market due to adverseeconomic conditions, declining capital spending levels, or other factors couldhave a material adverse effect on our business, financial condition, andresults of operations.  In addition, wecontinue to see industry-wide initiatives by OEMs and by distributors and resellersto reduce their inventories and to shorten their lead times, thereby reducingearly commitments to firm orders by our major OEM and our distributor andreseller customers.

 

**We have limited protection ofproprietary rights and face risks of third party infringements.**

 

Our future success dependsin part upon our ability to protect proprietary rights in our products.  We seek to protect our intellectual propertyrights by invoking the benefits of the patent, trademark, copyright, tradesecret, and unfair competition laws of the United States and othercountries.  These laws, however, affordonly limited protection.  There can be noassurance that the steps we have taken to protect our intellectual propertyrights, or that the steps we take in the future, will be adequate to preventmisappropriation of our intellectual property or technologies or that ourcompetitors will not independently develop proprietary or other technologiesthat are substantially equivalent or superior to our products or technologies.

 

The U.S. Patent andTrademark Office has issued several patents to us for various aspects of ourproducts.  We have various correspondingpatent applications pending under the provisions of the Patent CooperationTreaty, which permits the filing of corresponding foreign patent applicationsin numerous foreign countries within a limited time period.  We also have other United States and foreignpatent applications pending.  There canbe no assurance that any additional patents will be issued from any of thosepending applications or that any patents will be issued in any additionalcountries where our products can be sold. Claims allowed in our patents or in any pending patent applications maynot be of sufficient scope or strength for, or provide meaningful protection orany commercial advantage to us.  Also,competitors may develop their own intellectual property or technologies, obtaintheir own patents, or challenge the validity of, or be able to design around,our patents.  The laws of certain foreigncountries in which our products are or may be developed, manufactured, or sold(particularly certain countries in Asia) may not protect our products orintellectual property rights to the same extent as do the laws of the UnitedStates and thus increase the likelihood of piracy of our technologies andproducts.

 

 In 2005, we settled our patent infringementsuit against Raritan Computer Inc.  Wereceived an initial payment of $5 million, and we will receive royalty paymentsfor five years based on a fixed percentage of the sales of certain Raritanproducts subject to a minimum quarterly payment of $750,000.

 

InOctober 2003, we filed a complaint for patent infringement in the United StatesDistrict Court for the Northern District of Alabama against ClearCubeTechnology, Inc.  The ClearCube complaintseeks injunctive relief, damages, attorneys’ fees, and costs under threeAvocent patents.  ClearCube has filedcounterclaims alleging non-infringement, unenforceability, invalidity, andmisuse of the Avocent patents.  A Markmanhearing on claims construction was held in February 2006.

 

We may initiate claims orlitigation against other third parties for infringement of proprietary rightsor to establish the validity of proprietary rights.  Similarly, our competitors may initiateclaims or litigation against us alleging infringement of their

 

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proprietary rights or improper use of theirintellectual property.  Existinglitigation, and any other litigation relating to intellectual property to whichwe become a party, is subject to numerous risks and uncertainties, includingthe risk of counterclaims or other litigation against us, and we may not besuccessful in any such litigation. Litigation is expensive, and the existing litigation or any other litigationby or against us could result in significant additional expense and divert theefforts of technical and management personnel, whether or not such litigationresults in a favorable determination.  Inthe event of an adverse result in any such litigation, we could be required topay substantial damages, suspend or cease the manufacture, use, and sale of anyinfringing products, expend significant resources to redesign products ordevelop non-infringing technology, discontinue the use of certain processes, orobtain licenses to the infringing technology. There can be no assurance that we would be successful in suchdevelopment or that such licenses would be available on reasonable terms, or atall, and any such development or license could require us to expend substantialtime and other resources.  In the eventthat any third party makes a successful claim against us, or our customers, anda license is not made available on commercially reasonable terms, our business,financial condition, and results of operations could be adversely affected.

 

The network server,electronics, and related industries are characterized by vigorous pursuit andprotection of intellectual property rights or positions, which has resulted insignificant and often protracted and expensive litigation.  We have in the past been, and we may fromtime to time in the future be, a party in proceedings alleging infringement ofintellectual property rights owned by third parties.  If necessary or desirable, we may seeklicenses under such intellectual property rights.  However, licenses may not be offered on termsacceptable to us, or at all.  The failureto obtain a license from a third party for technology used by us could cause usto incur substantial liabilities and to suspend or cease the manufacture ofproducts requiring such technology. Additionally, current or future competitors could obtain patents thatmay prevent us from developing or selling our products.

 

**We have acquired, and expect tocontinue to acquire, technologies and companies that could disrupt our businessor expose us to other risks.**

 

A key component of ourengineering and product development strategy is the acquisition of technologiesand companies.  We recently announcedthat we have signed a definitive agreement to acquire Cyclades Corporation, andthat transaction is expected to close in the first quarter of 2006.  We acquired Equinox Systems Inc. in2001, 2C Computing, Inc. in 2002, Soronti, Inc. in 2003, and Crystal LinkTechnologies, OSA Technologies, Inc., and Sonic Mobility, Inc. in 2004.  We intend to continue to execute our strategythrough the acquisition of technologies or companies or through investments incomplementary companies, products, or technologies, and it is likely we willcomplete such acquisitions or investments in the future.  These acquisitions and investments involvemany risks, including the following:

 

•              Difficulty integrating theacquired company’s personnel, products, technologies, and operations;

 

•              Diversion of management’sattention;

 

•              Difficulty in combining productand technology offerings and entering into new markets or geographical areas inwhich we have no or limited direct experience and where our competitors mayhave stronger market positions;

 

•              Loss of key personnel;

 

•              Delays or difficulties incoordinating and combining administrative, manufacturing, research anddevelopment and other operations, facilities, and relationships with thirdparties in accordance with local laws and other obligations while maintainingadequate standards, controls and procedures;

 

•              Difficulty in completing projectsassociated with acquired in-process research and development;

 

•              Incurring amortization expenserelated to certain intangible assets and recording goodwill and non-amortizableassets that will be subject to impairment testing and possible impairmentcharges;

 

•              Dilution of existing stockholdersas a result of issuing equity securities, including the assumption of any stockoptions issued by the acquired company;

 

•              Overpayment for any acquisition orinvestment;

 

•              Assumption of liabilities of theacquired company, including any potential intellectual property infringementclaims; and

 

•              Incurring substantial write-offs,restructuring charges, and transactional expenses.

 

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**Our failure to manage these risksand challenges could materially harm our business, financial condition, andresults of operations.  Further, if we donot successfully address these challenges in a timely manner, we may not fullyrealize all of the anticipated benefits or synergies on which the value of atransaction was based.  Futuretransactions could cause our financial results to differ from expectations ofmarket analysts or investors for any given quarter.**

 

**Ourreorganization into five separate business divisions or units could disrupt ourbusiness or affect our profitability.**

 

                Our reorganization into five newbusiness divisions became effective in the first quarter of 2006.  The creation of these five business units wasdesigned to streamline our operations and put vital decisions closer to ourcustomers, but the allocation of our previously existing business among thefive divisions could confuse and distract our customers, suppliers, andemployees.  In addition, thereorganization could adversely affect or delay our development and introductionof new products and technologies, result in the loss of management, technical,or other key personnel, disrupt our supplier or customer relationships,jeopardize our supplier or sales channels and our branding and marketingefforts, and increase our administrative expense, all of which could affect ourprofitability.

 

**Unanticipatedchanges in our tax rates or exposure to additional income tax liabilities couldaffect our profitability.**

 

We are subject to incometaxes in both the United States and various foreign jurisdictions, and ourdomestic and international tax liabilities are subject to the allocation ofexpenses in different jurisdictions.  Oureffective tax rates could be adversely affected by changes in the mix ofearnings in countries with differing statutory tax rates, in the valuation ofdeferred tax assets and liabilities, in tax laws, or by material auditassessments, which could affect our profitability.  In addition, the amount of income taxes wepay is subject to audit in various jurisdictions, and a material assessment bya governing tax authority could affect our profitability.

 

**Fluctuations in the value offoreign currencies could result in currency exchange losses.**

 

Currently, a majority of ourinternational business is conducted in U.S. dollars.  However, as we expand our internationaloperations, it is likely that international business will increasingly beconducted in foreign currencies.  Inparticular, the introduction of the euro has led many of our European customersto request or insist that our sales to them be denominated in euros instead ofU.S. dollars.  Fluctuations in the valueof foreign currencies relative to the U.S. dollar have caused, and are expectedto increasingly cause, currency translation gains and losses.  While we attempt to hedge our foreigncurrency exposure, we cannot predict the effect of exchange rate fluctuationsupon future quarterly and annual operating results, and we may experiencecurrency losses in the future.

 

**Unforeseenenvironmental costs could negatively affect our future earnings.**

 

Some of our operations usesubstances regulated under various federal, state, and international lawsgoverning the environment, including those governing the discharge ofpollutants into the air and water, the management and disposal of hazardoussubstances and wastes, and the cleanup of contaminated sites.  Many of our products are subject to variousfederal, state, and international laws governing chemical substances inproducts, including those regulating the manufacture and distribution ofchemical substances and those restricting the presence of certain substances inelectronics products.  We could incursubstantial costs, including cleanup costs, fines, civil or criminal sanctions,third-party property damage, or personal injury claims if we were to violate orbecome liable under environmental laws or if our products become non-compliantwith environmental laws.  We also faceincreasing complexity in our product design and procurement operations as weadjust to new and future requirements relating to the materials composition ofour products, including the restrictions on lead and certain other substancesthat will apply to specified electronics products put on the market in theEuropean Union as of July 1, 2006 (Restriction of Hazardous SubstancesDirective) and similar legislation currently proposed in China and othercountries.  The ultimate costs underenvironmental laws and the timing of these costs are difficult to predict, andliability under some environmental laws relating to contaminated sites can beimposed retroactively and on a joint and several basis.

 

We could also facesignificant costs and liabilities in connection with product take-backlegislation.  The European Union hasfinalized the Waste Electrical and Electronic Equipment Directive, which makesproducers of electrical goods, including computers and peripherals, financiallyresponsible for specified collection, recycling, treatment, and disposal ofpast and future covered products.  Thisdeadline to enact and implement the directive by individual European Uniongovernments generally was August 13, 2004, although extensions were grantedto some countries (such legislation, together with the directive, the “WEEELegislation”), and producers are financially responsible under the WEEELegislation beginning in August 2005. Similar legislation has been or may be enacted in other geographies,including in the United States and Japan, the cumulative impact of which couldbe significant for us.  We will incursome costs under the WEEE legislation but the amount and timing of these costsare difficult to predict.

 

**Provisions in our charterdocuments and in Delaware law may discourage potential acquisition bids for usand may prevent changes in management that stockholders may favor.**

 

Provisions in our charterdocuments could discourage potential acquisition proposals and could delay orprevent a change in control transaction that stockholders may favor.  These provisions could have the effect ofdiscouraging others from making tender

 

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offers for shares, and as a result, theseprovisions may prevent the market price of our common stock from reflecting theeffects of actual or rumored takeover attempts and may prevent stockholdersfrom reselling their shares at or above the price at which they purchased theirshares.  These provisions may also preventchanges in management that stockholders may favor.  Our charter documents do not permitstockholders to act by written consent, limit the ability of stockholders tocall a stockholders meeting, and provide for a classified board of directors,which means stockholders can only elect, or remove, a limited number ofdirectors in any given year. Furthermore, the board of directors has the authority to issue up tofive million shares of preferred stock in one or more series.  The board of directors can fix the price,rights, preferences, privileges, and restrictions of such preferred stockwithout any further vote or action by our stockholders.  The issuance of shares of preferred stock maydelay or prevent a change in control transaction without further action by ourstockholders.

 

In addition, Delaware lawmay inhibit potential acquisition bids for us. Delaware law prevents certain Delaware corporations, including Avocent,from engaging, under certain circumstances, in a business combination with anyinterested stockholder for three years following the date that such stockholderbecame an interested stockholder.

 

**Item 1B. Unresolved Staff Comments.**

 

None

 

**Item 2.  Properties.**

 

Our world-wide headquarters,occupying approximately 181,000 square feet and containing administrative,sales, marketing, research and development, engineering, manufacturing, anddistribution facilities, are located in Huntsville, Alabama, on an 18-acretract of land owned by us in Cummings Research Park.

 

Our Redmond, Washingtonfacility, which consists of approximately 82,000 square feet in an industrialoffice building, contains administrative, sales, marketing, research anddevelopment, engineering, manufacturing, and distribution operations.  In 2002, we renegotiated the lease for thisspace for occupancy through March 2009, and the current base rent under theamended lease is approximately $816,000 per year, plus taxes, insurance, andmaintenance of approximately $267,000 per year.

 

Our internationaladministrative, sales, marketing, research and development, engineering,manufacturing, and distribution operations are located in a 129,000 square footbuilding owned by us in the free trade zone in Shannon, Ireland.

 

We also own a 45,000 squarefoot building on 6.5 acres of land in Sunrise, Florida.  Our Sunrise facility contains sales,marketing, research and development, and engineering personnel.

 

In addition, we lease officespace in San, Jose California (administrative, sales, marketing, research anddevelopment, and engineering operations for our Embedded Solutions and SoftwareDivision), Austin, Texas (sales and marketing personnel to support our OEMoperations), Calgary, Canada (administrative, sales, marketing, and engineeringoperations for our Mobile Technologies Division), Taipei, Taiwan(administrative, sales, marketing, and engineering personnel), and Shanghai,China (engineering personnel).

 

We also lease sales officesin various United States and international locations, none of which is materialto our operations.

 

We believe that thesefacilities are sufficient to support our current operations.

 

**Item 3.  LegalProceedings.**

** **

 In 2005 we settled our patent infringementsuit against Raritan Computer Inc.  Wereceived an initial payment of $5 million, and we will receive royalty paymentsfor five years from the date of settlement based on a fixed percentage of thesales of certain Raritan products subject to a minimum quarterly payment of$750,000.

 

InOctober 2003, we filed a complaint for patent infringement in the United StatesDistrict Court for the Northern District of Alabama against ClearCubeTechnology, Inc.  The ClearCube complaintseeks injunctive relief, damages, attorneys’ fees, and costs under threeAvocent patents.  ClearCube has filedcounterclaims alleging non-infringement, unenforceability, invalidity, andmisuse of the Avocent patents.  A Markman hearing on claims construction washeld in February 2006.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

None.

 

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**PART II**

 

**Item 5.  Market For Registrant’s Common Equity andRelated Stockholder Matters and Issuer Purchases of Equity Securities.**

 

**Price Range of Common Stock;Holders of Record**

 

Our common stock is quotedon The Nasdaq National Market System under the symbol “AVCT.” The followingtable shows the high and low sales prices of our common stock for eachquarterly period within the last two fiscal years as reported by the NasdaqNational Market System.

 
| ** **                        | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------|------------|----------|------------|---------|------------|
| Quarter ended December 31,  2005  |       | $        | 33.88      |    | $          | 26.84 |   |
| Quarter ended September  30, 2005 |       | $        | 35.38      |    | $          | 26.48 |   |
| Quarter ended July 1, 2005        |       | $        | 29.09      |    | $          | 23.05 |   |
| Quarter ended April 1,  2005      |       | $        | 40.70      |    | $          | 22.99 |   |
| Quarter ended December 31,  2004  |       | $        | 40.69      |    | $          | 26.53 |   |
| Quarter ended October 1,  2004    |       | $        | 35.69      |    | $          | 25.59 |   |
| Quarter ended July 2, 2004        |       | $        | 38.24      |    | $          | 30.86 |   |
| Quarter ended April 2,  2004      |       | $        | 42.20      |    | $          | 35.64 |   |

 

As of February 28, 2006,there were 342 holders of record of our common stock.

 

**Dividend Policy**

 

We have not declared or paidany cash dividends in the past and, for the foreseeable future, we expect toretain earnings to finance the expansion and development of our business.  The payment of dividends is within thediscretion of our Board of Directors and will depend on our earnings, capitalrequirements and operating and financial condition, among other factors.

 

**Equity Compensation PlanInformation**

 

Please see Item 12 of thisAnnual Report on form 10-K for disclosures relating to our equity compensationplans.  Such information is incorporatedby reference from our 2006 proxy statement.

 

 

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**RecentPurchases of Treasury Stock**

 

In the fourth quarter of2004 our Board of Directors approved a stock repurchase program whereby we may,from time to time, purchase up to 2 million shares of our common stock in theopen market, in privately negotiated transactions or otherwise, at prices thatwe deem appropriate.  On April 29, 2005,our Board added 2 million shares to this program and now a total of 4 millionshares is authorized to be repurchased. The plan has no expiration date. Details of these purchases under the plan are as follows:

 

 
| **Period:**                                 | ** ** | **Total Number of  Shares Purchased During the Period** | ** ** | **Average Price Paid  Per Share for Period Presented** | ** ** | **Total Cumulative Number of  Shares Purchased as  Part of Publicly  Announced Plan** | ** ** | **Maximum Number of  Shares Remaining to  Purchase Under the  Plan (1)** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
|                                        |       |                                                    |       |                                                   |       |                                                                                  |       |                                                                     |       |
| January 1, 2005 — January  31, 2005    |       | 195,600                                                 |       | $                                                      | 36.04      |                                                                                  | 295,600    |                                                                     | 1,704,400  |   |
| February 1, 2005 —  February 28, 2005  |       | 154,400                                                 |       | $                                                      | 35.41      |                                                                                  | 450,000    |                                                                     | 1,550,000  |   |
| March 1, 2005 — April 1,  2005         |       | 350,000                                                 |       | $                                                      | 26.70      |                                                                                  | 800,000    |                                                                     | 1,200,000  |   |
| Quarter ended April 1,  2005                |       | 700,000                                                 |       | $                                                      | 31.23      |                                                                                  |       |                                                                     |       |   |
|                                        |       |                                                    |       |                                                   |       |                                                                                  |       |                                                                     |       |
| April 2, 2005 — April 29,  2005        |       | 275,000                                                 |       | $                                                      | 24.92      |                                                                                  | 1,075,000  |                                                                     | 2,925,000  |   |
| April 30, 2005 — May 27,  2005         |       | 294,969                                                 |       | $                                                      | 26.07      |                                                                                  | 1,369,969  |                                                                     | 2,630,031  |   |
| May 28, 2005 — July 1,  2005           |       | 505,031                                                 |       | $                                                      | 27.46      |                                                                                  | 1,875,000  |                                                                     | 2,125,000  |   |
| Quarter ended July 1, 2005                  |       | 1,075,000                                               |       | $                                                      | 26.43      |                                                                                  |       |                                                                     |       |   |
|                                        |       |                                                    |       |                                                   |       |                                                                                  |       |                                                                     |       |
| July 2, 2005 — July 29,  2005          |       | 200,000                                                 |       | $                                                      | 29.62      |                                                                                  | 2,075,000  |                                                                     | 1,925,000  |   |
| July 30, 2005 — August 26,  2005       |       | 125,000                                                 |       | $                                                      | 33.28      |                                                                                  | 2,200,000  |                                                                     | 1,800,000  |   |
| August 27, 2005 —  September 30, 2005  |       | 175,000                                                 |       | $                                                      | 32.77      |                                                                                  | 2,375,000  |                                                                     | 1,625,000  |   |
| Quarter ended September  30, 2005           |       | 500,000                                                 |       | $                                                      | 31.64      |                                                                                  |       |                                                                     |       |   |
|                                        |       |                                                    |       |                                                   |       |                                                                                  |       |                                                                     |       |
| October 1, 2005 — October  28, 2005    |       | 150,000                                                 |       | $                                                      | 30.19      |                                                                                  | 2,525,000  |                                                                     | 1,475,000  |   |
| October 29, 2005 —  November 25, 2005  |       | —                                                  |       | $                                                      | —     |                                                                                  | 2,525,000  |                                                                     | 1,475,000  |   |
| November 26, 2005 —  December 31, 2005 |       | 250,000                                                 |       | $                                                      | 28.14      |                                                                                  | 2,775,000  |                                                                     | 1,225,000  |   |
| Quarter ended December 31,  2005            |       | 400,000                                                 |       | $                                                      | 28.91      |                                                                                  |       |                                                                     |       |   |
|                                        |       |                                                    |       |                                                   |       |                                                                                  |       |                                                                     |       |
| Totals for 2005                             |       | 2,675,000                                               |       | $                                                      | 29.03      |                                                                                  |       |                                                                     |       |   |

 

**Item 6.  Selected Financial Data.**

(Amounts in thousands, except per share dataand amounts in note (1) below.)

 
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                            |       | $        | 369,888    |     | $          | 365,255  |       | $        | 304,238    |     | $          | 260,600 |   | $ | 255,911 |   |
| Net income (loss) (1)                |       | $        | 48,349     |     | $          | 18,040   |       | $        | 38,547     |     | $          | 10,738 |   | $ | (320,466 | ) |
| Basic net income (loss)per  share    |       | $        | 0.98       |     | $          | 0.37     |       | $        | 0.83       |     | $          | 0.24 |   | $ | (7.22 | ) |
| Diluted net income (loss)  per share |       | $        | 0.96       |     | $          | 0.36     |       | $        | 0.81       |     | $          | 0.24 |   | $ | (7.22 | ) |
| Total assets                         |       | $        | 773,751    |     | $          | 770,781  |       | $        | 660,763    |     | $          | 568,607 |   | $ | 547,198 |   |
|                                      |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |  |

 

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(1)For the periods presented, we recognized charges for acquired in-processresearch and development expenses for the following acquisitions: $4.6 millionfor Equinox Systems Inc. in 2001, $6.0 million for 2C Computing, Inc. in 2002,$3.9 million for Soronti, Inc. in 2003, and $6.5 million for Crystal LinkTechnologies, $21.7 million for OSA Technologies, Inc. and $1.1 million forSonic Mobility Inc. in 2004, (*see note 3 to thefinancial statements*). Additionally, we recorded an impairment charge of $195.4 million in 2001as a reduction in the remaining carrying value of goodwill arising from themerger of Apex and Cybex.  Effective January 1, 2002, we adopted SFASNo. 142 and ceased amortizing goodwill created from mergers andacquisitions.  However, prior to theadoption of SFAS 142, we recorded $111.0 million of goodwill amortizationduring 2001.

 

 

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**Item 7.    Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

 

THE INFORMATION IN THIS ITEM7—”MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS” CONTAINS FORWARD-LOOKING STATEMENTS, INCLUDING, WITHOUT LIMITATION,STATEMENTS RELATING TO OUR REVENUES, EXPENSES, MARGINS, LIQUIDITY, CAPITALNEEDS, INVESTMENTS, SEGMENT REPORTING, STOCK BASED COMPENSATION, ACQUISITONACCOUNTING, ACQUISITION AND TRANSACTION COSTS AND ADJUSTMENTS INCLUDING, AMONGOTHER THINGS, WRITE OFF OF IN-PROCESS RESEARCH AND DEVELOPMENT COSTS ANDAMORTIZATION OF INTANGIBLE ASSETS.  THESEFORWARD-LOOKING STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES THATCOULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THEFORWARD-LOOKING STATEMENTS.  FACTORS THATMIGHT CAUSE SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSEDUNDER THE CAPTION “FACTORS THAT MAY AFFECT FUTURE RESULTS.”

 

**Overview**

 

Avocentdesigns, manufactures, licenses and sells products and technologies thatprovide connectivity and centralized management of IT infrastructure.  We provide connectivity and managementproducts and technologies that centralize control of servers, desktopcomputers, serial devices, wireless devices, mobile devices, and networkappliances, increasing the efficiency of IT personnel.  Server manufacturers rely on Avocent KVMswitches and embedded technology in their systems and companies large and smalldepend on our products and technologies for managing their growing ITinfrastructure.

 

Our innovations includeIP-based switching, centralized management, and intuitive softwareinterfaces.  Our products andtechnologies manage servers, desktop computers, serial devices, wirelessdevices, mobile devices, and embedded infrastructure.  With more than two decades of experience, wehave grown through product innovations, global expansion, and strategicacquisitions.  Formed as a result of themerger in 2000 between Apex Inc. and Cybex Computer Products Corporation, wesubsequently acquired Equinox Systems Inc. in 2001, 2C Computing, Inc. in 2002,Soronti, Inc. in 2003, and Crystal Link Technologies, OSA Technologies, Inc.,and Sonic Mobility, Inc. in 2004.  InJanuary 2006, we announced the signing of a definitive agreement to acquireCyclades Corporation, and this acquisition is expected to close in March 2006.

 

Most of our revenue isderived from sales to a limited number of OEMs (who purchase our switchingsystems on a private-label or branded basis for integration and sale with theirown products), sales through our reseller and distributor network, and sales toa limited number of direct customers. Sales to our OEM customers accounted for 48% of sales in 2005, 45% ofsales in 2004 and 46% in 2003.  Sales toour branded customers accounted for 52% of sales in 2005, 55% of sales in 2004and 54% of sales in 2003.  We do not havecontracts with many of our branded customers, and in general, our OEM andbranded business customers are obligated to purchase products from us onlypursuant to binding purchase orders.  Theloss of, or material decline in orders from, these customers would have a materialadverse effect on our business, financial condition, results of operations, andcash flows.  Our top five customersinclude both OEM and branded customers and accounted for 64% of sales in 2005,2004 and 2003.

 

We sell products to dealers,end-users, and OEMs in the United States, Canada, Europe, and Asia as well asin other foreign markets.  Sales withinthe United States accounted for approximately 57% of 2005 sales, 59% of 2004sales and 60% of 2003 sales.  Salesoutside of the United States accounted for 43% of 2005 sales, 41% of 2004 salesand 40% of 2003 sales.  Sales tocustomers in the Netherlands, including the European distribution facility forone of our OEM customers, accounted for 10% of sales in 2004.  Sales to customers in the United Kingdom,including the European distribution facility for one of our OEM customers,accounted for 10% of 2003 sales.  Noother country accounted for more than 10% of 2005, 2004, or 2003 sales.

 

With continued industry-wideinitiatives to reduce all channel inventories and to shorten lead times, trendswith our major customers are, generally, to reduce the number of weeks offorward-committed firm orders.  Thistrend continues to affect our business with certain distributors, OEMs andother server manufacturers, and we believe that it will continue to make ourfuture sales more difficult to predict and inventory levels more difficult tomanage.

 

Wecontinue to experience significant price competition in the market for all ofour products, and we expect that pricing pressures will continue in the future.  In addition, general economic conditions arenot predictable and we expect our revenue growth rate to fluctuate in relationto economic conditions and IT related spending trends.

 

Manyof our executive officers and directors are vested in significant amounts ofoptions to purchase shares of our common stock and continue to vest inadditional shares on a regular basis. These officers and directors have informed us that they have sold, andmay sell additional, shares of our common stock to provide liquidity anddiversify their portfolios. Additionally, many of the stock options previously granted to employeesare now fully vested.  Our board ofdirectors is considering changes to our stock-based compensation programs andis expected to implement significant changes in 2006, including a movement awayfrom traditional stock options towards restricted stock and performance basedawards.

 

In the first quarter of 2006, we organized our business into fivedivisions within Avocent:

 

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•                  Management Systems Division,which includes our branded and OEM KVM, serial console, power control, andmanagement appliance businesses;

•                  Embedded Software &Solutions Division, focused on developing and marketing embedded systems andsoftware including IPMI and embedded KVM technologies primarily for our OEMcustomers;

•                  Retail Point-of-Sale andAudio/Visual Solutions Division, focused on expanding the markets for ourserial and wireless products;

•                  Desktop Solutions Division,which includes our existing digital extension products with emphasis ondevelopment of major new products and markets in this area; and

•                  Mobile TechnologiesDivision, which includes mobile device management and secure wireless systems administration.

 

**Althoughwe have now substantially completed reconfiguring our systems and defining newcost centers and operating measures to track the performance of the divisionsand to use as a basis for managing and allocating resources, we did not manageour business under these divisions during 2005. We will evaluate our new divisions based on the requirements in SFAS No.131, and we expect to provide applicable segment data on the new divisions inour 2006 financial reports.  On a recastbasis, the Management Systems Division comprised 89% and the Embedded Softwareand Solutions Division comprised 6% of our consolidated net revenues in2005.  The other three divisions andunallocated revenues comprised the remaining 5% of our consolidated netrevenues in 2005.**

** **

**Webelieve our new business divisions will allow us to focus on new technology andgrowth opportunities to add product and shareholder value in the future.  We expect our new corporate structure willenhance customer service, speed delivery of products to market and better focusAvocent’s research, development and marketing expenditures.**

 

**Results of Operations**

 

Our consolidated statementsof operations, stockholders’ equity, and cash flows reflect the results ofacquired companies from the respective dates of acquisition.  The following table sets forth, for theperiods indicated, selected statement of operations data expressed as apercentage of net sales:

 
| ** **                                            | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|
| ** **                                            | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                             |       | 100.0                        | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                         |       | 40.8                         |       | 41.7 |   | 43.5 |   |
| Gross profit                                          |       | 59.2                         |       | 58.3 |   | 56.5 |   |
| Operating expenses:                                   |       |                         |       |   |   |   |   |
| Research and development  expenses                    |       | 15.4                         |       | 12.4 |   | 9.8 |   |
| Acquired in-process  research and development expense |       | —                       |       | 8.0 |   | 1.3 |   |
| Selling, general and  administrative expenses         |       | 24.4                         |       | 23.2 |   | 23.1 |   |
| Amortization of intangible  assets                    |       | 5.0                          |       | 6.7 |   | 7.2 |   |
| Total operating expenses                              |       | 44.8                         |       | 50.3 |   | 41.4 |   |
| Income from operations                                |       | 14.4                         |       | 8.0 |   | 15.1 |   |
| Income from settlement of  lawsuit                    |       | 1.4                          |       | — |   | — |   |
| Net investment income                                 |       | 2.5                          |       | 1.4 |   | 1.6 |   |
| Net realized investment  gains (losses)               |       | (0.1                         | )          | (1.1 | ) | 0.9 |   |
| Other income (expense),  net                          |       | (0.1                         | )          | — |   | (0.1 | ) |
| Income before provision for income taxes              |       | 18.1                         |       | 8.3 |   | 17.5 |   |
| Provision for income taxes                            |       | 5.0                          |       | 3.4 |   | 4.8 |   |
| Net income                                            |       | 13.1                         | %          | 4.9 | % | 12.7 | % |

 

*YearsEnded December 31, 2005 and 2004*

 

*Net sales.*  Our net sales consist of sales of keyboard,video, and mouse console switching systems, digital connectivity products andtechnologies, serial connectivity devices, wireless extension products, IPMI,extension, and remote access and management products and technologies, androyalties from licensing our intellectual property.  In 2005, net sales increased to $369.9million from $365.3 million in 2004. Despite this year-over-year increase, we experienced a revenue shortfallin the first quarter of 2005, which was primarily due to problems related tothe launch of a significant upgrade to the software component of our digitalswitching systems and lower than expected sales to one of our OEM customers.  The effects of the problems surrounding theproduct launch continued into the second quarter of 2005.  The increased demand in subsequent quartersis attributed to our OEM customers across all geographic regions and our internationalbranded customers.  OEM sales increased9% in 2005 over 2004.  Branded sales,however, declined approximately 5% in 2005 from 2004, primarily as a result ofthe software upgrade launch issues mentioned previously, which reduced oursales in the first and second quarter of 2005. Branded sales accounted for 52% of sales in 2005 and 

 

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55% of sales in 2004.  OEM sales were 48% of sales in 2005 and 45%of sales in 2004.  The continued growthof our digital product line contributed to our sales growth for 2005, as thedigital product line contributed over 50% of revenue for all of 2005.  Contributions from IPMI and embedded KVMroyalty revenues also increased our net sales. Sales of our digital products and technologies accounted for $196.7million or 53% of sales in 2005 compared with $175.0 million or 48% of sales in2004.  Our IPMI and embedded KVM royaltyrevenues totaled $22.0 million in 2005, compared to $6.8 million in 2004, thefirst year we recognized revenues from these technologies.

 

International salesaccounted for 43% of sales in 2005 and 41% of sales in 2004, while sales withinthe United States were 57% of sales in 2005 and 59% of sales in 2004.  International sales increased 7% from $148.6 millionin 2004 to $159.0 million in 2005.  Salesin the U.S. decreased 3% from $216.7 million in 2004, to $210.8 million in2005.  This decrease in sales in the U.S.was due to the branded software launch problem in the U.S. in the first quarterof 2005 as described above.  Weexperienced a rebound in branded U.S. sales that began during the secondquarter of 2005 and carried over into the remainder of the year, but therebound was not strong enough to entirely offset the decline in sales weexperienced early in 2005.  The strengthin our international sales was most evident in the European and Asia Pacificregions, where both branded and OEM sales were strong.  We believe the overall strength in theseregions is the result of our continued investments in international sales andmarketing programs over recent years.

 

We believe our current andexpanding product platforms will provide for continued growth of ourbusiness.  We expect the design winsannounced in our IPMI and embedded KVM business to contribute to revenue growthin 2006.  However, we traditionallyexperience a sequential decline in revenues from the fourth quarter to thefirst quarter of the following year, and we expect the trend to continue fromthe fourth quarter of 2005 to the first quarter of 2006.  Generally, the tone of business is good andcertain industry analysts are predicting growth in IT spending and servershipments for 2006.  Based on ourtraditional sequential trend, we expect our revenues for the first quarter of2006 to be between $96.0 million and $102.0 million.

 

*Gross profit.*  Gross profit is affected by a variety offactors, including the ratio of sales among our distribution channels, as OEMsales have lower gross margins than our branded sales; absorption of fixedcosts as sales levels fluctuate; product mix, raw materials, and labor costs;new product introductions by us and by our competitors; and the level of ouroutsourcing of manufacturing and assembly services.  Gross margins continued to improve, growingto 59.2% in 2005 from 58.3% in 2004. Gross margin in 2005 benefited from higher sales of our digital productsand technologies, which typically have a higher margin than our analogproducts, and accounted for over 53% of sales in 2005 compared to 48% of salesin 2004.  Gross margins also benefitedfrom our IPMI and KVM embedded royalty revenues, which have higher than ouraverage gross margins.  Gross margin wasalso positively affected by $3.3 million of Raritan royalty revenue recordedduring 2005.  These positive influenceson gross margin were partially offset by additional product costs fromimplementing new environmental regulations, costs related to transitioning to anew contract manufacturer during 2005 and the lower gross margin experienced inthe first quarter of 2005, as a result of the revenue shortfall in thatquarter.

 

We expect that thecontributions from our digital products and higher revenues from our IPMI andembedded KVM products and technologies will continue to offset price declinesand the additional costs we expect from our environmental regulation complianceefforts.  We expect gross margins to bein the 59% to 60% range in the first quarter of 2006.

 

*Research and development expenses.*  Research and development expenses includecompensation for engineers, support personnel, outside contracted services andmaterials costs, and are expensed as they are incurred.  Research and development expenses were $56.9million, or 15.4% of net sales, in 2005, compared to $45.4 million, or12.4% of net sales, in 2004.  Theincreased research and development expense resulted from an increase in thenumber of engineers, and an increase in materials, certification, and testingof products in development.  The increasein headcount was the result of the addition of engineers from the acquisitionswe completed in 2004 and the hiring of software engineers to support thesoftware development efforts for our Embedded Software and Solutionsgroup.  In addition, research anddevelopment expenses include over $800,000 of severance accruals recordedduring the second quarter of 2005 related to the closing of three satelliteresearch and development sites.  Wecontinue to believe that the timely development of innovative products andenhancements to existing products is essential to maintaining our competitive position.  As a result of cost containment plans and theclosing of the satellite offices mentioned, we expect research and developmentexpenses to remain flat in dollars from the fourth quarter of 2005 and be inthe $13.0 to $14.0 million range in the first quarter of 2006.

 

*Acquired in-processresearch and development expense.*  Acquisition related expenses in 2004 werecomprised solely of the write-off of in-process research and developmentexpenses related to our acquisitions, including $6.5 million for Crystal Link,$21.7 million for OSA and $1.1 million for Sonic Mobility.  There were no acquired in-process researchand development expenses during 2005.

 

*Selling, general andadministrative expenses.* Selling, general and administrative expenses include personnel costs foradministration, finance, information systems, human resources, sales andmarketing and general management, certain merger and acquisition relatedexpenses, rent, utilities, legal and accounting expenses, bad debts,advertising, promotional material, trade show expenses and related travelcosts.  Selling, general andadministrative expenses were $90.4 million, or 24.4% of net sales, in 2005compared to $84.8 million, or 23.2% of net sales, in 2004.  The increase in selling, general and administrativeexpenses is primarily related to increased headcount as a result of theacquisitions we completed during 2004. Other factors contributing to higher selling, 

 

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general and administrative expenses werehigher legal fees associated with protecting our intellectual property rightsincluding the Raritan case that settled in the second quarter of 2005 andincreased activity in the ClearCube case in late 2005.  We also recorded $500,000 in severanceaccruals during the second quarter of 2005 related to certain headcountreductions and experienced increased costs related to the localization oftechnical manuals and publications for certain products shippedinternationally.  In 2006, we expect toinvest more in marketing expenses as we promote our newer products.  We will also incur higher fees for thecontinued protection of our intellectual property rights in 2006.  However, we expect selling, general andadministrative expenses in the first quarter of 2006to be flat in dollars ascompared to the fourth quarter of 2005 and be in the range of $23.0 to $24.0million.

 

*Amortization of intangibleassets.*  Amortization of $18.5 millionin 2005 and $24.2 million in 2004 includes the amortization of the identifiableintangible assets created as a result of the merger transaction between Apexand Cybex and the acquisitions of Equinox, 2C, Soronti, Crystal Link, OSA, andSonic Mobility.  The decrease inamortization expense during 2005 relates primarily to recording no amortizationexpense for developed technology or patents and trademarks recorded inconnection with the merger of Apex and Cybex, as these assets had an estimatedlife of five years and were fully amortized at the end of the second quarter of2005.  Amortization expense is expectedto remain flat in terms of dollars in the first quarter of 2006 compared to thefourth quarter of 2005.

 

*Income from settlement oflawsuit**.** *The $5 million of incomefrom the settlement of a lawsuit in 2005 is comprised entirely of the paymentreceived in the second quarter of 2005 as a result of the settled patentinfringement lawsuit brought by Avocent against Raritan Computer Inc.  The terms of the settlement provided for a initialpayment of $5 million related to past product sales by Raritan.

 

*Net investmentincome. *Net******investmentincome increased from $5.1 million in 2004 to $9.2 million in 2005.  Theimproved results were due to higher interest rates on investments and higheramounts invested from cash generated from operations.

 

*Net realized investmentgains (losses). *Net realizedinvestment gains (losses) improved from a loss of  $3.8 million in 2004 to a loss of $83,000 in2005.  The primary reason for the largechange was the result of recording other-than-temporary declines in ourinvestments in VIEO and Rymic, two privately held entities, of $3.5 million in2004.** **Ourinvestments in VIEO and Rymic now have a carrying value of nil.

 

*Other income (expense),net.*  Net other income (expense)declined from income of $23,000 in 2004 to expense of $174,000, primarily as aresult of fluctuating foreign currency exchange rates.

 

*Provision for incometaxes.*  The provision for income taxeswas $18.7 million in 2005 compared to $12.5 million in 2004.  The effective tax rate decrease is primarilyattributable to the impact of $21.7 million of acquired in-process research anddevelopment expense recorded in second quarter of 2004 related to theacquisition of OSA, which was not deductible for tax purposes.  These amounts were also affected by the taximpact of a higher mix of pre-tax income contributed by our Shannon, Ireland,operations in 2005 which is taxed at a lower rate and an increase in tax exemptincome from investment securities. However, these effects are partially offset by $3.8 million in taxesrecorded related to the repatriation of $90 million of earnings from ouroverseas subsidiaries pursuant to the American Jobs Creation Act of 2004 in thefourth quarter of 2005.

 

*Net income.*  Net income in 2005 was $48.3 millioncompared to $18.0 million in 2004, as a result of the above factors.  Net income as a percentage of sales for 2005was 13.1%, compared to 4.9% for 2004.

 

*YearsEnded December 31, 2004 and 2003*

 

*Net sales.*  In 2004, net sales increased 20% to $365.3million from $304.2 million in 2003. This increase in sales resulted from increased demand from our brandedand OEM customers across all geographic regions.  Branded sales in 2004 increased 22% over2003, while OEM sales in 2004 increased 18% over 2003.  Branded sales accounted for 55% of sales in2004 and 54% of sales in 2003.  OEM saleswere 45% of sales in 2004 and 46% of sales in 2003.  Continued strong demand for our digital productline contributed to our sales growth. Contributions from IPMI and embedded KVM royalty revenues also increasedour net sales.  The primary contributorto the growth of our digital product revenue was the increased sales of the OEMversions of our digital product line, which was introduced in mid-2002.  Sales of our digital products andtechnologies accounted for $175.0 million or 48% of sales in 2004 compared with$114.8 million or 38% of sales for 2003. Our IPMI and embedded KVM royalty revenues totaled $6.8 million in 2004,the first year we recognized revenues from these technologies.

 

Sales in 2004 were stronginternationally and in the United States. International sales accounted for 41% of sales in 2004 and 40% of salesin 2003, while sales within the United States were 59% of sales in 2004 and 60%of sales in 2003.  Sales in the U.S.increased 19% from $182.1 million in 2003 to $216.7 million in 2004, whileinternational sales increased 21.7% from $122.1 million in 2003 to $148.6million in 2004.  This increase in salesin the U.S. is resulted from the continued strength of our branded sales, thestrong sales of our digital products and technologies, and the contributionsfrom our IPMI and embedded KVM royalty revenues.  The strength in our international sales wasmost evident in the European and the Asia Pacific regions, where both brandedand OEM sales were strong.  We believethe overall strength in these regions is the result of our continuedinvestments in international sales and marketing programs over the past threeyears.

 

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*Gross profit.*  Gross profit is affected by a variety offactors, including: the ratio of sales among our distribution channels, as OEMsales have lower gross margins than our branded sales; absorption of fixedcosts as sales levels fluctuate; product mix, raw materials, and labor costs;new product introductions by us and by our competitors; and the level of ouroutsourcing of manufacturing and assembly services.  Gross margins continued to improve significantly,as they grew to 58.3% in 2004 from 56.5% in 2003.  Gross margin in 2004 benefited from highersales of our digital products and technologies, which typically have a highermargin than our analog products, and accounted for almost 48% of sales in 2004compared to 38% of sales in 2003.  Grossmargins also benefited from our IPMI and KVM embedded royalty revenues, whichhave higher than our average gross margins. Margins were positively affected by our efforts both to lower productcosts through product redesigns that eliminated costly components and to reducecosts in our supply chain.

 

*Research and development expenses.*  Research and development expenses includecompensation for engineers, support personnel, outside contracted services andmaterials costs, and are expensed as they are incurred. Research anddevelopment expenses were $45.4 million, or 12.4% of net sales in 2004,compared to $29.8 million, or 9.8% of net sales in 2003.  The increased research and developmentexpense resulted from an increase in the number of engineers, and an increasein materials, certification, and testing of products currently indevelopment.  The increase in headcountwas the result of the addition of engineers through our recent acquisitions andthe hiring of software engineers to support the software development effortsfor our IPMI and embedded KVM products and technologies.  We invested in expanding our test labfacilities during 2004, which were completed in the fourth quarter.  During the second half of 2004, we expandedour use of contracted services in order to meet our aggressive productdevelopment goals for the year.  Thedevelopment goals included the completely refreshed versions of our digitalproduct family that were announced in January 2005 and the release of DSView3,our management software that was also released in January 2005.  Other efforts included the release of theAvocent Integrated Access Module (iRAM), an embedded product for remote servermanagement and the DSI5100 appliance released in January 2005, which integratesour IPMI management software into our DS Series product line.  These product introductions represent thelargest number of new product releases and product refreshes completed duringany single quarter in Avocent’s history. We believe that the timely development of innovative products andenhancements to existing products is essential to maintaining our competitiveposition.

 

*Acquired in-processresearch and development expense.*  Acquisition related expenses in 2004 werecomprised solely of the write-off of in-process research and developmentexpenses related to our acquisitions, including $6.5 million for Crystal Link,$21.7 million for OSA and $1.1 million for Sonic Mobility.  Acquisition related expenses in 2003 werecomprised solely of the write-off of $3.9 million of in-process researchand development expense related to our acquisition of Soronti.

 

*Selling, general andadministrative expenses.* Selling, general and administrative expenses include personnel costs foradministration, finance, information systems, human resources, sales andmarketing and general management, certain merger and acquisition relatedexpenses, rent, utilities, legal and accounting expenses, bad debts,advertising, promotional material, trade show expenses and related travelcosts.  Selling, general andadministrative expenses were $84.8 million, or 23.2% of net sales in 2004compared to $70.4 million, or 23.1% of net sales for 2003.  The increase in selling, general andadministrative expenses is primarily related to increased headcount as a resultof the Soronti, Crystal Link, OSA and Sonic Mobility acquisitions.  We also continue to expand our internationalsales infrastructure.  Other factorscontributing to higher selling, general and administrative expenses were higherdepreciation expenses related to the SAP implementation, costs of compliancewith the Sarbanes-Oxley Act of 2002, and higher legal fees associated withprotecting our intellectual property rights.

 

*Amortization of intangibleassets.*  Amortization of $24.2 millionin 2004 includes the amortization of the identifiable intangible assets createdas a result of the merger transaction between Apex and Cybex and theacquisitions of Equinox, 2C, Soronti, Crystal Link, OSA and SonicMobility.  Amortization of $21.8 millionin 2003 is comprised of the amortization of the identifiable intangible assetscreated as a result of the merger transaction between Apex and Cybex, theacquisitions of Equinox and 2C and a small amount for Soronti, acquired inNovember 2003.

 

*Net investment income**.** *Net******investment income increased from$4.8 million in 2003 to $5.1 million in 2004, as a result of an increase incash and investments generated by our operations and slightly higher interestrates in 2004.

 

*Net realized investmentgains (losses). *Net realizedinvestment gains (losses) declined significantly from a gain of $2.6 million in2003 to a loss of $3.8 million in 2004. This change was the result of recording other-than-temporary declines inour investments in VIEO and Rymic, two privately held entities, of $3.5 millionin 2004 versus a gain of $3.2 million on the disposition of a previouslywritten down equity investment recognized in the third quarter of 2003.** **Our investments inVIEO and Rymic are now fully reserved**.**

 

*Other income (expense),net.*  Net other income (expense)improved from expense of $288,000 in 2003 to income of $23,000 in 2004primarily as a result of recording larger foreign currency exchange losses inthe first half of 2003.

 

*Provision for incometaxes.*  The provision for income taxeswas $12.5 million in 2004 compared to $14.5 million in 2003.  The increase in the effective tax rate isprimarily attributable to the impact of $21.7 million of acquired in-processresearch and 

 

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development expense, which is not deductiblefor tax purposes, and $4.2 million of additional deferred compensation expense(related to assumed incentive stock options which have no tax benefit to us)recorded as a result of the acquisition of OSA.  These amounts were partially offset by the taximpact of a higher mix of pre-tax income contributed by our Shannon operationsthat is taxed at a lower rate.

 

*Net income.*  Net income in 2004 was $18.0 millioncompared to $38.5 million in 2003, as a result of the above factors,including the increase in our revenues, an increase in our margins, which wereoffset by realized investment losses, an increase in selling, general andadministrative expenses and higher research and development expenses.  The difference in amounts charged foracquired research and development expense upon the acquisitions of Soronti in2003 versus the amounts charged upon the acquisitions of Crystal Link, OSA andSonic Mobility also reduced net income in 2004. Net income as a percentage of sales for 2004 was 4.9%, compared to 12.7%for 2003.

 

**Liquidity and Capital Resources**

 

As of December 31, 2005our principal sources of liquidity consisted of approximately $346 millionin cash, cash equivalents, and investments.   We have no outstanding debt or available credit facilities as of thedate of this filing.

 

Our operating activitiesgenerated cash of approximately $71.0 million in 2005, $76.5 million in2004, and $82.5 million in 2003. The moderate reduction in positive cash flow in 2005 is primarily theresult of an increase in accounts receivable and higher cash operating expensesfrom our acquisitions.  We experienced anincrease in receivables as a result of the timing and volume of sales in thefourth quarter of 2005, which also caused our days sales outstanding (DSOs) toincrease to 59 days from 55 days for the same period in 2004.  Our goal is to keep DSOs under 60 days.  However, our accounts receivable agingremains strong, with only 1% of the balance greater than 30 days past due.  A decline in accrued wages and commissionsalso affected cash flow from operations in 2005, as bonuses accrued for 2005,which were paid during early 2006, were lower than bonuses accrued at the endof 2004.

 

Inthe ordinary course of our business, we may at any point in time have asignificant amount of contractual commitments not yet recognized in ourfinancial statements.  These commitmentsrelate primarily to our need to schedule the purchase of inventories in advanceof the related forecasted sales to customers. We have longer lead times for the products we purchase from suppliersbased in Asia than those from suppliers based in the U.S. and Europe. Ouractual contractual commitments are typically limited to products needed for oneto three months of forecasted sales.  Theliabilities for these inventory purchases along with the related inventoryassets are typically recognized upon our receipt of the products.  We also have at any point in time a varietyof short-term contractual commitments for services such as advertising,marketing, accounting, legal, and research and development activities.  The liabilities for these services and therelated expenses are typically recognized upon our receipt of the related services.  None of our purchase commitments requirepayment beyond the next year.

 

Thefollowing table sets forth the annual payments we are required to make undercontractual obligations and other commercial commitments for operating leasesand for purchases of inventory and services, in thousands, at December 31,2005.

 
| ** ** | ** ** | **Operating Leases** | ** ** | **Purchase Commitments** | ** ** |
|------------|------------|----------------------|------------|--------------------------|------------|
|       |       |                 |       |                     |       |
| 2006       |       | $                    | 2,351      |                     | $          | 30,623 |   |
| 2007       |       | 1,795                |       | —                   |       |
| 2008       |       | 1,199                |       | —                   |       |
| 2009       |       | 449                  |       | —                   |       |
| 2010       |       | 76                   |       | —                   |       |
| Thereafter |       | —               |       | —                   |       |
|       |       |                 |       |                     |       |
| Total      |       | $                    | 5,870      |                     | $          | 30,623 |   |

 

Under our board-approvedstock repurchase plan, we repurchased 2.7 million shares of our common stockduring 2005 at a cost totaling $77.7 million. During the period January 1, 2006 through February 28, 2006 werepurchased an additional 360 shares under this program at a total cost ofapproximately $11.9 million.  We expectto continue to repurchase shares from time to time to offset the dilution fromstock option exercises and to return a portion of our cash and investments toshareholders.  As of February 28, 2006,we have repurchased a total of 3.1 million shares under the program, leaving865,000 available to repurchase.

 

On April 29, 2005, our Boardof Directors approved a plan to accelerate vesting of all then outstandingstock options with an exercise price of greater than $25.00 that were unvestedon December 25, 2005.  Under theprovisions of APB 25, there was no compensation expense related to acceleratingthese options as the options affected by the acceleration had exercise priceshigher than the closing price of our common stock as of the modificationdate.  As a result of the Board’s action,stock options to purchase approximately 1.1 million shares of our common stockbecame exercisable on December 25, 2005. The exercise prices of the affected stock options ranged from $25.17 to$41.57 per share.  The closing price ofAvocent’s common stock on April 29, 2005 was $25.14.  We expect the acceleration of these stockoptions to reduce compensation expense that would have been recorded in futureperiods 

 

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following the adoption of SFAS 123R onJanuary 1, 2006.  We estimate that futurecompensation expense will be $13 million lower as a result of the accelerationof the vesting of these stock options with approximately $1.9 million ofunamortized compensation related to past grants as of December 31, 2005.  Excluding expense for any awards grantedduring the first quarter of 2006, we expect stock based compensation expensefor the first quarter of 2006 will be approximately in the range of $700,000 to$800,000.

 

We intend to use a portionof our cash and investments for strategic acquisitions of technologies andcompanies that will enhance and complement our existing technologies and helpincrease our sales.

 

InJanuary 2006, we announced that we had signed a definitive agreement to acquireCyclades Corporation, a privately-held company based in Fremont, California,with offices in Sao Paolo, Brazil and Munich, Germany.  Cyclades employsapproximately 350 people in 19 locations around the world.  The Cyclades product lines include serial andpower management products, and Linux based server switching products andtechnologies.  The agreement provides fora total cash purchase price of approximately $90 million plus the assumption ofliabilities and payment of certain transaction costs.  In addition to thepurchase price, we have set aside $6 million for retention bonuses to keyemployees and will provide post closing stock awards to certain employees.

 

 Cyclades had unaudited revenues ofapproximately $60 million in 2005.  Theserevenues included 55% of revenues shipped in the U.S. and the remaining 45%shipped internationally.  The Cycladesunaudited balance sheet includes $24.4 million in assets and $16.5 million inliabilities as of December 31, 2005.  Theacquisition is expected to be completed in March 2006.  At the closing of the acquisition we expectto record a charge for in-process research and development expenses, goodwilland certain intangibles that will require future amortization including, butnot limited to, developed technology, patents, trademarks, non-competeagreements and customer relationships.

 

**CriticalAccounting Policies**

 

We believe the followingcritical accounting policies affect the more significant judgments andestimates used in the preparation of our consolidated financial statements:

 

•                                          We reviewcustomer contracts to determine if all of the requirements for revenuerecognition have been met prior to recording revenues from salestransactions.  We generally record salesrevenue upon shipment of our products, net of any discounts, since we generallydo not have significant post delivery obligations, the product price is fixedand determinable, collection of the resulting receivable is probable, and productreturns are reasonably estimable.  Wegenerally ship products upon receipt of a purchase order from a customer.  We record revenue in accordance with theapplicable terms of each respective customer contract.  Accordingly, revenue on products shipped FOBdestination is recorded when the customer takes possession of the goods, andrevenue on products shipped FOB shipping point is recorded when the goods leaveour facilities.  Shipping and handlingfees are included in net sales, and the related costs are included in cost ofsales in the accompanying consolidated statements of income.

 

We generally record royaltyrevenue from OEMs upon shipment of the related products in which our softwareor firmware is embedded by the OEMs, based upon shipment data provided by theOEMs.  We generally record licenserevenue from sales of our software upon shipment or electronic transfer of thesoftware.  We generally defer revenuesfrom the sale of extended warranty agreements and software support andmaintenance agreements.  The deferredrevenue is amortized into income on a pro rata basis over the applicablecontract lives.

 

We accrue for sales returnsas a reduction of sales and cost of sales based on our experience fromhistorical customer returns, which we believe provides a reasonable estimate offuture returns.  Our sales agreementsgenerally include a one-month unconditional return policy.  We also allow additional rights of return tocertain distributors, which generally extend the return period to 90 days.  If actual future customer returns are lessfavorable than those projected by management, additional sales return costs maybe incurred.  Our allowance for salesreturns totaled $2.9 million and $3.2 million at December 31, 2005 and 2004,respectively.  The reserve is included asa reduction in the carrying value of accounts receivable in the accompanyingconsolidated balance sheets.

 

Prior to extending creditto a new customer, we perform a detailed credit review of the customer andestablish credit limits based on the results of our credit review.  We review collection experience periodicallyto determine if the customer’s payment terms and credit limits need to berevised.  We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments.  Ifthe financial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.  If circumstances change withregard to individual receivable balances that had previously been determined tobe uncollectible (and for which a specific reserve had been established), areduction in our allowance for doubtful accounts may be required.  Our allowance for doubtful accounts was $1.1million and $1.7 million at December 31, 2005 and 2004, respectively.

 

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We participate incooperative advertising and market development programs with certaindistributors and OEMs.  We use these programsto reimburse distributors and OEMs for the actual costs of certain forms ofadvertising, and in general, allow distributors and OEMs reimbursement up to aspecified percentage of net purchases. Our costs associated with these programs are estimated and accrued atthe time of sale, and are included in sales and marketing expenses in theaccompanying consolidated statements of income.

 

•                                          We carry ourinventory at the lower of cost or market, with cost being determined using thefirst-in, first-out method.  We usestandard costs for material, labor, and manufacturing overhead to value ourinventory.  We review and revise ourstandard costs on a quarterly basis. Therefore, our inventory costs approximate actual costs at the end ofeach reporting period.  We write down our inventory forestimated obsolescence or unmarketable inventory to the estimated market valuebased upon assumptions about future demand and market conditions.  If actual future demand or market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.  Our reservefor excess and obsolete inventory was $4.6 million and $3.8 million at December31, 2005 and 2004, respectively.

 

•                                          We provide forthe estimated cost of product warranties at the time revenue isrecognized.  While we engage in extensiveproduct quality programs and processes, including actively monitoring andevaluating the quality of our component suppliers and contract manufacturers,our warranty obligation is affected by product failure rates, failure rates ofpurchased components integrated into our products, material usage, and otherrework costs incurred in correcting a product failure.  Should actual product failure rates, materialusage, or other rework costs differ from our estimates, revisions to ourestimated warranty liability may be required. Our warranty reserve was $2.5 million and $2.8 million at December 31,2005 and 2004, respectively.

 

•                                          We holdinvestments in various publicly traded debt securities, includingmortgaged-backed and other asset-backed securities.  We record an investment impairment chargewhen we believe an investment has experienced a decline in value that is otherthan temporary.  Future adverse changesin market conditions or poor operating results of underlying investments couldresult in losses or an inability to recover the carrying value of theinvestments that may not be reflected in an investments current carrying value,thereby possibly requiring an impairment charge in the future.  There were no other-than-temporary impairmentcharges recorded against these investments in 2005, 2004 or 2003.

 

We also invest in privatelyheld entities and generally record our investments in these entities at cost orwe use the equity method if we have the ability to exercise significantinfluence over the entity.  We review ourinvestments in these entities periodically to determine if circumstances (bothfinancial and non-financial) exist that indicate that we will not recover ourinitial investment.  We record impairmentcharges on investments having a carrying value that is greater than the valuethat we would reasonably expect to receive in an arm’s length sale of theinvestment.  We recorded $3.5 million ofwrite-downs against such investments for the year ended December 31, 2004.  We did not record any such write-downsagainst these investments in 2005 or in 2003. As of December 31, 2005 our net carrying value of such investments isnil.

 

**•**                                          Our annual tests for goodwill impairment, performed in the fourthquarters of 2005, 2004 and 2003, determined that no adjustment for impairmentwas required.  Our testing indicated thatthe implied fair value of our goodwill exceeded its carrying value;accordingly, in accordance with SFAS 142, no further impairment analysis wasrequired.  If economic conditionsdeteriorate and indicators of impairment become present, an adjustment to thecarrying value of goodwill and other intangible assets may be required.

 

•**                                         **We review long-lived assets forimpairment under the guidance prescribed by SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*.  We recognize impairment losses on long-livedassets used in operations when indicators of impairment are present and theundiscounted cash flows estimated to be generated by those assets are less thanthe assets’ carrying values.  Animpairment loss would be recognized in the amount by which the recorded valueof the asset exceeds the fair value of the asset, measured by the quoted marketprice of an asset or an estimate based on the best information available in thecircumstances.  There were no such lossesrecognized during 2005, 2004, or 2003.

 

•**                                         **We account for income taxes using theasset and liability method.  We providefor income taxes currently payable and, in addition, provide deferred incometaxes for temporary differences between the tax bases of assets and liabilitiesand their reported amounts in the financial statements and for knowncontingencies.  Temporary differencesrelate principally to the allowance for doubtful accounts, allowance for salesreturns, liability for warranty claims, unrealized gain (loss) on investments,acquired intangible assets, accumulated depreciation, loss on write-down ofinvestments, and inventory reserves. We intend to permanently reinvest earningsfrom our foreign subsidiaries in our international operations and, accordingly,no provision for any incremental net U.S. federal or state income taxes hasbeen made for these unremitted earnings.  Valuation allowances are established whennecessary to reduce 

 

30

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deferred tax assets tothe amount expected to be realized.  Wehave approximately $554,000 and $2.9 million of valuation allowances recordedagainst deferred tax assets arising from a foreign subsidiary and certain stateresearch credits at December 31, 2005 and 2004, respectively.

 

**RecentlyIssued Accounting Standards and Recent Legislation**

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-based Payment*, which replaces SFAS No. 123 *Accounting for Stock Based Compensation* and APB Opinion No25 *Accounting for Stock Issued to Employees*.  SFAS 123R requires all share-based paymentsto employees and directors, including grants of employee stock options, to berecognized in the financial statements based on their fair values beginningwith the first annual period after June 15, 2005.  The pro-forma disclosures previouslypermitted under SFAS No. 123 no longer will be an alternative to inclusion ofthe expense in the financial statements. We adopted SFAS 123R beginning January 1, 2006.  Under SFAS 123R, we must determine theappropriate fair value model to be used for valuing share-based payments, theamortization method for compensation cost and the transition method to be usedat date of adoption.  The transitionmethods include prospective and retroactive adoption options.  We expect to use the Black-Scholes optionpricing model to value options after the adoption.  In addition, we expect to utilize thestraight line method to amortize the expense and utilize the prospectivetransition method which requires that compensation expense begin being recordedfor all unvested stock options and restricted stock at the beginning of thefirst quarter of adoption of SFAS 123R. We expect the adoption of SFAS 123R will have a material impact on ourfuture consolidated results of operations and earnings per share.  Upon adoption of SFAS 123R, the tax benefitfrom stock options will be presented as a component of financing activities.Compensation expense for outstanding awards for which the requisite service hadnot been rendered as of the effective date will be recognized over theremaining service period using the compensation cost calculated for pro-formadisclosure purposes under SFAS 123.  Webelieve the balance to be expensed, before tax, in future periods will beapproximately $1.9 million for stock options outstanding as of December 31,2005 under the SFAS 123 methodology.  Ifany new awards are granted, we will incur additional expense in future periodsrelated to those awards.

 

The European Union hasfinalized the Waste Electrical and Electronic Equipment Directive, which makesproducers of electrical goods, including computers and peripherals, financiallyresponsible for specified collection, recycling, treatment, and disposal ofpast and future covered products.  Thisdeadline to enact and implement the directive by individual European Uniongovernments generally was August 13, 2004, although extensions weregranted to some countries (such legislation, together with the directive, the “WEEELegislation”), and producers are financially responsible under the WEEELegislation beginning in August 2005. Similar legislation has been or may be enacted in other geographies,including in the United States and Japan, the cumulative impact of which couldbe significant for us.  We will incursome costs under the WEEE legislation but the level and timing of these costsare difficult to predict.

 

On October 22, 2004, the American Jobs CreationAct of 2004 became law.  This legislationrepeals export tax benefits, which have historically reduced our effective taxrate.  This legislation phases in therepealed export tax benefits by allowing 100 percent of the repealed exportbenefits in 2004, 80 percent in 2005 and 60 percent in 2006.  This change did not have a material impact onour effective tax rate or provision for taxes.

 

The legislation also transitions in a new taxdeduction for qualifying U.S. manufacturing activities.  Under the guidance in FASB Staff Position No.FAS 109-1 which articulates the application of SFAS 109, *Accountingfor Income Taxes*, to the tax deduction on qualified productionactivities provided by this Act, the deduction will be treated as a “specialdeduction” as described in SFAS 109.  Assuch, we expect the new manufacturing activities deduction provision of the newlegislation may reduce our effective rate in future periods as the deduction istaken on our tax returns.  The deductiondid not have a material impact on our effective tax rate or income taxprovision.

 

The legislation also provides for the optionalrepatriation of earnings from foreign subsidiaries allowing an 85 percentdividends received deduction. The deduction is subject to a number oflimitations.   We repatriated $90.0million from overseas earnings pursuant to this provision during the fourthquarter of 2005.  We incurred additionalincome tax expense equal to the incremental U.S. income tax in excess of thecredits available for taxes already paid overseas in the amount of $3.8million.

 

**Item 7A.  Quantitative and Qualitative Disclosuresabout Market Risks.**

 

Our primary market risk isthe potential loss arising from increases in interest rates, which could havean adverse impact on the fair value of our investment securities.  Our investment policy is to manage ourinvestment portfolio to preserve principal and liquidity while maximizing thereturn on our investment portfolio through the investment of available funds.\We diversify our investment portfolio by investing in a variety of highly-ratedinvestment-grade securities and through the use of different investmentmanagers.  Our investment securitiesportfolio is primarily invested in securities with maturities (or interest rateresets) of two years or less with at least an investment grade rating tominimize interest rate and credit risk as well as to provide for an immediatesource of funds.  Market risk, calculatedas the potential change in fair value in our investment portfolio resultingfrom a hypothetical 10% change in interest rates, was not material atDecember 31, 2005.  We generallyhold investment securities until maturity.

 

We also face foreigncurrency exchange rate risk to the extent that the value of certain foreigncurrencies relative to the U.S. 

 

31

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dollar affects our financial results.  Our international operations transact aportion of our business in currencies other than the U.S. dollar, predominantlythe euro, and changes in exchange rates may positively or negatively affect ourrevenues, gross margins, operating expenses, and retained earnings since thesetransactions are reported by us in U.S. dollars.  We occasionally purchase foreign currencyforwards aimed at limiting the impact of currency fluctuations.  These instruments provide only limitedprotection against currency exchange risks, and there can be no assurance thatsuch an approach will be successful, especially if a significant and suddendecline occurs in the value of local currencies.  As of December 31, 2005, we had one openforward contract with a fair value of zero.

 

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**Item 8.**

** Financial Statements.**

 

**Indexto Consolidated Financial Statements**

 
| ** **                                                                                                      | ** ** | **Page Number** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|
|                                                                                                            |       |            |       |
| Management’s  Report on Internal Control over Financial Reporting                                          |       | 34              |       |
| Report  of Independent Registered Public Accounting Firm                                                        |       | 35              |       |
|                                                                                                            |       |            |       |
| Consolidated Financial  Statements:                                                                             |       |            |       |
|                                                                                                            |       |            |       |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                              |       | 36              |       |
| Consolidated Statements of Income for the years ended  December 31, 2005, 2004 and 2003                    |       | 37              |       |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2005, 2004 and 2003 |       | 38              |       |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                |       | 39              |       |
| Notes to Consolidated Financial Statements                                                                      |       | 40              |       |
| Schedule II - Valuation and Qualifying Accounts                                                                 |       | 61              |       |

 

 

33

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**Management’sReport on Internal Control over Financial Reporting**

 

Management of Avocent Corporation isresponsible for establishing and maintaining adequate internal control overfinancial reporting.  The Company’sinternal control over financial reporting is a process designed under thesupervision of Avocent’s principal executive and principal financial officersto provide reasonable assurance regarding the reliability of financialreporting and the preparation of the Company’s financial statements forexternal purposes in accordance with U.S. generally accepted accountingprinciples.

 

As of the end of the Company’s 2005 fiscalyear, management conducted an assessment of the Company’s internal control overfinancial reporting based on the framework established in Internal Control -Integrated Framework issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Based on this assessment, management has determinedthat the Company’s internal control over financial reporting as of December 31,2005 was effective.

 

The Company’s internal control over financialreporting includes policies and procedures that pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect transactionsand dispositions of assets; provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with U.S. generally accepted accounting principles, and thatreceipts and expenditures are being made only in accordance with authorizationsof management and the directors of the Company; and provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use or disposition of the Company’s assets that could have a material effect onthe financial statements.

 

Management’s assessment of the effectivenessof the Company’s internal control over financial reporting as of December 31,2005 has been audited by PricewaterhouseCoopers LLP, an independent registeredpublic accounting firm, as stated in their report appearing on page 35, whichexpresses unqualified opinions on management’s assessment of the effectivenessof internal control over financial reporting and on the effectiveness of theCompany’s internal control over financial reporting as of December 31, 2005.

 

 

34

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**Reportof Independent Registered Public Accounting Firm**

 

To the Board of Directors and Stockholdersof AvocentCorporation

 

We have completed integrated audits of AvocentCorporation’s 2005 and 2004 consolidated financial statements and of itsinternal control over financial reporting as of December 31, 2005 and an auditof its 2003 consolidated financial statements in accordance with the standardsof the Public Company Accounting Oversight Board (United States).  Ouropinions, based on our audits, are presented below.

 

Consolidated financialstatements and financial statement schedule

 

In our opinion, the consolidated financialstatements listed in the accompanying index present fairly, in all materialrespects, the financial position of Avocent Corporation and its subsidiaries****at December 31, 2005 and 2004, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2005****in conformity with accountingprinciples generally accepted in the United States of America.  In addition, in our opinion, the financialstatement schedule listed in the accompanying index****presentsfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements.  These financial statements and financialstatement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements and financial statement schedule****based on our audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

Internal control overfinancial reporting

 

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing on page 34, that the Company maintained effective internal controlover financial reporting as of December 31, 2005 based on criteria establishedin *Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), is fairly stated, in all material respects, based on those criteria.Furthermore, in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31, 2005,based on criteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

 

A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  A company’s internal controlover financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’s assetsthat could have a material effect on the financial statements.

 

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

 
| /s/ PricewaterhouseCoopers  LLP |   |
|---------------------------------|--------|
| Birmingham, Alabama             |   |
| March  6, 2006             |   |

** **

 

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**Avocent Corporation**

**Consolidated Balance Sheets**

**December 31, 2005 and 2004**

**(In thousands, except per share data)**

 

 
| ** **                                                                                                                                                                              | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                         |       |       |       |       |       |
| Cash and cash equivalents                                                                                                                                                               |       | $          | 66,425     |       | $          | 44,724 |   |
| Investments maturing within one year                                                                                                                                                    |       | 227,478    |       | 195,075    |       |
| Accounts receivable, less allowance for doubtful accounts of $1,129  and $1,740 at December 31, 2005 and 2004, respectively                                                             |       | 68,712     |       | 60,948     |       |
| Inventories, net                                                                                                                                                                        |       | 21,178     |       | 21,232     |       |
| Other current assets                                                                                                                                                                    |       | 10,524     |       | 5,923      |       |
| Deferred tax assets, net                                                                                                                                                                |       | 4,054      |       | 6,720      |       |
| Total current assets                                                                                                                                                                    |       | 398,371    |       | 334,622    |       |
|                                                                                                                                                                                    |       |       |       |       |       |
| Investments                                                                                                                                                                             |       | 51,939     |       | 90,217     |       |
| Property held for lease, net                                                                                                                                                            |       | —     |       | 1,330      |       |
| Property and equipment, net                                                                                                                                                             |       | 36,801     |       | 39,896     |       |
| Goodwill                                                                                                                                                                                |       | 269,992    |       | 269,892    |       |
| Other intangible assets, net                                                                                                                                                            |       | 15,763     |       | 33,981     |       |
| Other assets                                                                                                                                                                            |       | 885        |       | 843        |       |
| Total assets                                                                                                                                                                            |       | $          | 773,751    |       | $          | 770,781 |   |
|                                                                                                                                                                                    |       |       |       |       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                           |       |       |       |       |       |
| Current liabilities:                                                                                                                                                                    |       |       |       |       |       |
| Accounts payable                                                                                                                                                                        |       | $          | 13,069     |       | $          | 9,171 |   |
| Accrued wages and commissions                                                                                                                                                           |       | 10,500     |       | 12,197     |       |
| Accrued liabilities                                                                                                                                                                     |       | 17,206     |       | 15,661     |       |
| Income taxes payable                                                                                                                                                                    |       | 11,270     |       | 8,494      |       |
| Other current liabilities                                                                                                                                                               |       | 1,702      |       | 1,106      |       |
| Total current liabilities                                                                                                                                                               |       | 53,747     |       | 46,629     |       |
|                                                                                                                                                                                    |       |       |       |       |       |
| Deferred tax liabilities, net                                                                                                                                                           |       | 2,564      |       | 8,985      |       |
| Other non-current liabilities                                                                                                                                                           |       | 2,118      |       | 1,870      |       |
| Total liabilities                                                                                                                                                                       |       | 58,429     |       | 57,484     |       |
|                                                                                                                                                                                    |       |       |       |       |       |
| Commitments and  contingencies *(Note 13)*                                                                                                                                              |       |       |       |       |       |
|                                                                                                                                                                                    |       |       |       |       |       |
| Stockholders’ equity:                                                                                                                                                              |       |       |       |       |       |
| Preferred stock, par value $0.001 per share; 5,000 shares authorized;  no shares issued and outstanding                                                                                 |       | —     |       | —     |       |
| Common stock, par value $0.001 per share; 200,000 shares authorized;  2005 — 51,612 shares issued and 48,837 outstanding; 2004 — 50,332 shares  issued and 50,232 outstanding |       | 52         |       | 50         |       |
| Additional paid-in capital                                                                                                                                                              |       | 1,104,899  |       | 1,075,171  |       |
| Unrealized gain (loss) on investments, net of deferred taxes                                                                                                                            |       | (502       | )          | (287       | )          |
| Foreign currency translation adjustment                                                                                                                                                 |       | 5          |       | 231        |       |
| Accumulated deficit                                                                                                                                                                     |       | (307,503   | )          | (355,852   | )          |
| Deferred compensation                                                                                                                                                                   |       | —     |       | (2,038     | )          |
| Treasury stock, at cost; 2005 — 2,775 shares; 2004 — 100 shares                                                                                                               |       | (81,629    | )          | (3,978     | )          |
| Total stockholders’ equity                                                                                                                                                         |       | 715,322    |       | 713,297    |       |
|                                                                                                                                                                                    |       |       |       |       |       |
| Total liabilities and stockholders’ equity                                                                                                                                         |       | $          | 773,751    |       | $          | 770,781 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

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**Avocent Corporation**

**Consolidated Statements of Income**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In thousands, except per share data)**

 
| ** **                                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                                                        |       | $        | 369,888    |     | $          | 365,255  |       | $ | 304,238 |   |
|                                                             |       |     |       |     |       |     |       |
| Cost of sales                                                    |       | 151,043  |       | 152,400  |       | 132,412  |       |
|                                                             |       |     |       |     |       |     |       |
| Gross profit                                                     |       | 218,845  |       | 212,855  |       | 171,826  |       |
|                                                             |       |     |       |     |       |     |       |
| Research and development  expenses                               |       | 56,885   |       | 45,353   |       | 29,793   |       |
| Acquired in-process  research and development expense *(Note 3)* |       | —   |       | 29,260   |       | 3,940    |       |
| Selling, general and  administrative expenses                    |       | 90,354   |       | 84,823   |       | 70,398   |       |
| Amortization of intangible  assets                               |       | 18,509   |       | 24,279   |       | 21,805   |       |
|                                                             |       |     |       |     |       |     |       |
| Total operating expenses                                         |       | 165,748  |       | 183,715  |       | 125,936  |       |
|                                                             |       |     |       |     |       |     |       |
| Income from operations                                           |       | 53,097   |       | 29,140   |       | 45,890   |       |
|                                                             |       |     |       |     |       |     |       |
| Income from settlement of  lawsuit                               |       | 5,000    |       | —   |       | —   |       |
| Net investment income                                            |       | 9,246    |       | 5,133    |       | 4,825    |       |
| Net realized investment  gains (losses)                          |       | (83      | )          | (3,804   | )          | 2,619    |       |
| Other income (expense),  net                                     |       | (174     | )          | 23       |       | (288     | )          |
|                                                             |       |     |       |     |       |     |       |
| Income before provision for income taxes                         |       | 67,086   |       | 30,492   |       | 53,046   |       |
|                                                             |       |     |       |     |       |     |       |
| Provision for income taxes                                       |       | 18,737   |       | 12,452   |       | 14,499   |       |
|                                                             |       |     |       |     |       |     |       |
| Net income                                                       |       | $        | 48,349     |     | $          | 18,040   |       | $ | 38,547 |   |
|                                                             |       |     |       |     |       |     |       |
| Net income per common  share:                                    |       |     |       |     |       |     |       |
| Basic                                                            |       | $        | 0.98       |     | $          | 0.37     |       | $ | 0.83 |   |
|                                                             |       |     |       |     |       |     |       |
| Diluted                                                          |       | $        | 0.96       |     | $          | 0.36     |       | $ | 0.81 |   |
|                                                             |       |     |       |     |       |     |       |
| Weighted average common  shares outstanding:                     |       |     |       |     |       |     |       |
| Basic                                                            |       | 49,318   |       | 48,964   |       | 46,194   |       |
|                                                             |       |     |       |     |       |     |       |
| Diluted                                                          |       | 50,254   |       | 50,530   |       | 47,693   |       |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

37

----

 

**AvocentCorporation**

**Consolidated Statements of Stockholders’ Equity**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In thousands)**

 
| ** **                                                                                | ** ** | ** **        | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                         | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------------------------|------------|------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------|------------|------------|------------|------------|------------|
| ** **                                                                                | ** ** | ** **        | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                         | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                                                                                | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In** | ** ** | **Unrealized  Gain (Loss) on** | ** ** | **Foreign  Currency  Translation** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Deferred** | ** ** | **Treasury**     | ** ** | ** ** | ** ** |
| ** **                                                                                | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **Capital**                    | ** ** | **Investments**                    | ** ** | **Adjustment**                       | ** ** | **Deficit)** | ** ** | **Compensation** | ** ** | **Stock**  | ** ** | **Total**  | ** ** |
| Balance, December 31, 2002                                                                |       | 45,210            |       | $                       | 45         |                           | $          | 936,288                            |       | $                                    | 43         |         | $          | (29              | )          | $          | (412,439   | )          | $          | (6,236 | ) | $ | — |   | $ | 517,672 |   |
| Acquisition of Soronti, Inc.                                                              |       | 31                |       | —                  |       | 1,152                          |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 1,152      |       |
| Net income                                                                                |       | —            |       | —                  |       | —                         |       | —                             |       | —                               |       | 38,547       |       | —           |       | —     |       | 38,547     |       |
| Change in foreign  currency translation adjustment                                        |       | —            |       | —                  |       | —                         |       | —                             |       | 93                                   |       | —       |       | —           |       | —     |       | 93         |       |
| Change in net  unrealized gains on investments, net of deferred income taxes of $65       |       | —            |       | —                  |       | —                         |       | 120                                |       | —                               |       | —       |       | —           |       | —     |       | 120        |       |
| Issuances of common stock                                                                 |       | 2,109             |       | 2                       |       | 34,618                         |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 34,620     |       |
| Income tax  benefit from exercise of stock options                                        |       | —            |       | —                  |       | 10,239                         |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 10,239     |       |
| Stock-based compensation                                                                  |       | —            |       | —                  |       | (79                            | )          | —                             |       | —                               |       | —       |       | 4,793            |       | —     |       | 4,714      |       |
| Balance, December 31, 2003                                                                |       | 47,350            |       | 47                      |       | 982,218                        |       | 163                                |       | 64                                   |       | (373,892     | )          | (1,443           | )          | —     |       | 607,157    |       |
| Acquisition of  Crystal Link Technologies                                                 |       | 107               |       | —                  |       | 3,500                          |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 3,500      |       |
| Acquisition of OSA Technologies                                                           |       | 1,229             |       | 1                       |       | 54,707                         |       | —                             |       | —                               |       | —       |       | (6,351           | )          | —     |       | 48,357     |       |
| Net income                                                                                |       | —            |       | —                  |       | —                         |       | —                             |       | —                               |       | 18,040       |       | —           |       | —     |       | 18,040     |       |
| Change in foreign  currency translation adjustment                                        |       | —            |       | —                  |       | —                         |       | —                             |       | 167                                  |       | —       |       | —           |       | —     |       | 167        |       |
| Change in net  unrealized gain on investments, net of deferred income tax benefit of $207 |       | —            |       | —                  |       | —                         |       | (450                               | )          | —                               |       | —       |       | —           |       | —     |       | (450       | )          |
| Issuances of common stock                                                                 |       | 1,646             |       | 2                       |       | 29,085                         |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 29,087     |       |
| Income tax  benefit from exercise of stock options                                        |       | —            |       | —                  |       | 5,748                          |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 5,748      |       |
| Stock-based compensation                                                                  |       | —            |       | —                  |       | (87                            | )          | —                             |       | —                               |       | —       |       | 5,756            |       | —     |       | 5,669      |       |
| Purchase of 100  shares of treasury stock                                                 |       | —            |       | —                  |       | —                         |       | —                             |       | —                               |       | —       |       | —           |       | (3,978     | )          | (3,978     | )          |
| Balance, December 31, 2004                                                                |       | 50,332            |       | 50                      |       | 1,075,171                      |       | (287                               | )          | 231                                  |       | (355,852     | )          | (2,038           | )          | (3,978     | )          | 713,297    |       |
| Net income                                                                                |       | —            |       | —                  |       | —                         |       | —                             |       | —                               |       | 48,349       |       | —           |       | —     |       | 48,349     |       |
| Change in foreign  currency translation adjustment                                        |       | —            |       | —                  |       | —                         |       | —                             |       | (226                                 | )          | —       |       | —           |       | —     |       | (226       | )          |
| Change in net  unrealized loss on investments, net of deferred income tax benefit of $138 |       | —            |       | —                  |       | —                         |       | (215                               | )          | —                               |       | —       |       | —           |       | —     |       | (215       | )          |
| Issuances of common stock                                                                 |       | 1,280             |       | 2                       |       | 25,089                         |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 25,091     |       |
| Income tax  benefit from exercise of stock options                                        |       | —            |       | —                  |       | 4,663                          |       | —                             |       | —                               |       | —       |       | —           |       | —     |       | 4,663      |       |
| Stock-based compensation                                                                  |       | —            |       | —                  |       | (24                            | )          | —                             |       | —                               |       | —       |       | 2,038            |       | —     |       | 2,014      |       |
| Purchase of 2,675  shares of treasury stock                                               |       | —            |       | —                  |       | —                         |       | —                             |       | —                               |       | —       |       | —           |       | (77,651    | )          | (77,651    | )          |
| Balance, December 31, 2005                                                                |       | 51,612            |       | $                       | 52         |                           | $          | 1,104,899                          |       | $                                    | (502       | )            | $          | 5                |       | $          | (307,503   | )          | $          | — |   | $ | (81,629 | ) | $ | 715,322 |   |
|                                                                                           |            |                   |            |                         |            |                                |            |                                    |            |                                      |            |              |            |                  |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

Comprehensiveincome in 2005 of $47,908 consists of $48,349 of net income, $215 of unrealizedloss on investments (net of deferred income taxes) and $226 of foreign currencytranslation adjustment.  The unrealizedloss on investments is net of $526, net of $284 tax benefit, of realized lossesthat are included in net realized investment gains (losses) in the accompanyingconsolidated statement of income.

 

Comprehensiveincome in 2004 of $17,757 consists of $18,040 of net income, $450 of unrealizedloss on investments (net of deferred income taxes) and $167 of foreign currencytranslation adjustment.  The unrealizedloss on investments is net of $230, net of $124 tax benefit, of realized lossesthat are included in net realized investment gains (losses) in the accompanyingconsolidated statement of income.

 

Comprehensiveincome in 2003 of $38,760 consists of $38,547 of net income, $120 of unrealizedgain on investments (net of deferred income taxes) and $93 of foreign currencytranslation adjustment.  The unrealizedgain on investments is net of $1,702, net of $917 tax expense, of realizedgains that are included in net realized investment gains (losses) in theaccompanying consolidated statement of income.

 

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

38

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**Avocent Corporation**

**Consolidated Statements of Cash Flows**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In thousands)**

 
| ** **                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from operating  activities:                                             |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 48,349     |     | $          | 18,040   |       | $ | 38,547 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |     |       |     |       |     |       |
| Depreciation                                                                       |       | 7,037    |       | 6,222    |       | 4,859    |       |
| Amortization of intangible assets                                                  |       | 18,509   |       | 24,279   |       | 21,805   |       |
| Stock-based compensation                                                           |       | 2,014    |       | 5,669    |       | 4,714    |       |
| Acquired in-process research and development expenses                              |       | —   |       | 29,260   |       | 3,940    |       |
| Other-than-temporary decline in fair value of investments                          |       | —   |       | 3,450    |       | —   |       |
| Amortization of premium on investments                                             |       | 934      |       | 3,236    |       | 3,339    |       |
| Net (gain) loss on sales of investments                                            |       | 810      |       | 354      |       | (2,619   | )          |
| Net gain on sale of property held for lease                                        |       | (727     | )          | —   |       | —   |       |
| Deferred income taxes                                                              |       | (3,973   | )          | (7,548   | )          | (4,283   | )          |
| Income tax benefit from exercise of stock options                                  |       | 4,663    |       | 5,748    |       | 10,239   |       |
| Changes in operating assets and liabilities (net of effects of  acquisitions):     |       |     |       |     |       |     |       |
| Accounts receivable, net                                                           |       | (7,763   | )          | (15,668  | )          | (8,677   | )          |
| Inventories, net                                                                   |       | 54       |       | 238      |       | 3,300    |       |
| Other assets                                                                       |       | (5,146   | )          | 162      |       | (17      | )          |
| Accounts payable                                                                   |       | 3,905    |       | (1,447   | )          | 3,430    |       |
| Accrued liabilities, wages and commissions                                         |       | (1,697   | )          | 2,080    |       | 1,277    |       |
| Income taxes, receivable and payable                                               |       | 2,776    |       | 1,831    |       | (5       | )          |
| Other liabilities                                                                  |       | 1,241    |       | 615      |       | 2,654    |       |
| Net cash provided by operating activities                                          |       | 70,986   |       | 76,521   |       | 82,503   |       |
| Cash flows from investing  activities:                                             |       |     |       |     |       |     |       |
| Purchase of Sonic Mobility, net of cash acquired                                   |       | —   |       | (9,141   | )          | —   |       |
| Purchase of OSA, net of cash acquired                                              |       | —   |       | (47,179  | )          | —   |       |
| Purchase of Crystal Link, net of cash acquired                                     |       | —   |       | (5,311   | )          | —   |       |
| Purchase of Soronti, net of cash acquired                                          |       | —   |       | —   |       | (5,520   | )          |
| Purchases of property and equipment                                                |       | (3,798   | )          | (7,137   | )          | (18,983  | )          |
| Proceeds from sale of property held for lease                                      |       | 1,912    |       | —   |       | —   |       |
| Purchases of available-for-sale investments                                        |       | (360,839 | )          | (306,634 | )          | (243,698 | )          |
| Proceeds from maturities and sales of available-for-sale investments               |       | 364,758  |       | 243,634  |       | 115,376  |       |
| Proceeds from maturities of held-to-maturity investments                           |       | —   |       | —   |       | 50,405   |       |
| Net cash provided by (used in) investing activities                                |       | 2,033    |       | (131,768 | )          | (102,420 | )          |
| Cash flows from financing  activities:                                             |       |     |       |     |       |     |       |
| Repayment of short-term debt assumed in acquisitions                               |       | —   |       | (1,797   | )          | (3       | )          |
| Proceeds from employee stock option exercises                                      |       | 19,059   |       | 25,876   |       | 32,811   |       |
| Proceeds from employee stock purchase plan                                         |       | 6,032    |       | 3,211    |       | 1,809    |       |
| Purchases of treasury stock                                                        |       | (76,279  | )          | (3,978   | )          | —   |       |
| Net cash (used in) provided by financing activities                                |       | (51,188  | )          | 23,312   |       | 34,617   |       |
|                                                                               |       |     |       |     |       |     |       |
| Effect of exchange rate  changes on cash and cash equivalents                      |       | (130     | )          | 167      |       | 93       |       |
|                                                                               |       |     |       |     |       |     |       |
| Net increase (decrease) in cash and cash equivalents                               |       | 21,701   |       | (31,768  | )          | 14,793   |       |
| Cash and cash equivalents,  beginning of year                                      |       | 44,724   |       | 76,492   |       | 61,699   |       |
|                                                                               |       |     |       |     |       |     |       |
| Cash and cash equivalents,  end of year                                            |       | $        | 66,425     |     | $          | 44,724   |       | $ | 76,492 |   |
|                                                                               |       |     |       |     |       |     |       |
| Supplemental disclosures  of cash flow information:                                |       |     |       |     |       |     |       |
| Cash paid during the year for income taxes                                         |       | $        | 14,487     |     | $          | 12,496   |       | $ | 9,658 |   |
|                                                                                    |            |          |            |          |            |          |            |  |  |  |  |  |  |

----

(1)          Supplemental disclosure — TheCompany recorded the purchase of 50 treasury shares at the end of 2005 for$1,372 and recorded a liability in the same amount as the transaction settledafter year-end.  The cash-flow has beenadjusted for this non-cash transaction.

(2)          Supplemental disclosure — Inaddition to the cash paid at the respective closings, the Company issued 106shares of its common stock valued at $3,500 to Crystal Link shareholders and1,229 shares of its common stock valued at $45,831 to OSA shareholders. Theissuance of common stock was recorded as non-cash consideration for the acquisitions.

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

39

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**Avocent Corporation**

**Notes to Consolidated Financial Statements**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

**1.**                                Nature of Business and Basis of Presentation

** **

Avocent Corporation (theCompany or Avocent) designs, manufactures and sells analog and digital KVM(keyboard, video and mouse) switching systems, serial connectivity devices,extension, wireless extension, remote access and management products,Intelligent Platform Management Interface (“IPMI”) firmware and software, andrelated technologies for the computer industry. The Company’s products and technologies help IT administrators managemultiple servers, serially controlled devices and mobile devices from a singlelocal or remote console facilitating efficient network management andadministration. The Company sells products to distributors, resellers, originalequipment manufacturers (“OEMs”) and end-users in the United States andinternationally.

 

The results of acquiredcompanies are included in the consolidated results from the respective dates ofacquisition, including Soronti, Inc. (“Soronti”), which was acquired onNovember 17, 2003, Crystal Link Technologies (“Crystal Link”), which wasacquired on January 6, 2004, OSA Technologies, Inc. (“OSA”), which was acquiredon April 6, 2004 and Sonic Mobility Inc. (“Sonic Mobility”), which was acquiredon August 31, 2004.

 

**2.**                                Summary of Significant Accounting Policies

 

The principal accountingpolicies of the Company are as follows:

 

**Principlesof Consolidation** —The Company’s consolidated financial statements include the Company and itswholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

**Cash andCash Equivalents** —The Company considers all highly liquid instruments with an original maturityof three months or less when purchased to be cash equivalents, except thatcertain investments with original maturities of less than 90 days areclassified as short term investments when such investments are a part of ourinvestment portfolio.

 

**Inventories** — Raw materials, work in process andfinished goods inventories are recorded using the lower of standard cost, whichapproximates first-in first-out (FIFO), or market.  Standard costs are reviewed and revised on aquarterly basis. Therefore, inventory costs approximate actual costs at the endof each reporting period.  The Company writes down inventory forestimated obsolescence or unmarketable inventory to the estimated market valuebased upon assumptions about future demand and market conditions.

 

**FinancialInstruments**— Thecarrying amounts reported in the balance sheets for cash and cash equivalents,short-term investments, accounts receivable and accounts payable approximatefair value because of the immediate or short-term maturity of these financialinstruments.

 

**Investments**—****The Company’sinvestments consist primarily of bank deposits, corporate bonds, commercialpaper, asset-backed securities, municipal bonds, U.S. government agencysecurities, and mortgage-backed securities guaranteed by U.S. governmentagencies.  Debt securities that theCompany has the positive intent and ability to hold to maturity are classifiedas held-to-maturity securities and are reported at amortized cost.  Debt and equity securities not classified aseither held-to-maturity securities or trading securities and that have readilydeterminable fair values are classified as available-for-sale securities andare reported at fair value, with unrealized gains and losses excluded fromearnings and reported as a separate component of stockholders’ equity, net ofdeferred income taxes. Unrealized losses are charged against earnings when adecline in fair value is determined to be other than temporary.  Certain investments with original maturitiesof less than 90 days are classified as short term investments when such are apart of our investment portfolio. Realized gains and losses are accounted for on the specificidentification method.

 

The Company also investsin privately-held companies and generally records its investments in theseentities at cost or using the equity method if the Company has the ability toexercise significant influence over the entity. The Company’s carrying value for such investments was nil as of December31, 2005 and 2004.  These investments areincluded in total long-term investments in the accompanying consolidatedbalance sheets.  The Company reviews itsinvestments in these entities periodically to determine if circumstances (bothfinancial and non-financial) exist that indicate that the investment will notbe recovered.  Impairment charges arerecorded on investments having a basis that is greater than the value that theCompany would reasonably expect to receive in an arm’s length sale of theinvestment.  The Company recognizedimpairment losses on these investments of zero in 2005, $3,450 in 2004, andzero in 2003 (*see note 5*).

 

40

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

**PropertyHeld for Lease**—****Property held for lease, which was sold in the fourthquarter of 2005,  is carried at cost,less accumulated depreciation, which was computed using the straight-linemethod over the estimated useful lives of the assets. Rental income from thisproperty is recorded on a monthly basis in accordance with the lease terms.Initial direct costs were deferred and matched against rental income over theinitial term of the lease *(see Note 6).*  Netrental income was reported within net investment income.

 

**Propertyand Equipment** —Property and equipment are carried at cost, less accumulated depreciation, andinclude expenditures that substantially increase the useful lives of existingassets. Maintenance and repairs are charged to current operations as incurred.Upon sale, retirement, or other disposition of these assets, the cost andrelated accumulated depreciation are removed from the respective accounts, andany gain or loss on the disposition is included in income from operations.

 

Depreciation expense iscomputed using the straight-line method over the following estimated usefullives:

 

| **Description**                  | ** ** | **Useful  Life**  |
|----------------------------------|------------|-------------------|
| Land improvements                |       | 30  years         |
| Buildings                        |       | 39  years         |
| Leasehold improvements           |       | lease  terms      |
| Computer software and  equipment |       | 3  — 5 years |
| Other equipment                  |       | 3  — 5 years |

 

**OtherIntangible Assets**— Other intangible assets include acquired intangible assets and capitalizedcosts directly incurred in obtaining an intangible.  Other intangible assets are amortized on astraight-line basis over the following estimated useful lives:

 

| **Description**                 | ** ** | **Useful  Life**           |
|---------------------------------|------------|----------------------------|
| Developed technology            |       | 3  — 5 years          |
| Patents and trademarks          |       | 5  — 7 years          |
| Customer base and certification |       | 3  — 6 years          |
| Non-compete agreements          |       | 3  years (contract period) |
| Other assets                    |       | 3  — 7 years          |

 

**Long-LivedAssets —** TheCompany recognizes impairment losses on long-lived assets used in operationswhen indicators of impairment are present and the undiscounted cash flowsestimated to be generated by those assets are less than the assets’ carryingvalues. An impairment loss would be recognized in the amount by which therecorded value of the asset exceeds the fair value of the asset, measured bythe quoted market price of an asset or an estimate based on the bestinformation available in the circumstances. There were no such losses recognized during 2005, 2004 or 2003.

 

**Goodwill —** The Company records goodwillwhen the cost of an acquired entity exceeds the net amounts assigned to theassets acquired (including other identified intangible assets) and liabilitiesassumed.  The Company performed an annualimpairment test of goodwill in the fourth quarters of 2005, 2004 and 2003.  The tests conducted during 2005, 2004 and2003 concluded that there had been no impairment of goodwill and that noadjustments were required (*see Note 8*).

** **

**Allowance for Doubtful Accounts**— Prior to extending credit to a new customer, theCompany performs a detailed credit review of the customer and establishescredit limits based on the results of the credit review. The Company reviewscollection experience periodically to determine if the customer’s payment termsand credit limits need to be revised. The Company maintains allowances fordoubtful accounts for estimated losses resulting from the inability of itscustomers to make required payments. If the financial condition of the Company’scustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required. If circumstances changewith regard to individual receivable balances that had previously beendetermined to be uncollectible (and for which a specific reserve had beenestablished), a reduction in the Company’s allowance for doubtful accounts maybe required. The Company’s allowance for doubtful accounts was $1,129 and$1,740 at December 31, 2005 and 2004, respectively.

** **

**Allowancefor Sales Returns**—The Company’s sales generally include a one-month unconditional returnpolicy.  The Company also allowsadditional rights of return to certain of its distributors, which generallyextend the return period to 90 days. The Company reserves for estimated salesreturns as a reduction of revenue and cost of sales at the time the productrevenue is recognized based on historical sales return experience, whichmanagement believes provides a reasonable estimate of future returns.  The allowance for sales returns totaledapproximately $2,877 and $3,174 at December 31, 2005 and 2004, respectively.The reserve is included as a reduction in the carrying value of accountsreceivable in the accompanying consolidated balance sheets.

 

**Liabilityfor Warranty Returns**— The Company’s products generally include warranties of one to three years forproduct 

 

41

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

defects. The Company accruesfor warranty returns at cost to repair or replace products. The Company alsooffers extended warranties to customers and recognizes the revenue associatedwith the extended warranties over the life of the warranty *(see Note 9*).  The liability for warranty returns totaledapproximately $2,536 and $2,760 at December 31, 2005 and 2004, respectively.These liabilities are included in accrued liabilities in the accompanyingconsolidated balance sheets.

 

**Stock-BasedCompensation**—****The Company generally records compensation expense for allstock-based compensation plans using the intrinsic value method in whichcompensation expense, if any, is measured as the excess of the market price ofthe stock over the exercise price of the award on the measurement date. Forunvested options of companies acquired that existed as of their respectiveacquisition dates, the intrinsic value was computed as of the acquisition dateand the pro rata portion related to future service was deferred (included indeferred compensation in the consolidated balance sheets) and is beingamortized over the remaining vesting period of the stock options. The fairvalue of these unvested options as of the consummation date was computed andthe amount in excess of the intrinsic value was included in the respectivepurchase consideration (*see**Note 3*).

 

The Company appliesAccounting Principles Board Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations in accounting forits stock-based compensation plans. Had compensation cost for the Company’sstock-based compensation plans been determined based on the fair value at thegrant dates for awards under those plans consistent with the method prescribedin SFAS No. 123, *Accounting for Stock-Based Compensation*,the Company’s net income and earnings per share would have been reduced to thepro forma amounts indicated below:

 
| ** **                                                                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income — as reported                                                                                                          |       | $        | 48,349     |     | $          | 18,040   |       | $ | 38,547 |   |
| Add: Stock-based employee compensation expense included in reported  net income, net of related tax effects                            |       | 2,014    |       | 5,617    |       | 4,367    |       |
| Deduct: Total stock based employee compensation expense determined  under fair value method for all awards, net of related tax effects |       | (28,684  | )          | (31,805  | )          | (29,001  | )          |
| Net income (loss) — pro forma                                                                                                     |       | $        | 21,679     |     | $          | (8,148   | )          | $ | 13,913 |   |
|                                                                                                                                   |       |     |       |     |       |     |       |
| Basic earnings per share —  as reported                                                                                           |       | $        | 0.98       |     | $          | 0.37     |       | $ | 0.  83 |   |
| Basic earnings (loss) per  share — pro forma                                                                                      |       | $        | 0.44       |     | $          | (0.17    | )          | $ | 0.30 |   |
| Diluted earnings per share  — as reported                                                                                         |       | $        | 0.96       |     | $          | 0.36     |       | $ | 0.81 |   |
| Diluted earnings (loss)  per share — pro forma                                                                                    |       | $        | 0.43       |     | $          | (0.17    | )          | $ | 0.29 |   |
|                                                                                                                                        |            |          |            |          |            |          |            |  |  |  |  |

 

The pro forma amountsreflected above are not representative of the effects on reported net income infuture years because, in general, options granted typically do not vest forseveral years and additional awards are made each year.  However, on April 29, 2005, the Company’sBoard of Directors approved a plan to accelerate vesting of certain options (*see Note 14*) resulting in additional pro-forma expense ofapproximately $13,000, before tax, in 2005. The fair value of each option grant is estimated on the grant date usingthe Black-Scholes option-pricing model using the following weighted-averageassumptions:

 
| ** **              | ** ** | **2005**          | ** ** | **2004**          | ** ** | **2003**          | ** ** |
|-------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| Dividend yield          |       | 0.0               | %          | 0.0               | %          | 0.0               | %          |
| Expected life (years)   |       | 1.5  — 4.5   |       | 1.0  — 4.5   |       | 4.5               |       |
| Expected volatility     |       | 28.5  — 48.1 | %          | 33.0  — 55.0 | %          | 60.0              | %          |
| Risk-free interest rate |       | 3.16  — 3.99 | %          | 1.17  — 3.54 | %          | 2.38  — 3.03 | %          |

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), *Share based Payment*, which replaces SFAS No. 123 *Accounting for Stock Based Compensation* and APB Opinion No25 *Accounting for Stock Issued to Employees*.  SFAS 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with the first annualperiod after June 15, 2005.  Thepro-forma disclosures previously permitted under SFAS No. 123 no longer will bean alternative to inclusion of the expense in the financial statements.  The Company is required to adopt SFAS 123Rbeginning January 1, 2006.  Under SFAS123R, the Company must determine the appropriate fair value model to be usedfor valuing share-based payments, the amortization method for compensation costand the transition method to be used at date of adoption.  The transition methods include prospectiveand retroactive adoption options. The Company expects to use the Black-Scholesoption pricing model to value options after the adoption.  In addition, the Company expects to utilizethe straight line method to amortize the expense and utilize the prospectivetransition method which requires that compensation expense begin being recordedfor all unvested stock options and restricted stock at the beginning of thefirst quarter of adoption of SFAS 123R. The Company has evaluated the requirements of SFAS 123R and expects theadoption of SFAS 123R will have a material impact on future consolidatedresults of operations and earnings per share. Upon adoption of SFAS 123R, thetax benefit from stock options will be presented as a component of financingactivities.  Compensation expense foroutstanding awards for which the requisite 

 

42

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

servicehad not been rendered as of the effective date will be recognized over theremaining service period using the compensation cost calculated for pro-formadisclosure purposes under SFAS 123.  TheCompany believes the balance to be expensed, before tax, in future periods willbe approximately $1,900 for stock options outstanding as of December 31, 2005under the SFAS 123 methodology.  If anynew awards are granted, the Company will incur additional expense in futureperiods related to those awards.

 

**Concentrationsof Customer Base and Credit Risk —**Four customers each exceeded 10% of the Company’ssales for 2005 and 2004, while only three customers exceeded 10% of sales for2003.** **The****four customers accounted for 55% of sales in 2005 and 57%of sales in 2004, while the three customers accounted for 48% of net sales in2003.  Accounts receivable from thesecustomers represented approximately 56% of trade receivables at December 31,2005 and 61% of trade receivables at December 31, 2004.  The Company’s top five customers, whichinclude three OEMs and two distributors, accounted for 64% of net sales for2005, 2004 and 2003.

 

The Company places cashand investments in several high-quality financial institutions and seeks tolimit the credit exposure from any one institution, issuer or instrument.

 

**IncomeTaxes** — TheCompany accounts for income taxes using the asset and liability method. TheCompany provides for income taxes currently payable and, in addition, providesdeferred income taxes for temporary differences between the tax bases of assetsand liabilities and their reported amounts in the financial statements.Temporary differences relate principally to the allowance for doubtfulaccounts, allowance for sales returns, liability for warranty claims,unrealized gain (loss) on investments, acquired in-process research anddevelopment expenses, acquired intangible assets, foreign subsidiaryintangibles, accumulated depreciation, loss on write-down of investments andinventory reserves. The Company intends to permanently reinvest its earningsfrom foreign subsidiaries in its international operations and, accordingly, noprovision for any incremental net U.S. federal or state income taxes has beenmade for these unremitted earnings. Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized.

 

**ForeignCurrency** — TheCompany records transactions denominated in foreign currencies on a monthlybasis using the average monthly exchange rate. Assets and liabilitiesdenominated in foreign currencies are translated at the balance sheet datesusing the closing rates of exchange between those foreign currencies and theU.S. Dollar with any transaction gains or losses reported in other income(expense). Adjustments from translating financial statements of internationalsubsidiaries are recorded as a separate component of stockholders’ equity.

 

The Company uses forwardcontracts to reduce its foreign currency exposure related to the net cash flowsfrom its European and Asian operations. The majority of these contracts areshort-term contracts (three months or less) and are marked-to-market eachquarter and included in trade payables, with the offsetting gain or lossincluded in other income (expense) in the accompanying consolidated statementsof income. At December 31, 2005 and 2004, the Company had one such contractoutstanding with a fair value of zero.

 

**RevenueRecognition** — TheCompany generally records sales upon shipment of the related product, net ofany discounts as the Company generally has no significant post deliveryobligations, the product price is fixed and determinable, collection of theresulting receivable is probable, and product returns are reasonably estimable.Product shipments occur upon receipt of a purchase order from a customer.Revenue on products shipped FOB destination is recorded when the customer takespossession of the goods. The Company’s shipping and handling fees are includedin net sales, and the related costs are included in cost of sales in theaccompanying consolidated statements of operations.

 

The Company generallyrecords royalty revenue from OEMs upon shipment of the related products inwhich its software or firmware is embedded by the OEMs, based upon shipmentdata provided by the OEMs.  The Companygenerally records license revenue from sales of its software upon shipment orelectronic transfer of the software.  TheCompany generally defers revenues from the sale of extended warranty agreementsand software support and maintenance agreements.  The deferred revenue is amortized into incomeon a pro rata basis over the applicable contract lives.

 

**Researchand Development Expense** — Research and development costs are expensed as incurred. In-processresearch and development obtained through acquisitions of other companies isexpensed upon consummation of the acquisition.

 

**SoftwareDevelopment Costs**—****The costs of software development for the Company’sproducts incurred between achieving technological feasibility and theintegration into the Company’s products available for sale to customers havenot been material to date. Such costs, if material, would be capitalized.Additionally, costs related to development of internal use software, other thanthose incurred during the application development stage, are expensed asincurred.

 

**AdvertisingExpense****—** Advertising costs are expensed as incurred and are includedas a component of selling, general and administrative expenses. Advertisingexpense totaled approximately $7,517, $6,254 and $6,793 for the years endedDecember 31, 2005, 2004 and 2003, respectively.

 

The Company participatesin cooperative advertising and market development programs with certaindistributors and OEMs. 

 

43

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

These programs are usedby the Company to reimburse distributors and OEMs for the actual costs ofcertain forms of advertising, and in general, allow distributors and OEMsreimbursement up to a specified percentage of net purchases. The Company’scosts associated with these programs are estimated and accrued at the time ofsale, and are included in sales and marketing expenses in the accompanyingconsolidated statements of operations.

 

**NetInvestment Income**—****Net investment income includes incomefrom interest, dividends, rental property held for lease and accretion of bondpremiums and discounts, net of related expenses.

 

**NetRealized Investment Gains (Losses) —**Net realized investment gains (losses) include gains(losses) realized upon the sales or calls of investments and losses realized oninvestments when a decline in fair value is determined by management to beother than temporary.

 

**OtherIncome (Expense), net —**Other income (expense), net consists primarily of foreign currencyexchange gains or losses and interest expense.

 

**ComprehensiveIncome —**Comprehensiveincome includes all changes in equity (net assets) during a period fromnon-owner sources. Items included in comprehensive income include net income,foreign currency translation adjustments, and unrealized gains and losses onavailable-for-sale securities.

 

**EarningsPer Share —**Earningsper common share, and earnings per common share assuming dilution, are based onthe weighted average number of common and common equivalent, when dilutive,shares outstanding during the year (see *Note 12*).

 

**Use ofEstimates**— Thepreparation of the Company’s consolidated financial statements in conformitywith accounting principles generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosures of contingent assets and liabilitiesat the dates of the financial statements and reported amounts of revenues andexpenses during the reporting periods. Actual results could differ from thoseestimates.

 

**Reclassifications**— Certainreclassifications have been made to the 2004 and 2003 consolidated financialstatements in order to conform to the 2005 presentation. These reclassificationshad no effect on previously reported net income, net cash provided by operatingactivities, net cash used in investing activities or total stockholders’equity.

 

**RecentlyIssued Accounting Standards and Recent Legislation**— See above fordiscussion regarding SFAS 123R.

 

TheEuropean Union has finalized the Waste Electrical and Electronic EquipmentDirective, which makes producers of electrical goods, including computers andperipherals, financially responsible for specified collection, recycling, treatment,and disposal of past and future covered products.  This deadline to enact and implement thedirective by individual European Union governments generally wasAugust 13, 2004, although extensions were granted to some countries (suchlegislation, together with the directive, the “WEEE Legislation”), andproducers are financially responsible under the WEEE Legislation beginning inAugust 2005.  Similar legislationhas been or may be enacted in other geographies, including in the United Statesand Japan, the cumulative impact of which could be significant for us.  The Company will incur some costs under theWEEE legislation but the level and timing of these costs are difficult topredict.

 

**3.             Acquisitions**

** **

**Sonic Mobility Inc.** — On August 31, 2004, theCompany acquired all of the outstanding stock of Sonic Mobility, based inCalgary, Canada. Sonic Mobility has developed (i) software products andtechnologies that allow for management of network and data centerinfrastructure from mobile devices, (ii) security software for intranet andextranet resource access from mobile handheld devices and (iii) softwareproducts and technologies for managing mobile devices centrally by ITadministrators. The Company’s current management products and technologiesprimarily provide management and access products and technologies for fixedplace IT devices.  The addition of SonicMobility’s proprietary products expands the Company’s markets to include bothintegrated and stand-alone products and technologies for the expanding mobileIT device market. The results of Sonic Mobility’s operations have been includedin the consolidated financial statements since the date of acquisition.

 

Theacquisition was recorded under the purchase method of accounting, and thepurchase price was allocated based on the fair value of the assets acquired andliabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and will be amortized over therespective estimated useful lives.  Theremaining amounts of purchased research and development were expensed upon theclosing of the transaction.  The goodwillrecorded as a result of the acquisition is not amortized but is included in theCompany’s review of goodwill for impairment. The goodwill is amortizable fortax purposes.  A summary of the totalpurchase consideration is as follows:

 

 

44

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 
| Cash paid for outstanding shares |   | $      | 8,948  |   |
|----------------------------------|--------|--------|--------|--------|
| Acquisition costs                |   | 299    |   |
|                             |   |   |   |
| Total purchase  consideration    |   | $      | 9,247  |   |

 

TheCompany funded the acquisition through available cash. On the closing of theSonic Mobility transaction, the Company acquired $106 in cash held by SonicMobility.

 

The purchaseconsideration was allocated to the estimated fair values of the assets acquiredand liabilities assumed, as follows:

 
| ** **                           | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                      |       | $                               | 491        |                     | Various    |   |
| In-process research and  development |       | 1,050                           |       | —                   |       |
| Developed technology                 |       | 1,420                           |       | 3  years                 |       |
| Customer base                        |       | 610                             |       | 5  years                 |       |
| Non-compete agreements               |       | 1,060                           |       | 3  years                 |       |
| Goodwill                             |       | 5,203                           |       | —                   |       |
| Assumed liabilities                  |       | (587                            | )          | —                   |       |
|                                 |       |                            |       |                     |       |
|                                 |       | $                               | 9,247      |                     |       |   |

 

Thefair value of all of the in-process research and development (“IPR&D”)received in the acquisition was determined using a form of the discounted cashflow method known as the multi-period excess earnings method.  These amounts were deemed to be forparticular research and development projects that have no alternative futureuses and were therefore expensed rather than capitalized at the time of purchase.

 

SonicMobility’s in-process research and development activities consisted of anupgrade of its Sonic Sentry product, software that allows for managing mobiledevices centrally by IT administrators. The upgrade was planned to roll out in two phases, one in the fall of2004 and the second in 2005.   The firstphase was completed and available for shipping during the fourth quarter of2004, while the second phase was completed and available for shipping during2005.

 

**OSA Technologies, Inc.** — On April 6, 2004, theCompany acquired the outstanding stock of OSA. OSA is headquartered in San Jose, California and has additional officesin Shanghai, China and Taipei, Taiwan. OSA has developed embedded manageabilityfirmware and software using Intelligent Platform Management Interface (“IPMI”)products and technologies. The acquisition of OSA enhances the Company’sposition in the embedded management market and OSA’s embedded managementproducts and technologies for the IPMI market complements the Company’s coreKVM business and builds upon prior acquisitions.  The results of OSA’s operations have beenincluded in the consolidated financial statements since the date ofacquisition.

 

Theacquisition was recorded under the purchase method of accounting, and the purchaseprice was allocated based on the fair value of the assets acquired andliabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and will be amortized over therespective estimated useful lives.  Theremaining amounts of purchased research and development were expensed upon theclosing of the transaction.  The goodwillrecorded as result of the acquisition is not amortized but is included in theCompany’s review of goodwill for impairment. Additionally, the goodwillrecorded upon the OSA acquisition is not amortizable for tax purposes.  The excess of the fair value over theintrinsic value of the unvested OSA options and the fair value of the vestedOSA options at the date of consummation have been included in the purchaseconsideration. A summary of the total purchase consideration is as follows:

 

 
| Cash paid for outstanding shares                     |   | $      | 51,685  |   |
|------------------------------------------------------|--------|--------|---------|--------|
| Value of common stock  issued for outstanding shares |   | 45,831 |    |
| Value of stock options  assumed                      |   | 2,526  |    |
| Acquisition costs                                    |   | 1,113  |    |
|                                                 |   |   |    |
| Total purchase  consideration                        |   | $      | 101,155 |   |

 

TheCompany funded the acquisition through available cash and by the issuance of1,229 shares of Avocent common stock. The common stock, valued at approximately $45,831, was recorded asnon-cash consideration for the acquisition of OSA. On 

 

45

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

theclosing of the OSA transaction, the Company acquired $5,619 in cash held byOSA.

 

The purchaseconsideration was allocated to the estimated fair values of the assets acquiredand liabilities assumed, as follows:

 
| ** **                           | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                      |       | $                               | 11,718     |                     | Various    |   |
| In-process research and  development |       | 21,720                          |       | —                   |       |
| Developed technology                 |       | 12,380                          |       | 3  years                 |       |
| Customer base                        |       | 4,260                           |       | 5  years                 |       |
| Trademarks                           |       | 3,240                           |       | 3  years                 |       |
| Non-compete agreements               |       | 960                             |       | 3  years                 |       |
| Goodwill                             |       | 57,131                          |       | —                   |       |
| Deferred taxes                       |       | (8,544                          | )          | Various                  |       |
| Assumed liabilities                  |       | (1,710                          | )          | —                   |       |
|                                 |       |                            |       |                     |       |
|                                 |       | $                               | 101,155    |                     |       |   |

 

Additionally,the Company recorded $6,351 of deferred compensation related to the intrinsicvalue of the unvested OSA employee stock options at the time of the acquisitionon April 6, 2004.  The deferredcompensation is being amortized on a straight-line basis over the vestingperiod of the options for which it was recorded.

 

The fair value of all ofthe in-process research and development (“IPR&D”) received in theacquisition was determined using a form of the discounted cash flow methodknown as the multi-period excess earnings method.  These amounts were deemed to be forparticular research and development projects that have no alternative futureuses and were therefore expensed rather than capitalized at the time ofpurchase.

 

OSA’s in-process researchand development activities consisted of an upgrade of its Firmware Suite toVersion 2.0 and an embedded server management product.  These projects were still in process at theend of 2005 but are expected to be completed during 2006.

 

The new generations ofproducts under development are projected to sell through sales channels and tocustomers that are substantially the same as current and historical saleschannels and customers. Pricing and margins will not differ significantly fromhistorical pricing and margins.  Revenuefor the projects under development was projected through 2012, with 50% of OSA’sforecasted revenue in 2006 coming from projects currently in development.   Net income attributable to IPR&D wascalculated by applying OSA’s projected gross, operating and net profit marginsto IPR&D revenue, while considering Avocent’s historical results andindustry prospects.

 

Revenue growth related tothe in-process research and development is embodied in products to be launchedduring 2006. These products have estimated economic lives ranging from approximatelysix to nine years. The product life cycle is characterized by a gradual 2 to 3year ramp up period, followed by a 1 to 2 year plateau, followed by a 3 to 4year decline period. Gross margins are projected to be well above historicalAvocent margins as these products are primarily software. The discount rateused to value IPR&D was 24%.

 

**Crystal Link Technologies**—On January 6,2004, the Company acquired the outstanding common shares of Crystal Link forapproximately $6,652 in cash and common stock, plus the assumption ofliabilities and payment of certain acquisition costs.  The purchase agreement called for additionalpotential earn-out payments of up to $5,000 based on future technicalenhancements and achievement of certain sales goals.  In October 2004, the Company paid $2,000 ofthe earn-out consideration based on the achievement of the specified technologyenhancements.  The remaining $3,000 ofpotential earn-out consideration was not paid as the goals specified were notmet.  The results of Crystal Link’soperations have been included in the consolidated financial statements sincethe date of acquisition.  Crystal Link,headquartered in Escondido, CA, has developed wireless technology for KVMswitching and extension products.

** **

Theacquisition was recorded under the purchase method of accounting, and thepurchase price was allocated based on the fair value of the assets acquired andliabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and are amortized over therespective estimated useful lives.  Theremaining amounts of purchased research and development were expensed upon theclosing of the transaction.  The goodwillrecorded as a result of the acquisition, including the earn-out consideration,is not amortized but is included in our review of goodwill for impairment.  The goodwill is amortizable for tax purposes.A summary of the total purchase consideration is as follows:

 

46

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 
| Cash paid for outstanding  shares                    |   | $      | 5,152 |
|------------------------------------------------------|--------|--------|-------|
| Value of common stock  issued for outstanding shares |   | 3,500  |
| Acquisition costs                                    |   | 163    |
|                                                 |   |   |
| Total purchase  consideration                        |   | $      | 8,815 |
|                                                      |        |        |       |  |

 

Thepurchase consideration was allocated to the estimated fair values of the assetsacquired and liabilities assumed, as follows:

 
| ** **                          | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                     |       | $                               | 295        |                     | Various    |   |
| In-process research and development |       | 6,490                           |       | —                   |       |
| Developed technology                |       | 520                             |       | 3  years                 |       |
| Non-compete agreements              |       | 500                             |       | 3  years                 |       |
| International marketing rights      |       | 1,250                           |       | 3  years                 |       |
| Goodwill                            |       | 1,857                           |       |                     |       |
| Assumed liabilities                 |       | (2,097                          | )          | —                   |       |
|                                |       |                            |       |                     |       |
|                                |       | $                               | 8,815      |                     |       |   |

 

Theacquisition was funded through available cash and by the issuance of 107 sharesof Avocent common stock.  The commonstock, valued at approximately $3,500, was recorded as non-cash considerationfor the acquisition of Crystal Link. On the closing of the Crystal Linktransaction, the Company acquired $4 in cash held by Crystal Link.

 

**Acquisition of Soronti —**On November 17, 2003, the Company acquired the outstanding preferredand common shares of Soronti for approximately $7,000 in cash and stock, plusthe assumption of liabilities and payment of certain acquisition costs.

** **

**The results of Soronti’s operations have been includedin the consolidated financial statements since that date.  Soronti, headquartered in Draper, Utah, hasdeveloped server and system management products for the control of IT.  Soronti’s products included a virtualpresence PCI adaptor and a virtual presence stand alone unit.**

** **

Theacquisition was recorded under the purchase method of accounting, and thepurchase price was allocated based on the fair value of the assets acquired andliabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and will be amortized over therespective estimated useful lives.  Theremaining amounts of purchased research and development were expensed upon theclosing of the transaction.  The goodwillrecorded as a result of the acquisition is not amortized but is included in theCompany’s annual review of goodwill for impairment.  A summary of the total purchase considerationis as follows:

 
| Cash paid for outstanding shares                     |   | $      | 5,848  |   |
|------------------------------------------------------|--------|--------|--------|--------|
| Value of common stock  issued for outstanding shares |   | 1,152  |   |
| Acquisition costs                                    |   | 207    |   |
|                                                 |   |   |   |
| Total purchase  consideration                        |   | $      | 7,207  |   |

 

 

47

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

The purchaseconsideration was allocated to the estimated fair values of the assets acquiredand liabilities assumed, as follows:

 
| ** **                           | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                      | ** ** | $                               | 800        | ** **               | Various    | ** ** |
| In-process research and  development |       | 3,940                           |       | —                   |       |
| Developed technology                 |       | 500                             |       | 3  years                 |       |
| International marketing  rights      |       | 668                             |       | 3  years                 |       |
| Goodwill                             |       | 2,412                           |       | —                   |       |
| Deferred taxes                       |       | (270                            | )          | 3  years                 |       |
| Assumed liabilities;                 |       | (843                            | )          | —                   |       |
|                                 |       |                            |       |                     |       |
|                                 |       | $                               | 7,207      |                     |       |   |

 

Theacquisition was funded through available cash and by the issuance of 31 sharesof Avocent common stock.  The commonstock, valued at approximately $1,152, was recorded as non-cash considerationfor the acquisition of Soronti, Inc. On the closing of the Soronti transaction,the Company acquired $535 in cash held by Soronti.

 

The fair value of all ofthe in-process research and development (“IPR&D”) received in theacquisition was determined using a form of the discounted cash flow methodknown as the multi-period excess earnings method.  These amounts were deemed to be forparticular research and development projects that have no alternative futureuses and were therefore expensed rather than capitalized at the time ofpurchase.

 

Soronti’s in-processresearch and development activities consisted of the development of the RemoteOffice Branch Office (“ROBO”) product, an appliance with both KVM and serialports that utilizes the SwitchView IP technology to provide the user accessover IP, a mezzanine card based on the virtual presence technology that is asmall form factor card designed for integration into existing analog KVMswitches, embedded KVM redirection circuitry for remote server management,which essentially integrates the technology from the mezzanine card into theserver motherboard, and a PCI card which is an add-in card that provides remotemanagement of a server. The work remaining to be performed on these projectsvaried, but at the time of the acquisition, the projects were considered to bein early concept form, prototype form, or mid-design form.  The ROBO project essentially competed withproducts currently sold by Avocent and the project has been abandoned at thistime.  The results of our IPR&Dvaluation work yielded no value from the ROBO product.  The other projects were completed during2004.

 

**Pro FormaFinancial Information —**The following unaudited pro forma summary combines the results ofoperations of Avocent, Soronti, Crystal Link, OSA and Sonic Mobility as if theacquisitions had occurred at the beginning of each period presented.  Certain adjustments have been made to reflectthe impact of the purchase transactions. These pro forma results have beenprepared for the years ended December 31, 2004 and 2003 for comparativepurposes only and do not purport to be indicative of what would have occurredhad the acquisitions been made at the beginning of each period presented, or ofresults which may occur in the future. The results of operations for all of these acquisitions are included inAvocent’s 2005 results of operations.

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |
| Net sales                |       | $        | 366,155    |     | $          | 307,032 |   |
| Net income               |       | $        | 44,844     |     | $          | 28,291 |   |
| Income per basic share   |       | $        | 0.92       |     | $          | 0.61 |   |
| Income per diluted share |       | $        | 0.89       |     | $          | 0.59 |   |

 

**The above amounts exclude acquired in-process researchand development expense of $789 (net of a $261 tax benefit) related to theSonic Mobility acquisition, $21,720 related to the OSA acquisition, $3,829 (netof a $2,661 tax benefit) related to the Crystal Link acquisition, and $3,940related to the Soronti acquisition.**

 

 

 

 

48

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

**4.**             Inventories

 

Inventories consist ofthe following at December 31, 2005 and 2004:

 
| ** **           | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------|------------|----------|------------|----------|------------|
| Raw materials, net   |       | $        | 3,625      |     | $          | 4,411 |   |
| Work in process, net |       | 173      |       | 356      |       |
| Finished goods, net  |       | 17,380   |       | 16,465   |       |
|                 |       |     |       |     |       |
| Inventories, net     |       | $        | 21,178     |     | $          | 21,232 |   |

 

Asof December 31, 2005 and 2004, inventories above have been reduced by reservesfor excess and obsolete inventories of $4,558 and $3,785, respectively.

 

**5.**             Investments

** **

All investments inpublicly traded securities at December 31, 2005 and 2004, are classified asavailable-for-sale and are carried at fair value.   The Company includes certain investmentswith original maturities of less than 90 days as short term investments whensuch investments are a part of our investment portfolio.  Investments at December 31, 2005 and 2004 areas follows:

 
| ** **                                                        | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| **Current investments:**                                          | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Corporate bonds                                                   |       | $                     | 28,949     |   | $ |   |   | $ | (253 | ) | $ | 28,696 |   |
| Municipal bonds                                                   |       | 162,654               |       | 16 |   | (61 | ) | 162,609 |   |
| Mortgage-backed securities guaranteed by U.S. government agencies |       | 12,682                |       | 86 |   | (22 | ) | 12,746 |   |
| U.S. government agency  obligations                               |       | 23,601                |       | — |   | (174 | ) | 23,427 |   |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Total                                                             |       | $                     | 227,886    |   | $ | 102 |   | $ | (510 | ) | $ | 227,478 |   |
|                                                                   |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                        | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| **Non-current investments:**                                      | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Corporate bonds                                                   |       | $                     | 4,749      |   | $ | — |   | $ | (41 | ) | $ | 4,708 |   |
| Municipal bonds                                                   |       | 3,083                 |       | — |   | (23 | ) | 3,060 |   |
| Mortgage-backed securities guaranteed by U.S. government agencies |       | 29,834                |       | 42 |   | (134 | ) | 29,742 |   |
| U.S. government agency  obligations                               |       | 14,624                |       |   |   | (195 | ) | 14,429 |   |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Totals                                                            |       | $                     | 52,290     |   | $ | 42 |   | $ | (393 | ) | $ | 51,939 |   |
|                                                                   |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

 
| ** **                                                        | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| **Current investments:**                                          | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Corporate bonds                                                   |       | $                     | 32,459     |   | $ | 1 |   | $ | (133 | ) | $ | 32,327 |   |
| Municipal bonds                                                   |       | 93,409                |       | 20 |   | (68 | ) | 93,361 |   |
| Mortgage-backed securities guaranteed by U.S. government agencies |       | 14,209                |       | 67 |   | (28 | ) | 14,248 |   |
| U.S. government agency obligations                                |       | 14,704                |       | — |   | (98 | ) | 14,606 |   |
| Time deposits                                                     |       | 40,533                |       | — |   | — |   | 40,533 |   |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Total                                                             |       | $                     | 195,314    |   | $ | 88 |   | $ | (327 | ) | $ | 195,075 |   |
|                                                                   |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

49

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 
| ** **                                                        | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| **Non-current investments:**                                      | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Corporate bonds                                                   |       | $                     | 32,672     |   | $ | — |   | $ | (155 | ) | $ | 32,517 |   |
| Municipal bonds                                                   |       | 5,654                 |       | — |   | (33 | ) | 5,621 |   |
| Asset-backed securities                                           |       | 1,222                 |       | — |   | (7 | ) | 1,215 |   |
| Mortgage-backed securities guaranteed by U.S. government agencies |       | 33,154                |       | 157 |   | (66 | ) | 33,245 |   |
| U.S. government agency  obligations                               |       | 17,726                |       | 3 |   | (110 | ) | 17,619 |   |
|                                                              |       |                  |       |   |   |   |   |   |   |
| Totals                                                            |       | $                     | 90,428     |   | $ | 160 |   | $ | (371 | ) | $ | 90,217 |   |
|                                                                   |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Scheduled maturities ofnon-current investments are as follows:

 
| ** **                 | ** ** | **December 31, 2005** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **Amortized  Cost**   | ** ** | **Estimated  Fair  Value** | ** ** |
| Due within two years       |       | $                     | 22,456     |   | $ | 22,197 |   |
| Due two to three years     |       | 0                     |       | 0 |   |
| Mortgage-backed securities |       | 29,834                |       | 29,742 |   |
|                       |       |                  |       |   |   |
| Totals                     |       | $                     | 52,290     |   | $ | 51,939 |   |
|                            |            |                       |            |  |  |  |  |  |  |  |

 

The Company anticipatesprepayments of approximately 25% per year on mortgage-backed securities.

 

As of December 31, 2005substantially all of the Company’s investments that had unrealized losses werein a loss position for less than twelve months. The unrealized losses include 96 individual securities and have beencaused by slight upward variations in interest rates in the particularsecurities since the time they were acquired. Most of these investments havebeen acquired within the past 12 months, are of high credit quality, areinsured or are guaranteed by an agency of the US government, and Avocentanticipates that the Company will realize the full par value upon maturity ofthese securities.

 

Net realized gains (losses)for the years ended December 31, 2005, 2004, and 2003 is comprised of thefollowing:

 
| ** **                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |     |       |
| Gross realized gains                    |       | $        | 20         |     | $          | 31       |       | $ | 3,191 |   |
| Gross realized losses                   |       | (830     | )          | (3,835   | )          | (572     | )          |
| Net realized investment  gains (losses) |       | $        | (810       | )        | $          | (3,804   | )          | $ | 2,619 |   |

 

In the second quarter of2002, the Company made a $1,000 investment in Rymic Systems, Inc., aprivately-held company based in Huntsville, Alabama, that develops hardware andsoftware products and technologies for remote monitoring and control ofvehicles and equipment over the internet using standard desktop webbrowsers.  The Company purchased 400shares of Rymic’s common stock, giving Avocent approximately a 14% equityposition in Rymic.  During 2004, as aresult of Rymic’s declining financial condition, the Company recorded animpairment charge of $450 against its investment in Rymic, which was includedin net realized investment losses in the accompanying consolidated statementsof income and which reduced its net carrying value to nil.

 

In the second quarter of2003 the Company made a $3,000 preferred stock investment in VIEO, Inc., aprivately held company based in Austin, Texas. VIEO provides managementproducts for Adaptive Application Infrastructure Management.  VIEO’s products combine application-awarenetworking hardware with intelligent infrastructure management software in asecure, purpose-built appliance to measure, analyze and control applicationresources.  The Company’s investment,which represents less than 10% ownership in VIEO, is being accounted for on thecost method. During 2004, as a result of VIEO’s declining financial conditionand its planned recapitalization, the Company recorded an impairment charge of$3,000 against its investment in VIEO, which was included in net realizedinvestment losses in the accompanying consolidated statements of income, andwhich reduced the net carrying value of the investment to nil.

 

50

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

**6.             PropertyHeld for Lease**

** **

In the fourth quarter of2005, the Company sold a building that it owned and had previously occupied inHuntsville, Alabama. The Company had an agreement to lease the building to anunrelated party. Rental income totaled approximately $202 for the year endedDecember 31, 2005 and $221 for each of the years ended December 31, 2004 and2003. The Company received approximately $1,912 from the sale of the building,resulting in a gain on disposal of approximately $727.

 

Property held for leaseconsisted of the following at December 31, 2004:

 
| ** **                   | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|
| Building                     |       | $        | 2,306      |   |
| Accumulated depreciation     |       | (976     | )          |
|                         |       |     |       |
| Property held for lease, net |       | $        | 1,330      |   |

 

**7.             Propertyand Equipment**

** **

Property and equipmentconsists of the following at December 31, 2005 and 2004:

 
| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Land and land improvements       |       | $        | 4,795      |     | $          | 4,814 |   |
| Buildings                        |       | 23,321   |       | 22,424   |       |
| Leasehold improvements           |       | 2,454    |       | 2,433    |       |
| Computer software and  equipment |       | 22,330   |       | 21,330   |       |
| Other equipment                  |       | 14,601   |       | 13,244   |       |
| Construction in progress         |       | 591      |       | 1,787    |       |
|                             |       |     |       |     |       |
|                             |       | 68,092   |       | 66,032   |       |
| Less accumulated  depreciation   |       | (31,291  | )          | (26,136  | )          |
|                             |       |     |       |     |       |
| Property and equipment, net      |       | $        | 36,801     |     | $          | 39,896 |   |

** **

Depreciation expense was$7,037, $6,222, and $4,859 for the years ended December 31, 2005, 2004 and2003, respectively.

 

**8**.             **Goodwill and OtherIntangible Assets**

** **

**Other intangible assets subject to amortization,including the intangible assets from the Crystal Link, OSA, Sonic Mobility, andSoronti acquisitions detailed in Note 3, are as follows:**

 
| ** **                       | ** ** | **December 31, 2005**        | ** ** | **December 31, 2004**         | ** ** |
|----------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | **Gross  Carrying  Amounts** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amounts** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed technology             |       | $                            | 14,820     |                          | $          | 8,293 |   | $ | 80,560 |   | $ | 62,293 |   |
| Patents and trademarks           |       | 9,174                        |       | 4,959                         |       | 21,508 |   | 14,318 |   |
| Customer base and  certification |       | 4,870                        |       | 1,719                         |       | 6,483 |   | 1,961 |   |
| Non-compete agreements           |       | 2,520                        |       | 1,289                         |       | 5,793 |   | 3,070 |   |
| Other assets                     |       | 1,814                        |       | 1,175                         |       | 1,814 |   | 535 |   |
|                             |       | $                            | 33,198     |                          | $          | 17,435 |   | $ | 116,158 |   | $ | 82,177 |   |

 

**For the years ended December 31, 2005, 2004 and 2003,amortization expense for other intangible assets was $18,509, $24,279 and$21,805, respectively. **During 2005, the Companyretired approximately $83,000 of fully amortized other intangible assets andthe related accumulated amortization, recorded as a result of prioracquisitions.  The retirement had noimpact on reported earnings. The approximate future annual amortization for other intangible assetsis as follows:

** **
| **Years ending  December 31:** |   |   |   |
|--------------------------------|--------|--------|--------|
| 2006                           |   | 9,500  |   |
| 2007                           |   | 3,900  |   |
| 2008                           |   | 1,900  |   |
| 2009                           |   | 500    |   |
| Total                          |   | $      | 15,800 |   |
|                                |        |        |        |  |

** **

**51**

----

** **

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

** **

**In 2005, the Company recorded $100 ofadditional goodwill related to the Crystal Link Technologies acquisition.**In 2004, the Company recorded$5,203 of goodwill as result of the Sonic Mobility acquisition, $57,131 ofgoodwill as result of the OSA acquisition and $1,857 of goodwill as a result ofthe acquisition of Crystal Link.

** **

**The Company performed an annual impairment test ofgoodwill in the fourth quarter of 2005, 2004 and 2003.  The test in the fourth quarter of each yearconcluded that there had been no impairment of goodwill and that no adjustmentswere required.**

** **

**9.             ProductWarranties**

** **

The activity within theliability for warranty returns in 2005 and 2004 is as follows:

 
| ** **                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                      |       |     |       |     |       |
| Balance, beginning of year                                |       | $        | 2,760      |     | $          | 2,652 |   |
|                                                      |       |     |       |     |       |
| Accruals for product  warranties issued during the period |       | 252      |       | 528      |       |
| Settlements made during  the period                       |       | (176     | )          | (420     | )          |
|                                                      |       |     |       |     |       |
| Balance, end of year                                      |       | $        | 2,836      |     | $          | 2,760 |   |
|                                                           |            |          |            |          |            |  |  |  |

 

Deferred revenue related tothe Company’s extended warranty program was $1,922 at December 31, 2005 and$1,666 at December 31, 2004.  The Companyrecorded earned revenue from the amortization of deferred revenue related toextended warranties of $912 during 2005, $607 during 2004 and $282 during2003.  In addition, the Company recordednew extended warranties of $1,168 during 2005, $1,227 during 2004, and $710during 2003.

 

**10.          Income Taxes**

** **

The provision for incometaxes for the years ended December 31, 2005, 2004 and 2003 is comprised of thefollowing:

 
| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Current:                         |       |     |       |     |       |     |       |
| U.S. Federal                     |       | $        | 17,667     |     | $          | 14,175   |       | $ | 13,356 |   |
| U.S. State                       |       | 273      |       | 1,582    |       | 1,198    |       |
| Foreign                          |       | 4,422    |       | 4,075    |       | 4,203    |       |
|                             |       |     |       |     |       |     |       |
|                             |       | 22,362   |       | 19,832   |       | 18,757   |       |
| Deferred:                        |       |     |       |     |       |     |       |
| U.S. Federal                     |       | (2,914   | )          | (6,367   | )          | (3,676   | )          |
| U.S. State                       |       | (345     | )          | (1,092   | )          | (540     | )          |
| Foreign                          |       | (366     | )          | 79       |       | (42      | )          |
|                             |       |     |       |     |       |     |       |
|                             |       | (3,625   | )          | (7,380   | )          | (4,258   | )          |
|                             |       |     |       |     |       |     |       |
| Total provision for income taxes |       | $        | 18,737     |     | $          | 12,452   |       | $ | 14,499 |   |
|                                  |            |          |            |          |            |          |            |  |  |  |  |  |

 

52

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

The provision for federal income taxesdiffers from the amount computed by applying the statutory rate of 35% totaxable income as follows:

 
| ** **                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                              |       |     |       |     |       |     |       |
| Expected federal income  tax provision                            |       | $        | 23,480     |     | $          | 10,672   |       | $ | 18,566 |   |
| Add (deduct):                                                     |       |     |       |     |       |     |       |
| Extraterritorial income exclusion benefit                         |       | (64      | )          | (35      | )          | (63      | )          |
| State income tax (benefit), net of federal tax                    |       | (47      | )          | 318      |       | (642     | )          |
| Tax effect resulting from foreign operations taxed at lower rates |       | (7,450   | )          | (7,848   | )          | (7,231   | )          |
| Acquired in-process research and development                      |       | —   |       | 7,602    |       | 1,379    |       |
| Compensation expense                                              |       | 705      |       | 1,984    |       | 1,488    |       |
| Municipal bond interest income                                    |       | (1,074   | )          | (602     | )          | (179     | )          |
| Foreign stock option incentive transfer                           |       | (517     | )          | (848     | )          | —   |       |
| Subpart F income                                                  |       | 1,447    |       | 1,110    |       | 449      |       |
| R & E Credit                                                  |       | (833     | )          | (325     | )          | (264     | )          |
| Repatriation dividend                                             |       | 3,809    |       | —   |       | —   |       |
| Other                                                             |       | (719     | )          | 424      |       | 996      |       |
|                                                              |       |     |       |     |       |     |       |
|                                                              |       | $        | 18,737     |     | $          | 12,452   |       | $ | 14,499 |   |

 

The components ofthe net deferred income tax assets and liabilities at December 31, 2005 and2004, are as follows:

 
| ** **                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net current deferred  income tax assets:                       |       |     |       |     |       |
| Allowance for doubtful accounts                                |       | $        | 340        |     | $          | 454 |   |
| Allowance for sales returns and liability for warranty returns |       | 1,289    |       | 1,377    |       |
| Inventory reserves                                             |       | 1,451    |       | 1,620    |       |
| Acquired operating loss carryforwards                          |       | 44       |       | 2,013    |       |
| Other                                                          |       | 930      |       | 1,256    |       |
|                                                           |       |     |       |     |       |
|                                                           |       | $        | 4,054      |     | $          | 6,720 |   |
|                                                           |       |     |       |     |       |
| Net noncurrent deferred  income tax liabilities:               |       |     |       |     |       |
| Accumulated depreciation                                       |       | $        | (2,608     | )        | $          | (3,258 | ) |
| Foreign subsidiary intangibles                                 |       | —   |       | 2,039    |       |
| Acquired developed technology                                  |       | 3,011    |       | 3,277    |       |
| Acquired intangible assets                                     |       | (4,986   | )          | (11,583  | )          |
| Loss on investments                                            |       | 272      |       | 136      |       |
| Acquired operating loss carryforwards                          |       | 478      |       | 1,380    |       |
| Capital loss carryforward                                      |       | 314      |       | 611      |       |
| Research credit carryforward                                   |       | 388      |       | 388      |       |
| Allowance for impairment on investments                        |       | 1,450    |       | 1,445    |       |
| Other                                                          |       | (329     | )          | (567     | )          |
|                                                           |       |     |       |     |       |
|                                                           |       | (2,010   | )          | (6,  132 | )          |
| Less valuation allowance                                       |       | (554     | )          | (2,853   | )          |
|                                                           |       |     |       |     |       |
|                                                           |       | $        | (2,564     | )        | $          | (8,985 | ) |
|                                                           |       |     |       |     |       |
| Net deferred income tax  asset (liability)                     |       | $        | 1,490      |     | $          | (2,265 | ) |
|                                                                |            |          |            |          |            |  |  |  |  |

 

During2005, the Company wrote off deferred tax assets of $2,466 arising from aforeign subsidiary.  Since the Companyhad full valuation allowances recorded against the deferred tax assets, thewrite off had no impact on reported earnings.

 

Periodically,the Company faces challenges from domestic and foreign tax authoritiesregarding the amount of taxes due. These challenges include questions regardingthe timing and amount of deductions and the allocation of income among varioustax jurisdictions. In evaluating the exposure associated with various taxfiling positions, the Company records reserves for probable exposures. Based onmanagement’s evaluation of the Company’s tax position, it is believed theamounts related to these tax exposures are appropriately accrued as of December31, 2005 and 2004. To the extent the Company were 

 

53

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

toprevail in matters for which accruals have been established or be required topay amounts in excess of the aforementioned reserves, the Company’s effectivetax rate in a given financial statement period may be impacted.

 

In 2005, the Companyrepatriated $90,000 of foreign earnings in accordance with the provisions ofthe American Jobs Creation Act of 2004. Additional income tax expense of $3,809resulted from this transaction.  TheCompany intends to permanently reinvest the undistributed earnings ofapproximately $35,226 as of December 31, 2005 of its foreign subsidiaries inits international operations. Should the Company’s intent change, additionalincome tax expense would likely be recorded due to the differential in taxrates between the U.S. and the international jurisdictions.

 

For state income taxpurposes, at December 31, 2005, the Company has approximately $5,898 of netoperating loss carry forwards available to offset future taxable income incertain states.  These state netoperating loss carryforwards are subject to certain limitations.  If not utilized, the state net operating losscarry forwards will expire from 2013 to 2021.

 

**11.          Stockholders’Equity**

 

**PreferredStock** — TheCompany has 5,000 shares of $0.001 par value preferred stock authorized and noshares issued and outstanding at December 31, 2005 and 2004.

 

**CommonStock** — TheCompany has 200,000 shares of $0.001 par value common stock authorized.  There were 51,612 and 50,332 shares issued atDecember 31, 2005 and 2004, respectively. There were 48,837 and 50,232 shares outstanding at December 31,2005 and 2004, respectively.

 

**Treasury Stock —**The Company’s Board of Directors approved astock repurchase program during the fourth quarter of 2004 whereby 2,000 of theCompany’s shares of common stock could be purchased from time-to-time on theopen market or in negotiated transactions. On April 29, 2005 the Company’s Board added 2,000 shares to the program,bringing the total shares authorized to be repurchased to 4,000.  The Company purchased 2,675 shares in 2005and 100 shares during the fourth quarter of 2004 under the approved repurchaseprogram.  The Company recorded the purchaseof 50 treasury shares at year-end for $1,372 and recorded a liability in thesame amount as the transaction settled after year-end.

 

**12.          Earnings Per Share**

** **

Asummary of the calculation of basic and diluted earnings per share (EPS) forthe years ended December 31, 2005, 2004 and 2003, is as follows:

 
| ** **                                     | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Earnings  Per-Share** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|---------------------------|------------|-------------------------|------------|
| **For the Year Ended  December 31, 2005** |       |                    |       |                      |       |                    |       |
| **Basic EPS**                                  |       |                    |       |                      |       |                    |       |
| Net income                                     |       | $                       | 48,349     |                      | 49,318     |                    | $          | 0.98 |   |
| **Effect of Dilutive Securities**              |       |                    |       |                      |       |                    |       |
| Stock options                                  |       |                    |       | 936                       |       |                    |       |
| **Diluted EPS**                                |       |                    |       |                      |       |                    |       |
| Net income and assumed conversions             |       | $                       | 48,349     |                      | 50,254     |                    | $          | 0.96 |   |
|                                           |       |                    |       |                      |       |                    |       |
| **For the Year Ended  December 31, 2004** |       |                    |       |                      |       |                    |       |
| **Basic EPS**                                  |       |                    |       |                      |       |                    |       |
| Net income                                     |       | $                       | 18,040     |                      | 48,964     |                    | $          | 0.37 |   |
| **Effect of Dilutive Securities**              |       |                    |       |                      |       |                    |       |
| Stock options                                  |       |                    |       | 1,566                     |       |                    |       |
| **Diluted EPS**                                |       |                    |       |                      |       |                    |       |
| Net income and assumed conversions             |       | $                       | 18,040     |                      | 50,530     |                    | $          | 0.36 |   |
|                                           |       |                    |       |                      |       |                    |       |
| **For the Year Ended  December 31, 2003** |       |                    |       |                      |       |                    |       |
| **Basic EPS**                                  |       |                    |       |                      |       |                    |       |
| Net income                                     |       | $                       | 38,547     |                      | 46,194     |                    | $          | 0.83 |   |
| **Effect of Dilutive Securities**              |       |                    |       |                      |       |                    |       |
| Stock options                                  |       |                    |       | 1,499                     |       |                    |       |
| **Diluted EPS**                                |       |                    |       |                      |       |                    |       |
| Net income and assumed conversions             |       | $                       | 38,547     |                      | 47,693     |                    | $          | 0.81 |   |
|                                           |       |                    |       |                      |       |                    |       |
|                                                |            |                         |            |                           |            |                         |            |  |  |  |  |

 

Anti-dilutiveoptions to purchase common stock outstanding were excluded from thecalculations above.  At December 31,

 

54

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

2005,2004 and 2003, options to purchase 2,375, 2,440 and 1,941 shares of commonstock, respectively, were outstanding but were not included in the computationof diluted earnings per share because inclusion of such options would have beenanti-dilutive.

 

**13.          Commitments and Contingencies**

** **

TheCompany leases buildings and certain equipment under various operating leases.Rent expense under these leases totaled approximately $3,578, $3,035 and $2,559for the years ended December 31, 2005, 2004 and 2003, respectively.  Future minimum rental payments undernon-cancelable operating leases are approximately as follows:

 
| **Years ending**      | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|
| **December 31:** | ** ** | ** ** | ** ** |
| 2006                  |       | $          | 2,351      |   |
| 2007                  |       | 1,795      |       |
| 2008                  |       | 1,199      |       |
| 2009                  |       | 449        |       |
| 2010                  |       | 76         |       |
| Thereafter            |       | —     |       |
|                  |       |       |       |
|                  |       | $          | 5,870      |   |

 

In the ordinary course of our business, the Company may atany point in time have a significant amount of contractual commitments not yetrecognized in our financial statements. These commitments totaled $30,623 as of December 31, 2005 and areall due within 2006. These commitments relate primarily to the Company’s needto schedule the purchase of inventories in advance of the relatedforecasted sales to customers. The Company also has at any point in time avariety of short-term contractual commitments for services such as advertising,marketing, accounting, legal, and research and development activities. Theliabilities for these services and the related expenses are typicallyrecognized upon the receipt of the related services.

 

The Company has been involved from time to time in litigationin the normal course of business. Management is not aware of any pending orthreatened litigation matters that will have a material adverse effect on theCompany’s business, operations, financial condition or cash flows (*see Note 18*).

 

**14.          Stock Option and Stock Purchase Plans**

** **

TheCompany has stock option plans covering substantially all of its employees anddirectors. Avocent assumed the stock option plans and the related underlyingoptions of Apex and Cybex at the merger effective July 1, 2000, of Equinoxat the acquisition effective January 3, 2001, of 2C at the acquisitioneffective August 20, 2002 and of OSA at the acquisition effectiveApril 6, 2004. With the exception of the assumed OSA plan, no additionaloptions have been or will be granted under these pre-existing plans.  Purchase prices for common stock subject tooptions issued under the assumed plans generally approximate the fair market valueof the related shares at the date of grant. Generally, options vest over fourto five years and typically expire 10 years from the grant date.

 

Priorto the June 2005 shareholder approval of the 2005 Avocent Corporation EquityIncentive Plan (the 2005 Plan), Avocent had adopted four additional stockoption plans, the 2000 Stock Option Plan (the 2000 Plan), the 2000 TransitionNonstatutory Stock Option Plan (the Transition Plan), the Avocent Corporation2003 Stock Option Plan (the 2003 Plan), and the Avocent Corporation 2003Inducement Plan (the Inducement Plan). The 2000 Stock Option Plan and the 2003Plan each provided for nonqualified and incentive stock options for officers,directors and employees.  The 2000Transition plan provided for nonqualified and incentive stock options foremployees and the Inducement Plan provided for nonqualified and incentive stockoptions for new employees.   Optionsunder these four plans generally expire 10 years from the date of grant.Purchase prices for common stock subject to options issued under these plansgenerally approximate the fair market value of the related shares at the dateof grant and options typically vest over two to four years.

 

Uponapproval of the 2005 Plan by stockholders, a total of 2,500 new shares ofcommon stock were available for issuance, plus (i) any shares remainingavailable for issuance under the previous stock option plans up to a maximum of1,187 shares and (ii) any shares subject to any outstanding options underour stock options plans that subsequently expire unexercised.  The 2005Plan allows for options, restricted stock, restricted stock units, stockappreciation rights, performance shares, performance units, deferred stockunits, and dividend equivalents to be granted under the 2005 Plan. Options granted under the 2005 Plan may be either incentive stock options ornonqualified stock options.  Nonqualified stock options, restricted stock,restricted stock units, performance shares, performance units, stockappreciation rights, deferred stock units, and dividend equivalents may begranted under the 2005 Plan to Avocent’s directors, employees, orconsultants.  Incentive stock 

 

55

----

 

**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

optionsmay be granted only to Avocent employees.  Options may not be granted atless than the fair market value on date of grant and may not have a term ofgreater than 10 years.

 

Anyshares subject to restricted stock, performance shares, or restricted stockunits with a per share price less than the fair market value of the Company’scommon stock on the date of the Award will be counted against the authorizedshare reserve as two shares for every one share subject to the Award, and ifany such shares are returned to the 2005 Plan, such shares will be counted astwo shares.  If an Award expires or becomes unexercisable without havingbeen exercised in full (or, with respect to restricted stock, performanceshares, or restricted stock units, is forfeited to or repurchased by Avocent),the unpurchased shares (or, for Awards other than options and stockappreciation rights, the forfeited or repurchased shares) will become availablefor future Awards. Shares of restricted stock, performance shares orrestricted stock units that are repurchased by Avocent at the fair market valueon the date of the original Award, or are forfeited to the Company, will becomeavailable for future grant under the 2005 Plan.  Shares used to pay theexercise price of an option will not become available for future Awards, andshares used to satisfy tax withholding obligations will also not becomeavailable for future Awards under the 2005 Plan.  To the extent a 2005 PlanAward is paid out in cash rather than stock, such cash payment will not reducethe number of shares available for issuance under the 2005 Plan.  Anypayout of dividend equivalents or performance units, because they are payableonly in cash, will not reduce the number of shares available for issuance underthe 2005 Plan.  Conversely, any forfeiture of dividend equivalents orperformance units will not increase the number of shares available for issuanceunder the 2005 Plan.  In 2005, theCompany granted only stock options under the 2005 Plan.

 

Pertinentinformation regarding the Company’s plans is as follows:

 
| ** **                                   | ** ** | **Number of  Options** | ** ** | **Range of  Exercise  Prices** | ** **           | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------------|------------|------------------------|------------|--------------------------------|----------------------|----------------------------------------|------------|
| Options outstanding,  December 31, 2002 |       | 7,941                  |       | $                              | 0.11  — $70.94  |                                   | $          | 25.82 |   |
| Options granted                              |       | 1,645                  |       | $                              | 21.79  — $38.20 |                                   | $          | 27.65 |   |
| Options forfeited and  cancelled             |       | (201                   | )          | $                              | 0.11  — $68.56  |                                   | $          | 25.26 |   |
| Options exercised                            |       | (1,978                 | )          | $                              | 0.11  — $30.38  |                                   | $          | 16.59 |   |
|                                         |       |                   |       |                           |                 |                                   |       |
| Options outstanding,  December 31, 2003 |       | 7,407                  |       | $                              | 0.11  — $70.94  |                                   | $          | 28.71 |   |
| Options assumed upon acquisition of OSA      |       | 245                    |       | $                              | 1.31                 |                                   | $          | 1.31 |   |
| Options granted                              |       | 1,330                  |       | $                              | 25.91  — $41.57 |                                   | $          | 34.28 |   |
| Options forfeited and  cancelled             |       | (111                   | )          | $                              | 1.28  — $68.56  |                                   | $          | 30.19 |   |
| Options exercised                            |       | (1,442                 | )          | $                              | 1.31  — $37.28  |                                   | $          | 17.94 |   |
|                                         |       |                   |       |                           |                 |                                   |       |
| Options outstanding,  December 31, 2004 |       | 7,429                  |       | $                              | 0.11  — $70.94  |                                   | $          | 30.87 |   |
| Options granted                              |       | 368                    |       | $                              | 23.90  — $39.65 |                                   | $          | 26.81 |   |
| Options forfeited and  cancelled             |       | (347                   | )          | $                              | 1.31  — $68.56  |                                   | $          | 42.61 |   |
| Options exercised                            |       | (1,033                 | )          | $                              | 0.11  — $30.48  |                                   | $          | 18.45 |   |
|                                         |       |                   |       |                           |                 |                                   |       |
| Options outstanding,  December 31, 2005 |       | 6,417                  |       | $                              | 0.11  — $70.94  |                                   | $          | 32.00 |   |

 

OnApril 29, 2005, the Company’s Board of Directors approved a plan to acceleratevesting of all then outstanding stock options with an exercise price of greaterthan $25.00 and unvested on December 25, 2005. Under the provisions of APB 25, there was no compensation expenserelated to accelerating these options as the options affected by the accelerationhad exercise prices higher than the closing price of Avocent’s common stock asof the modification date.  As a result ofthe Board’s action, stock options to purchase approximately 1,100 shares ofAvocent’s common stock became exercisable effective December 25, 2005.  The exercise prices of the affected stockoptions ranged from $25.17 to $41.57 per share. The closing price of Avocent’s common stock on April 29, 2005 was$25.14. There were no such accelerations during 2004 or 2003.

 

56

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

The following table summarizes information about stockoptions outstanding at December 31, 2005:

 
| ** **                   | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                           | ** ** |
|------------------------------|------------|-------------------------|------------|---------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Number Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $ 0.11 - $9.48          |       | 236                     |       | 4.42                                              |       | $ | 5.78 |   | 219 |   | $ | 6.11 |   |
| $ 10.46 - $20.00        |       | 321                     |       | 4.71                                              |       | $ | 15.09 |   | 285 |   | $ | 15.01 |   |
| $20.33 - $29.95              |       | 3,465                   |       | 6.96                                              |       | $ | 24.99 |   | 3,359 |   | $ | 25.07 |   |
| $30.02 - $44.25              |       | 930                     |       | 7.95                                              |       | $ | 38.34 |   | 920 |   | $ | 38.41 |   |
| $ 46.19 - $70.94        |       | 1,465                   |       | 4.72                                              |       | $ | 52.46 |   | 1,465 |   | $ | 52.46 |   |
|                         |       |                    |       |                                              |       |   |   |   |   |   |   |
|                         |       | 6,417                   |       |                                              |       |   |   | 6,248 |   |   |   |

 

The options above were issued with exercise pricesthat approximated fair value at the date of grant. At December 31, 2005, 3,641shares are available for grant under the Company’s 2005 plan.

 

On December 6, 2000, the stockholders approved anemployee stock purchase plan for all Avocent employees (the AESPP), throughwhich qualified employees may participate in common stock ownership. The AESPPqualifies as a non-compensatory plan under Section 423 of the Internal RevenueCode. The Company has reserved 1,500 shares of common stock for issuance underthe AESPP. The price of stock purchased under the AESPP is generally 85% of thelower of the fair market value of the common stock (i) at the beginning of the offeringperiod or (ii) at the end of the purchase period. In the event the fair marketvalue at the end of a purchase period is less than the fair market value at thebeginning of the offering period, the participants will be withdrawn from thecurrent offering period following exercise and automatically re-enrolled in anew offering period. The new offering period will use the lower fair marketvalue as of the first date of the new offering period to determine the purchaseprice for future purchase periods. The AESPP administrator administers andinterprets all rules and regulations applicable to the AESPP.  Pursuant to the AESPP, 247 shares were issuedat a weighted average price of $24.42 per share for the year ended December 31,2005, 204 shares were issued at a weighted average price of $15.76  per share for the year ended December 31,2004 and 131 shares were issued at a weighted average price of $13.84 per sharefor the year ended December 31, 2003. The Company’s Board of Directors has indefinitely suspendedparticipation in the AESPP following the 2005 purchase periods.

 

**15.          Retirement Plans**

 

The Company sponsors a 401(k) savings plan coveringsubstantially all U.S. employees and a profit-sharing plan coveringsubstantially all international employees. Under the 401(k) savings plan, the Company makes discretionarycontributions to match 50% of an employee’s contributions up to 6% of theemployee’s compensation. The Company may also elect to make additionaldiscretionary contributions as determined by its Board of Directors. Nodiscretionary contributions were made during the years ended December 31, 2005,2004 or 2003 under the 401(k) savings plan. The Company’s expense forcontributions under these plans totaled approximately $1,658, $1,408 and $1,072for the years ended December 31, 2005, 2004 and 2003, respectively.

 

**16.          Segment Reporting**

 

The Company has evaluated, and will at least annuallyre-evaluate, its business in light of the segment reporting requirementsprescribed by SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information.*  Avocent has determined that it should reportits operations as a single operating segment based on the requirements of theSFAS No. 131, including the review of materials used by the chief operatingdecision maker to allocate resources and assess the performance of keyexecutives and the functional departments they lead.  However, the Company supplementally reportssales by geographic region, as well as by customer type.  Following is a presentation of sales bygeographic region for the years ended December 31, 2005, 2004 and 2003:

 
| ** **    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales:    |       |     |       |     |       |     |       |
| United States |       | $        | 210,844    |     | $          | 216,687  |       | $ | 182,153 |   |
| International |       | 159,044  |       | 148,568  |       | 122,085  |       |
|          |       |     |       |     |       |     |       |
|          |       | $        | 369,888    |     | $          | 365,255  |       | $ | 304,238 |   |
|               |            |          |            |          |            |          |            |  |  |  |  |  |

 

57

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 

Following is a presentation of sales by customer typefor the years ended December 31, 2005, 2004 and 2003:

 
| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales: |       |     |       |     |       |     |       |
| Branded    |       | $        | 191,901    |     | $          | 201,308  |       | $ | 164,684 |   |
| OEM        |       | 177,987  |       | 163,947  |       | 139,554  |       |
|       |       |     |       |     |       |     |       |
|       |       | $        | 369,888    |     | $          | 365,255  |       | $ | 304,238 |   |
|            |            |          |            |          |            |          |            |  |  |  |  |

** **

**KVMproducts and technologies accounted for at least 90% of the Company’s revenuesduring 2005, 2004 and 2003.**

** **

**TheCompany sells its products internationally to customers in several countries.No country accounted for more than 10% of sales in 2005.  Sales to customers in the Netherlands,including the European distribution facility for an OEM customer, accounted for$37,464 of sales in 2004.  Sales tocustomers in the United Kingdom, including sales to the European distributioncenter of an OEM customer, accounted for $30,334 in 2003.  No other country accounted for more than 10%of sales in 2004 or 2003.**

** **

**Asof December 31, 2005, long-lived assets totaled $322,556, which includes$305,286 held in the U.S. and $17,270 held outside of the U.S.  As of December 31, 2004, long-lived assetstotaled $345,099, which includes $324,417 held in the U.S. and $20,682 heldoutside of the U.S.**

 

In the first quarter of 2006, the Company organized its business intofive divisions within Avocent:

 

•                  Management Systems division,which includes Avocent’s branded and OEM KVM, serial console, power control andmanagement appliance businesses;

•                  Embedded Software &Solutions division, focused on developing and marketing embedded systems andsoftware including IPMI and embedded KVM technologies primarily for Avocent’sOEM customers;

•                  Retail Point-of-Sale andAudio/visual Solutions division, focused on expanding the markets for Avocent’sserial and wireless products;

•                  Desktop Solutions division,which will focus on developing new products to facilitate client bladedeployments; and

•                  Mobile Technologiesdivision, which includes mobile device management and secure wireless systems administration.

 

**TheCompany did not manage its business under these divisions during 2005 but willre-evaluate its future segment disclosures based on the requirements in SFASNo. 131.**

** **

**17.          Summarized Quarterly Financial Data(Unaudited)**

 

The following table presents unaudited quarterlyconsolidated operating results for each of the Company’s last eight fiscalquarters. This information has been prepared by the Company on a basisconsistent with the Company’s audited consolidated financial statements andincludes all adjustments, consisting only of normal recurring adjustments thatthe Company considers necessary for a fair presentation of the data.

 
| ** **                | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|------------------------|------------|
| ** **                | ** ** | **April 1,  2005**     | ** ** | **July 1,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| Net sales                 |       | $                      | 76,805     |   | $ | 89,538 |   | $ | 96,708 |   | $ | 106,837 |   |
| Gross profit              |       | $                      | 43,582     |   | $ | 52,827 |   | $ | 57,320 |   | $ | 65,116 |   |
| Income from operations    |       | $                      | 213        |   | $ | 7,791 |   | $ | 19,185 |   | $ | 25,908 |   |
| Net income (3)            |       | $                      | 1,834      |   | $ | 11,099 |   | $ | 16,365 |   | $ | 19,051 |   |
| Net income per share (1): |       |                   |       |   |   |   |   |   |   |
| Basic                     |       | $                      | 0.04       |   | $ | 0.22 |   | $ | 0.33 |   | $ | 0.39 |   |
| Diluted                   |       | $                      | 0.04       |   | $ | 0.22 |   | $ | 0.33 |   | $ | 0.38 |   |

 

58

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**Avocent Corporation**

**Notes to Consolidated FinancialStatements (Continued)**

**For the Years Ended December 31, 2005, 2004 and 2003**

**(In Thousands, except per share data)**

 
| ** **                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **April 2,  2004**     | ** ** | **July 2,  2004** | ** ** | **October 1,  2004** | ** ** | **December 31,  2004** | ** ** |
| Net sales                          |       | $                      | 86,085     |   | $ | 87,796 |   | $ | 91,325 |   | $ | 100,049 |   |
| Gross profit                       |       | $                      | 50,102     |   | $ | 50,600 |   | $ | 53,125 |   | $ | 59,028 |   |
| Income (loss) from  operations (2) |       | $                      | 9,087      |   | $ | (10,795 | ) | $ | 12,613 |   | $ | 18,235 |   |
| Net income (loss) (2) (4)          |       | $                      | 8,543      |   | $ | (13,392 | ) | $ | 10,822 |   | $ | 12,067 |   |
| Net income (loss) per  share (1):  |       |                   |       |   |   |   |   |   |   |
| Basic                              |       | $                      | 0.18       |   | $ | (0.27 | ) | $ | 0.22 |   | $ | 0.24 |   |
| Diluted                            |       | $                      | 0.17       |   | $ | (0.27 | ) | $ | 0.21 |   | $ | 0.23 |   |

 

----

(1)          The net income (loss) per share for each quarterwithin a fiscal year does not equal the total net income (loss) per share forthe particular fiscal year due to variations in the estimated value of theCompany’s common stock during the year and the effect these variations had onthe shares outstanding calculation.

 

(2)          The loss from operations and net loss for the quarterended July 2, 2004 include a non-recurring charge of $21,720 for acquiredin-process research and development related to the OSA acquisition.  Similar charges were incurred in the quarterended April 1, 2004, for Crystal Link and the quarter ended October 1, 2004 forSonic Mobility totaling $6,490 and $1,050 respectively.

 

(3)          The quarter ended July 1, 2005 included a settlementfrom a lawsuit of $5,000 related to the Company’s patent infringement caseagainst Raritan.

 

(4)          The quarter ended December 31, 2004 includedimpairment losses of $3,450 related to the Company’s investments in VIEO andRymic.

 

**18.          Patent Litigation**

 

Duringthe second quarter of 2005, the Company settled its patent infringement suitagainst Raritan Computer Inc. (Raritan). The Company received an initial payment of $5,000 and will receiveroyalty payments for five years based on a fixed percentage of the sales ofcertain Raritan products subject to a minimum quarterly payment of $750.

 

In October 2003, Avocent filed a complaint forpatent infringement in the United States District Court for the NorthernDistrict of Alabama against ClearCube Technology, Inc.  The ClearCube complaint seeks injunctiverelief, damages, attorneys’ fees, and costs under two of the Companies patents.ClearCube has filed counterclaims alleging non-infringement, unenforceability,invalidity, and misuse of the Avocent patents. A Markman hearing on claimsconstruction was held in February 2006.

 

**19.****                             ****Announced Acquisition (Unaudited)**

 

InJanuary 2006, the Company announced it had signed a definitive agreement toacquire Cyclades Corporation, a privately-held company based in Fremont,California, with offices in Sao Paolo, Brazil and Munich, Germany. Cyclades employs approximately 350 people in 19 locations around the world. TheCyclades product lines include serial and power management products.  The agreement provides for a total cashpurchase price of approximately $90,000 plus the assumption of liabilities andpayment of certain transaction costs.  In addition to the purchase price,the Company plans to commit $6,000 for retention bonuses to key employees andwill provide post closing stock awards to certain employees.

 

Cycladeshad unaudited revenues of approximately $60,000 in 2005.  These revenues included 55% of revenuesshipped in the U.S. with the remaining 45% shipped internationally.  Cyclades had $24,365 in unaudited assets and$16,468 in unaudited liabilities as of December 31, 2005.

 

 

**20.****                             ****Subsequent Events**

 

During the period from January 1, 2006 throughFebruary 28, 2006, the Company purchased 360 additional shares of its commonstock on the open market under its Board approved treasury stock program, for atotal cost of $11,872  Also during thisperiod, the Company issued 795 additional shares of its common stock pursuantto stock option exercises.

 

59

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**Item 9.  Changes in and Disagreements With Accountantson Accounting and Financial Disclosure.**

 

None.

 

**Item 9A. Controls and Procedures.**

 

(a)*Evaluation of disclosure controls andprocedures.*    Based on theirevaluation as of December 31, 2005, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and procedures(as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Actof 1934) are effective to ensure that information required to be disclosed byus in reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

(b)*Changes in internal controls*.    There were no significant changes in ourinternal controls or in other factors that could significantly affect thesecontrols subsequent to the date of their evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.  However, during the year we completed severalinitiatives which we believe has improved our internal controls.  We extended our ERP system to our location inSan Jose, California, which has enhanced our internal control over financialreporting through the automation and standardization of certain controls andprocesses, as all of our financially significant locations are now operatingunder the same ERP system. We also created a new corporate treasurer positionduring the first quarter of 2005 to provide enhanced oversight of ourinvestments, tax planning, and risk management activities.  We also automated the approval process forour purchase requisitions within our ERP system during the second quarter of2005.   Additionally, we implemented a newinvestment software package in the third quarter of 2005, which we believe willenhance our internal controls over our accounting for investments.

 

Management’s Report onInternal Control over Financial Reporting and the Report of IndependentRegistered Public Accounting Firm is included in Part II, Item 8 ofthis Annual Report on Form 10-K.

 

**Item 9B. Other.**

 

None.

 

**PARTIII**

 

Information with respect toItems 10 through 14 of this Part III may be found in the definitive proxystatement to be delivered to stockholders in connection with the 2006 AnnualMeeting of Stockholders. Such information is incorporated herein by reference.

 

60

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**PART IV**

 

**Item 15. Exhibits, Financial Statement Schedules, and Reports onForm 8-K.**

 

**(a)Financial Statement Schedule**

 

**Scheduleof Valuation and Qualifying Accounts**

*For theyears ended December 31, 2005, 2004 and 2003 (in thousands)*

 
| ** **                           | ** ** | **Beginning Balance** | ** ** | **Assumed on  Acquisitions(1)** | ** ** | **Charged to  Income** | ** ** | **Deductions from  Reserves** | ** ** | **Ending Balance** | ** ** |
|--------------------------------------|------------|-----------------------|------------|---------------------------------|------------|------------------------|------------|-------------------------------|------------|--------------------|------------|
|                                 |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Year ended  December 31, 2003:  |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Allowance for doubtful accounts      |       | $                     | 2,563      |                            | —     |                   | (386       | )                             | (186       | )                  | $          | 1,991 |   |
| Allowance for inventory obsolescence |       | $                     | 7,502      |                            | —     |                   | 1,967      |                          | (5,449     | )                  | $          | 4,020 |   |
| Allowance for sales returns          |       | $                     | 3,769      |                            | —     |                   | 5,461      |                          | (5,321     | )                  | $          | 3,909 |   |
| Liability for warranty returns       |       | $                     | 2,435      |                            | —     |                   | 597        |                          | (380       | )                  | $          | 2,652 |   |
| Valuation allowance for income taxes |       | $                     | 2,039      |                            | 426        |                   | —     |                          | —     |               | $          | 2,465 |   |
|                                 |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Year ended  December 31, 2004:  |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Allowance for doubtful accounts      |       | $                     | 1,991      |                            | —     |                   | (265       | )                             | 14         |               | $          | 1,740 |   |
| Allowance for inventory obsolescence |       | $                     | 4,020      |                            | —     |                   | 2,052      |                          | (2,287     | )                  | $          | 3,785 |   |
| Allowance for sales returns          |       | $                     | 3,909      |                            | —     |                   | 6,366      |                          | (7,101     | )                  | $          | 3,174 |   |
| Liability for warranty returns       |       | $                     | 2,652      |                            | —     |                   | 528        |                          | (420       | )                  | $          | 2,760 |   |
| Valuation allowance for income taxes |       | $                     | 2,465      |                            | 388        |                   | —     |                          | —     |               | $          | 2,853 |   |
|                                 |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Year ended  December 31, 2005:  |       |                  |       |                            |       |                   |       |                          |       |               |       |
| Allowance for doubtful accounts      |       | $                     | 1,740      |                            | —     |                   | (585       | )                             | (26        | )                  | $          | 1,129 |   |
| Allowance for inventory obsolescence |       | $                     | 3,785      |                            | —     |                   | 3,308      |                          | (2,535     | )                  | $          | 4,558 |   |
| Allowance for sales returns          |       | $                     | 3,174      |                            | —     |                   | 7,923      |                          | (8,220     | )                  | $          | 2,877 |   |
| Liability for warranty returns       |       | $                     | 2,760      |                            | —     |                   | 252        |                          | (176       | )                  | $          | 2,836 |   |
| Valuation allowance for income taxes |       | $                     | 2,853      |                            | —     |                   | 167        |                          | (2,466     | )                  | $          | 554 |   |

 

----

(1)                                  Amountsrepresent balances assumed from the acquisition of OSA in 2004 and Soronti in2003.

 

61

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**(b) Exhibits**

 
| ** **          | ** ** | ** **                                                                                                                                                    | ** ** | ** ** | ** ** | **Incorporated by Reference** | ** ** | ** ** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|------------|
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                       | ** ** | **Form**   | ** ** | **Entity(1)**                 | ** ** | **Date**   | ** ** | **Number** | ** ** | **Included** |
| 3.1                 |       | Certificate  of Incorporation of Aegean Sea Inc.                                                                                                         |       | S-4        |       | AGI                           |       | 3/31/00    |   | Ex. 3.1 |   |   |
| 3.1.1               |       | Certificate  of Amendment of Certificate of Incorporation (changing name from Aegean  Sea Inc. to Avocent Corporation)                                   |       | 10-K       |       | AVCT                          |       | 3/27/01    |   | Ex 3.1.1 |   |   |
| 3.2                 |       | Amended  and Restated Bylaws of Avocent Corporation                                                                                                           |       | 10-K       |       | AVCT                          |       | 3/12/04    |   | Ex. 3.2 |   |   |
| 10.1                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and John R. Cooper        |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.13 |   |   |
| 10.2                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and William A. Dambrackas |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.14 |   |   |
| 10.3                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and R. Byron Driver  |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.15 |   |   |
| 10.4                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and Gary R. Johnson       |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.16 |   | ; |
| 10.5                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent International Ltd., the Company, and Kieran MacSweeney   |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.17 |   |   |
| 10.6                |       | Employment  and Noncompetition Agreement dated January 5, 2004, among Avocent California  Corp., Avocent Huntsville Corp., the Company, and Rick Moore        |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.18 |   |   |
| 10.7                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Texas, L.P., the Company, and C. David Perry   |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.19 |   |   |
| 10.8                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and Douglas E. Pritchett  |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.20 |   |   |
| 10.9                |       | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Redmond                                                  |       | 10-K       |       | AVCT                          |       | 3-12-04    |   | Ex. 10.21 |   |   |

 

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|   |   | Corp.,  the Company, and Samuel F. Saracino                                                                                                                                                |   |   |   |   |   |    |   |        |   |   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|---------|--------|-------------|--------|--------|
| 10.10  |   | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and Christopher Thomas                                 |   | 10-K   |   | AVCT   |   | 3-12-04 |   | Ex. 10.22   |   |   |
| 10.11  |   | Amended  and Restated Employment and Noncompetition Agreement dated October 10, 2003,  among Avocent Huntsville Corp., the Company, and Doyle C. Weeks                                     |   | 10-K   |   | AVCT   |   | 3-12-04 |   | Ex. 10.23   |   |   |
| 10.12  |   | Amended  and Restated Amendment Agreement among the Company, Avocent Employment  Services Company, Cybex Computer Products Corporation and Stephen F. Thornton                             |   | 10-Q   |   | AVCT   |   | 8/9/02  |   | Ex. 10.30.1 |   |   |
| 10.13  |   | Form  of Avocent Corporation Indemnification Agreement for Officers and Directors                                                                                                          |   | 10-Q   |   | AVCT   |   | 9/29/00 |   | Ex. 10.11   |   |   |
| 10.14  |   | Avocent  Corporation 2005 Equity Incentive Plan and Form of Agreements                                                                                                                     |   | 8-K    |   | AVCT   |   | 6/23/05 |   | Ex. 99.11   |   |   |
| 10.15  |   | Employment  and Noncompetition Agreement entered into as of July 19, 2005 by and  among Avocent Huntsville Corp., Avocent Corporation, and Edward H. Blankenship.                     |   | 10-Q   |   | AVCT   |   | 8/09/06 |   | Ex. 10.31   |   |   |
| 10.16  |   | Amended  and Restated Employment and Noncompetition Agreement entered into as of  February 8, 2005, by and among Avocent Huntsville Corp., Avocent  Corporation, and Stephen M. Daly. |   | 10-Q   |   | AVCT   |   | 8/09/05 |   | Ex. 10.32   |   |   |
| 10.17  |   | Employment  and Noncompetition Agreement entered into as of February 8, 2005, by and  among Avocent Huntsville Corp., Avocent Corporation, and Dudley A. DeVore.                      |   | 10-Q   |   | AVCT   |   | 8/09/05 |   | Ex. 10.33   |   |   |
| 10.18  |   | Employment  and Noncompetition Agreement entered into as of May 3, 2005, by and  among Avocent Texas L.P., Avocent Corporation, and Thomas J. Miller.                                 |   | 10-Q   |   | AVCT   |   | 8/09/05 |   | Ex. 10.34   |   |   |
| 10.19  |   | Employment  and Noncompetition Agreement entered into as of February 8, 2005, by and  among Avocent Redmond Corp., Avocent Corporation, and Eugene F. Mulligan                        |   | 10-Q   |   | AVCT   |   | 8/09/05 |   | Ex. 10.35   |   |   |
| 10.20  |   | Form  of Amendment to Option Agreement for Directors regarding Change of Control of  the Company                                                                                           |   | 10-K   |   | AVCT   |   | 3/12/04 |   | Ex. 10.31   |   |   |

 

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| 10.21  |   | Fourth  Amendment to the Net Lease Agreement dated October 17, 2002, by and between  Avocent’s subsidiary, Apex Inc., and Willows Redmond, L.L.C.                                  |   | 10-Q   |   | AVCT   |   | 9/27/02 |   | Ex. 10.37.1 |   |   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|---------|--------|-------------|--------|--------|
| 21.1   |   | Subsidiaries  of Avocent Corporation                                                                                                                                                    |   |   |   |   |   |    |   |        |   | X      |
| 23.1   |   | Consent  of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm                                                                                                   |   |   |   |   |   |    |   |        |   | X      |
| 24.1   |   | Power  of Attorney(2)                                                                                                                                                                   |   |   |   |   |   |    |   |        |   | X      |
| 31.1   |   | Sarbanes-Oxley Act of 2002 Section 302(a)  Certification of the Chief Executive Officer                                                                                                 |   |   |   |   |   |    |   |        |   | X      |
| 31.2   |   | Sarbanes-Oxley Act of 2002 Section 302(a)  Certification of the Chief Financial Officer                                                                                                 |   |   |   |   |   |    |   |        |   | X      |
| 32.1   |   | Certification of the Chief Executive Officer and  the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |   |   |   |   |   |    |   |        |   | X      |
|   |   |                                                                                                                                                                                    |   |   |   |   |   |    |   |        |   |   |

 

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(1)                                  The followingabbreviations are used to identify corporate entities:

 

AVCT = AvocentCorporation and AGI = Aegean Sea Inc. (now known as AvocentCorporation)

 

(2)                                  Set forth onthe signature page and incorporated herein by reference.

 

**(c)  Reports on Form 8-K**

 

None

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | **AVOCENT CORPORATION**   |               |
|--------|---------------------------|--------------------|
|   | By:                       | /s/ John R. Cooper |   |
|   | John R. Cooper            |               |
|   | *Chief Executive Officer* |               |
|   | Date: March 6, 2006       |               |
|        |                           |                    |  |  |

 

**POWEROF ATTORNEY**

 

KNOW ALL PERSONS BY THESE PRESENTS:

 

That the undersignedofficers and directors of Avocent Corporation do hereby constitute and appointEdward H. Blankenship, Samuel F. Saracino, and Doyle C. Weeks, andeach of them, the lawful attorney and agent with power and authority to do anyand all acts and things and to execute any and all instruments which saidattorneys and agents, or either of them, determine may be necessary oradvisable or required to enable Avocent Corporation to comply with theSecurities Exchange Act of 1934, as amended, and any rules or regulations orrequirements of the Securities Exchange Act of 1934, as amended, and any rulesor regulations or requirements of the Securities and Exchange Commission inconnection with this Form 10-K Report. Without limiting the generality ofthe foregoing power and authority, the powers granted include the power andauthority to sign the names of the undersigned officers and directors in thecapacities indicated below to this Form 10-K Report of amendments orsupplements thereto, and each of the undersigned hereby ratifies and confirmsall that said attorneys and agents or either of them, shall do or cause to bedone by virtue hereof. This Power of Attorney may be signed in severalcounterparts.

 

IN WITNESS WHEREOF, each ofthe undersigned has executed this Power of Attorney as of the date indicatedopposite his name.

 

In accordance with theExchange Act, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the dates indicated.

 
| **Signature**              |   | **Title**                                                                           |   | **Date**       |
|----------------------------|--------|-------------------------------------------------------------------------------------|--------|----------------|
|                       |   |                                                                                |   |           |
| /s/  John R. Cooper        |   | Chief Executive Officer  and Chairman of the Board of Directors                     |   | March  6, 2006 |
| John  R. Cooper            |   | (Principal Executive  Officer)                                                      |   |           |
|                       |   |                                                                                |   |           |
| /s/  Edward H. Blankenship |   | Senior Vice President of  Finance, Chief Financial Officer, and Assistant Secretary |   |           |
| Edward  H. Blankenship     |   | (Principal Financial and  Accounting Officer)                                       |   | March  6, 2006 |
|                       |   |                                                                                |   |           |
| /s/  Harold D. Copperman   |   | Director                                                                            |   | March  6, 2006 |
| Harold  D. Copperman       |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/ Francis A. Dramis, Jr. |   | Director                                                                            |   | March  6, 2006 |
| Francis A. Dramis, Jr.     |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/  Edwin L. Harper       |   | Director                                                                            |   | March  6, 2006 |
| Edwin  L. Harper           |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/  William H. McAleer    |   | Director                                                                            |   | March  6, 2006 |
| William  H. McAleer        |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/  Stephen F. Thornton   |   | Director                                                                            |   | March  6, 2006 |
| Stephen  F. Thornton       |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/  David P. Vieau        |   | Director                                                                            |   | March  6, 2006 |
| David  P. Vieau            |   |                                                                                |   |           |
|                       |   |                                                                                |   |           |
| /s/  Doyle C. Weeks        |   | President and Director                                                              |   | March  6, 2006 |
| Doyle  C. Weeks            |   |                                                                                |   |           |

 

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