##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2004 OR [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 000-26689 FOUNDRY NETWORKS, INC.  Delaware
(State or other jurisdiction of
incorporation or organization)
    
    77-0431154
(I.R.S. Employer
Identification No.)
 2100 Gold Street
P.O. Box 649100
San Jose, CA 95164-9100
(Address of principal executive offices, including zip code) (408) 586-1700
(Registrants telephone number, including area code) N/A
(Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]     No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X]     No [  ] As of November 3, 2004, there were 136,718,958 shares of the registrants
common stock, par value $0.0001, outstanding.




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FOUNDRY NETWORKS, INC.
TABLE OF CONTENTS  
 PAGEPART I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (Unaudited):Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Risk Factors That May Affect Future Results and the Market Price of Our Stock
    
    
    22Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4.
    
    Controls and Procedures
    
    
    31PART II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    33Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3.
    
    Defaults Upon Senior Securities
    
    
    34Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 5.
    
    Other Information
    
    
    34Item 6.
    
    Exhibits
    
    
    35SIGNATURES
    
    
    
    
    37EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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FOUNDRY NETWORKS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 September 30,
    
    December 31,2004
    
    2003(unaudited)
    
    (1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    137,490
    
    
    $
    161,718Short-term investments
    
    
    276,770
    
    
    
    184,859Accounts receivable, net of allowances for
doubtful accounts of $4,020 and $4,151 and
sales returns of $1,360 and $2,020 at September
30, 2004 and December 31, 2003, respectively
    
    
    75,295
    
    
    
    77,077Inventories
    
    
    36,701
    
    
    
    28,017Deferred tax assets
    
    
    34,975
    
    
    
    33,308Prepaid expenses and other current assets
    
    
    12,373
    
    
    
    5,001Total current assets
    
    
    573,604
    
    
    
    489,980Property and equipment, net
    
    
    9,323
    
    
    
    7,866Long-term investments
    
    
    206,214
    
    
    
    159,107Other long-term assets
    
    
    5,959
    
    
    
    1,191Total assets
    
    $
    795,100
    
    
    $
    658,144LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    15,330
    
    
    $
    10,080Accrued payroll and related expenses
    
    
    14,934
    
    
    
    16,650Other accrued expenses
    
    
    10,504
    
    
    
    5,742Litigation settlement payable
    
    
    35,000
    
    
    
    Current portion of deferred support revenue
    
    
    31,874
    
    
    
    27,408Total current liabilities
    
    
    107,642
    
    
    
    59,942Deferred support revenue
    
    
    11,645
    
    
    
    7,707Total liabilities
    
    
    119,287
    
    
    
    67,649Commitments and contingenciesStockholders equity:Common stock
    
    
    14
    
    
    
    13Additional paid-in capital
    
    
    453,577
    
    
    
    399,789Note receivable from stockholder
    
    
    
    
    
    
    (480
    )Accumulated other comprehensive income (loss)
    
    
    (175
    )
    
    
    47Retained earnings
    
    
    222,397
    
    
    
    191,126Total stockholders equity
    
    
    675,813
    
    
    
    590,495Total liabilities and stockholders equity
    
    $
    795,100
    
    
    $
    658,144
  (1)
    
    Derived from December 31, 2003 audited consolidated financial statements. The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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FOUNDRY NETWORKS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
 (in thousands, except per share amounts)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net revenues:Product
    
    $
    87,450
    
    
    $
    89,450
    
    
    $
    260,239
    
    
    $
    253,907Service
    
    
    15,061
    
    
    
    12,233
    
    
    
    44,115
    
    
    
    34,626Total net revenues
    
    
    102,511
    
    
    
    101,683
    
    
    
    304,354
    
    
    
    288,533Cost of revenues:Product
    
    
    33,194
    
    
    
    31,754
    
    
    
    95,630
    
    
    
    99,624Service
    
    
    3,785
    
    
    
    1,688
    
    
    
    10,477
    
    
    
    5,945Total cost of revenues
    
    
    36,979
    
    
    
    33,442
    
    
    
    106,107
    
    
    
    105,569Gross profit
    
    
    65,532
    
    
    
    68,241
    
    
    
    198,247
    
    
    
    182,964Operating expenses:Research and development
    
    
    11,686
    
    
    
    10,432
    
    
    
    31,701
    
    
    
    30,398Sales and marketing
    
    
    23,228
    
    
    
    21,428
    
    
    
    71,490
    
    
    
    64,824General and administrative
    
    
    10,204
    
    
    
    4,852
    
    
    
    21,897
    
    
    
    11,799Litigation settlement
    
    
    30,193
    
    
    
    
    
    
    
    30,193
    
    
    
    Amortization of deferred stock
compensation
    
    
    
    
    
    
    21
    
    
    
    
    
    
    
    215Total operating expenses
    
    
    75,311
    
    
    
    36,733
    
    
    
    155,281
    
    
    
    107,236Income (loss) from operations
    
    
    (9,779
    )
    
    
    31,508
    
    
    
    42,966
    
    
    
    75,728Interest and other income, net
    
    
    2,568
    
    
    
    1,475
    
    
    
    6,095
    
    
    
    3,769Income (loss) before provision for
income taxes
    
    
    (7,211
    )
    
    
    32,983
    
    
    
    49,061
    
    
    
    79,497Provision (benefit) for income taxes
    
    
    (3,593
    )
    
    
    12,204
    
    
    
    17,790
    
    
    
    28,484Net income (loss)
    
    $
    (3,618
    )
    
    $
    20,779
    
    
    $
    31,271
    
    
    $
    51,013Basic net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.16
    
    
    $
    0.23
    
    
    $
    0.41Weighted average shares used in
computing basic net income (loss)
per share
    
    
    136,038
    
    
    
    126,796
    
    
    
    134,975
    
    
    
    123,638Diluted net income (loss) per share
    
    $
    (0.03
    )
    
    $
    0.15
    
    
    $
    0.22
    
    
    $
    0.38Weighted average shares used in
computing diluted net income (loss)
per share
    
    
    136,038
    
    
    
    138,659
    
    
    
    142,730
    
    
    
    132,813
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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FOUNDRY NETWORKS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
 (in thousands)
 Nine Months Ended September 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    31,271
    
    
    $
    51,013Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    5,434
    
    
    
    3,882Amortization of deferred stock compensation
    
    
    
    
    
    
    215Reduction of allowance for doubtful accounts
    
    
    
    
    
    
    (862
    )Inventory provisions
    
    
    12,671
    
    
    
    8,901Tax benefit from stock option exercises
    
    
    20,772
    
    
    
    21,343Changes in operating assets and liabilities:Accounts receivable
    
    
    1,782
    
    
    
    (14,930
    )Inventories
    
    
    (21,355
    )
    
    
    (3,671
    )Deferred tax assets, prepaid expenses and other assets
    
    
    (13,807
    )
    
    
    (178
    )Accounts payable
    
    
    5,250
    
    
    
    5,691Accrued payroll and related expenses
    
    
    (1,716
    )
    
    
    590Other accrued expenses
    
    
    4,700
    
    
    
    3,807Litigation settlement payable
    
    
    35,000
    
    
    
    Deferred support revenue
    
    
    8,404
    
    
    
    10,517Net cash provided by operating activities
    
    
    88,406
    
    
    
    86,318CASH FLOWS FROM INVESTING ACTIVITIES:Maturities of short-term investments
    
    
    386,001
    
    
    
    176,662Purchases of short-term and long-term investments
    
    
    (525,019
    )
    
    
    (222,100
    )Purchases of property and equipment, net
    
    
    (6,891
    )
    
    
    (4,782
    )Net cash used in investing activities
    
    
    (145,909
    )
    
    
    (50,220
    )CASH FLOWS FROM FINANCING ACTIVITIES:Repayment of note receivable
    
    
    480
    
    
    
    Proceeds from issuances of common stock
    
    
    33,017
    
    
    
    47,741Net cash provided by financing activities
    
    
    33,497
    
    
    
    47,741INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (24,006
    )
    
    
    83,839Effect of exchange rate changes on cash
    
    
    (222
    )
    
    
    (36
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    161,718
    
    
    
    187,719CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    137,490
    
    
    $
    271,522SUPPLEMENTAL CASH FLOW INFORMATION:Cash paid for income taxes, net of refunds received
    
    $
    (5,415
    )
    
    $
    (4,043
    )
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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FOUNDRY NETWORKS, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Information for the three and nine months ended September 30, 2004 and 2003 is unaudited)
 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The condensed interim consolidated financial statements included herein
have been prepared by Foundry Networks, Inc., without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission (SEC) and
include the accounts of Foundry Networks, Inc. and its wholly-owned
subsidiaries (collectively Foundry or we). Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with U.S generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. The information included in
this Quarterly Report on Form 10-Q should be read in conjunction with
Managements Discussion and Analysis of Financial Condition and Results of
Operations, Quantitative and Qualitative Disclosures About Market Risk, and
the Consolidated Financial Statements and notes thereto included in Items 7,
7A, and 8, respectively, of the Foundry Networks, Inc. Annual Report on Form
10-K for the year ended December 31, 2003. The unaudited condensed consolidated financial statements included herein
reflect all adjustments, including normal recurring adjustments, which are, in
the opinion of management, necessary for a fair presentation of financial
position, results of operations and cash flows for the periods presented. The
results of operations for the three and nine months ended September 30, 2004
are not necessarily indicative of the results that may be expected for future
quarters or for the year ending December 31, 2004. Principles of Consolidation and Foreign Currency Translation Our condensed consolidated financial statements reflect the operations of
Foundry and our wholly-owned subsidiaries. All intercompany transactions and
balances have been eliminated. The functional currency of our foreign
subsidiaries is deemed to be the local countrys currency. Assets and
liabilities of foreign operations are translated into U.S. dollars at the
exchange rate in effect at the applicable balance sheet date, and revenues and
expenses are translated into U.S. dollars using average exchange rates
prevailing during that period. Translation adjustments have not been material
to date and are included as a component of accumulated other comprehensive
income or loss within stockholders equity. Reclassifications Certain prior period amounts have been reclassified to conform to the
September 30, 2004 presentation. Use of Estimates The preparation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates,
judgments, and assumptions that affect the amounts reported in the financial
statements and accompanying footnotes. Actual results could differ from those
estimates. Estimates, judgments and assumptions are used in the recognition of
revenue, accounting for allowances for doubtful accounts and sales returns,
inventory provisions, product warranty liability, income taxes, deferred tax
assets, contingencies and similar items. Estimates, judgments and assumptions
are reviewed periodically by management and the effects of revisions are
reflected in the consolidated financial statements in the period in which they
are made. Cash Equivalents and Investments We consider all investments with original maturities of 90 days or less to
be cash equivalents. Cash and cash equivalents consist of commercial paper,
corporate and government debt securities, and cash deposited in checking 6




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and money market accounts. Our investment portfolio includes only
marketable securities with original maturities of less than two years and with
secondary or resale markets to ensure portfolio liquidity. Investments in financial instruments that mature less than one year from
the balance sheet date are classified as short-term investments and investments
that mature greater than one year from the balance sheet date are classified as
long-term investments. All of our investments are stated at amortized cost and
are held-to-maturity. We monitor our investments for impairment on a quarterly basis to
determine whether a decline in fair value is other-than-temporary by
considering factors such as current economic and market conditions, the credit
rating of the securitys issuer, the length of time an investments fair value
has been below our carrying value, and our ability and intent to hold
investments to maturity. If an investments decline in fair value, caused by
factors other than changes in interest rates, is deemed to be
other-than-temporary, we would reduce its carrying value to its estimated fair
value, as determined based on quoted market prices or liquidation values.
Declines in value judged to be other-than-temporary, if any, are recorded in
operations as incurred. Cash equivalents and investments consist of the following (in thousands): September 30, 2004Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost
    
    Gains
    
    Losses
    
    Fair ValueMoney market funds
    
    $
    91,780
    
    
    $
    
    
    
    $
    
    
    
    $
    91,780Corporate securities
    
    
    16,011
    
    
    
    
    
    
    
    (47
    )
    
    
    15,964Corporate commercial paper
    
    
    9,991
    
    
    
    
    
    
    
    (1
    )
    
    
    9,990Government securities
    
    
    466,972
    
    
    
    66
    
    
    
    (824
    )
    
    
    466,214$
    584,754
    
    
    $
    66
    
    
    $
    (872
    )
    
    $
    583,948Cash equivalents
    
    $
    101,770
    
    
    $
    
    
    
    $
    
    
    
    $
    101,770Short-term investments
    
    
    276,770
    
    
    
    6
    
    
    
    (175
    )
    
    
    276,601Long-term investments
    
    
    206,214
    
    
    
    60
    
    
    
    (697
    )
    
    
    205,577$
    584,754
    
    
    $
    66
    
    
    $
    (872
    )
    
    $
    583,948
 December 31, 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    EstimatedCost
    
    Gains
    
    Losses
    
    Fair ValueMoney market funds
    
    $
    84,952
    
    
    $
    
    
    
    $
    
    
    
    $
    84,952Corporate securities
    
    
    14,388
    
    
    
    4
    
    
    
    
    
    
    
    14,392Corporate commercial paper
    
    
    21,983
    
    
    
    
    
    
    
    
    
    
    
    21,983Government securities
    
    
    338,741
    
    
    
    293
    
    
    
    (56
    )
    
    
    338,978$
    460,064
    
    
    $
    297
    
    
    $
    (56
    )
    
    $
    460,305Cash equivalents
    
    $
    116,098
    
    
    $
    
    
    
    $
    
    
    
    $
    116,098Short-term investments
    
    
    184,859
    
    
    
    1
    
    
    
    (34
    )
    
    
    184,826Long-term investments
    
    
    159,107
    
    
    
    296
    
    
    
    (22
    )
    
    
    159,381$
    460,064
    
    
    $
    297
    
    
    $
    (56
    )
    
    $
    460,305
 Inventories Inventories are stated on a first-in, first-out basis at the lower of cost
or estimated net realizable value, and include purchased parts, labor and
manufacturing overhead. Inventories consist of the following (in thousands): 7




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September 30,
    
    December 31,2004
    
    2003Purchased parts
    
    $
    10,140
    
    
    $
    9,495Work-in-process
    
    
    19,746
    
    
    
    13,528Finished goods
    
    
    6,815
    
    
    
    4,994$
    36,701
    
    
    $
    28,017
 The networking industry is characterized by rapid technological change,
frequent new product introductions, changes in customer requirements, and
evolving industry standards. Our inventory purchases and commitments are made
based on anticipated demand for our products, as estimated by management, and
our expected service requirements. We perform an assessment of our inventory
each period, which includes a review of, among other factors, demand
requirements, manufacturing lead-times, product life cycles and development
plans, component cost trends, product pricing and quality issues. Based on this
analysis, we estimate the amount of excess and obsolete inventory on hand and
make adjustments to record inventory at the lower of cost or estimated net
realizable value. Once inventory has been written down to the lower of cost or
estimated net realizable value, it is reflected on our balance sheet at its new
carrying value until it is sold or otherwise disposed. We have recorded
inventory adjustments of $27.2 million and $25.6 million as of September 30,
2004 and December 31, 2003, respectively, and such adjustments are reflected in
the amounts above. Concentrations Financial instruments that potentially subject us to a concentration of
credit risk consist principally of cash equivalents, short and long-term
investments and accounts receivable. We seek to reduce credit risk on financial
instruments by investing in high-quality debt issuances and, by policy, we
limit the amount of credit exposure with any one issuer or fund. Additionally,
we grant credit only to customers deemed credit worthy in the judgment of
management. As of September 30, 2004 and December 31, 2003, ten customers
accounted for approximately 34% and 55%, respectively, of our net outstanding
trade receivables. Proprietary ASICs used in the manufacture of our products are purchased
from sole sources. Our custom designed ASICs may not be readily available from
other suppliers as the development period required to fabricate our ASICs can
be lengthy. The inability of an ASIC supplier to fulfill our production
requirements, or the time required for us to identify new suppliers if a
relationship is terminated, could negatively affect our future results of
operations. Revenue Recognition General.We sell our products through our direct sales force to domestic
customers and through reseller channels to international customers. We generate
the majority of our revenue from sales of chassis and stackable-based
networking equipment, with the remainder of our revenue coming from customer
support fees, training and installation services. We recognize revenue when
persuasive evidence of an arrangement exists, delivery or performance has
occurred, the sales price is fixed or determinable and collectibility is
reasonably assured. Evidence of an arrangement generally consists of customer
purchase orders and, in certain instances, sales contracts or agreements.
Shipping terms and related documents, or written evidence of customer
acceptance, when applicable, are used to verify delivery or performance. We
assess whether the sales price is fixed or determinable based on payment terms
and whether the sales price is subject to refund or adjustment. We assess
collectibility based on the creditworthiness of the customer as determined by
our credit checks and the customers payment history with us. When sales arrangements contain multiple elements (e.g., hardware and
installation), we allocate revenue to each element based on its relative fair
value, which is generally the price we charge when we sell the item separately,
and recognize revenue for each element when revenue recognition criteria have
been met for that element. This is in accordance with Emerging Issues Task
Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF
00-21), which was effective for revenue arrangements entered into in fiscal
periods beginning after June 15, 8




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2003. We adopted EITF 00-21 in the third quarter of 2003, and its adoption
did not have a material effect on our results of operations or financial
position. Product.Product revenue is generally recognized at the time of shipment,
unless an acceptance period or other contingency exists, in which case revenue
is recognized upon the earlier of customer acceptance or expiration of the
acceptance period, or upon satisfaction of the contingency. Shipping charges
billed to customers are included in product revenue and the related shipping
costs are included in cost of product revenues. At the time product revenue is recognized, we estimate the amount of
warranty costs to be incurred and record the amount as a cost of product
revenue. Our standard warranty period extends 12 months from the date of sale,
and our estimate of the amount necessary to settle warranty claims is based
primarily on our past experience. We also provide for estimated sales returns
at the time product revenue is recognized and record that amount as a reduction
to product revenue. Our sales return provision is based primarily on actual
historical sales returns and our return policies. Our resellers generally do
not have a right of return and our contracts with original equipment
manufacturers only provide for rights of return in the event our products do
not meet our published specifications or there is an epidemic failure, as
defined in the contracts. Services.Service revenues consist primarily of fees for customer support
services and, to a lesser extent, training and installation services. Our suite
of customer support programs provides customers with access to technical
assistance, unspecified software updates and upgrades on a when-and-if
available basis, hardware repair and replacement parts. Support services are offered under renewable, fee-based contracts. Revenue from customer support contracts
is deferred and recognized ratably over the contractual support period, which
generally ranges from one to five years. Revenue from training and installation services is recognized when
services have been performed, and represented less than 1% of total revenues
for all periods presented. Segment and Geographic Information Operating segments are defined as components of an enterprise for which
separate financial information is available and evaluated regularly by the
chief operating decision-maker, or decision-making group, in deciding how to
allocate resources and in assessing performance. We are organized as, and
operate in, one reportable segment: the design, development, manufacturing and
marketing of a comprehensive, end-to-end suite of high-performance data
networking solutions, including Ethernet Layer 2 and Layer 3 switches, Metro
routers and Internet traffic management products. Our chief operating
decision-making group reviews consolidated financial information, accompanied
by information about revenues by geographic region and
configuration type. We manage our business based on four geographic regions: the Americas
(primarily the United States); Europe, the Middle East, and Africa (EMEA);
Japan; and Asia Pacific. Our foreign offices conduct sales, marketing and
support activities. We determine revenues by geographic location based on the
physical destination of our product shipments. Net product revenue by region as
a percentage of net product revenue was as follows: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Americas
    
    
    64
    %
    
    
    61
    %
    
    
    67
    %
    
    
    66
    %EMEA
    
    
    15
    %
    
    
    12
    %
    
    
    15
    %
    
    
    13
    %Japan
    
    
    13
    %
    
    
    17
    %
    
    
    11
    %
    
    
    13
    %Asia Pacific
    
    
    8
    %
    
    
    10
    %
    
    
    7
    %
    
    
    8
    %
 9




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##### Table of Contents



Sales to the U.S. federal government accounted for approximately 28% and
29% of our total revenues in the three and nine months ended September 30,
2004, respectively, and approximately 31% and 30% of our total revenues in the
three and nine months ended September 30, 2003, respectively. Net product revenue from customers representing 10% or more of net product
revenue for the respective periods was as follows: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Customer A
    
    
    <10
    %
    
    
    11
    %
    
    
    <10
    %
    
    
    16
    %Customer B
    
    
    <10
    %
    
    
    16
    %
    
    
    <10
    %
    
    
    12
    %
 Computation of Per Share Amounts Basic earnings or loss per share has been calculated using the
weighted-average number of shares of common stock outstanding during the
period. Diluted earnings per share (EPS) has been calculated using the
weighted-average number of shares of common stock outstanding during the period
and potentially dilutive weighted-average common stock equivalents.
Weighted-average common stock equivalents include the potentially dilutive
effect of in-the-money stock options, determined based on the average share
price for each period using the treasury stock method. Under the treasury stock
method, the tax-effected proceeds that would be received assuming the exercise
of all in-the-money stock options are assumed to be used to repurchase shares
in the open market. Certain common stock equivalents were excluded from the
calculation of diluted EPS because the exercise price of these common stock
equivalents was greater than the average market price of the common stock for
the respective period or because a net loss was reported for the respective
period and, therefore, their inclusion would have been anti-dilutive. There
were 17.9 million and 2.2 million anti-dilutive common stock equivalents for
the three months ended September 30, 2004 and 2003, respectively. For the nine
months ended September 30, 2004 and 2003, there were 6.4 million and 3.3
million anti-dilutive common stock equivalents, respectively. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands, except per share data)Net income (loss)
    
    $
    (3,618
    )
    
    $
    20,779
    
    
    $
    31,271
    
    
    $
    51,013Basic:Weighted average shares outstanding
    
    
    136,038
    
    
    
    126,796
    
    
    
    134,975
    
    
    
    123,638Basic earnings (loss) per share
    
    $
    (0.03
    )
    
    $
    0.16
    
    
    $
    0.23
    
    
    $
    0.41Diluted:Weighted average shares outstanding
    
    
    136,038
    
    
    
    126,796
    
    
    
    134,975
    
    
    
    123,638Add: Weighted average dilutive
potential shares
    
    
    
    
    
    
    11,863
    
    
    
    7,755
    
    
    
    9,175Weighted average shares used in
computing diluted EPS
    
    
    136,038
    
    
    
    138,659
    
    
    
    142,730
    
    
    
    132,813Diluted earnings (loss) per share
    
    $
    (0.03
    )
    
    $
    0.15
    
    
    $
    0.22
    
    
    $
    0.38
 Stock-Based Compensation As permitted by Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (SFAS 123), we follow the intrinsic
value method of accounting for employee stock options as prescribed by
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees. Accordingly, we recognize compensation expense if options are
granted with an exercise price below fair market value at the date of grant or
if options are modified subsequent to the date of grant. Any resulting
compensation 10




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##### Table of Contents



expense is recognized either ratably over the vesting period or using
variable accounting over the period from the date of modification to exercise
or cancellation of the award. The following table illustrates the effect on reported net income or loss
and earnings or loss per share had we accounted for our employee stock options
and employee stock purchase plan under the fair value method prescribed by SFAS
123. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands, except per share data)Net income (loss) as reported
    
    $
    (3,618
    )
    
    $
    20,779
    
    
    $
    31,271
    
    
    $
    51,013Add: Total stock-based compensation
expense included in reported net
income (loss), net of tax effect
    
    
    
    
    
    
    13
    
    
    
    
    
    
    
    139Deduct: Total stock-based
compensation expense determined
under fair value method for all
awards, net of related tax effect
    
    
    (9,720
    )
    
    
    (8,148
    )
    
    
    (28,082
    )
    
    
    (23,201
    )Pro forma net income (loss)
    
    $
    (13,338
    )
    
    $
    12,644
    
    
    $
    3,189
    
    
    $
    27,951Basic net income (loss) per share:As reported
    
    $
    (0.03
    )
    
    $
    0.16
    
    
    $
    0.23
    
    
    $
    0.41Pro forma
    
    $
    (0.10
    )
    
    $
    0.10
    
    
    $
    0.02
    
    
    $
    0.23Diluted net income (loss) per share:As reported
    
    $
    (0.03
    )
    
    $
    0.15
    
    
    $
    0.22
    
    
    $
    0.38Pro forma
    
    $
    (0.10
    )
    
    $
    0.09
    
    
    $
    0.02
    
    
    $
    0.21
 We estimate the fair value of our stock options using the Black-Scholes
option valuation model, which is the most commonly used model for purposes of
disclosure pursuant to SFAS 123. The Black-Scholes option-pricing model
includes assumptions regarding expected volatility, lives, dividend yields, and
risk-free interest rates. These assumptions reflect our best estimates, but
these items involve uncertainties based on market conditions generally outside
of our control. The following weighted-average assumptions were used to
estimate the fair value of option grants and employee stock purchase plan
purchase rights: Three Months
    
    Nine MonthsEnded September 30,
    
    Ended September 30,2004
    
    2003
    
    2004
    
    2003Stock Option Plan:Average risk free interest rate
    
    
    2.89
    %
    
    
    2.41
    %
    
    
    2.90
    %
    
    
    2.15
    %Average expected life of option
    
    2.8 years
    
    3.8 years
    
    3.5 years
    
    3.8 yearsDividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility of common stock
    
    
    70
    %
    
    
    52
    %
    
    
    72
    %
    
    
    64
    %
 Three Months
    
    Nine MonthsEnded September 30,
    
    Ended September 30,2004
    
    2003
    
    2004
    
    2003Employee Stock Purchase Plan:Average risk free interest rate
    
    
    2.33
    %
    
    
    1.88
    %
    
    
    2.12
    %
    
    
    1.88
    %Average expected life of option
    
    1.4 years
    
    2.0 years
    
    1.4 years
    
    2.0 yearsDividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility of common stock
    
    
    68
    %
    
    
    74
    %
    
    
    67
    %
    
    
    74
    %
 11




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##### Table of Contents



Recent Accounting Pronouncements The Financial Accounting Standard Board (FASB) issued an exposure draft
entitled Share-Based Payment, an Amendment of FASB Statements Nos. 123 and
95.This exposure draft would require stock-based compensation to employees to
be recognized as a cost in the financial statements and that such cost be
measured according to the fair value of the stock options. In the absence of an
observable market price for the stock awards, the fair value of the stock
options would be based upon a valuation methodology that takes into
consideration various factors, including the exercise price of the option, the
expected term of the option, the current price of the underlying shares, the
expected volatility of the underlying share price, expected dividends on the
underlying shares and a risk-free interest rate. The proposed requirements in
the exposure draft would be effective for interim periods beginning after June
15, 2005. The FASB intends to issue a final Statement in late 2004. We have not
yet assessed the impact of adopting this new standard. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus
on recognition and measurement guidance previously discussed under EITF 03-01,
The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. The consensus clarifies the meaning of other-than-temporary
impairment and its application to investments classified as either
available-for-sale or held-to-maturity under SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities, and investments accounted
for under the cost method or the equity method. The Task Force developed a
basic three-step model in evaluating whether an investment is
other-than-temporarily impaired and reached a consensus that additional
disclosures are required for cost method investments. The recognition and
measurement guidance is applied to other-than-temporary impairment evaluations
in reporting periods beginning after June 15, 2004. Quantitative and
qualitative disclosures required by EITF 03-1 for investments accounted for
under SFAS No. 115 are effective for our fiscal year ending December 31, 2004.
The adoption of EITF 03-1 did not have a material effect on our results of
operations and financial condition. 2.COMPREHENSIVE INCOME OR LOSS Comprehensive income or loss is defined as the change in equity of an
enterprise excluding changes resulting from stockholder transactions. Non-net
income components of comprehensive income or loss for the three and nine months
ended September 30, 2004 and 2003 were insignificant and consisted entirely of
foreign currency translation adjustments. 3.COMMITMENTS AND CONTINGENCIES Guarantees and Product Warranties FASB Interpretation No. 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others (FIN 45), requires that upon issuance of a guarantee, the guarantor
must disclose and record a liability for the fair value of the obligation it
assumes under that guarantee. FIN 45 is applicable to our product warranty
liability and, for disclosure purposes, to indemnification obligations
contained in commercial agreements, including customary intellectual property
indemnifications for our products contained in agreements with our resellers
and end-users. We generally provide customers with a standard one-year hardware and
90-day software warranty. Customers can upgrade and/or extend the warranty for
up to five years by purchasing one of our customer support programs. Our
warranty accrual represents our best estimate of the amount necessary to settle
future and existing claims as of the balance sheet date. We periodically assess
the adequacy of our warranty accrual and adjust the amount as considered
necessary. 12




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##### Table of Contents



Changes in product warranty liability for the nine months ended September
30, 2004 were as follows: Balance, December 31, 2003
    
    $
    1,781Liabilities accrued for warranties issued during the period
    
    
    761Warranty claims settled during the period
    
    
    (540
    )Expirations and changes in estimates
    
    
    (482
    )Balance, September 30, 2004
    
    $
    1,520
 We offer our customers renewable support arrangements, including extended
warranties, that generally range from one to five years. We do not separate
extended warranty revenues from routine support service revenues, as it is not
practical to do so. The change in our deferred support revenue balance was as
follows for the nine months ended September 30, 2004: Balance, December 31, 2003
    
    $
    35,115Additions to deferred support revenue
    
    
    51,479Recognition of support revenue
    
    
    (43,075
    )Balance, September 30, 2004
    
    $
    43,519
 In the ordinary course of business, we enter into contractual arrangements
under which we may agree to indemnify the counter-party from any losses
relating to a breach of representations and warranties, a failure to perform
certain covenants, or claims and losses arising from certain external events as
outlined within the particular contract, which may include, for example, losses
arising from litigation or claims relating to past performance. Such
indemnification clauses may not be subject to maximum loss clauses. No amounts
are reflected in our condensed consolidated financial statements as of
September 30, 2004 or December 31, 2003 related to these indemnifications as,
historically, payments made related to these indemnifications have not been
material to our financial position or results of operations. Purchase Commitments with Suppliers and Third-Party Manufacturers We use contract manufacturers to assemble and test our products. We also
utilize third-party original equipment manufacturers (OEMs) to manufacture
certain Foundry-branded products. In order to reduce manufacturing lead-times
and ensure an adequate supply of inventories, our agreements with some of these
manufacturers allow them to procure long lead-time component inventory on our
behalf based on a rolling production forecast provided by us. We may be
contractually obligated to purchase long lead-time component inventory procured
by certain manufacturers in accordance with our forecast, unless we give notice
of order cancellation at least 90 days prior to the delivery date. In addition,
we issue purchase orders to our component suppliers and third-party
manufacturers that may not be cancelable at any time. As of September 30, 2004,
we had approximately $42.9 million of open purchase orders with our component
suppliers and third-party manufacturers that may not be cancelable. Litigation In December 2000, several similar stockholder class action lawsuits were
filed against us and certain of our officers in the United States District
Court for the Northern District of California, following our announcement of
our anticipated financial results for the fourth quarter ended December 31,
2000. The lawsuits were subsequently consolidated as a class action by the
District Court, under the caption In re Foundry Networks, Inc. Securities
Litigation,Master File No. C-00-4823-MMC, and lead plaintiffs were selected
and filed a consolidated amended complaint which alleged violations of federal
securities laws and purported to seek damages on behalf of a class of
stockholders who purchased our common stock during the period from September 7,
2000 to December 19, 2000. We then brought four successful motions to dismiss
the complaint. Although the District Court granted each of the four dismissal
motions, it also provided plaintiffs leave to amend the complaint. On August
29, 2003, following the dismissal of the four amended complaints, the District
Court granted our motion to dismiss the case with prejudice and without leave
to amend and, on September 2, 2003, entered judgment in our favor, dismissing
the plaintiffs fifth amended complaint. On September 29, 2003, plaintiffs
filed a Notice of Appeal with the United States Court of 13




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##### Table of Contents



Appeals for the Ninth Circuit (Court of Appeals). On January 15, 2004,
the plaintiff/appellants filed their opening brief with the Court of Appeals.
On April 2, 2004, we filed our responsive brief. On May 14, 2004, the plaintiff
appellants filed a reply brief. The briefing is now complete and the parties
are awaiting a schedule for oral argument from the Court of Appeals. We believe
the District Courts judgment validates our conviction that the lawsuit is
without merit and we will defend the District Courts judgment vigorously. A class action lawsuit was filed on November 27, 2001 in the United States
District Court for the Southern District of New York on behalf of purchasers of
our common stock alleging violations of federal securities laws. The case was
designated as In re Foundry Networks, Inc. Initial Public Offering Securities
Litigation,No. 01-CV-10640 (SAS) (S.D.N.Y.), related to In re Initial Public
Offering Securities Litigation,No. 21 MC 92 (SAS) (S.D.N.Y.). The case is
brought purportedly on behalf of all persons who purchased our common stock
from September 27, 1999 through December 6, 2000. The operative amended
complaint names as defendants us and three of our officers (the Foundry
Defendants), including our Chief Executive Officer and Chief Financial
Officer; and investment banking firms that served as underwriters for our
initial public offering in September 1999. The amended complaint alleged
violations of Sections 11 and 15 of the Securities Act of 1933, and Section
10(b) of the Securities Exchange Act of 1934, on the grounds that the
registration statement for the initial public offering ( IPO) failed to
disclose that (i) the underwriters agreed to allow certain customers to
purchase shares in the IPO in exchange for excess commissions to be paid to the
underwriters, and (ii) the underwriters arranged for certain customers to
purchase additional shares in the aftermarket at predetermined prices. The
amended complaint also appears to allege that false or misleading analyst
reports were issued. Similar allegations were made in lawsuits challenging over
300 other initial public offerings conducted in 1999 and 2000. The cases were
consolidated for pretrial purposes. On February 19, 2003, the Court ruled on
all defendants motions to dismiss. In ruling on motions to dismiss, the Court
must treat the allegations in the complaint as if they were true solely for
purposes of deciding the motions. The motion was denied as to claims under the
Securities Act of 1933 in the case involving us. The same ruling was made in
all but 10 of the other cases. The Court dismissed the claims under Section
10(b) of the Securities Exchange Act of 1934 against us and one of the
individual defendants and dismissed all of the Section 20(a) control person
claims. The Court denied the motion to dismiss the Section 10(b) claims against
our remaining individual defendants on the basis that those defendants
allegedly sold our stock following the IPO, allegations found sufficient purely
for pleading purposes to allow those claims to move forward. A similar ruling
was made with respect to 62 of the individual defendants in the other cases. We
have accepted a settlement proposal presented to all issuer defendants. Under
the terms of this settlement, plaintiffs will dismiss and release all claims
against the Foundry Defendants in exchange for a contingent payment by the
insurance companies collectively responsible for insuring the issuers in all of
the IPO cases and for the assignment or surrender of control of certain claims
we may have against the underwriters. The settlement will require approval of
the Court, which cannot be assured, after class members are given the
opportunity to object to the settlement or opt out of the settlement. Since March 2001, we have reported on patent litigation between us and
Nortel Networks Corp. (Nortel). Nortel filed the initial complaint in United
States District Court for the District of Massachusetts. In October 2002, we
filed our own patent complaint against Nortel in the United States District
Court, Northern District of California. Subsequently, Nortel filed an Answer
and Counter Claim asserting additional patents. On October 25, 2004, we entered
into a settlement agreement and cross patent license (the agreements)
covering technologies that were at issue in the case with Nortel. The
agreements resolved both the litigation in Massachusetts and in California.
Under the terms of the agreements, we paid Nortel $35.0 million in early
November 2004. In May 2003, Lucent Technologies Inc. (Lucent) filed a lawsuit against
us in the United States District Court for the District of Delaware alleging
that certain of our products infringe several of Lucents patents, and seeking
injunctive relief, as well as unspecified damages. Lucent also brought suit on
the same patents (and one additional patent) against one of our competitors. On
August 12, 2003, we filed a motion to sever the cases, and on February 6, 2004,
the District Court granted the motion. Fact Discovery is now closed. Initial expert reports
have been exchanged and rebuttal reports are due November 22, 2004. A Markman Hearing (claims construction) is
scheduled for January 14, 2005. The parties have
been instructed by the court to be prepared for trial in the spring of 2005. We
have analyzed the validity of Lucents claims and believe that Lucents suit is
without merit. We are committed to vigorously defending ourselves against
Lucents claims. On February 13, 2004, we filed a lawsuit against Lucent in the United
States District Court, Eastern District of Texas, Marshall Division. The
lawsuit alleges that certain of Lucents products infringe one of our patents.
We are 14




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##### Table of Contents



seeking injunctive relief and damages. On March 22, 2004, Lucent filed an
Answer and Counter Claim seeking a declaration of invalidity as to our asserted
patent. On April 9, 2004, Lucent filed an Amended Answer and Counter Claim
asserting infringement of U.S. patent #5649131. We analyzed the validity of
Lucents counter claim and believe it is without merit. Discovery has begun
and is scheduled to close on June 17, 2005. A Markman Hearing (claims construction)
is scheduled for March 24, 2005. Trial is scheduled to begin
August 1, 2005. From time to time, we are subject to other legal proceedings and claims in
the ordinary course of business, including claims of alleged infringement of
trademarks, copyrights, patents and other intellectual property rights. In
addition, from time to time, third parties assert patent infringement claims
against us in the form of letters, lawsuits and other forms of communication.
Regardless of the merits of our position, litigation is always an expensive and
uncertain proposition. In accordance with SFAS No. 5, Accounting for
Contingencies (SFAS 5), we record a liability when it is both probable that
a liability has been incurred and the amount of the loss can be reasonably
estimated. We review the need for any such provision on a quarterly basis and
record any necessary adjustments to reflect the effect of ongoing negotiations,
settlements, rulings, advice of legal counsel, and other information and events
pertaining to a particular case in the period they become known. To date, we
have not recorded any such provisions in accordance with SFAS 5. We believe we
have valid defenses with respect to the legal matters pending against us. In
the event of a determination adverse to us, we could incur substantial monetary
liability, and be required to change our business practices. Any unfavorable
determination could have a material adverse effect on our financial position,
results of operations, or cash flows. 4. INCOME TAXES: Our interim effective income tax rate is based on our best estimate of our
annual effective income tax rate. During the third quarter of 2004, we changed
our estimate of our annual effective income tax rate to 37%, excluding the tax effect of the Nortel settlement, from 38% in the
prior quarter, primarily due to a reduction in estimated pre-tax income and an
expected increase in tax-exempt interest income. The effect of this change in
estimate was a decrease in net loss of $0.7 million for the three months ended
September 30, 2004. The effective tax rate for the three and nine months ended
September 30, 2004 was 50% and 36%, respectively, compared to 37% and 36% for
the three and nine months ended September 30, 2003, respectively. These rates
reflect federal and state statutory tax rates, offset by expected tax benefits
associated with research and development tax credits, export sales incentives,
tax-exempt interest income, and the tax effect of the Nortel settlement. We expect our effective tax rate to be
approximately 35% in the fourth quarter of 2004 due to the resolution of certain tax contingencies and the effect of the
reinstatement of the research and development credit. Our income taxes payable for federal and state purposes has been reduced
by the tax benefits associated with taxable dispositions of employee stock
options. When an employee exercises a stock option issued under a nonqualified
plan or has a disqualifying disposition related to a qualified plan, we receive
an income tax benefit for the difference between the fair market value of the
stock issued at the time of exercise or disposition and the option price, tax
effected. These benefits are recorded in stockholders equity and were $20.8
million and $21.3 million for the nine months ended September 30, 2004 and
2003, respectively. Management believes Foundry will likely generate sufficient taxable income
in the future to realize the tax benefits arising from its existing net
deferred tax assets of $35.0 million at September 30, 2004. 5. SUBSEQUENT EVENT: On October 25, 2004, we entered into a settlement agreement and cross
patent license agreement (the agreements) with Nortel. Pursuant to the
agreements, we paid $35.0 million to Nortel in early November 2004. As a result
of the agreements, Nortels actions for monetary damages and an injunction
against us will be dismissed, and our suit against Nortel will also be
dismissed. In conjunction with the agreements, and based on the results of a
third-party valuation analysis, we recorded an operating expense of
$30.2 million in the third quarter of 2004. The remaining $4.8 million paid to
Nortel represents consideration for a four year license of Nortels patents and
is recorded as a long-term asset on the accompanying condensed consolidated
balance sheet as of September 30, 2004. This amount will be amortized ratably
to cost of product revenue over the four year license term. 15




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results Of Operations The following discussion and analysis of our financial condition and
results of operations should be read together with our condensed consolidated
financial statements and related notes appearing elsewhere in thisForm 10-Q.
This discussion and analysis contain forward-looking statements that involve
risks, uncertainties and assumptions. Our actual results may differ materially
from those anticipated in these forward-looking statements as a result of many
factors, including, but not limited to, those discussed in the section entitled
Managements Discussion and Analysis of Financial Condition and Results of
Operations-Risk Factors That May Affect Future Results and the Market Price of
Our Stock. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect managements opinions only as of the
date hereof. We undertake no obligation to revise or publicly release the
results of any revision to these forward-looking statements. Readers should
carefully review the risk factors described in this document as well as in
other documents we file from time to time with the SEC. All public reports
filed by us with the SEC are available free of charge on our website at
www.foundrynetworks.com or from the SEC at www.sec.gov as soon as practicable
after we electronically file such reports with the SEC. Overview Founded in 1996, Foundry designs, develops, manufactures and markets a
comprehensive, end-to-end suite of high performance data networking solutions,
including Ethernet Layer 2 and Layer 3 switches, Metro routers, and Internet
traffic management products. Our customers include U.S. government agencies,
universities, e-commerce sites, and enterprises such as healthcare, financial,
manufacturing and entertainment companies, as well as Internet and Metro
service providers. Changes to Previously Announced Third Quarter Results On October 25, 2004, we entered into a settlement agreement and cross
patent license agreement (the agreements) with Nortel . Pursuant to the
agreements, we paid $35.0 million to Nortel in early November 2004. As a result
of the agreements, Nortels actions for monetary damages and an injunction
against us will be dismissed, and our suit against Nortel will also be
dismissed. In conjunction with the agreements, and based on the results of a
third-party valuation analysis, we adjusted our previously announced third quarter 2004 results
of operations by recording an operating expense of
$30.2 million in the third quarter of 2004. The remaining $4.8 million paid to
Nortel represents consideration for a four year license of Nortels patents and
is recorded as a long-term asset on the accompanying condensed consolidated
balance sheet as of September 30, 2004. This amount will be amortized ratably
to cost of product revenue over the four year license term. Critical Accounting Policies and Use of Estimates Managements discussion and analysis of financial condition and results of
operations are based on our condensed consolidated financial statements, which
have been prepared in accordance with U.S. generally accepted accounting
principles. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the condensed consolidated financial statements, and the reported amounts of
revenue and expenses during the period reported. By their nature, these
estimates and judgments are subject to an inherent degree of uncertainty.
Management bases its estimates and judgments on historical experience, market
trends, and other factors that are believed to be reasonable under the
circumstances. The results of these estimates form the basis for judgments
about the carrying value of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions. Management believes critical
accounting policies as disclosed in our Annual Report on Form 10-K for the year
ended December 31, 2003 reflect the more significant judgments and estimates
used in preparation of our financial statements. Management has discussed the
development, selection, and disclosure of these estimates with the Audit
Committee of Foundrys Board of Directors. Management believes there have been
no material changes to our critical accounting policies and estimates during
the nine months ended September 30, 2004 compared to those discussed in our
Annual Report on Form 10-K for the year ended December 31, 2003. Results of Operations 16




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##### Table of Contents



Net Revenues We offer products in two configuration platforms, a fixed configuration
stackable and a flexible configuration chassis. A stackable has a fixed
configuration that cannot be altered. Chassis use a modular platform that can
be populated and reconfigured with various management and line card modules as
frequently as desired by the customer. For example, customers can use our
chassis products at the edge of their network and then reconfigure the chassis
to be used in the backbone or core of their network. Our selling prices and
gross margins on chassis-based products are generally higher than our stackable
products because of the flexible configuration offered by chassis-based
products. Net revenue information is as follows (dollars in thousands): Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003% of
    
    
    
    
    
    % of
    
    
    
    
    
    % of
    
    
    
    
    
    % of$
    
    Revenues
    
    $
    
    Revenues
    
    $
    
    Revenues
    
    $
    
    RevenuesNet revenues:Product
    
    $
    87,450
    
    
    
    85
    %
    
    $
    89,450
    
    
    
    88
    %
    
    $
    260,239
    
    
    
    86
    %
    
    $
    253,907
    
    
    
    88
    %Service
    
    
    15,061
    
    
    
    15
    %
    
    
    12,233
    
    
    
    12
    %
    
    
    44,115
    
    
    
    14
    %
    
    
    34,626
    
    
    
    12
    %Total net revenues
    
    $
    102,511
    
    
    
    100
    %
    
    $
    101,683
    
    
    
    100
    %
    
    $
    304,354
    
    
    
    100
    %
    
    $
    288,533
    
    
    
    100
    %Chassis
    
    $
    70,733
    
    
    
    69
    %
    
    $
    78,296
    
    
    
    77
    %
    
    $
    228,266
    
    
    
    75
    %
    
    $
    230,826
    
    
    
    80
    %Stackable
    
    
    31,778
    
    
    
    31
    %
    
    
    23,387
    
    
    
    23
    %
    
    
    76,088
    
    
    
    25
    %
    
    
    57,707
    
    
    
    20
    %Total net revenues
    
    $
    102,511
    
    
    
    100
    %
    
    $
    101,683
    
    
    
    100
    %
    
    $
    304,354
    
    
    
    100
    %
    
    $
    288,533
    
    
    
    100
    %
 For the three month period, product revenues decreased slightly primarily
due to selling price erosion caused by heightened competition in the IT
marketplace and reduced demand for chassis products. The effect of these
factors was offset somewhat by the success of our new 10-Gigabit Ethernet
FastIron Edge stackable, which was introduced in the second quarter of 2004 and
gained customer acceptance in the third quarter. For the nine month period,
product revenue increased due to stronger overall demand for networking
products in the first quarter of 2004 as compared to the first quarter of 2003,
offset somewhat by lower average selling prices resulting from continuing
competitive pressures. Sales to the U.S. federal government as a percentage of
total revenues were approximately 28% and 31% for the three months ended
September 30, 2004 and 2003, respectively, and approximately 29% and 30% for
the nine months ended September 30, 2004 and 2003, respectively. Service revenues consist primarily of revenue from customer support
contracts, and to a lesser extent, from training and installation services.
Service revenues increased in absolute dollars in 2004 due to growth in our
installed base of networking equipment and increased efforts to renew customer
support contracts. We manage our business based on four geographic regions: the Americas
(primarily the United States); Europe, the Middle East, and Africa (EMEA);
Japan; and Asia Pacific. We determine revenues by geographic location based on
the physical destination of our product shipments. Net product revenue by
region as a percentage of net product revenue was as follows: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Americas
    
    
    64
    %
    
    
    61
    %
    
    
    67
    %
    
    
    66
    %EMEA
    
    
    15
    %
    
    
    12
    %
    
    
    15
    %
    
    
    13
    %Japan
    
    
    13
    %
    
    
    17
    %
    
    
    11
    %
    
    
    13
    %Asia Pacific
    
    
    8
    %
    
    
    10
    %
    
    
    7
    %
    
    
    8
    %
 17




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##### Table of Contents



The shift in product sales from Japan to EMEA in 2004 was due to large
deployments of our products in Europe by the U.S. government during 2004,
compared to large deployments of our products by major service providers in
Japan during 2003. Product sales in the Americas increased slightly during
2004 due to stronger demand for our networking equipment from enterprise
customers. Net product revenue from customers representing 10% or more of net product
revenue was as follows: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Customer A
    
    
    <10
    %
    
    
    11
    %
    
    
    <10
    %
    
    
    16
    %Customer B
    
    
    <10
    %
    
    
    16
    %
    
    
    <10
    %
    
    
    12
    %
 Gross Margins The following table presents gross margins and the related gross margin
percentages for the three and nine months ended September 30, 2004 and 2003
(dollars in thousands): Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Gross
    
    
    
    
    
    Gross
    
    
    
    
    
    Gross
    
    
    
    
    
    Gross$
    
    Margin %
    
    $
    
    Margin %
    
    $
    
    Margin %
    
    $
    
    Margin %Gross margins:Product
    
    $
    54,256
    
    
    
    62
    %
    
    $
    57,696
    
    
    
    65
    %
    
    $
    164,609
    
    
    
    63
    %
    
    $
    154,283
    
    
    
    61
    %Service
    
    
    11,276
    
    
    
    75
    %
    
    
    10,545
    
    
    
    86
    %
    
    
    33,638
    
    
    
    76
    %
    
    
    28,681
    
    
    
    83
    %Total gross margins
    
    $
    65,532
    
    
    
    64
    %
    
    $
    68,241
    
    
    
    67
    %
    
    $
    198,247
    
    
    
    65
    %
    
    $
    182,964
    
    
    
    63
    %
 Our cost of product revenue consists primarily of material, labor,
manufacturing overhead, freight, warranty costs, and provisions for excess and
obsolete inventory. The decrease in product gross margins as a percentage of
net product revenue for the three months ended September 30, 2004 was due to
increased competitive pricing pressure on our products, a shift in product mix
to lower margin stackable products, and slightly higher inventory provisions,
offset somewhat by reduced component costs for our newer products. During the
third quarter of 2004, our product mix shifted from higher-margin chassis
products to lower-margin stackable products due to the successful introduction
of our new 10-gigabit stackable switches for the network edge. The increase in
product gross margins as a percentage of net product revenue for the nine
months ended September 30, 2004 was due to increased sales volume and lower
contract manufacturing and component costs such as memory devices and printed
circuit boards in 2004, offset somewhat by lower average selling prices. Our cost of service revenues consists primarily of costs of providing
services under customer support contracts. These costs include material costs,
labor, and overhead. The decreases in our service gross margin percentages were
due primarily to increased inventory provisions associated with carrying higher
inventory levels to support a larger customer base and a broader product
portfolio, and costs associated with operating more service facilities. Our gross margins may be adversely affected by increased price
competition, component shortages, increases in material or labor costs, excess
and obsolete inventory charges, changes in channels of distribution, or
customer, product and geographic mix. See also Risk Factors That May Affect
Future Results and Market Price of Stock-Our gross margins may decline over
time and the average selling prices of our products may decrease as a result of
competitive pressures and other factors. 18




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##### Table of Contents



Operating Expenses The following table presents operating expenses for the three and nine
months ended September 30, 2004 and 2003 (dollars in thousands): Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003% of
    
    
    
    
    
    % of
    
    
    
    
    
    % of
    
    
    
    
    
    % of$
    
    Revenues
    
    $
    
    Revenues
    
    $
    
    Revenues
    
    $
    
    RevenuesResearch and
Development
    
    $
    11,686
    
    
    
    11
    %
    
    $
    10,432
    
    
    
    10
    %
    
    $
    31,701
    
    
    
    10
    %
    
    $
    30,398
    
    
    
    11
    %Sales and Marketing
    
    
    23,228
    
    
    
    23
    %
    
    
    21,428
    
    
    
    21
    %
    
    
    71,490
    
    
    
    23
    %
    
    
    64,824
    
    
    
    22
    %General and
Administrative
    
    
    10,204
    
    
    
    10
    %
    
    
    4,852
    
    
    
    5
    %
    
    
    21,897
    
    
    
    7
    %
    
    
    11,799
    
    
    
    4
    %Litigation
settlement
    
    
    30,193
    
    
    
    29
    %
    
    
    
    
    
    
    
    
    
    
    30,193
    
    
    
    10
    %
    
    
    
    
    
    
    
 Research and development expenses consist primarily of salaries and
related personnel expenses, prototype materials, costs incurred for the
development of our ASICs, software development and testing costs, and
depreciation of equipment used in research and development activities. The
increases in research and development expenses in 2004 were due primarily to
higher depreciation expense as a result of significant purchases of advanced
test equipment during the first half of 2004, and to a lesser extent, increased
headcount. The effects of these factors were offset somewhat by reduced costs
for prototype materials. We believe that investments in research and
development, including the recruiting and hiring of engineers, are critical to
our ability to remain competitive in the marketplace. Sales and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in marketing, sales and customer
service functions, as well as trade shows, advertising, promotional expenses
and the cost of facilities. The increase in absolute dollars for the three
months ended September 30, 2004 was primarily due to higher incentive
compensation as a result of better sales performance relative to sales quotas
and increased payroll costs associated with a 5% growth in headcount. The
increase in absolute dollars for the nine months ended September 30, 2004 was
primarily due to a $4.7 million increase in advertising and trade show expenses
to enhance our brand recognition and to announce our new products such as our
Terabit-capacity chassis and 10-Gigabit stackable products. Expenses for the
nine months ended September 30, 2004 also increased due to higher costs
associated with demonstration and evaluation equipment at customer sites and
hiring of sales personnel throughout 2004. General and administrative expenses consist primarily of salaries and
related expenses for executive, finance and administrative personnel,
facilities, bad debt, legal, and other general corporate expenses. The increase
in absolute dollars for the three months ended September 30, 2004 was due
primarily to an increase of $4.7 million in legal fees related to the Nortel
and Lucent patent infringement cases discussed in Note 3 and an increase of
$0.5 million for consulting fees related to compliance with Section 404 of the
Sarbanes-Oxley Act. The increase in absolute dollars for the nine months ended
September 30, 2004 was due to increases of $7.0 million in legal fees related
to the Nortel and Lucent patent infringement cases, $1.1 million for consulting
fees related to compliance with Section 404 of the Sarbanes-Oxley Act, and $0.9
million from reduced bad debt reserve requirements in 2003, compared to no bad
debt reserve requirements in 2004. On October 25, 2004, we entered into a settlement agreement and cross
patent license agreement (the agreements) with Nortel . Pursuant to the
agreements, we paid $35.0 million to Nortel in early November 2004. As a result
of the agreements, Nortels actions for monetary damages and an injunction
against us will be dismissed, and our suit against Nortel will also be
dismissed. In conjunction with the agreements, and based on the results of a 19




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third-party valuation analysis, we recorded an operating expense
of $30.2 million in the third quarter of 2004. The remaining $4.8 million paid
to Nortel represents consideration for a four year license of Nortels patents
and is recorded as a long-term asset on the accompanying condensed consolidated
balance sheet as of September 30, 2004. This amount will be amortized ratably
to cost of product revenue over the four year license term. Interest and other income, net We earn interest income on funds maintained in interest-bearing money
market and investment accounts. The increase in net interest and other income
in 2004 was primarily a result of higher interest rates and investment balances
and, to a lesser extent, realized gains from favorable movements in foreign
currency exchange rates. Our total cash and investments increased $164.8
million from September 30, 2003 to September 30, 2004. Income Taxes Our effective tax rates for the three months ended September 30, 2004 and
2003 were 50% and 37%, respectively. The effective tax rate for the nine months
ended September 30, 2004 and 2003 was 36%. During the
third quarter of 2004, we changed our estimate of our annual effective income
tax rate to 37%, excluding the tax effect of the Nortel settlement, from 38% in the prior quarter, primarily due to a reduction in
estimated pre-tax income and an expected increase in tax-exempt interest
income. The effect of this change in estimate was a decrease in net loss of
$0.7 million for the three months ended September 30, 2004. We expect our effective tax
rate to be approximately 35% in the fourth quarter of 2004 due to the resolution of certain tax
contingencies and the effect of
the reinstatement of the research and development credit. Our income taxes payable for federal and state purposes has been reduced,
and stockholders equity increased, by the tax benefits associated with taxable
dispositions of employee stock options. When an employee exercises a stock
option issued under a nonqualified plan, or has a disqualifying disposition
related to a qualified plan, we receive an income tax benefit for the
difference between the fair market value of the stock issued at the time of the
exercise or disposition and the employees option price, tax effected. These
benefits are recorded in stockholders equity and were $20.8 million and $21.3
million for the nine months ended September 30, 2004 and 2003, respectively. Liquidity and Capital Resources At September 30, 2004, we had cash and investments totaling $620.5
million, an increase of $114.8 million from $505.7 million at December 31,
2003. The increase can be attributed to $88.4 million of cash from operations
and $33.0 million of proceeds from the exercise of employee stock options
during the nine months ended September 30, 2004, offset by $6.9 million of
equipment purchases. Net accounts receivable was $75.3 million at September 30, 2004 and $77.1
million at December 31, 2003. Our accounts receivable and days sales
outstanding (DSO) are primarily affected by sale volume, shipment linearity
and collections performance. Our DSO was 66 days as of September 30, 2004,
compared to 69 days as of June 30, 2004 and 63 days as of December 31, 2003. We receive significant tax benefits in the form of reduced tax payments
associated with disqualifying dispositions of employee stock options. If stock
option exercise patterns change, we may receive less cash from stock option
exercises and may not receive the same level of tax benefits in the future,
which could cause our cash payments for income taxes to increase. Inventories were $36.7 million and $28.0 million as of September 30, 2004
and December 31, 2003, respectively. We significantly increased our production
inventory levels to support a broader product offering, including new products,
and also increased our service inventory levels to support a growing installed
customer base. Annualized inventory turnover was approximately 3.9 and 5.0 for
the three months ended September 30, 2004 and December 31, 2003, respectively.
The decrease in inventory turns was due to lower product sales and higher
average inventory levels during the third quarter of 2004. 20




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In early November 2004, we paid $35.0 million to Nortel in conjunction
with the settlement of patent litigation between the parties. Based on past
performance and current expectations, we believe our cash and cash equivalents,
short-term investments, and cash generated from operations will satisfy our
working capital needs, capital expenditures, commitments, and other liquidity
requirements associated with our existing operations through at least the next
twelve months. Disclosures about Contractual Obligations and Commercial Commitments The following table summarizes our contractual obligations as of September
30, 2004 and the effect such obligations are expected to have on our liquidity
and cash flow in future periods (in thousands): Less Than
    
    1-3
    
    MoreTotal
    
    1 Year
    
    Years
    
    Than 3 YearsOperating leases- facilities
    
    $
    12,003
    
    
    $
    4,397
    
    
    $
    6,110
    
    
    $
    1,496Inventory purchase commitments
    
    
    42,858
    
    
    
    42,858
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    54,861
    
    
    $
    47,255
    
    
    $
    6,110
    
    
    $
    1,496
 Operating lease obligations represent the minimum lease rental payments
under non-cancelable leases for our office space in various locations around
the world. Purchase commitments represent agreements to purchase component
inventory from our suppliers and third-party manufacturers that are enforceable
and legally binding against us. Key factors affecting our cash flows include our ability to effectively
manage our working capital, in particular inventory and accounts receivable, as
well as future demand for our products and related pricing. We may incur higher
capital expenditures in the near future if market conditions improve and we
expand our operations. Although we do not have any current plans or commitments
to do so, from time to time, we may also consider the acquisition of products
and businesses complementary to our business. Any acquisition or investment may
reduce our current capital or require additional capital. Off-Balance Sheet Arrangements We do not maintain any off-balance sheet transactions, arrangements, or
obligations that are reasonably likely to have a material effect on our
financial condition, results of operations, liquidity, or capital resources. 21




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RISK FACTORS THAT MAY AFFECT FUTURE RESULTS AND THE MARKET PRICE OF OUR STOCK Weak economic and market conditions or geopolitical turmoil may adversely
affect our revenues, gross margins and expenses. Our quarterly revenues and operating results may continue to fluctuate,
due to the effects of general economic conditions in the United States and
globally, and, in particular, market conditions in the communications and
networking industries. Additionally, current political turmoil in many parts of
the world, including terrorist and military actions, may weaken the global
economy. If economic conditions in the United States and globally do not
improve, or if they worsen, we may experience material negative effects on our
business, operating results and financial condition. There can be no assurance
that we will be able to maintain or improve our financial results or that
economic and market conditions will continue to improve and will not
deteriorate. Because our financial results are difficult to predict, we may not meet
quarterly financial expectations, which could cause our stock price to decline. Our quarterly revenues and operating results are difficult to predict and
may fluctuate significantly from quarter to quarter. Our quarterly revenue and
earnings per share guidance is our best estimate at the time we provide
guidance. Delays in generating or recognizing forecasted revenues could cause
our quarterly operating results to be below our expectations and those of
public market analysts or investors, which could cause the price of our common
stock to fall. We may experience a delay in generating or recognizing revenue for a
number of reasons. Unfulfilled orders at the beginning of each quarter are
typically substantially less than our expected revenue for that quarter.
Therefore, we depend on obtaining orders in a quarter for shipment in that
quarter to achieve our revenue objectives. In addition, our reseller agreements
typically allow the reseller to delay scheduled delivery dates without penalty.
Moreover, demand for our products may fluctuate as a result of seasonality. Orders are generally cancelable at any time prior to shipment. Reasons for
cancellation could include our inability to deliver products within the
customers specified timeframe due to component shortages or high priority
government orders that take precedence to commercial enterprise orders, as well
as other reasons. Our revenues for a particular period may also be difficult to predict and
may be adversely affected if we experience a non-linear (back-end loaded) sales
pattern during the period. We sometimes experience significantly higher levels
of sales towards the end of a period as a result of customers submitting their
orders late in the period or as a result of manufacturing issues or component
shortages which may delay shipments. Such non-linearity in shipments can
increase costs, as irregular shipment patterns result in periods of
underutilized capacity and periods when overtime expenses may be incurred, as
well as leading to additional costs associated with inventory planning and
management. Furthermore, orders received towards the end of the period may not
ship within the period due to our manufacturing lead times. In addition, we may incur increased costs and expenses related to sales
and marketing, including expansion of our direct sales operations and
distribution channels, product marketing, customer support, expansion of our
corporate infrastructure, legal matters, and facilities expansion. We base our
operating expenses on anticipated revenue levels, and a high percentage of our
expenses are fixed in the short-term. As a result, any significant shortfall in
revenue relative to our expectations could cause a significant decline in our
quarterly operating results. Because of the uncertain nature of the economic environment and rapidly
changing market we serve, period-to-period comparisons of operating results may
not be meaningful. In addition, you may not be able to rely on the results for
any period as an indication of future performance. In the future, our revenue
may remain the same, decrease or increase, and we may not be able to sustain or
increase profitability on a quarterly or annual basis. As a consequence,
operating results for a particular quarter are extremely difficult to predict. 22




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Although our customer base has increased, we still depend on large,
recurring purchases from certain customers, and a loss, cancellation or delay
in purchases by these customers could negatively affect our revenue. Sales to our ten largest customers accounted for 40% and 50% of net
product revenue for the nine months ended September 30, 2004 and 2003,
respectively. The loss of continued orders from any of our more significant
customers, such as the U.S. government or individual agencies within the U.S.
government, Mitsui, or Hewlett Packard, could cause our revenue and
profitability to suffer. Our ability to attract new customers will depend on a
variety of factors, including the cost-effectiveness, reliability, scalability,
breadth and depth of our products. Although our financial performance may depend on large, recurring orders
from certain customers and resellers, we do not generally have binding
commitments from them. For example:  
    
    our reseller agreements generally do not require minimum purchases;
    
    our customers can stop purchasing and our resellers can stop
marketing our products at any time; and
    
    our reseller agreements generally are not exclusive and are for
one-year terms, with no obligation of the resellers to renew the
agreements. Because our expenses are based on our revenue forecasts, a substantial
reduction or delay in sales of our products to, or unexpected returns from,
customers and resellers, or the loss of any significant customer or reseller,
could harm our business. Although our largest customers may vary from period to
period, we anticipate that our operating results for any given period will
continue to depend on large orders from a small number of customers. The United States government is a significant customer and has been one
key to our financial success. However, government demand is unpredictable and
there is no guarantee of future contract awards. As part of the changing economic environment, the United States government
has become an important customer for the networking industry, and for us in
particular. The process of becoming a qualified government vendor, especially
for high-security projects, takes considerable time and effort, and the timing
of contract awards and deployment of our products are hard to predict.
Typically, six to twelve months may elapse between the initial evaluation of
our systems by governmental agencies and the execution of a contract. The
revenue stream from these contracts is hard to predict and may be materially
uneven between quarters. Government agency contracts are frequently awarded
only after formal competitive bidding processes, which are often protracted and
may contain provisions that permit cancellation in the event funds are
unavailable to the government agency. Even if we are awarded contracts,
substantial delays or cancellations of purchases could result from protests
initiated by losing bidders. In addition, government agencies are subject to
budgetary processes and expenditure constraints that could lead to delays or
decreased capital expenditures in certain areas. If we fail to win significant
government contract awards, if the government or individual agencies within the
government terminate or reduce the scope and value of our existing contracts,
or if the government fails to reduce the budget deficit, our financial results
may be harmed. Additionally, government orders may be subject to priority
requirements that may affect scheduled shipments to our other customers. Intense competition in the market for network solutions could prevent us
from maintaining or increasing revenue and sustaining profitability. The market for network solutions is intensely competitive. In particular,
Cisco Systems, Inc. maintains a dominant position in this market and several of
its products compete directly with our products. Ciscos substantial resources
and market dominance have enabled it to reduce prices on its products within a
short period of time following the introduction of these products, which
reduces margins and, therefore, the profitability of its competitors.
Purchasers of networking solutions may choose Ciscos products because of its
longer operating history, broader product line and strong reputation in the
networking market. In addition, Cisco may have developed, or could in the
future develop, new technologies that directly compete with our products or
render our 23




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products obsolete. Although we are currently among the top providers of
network infrastructure solutions, we cannot assure you that we will be able to
compete successfully against Cisco, currently the leading provider in the
networking market. We also compete with other companies, such as Extreme Networks, Juniper
Networks, Nortel Networks, Enterasys Networks, 3Com, Huawei, and Alcatel. Some
of our current and potential competitors have greater market leverage, longer
operating histories, greater financial, technical, sales, marketing and other
resources, more name recognition and larger installed customer bases.
Additionally, we may face competition from unknown companies and emerging
technologies that may offer new LAN, MAN and LAN/WAN solutions. Furthermore, a
number of these competitors may merge or form strategic relationships that
would enable them to apply greater resources and sales coverage than we can,
and to offer, or bring to market earlier, products that are superior to ours in
terms of features, quality, pricing or other factors. In order to remain competitive, we must, among other things, invest
significant resources in developing new products with superior performance at
lower prices than our competitors, enhance our current products and maintain
customer satisfaction. In addition, we must make certain our sales and
marketing capabilities allow us to compete effectively against our competitors.
If we fail to do so, our products may not compete favorably with those of our
competitors and our revenues and profitability could suffer. We must continue to introduce new products with superior performance and
features in a timely manner in order to sustain and increase our revenue. The networking industry is characterized by rapid technological change,
frequent new product introductions, changes in customer requirements, and
evolving industry standards. Therefore, in order to remain competitive, we must
introduce new products in a timely manner that offer substantially greater
performance and support a greater number of users per device, all at lower
price points. Even if these objectives are accomplished, new products may not
be successful in the marketplace, or may take more time than anticipated to
start generating meaningful revenue. The process of developing new technology
is complex and uncertain, and if we fail to develop or obtain important
intellectual property and accurately predict customers changing needs and
emerging technological trends, our business could be harmed. We must commit
significant resources to develop new products before knowing whether our
investments will eventually result in products the market will accept. After a
product is developed, we must be able to forecast sales volumes and quickly
manufacture a sufficient volume of products and mix of configurations that meet
customer requirements, all at low costs. The current life cycle of our products is typically 18 to 24 months. The
introduction of new products or product enhancements may shorten the life cycle
of our existing products or replace sales of some of our current products,
thereby offsetting the benefit of even a successful product introduction, and
may cause customers to defer purchasing our existing products in anticipation
of the new products. This could harm our operating results by decreasing sales,
increasing our inventory levels of older products and exposing us to greater
risk of product obsolescence. In addition, we have experienced, and may in the
future experience, delays in developing and releasing new products and product
enhancements and in achieving volume manufacturing for such new products. This
has led to, and may in the future lead to, delayed sales, increased expenses
and lower quarterly revenues than anticipated. During the development of our
products, we have also experienced delays in the prototyping of our ASICs,
which in turn has led to delays in product introductions. If we fail to protect our intellectual property, our business and ability
to compete could suffer. Our success and ability to compete are substantially dependent on our
internally developed technology and know-how. Our proprietary technology
includes our ASICs, our IronCore, JetCore, and Terathon hardware architecture,
our IronWare software, our IronView network management software, and certain
mechanical designs. We rely on a combination of patent, copyright, trademark
and trade secret laws and contractual restrictions on disclosure to protect our
intellectual property rights in these proprietary technologies. Although we
have patent applications pending, there can be no assurance that patents will
be issued from pending applications, or that claims allowed on any future
patents will be sufficiently broad to protect our technology. 24




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We provide software to customers under license agreements included in the
packaged software. These agreements are not negotiated with or signed by the
licensee, and thus may not be enforceable in some jurisdictions. Despite our
efforts to protect our proprietary rights through confidentiality and license
agreements, unauthorized parties may attempt to copy or otherwise obtain and
use our products or technology. These precautions may not prevent
misappropriation or infringement of our intellectual property. Monitoring
unauthorized use of our products is difficult and the steps we have taken may
not prevent misappropriation of our technology, particularly in some foreign
countries in which the laws may not protect our proprietary rights as fully as
in the United States. We may be subject to litigation risks and intellectual property
infringement claims that are costly to defend and could limit our ability to
use certain technologies in the future. The networking industry is increasingly characterized by the existence of
a large number of patent claims and related litigation regarding patent and
other intellectual property rights. In particular, some companies in the
networking industry claim extensive patent portfolios. As a result of the
existence of a large number of patents and rate of issuance of new patents in
the networking industry, it is practically impossible for a company to
determine in advance whether a product or any of its components may infringe
upon intellectual property rights that may be claimed by others. From
time-to-time third parties have asserted exclusive patent, copyright and
trademark rights to technologies and related standards that are important to
us. Such third parties may assert claims or initiate litigation against us or
our manufacturers, suppliers or customers alleging infringement of their
intellectual property rights with respect to our existing or future products.
We are committed to vigorously defending ourselves against such claims.
Regardless of the merits of our position, we may incur substantial expenses in
defending against third party claims. In the event of a determination adverse
to us, we could incur substantial monetary liability, and be required to change
our business practices. Either of these could have a material adverse effect on
our financial position, results of operations, or cash flows. In difficult economic times, some companies have attempted to realize
revenues from their patent portfolios by using licensing programs. Some of
these companies have contacted us regarding a license. We carefully review all
license requests, but are unwilling to license technology not required for our
product portfolio. However, any asserted license demand can require
considerable effort to review and respond. Moreover, a refusal by us to a
license request could result in threats of litigation or actual litigation,
which, if initiated, could harm our business. We are a party to lawsuits in the normal course of our business.
Litigation in general, and intellectual property and securities litigation in
particular, can be expensive, lengthy and disruptive to normal business
operations. Moreover, the results of complex legal proceedings are difficult to
predict. We believe that we have defenses in the lawsuits pending against us as
indicated in Part II, Item 1 Legal Proceedings, and we are vigorously
contesting these allegations. Responding to the allegations has been, and
probably will continue to be, expensive and time-consuming for us. An
unfavorable resolution of the lawsuits could adversely affect our business,
results of operations, or financial condition. Our ability to increase our revenues depends on expanding our direct sales
operations and reseller distribution channels and continuing to provide
excellent customer support. If we are unable to effectively develop and retain our sales and support
staff, or establish and cultivate relationships with our indirect distribution
channels, our ability to grow and increase revenue could be harmed.
Additionally, if our resellers are not successful in their sales efforts, sales
of our products may decrease and our operating results could suffer. Some of
our resellers also sell products that compete with our products. As a result,
we cannot assure you that our resellers will market our products effectively or
continue to devote the resources necessary to provide us with adequate sales,
marketing and technical support. In an effort to gain market share and support our customers, we may need
to expand our direct sales operations and customer service staff to support new
and existing customers. The timing and extent of any such expansion are
uncertain in light of the current economic environment. Expansion of our direct
sales operations and reseller 25




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distribution channels may not be successfully implemented and the cost of
any expansion may exceed the revenues generated. Our gross margins may decline over time and the average selling prices of
our products may decrease as a result of competitive pressures and other
factors. Our industry has experienced erosion of average product selling prices due
to a number of factors, particularly competitive and macroeconomic pressures
and rapid technological change. The average selling prices of our products have
decreased in the past and may continue to decrease in response to competitive
pressures, increased sales discounts, new product introductions by our
competitors or other factors. Both we and our competitors occasionally lower
sales prices in order to gain market share or create more demand. Furthermore,
as a result of the recent disruption in the technology sector, coupled with
more broad macro-economic factors, both we and our competitors may pursue more
aggressive pricing strategies in an effort to maintain sales levels. Such
intense pricing competition could cause our gross margins to decline and may
adversely affect our business, operating results or financial condition. Our gross margins may be adversely affected if we are unable to reduce
manufacturing costs and effectively manage our inventory levels. Although
management continues to closely monitor inventory levels, declines in demand
for our products could result in additional provisions for excess inventory.
Additionally, our gross margins may be negatively affected by fluctuations in
manufacturing volumes, component costs, the mix of product configurations sold
and the mix of distribution channels through which our products are sold. For
example, we generally realize higher gross margins on direct sales to an end
user than on sales through resellers or to our OEMs. As a result, any
significant shift in revenues through resellers or to our OEMs could harm our
gross margins. If product or related warranty costs associated with our
products are greater than we have experienced, our gross margins may also be
adversely affected. We need additional qualified personnel to maintain and expand our
business. If we are unable to promptly attract and retain qualified personnel,
our business may be harmed. We believe our future success will depend in large part on our ability to
identify, attract and retain highly-skilled managerial, engineering, sales and
marketing, finance and manufacturing personnel. Competition for these personnel
can be intense, especially in the San Francisco Bay Area, and we may experience
some difficulty hiring employees in the timeframe we desire, particularly
engineering and sales personnel. Volatility or lack of positive performance in
our stock price may also adversely affect our ability to retain key employees,
all of whom have been granted stock options. In order to improve productivity,
we have historically used stock options to motivate and retain our employees.
Some of the proposals currently under consideration by the accounting standard
setting body regarding the accounting treatment of stock options could limit
our ability to continue to use stock options as an incentive and retention
tool. We may not succeed in identifying, attracting and retaining personnel.
The loss of the services of any of our key personnel, the inability to
identify, attract or retain qualified personnel in the future, or delays in
hiring required personnel, particularly engineers and sales personnel, could
make it difficult for us to manage our business and meet key objectives, such
as timely product introductions. Our success also depends to a significant degree on the continued
contributions of our key management, engineering, sales and marketing, finance
and manufacturing personnel, many of whom would be difficult to replace. In
particular, we believe that our future success depends on Bobby R. Johnson,
Jr., President, Chief Executive Officer and Chairman of the Board. We do not
have employment contracts or key person life insurance for any of our
personnel. Our operations in international markets involves inherent risks that we
may not be able to control. As a result, our business may be harmed if we are
unable to successfully address these risks. Our success will depend, in part, on increasing international sales and
expanding our international operations. Our international sales primarily
depend on our resellers, including Pervasive Networks and Spot Distribution
Ltd. in Europe, Mitsui in Japan, Shanghai Gentek and GTI in China, and Samsung
in Korea. The failure of our 26




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international resellers to sell our products would limit our ability to
sustain and grow our revenue. In particular, our revenue from Japan depends
primarily on Mitsuis ability to sell our products and on the strength of the
Japanese economy, which has been weak in recent years. There are a number of
risks arising from our international business, including:  
    
    potential recessions in economies outside the United States;
    
    longer accounts receivable collection cycles;
    
    seasonal reductions in business activity;
    
    higher costs of doing business in foreign countries;
    
    difficulties in managing operations across disparate geographic areas;
    
    difficulties associated with enforcing agreements through foreign legal
systems;
    
    political instability and export restrictions;
    
    potential adverse tax consequences;
    
    unexpected changes in regulatory requirements;
    
    military conflict and terrorist activities; and
    
    natural disasters and widespread medical epidemics, such as SARS. The factors described above could also disrupt our product and component
manufacturers and key suppliers located outside of the United States. One or
more of such factors may have a material adverse effect on our future
international operations and, consequently, on our business, operating results
and financial condition. Generally, our international sales are denominated in U.S. dollars. As a
result, an increase in the value of the U.S. dollar relative to foreign
currencies could make our products less competitive on a price basis in
international markets. In the future, we may elect to invoice some of our
international customers in local currency, which could subject us to
fluctuations in exchange rates between the U.S. dollar and the local currency. We purchase several key components for our products from sole sources; if
these components are not available, our revenues may be harmed. We purchase several key components used in our products from sole sources,
and depend on supply from these sources to meet our needs. The inability of any
supplier to provide us with an adequate supply of key components, or the loss
of any of our suppliers, may cause a delay in our ability to fulfill orders and
may have a material adverse effect on our business and financial condition.
Lead-times for various components have lengthened recently as a result of
limits on IT spending and the economic uncertainty, which has made certain
components scarce. As component demand increases and lead-times become longer,
our suppliers may increase component costs. If component costs increase, our
gross margins may also decline. Our principal limited or sole-sourced components include high-speed
dynamic and static random access memories, commonly known as DRAMs and SRAMs,
ASICs, printed circuit boards, optical components, microprocessors and power
supplies. We acquire these components through purchase orders and have no
long-term commitments regarding supply or price from these suppliers. From
time-to-time, we have experienced shortages in allocations of components,
resulting in delays in filling orders. We may encounter shortages and delays in
obtaining components in the future which could impede our ability to meet
customer orders. 27




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We depend on anticipated product orders to determine our material
requirements. Lead-times for limited-sourced materials and components can be as
long as six months, vary significantly and depend on factors such as the
specific supplier, contract terms and demand for a component at a given time.
Inventory management remains an area of focus as we balance the need to
maintain strategic inventory levels to ensure competitive lead-times with the
risk of inventory obsolescence due to rapidly changing technology and customer
requirements. If orders do not match forecasts, or if we do not manage
inventory effectively, we may have either excess or insufficient inventory of
materials and components, which could negatively affect our operating results
and financial condition. Our reliance on third-party manufacturing vendors to manufacture our
products may cause a delay in our ability to fill orders. We subcontract substantially all of our manufacturing to companies that
assemble and test our products. In addition, some Foundry-branded products are
manufactured by third party OEMs. Our agreements with some of these companies
allow them to procure long lead-time component inventory on our behalf based on
a rolling production forecast provided by us. We may be contractually obligated
to purchase long lead-time component inventory procured by certain suppliers
and third-party manufacturers in accordance with our forecast, unless we give
notice of order cancellation at least 90 days prior to the delivery date. If
actual demand for our products is below our projections, we may have excess
inventory as a result of our purchase commitments. We do not have long-term
contracts with these suppliers and third-party manufacturers. We have experienced delays in product shipments from our contract
manufacturers, which in turn delayed product shipments to our customers. We may
in the future experience similar delays or other problems, such as inferior
quality and insufficient quantity of product, any of which could harm our
business and operating results. We intend to regularly introduce new products
and product enhancements, which will require us to rapidly achieve volume
production by coordinating our efforts with our suppliers and contract
manufacturers. We attempt to increase our material purchases, contract
manufacturing capacity and internal test and quality functions to meet
anticipated demand. The inability of our contract manufacturers or OEMs to
provide us with adequate supplies of high-quality products, the loss of any of
our third-party manufacturers, or the inability to obtain raw materials, could
cause a delay in our ability to fulfill orders. Additionally, from time to
time, we transition, via our contract manufacturers, to different manufacturing
locations, including lower-cost foreign countries. Such transitions are
inherently risky and could cause a delay in our ability to fulfill orders or a
deterioration in product quality. Due to the lengthy sales cycles of some of our products, the timing of our
revenue is difficult to predict and may cause us to fail to meet our revenue
expectations. Some of our products have a relatively high sales price, and often
represent a significant and strategic decision by a customer. The decision by
customers to purchase our products is often based on their internal budgets and
procedures involving rigorous evaluation, testing, implementation and
acceptance of new technologies. As a result, our sales cycle in these
situations can be as long as 12 months and may vary substantially from customer
to customer. While our customers are evaluating our products and before they
may place an order with us, we may incur substantial sales and marketing
expenses and expend significant management effort. Consequently, if sales
forecasted from a specific customer for a particular quarter are not realized
in that quarter, we may not meet our revenue expectations. If we do not adequately manage and evolve our financial reporting and
managerial systems and processes, our ability to manage and grow our business
may be harmed. Our ability to successfully implement our business plan and comply with
regulations requires an effective planning and management process. We expect
that we will need to continue to improve existing, and implement new,
operational and financial systems, procedures and controls to manage our
business effectively in the future. Any delay in the implementation of, or
disruption in the transition to, new or enhanced systems, procedures or
controls, could harm our ability to accurately forecast sales demand, manage
our supply chain and record and report financial and management information on
a timely and accurate basis. 28




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In addition, rules adopted by the Securities and Exchange Commission
pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 require annual review
and evaluation of our internal control systems, and attestation of these
systems by our independent auditors. We are currently undergoing a review of
our internal control systems and procedures and considering improvements that
will be necessary in order for us to comply with the requirements of Section
404 by the end of 2004. Although we believe that our efforts will enable us to
provide the required management report and enable our independent auditors to
provide their attestation report concerning our assessment and the
effectiveness of our internal controls over financial reporting as of our
fiscal year end, we can give no assurance that such efforts will be completed
in a timely manner and on a successful basis, which could adversely affect the
market price of our common stock. If we are required to record compensation expense in connection with stock
option grants, our profitability may be reduced significantly. The Financial Accounting Standards Board (FASB) has recently proposed an
accounting standard that will require the fair value of all equity-based awards
granted to employees be recognized in the statement of operations as
compensation expense, beginning in the third quarter of 2005. The various
methods for determining the fair value of stock options are based on, among
other things, the volatility of the underlying stock. As noted above, our stock
price has historically been volatile. Therefore, the adoption of an accounting
standard requiring companies to expense stock options could negatively affect
our profitability and may adversely affect our stock price. Such adoption could
also limit our ability to continue to use stock options as an incentive and
retention tool, which could, in turn, hurt our ability to recruit employees and
retain existing employees. FASB is expected to issue final rules on stock
option expensing in late 2004. We will continue to monitor FASBs progress on
the issuance of this standard. The timing of the adoption of industry standards may negatively affect
widespread market acceptance of our products. Our success depends in part on both the adoption of industry standards for
new technologies in our market and our products compliance with industry
standards. Many technological developments occur prior to the adoption of the
related industry standard. The absence or delay of an industry standard related
to a specific technology may prevent market acceptance of products using the
technology. We intend to develop products using new technological advancements,
such as MPLS Draft-Martini, and may develop these products prior to the
adoption of industry standards related to these technologies. As a result, we
may incur significant expenses and losses due to lack of customer demand,
unusable purchased components for these products and the diversion of our
engineers from future product development efforts. Further, if the adoption of
industry standards moves too quickly, we may develop products that do not
comply with a later-adopted industry standard, which could hurt our ability to
sell these products. If the industry evolves to new standards, we may not be
able to successfully design and manufacture new products in a timely fashion
that meet these new standards. Even after industry standards are adopted, the
future success of our products depends on widespread market acceptance of their
underlying technologies. At least one networking equipment standards body has
reportedly stopped all work on a standard in response to assertions by Nortel
that it controls the patent rights to certain industry standards. Attempts by
third parties to impose licensing fees on industry standards could undermine
the adoption of such standards and lessen industry opportunities. If our products contain undetected software or hardware errors, we could
incur significant unexpected expenses and lost sales and be subject to product
liability claims. Our products are complex and may contain undetected defects or errors,
particularly when first introduced or as new enhancements and versions are
released. Despite our testing procedures, these defects and errors may be found
after commencement of commercial shipments. Any defects or errors in our
products discovered in the future or failures of our customers networks,
whether caused by our products or another vendors products, could result in:  
    
    negative customer reactions;
    
    product liability claims; 29




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
    
    negative publicity regarding us and our products;
    
    delays in or loss of market acceptance of our products;
    
    product returns;
    
    lost sales; and
    
    unexpected expenses to remedy defects or errors. Our products may not meet the standards required for their sale, which may
harm our business. In the United States, our products must comply with various regulations
and standards defined by the Federal Communications Commission and Underwriters
Laboratories. Internationally, products that we develop may be required to
comply with standards established by telecommunications authorities in various
countries, as well as those of certain international bodies. Although we
believe our products are currently in compliance with domestic and
international standards and regulations in countries in which we currently
sell, there can be no assurance that our existing and future product offerings
will continue to comply with evolving standards and regulations. If we fail to
obtain timely domestic or foreign regulatory approvals or certification, we may
not be able to sell our products where these standards or regulations apply,
which may prevent us from sustaining our revenues or maintaining profitability. We may engage in acquisitions that could result in the dilution of our
stockholders, cause us to incur substantial expenses and harm our business if
we cannot successfully integrate the acquired business, products, technologies
or personnel. Although we focus on internal product development and growth, we may learn
of acquisition prospects that would complement our existing business or enhance
our technological capabilities. Any acquisition by us could result in large and
immediate write-offs, the incurrence of debt and contingent liabilities, or
amortization expenses related to amortizable intangible assets, any of which
could negatively affect our results of operations. Furthermore, acquisitions
involve numerous risks and uncertainties, including:  
    
    difficulties in the assimilation of products, operations, personnel and
technologies of the acquired companies;
    
    diversion of managements attention from other business concerns;
    
    risks of entering geographic and business markets in which we have no or
limited prior experience; and
    
    potential loss of key employees of acquired organizations. Although we do not currently have any agreements or plans with respect to
any material acquisitions, we may make acquisitions of complementary
businesses, products or technologies in the future. We may not be able to
successfully integrate any businesses, products, technologies or personnel that
might be acquired, and our failure to do so could harm our business. Our stock price has been volatile historically, which may make it more
difficult to sell shares when needed at attractive prices. The trading price of our common stock has been, and may continue to be,
subject to wide fluctuations. Our stock price may fluctuate in response to a
number of events and factors, such as quarterly variations in operating
results, announcements of technological innovations or new products by us or
our competitors, changes in financial estimates and recommendations by
securities analysts, the operating and stock price performance of other
companies that investors may deem comparable, and news reports relating to
trends in our markets. In addition, the stock 30




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market in general, and technology companies in particular, have
experienced extreme volatility that often has been unrelated to the operating
performance of such companies. These broad market and industry fluctuations may
adversely affect the price of our stock, regardless of our operating
performance. Additionally, volatility or lack of positive performance in our
stock price may adversely affect our ability to retain key employees, all of
whom have been granted stock options. Anti-takeover provisions could make it more difficult for a third party to
acquire us. Our board of directors has the authority to issue up to 5,000,000 shares
of preferred stock and to determine the price, rights, preferences, privileges
and restrictions, including voting rights, of those shares without any further
vote or action by the stockholders. The rights of the holders of common stock
may be subject to, and may be adversely affected by, the rights of the holders
of any preferred stock that may be issued in the future. The issuance of
preferred stock may have the effect of delaying, deferring or preventing a
change of control of Foundry without further action by the stockholders and may
adversely affect the voting and other rights of the holders of common stock. We
have no present plans to issue shares of preferred stock. Further, certain
provisions of our charter documents, including provisions eliminating the
ability of stockholders to take action by written consent and limiting the
ability of stockholders to raise matters at a meeting of stockholders without
giving advance notice, may have the effect of delaying or preventing changes in
control or management of Foundry, which could have an adverse effect on the
market price of our stock. In addition, our charter documents do not permit
cumulative voting, which may make it more difficult for a third party to gain
control of our board of directors. Our operations could be significantly hindered by the occurrence of a
natural disaster, terrorist acts or other catastrophic event. Our operations are susceptible to outages due to fire, floods, power loss,
power shortages, telecommunications failures, break-ins and similar events. In
addition, certain of our local and foreign offices, OEMs, and contract
manufacturers are located in areas susceptible to earthquakes and acts of
terrorism, which could cause a material disruption in our operations. For
example, we procure critical components from Japan, which periodically
experiences earthquakes and typhoons. The prospect of such unscheduled
interruptions may continue for the foreseeable future and we are unable to
predict either their occurrence, duration or cessation. We do not have multiple
site capacity for all of our services in the event of any such occurrence.
Despite our implementation of network security measures, our servers are
vulnerable to computer viruses, break-ins, and similar disruptions from
unauthorized tampering with our computer systems. We may not carry sufficient
insurance to compensate us for losses that may occur as a result of any of
these events. Any such event could have a material adverse effect on our
business, operating results, and financial condition. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk. Management believes there have been no material changes to our
quantitative and qualitative disclosures about market risk during the
nine-month period ended September 30, 2004, compared to those discussed in our
Annual Report on Form 10-K for the year ended December 31, 2003. 
 Item 4. Controls and Procedures We evaluated the design and operation of our disclosure controls and
procedures to determine whether they are effective in ensuring that the
disclosure of required information is made in accordance with the Securities
Exchange Act of 1934, as amended (the Exchange Act), and the rules and forms
of the Securities and Exchange Commission. This evaluation was made under the
supervision, and with the participation of, management, including our principal
executive officer and principal financial officer, as of the end of the period
covered by this Quarterly Report on Form 10-Q. There are inherent limitations
to the effectiveness of any system of disclosure controls and procedures,
including the possibility of human error and the circumvention or overriding of
the controls and procedures. Accordingly, even effective disclosure controls
and procedures can only provide reasonable assurance of achieving their control
objectives. Subject to these limitations, our Chief Executive Officer and Chief
Financial Officer have concluded that, as of the evaluation date, the
disclosure controls and procedures were effective to 31




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provide reasonable assurance that information required to be disclosed in
the reports we file and submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms. As required by Section 404 of the Sarbanes Oxley Act of 2002, management
is continuing to test and evaluate its internal control structure to determine
whether our controls are designed and operating effectively. As a result of our
testing and evaluation performed to date, we have noted that improvements could
be made in the design or operation of our internal control structure,
particularly with respect to general computer controls, segregation of duties,
and inventory monitoring. We believe adequate compensating controls exist in
these areas; however, we are developing plans to implement improvements. We
have disclosed these matters to the audit committee of our board of directors
and to our independent auditors. There were no changes to our
internal controls during our most recent quarter that have materially affected,
or are reasonably likely to materially affect, our internal controls over
financial reporting. 32




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings. In December 2000, several similar stockholder class action lawsuits were
filed against us and certain of our officers in the United States District
Court for the Northern District of California, following our announcement of
our anticipated financial results for the fourth quarter ended December 31,
2000. The lawsuits were subsequently consolidated as a class action by the
District Court, under the caption In re Foundry Networks, Inc. Securities
Litigation,Master File No. C-00-4823-MMC, and lead plaintiffs were selected
and filed a consolidated amended complaint which alleged violations of federal
securities laws and purported to seek damages on behalf of a class of
stockholders who purchased our common stock during the period from September 7,
2000 to December 19, 2000. We then brought four successful motions to dismiss
the complaint. Although the District Court granted each of the four dismissal
motions, it also provided plaintiffs leave to amend the complaint. On August
29, 2003, following the dismissal of the four amended complaints, the District
Court granted our motion to dismiss the case with prejudice and without leave
to amend and, on September 2, 2003, entered judgment in our favor, dismissing
the plaintiffs fifth amended complaint. On September 29, 2003, plaintiffs
filed a Notice of Appeal with the United States Court of Appeals for the Ninth
Circuit (Court of Appeals). On January 15, 2004, the plaintiff/appellants
filed their opening brief with the Court of Appeals. On April 2, 2004, we filed
our responsive brief. On May 14, 2004, the plaintiff appellants filed a reply
brief. The briefing is now complete and the parties are awaiting a schedule for
oral argument from the Court of Appeals. We believe the District Courts
judgment validates our conviction that the lawsuit is without merit and we will
defend the District Courts judgment vigorously. A class action lawsuit was filed on November 27, 2001 in the United States
District Court for the Southern District of New York on behalf of purchasers of
our common stock alleging violations of federal securities laws. The case was
designated as In re Foundry Networks, Inc. Initial Public Offering Securities
Litigation,No. 01-CV-10640 (SAS) (S.D.N.Y.), related to In re Initial Public
Offering Securities Litigation,No. 21 MC 92 (SAS) (S.D.N.Y.). The case is
brought purportedly on behalf of all persons who purchased our common stock
from September 27, 1999 through December 6, 2000. The operative amended
complaint names as defendants us and three of our officers (the Foundry
Defendants), including our Chief Executive Officer and Chief Financial
Officer; and investment banking firms that served as underwriters for our
initial public offering in September 1999. The amended complaint alleged
violations of Sections 11 and 15 of the Securities Act of 1933, and Section
10(b) of the Securities Exchange Act of 1934, on the grounds that the
registration statement for the initial public offering ( IPO) failed to
disclose that (i) the underwriters agreed to allow certain customers to
purchase shares in the IPO in exchange for excess commissions to be paid to the
underwriters, and (ii) the underwriters arranged for certain customers to
purchase additional shares in the aftermarket at predetermined prices. The
amended complaint also appears to allege that false or misleading analyst
reports were issued. Similar allegations were made in lawsuits challenging over
300 other initial public offerings conducted in 1999 and 2000. The cases were
consolidated for pretrial purposes. On February 19, 2003, the Court ruled on
all defendants motions to dismiss. In ruling on motions to dismiss, the Court
must treat the allegations in the complaint as if they were true solely for
purposes of deciding the motions. The motion was denied as to claims under the
Securities Act of 1933 in the case involving us. The same ruling was made in
all but 10 of the other cases. The Court dismissed the claims under Section
10(b) of the Securities Exchange Act of 1934 against us and one of the
individual defendants and dismissed all of the Section 20(a) control person
claims. The Court denied the motion to dismiss the Section 10(b) claims against
our remaining individual defendants on the basis that those defendants
allegedly sold our stock following the IPO, allegations found sufficient purely
for pleading purposes to allow those claims to move forward. A similar ruling
was made with respect to 62 of the individual defendants in the other cases. We
have accepted a settlement proposal presented to all issuer defendants. Under
the terms of this settlement, plaintiffs will dismiss and release all claims
against the Foundry Defendants in exchange for a contingent payment by the
insurance companies collectively responsible for insuring the issuers in all of
the IPO cases and for the assignment or surrender of control of certain claims
we may have against the underwriters. The settlement will require approval of
the Court, which cannot be assured, after class members are given the
opportunity to object to the settlement or opt out of the settlement. 33




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Since March 2001, we have reported on patent litigation between us and
Nortel. Nortel filed the initial complaint in United States District Court for
the District of Massachusetts. In October 2002, we filed our own patent
complaint against Nortel in the United States District Court, Northern District
of California. Subsequently, Nortel filed an Answer and Counter Claim
asserting additional patents. On October 25, 2004, we entered into a settlement
agreement and cross patent license (the agreements) covering technologies
that were at issue in the case with Nortel. The agreements resolved both the
litigation in Massachusetts and in California. Under the terms of the
agreements, we paid Nortel $35.0 million in early November 2004. In May 2003, Lucent Technologies Inc. (Lucent) filed a lawsuit against
us in the United States District Court for the District of Delaware alleging
that certain of our products infringe several of Lucents patents, and seeking
injunctive relief, as well as unspecified damages. Lucent also brought suit on
the same patents (and one additional patent) against one of our competitors. On
August 12, 2003, we filed a motion to sever the cases, and on February 6, 2004,
the District Court granted the motion. Fact Discovery is now closed. Initial expert reports have been
exchanged and rebuttal reports are due November 22, 2004. A Markman Hearing (claims construction) is scheduled for
January 14, 2005. The parties have
been instructed by the court to be prepared for trial in the spring of 2005. We
have analyzed the validity of Lucents claims and believe that Lucents suit is
without merit. We are committed to vigorously defending ourselves against
Lucents claims. On February 13, 2004, we filed a lawsuit against Lucent in the United
States District Court, Eastern District of Texas, Marshall Division. The
lawsuit alleges that certain of Lucents products infringe one of our patents.
We are seeking injunctive relief and damages. On March 22, 2004, Lucent filed
an Answer and Counter Claim seeking a declaration of invalidity as to our
asserted patent. On April 9, 2004, Lucent filed an Amended Answer and Counter
Claim asserting infringement of U.S. patent #5649131. We analyzed the validity
of Lucents counter claim and believe it is without merit. Discovery has begun and is
scheduled to close on June 17, 2005. A Markman Hearing (claims construction) is scheduled
for March 24, 2005. Trial is scheduled to begin August 1, 2005. From time to time, we are subject to other legal proceedings and claims in
the ordinary course of business, including claims of alleged infringement of
trademarks, copyrights, patents and other intellectual property rights. In
addition, from time to time, third parties assert patent infringement claims
against us in the form of letters, lawsuits and other forms of communication.
Regardless of the merits of our position, litigation is always an expensive and
uncertain proposition. In accordance with SFAS No. 5, Accounting for
Contingencies (SFAS 5), we record a liability when it is both probable that
a liability has been incurred and the amount of the loss can be reasonably
estimated. We review the need for any such provision on a quarterly basis and
record any necessary adjustments to reflect the effect of ongoing negotiations,
settlements, rulings, advice of legal counsel, and other information and events
pertaining to a particular case in the period they become known. To date, we
have not recorded any such provisions in accordance with SFAS 5. We believe we
have valid defenses with respect to the legal matters pending against us. In
the event of a determination adverse to us, we could incur substantial monetary
liability, and be required to change our business practices. Any unfavorable
determination could have a material adverse effect on our financial position,
results of operations, or cash flows. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None. 
 Item 3. Defaults Upon Senior Securities. None 
 Item 4. Submission of Matters to a Vote of Security Holders. None. 
 Item 5. Other Information. Foundrys independent auditor, Ernst & Young LLP (E&Y), has recently
advised the Audit Committee of Foundrys Board of Directors that certain cash
handling services performed for a Foundry subsidiary by an E&Y member firm in
China, and certain secretarial and directorship services performed by an E&Y
associated entity in Singapore, have 34




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raised questions regarding E&Ys independence with respect to its
performance of audit services for Foundry. The non-audit services described
above are not permitted under the auditor independence rules. E&Y has informed
the Company and its Audit Committee that it has concluded that the services
performed have not impaired its independence with respect to performance of its
audit services. The Company and its Audit Committee have considered the impact
these services may have had on E&Ys independence with respect to the Company
and concluded there has been no impairment of E&Ys independence. The fees
over the period the services were provided, which was July 2002 through
September 2003, totaled approximately $5,900. The services have been
discontinued. 
 Item 6. Exhibits. Number
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation of Foundry
Networks, Inc. (Amended and Restated Certificate of Incorporation
filed as Exhibit 3.2 to Registrants Registration Statement on Form
S-1 (Commission File No. 333-82577) and incorporated herein by
reference; Certificate of Amendment to the foregoing filed as
Exhibit 3.1 to Registrants Quarterly Report on Form 10-Q for the
quarter ended June 30, 2000 and incorporated herein by reference.)3.2
    
    Amended and Restated Bylaws of Foundry Networks, Inc. (Filed as
Exhibit 3.2 to Registrants Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000 and incorporated herein by
reference.)10.1
    
    1996 Stock Plan. (1)10.2
    
    1999 Employee Stock Purchase Plan. (2)10.3
    
    1999 Directors Stock Option Plan. (3)10.5
    
    OEM Purchase Agreement dated January 6, 1999 between Foundry
Networks, Inc. and Hewlett-Packard Company, Workgroup Networks
Division. (4)10.6
    
    Reseller Agreement dated July 1, 1997 between Foundry Networks,
Inc. and Mitsui & Co., Ltd. (4)10.7
    
    2000 Non-Executive Stock Option Plan. (5)10.11
    
    Lease agreement dated September 28, 1999, between Foundry Networks,
Inc., and Legacy Partners Commercial Inc., for offices located at
2100 Gold Street, San Jose, CA 95002. (6)31.1
    
    Rule 13a-14(a) Certification (CEO)31.2
    
    Rule 13a-14(a) Certification (CFO)32.1
    
    Section 1350 Certification (CEO)32.2
    
    Section 1350 Certification (CFO)
   (1)
    
    Copy of original 1996 Stock Plan incorporated herein by reference to the
exhibit filed with the Companys Registration Statement on Form S-1
(Commission File No. 333-82577). Copy of 1996 Stock Plan reflecting the
amendments approved at the 2000 Annual Meeting of Stockholders
incorporated by reference to the Companys Definitive Proxy Statement for
such meeting (Commission File No. 000-26689). Copy of 1996 Stock Plan
reflecting the amendments for approval at the 2002 Annual Meeting of
Stockholders incorporated by reference to the Companys Definitive Proxy
Statement for such meeting (Commission File No. 000-26689).(2)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577).(3)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577). Copy
of Directors Plan reflecting the amendment for approval at the 2002
Annual Meeting of Stockholders incorporated by reference to the Companys
Definitive Proxy Statement for such meeting (Commission File No.
000-26689). 35




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(4)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577);
Confidential treatment has been granted by the Securities and Exchange
Commission with respect to this exhibit.(5)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-8 filed on October 25, 2000 (Commission
File No. 333-48560).(6)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Form 10-Q for the quarter ended September 30, 1999 (Commission File No.
000-26689). 36




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Foundry Networks, Inc.(Registrant)By:
    
    /s/ TIMOTHY D. HEFFNERTimothy D. HeffnerVice President, Finance andAdministration, Chief Financial Officer(Principal Financial and Accounting Officer)
 Date: November 9, 2004 37




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EXHIBIT INDEX Number
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation of Foundry
Networks, Inc. (Amended and Restated Certificate of Incorporation
filed as Exhibit 3.2 to Registrants Registration Statement on Form
S-1 (Commission File No. 333-82577) and incorporated herein by
reference; Certificate of Amendment to the foregoing filed as
Exhibit 3.1 to Registrants Quarterly Report on Form 10-Q for the
quarter ended June 30, 2000 and incorporated herein by reference.)3.2
    
    Amended and Restated Bylaws of Foundry Networks, Inc. (Filed as
Exhibit 3.2 to Registrants Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000 and incorporated herein by
reference.)10.1
    
    1996 Stock Plan. (1)10.2
    
    1999 Employee Stock Purchase Plan. (2)10.3
    
    1999 Directors Stock Option Plan. (3)10.5
    
    OEM Purchase Agreement dated January 6, 1999 between Foundry
Networks, Inc. and Hewlett-Packard Company, Workgroup Networks
Division. (4)10.6
    
    Reseller Agreement dated July 1, 1997 between Foundry Networks,
Inc. and Mitsui & Co., Ltd. (4)10.7
    
    2000 Non-Executive Stock Option Plan. (5)10.11
    
    Lease agreement dated September 28, 1999, between Foundry Networks,
Inc., and Legacy Partners Commercial Inc., for offices located at
2100 Gold Street, San Jose, CA 95002. (6)31.1
    
    Rule 13a-14(a) Certification (CEO)31.2
    
    Rule 13a-14(a) Certification (CFO)32.1
    
    Section 1350 Certification (CEO)32.2
    
    Section 1350 Certification (CFO)
   (1)
    
    Copy of original 1996 Stock Plan incorporated herein by reference to the
exhibit filed with the Companys Registration Statement on Form S-1
(Commission File No. 333-82577). Copy of 1996 Stock Plan reflecting the
amendments approved at the 2000 Annual Meeting of Stockholders
incorporated by reference to the Companys Definitive Proxy Statement for
such meeting (Commission File No. 000-26689). Copy of 1996 Stock Plan
reflecting the amendments for approval at the 2002 Annual Meeting of
Stockholders incorporated by reference to the Companys Definitive Proxy
Statement for such meeting (Commission File No. 000-26689).(2)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577).(3)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577). Copy
of Directors Plan reflecting the amendment for approval at the 2002
Annual Meeting of Stockholders incorporated by reference to the Companys
Definitive Proxy Statement for such meeting (Commission File No.
000-26689).(4)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-1 (Commission File No. 333-82577);
Confidential treatment has been granted by the Securities and Exchange
Commission with respect to this exhibit.(5)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Registration Statement on Form S-8 filed on October 25, 2000 (Commission
File No. 333-48560).




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(6)
    
    Incorporated herein by reference to the exhibit filed with the Companys
Form 10-Q for the quarter ended September 30, 1999 (Commission File No.
000-26689).